Measuring the Value of a Portfolio Liquidity Line
We provide CIOs with a framework to quantify the portfolio performance and liquidity consequences of using an external liquidity facility.
In the first episode of PGIM’s podcast series Insight for OUTComes', Junying Shen, vice president and co-head of the private assets research program in the Institutional Advisory & Solutions (IAS) group at PGIM, speaks with Amanda White, editor of Top1000Funds.com (Investment Magazine’s sister publication), on how historical performance and cash flow characteristics differ enormously among infrastructure asset sectors.
>> I'm joined today by Junying Shen, who is Vice President and Co-Head of the Private Assets Research Program in the Institutional Advisory and Solutions Group at PGIM. PGIM is the global investment management business of Prudential Financial. Junying has been at the IAS group since June 2017 and focuses on quantitative research related to traditional and alternative assets and the development of asset allocation models. The IAS team conducts bespoke quantitative client research that focuses on strategic asset allocation and portfolio and asset class analysis across both public and private markets. Welcome to you, Junying. How are things for you?
>> I'm doing great, Amanda. Thank you very much for having me.
>> So it's a pleasure to have you here, Junying. We're seeing more and more demand for private assets as investors search for diversification. Today, we're going to talk specifically about infrastructure and the research you've done in that asset class.
>> Sure. I'm very excited about sharing our infrastructure research program here at IAS.
>> Great. Well, look, let's start there. So institutional investing in infrastructure has been around for a while. What new questions and research approaches have you been bringing to the issue? What's the work that IAS has been doing with regards to infrastructure?
>> No problem. In a nutshell, we believe IAS contributes to the study of portfolio allocation with infrastructure investing really in three aspects. The first aspect is the importance of the investment vehicles. The second aspect is the wide range of infrastructure assets. And the third and final aspect is the portfolio construction process in which we model infrastructure cash flows that refects the asset classes diversity at idiosyncratic risk. Allow me to go into detail in each of the three aspects. So first IAS is examining infrastructure universe by the investment vehicle type through which institutional investors invest. And there are two main vehicles for infrastructure investments: closed-end funds and direct investments in infrastructure assets. Closed-end fund is the most prevalent vehicle followed by direct investments in infrastructure assets. That is predominantly observed in public entities such as public pension plans and sovereign wealth funds. The cash flows investors receive from an infrastructure fund is in the form of distributions from the funds they invest. On the other hand, investors' infrastructure equity and debt assets directly receive cash flows in the form of dividend and interest payments. And this difference made us curious to investigate how historical performance and cash flow characteristics differ for these two investment vehicle types, and in turn, how they compare with other public assets such as stocks and bonds, and other private assets such as private equity. You notice probably we are especially interested in the cash flow characteristics of infrastructure investing because later, we will model infrastructure investments consistently with public and other private assets in a portfolio allocation framework that integrates liquidity measurement and cash flow management into a multi-asset, multi-period portfolio construction process. The second component of our research analyzes the wide variation in infrastructure assets. When investor talk about infrastructure, they're not just talk about one asset class. They refer to an asset class that encompasses a wide range of sectors, business models, regulation coverage, amount of leverage applied. For example, for the network utility sector, it is composed of highly regulated large corporations. On one hand, they benefit from natural monopoly. But they're also more subject to regulation risks. This makes this industry, the network utility, more volatile than the overall, for example, renewable power sector whose business models are mainly contracted. In a contracted arrangement, the investor of the infrastructure asset received a fixed payout at regular intervals based on a specific task and service arrangements. And finally, the third and the most important component of our research detail, it deal with the portfolio construction. And, Amanda, as your listeners may recall, you had a speaker from my group, Michelle Tan, who spoke in detail about OASIS framework that incorporates both public assets and illiquid private assets. To just provide a little recap, the OASIS framework examines the interrelationship among top-down asset allocation, bottom-up private asset investing decisions, and portfolio liquidity demands. Together, they form a complete understanding of the trade-off between portfolio liquidity risk and performance. And so far, little research has been done with respect to portfolio construction with infrastructure investments. And our goal here is to expand our framework to include this very important asset class. And to achieve that, we'll model cash flows of infrastructure funds and assets separately based on historical data which helps ensure we capture the sexual diversity and idiosyncratic cash flow risks in our modeling. This allocation framework would then allow CIOs to study the trade-off between enhancing portfolio performance while always satisfying their portfolios' liquidity demands across different market environments.
>> Look, that's great, Junying. Thanks for that outline. And we'll come into some of the detail and look at, in particular, you know, how funds and assets compare with other public and private assets in a second. But I just want to, before we go into that, sort of get from you what you think is the conventional wisdom of investing in infrastructure. What is the main purpose for a lot of investors and the main goal that they're trying to achieve?
>> So as you know, Amanda, as interest rates fell and stayed low around the world over the past decade, and investors has looked beyond the traditional public assets for higher returns. And infrastructure has its unique appeal among private assets, as it is often thought of having a feature of stable income yields from their long-lasting inflation-linked cash flows. Additionally, they are believed to be a strong diversifier to the rest of investment profile, especially during market downturns when public equity returns plummet. And finally, infrastructure as its long-term nature and a lot of institutional investors such as corporate pension plans with long-term viability are thinking of this asset as a natural part of their asset-liability management strategy.
