The terms core and core-plus, originally used in real estate, have become commonplace in infrastructure to categorise assets by risk profile. Core is used as a label for the lower-risk bucket of the two. This distinction, however, gives an overly simplistic impression of risk and return.
In recent years, due to yield hunger and low interest rates, traditional core assets have performed well. But they cannot be relied on to do so in future, and the risks have been largely ignored. This is due to the ‘oven-ready’ nature of traditional core assets, which require minimal operational input from owners while delivering consistent cashflows.
Yet the existence of point risks combined with low single-digit returns – typically while using high leverage – can lead to an unattractive risk/return balance. Examples include regulatory price resets, political instability, large fines, curtailment of energy supplies or an increase in bad debts for a mandatory service provision, the latter being particularly relevant during the current pandemic. If we extend the definition of core to include renewables, we can add wind risk – and, for UK contracts for difference, electricity price risk. These risks are almost always external to an investee company. They have a fundamental impact on its performance but lie outside the corporate box.
Where a core business has significant operations, the risk can be underestimated by investors that believe core infra behaves like a ‘bond-plus’ investment. Current valuations suggest such assets are being priced this way.
There is little value in being restricted by the traditional asset buckets. Guided by our definition of infrastructure, AMP Capital aims to invest in businesses that provide essential services with high barriers to entry and that are growth platforms. Our goal is to spend new capital to make services cheaper and better for end-users.
The key is to identify sub-sectors that are not regarded as core but will be in the future as their essential nature becomes better understood. These are typically found not by looking within infrastructure sub-sectors, but by applying the above criteria to invest in essential service companies with high barriers to entry. Sub-sectors where we have taken advantage of this include district heating and rolling stock.
Core-plus investments have more operating moving parts or more capex-driven growth to capture, which gives the impression that they are riskier. Examples include businesses that need more employees, that provide more ‘asset-light’ services or that create new supply in underserved markets.
It is worth not only acknowledging the presence of this operating environment but embracing it, as these types of operating activities and the associated risks fall within a company’s control.
Moreover, they can be adjusted to respond to changing external environments. These adjustments might be made to mitigate downside – such as by removing marginal costs if demand temporarily stalls, as we have seen recently in covid-19. Alternatively, they might be made to take advantage of an unexpected upside, such as a new adjacent business line with an existing client.
Managed correctly with an intense operating focus, these ‘moving parts’ can become a major advantage for essential service companies. They can give a company and its investors levers ‘inside the box’ with which to navigate risks, while traditional core businesses remain vulnerable to external risks.