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Exchange Fund’s Investment in Infrastructure – Creating Value by Adopting a Gradual and Prudent Approach


The HKMA Infrastructure Financing Facilitation Office (IFFO) held the second Investors and Debt Financing Roundtables last week (25-26 October).  The Roundtables were well attended by representatives of key stakeholders such as institutional investors, multilateral financial institutions, debt financiers and infrastructure project operators.  The main themes of the Roundtables were equity and debt financing of infrastructure investment, with particular focus on emerging markets.

During the past two years or so, IFFO has brought together many prominent stakeholders and laid a solid foundation for promoting Hong Kong as a platform for infrastructure investment and financing.  Meanwhile, the Exchange Fund has also recently started investing in infrastructure projects under its Long-Term Growth Portfolio (LTGP).  In the inSight article “Infrastructure Investment – a Timeless Form of Investment” published last year, I had discussed the reasons why long-term institutional investors are attracted to infrastructure investment.  This article discusses the Exchange Fund’s objectives and considerations when investing in infrastructure projects, and explains how we manage the associated risks.  I hope this will help the public better understand the Exchange Fund’s approach to this important subject.

The Exchange Fund started investing in private equity and real estate (commonly known as “alternative assets”) under the LTGP in 2009, with the aim to diversify its portfolio, spread the investment risks associated with “traditional assets” (primarily bonds and equities), and enhance long-term return.  The LTGP has worked as intended during the past decade, achieving a decent internal rate of return of 13.7% at end-2017 on a since-inception annualised basis.

Since the LTGP comprises assets with lower liquidity, the size of LTGP has been capped at one-third of the Accumulated Surplus of the Exchange Fund to ensure that the Fund has sufficient liquidity for maintaining monetary and financial stability.  In 2016, the Government established the HK$220 billion Future Fund and entrusted its management to the HKMA.  As around half of the Future Fund’s capital is placed with the LTGP, the total amount of capital available for investment under the LTGP has increased correspondingly.  At the end of 2017, the total market value of investments under the LTGP reached HK$235.6 billion (with HK$157.2 billion in private equity and HK$78.4 billion in real estate), or about 5.9% of the Exchange Fund’s total assets.

Diversification into infrastructure to enhance resilience to adverse shocks

Although the US interest rates are on a rising path, the relatively low interest rate environment around the world is unlikely to reverse substantially in the foreseeable future.  This has not only resulted in lofty valuations of traditional assets, but also led to strong competition for alternative assets by investors.  Should the LTGP only invest in private equity and real estate, it will inevitably overlook some other alternative asset classes that offer great potential.  It is therefore important for us to continue broadening the spectrum of asset classes.

Infrastructure is an attractive alternative asset class that generates relatively stable cash flows with low loss ratios.  As infrastructure is essential to economic development and people’s livelihood, its returns are less affected by economic cycles and have lower correlation with those of traditional assets.  At a time when the valuations of most traditional assets are stretched, the inclusion of infrastructure investment in the portfolio will serve as a hedge, enhancing resilience to adverse economic shocks and reducing volatility of the overall return.  Furthermore, the returns of many infrastructure investments are inflation-linked due to franchise arrangement or contract protection, which would help reduce inflation risk.

When making investment decisions, one should consider not only the returns, but also risks.  That is why professional investors will combine these two factors and look at “risk-adjusted returns”, which, simply put, are returns net of risks.  Some may think that infrastructure investment is risky, but empirical data show that infrastructure investment in general outperforms traditional assets on a risk-adjusted basis.

Because of the attractive attributes mentioned above, many medium- and long-term institutional investors, such as sovereign wealth funds, pension funds and insurance companies, have been increasing their allocation to infrastructure in recent years.  These investors, like the Exchange Fund, all seek to achieve stable long-term returns.  According to a study by the Organisation for Economic Co-operation and Development (OECD), infrastructure accounted for around 10% of the alternative asset portfolio of pension funds in 2016.  In addition, it is increasingly common for long-term investors to treat infrastructure as a separate asset class in their portfolios.

Increasing infrastructure investment in a gradual and prudent manner

After thorough research and preparatory work, the Exchange Fund has begun investing in this asset class in recent years by allocating a small portion of the LTGP to infrastructure projects.  Starting off with developed markets where we are more familiar with, we have invested in a renewable energy project in Northern Europe by partnering with renowned global investors.  As the infrastructure space in developed markets has become increasingly crowded with declining returns, we have started looking into emerging markets as well.  Recently, we have invested in another renewable energy project in South America in partnership with a company with sound track record in emerging market investments.

