A Bridge Too Far: The Pitfalls of Private Infrastructure Funds

America’s infrastructure was once the envy of the world. Boy, are those days gone. After decades of neglect, the nation’s roads, bridges, dams, airports, harbors, pipelines, and power plants are crumbling and out of date. In its 2017 “report card,” the American Society of Civil Engineers (ASCE) gave the United States’ physical infrastructure a D+.

On August 10, the Senate passed President Joe Biden’s $1.2 trillion Infrastructure Investment and Jobs Act with strong bipartisan support. If it gets through the House of Representatives, the package would be a major step, though it still falls short of the $2.6 trillion ASCE would like to see budgeted.

However, infrastructure investments don’t need to come from government spending alone. In fact, says Stanford Graduate School of Business economist Joshua Rauh, institutional investors have become very active in funding such projects in the past decade. “Private infrastructure funds grew from about $50 billion in assets under management to around $500 billion in 2019,” he notes.

For investors with long time horizons — such as public and private pension funds, sovereign wealth funds, endowments, and insurance companies — long-lived infrastructure assets should provide stable returns and protection from inflation and market swings. After all, people don’t stop using highways and tunnels in a recession.

Anyway, that’s the pitch that a new class of infrastructure equity funds are using to attract investors. Rauh, a professor of finance at Stanford GSB and a senior fellow at the Hoover Institution, wanted to find out if these investment vehicles are delivering on their promise.

The startling answer is no. In a new paper, Rauh and coauthors Roman Kräussl and Aleksandar Andonov analyzed the cash flows in and out of 633 infrastructure funds — encompassing more than 82,000 investor-deal observations. They found that the returns were not only below market rates, they were just as volatile and sensitive to business cycles as other private equity investments.

“Institutional investors are making huge commitments to this new asset class with the understanding that it’s safer and offers more predictable returns,” Rauh says. “And they’re not getting the benefits they expected.” That finding may be unwelcome news to investors, including many who chose infrastructure as a way to pursue impact investing goals.

It also raises the question of whether institutional investors will continue to fund infrastructure projects in the future. And without them, cash-strapped federal, state, and local governments are clearly unable to make up the difference. Rauh thinks this could severely hamper the country’s future prosperity and competitiveness in global markets.

The Same Old Model

Why aren’t these investments delivering on their promise? The problem, Rauh says, is not with the concept but with the funds. Perhaps because they were first developed in the private equity market, most infrastructure funds are set up as traditional closed-end funds. Bridges and dams may last 50 years, but infrastructure funds last only 10 to 12 years.

The compensation structure also plays a role. Typically, funds take an annual management fee of 2% of assets plus 20% of any profits. That hefty “carry” gives managers a strong incentive to chase the upside — mainly by selling off assets long before they mature. “That focus on quick exits decouples the funds’ returns from the underlying assets,” Rauh says.

It also creates an incentive to ratchet up profits by borrowing heavily. Rauh’s data show that infrastructure deals are often financed with a lot of debt. “You can invest in a stable asset, but if you then lever it up to the max, you’re just reintroducing all that market risk,” he observes. “You’re defeating the purpose.”

The result, he says, is that the risk-return profiles of infrastructure funds are no different from those of traditional private equity funds. “The industry is selling this as something new, saying it’s all about stable cash flows, but really it’s driven by the same old pursuit of capital gains.”

Doing Good, If Not Well

Still, there’s no sign that institutional investors are retreating from infrastructure. One possible reason, Rauh says, is that they may not be fixated on the financials. “Public pension funds and endowments in particular are under pressure to choose investments that have some social benefit.” For investors focused on environment, social, and governance (ESG) outcomes, he says, “lower cash flows might be offset by accounting for positive externalities.”

Rauh and his coauthors found that 15% of the funds in their sample explicitly mention objectives such as addressing climate change or contributing to economic development abroad. For other investors, social or environmental goals may be a prestige factor to highlight in their marketing. Altogether, the researchers found that ESG commitments explained as much as 40% of public infrastructure funds’ growth — as well as 30% of their underperformance.

That’s not to say renewable energy or emerging economies per se are poor investments. It may be just that these investors take on financially marginal deals that have been spurned by traditional funds to meet their ESG mandates.

It could also be that infrastructure investors don’t yet realize they’re drawing a short straw. Rauh’s analysis of risk-adjusted cash flows is quite sophisticated. And, of course, each investor sees only their own results, while this study draws on a large sample to offer an assessment of the sector as a whole.

But perhaps the main reason is that financial markets have been on a tear for the past 10 years. “Fiscal and monetary policies have been piping money into the economy, inflating the prices of all assets,” Rauh says. “That’s not an environment that leads to a lot of soul-searching.”

He thinks a reassessment of this market is inevitable. “When there’s a general downturn, investors are going to be saying, ‘Hey, this infrastructure fund was supposed to be safe and diversifying. And it just tanked the same way that the rest of our private equity tanked.’”

But that realization may have to wait for another market correction — “and there will be another correction — it’s just a matter of time.” Rauh adds, apologetically, “Sorry, that’s the dismal scientist speaking.”

The Road Ahead

Still, Rauh says the premise of private financing is sound, and he believes it can play a major role in modernizing U.S. infrastructure. What it’ll take, he says, is some financial market innovation and smarter alternatives to the traditional closed-end funds that are the primary investment vehicles today.

He points to the fee structure that encourages fund managers to target high returns. “It works perfectly well in venture capital, where you’re making a lot of small bets and hoping to find the next Facebook. But it’s the wrong incentive mechanism for infrastructure, especially with clients who are seeking predictable, not spectacular, returns.”

One alternative is direct investment, where an investor contracts to own, say, a toll road. But that approach is rare in the U.S. It takes a massive commitment of capital, beyond the reach of all but the biggest investors, and it lacks the advantages of diversification. “With a fund you can own a little bit of the toll road, a little bit of the wind farm,” Rauh says.

There are also open fund structures called evergreen funds that don’t have a set end date, which Rauh says could alleviate some of the problems. “For things to really move forward with infrastructure as an asset class, I think there needs to be an evolution toward some of these other models, to better align with what institutional investors are actually looking for,” he says.

The highways of the future, in other words, may require a different kind of vehicle.