Vauban: All eyes on core

This article is sponsored by Vauban Infrastructure Partners

How have you seen the market evolve in terms of the emergence of clearly defined core and value-add strategies?

Vauban launched its first brownfield core infrastructure strategy back in 2014. Going to market with a 25-year yield-driven fund at that time, we were initially greeted with surprise. Back then, all infrastructure investment was lumped into a single bucket. You had the higher-risk development plays at one end of the spectrum, and the brownfield acquisitions of toll roads or hospital PPPs at the other end. All these came under the same broad umbrella, but, of course, those are two very different types of assets.

Since then, we have seen the emergence of other dedicated core strategies. This has become a well-understood approach, which we see as a tribute to our own early moves almost 10 years ago.

There is now clear differentiation between core infrastructure and what has become known as value-add. At its simplest, a value-add strategy pursues growth and capital gains, while core is primarily focused on downside protection, cash yield and a long-term investment horizon.

It really is two different sub-classes of assets co-existing within the infrastructure space, and so we believe this evolution has been positive for the industry.

In addition to the clear dichotomy that is core and value-add infrastructure, a number of other descriptors have emerged in recent years. Is there any real difference between core and super-core, for example, or between core-plus and value-add?

In my opinion, no. There are clear differences that distinguish core from value-add from an investor’s perspective. Either the investor is looking for growth, capital gains and outsized returns, in which case they will focus on value-add, or they are looking for downside protection and yield, in which case they will focus on core.

You can readily identify differentiated core and value-add investment opportunities in each infrastructure sector. In social infrastructure, for example, you may target PPPs where you own and maintain the asset but are not responsible for providing services. That’s core. Or you may target private clinics or care homes, where you are also providing clinical services, so there is a higher risk-return profile.

Similarly, with fibre, there are the core concession-based investment opportunities that we focus on, but there are also opportunities at the upper end of the risk spectrum in Germany and the UK, for example, where it is more of a land-grab situation.

Super-core and core-plus, however, are more marketing techniques than anything else. You do see super-core funds, but they tend to focus purely on utilities, for example, and I think that makes them over-specialised and over-concentrated on one particular type of risk-return profile that by nature makes the overall fund strategy less protective and less ‘core’.

Diversification is a key element to building a resilient fund portfolio, as we all had a chance to observe during the recent pandemic crisis; it is indeed critical for core strategies because of the emphasis on downside protection. As a core manager, we look at PPPs and regulated utilities, but we also look at long-term private offtake contracts with solid counterparties and concession schemes. That diversity of revenue stream is extremely important.

Core-plus is even more challenging to define. You could say that it is core with embedded growth. But ultimately, this all comes back to the way that the manager is making its return.

If you are generating the majority of value through the capital gain you achieve at exit, it is a value-add strategy. If you have a long-term, yield-driven approach, with a focus on downside protection and on the resilience and low volatility of returns, it is a core strategy. I don’t think the additional terminology that has emerged is particularly helpful.

Does the focus on capital gain vs yield inform the role of asset management in core and value-add strategies?

There is a commonly held misconception that core assets are boring and core investment is just about buy and hold. The reality is that these are fascinating assets, and because they are providing essential services and because they have multiple stakeholders, they are very complex assets to manage.

The first pillar of core asset management involves a structured approach to managing stakeholder engagement. The second involves optimising the capital structure, which is more important than ever in the current environment. We are very focused on financing and refinancing our assets with long-term debt solutions with fixed or swap rates. It is not about maximising leverage, but rather about maximising the maturity of our financing structures so that they match the long-dated and core nature of the assets.

We also have the ability to build platforms by combining assets and therefore creating synergies, as we have done in the fibre space and as we are currently doing with railcars. We work with experts to improve operational efficiencies. For example, we have made 30 percent operating expense savings at French highway A28. We also have ongoing capital expenditure efficiency programmes in our electricity transmission assets in the Nordic region that are creating a lot of value.

Finally, there is always the opportunity to generate additional sources of revenue. For example, we have repurposed the first floor of some of our city-centre car parks into last-mile logistics warehouses, as well as implementing a lot of EV charging slots. This is not only adding value, but also matches our carbon footprint reduction objectives – we have set targets for our car park assets to be carbon neutral by 2025. In short, there is a lot you can do with asset management within a core infrastructure strategy. Asset management is not the exclusive domain of value-add funds.

How do you believe both core and value-add infrastructure are likely to fare in a more volatile, inflationary and high interest rate economic environment?

In theory, both core and value-add infrastructure should perform well across economic cycles because infrastructure assets provide essential services and so are relatively insulated from the broader macro backdrop. Clearly, there is a greater focus on downside protection with core assets, and revenues tend to be linked to the consumer price index. Around 90 percent of Vauban’s assets’ revenues correlate with CPI. If you then also secure long-term financing on assets, a rise in interest rates should not impact portfolio company valuations. So, I definitely think core infrastructure will prove a safe haven for investors in the months to come.

Meanwhile, there is still a lot of room for growth in the value-add infrastructure space as well, driven largely by those underlying decarbonisation and digitalisation mega-trends. Those value-add firms that have done their jobs well will continue to generate strong returns in the current environment.

However, when the tide goes out, we will see who has been swimming without any trunks on. There are managers whose performance has largely been based on the re-rating of the markets and decreasing interest rates. In a rising interest rate environment, we will be able to see who has really been adding value and who has just been benefiting from market trends.

Against that backdrop, how do you expect LP appetite for the two strategies to evolve?

I certainly feel that within private markets, it will be real estate and private equity that suffer more than infrastructure in this new cycle. Some LPs are already feeling the denominator effect and are finding themselves over-allocated to those asset classes. However, I believe that allocations to infrastructure will continue to increase and, due to the importance of diversification, I believe investors will want exposure to both core and value-add strategies.

In most cases, they will have started out with core and progressed to value-add. In some cases, they will have started with value-add if they were investing out of their private equity bucket. But both will continue to be in demand as LPs that are already invested with core managers look for additional returns in the value-add space, and as others that are under-allocated to the asset class – or else started out in value-add – increase their core exposure.

Of course, core funds will be in favour in a period of economic uncertainty, while investors will continue to prioritise resilience, downside protection and inflation linkage, as well as the stability and low volatility of returns provided by the ‘core’ strategies. I therefore believe that core infrastructure fund managers should benefit from the strong momentum in current market conditions, but longer term I expect appetite to remain strong and balanced for both core and value-add strategies.

What sorts of core infrastructure investment opportunities are you seeing within the various sectors where you operate?

We see a huge range of opportunities across the four main sectors of infrastructure: mobility, social infrastructure, digital infrastructure and the energy transition. Indeed, the digitalisation and decarbonisation mega-trends, in particular, are driving an enormous amount of investment need in all four areas.

For example, we are currently doing a lot of work in the European railcar sector, where there is a strong need to drive decarbonisation by moving more freight from road to rail, and where the incumbent transport operators are facing financial difficulties and seeking private capital to maintain and develop their fleet. We have created a platform, Rhine Rail Investment, to build out our exposure to this sector, initially taking Aves One private last year and then acquiring the family-owned Wascosa in June 2022, which is active in more than 20 European countries and has a fleet of more than 15,000 wagons.

Another sector where we see a lot of really interesting core investment opportunities is fibre. We particularly like the deployment of fibre in France, where there are dedicated concession schemes that are well suited to core strategies because they offer a contractual monopoly. We started out focusing on fibre concessions in rural areas, but have also now built exposure to mid-density and urban areas. We then brought all of these assets together into a new, mutualised platform called Vauban Infra Fibre, which is now the largest national independent broadband platform in France.