Private Investors to the Rescue for Ailing Infrastructure? Not So Fast
Art by Johanna Goodman
Infrastructure is undeniably the backbone of any economy. But these days it requires a lot of orthopedic surgery. Any trip across America’s moonscape-like highways, with their spectacular potholes, testifies to that.
So this is going to be remedied, right? Fixing infrastructure is the one issue Republicans and Democrats can agree on. GOP President Donald Trump has called for a $2 trillion building campaign, with the enthusiastic assent of House Speaker Nancy Pelosi, a Democrat. But the job is so daunting that government—whether federal, state or local—lacks the wherewithal to pay for everything.
As a result, private investors are moving in to make up the difference. Is this the panacea?
Perhaps not. There are three problems.
First, the American Society of Civil Engineers estimates that the nation needs to spend a stunning $4.6 trillion by 2026 to improve its roads and other physical assets.
Right now, all levels of government, plus the private sector, spend about $1 trillion annually. Where Trump’s $2 trillion will come from is unclear. It remains to be seen if the private sector will be able to summon enough funding to meet the vast need.
The second problem is that government public works projects can run into political snags, which is an unsettling prospect for private financiers. Officials in New York and New Jersey would like to enlist private financing for a much-needed new tunnel under the Hudson River. But when Chris Christie was New Jersey’s governor and a 2016 GOP presidential aspirant, he suddenly scotched the project, which pleased Republican budget hawks. More recently, the Trump Administration has gone back and forth about giving any federal money to the undertaking.
A third problem: The part of US infrastructure with the biggest need is the toughest sell to private investors, which raises the question of whether enough will be attracted to get the job done. The need is focused on transportation-related assets: roads, bridges, tunnels, and to a lesser extent, seaports and airports. When you hear the phrase “America’s crumbling infrastructure,” these vital but strained arteries are what’s meant.
The newer forms of infrastructure—such as oil and gas pipelines, renewable energy facilities, and data networks—aren’t lacking for investors. These investments bring decent, and sometimes, lush profit potential. America’s fiber-optic networks, for instance, were privately funded.
What proponents are counting on is that traditional infrastructure, as in roads and bridges, can have an allure for private investors, if set up properly. Revenue comes from road and bridge tolls, harbor fees, airport landing rights, and the like. While subject to fluctuation amid economic cycles, this is mostly an annuity-like income stream.
“Investors are becoming aware of the key attributes of infrastructure: predictable cash flows of assets, indexation to inflation, and reduced correlation to the broader markets,” said Andrew Hsu, portfolio manager for global infrastructure investments at DoubleLine Capital.
Large-scale private funding for traditional infrastructure is relatively new, at least in the US. For the longest time, traditional infrastructure has been the province of government spending, whether through federal grants or state/local efforts, often funded via municipal bonds, which have the advantage of being federal-tax-exempt.
Budgetary constraints, however, make finding the money from taxpayers difficult. Governments, said Darren Spencer, chief portfolio manager, alternative investments, at Russell Investments, “can’t do it themselves.”
These days, a lot of states are strapped. Illinois, for example, has deep fiscal woes, partly from an underfunded public pension program. In Washington, the seeming entente between the Trump administration and congressional Democrats on infrastructure may be headed for trouble amid different philosophies over how these projects are to be financed.
It’s not that government is skimping on infrastructure, in nominal terms at least: In inflation-adjusted dollars, federal, state, and local spending on it doubled from the 1950s, by the American Action Forum’s count. The difference is that today’s America is larger in terms of the economy, population, and physical plant. And those worn-out existing physical assets must be upgraded at the same time as new projects are added to service growing needs.
Federal outlays for transportation peaked at almost 6% of gross domestic product in 1965, amid the nationwide building boom for freeways, and lately is half that, the Eno Center for Transportation reports. Put another way, while government infrastructure spending has increased, it hasn’t kept up with the economy’s growth. And an expanding economy puts greater stress on infrastructure.
And how. The American Society of Civil Engineers’ most recent (2017) quadrennial Infrastructure Report Card gave it a D+, the same grade it got in 2013.
Private Interest Is Rising
The vehicle to deliver investor financing is the private-public partnership, known as a PPP. Such alliances are more common in Europe and Australia. Since the 1990s, Canada has turned to PPPs for its roads.
The King’s Highway 407, in the Toronto area, is a toll road with, since 1998, publicly owned and privately owned portions. The private part is mainly owned by a Spanish conglomerate, Ferrovial (42.2% stake), and the Canadian Pension Plan Investment Board (40%). Only lately has the PPP notion started to generate significant interest in the US.
“The US is a much larger market” than those served by PPPs elsewhere, said Connie Luecke, senior portfolio manager of the Virtus Duff & Phelps Global Infrastructure Fund. That presents a good opportunity for her and her investors: Luecke’s mutual fund, which has positions in companies that specialize in infrastructure, is up an annual 10.4% over 10 years, almost a half-point ahead of its benchmark.
An attractive feature of infrastructure investing is that it is highly uncorrelated to conventional investments, meaning stocks and bonds. A Nuveen study measured how a 15% investment in infrastructure equity fared in a portfolio otherwise populated by stocks and bonds. Result: Returns of the portfolio increased by 48 basis points, to 7.57% from 7.09%; volatility decreased 189 basis points, to 17.47% from 19.36%; and its Sharpe ratio (i.e., risk-adjusted return) increased to 0.36 from 0.30.
