FIRSTavenue on entering a new phase

This article is sponsored by FIRSTavenue

How will infrastructure as an asset class fare in this new macroeconomic environment?

There are two key characteristics to this new environment. The first is a significant and possibly structural step up in inflation, which, in my view, is going to be with us longer than many currently believe.

Linked to that, we are also seeing a cyclical, but perhaps also secular, increase in interest rates together with a heightened risk of recession. All of these things have notably impacted public markets and private equity valuations. However, infrastructure equity and debt valuations remain relatively untouched today.

When the dust clears, I believe that investors will recognise how the hard asset value embedded in infrastructure debt and equity has provided great downside protection. The asset class will have proven itself in a down market.

Meanwhile, rising interest rates improve the attractiveness of infrastructure debt, in particular, and inflation benefits infrastructure equity. My expectation would therefore be that the massive reallocation of capital out of public market portfolios and into private infrastructure, which was already taking place, will continue with even greater force.

How do you expect the industry to evolve geographically over the years ahead?

Infrastructure has its genesis in Australia, and then quickly spread to the UK and then to the EU. It has demonstrated its resilience as an asset class in these markets and I expect that proven performance will drive continued regional expansion into the US, Northern Asia – China and Japan, in particular – as well as Eastern Europe. Growth will also be driven by governments anxious to spend in order to avoid recession and to meet energy transition targets.

And what changes do you expect to see in terms of sector and strategy?

As markets develop and scale in terms of primary volumes, several natural phenomena occur including stratification by strategy. We have seen that in how infrastructure has adopted the nomenclature of real estate: core, core-plus, value-add and opportunistic.

Another clear trend that occurs as markets develop is the growth of particular sectors. In the context of infrastructure, the energy transition and digital are the two most notable, due to their scale and therefore inherent diversification, as well as their secular growth characteristics.

The final evolution that we typically see when primary volumes scale is, of course, the growth of a secondaries market. We have clearly seen that in private equity, but less so in other private markets asset classes. So, I think we are poised for big growth in both LP infrastructure secondaries and GP solutions.

How would you say investor appetite is evolving in terms of those risk-return stratifications you mentioned?

It depends on the investor and their objectives, which is why these risk stratifications emerged in the first place. Obviously, the global pension fund industry is in a deficit, for example, which is great for infrastructure because pension funds are looking for returns in excess of their actuarial goals, in addition to stable NAV and downside protection. But that level of pension funding is critical. An investor that has plenty of funding will be willing to take more growth risk and will look at value-add and opportunistic strategies. A pension fund in a deficit will be drawn to core and core-plus.

Target returns and target income, as well as growth within target returns, also influence where an investor will choose to put their money. A pension plan with clear delineated liabilities of 30 to 50 years may be inclined to invest in a core or core-plus open-end fund that pays out income over that entire period. But a pension plan with lots of young workers may be inclined to invest in value-add or opportunistic strategies.

The final characteristic that determines investor appetite is regulatory capital considerations. That is most relevant to the insurance sector.

How would you say investor appetite has evolved when it comes to balancing generalist and specialist managers in portfolio construction?

Most investors start out focusing on either European, US or global generalist infrastructure funds, which gives them geographical and sector diversification. Then, when they start looking to augment that with specialist managers, they look for sectors that have secular growth themes and are highly diversified. To offer an analogy on the private equity side, oil and gas developed into a huge sector, particularly in the US, and it was highly diversified: opportunities exist in downstream, upstream, midstream and in multiple subsectors within each of those categories.

The energy transition is similar for infrastructure. You have solar and wind, and increasingly battery storage and green hydrogen are on the horizon. Further, there is waste-to-energy. So, the sector is beginning to exhibit a lot of those diversification characteristics. And, of course, digital is an overlay to all sectors of generalist infrastructure. That diversification is what investors look for in a specialist sector and that is where they are putting their money.

In addition to the energy transition and digital infrastructure, are there any other sectors that you see as poised for significant growth?

There is currently a global squeeze on the middle and lower classes associated with food and energy inflation, in particular. Coupled with governments’ desire to spend their way out of recession, I believe that will impact plans to stimulate investment in social infrastructure – hospitals and schools, for example. So, I see social infrastructure as a sector poised to experience tailwinds, in addition to the energy transition and digital infrastructure.

What changes do you expect to see in terms of fund format?

When infrastructure got going as an asset class many years ago, it simply copied the private equity format: a five-year investment period, five-year realisation period, plus extensions. But the truth is that for an investor looking for long-duration exposure to assets, and in particular those looking for income instead of growth, that is not the ideal model. In that format, GPs are incentivised to realise assets, and realisation crystallises a gain that lowers the investor’s exposure to that asset class.

The two fund formats that have emerged in recent years to help remedy this are the continuation fund and the open-end fund. Both allow investors to obtain longer-duration exposure to infrastructure assets. I believe the market will gradually evolve to offer a better balance between capital gains funds and open-end funds.

What do you think the infrastructure market will look like in 10 years’ time?

I believe it will have become the third-largest market after private equity and private credit in terms of total commitments outstanding. The stratification between core, core-plus, opportunistic and value-add will only increase, and the opportunistic end of the spectrum will see real growth as investors start to view it as private equity with great downside protection.

I think LPs will increasingly focus on the value creation skill set of the GP, particularly as it relates to greenfield development. There will be a greater acceptance of greenfield risk as a means of obtaining higher returns, particularly among pension fund investors that need to close their deficits.

I also expect to see marked growth in the infrastructure secondaries market. There is probably around 2-3 percent of annual outstanding investor commitments being transacted currently. I believe that will increase to 5-10 percent of a growing market.

And the issue of ESG is not going away, of course. This is a once-in-a-lifetime change to the way we invest, and the implications are still working their way through the system. Ultimately, it will be reflected in how GPs view deals and how they are compensated. I certainly think we will quickly reach a point where it is no longer good enough to just make a financial return. Managers will also need to account for their environmental and social impact.

Finally, with covid having accelerated consolidation around the big fund managers, those behemoths increasingly hold all the power. I don’t think that is ever going to change. It will remain challenging to raise a first-time infrastructure fund.

What impact will an increased investor focus on ESG have on the infrastructure market?

In recent years, ESG has moved from being a token gesture – a page in the pitchbook – to something that GPs and LPs are paying close attention to. That focus has intensified with covid, for example – investors are embracing defined ESG standards. On the environmental side, that means the reduction of carbon emissions. On the social side, there is no clear market standard yet, but I expect it will ultimately be based on livelihood creation.

The result of investors adopting ESG objectives alongside financial objectives is that the GP world needs to quickly develop clear ESG metrics and adopt them for their funds. GPs have to factor how they gather information with respect to those metrics, and how they report in a format that allows investors to aggregate that information and share it with their own stakeholders.

And while the focus has primarily been on the environment to date, I expect the S in ESG will become more important because of this squeeze on the lower and middle classes. Further, I envision the LP community to insist on defined reporting standards so that they can track their own ESG performance.

In addition, I expect LPs will increasingly look to tie economics to ESG goals. We have already seen funds where the carry can move up and down depending on ESG performance. Personally, however, I believe a more effective model would involve the GP reserving carry to award staff that are ESG outperformers, instead of a change to the headline economics.