A multi-pronged approach to manage risks

Undoubtedly, infrastructure investment carries risks that are different from those usually involved in bonds or equities.  The political, regulatory and currency risks associated with emerging market projects are also generally higher than those in developed markets. Therefore, when investing in infrastructure projects, we have been very prudent and adopt a multi-pronged approach to assess, mitigate and contain the associated risks by implementing various risk management measures that are commensurate with the projects concerned.  These include:

       i. Appropriate allocation – The Exchange Fund’s total infrastructure investments (including commitments) amounts to about US$2.2 billion currently, accounting for only a small portion of the LTGP.
  ii. Diversified portfolio – We seek to build a diversified portfolio of infrastructure investment across different regions (both developed and emerging markets), sectors (e.g. transportation, renewable energy), capital structures (both debt and equity investments) and partners to avoid undue concentration.
  iii. Due diligence – Before committing to an investment, we must conduct rigorous due diligence, including assessing carefully its financial conditions, growth potential, exit mechanism, risks and other factors, to ensure that the project is commercially viable.   Priority is accorded to jurisdictions with proper governance and environmental protection framework.  Citing the aforementioned project in South America as an example, our investment and risk management teams had to travel across continents to conduct on-site inspection and obtain first-hand information.
  iv. Selection of partners – We seek to partner with reputable and experienced institutional investors and asset managers to capitalise on their broad and deep expertise.  These include international organisations and leading industry operators.  We will also ensure that our partners have good integrity and governance standards and are trust-worthy long-term partners of the Exchange Fund.
  v. External advisors – We engage external advisors to provide independent and professional opinions on tax, legal, regulatory, and environmental issues.
  vi. Stress testing – We conduct stress testing on projects’ financial assumptions and models to ensure the projects remain resilient amid unfavourable market conditions.
  vii. Risk mitigation measures – We assess if appropriate risk mitigation measures should be adopted for the projects, such as arranging insurance against political risk, and currency hedging against foreign exchange risk.  At the negotiation stage of legal documentation, we will also secure the requisite governance rights in the projects, including their funding arrangements, operating budget, investment and operation strategies, senior personnel appointments, etc., and ensure we have the participation rights in devising asset disposal plans.
  viii. Reference checks – We conduct reference checks with peer investors as external validation of individual partners’ capability and project viability.
  ix. Post-investment monitoring – Post-investment monitoring is as important as pre-deal due diligence.  We will maintain regular contact with our partners and closely monitor the progress of the projects to identify any potential issues at an early stage.
  x. Stringent gate-keeping – The most important thing is that we will strictly adhere to the above requirements and processes when selecting the projects.  We will turn down a project if it fails any of the above requirements, no matter how promising the returns could be.

There have been some recent discussions on whether the Exchange Fund should invest in the “Belt and Road” regions, or co-operate with Mainland state-owned enterprises (SOEs).  Let’s take an objective look.  There are more than 80 jurisdictions along the “Belt and Road”, covering both developed and emerging markets.  Many of them have strong demand for infrastructure development, and some are viewed by seasoned investors with much optimism.  It would only be natural that the Exchange Fund ends up investing in projects located in some of these countries.  On the other hand, some Mainland SOEs have ample expertise and experience in investing in, constructing and operating overseas infrastructure projects, making them partners of choice for major institutional investors.  While the Exchange Fund has yet to partner with any SOE in infrastructure investment, we should not rule out such possibility.  When assessing a potential investment in infrastructure project, we look at its commercial viability, reasonableness of returns and the prospect of proper risk management.  Every single project, regardless of its location or business partnership, must go through the established mechanism and processes that underpin our robust, professional and objective due diligence and risk management.  We are here to create value – assess and select investment projects with prudence and a discerning eye, yet do not tie our own hands and pass up good opportunities.

Safeguarding the wealth of Hong Kong people is of the essence in managing the Exchange Fund.  We will continue to adhere to the investment principle of ensuring “Capital Preservation First, Long-Term Growth Next”.  While remaining prudent, we will also be flexible and proactive in managing the Exchange Fund with a view to achieving a better long-term return.


Eddie Yue
Deputy Chief Executive
Hong Kong Monetary Authority

29 October 2018

Last revision date: 29 October 2018
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