Core’s cause for concern

Core infrastructure was a clear beneficiary of the global financial crisis, as equity investors shunned risk in the face of a tumultuous macro environment. As we once again feel shockwaves reverberate through the global economy, it might be reasonable to expect a similar flight to safety. However, the dynamics this time around are different and the picture a lot less clear.

On the one hand, core infrastructure evidently presents a sound option for the risk averse. “We continue to think this is a fantastic macro environment for core, with recent inflationary pressures making cash-yielding, low volatility assets that have revenue directly linked to inflation very attractive for investors,” says Luke Taylor, co-chief operating officer at Stonepeak.

Natalie Hadad, managing partner in Brookfield Asset Management’s infrastructure group and co-head of the firm’s open-end core infrastructure fund, agrees. “We see strong investor interest in core strategies. The current macroeconomic environment, characterised by elevated interest rates and economic headwinds, has highlighted the benefits of inflation-linked assets with availability-based revenue models.”

Tara Davies, partner and global head of core infrastructure at KKR, adds: “The denominator effect is putting a great deal of pressure on institutional investors but when markets dislocate there is always a flight to quality. Furthermore, core infrastructure tends to be directly inflation-linked, which makes it attractive given current market conditions.”

However, the crucial difference between the global financial crisis and today is the direction of travel of interest rates. Core players are nonetheless sanguine about the impact on their asset class.

“Of course, investors want to ensure they are going to generate appropriate returns in the context of a rising interest rate environment,” says chief executive and founding partner of Vauban Infrastructure Partners, Gwenola Chambon.

“What they are finding is that existing portfolios are not being negatively impacted by the increased cost of financing because most core infrastructure is financed with fixed rate long-term debt, while at the same time, those assets are benefiting from inflation.

“Meanwhile, the increased risk-free rate that can be applied when discounting future cashflows mean when it comes to new investment, assets are being repriced by between 200 and 300 basis points. Again, that is making this space extremely interesting for investors who want the capacity to generate yield in a resilient and predictable manner.”

Taylor agrees that the market is ripe for core investment today, although he is less bullish on some legacy core portfolios. “Rising interest rates have driven a re-rating of core investments, which is creating more attractive entry prices for investors that can invest in new strategies,” he says. “In our view, core infrastructure previously purchased in a low interest rate environment without adequate inflation protection or long-term debt will not perform nearly as well as core infrastructure assets acquired more recently with strong inflation linkage, steady cash yields, and low volatility.

“We believe that core strategies purpose-built for today’s macro challenges will produce a strong vintage and perform well both in the current environment and over the long-term.”

Waiting for re-rating

Other market players suggest that core infrastructure fundraising is extremely challenged in today’s market, not least because while core exponents are extolling the virtues of deployment in a re-rated environment, there are question marks surrounding the extent to which the segment has, in fact, re-priced.

“One reason for the decline in appetite for core that we are seeing is the consistent negative messaging, stating that core is a challenged space to be deploying capital given a lack of repricing,” explains Threadmark founder Bruce Chapman.

German pension funds, for example, have represented a significant source of capital for core infrastructure in recent years. “These institutions were 80-100 percent concentrated in fixed income until around 2010, so the shift to core infrastructure was a natural one,” Chapman adds. “However, we are hearing that due to issues with a lack of repricing, those investors are holding fire. That is a major headwind for core infrastructure right now.”

A reversion to fixed income is a significant issue for core players in the fundraising market today. “We have seen a decrease in appetite for core infrastructure, which was something of a surprise because there was a marked increase in appetite following the global financial crisis,” says Chapman.

“However, the situation today is different. Not least, because interest rates have spiked and are likely to remain high for the next few years. That means that fixed income is presenting a much more interesting opportunity than it has since 2008. A large amount of money has flowed into infrastructure from fixed income allocations that have been repurposed over the past decade. A lot of that money is now starting to be redeployed back into fixed income at attractive rates.

“Super core returns are generally in the 5-6 percent range and core returns somewhere between 8 and 9 percent. You can get rates at those levels on bonds that can be bought from a Bloomberg terminal with very little purchase, management or liquidation costs associated with them.”

Gordon Bajnai, partner and head of global infrastructure at Campbell Lutyens, agrees: “With the disappearance of the negative yield on fixed income products, appetite has moved to higher returning categories and to credit. At the peak of covid-19, there was around $18 trillion in negative yielding fixed income. Today, that figure is around zero. Unsurprisingly, therefore, we are seeing money move from core infrastructure and back into fixed income strategies.

“Furthermore, high interest rates mean that you can now achieve north of 8 percent from infrastructure credit – or other credit strategies – on a par with the returns available from core. Finally, a lot of LPs are now favouring core plus and value add, just to distance themselves from today’s level of inflation.”