>> So let's have a dive into what the data has told us a little bit then, Junying, in terms of your research. How do infrastructure investments, both funds and assets, as you define them, compare with other public and private assets? What does the data --- what is the data telling you about that?
>> Yeah. This is an important question, and the results depend on what type of investment vehicle you're looking at. Although the underlying infrastructure assets could be the same, if you're investing in a closed-end fund vehicle, the return and risk profile and cash flow characteristics, we think, will be quite different than if you're a direct investor in the infrastructure assets themselves. So we study historical infrastructure asset performance and find that the total returns of infrastructure equity and debt assets are comparable to other public equity and debt assets. What stood out, though, in our research is that the income return for infrastructure equity assets when pulling all of them together represent a large component of total returns. In terms of correlation, infrastructure equity assets show only moderate correlation with public debt and a low correlation with public equity. And infrastructure debt assets, on the other hand, when put together, is highly correlated with public debt. So that's big for infrastructure assets. And for infrastructure funds, however, looking from the cash flow perspective, when pulling all the vintages, we find no significant difference in the average valuation profile over time for private equity, private debt, and infrastructure funds. Additionally, we find average annual distributions of the infrastructure funds are lower than that for either private equity and private credit funds. Well, we wanted to be very careful when interpreting these data from the perspective of [inaudible] diversification. So on one hand, we know from our prior work that private equity allocation improves a portfolio's efficient frontier by offering diversification benefits in addition to just enhancing returns. But on the other hand, the term of the closed-end funds is limited. While in the specific case of infrastructure, the underlying assets, the term of that could last for multiple decades. And depending on how the interests of GPs are aligned with their LPs, the closed-end fund structure could alter the underlying infrastructure asset's cash flow or dividend payout characteristics.
>> So it's really interesting, the difference, isn't it? Between the assets and the funds. And we'll come to that a little bit more detail. But, you know, looking at the sort of economic environment that investors are facing at the moment, it seems like uncertainty and volatility is certainly two things that are front of mind for investors. What did you find out about infrastructure in terms of its sensitivity to market dislocations?
>> Yes, you're absolutely right. And these are on top of our minds as well to investigate. So we examine how the two infrastructure investment vehicles: the closed-end funds and assets, and then how they do they perform during volatile market periods compared to other public and private assets. And interestingly, we find for both infrastructure funds and assets, they perform resiliently during periods of public market volatility, and compared to public equity in the high yield credit, that on average decline around 10% and 5.5% respectively. When market volatility spiked up, infrastructure equity assets rose 2.4% during such periods on average, while infrastructure debt assets and infrastructure funds both had only moderate losses of around 1%.
>> So let's just pause for a second, Junying, and kind of summarize. I guess as a result of your research, at this point, what do you think is the most important kind of result, if you like, for the infrastructure investors to know given what you've discovered here?
>> So, for what I have described so far, I just described the overall post-performance of infrastructure asset and funds. And the number sound promising, and as you notice, and tend to conform with the conventional wisdom of infrastructure investing. However, we actually wanted to bring out three things that we think are very important for infrastructure investors to know. And they are performance dispersion, cashflow variability, and the idiosyncratic risks of infrastructure assets. So digging deeper from report performance of infrastructure asset and funds, we find a wide range of risk-return profile for sector-specific infrastructure equity assets. For example, the annualized total returns, it can range from 13% with a mature traditional power generation sector to a low of like 6% for gas pipeline. And the volatility of those returns also has wide dispersion. In addition, we also observed a large dispersion of dividend payout from infrastructure equity investments by sector and development stage. For example, investors in established network utilities company could expect to receive dividend payments from the beginning of the investment. However, for a greenfield solar project, for example, the investor probably will not receive dividends in the initial years of investment and only start to experience positive and rising cash inflows as the project matures. And finally, idiosyncratic risk is an important attributes of individual infrastructure assets. Across sectors, we find there are infrastructure assets that do not pay out any dividends. Even if the respective sector is priced attractively in market, investors who choose to directly invest in infrastructure assets need to conduct thorough due diligence. And finally, bring everything to the perspective of the CIO's portfolio construction process. We think the cash flow risk can be best contained and managed by diversifying within the infrastructure allocation and across other asset classes that have different risk exposures. So an example will be, let's say, a sovereign wealth fund that already investing in private equity funds and commodity as part of a real asset program. The CIO can further diversify their portfolio by directly investing in multiple infrastructure assets, if in-house resource is allowed, and from sectors probably not including traditional power generation and network utilities.
>> That's great. Thanks, Junying. So the investment vehicle and implementation of infrastructure assets has different performance and cash flow characteristics. What does that mean, in sort of more detail, for investors in assessing infrastructure risks and opportunities?
