The art of navigating cycles

The ability to deal with changing markets is critical. So how does one go about investing in a bull market? We ask Hamish Mackenzie, DWS’s head of infrastructure

This article is sponsored by DWS

Q: Infrastructure is often held as a defensive asset class. How does that play out in a bull market?

HM: I think ‘defensive’ is a relative term. We’ve seen in the current market that liquidity has driven up prices in all asset classes, including infrastructure. That said, the fundamentals of infrastructure could remain strong whatever the market environment – we’re talking about asset-backed businesses that are highly cash-generative and may offer stability in a downturn.

The challenge in a bull market, however, is that to achieve target returns, it is critically important to select the right asset at the right price. This means appropriate due diligence, asset selection and price discipline are more important than ever, because there’s an increased risk of overpaying. In the current market, we’ve seen a significant amount of capital come into infrastructure, large direct investors increasing allocations and infrastructure funds increasing in size. All this capital needs to find a home, so this is pushing up prices.

Q: Given that you were raising funds and investing before the Global Financial Crisis, what lessons did you take from it?

HM: One of the key lessons in the current market environment is that it’s important to have a view on valuations throughout a cycle. If you take the Capital Asset Pricing Model to determine the theoretical price of an asset, and apply it to most infrastructure sectors, you may end up with tight return expectations. So, are those assumptions around CAPM the right assumptions to be making, or do we need to adopt a more mid-cycle view of value? We found that by taking a more realistic mid-cycle approach and applying alpha to discount rates, we were able to keep a fairly consistent and stable view of value across the portfolio.

As with the pre-GFC period, the bull market generates very high levels of activity, so the deal pipeline is very deep and there is a huge amount of deal activity. I think it’s particularly important in that sort of environment for managers to remain focused on which assets they pursue and how much they pay.

Another valuable experience was living with the performance of the portfolio throughout the downturn and understanding which assets performed well and which assets didn’t. The ability to identify assets that provide cashflow visibility to support income- based return, rather than just seeking capital appreciation, was key. But also focusing on those assets that provided flexibility on both sides of the profit and loss (P&L) – the ability to manage revenues and introduce new business lines to offset a decline in underlying volumes, as well as the ability to manage the cost base against a lower revenue line –- helped us manage cashflow stability in a changing market environment.

A third lesson is around the value of being able to invest in and grow a business. A recession may not seem like the best time to invest, but in terms of capital expenditure and providing a platform for growth into a recovery, the last recession was a good time to invest for some of the assets in our portfolio.

For example, two of the largest assets in our Pan-European Infrastructure Fund I (PEIF) portfolio (now closed to investors) – Peel Ports and Tank & Rast (the latter realised in September 2015) – were arguably the two assets most exposed to GDP, one as a port and the other as a motorway-service station. But in both businesses, we had some flexibility to introduce new revenue streams and reduce costs, and as a result, the two businesses didn’t experience a reduction in EBITDA, even during the trough of the crisis of 2009. At the same time, for example, some regulated assets in our portfolio, did not offer us the same degree of operational flexibility. The takeaway is in trying to identify infrastructure businesses supported by resilient business profiles and some flexibility that can support levers that may continue to protect and grow the P&L.

Q: How can managers like DWS use this market as an opportunity and what risks do you need to be aware of?

HM: This environment with a lot of deal activity is conducive to buy-and-build strategies, so we’re buying businesses with the intention to add to them through M&A and to support growth into different business areas or different geographies. Linked to that, the low-interest environment is a good time to lock in financing for capital expenditure as well as M&A.

I think from a portfolio perspective, regulated assets may be beneficial to balance systematic risk in portfolios – but they are currently expensive, since they are perceived as lower-risk, low-volatility assets. More importantly, with these sorts of businesses when the environment changes, you’ve actually got limited ability to adjust quickly.

Q: How does this approach differ in a market where we’re expecting a rise in interest rates?

HM: Interest rates have already started to increase in the US and the UK and I think they may continue to increase gradually, and that would push up yields. That said, our in-house research view is that interest rates may continue to remain below the long-term historical average, which underpins the importance of infrastructure as a yielding asset class.

We’re in a relatively low interest-rate environment, so investors may continue to see comparatively lower returns from traditional asset classes, and may therefore look to alternatives like unlisted infrastructure as a way of complementing their portfolio. So, I think that even in a gradually increasing interest rate environment, we may continue to see strong investor interest in infrastructure.

Second, as infrastructure investors, we don’t speculate on interest- rate cycles and, generally, when we invest, we try and put in place longer-term financing and/or hedging around the interest rate, to mitigate the risk of increases or decreases.

Q: What pressure does a bull market place on a firm’s asset-management skills?

HM: Asset management is critical. Firstly, in bull markets, no assets are trading cheaply as even in bilateral situations, asset owners are aware of the value of the assets. So, by avoiding auction processes, you may avoid paying unreasonable prices. But the fact is, that even in bilateral processes, you are having to pay a reasonable but fairly full price. So, we need to actively manage investments to deliver growth and to deliver the returns we are targeting for investors. And that requires asset management.

The second point is that a bull market will inevitably, and particularly if you’re taking a long-term investment view, be followed by a bear market or an economic downturn at some point, and it’s important that you have the skill set to manage assets during the downturn – just sitting and waiting for the economy to bounce back is not enough. As discussed, that’s something that comes back to the experience we had through our Pan-European Infrastructure Fund I (now closed to investors) of managing and investing in assets through the downturn, managing the cost base and using levers to play on both sides of the P&L, helping businesses grow out of the recession.

Q: Does technology play a role in this?

HM: Technology is critical in asset management, whether in terms of managing costs through mechanising tasks or generally making business more efficient but also on the revenue side. Technology has historically been a real driver of revenues, even in old-school infrastructure assets.

In Tank & Rast, one of the more interesting revenue lines we introduced during our ownership was screen-based advertising – selling TV -screen space, whether that was smaller screens in the washrooms or larger screens in the stations and selling that space to advertising companies. In airports, the ability to do target-retail advertising, use loyalty programmes, use Wi-Fi to collate customer information – these are all key drivers of revenue. In another of our portfolio assets, TCR, Europe’s leading independent provider of airport ground support equipment services, we’ve been investing very heavily in new telematics technologies that allow us to offer a higher-quality service to customers and improve on-time performance.

Technology also clearly throws up new investment opportunities, whether that is in renewable energy, battery storage, smart networks, data storage, fibre networks, smart meters, EV charging – all this is a key part of the evolving and growing infrastructure landscape.