“The current macroeconomic environment has highlighted the benefits of inflation-linked assets with availability-based revenue models”

Natalie Hadad,
Brookfield Asset Management

Paul Buckley, managing partner at First Avenue, also sees investors favouring alternatives to core in the current environment. “Both core and super core strategies are suffering from the rising rate environment and as a result, we are seeing increased appetite from LPs for infrastructure debt as allocators prefer the yielding contracted cash flows the asset class offers.”

“We are seeing a shift away from super core and core strategies,” agrees Graham Matthews, infrastructure chief executive at Patrizia. “At the lower end of the risk spectrum, investors are favouring infrastructure debt instead – with high-yield infrastructure debt in particular offering very similar returns without the equity risk.

“At the other end, investors are looking for a greater premium over risk-free rates, which means that they are shifting towards core-plus and value add strategies. This has resulted in a hollowing out of investor demand for super core and core infrastructure equity.”

A core comeback

Any challenges facing core infrastructure fundraising should, however, be relatively short lived. “In the medium term, I believe inflation and interest rates will fall, and the longer-term nature of equity versus credit will bring core back into its proper place,” says Bajnai. “It may not be as hot as it was before the current crisis, but it will be in a far better position than it is today.”

“The situation will not last forever. Interest rates will come down – maybe not all the way to zero, but at least to the low single digits,” Chapman says. “Whatever repricing needs to take place in the core space will take place and the denominator effect that has hamstrung a lot of investors will ease. Either listed markets will adjust, or investors will reassess the benchmarks by which they measure their unlisted portfolio.”

Davies is confident that core infrastructure will ultimately benefit from current market conditions as investors are reminded of what made them allocate to the asset class in the first place: “Those that had 60:40 allocations to equity and bonds last year will not have fared as well as those that had some element of infrastructure exposure in their portfolios. That is because infrastructure is downside protected. People use infrastructure regardless of whether GDP is contracting or expanding. It also benefits from inflation linkage.”

After all, there have been few, if any, reports of meaningful underperformance in core infrastructure. “On the contrary,” says Chapman, “investors value the stability, predictability and security that core brings. Core infrastructure fundraising is experiencing challenging times, certainly, but the tougher this period, the shorter it is likely to be, and the faster markets will bounce back to where they once were.”

“Infrastructure, especially core infrastructure, is proving itself with flying colours in this ongoing macroeconomic turmoil,” adds François Bornens, partner and head of investor relations at Arjun Infrastructure Partners.

“Core infrastructure is by far the best performing asset class since the start of covid-19 – think of what has happened to real estate, equities, fixed income and private equity in the past three years. When the dust settles, and the tactical short-term considerations fade away, core infrastructure will be front and centre for all investors.”

Defining core

At the heart of any definition of core infrastructure is the concept that you are unlikely to lose money.

“The returns may not be all that exciting, but it should be pretty safe,” says Threadmark’s Bruce Chapman of core infrastructure.

“Core infrastructure for us means holding the keys to assets that provide essential services to communities,” adds Vauban’s Gwenola Chambon. “These assets will typically hold a monopolistic position and have long-term contracted revenues, as well as positive correlation to inflation and decorrelation to GDP.”

However, the parameters of core have undoubtedly expanded over the years. “The definition of core has definitely been stretched by some to incorporate services to infrastructure rather than simply the infrastructure itself,” says Chambon. “You get less correlation to inflation and decorrelation to GDP the further you stray from the original definition of core and the closer you move to private equity.”

Chapman agrees and points to regulated assets in particular. “In the buoyant and rather loose market that existed for a long time, the definition of core was extended to include assets that it probably shouldn’t. I don’t understand why [regulated assets] are considered core given the level of political risk that is often involved.

“When you hit tough economic conditions, policy makers need to respond to public pressure, and nothing hurts the public more than paying for privately held infrastructure that they cannot afford. I think those assets will continue to be viewed as core, simply because there is so much appetite for them that people will continue to pay high prices, meaning the returns coming off them will be core. But I think the risks involved are far greater than for other truly core assets.”

The definition of core has also evolved for positive reasons. “For example, 15 years ago, no-one would have considered fibre to represent core infrastructure. However, fibre networks undoubtedly provide an essential service today and, depending on the framework, offer resilient investment opportunities as well,” says Chambon.

“Historically, core infrastructure used to mean utilities or PPPs. Now that definition has moved on materially,” adds Campbell Lutyens’ Gordon Bajnai. “We have seen new sectors enter the core space, most recently digital infrastructure and renewables. There are now high-quality digital assets that are fully built out with long-term contracts with blue-chip off-takers. There are also commercial and industrial renewables assets with 15- to 20-year contracts that make those attractive core propositions as well.”