This article is sponsored by EDHECinfra
There are no universally accepted definitions of core, core-plus or any of the main strategies. The notion of ‘core infrastructure’ relies on several intuitions about the inherent stability and essential aspects of the business of certain infrastructure companies, such as water and gas networks. But investors also know that some investments are riskier than others and may, for example, include a degree of market risk. Infrastructure investment also means taking greenfield or country risks, which can further change the risk profile of the investment towards so-called ‘opportunistic’ assets.
Hence, the difference between core, core-plus and opportunistic is intuitively about risk appetite and expected returns. Indeed, investors require higher returns to be exposed to riskier investments. So, we define these strategies as the different quartiles of the distribution of expected returns (see chart 1).
Core infrastructure is the first two quartiles of the distribution of expected returns, covering the lower part of the risk spectrum. Core-plus is a riskier slice of the market, defined as the third quartile of expected returns. Opportunistic is anything with expected returns in the highest quartile, also signalling higher risk.
Investors in the mid-market space argue that the larger asset segment of the market is crowded, with large investors chasing large ‘trophy assets’ and that mid-size investments are more likely to be priced attractively. Defining this style is straightforward – it is any assets in the second and third quartiles of the size (total assets) distribution of available investments.
Table 1 confirms that the quartiles of expected returns capture different levels of risk. Volatility is higher for opportunistic and, to some extent, core-plus investments. Core infra is clearly less risky. In terms of the volatility of total returns, of the drawdown experienced in March 2020, as covid-19 began to affect asset prices, and of the exposure to emerging markets of each strategy, core has the lowest risk and the lowest returns.
The core-plus style can seem close to opportunistic infra. This is driven by several factors, in particular the crowding of the core-plus trades, which have boosted prices, compressed discount rate and resulted in more significant capital gains for investors in this segment.
The cash yield of core-plus assets is also higher than that of opportunistic trades. Finally, more of the opportunistic segment is exposed to emerging markets where rates have been higher than in advanced economies, where very low rates further increased capital gains by contributing to lower market discount rates.
Core-plus and mid-market infrastructure turn out to have comparable risk profiles, but core-plus performed better historically also because of the capital gains realised on larger assets that meet the core-plus expected return criteria.
Realised vs expected returns
All strategies have benefited from a significant repricing over the past 15 years, which contributed significantly to their double-digit annualised performance over that period. This yield compression is universal across strategies: core expected returns, as measured from secondary market transactions, have fallen by almost 40 percent over the past decade, to less than 6 percent in 2021. Likewise, core-plus and opportunistic now exhibit expected returns of 8 percent+ and 12 percent+ respectively, down from 13.7 percent and 18 percent a decade ago.
Such strong historical performance is sometimes a source of confusion when looking at a benchmark for different strategies. Unlike stocks, for which the long-term mean reversion of the equity risk premium allows investors to use historical time series to build expected return views, unlisted infra is a new asset class which has been repriced since it became more popular with institutional investors. Fifteen years ago, infrastructure was cheap. The hurdle rates of equity investors, mostly large construction companies investing equity in their own projects, were also higher. Other investors in infra 15 years ago were pioneers. The asset class was opaque, liquidity/exits were mostly unknown, and senior debt was more expensive.
Today, the asset class is more de rigueur. Most large investors allocate explicitly to infrastructure and the demand for these assets has increased considerably. The market price of unlisted infra equity risk has declined accordingly, creating large one-off capital gains. Infrastructure is now priced for the institutional market, and is a better understood and increasingly better documented asset class. Hence, expected returns are now lower than realised historical returns.
Opportunistic strategies, with their higher risk exposures, deliver the highest cumulative performance while core has the lowest performance but with a comparable risk-return trade-off. Until 2017, the unlisted infrastructure equity risk premia (not shown) decreased steadily before stabilising. From 2018 onward, new cuts in interest rates added to previous capital gains. The market peaked in late 2019, first because of a steepening of the yield curve, and then in 2020 with the covid lockdowns, which impacted cashflows but also increased the unlisted infrastructure equity risk premia on a scale not seen since the 2012 euro debt crisis.
Since then, all strategies have returned to positive returns, with the strongest rebound in the opportunistic segment, with core-plus and mid-market close at about 8.5 percent expected returns in Q2 2021. Core can be expected to yield less than 6 percent (and even less in the renewables space).
The four strategies entail different exposures to the asset class. Table 3 shows their exposure to each pillar of The Infrastructure Company Classification Standard. Indeed, rather than sectors, which can include very heterogeneous assets, each strategy or style corresponds to a combination of asset-level characteristics.
Core is primarily made of ‘contracted’ businesses (companies that benefit from long-term revenue contracts). These are also mostly project finance vehicles (89 percent) and one-third is on the renewables space (wind and solar). Another third consists of transport PPPs.
Merchant assets, which are exposed to demand risk, tend to belong to core-plus (almost a third) and especially opportunistic styles (about half). Mid-market, in comparison, is a different style insofar as it includes as much merchant infrastructure as core-plus, but much more contracted and less regulated assets. Indeed, regulated assets tend to be large, hence they are found in core-plus strategies.
Core-plus and opportunistic also tend to include a larger share of corporates, such as utilities and airports, even though project finance constitutes at least 60 percent of the exposure to different corporate structures.
From a sector standpoint, as styles become riskier, the exposure to the transport sector increases from a third to more than 40 percent (and more of these transport assets are also merchant). The same is true of the power sector. Conversely, riskier strategies are less exposed to contracted projects such as renewables and social infrastructure.
Risk factor exposures
EDHECinfra considers five key risk factors which have been shown to explain the variability of the unlisted infrastructure equity risk premia from one deal to the next.
Looking at (book) leverage, table 4 shows that lower risk allows more leverage in infrastructure companies, with core having a median of 86 percent book leverage while opportunistic corresponds to less than 80 percent on average. Still, all infrastructure equity strategies imply a high exposure to leverage.
Exposure to larger assets is also a function of style – the average company size as measured by total assets more than doubles between core and opportunistic, but the largest outliers are found in the core-plus segment, where more regulated utilities are also found.
Exposure to country risk, as measured by the term spread, also varies significantly with, unsurprisingly, higher country risk exposure in opportunistic strategies.
Apart from leverage and size, the most significant discriminants between infrastructure investment styles are exposures to the profitability (return on assets) and the investment (capex) factors. Core investments are more profitable with a median ROA before tax of 10 percent. Mid-market is close to core infra in this case, with a median ROA of 9.2 percent.
Core-plus and opportunistic investment styles provide a lower exposure to profitability, with median ROAs of 7.6 percent and 3.2 percent on average, respectively. Indeed, opportunistic investments are more exposed to the investment factor, which is typically higher during the development or greenfield phase of infrastructure projects.
More analytics of infrastructure equity investment styles are available on the EDHECinfra platform.