The seemingly robust post-covid global economic recovery has ground to a halt this year, amid a cavalcade of concerns. Inflation has returned as a serious problem in developed markets for the first time in decades. Interest rates are rising around the world. Europe is facing power rationing. China is still imposing lockdowns. Recession appears inevitable across many of the world’s leading economies.
The barrage of bad news has clearly dented confidence in both public and private markets. The MSCI global stock index recorded its biggest-ever first-half drop this year, while private equity fundraising declined by 27 percent year-on-year in the first six months of 2022, as reported by affiliate title Private Equity International.
All things considered, the situation for infrastructure investors does not look quite so bleak. The defensive characteristics of the asset class should offer inherent protection, while long-term trends point to more demand for infrastructure investment. For investors searching for a harbour in the storm, is infrastructure still on their radar? And which strategies are likely to offer that much-needed sanctuary?
Infrastructure Investor surveyed institutional investors in August and September 2021 for our LP Perspectives 2022 Study. Some 35 percent of respondents identified political instability as one of their biggest concerns, while a further 27 percent cited rising interest rates.
One year later, these fears have become a reality. The Russian invasion of Ukraine has plunged Europe into an energy security crisis and exacerbated global inflationary trends. Central banks have responded with the largest interest rate hikes in many years. The Fed raised rates four times between March and July, while the European Central Bank announced its first rate rise since 2011 in July.
But infrastructure managers are keen to emphasise that the asset class is capable of riding out the inflationary storm. “One of infrastructure’s strongest and most attractive traits is its inflation hedge,” says Daniel McCormack, head of research at Macquarie Group. “Many infrastructure assets have a good link between revenue and earnings on the one hand, and CPI inflation on the other. This can come courtesy of regulation, contractual arrangements or market position.
“While rising interest rates are a headwind to the performance of all equity asset classes, infrastructure’s relatively tight and reliable inflation hedge is likely to stand it in good stead relative to others.”
Some fallout is inevitable, however. Fund managers are not immune to the effects of inflation, especially when investing in greenfield projects. “The main impact on our business is the increased cost to build new infrastructure assets,” says Todd Bright, co-head of private infrastructure for the Americas at Partners Group. “The equipment, construction, labour and borrowing costs for new-build infrastructure have all materially increased.”
Bright says there has not yet been a “major impact” on valuations, but he warns that managers need to be prepared for this. “Buyer discount rates should eventually trend up with interest rates, and this is something we have been underwriting and positioning our portfolio for when it comes to our exits for a long time now.”
Appetite for commitments looked strong towards the end of last year, at least. Our LP Perspectives 2022 Study found that 65 percent of LPs expected to increase allocations to infrastructure in the next 12 months – a considerably higher figure than for any other asset class. And this has followed through: the first half of 2022 set a new record for infrastructure fundraising: the $112.7 billion raised equates to some 75 percent of the total figure for the whole of 2021.
It remains to be seen how long this upsurge in investor appetite will last. “There are still a lot of funds in the market,” says So Yeun Lim, global head of infrastructure research at WTW (formerly Willis Towers Watson). But she adds that “some fund managers might see that their fundraising periods become slightly more prolonged”.
Infrastructure funds are also vulnerable to the denominator effect, in which the decline in public market valuations increases investors’ relative exposure to private market equities, warns Bright. This trend “may cause some investors to reassess their private market allocations relative to public market holdings”, he says.
Meanwhile, the choppy macroeconomic waters make it harder for first-time managers to persuade investors to trust them with their capital. “I think there may be a gravitation towards the more established GPs with good performance through the cycles, executing a consistent strategy and with long-tenured teams,” says Bright.
“There’s been a volume of capital chasing that core part of the infrastructure market, and I think that has inherently led to pressure on pricing”
Amber Infrastructure Group
Intuitively, super-core or core infrastructure assets would appear to represent the most attractive investments for LPs, given the volatile macroeconomic and geopolitical environment.
Indeed, McCormack says the most desirable characteristics in infrastructure assets, such as an inflation hedge and dependable cashflows, “are more prevalent, generally speaking, in core infrastructure than they are in the core-plus or value-add part of the infrastructure spectrum”. He notes that assets such as regulated utilities “arguably offer a better risk-adjusted return at the current juncture”.
