Private vs. Public Investment Strategies: Reported and Real-World Performance
We estimate the real-world performance of a private strategy – different vs. the reported performance – and fairly compare it with that of a public strategy.
Institutional portfolio allocations to unlisted, illiquid infrastructure investments (funds & direct asset investments) have increased for their potential diversification and income benefits. This trend will likely continue as governments encourage institutions to invest for the energy transition and national welfare. However, as allocations grow, CIOs are confronted with many questions:
Using asset-level and fund-level data, we find that infrastructure equity asset price returns and total returns are correlated with public equity total returns. Consequently, we model infrastructure asset price returns based on their historical performance and correlations with other public asset returns.
In contrast, infrastructure equity income returns are relatively stable with low correlations with public market returns. As a result, we model income returns (and cash flows) based on the historical (and idiosyncratic) income generating capacity of the asset, based on sector and age, but not as a function of the public market environment.
Empirically, we find income returns display “short-term persistence.” For example, if an asset pays dividends in one period, it will be likely to pay in the following period. Also, the magnitude of the dividend paid tends to be “sticky” from one period to the next. Occasional zero income returns are a possibility, even as the asset becomes mature, complicating portfolio liquidity. We construct an infrastructure asset income return model to reflect such characteristics.
Is an infrastructure equity asset more like public equity, public debt or a mix of the two, and how does this vary by age, sector, business risk, corporate structure and investment vehicle? Infrastructure assets, both equity and debt at the aggregate level, show significant betas to public debt and equity. While infrastructure funds also have a significant public equity coefficient, it is the lowest among infrastructure investments. Although not shown below, young infrastructure equity assets (e.g., greenfield) only show significant beta to public equity while mature (e.g., brownfield) equity assets also show significant beta to public debt.
Infrastructure assets are diverse with high idiosyncratic risk. There is wide variation in asset performance – even within a given sector. For example, the cross-sectional range of annualized income returns for Renewable Power assets has been over 30pp. To minimize uncompensated idiosyncratic risk a CIO should incorporate this information when constructing portfolios. Using estimates for the income return of infrastructure portfolios with varying numbers of assets, age groups and sector composition, adding assets from the same sector may be as efficacious as adding the same number of assets from different sectors to reduce a portfolio’s idiosyncratic income risk. We show that idiosyncratic risk levels off after about seven assets.
Finally, to study how various allocations to infrastructure investments interact with other private assets (e.g., private equity) and impact portfolio performance and liquidity risk, we incorporate infrastructure investment cash flows into PGIM IAS’ asset-allocation framework (OASIS). Illustrating with a hypothetical foundation portfolio, we find that adding infrastructure investments, especially infrastructure assets, could improve portfolio diversification and liquidity, driven by infrastructure assets’ more stable income compared to PE funds.