Infrastructure is, naturally, a long-term investment. Of the $400 billion raised for it by specialist funds and institutions such as pension plans since 2006, 48% had a maturity over 10 years, according to a PwC report. The New York Common Retirement Fund, Oregon Public Employees Retirement Fund, California State Teachers’ Retirement System, and State of Michigan Retirement System are among the major pension funds investing in infrastructure.
A number of state and local agencies have signed on. Virginia inked a contract in January with Transurban, which owns highways in Australia. The company will build toll-road extensions to alleviate congestion in the Old Dominion’s suburban sprawl outside Washington.
Crowded and outmoded John F. Kennedy International Airport in New York will get a $13 billion makeover, slated to start next year. But the Port Authority of New York and New Jersey can’t afford to foot the tab to revamp JFK. Thus, it is turning to private equity powerhouse Carlyle Group, which is leading an investment consortium, and will in effect take charge of the airport. The Carlyle consortium will pony up $12 billion, and the Port Authority just $1 billion.
Odds are that a public works project has the firm backing of solid investors. As JP Morgan Asset Management’s recent study on alternative assets put it, infrastructure plays provide the comfort that “income generation is relatively protected by long-term leases and the strength of lessees’ balance sheets.”
Deal Structure Can be Tricky
Despite the potential returns, pitfalls galore await a partnership if its agreement doesn’t spell out every eventuality. Some examples, per Joel Moser, CEO of Aquamarine Investment Partners, writing in Forbes: Toll roads “along unproven routes, even core assets like mature highways but lacking binding noncompetition agreements from the government, stable assets in unstable countries.”
Private partners in a PPP arrangement need to build in some flexibility in how they accrue revenue, lest they suffer if the ground shifts. Case in point: the ill-starred alliance of Australian bank Macquarie and Spanish construction outfit Cintra, which took over management of the Indiana Toll Road in 2005. Come the Great Recession, toll income plummeted. The partnership declared bankruptcy. (Another private operator, IFM partners of Australia, later replaced Macquarie.)
For a better alternative, consider how Ardian, the French investment house, handles the five motorways it runs in Portugal. Ardian splits the toll revenue 50-50 with the Portuguese government. If revenue falls below a given level, perhaps because of an economic downturn, said Mathias Burghardt, the firm’s head of infrastructure, “we renegotiate.”
That provision proved helpful. In 2011, when Portugal was embroiled in the European debt crisis and toll income fell, Ardian’s predecessor in the partnership agreed to lower its contracted payments in exchange for reduced operations and maintenance outlays, such as how often the roads were cleaned. (At the time, the private partner was Motal-Engil, a Portuguese construction group.)
Highways in the US used to be privately owned. The Philadelphia and Lancaster Turnpike, which opened in 1794, was the first large US toll road, in the United States. It also was the first thoroughfare to be constructed entirely with private money, because the state of Pennsylvania couldn’t afford to do the job.
In the 20th Century, this changed, as governments assumed control of the roads. The state highway department took over the Philadelphia-Lancaster route in 1917, and made it toll-free. In 1956, Congress approved construction of the interstate highway system, funded mostly by a federal gasoline tax. There was a lot of political tugging before to get the program enacted, of course. As states kicked in some of the money, some insisted that their portion of roadway have tolls, which was a revenue source for their coffers.
Politics Remain a Factor, Unfortunately
Government is still a large presence in PPPs, certainly, even with more and more private capital entering the picture. There’s a cost of doing business embedded in expensive public-works, rendering them boondoggles that take forever to gain the regulatory go-ahead and manage to fritter away money on high-end consultants.
The libertarian Cato Institute argues, not without reason, that “when huge amounts of federal money is seen as a communal pot for a host of social, environmental, local and make work objectives, the chances that such money will be spent wisely looks slim.”
Indeed, soaring promises from politicians have a way of bumping ignominiously against political realities. Trump, in his State of the Union address last year, promised: “We will build gleaming new roads, bridges, highways, railways, and waterways across our land.” But where exactly will the money come from to fund the $2 trillion campaign that Trump, Pelosi, and other pols are eyeing?
Democrats are talking about raising the gas tax, which now is 18.4 cents per gallon, the same level it’s been for 26 years. Yet the nonpartisan Tax Foundation estimates that even hiking the levy to 50 cents and pegging it to inflation would only generate $306 billion over a decade. Trump and the Republicans, on the other hand, are cool toward a gas tax boost and favor putting the onus on states and private investors. Could private funding make up the difference? Maybe, maybe not.
Beyond the funding question lies the political interference threat—that political forces could waylay even large public works projects that are underway, sticking it to private investors.
Witness Mexican President Andrés Manuel López Obrador’s decision last year to ax the new Mexico City airport, which was partly funded via private investment. Even though the facility was one-third complete and the older airport is in bad shape, the Mexican leader complained that the airport construction was riddled with graft.
“Politics will control privatizing,” noted Russell’s Spencer. “But the fact is that we need private money to close the financing gap.”
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