But Amanda Woods, chief investment officer at Amber Infrastructure Group, tells us that a highly competitive market in recent years has led to some managers taking excessive risks to get hold of nominally ‘core’ infrastructure.
“There’s been a volume of capital chasing that core part of the infrastructure market, and I think that has inherently led to pressure on pricing,” she says. “[Some firms] have taken low-risk infrastructure and then introduced aggressive capital structures, such that you’re in danger of losing some of the inherently low risk and defensive characteristics.
“To my mind, it’s no longer ‘core’ when you’ve introduced a very aggressive capital structure. Those are likely to be the more vulnerable investments in a high interest rate environment.
“Core-plus doesn’t equal ‘wrong’ in this backdrop – quite the opposite. In times where base rates are increasing and spreads are widening, actually investors are looking for better risk-adjusted returns than they’ve perhaps previously been able to see in the core sector.”
Indeed, a report published by McKinsey in August argued that the familiar understanding of what types of infrastructure belong in the buckets of super-core, core and core-plus needs to be reassessed. For example, gas distribution assets that were once considered super-core may now be seen as core-plus in some circumstances. Other asset types, such as digital infrastructure, are moving in the opposite direction along the risk spectrum.
“We think the most resilient assets are the ones that benefit from strong thematic tailwinds (like decarbonisation) and have a lower cost basis because they are being built rather than bought in a growth platform way,” says Bright. “Those types of infra businesses are as well positioned as any to create value and generate returns in a safe and predictable way.”
“We can expect clean energy to be where we invest most in the coming years”
UK Infrastructure Bank
Turning crisis into opportunity
The Russian invasion of Ukraine, with its drastic effects on commodity prices, has been a major factor in driving inflation and undermining the post-covid global economic recovery. But the war has also left Europe, in particular, with an urgent mission to redraw its energy map.
“I think one major impact from the situation will be a renewed and deeper focus from all regions, including the US and Europe, on energy independence,” says Bright. “This obviously translates to an increased need for infrastructure that furthers that goal.”
Bright notes that Partners Group is a partner in a consortium that is building a liquefied natural gas import and regasification facility in Germany, helping the country escape from its dependence on Russian gas. But it is the shift towards renewable energy that creates a truly colossal opportunity for infrastructure investment. The International Energy Agency estimates that a whopping $5 trillion in energy investment is needed each and every year to reach net zero by 2050.
John Flint, CEO of the UK Infrastructure Bank, tells Infrastructure Investor that “Russia’s invasion of Ukraine highlights the UK’s dependence on fossil fuels and the impact this can have on people’s bills”.
“The strategic importance of energy security has never been more central to the UK’s economic future,” he adds. “We can expect clean energy to be where we invest most in the coming years.”
The build-out of green infrastructure, in particular, will be a driving factor in the continued vitality of the asset class.
“Investors will still want exposure to infrastructure and will probably increase their exposure over the long term,” says Woods. “Sustainable investments will always be the most resilient investments.”
Emerging markets have to fight harder to retain investor interest in a challenging macro environment.
Infrastructure investors have long been wary of emerging markets. Current macroeconomic conditions mean that managers are “less likely to venture into unknowns”, says WTW’s So Yeun Lim.
Partners Group has “always favoured developed markets”, Todd Bright tells us. “Macro and country dynamics in emerging markets (that are totally beyond your control) can offset good business performance on the ground, so you can do everything right from an execution standpoint and still have a disappointing result.”
The Fed’s hawkish stance has strengthened the dollar since the beginning of 2022. Emerging market economies that are dependent on food and fuel impacts have been badly hit by currency depreciation – Sri Lanka, Argentina, Ghana and Turkey are among the worst affected.
Vuyo Ntoi, co-managing director at African Infrastructure Investment Managers, concedes that global macroeconomic conditions are a “concern” for emerging market infrastructure investors. But he highlights the opportunities arising from the energy transition, digitalisation and urbanisation trends in Africa – and says that investing in these assets can position investors to reap long-term rewards.
“The recent crises have highlighted the attractions of infrastructure as an investment class,” he says. “We believe that for any investor who is seeking an Africa exposure, infrastructure is a risk-mitigated entry into the African market.”