>> Yeah, we believe the key takeaway for investors is to evaluate the role of infrastructure in portfolio allocation really from their actual cash flow experience, rather than just like assuming a certain risk or performance attribute for the overall asset class. So for example, when other assets experience significant drawdown, do investor find stable dividends from their infrastructure assets to directly invest? And do they also find sustainable distributions from the fund they invest? Similarly, in terms of the role of diversification provided by infrastructure investment, we also encourage investors to evaluate from the cash flow perspective. So, and the question, for example, will be, how does the infrastructure fund's cash flows such as capital costs and distributions differ from their private equity fund investments? And here, of course, we acknowledge that direct investment in infrastructure assets requires in-house capital and human resources with considerable expertise in this particular asset class. And it may not be feasible for all investors, particularly for small corporate pension plans, for example, to directly invest in infrastructure assets. Plus, because of the high idiosyncratic cash flow risks that I just mentioned within this asset class, investing in just one or two infrastructure projects will probably fail to capture the cash flow characteristics of all of the poor infrastructure equity and debt assets. But on the other hand, a closed-end fund vehicles allows investors to at least diversify their infrastructure investment exposure through a full spectrum of strategies, including core, core plus, opportunistic, green energy, region-specific niche strategy. So I think the key question for investors, and they also need to ask for themselves, is what are the specific goals they wanted to achieve with infrastructure investment? And with that, what kind of infrastructure investment vehicles sector exposure, geographic, regional exposure, so on and so forth, will fit in those goals in the context of asset allocation?
>> You mentioned at the outset some past research by that IAS group and my conversation with Michelle last year, which looked at the impact of performance and liquidity of various asset classes from that total portfolio context. And I think that's really important to CIOs. So this is additional to that. This improves that research with the addition of infrastructure. What are the next steps in terms of incorporating that into that overall performance and liquidity from that total portfolio context? And what are the next steps? And what are you trying to -- what are you expecting to find with that research?
>> Yeah, I'm really happy to share that, Amanda, and thank you for asking that. So as I mentioned, we model cash flows for both infrastructure funds and assets and then integrate them into our OASIS asset allocation framework. So the next step really is to evaluate on the role of infrastructure in the portfolio allocation context. And then, we will examine various possible infrastructure allocations. For example, from starting from a portfolio that does not have any infrastructure allocation, we could choose to include 10% infrastructure find investment. Or we include a handful of infrastructure assets from all sectors that also total about 10% of the portfolio. Or we just include a handful of infrastructure assets from just selected sectors, for example, from renewable energy. And with that, we wanted to study how the portfolio performance and risk profile shifted with the inclusion of infrastructure investments. Using a corporate pension plan as an example, does the funding ratio variability improve or worsen over time? And how does the portfolio's ability to withstand the [inaudible] changes? And in addition, you may notice that in the examples allocations I just mentioned, they all consider a 10% portfolio allocation to infrastructure. But the impact they each have on portfolio performance, liquidity risk, drawdown risk, and sensitivity to market performance actually vary a lot. So the next step in our research program involves scrutinizing infrastructure allocations with various investment vehicles and sector exposures, and potentially strategize on how to take advantage of the diversity within infrastructure to manage cash flow risk. So looking forward to seeing how that unfolds, Junying, and I'm sure we can have additional conversations around that sort of very important work as investors look more to private assets. But a common problem with researchers, and I'm sure I don't need to tell you, seems to be data gathering, especially when it comes to private assets and the availability of the data that you need. Can you describe your infrastructure data gathering experiences and some of the challenges that you face there?
>> Yeah, sure, no problem. And the data gathering process, as you would expect, Amanda, is indeed time-consuming and cumbersome mainly due to the lack of data on the space of infrastructure investments, either or funds or assets. Most of the private asset data providers report performance measure based on firm managers' appraisal valuation. And those values may not reflect the fair market value of institutional funds or assets if they're to be transacted in the market at the time of valuation. They also exhibit smooth volatility caused by infrequent valuation updates from the GPs. Some data providers we're working with endeavor to provide a fair market evaluation for individual infrastructure assets based on dividend forecasts at a time of valuation, the term structure of interest rates matching the duration of the investments, and risk premia based on a factor of pricing models. These data allow us actually to study infrastructure asset performance based on sector, geographic region, business models, and the corporate structure classification. And because they are trying to fair market value of the infrastructure assets, we have access to total returns, price returns, and income returns. And then with that, we will be able to compare the infrastructure asset performance consistently with public assets. For closed-end funds, investors receive cash flows in the form of distributions that may not actually match the dividend or interest payments of the underlying assets, and could be more subject, so those cash flow could be more subject to GP's discretion and investment exit strategies. Therefore, for infrastructure fund vehicle performance, we source capital course distributions and net asset values supplied from LPs that reflect the GP valuations. We'll in turn model the cash flow profile of the infrastructure fund vehicle and try to capture how they differ or perform similarly during different market environments and from other private asset funds.
>> Well, Junying, you've done an amazing job explaining something that's very, very complex. And I can see the work that's gone into it. We really appreciate you taking the time to share some of your research with us and we'll watch closely how that unfolds from the total portfolio construction perspective as well. Thank you very much for your time today. It's been a pleasure speaking with you.
>> My pleasure as well. Thank you, Amanda.