What are Infrastructure investments?
Infrastructure as an asset class offers investment opportunities derived from the provision of essential services to society. These are typically characterized by asset-heavy, high-valued and hard-to-replace assets. The asset class has investment benefits which include:
- income and capital returns;
- mostly offers steadier and defensive return streams through contractual or essential services;
- diversification benefits versus other asset classes; and
- direct or indirect inflation hedging characteristic through CPI linked leases or pass through of costs.
Infrastructure investments can partake in secular megatrends such as
- Digitalization such as data centres and digital infrastructure;
- Decarbonisation such as energy transition;
- Deglobalisation such as transport and logistics; and
- Demographics including social infrastructure.
Infrastructure assets include a spectrum of risk and return from ‘super core’ to ‘core’, ‘core-plus’, ‘value-add’, ‘special situations’ and ‘opportunistic’.
Super Core
‘Super core’ infrastructure assets are very stable. A prime example is ‘social infrastructure’ assets which include hospitals, prisons, courts and schools. These have a long-term contracted revenue for availability that does not have any material sensitivity to the economy. The government, being the usual contractual counterparty, is very secure with revenue streams that are not dependent on economic factors. The infrastructure operator has minimal risks delivering on availability to pre-determined contractual service standards.
Core
‘Core’ infrastructure can include assets that may have some government or economic exposure to patronage such as a toll road, airport, electricity transmission or telecommunication tower network.
Core-Plus
‘Core-Plus’ infrastructure could be a ‘core’ asset with some ‘brown field’ expansion opportunity. For example, the Melbourne Citylink toll road was expanded by the operator following a proposal to the Victorian government.
Value-Add
‘Value-Add; infrastructure is likely to have some significant new construction risk, for example a new wind generation plant built from scratch as a ‘greenfield; project on approved land. This could also be a significant new construction adjacent to current assets. There is a construction / development risk premium expected for a ‘greenfield’ asset.
Special Situations
‘Special Situations’ can include new niche assets that will become the core assets of the future or a particular industry structure that makes that niche attractive. For example, data centres were a special situation a few years ago, however these have grown, aggregated and matured into core and core-plus assets once constructed. The returns can be significant as a new infrastructure type attracts early entrants prepared to take perceived additional risk.
Opportunistic
‘Opportunistic’ may include buying cheaply from distressed sellers, or when a sub-sector or geography is out of favour or less well understood. Experienced infrastructure investors are better able to identify, research, and diligence opportunities.
Returns
Apart from the categorization above, the size of infrastructure assets has another impact on returns, with very large institutions such as super funds and sovereign wealth funds dominating ownership. Large infrastructure managers recognise these investors are compelled to deploy very large amounts of capital and as such, will accept a lower return. An example of large investors is IFM’s Australian Infrastructure Fund which is $100m and has 600 institutional clients including their 17 super fund owners of IFM. At large sizes, you would expect:
- Super core returns to be in the 5% - 8%.
- Core infrastructure may deliver 8% - 10%.
- Special situations and opportunistic strategies may add 15%, 20% and potentially more returns.
Some infrastructure firms focus on middle-market and value-add opportunities. Middle market strategies can add at least 2% to expected returns and value-add through construction, development and operational improvement can provide additional returns. The spectrum may be from 10% - 15%.
Infrastructure funds can range from single asset to multi asset with a mix of sub-sectors and geography. A recent innovation has been a fund of fund which provides extremely broad diversification, however this can be offset by more modest returns.
Risks
Key risks are as follows:
- Valuation changes could be material, given that most infrastructure assets are very long dated and could be valued like an inflation linked bond. An initial interest rate increase may be offset over time by an uplift in inflation and associated revenues, but there could be a mismatch at times.
- A slower than expected rate of domestic and international economic recovery following periods of cyclical decline. Patronage risk and revenues in infrastructure assets may suffer more than expected in these periods.
- Delays in greenfield or brownfield growth capital programs stemming from regulatory body delays and barriers from poor community engagement.
Ideally a better return profile can justify costs of access, as better assets are more sought after and harder to access.
Position sizing should be considered depending on the risk profile of the individual and the composition of risks of other investments. Generally, a riskier investment should be sized less than a more stable investment.
Partners Private View
We believe that Infrastructure investments offer a differentiated return and risk character from other asset classes. There are strong defensive characteristics in Infrastructure not seen in too many asset classes, stemming from long term inflation linkages, provision of essential services, high barriers of entry and having hard to replace, capital intensive assets.
We believe that the optimal area to participate in for additional return enhancements whilst having an appropriate level of risk is in the middle market and core plus to value-add space. This strategy also has less sensitivity to interest rates (compared to a core strategy) due to the value-add return component which alleviates the effect of rising long-term interest rates and discounted rates.
The ability to have a strong operational expertise applied to the asset through in-house operating teams is a feature we look for in infrastructure managers.
Premiums we seek for middle market strategies are around 2% more than larger asset infrastructure strategies and development premium which can be an additional 2% - 5% for brownfield to greenfield developments.
