A broad universe
Given that infrastructure investment comprises a range of assets, from renewable energy and pipelines to schools and hospitals, it can be helpful to break the sector into two illustrative groups: core and non-core.
Core infrastructure includes highly regulated assets that are not subject to changes in demand, have predictable revenue streams and are, effectively, a monopoly. Network assets such as electricity grids, water systems, transport links and telecom systems are good examples.
Non-core infrastructure is a broader category. It includes assets with more exposure to markets and demand and greater variability in revenue: think car parks, toll roads and renewable energy assets such as wind turbines and solar panels. Core assets in emerging market countries with shorter track records of providing such services may also fall into this group.
Diverse financial benefits and risks
Core assets can deliver stable and predictable income streams with low correlation to traditional asset classes. Many of these assets are concessionary, meaning that their income is linked to the number of hours they operate for. Such assets are described as ‘availability-based’, because the investor is paid for the asset as long as it is available and properly maintained. They tend to be less sensitive to changes in GDP, offering an element of resilience during periods of economic stress.
Non-core assets, on the hand, can offer a different risk/return profile. Take toll roads: we would expect a well-managed toll road, if purchased at the right price, to generate a higher return over time as compensation for the risk of depressed usage. This risk materialised during the lockdown as usage fell, although traffic volumes have started to recover in recent weeks.
Infrastructure investment is well placed for growth as economies move towards a low-carbon future. Investors seeking assets with tangible environmental and social benefits may wish to consider cleaner, more modern infrastructure projects, such as clean power generation. Renewables are expected to account for an increasing amount of electricity generation (see chart). Another example is the Thames Tideway Tunnel. This 15-mile-long sewer is set to intercept 94 per cent of the raw sewage discharged into the Thames, according to Thames Water, with considerable benefits to human and wildlife health.
Finally, infrastructure assets can provide an inflation hedge. Many offer cash flows explicitly linked to inflation through regulation, concession agreements or government contracts. Those without explicit inflation links may still be able to pass price changes onto customers, due to their strategic position and lack of competition, where it appears fair to do so. Companies in the sector may also benefit from soft inflation linkage through owning the real assets themselves, as their value typically, but not always, correlates with inflation.
Managing political and regulatory risk
While often less sensitive to some degree of financial risk, infrastructure remains vulnerable to political risks. In extreme cases, governments can nationalise assets below their market value. This is generally more of an issue in emerging markets, but it was important to consider the potential mechanics of nationalisation during the 2019 UK general election. Government intervention in companies is rising as a result of the pandemic, so investors in both infrastructure and other asset classes will have to find ways to navigate this kind of risk.
Many infrastructure assets, such as public utilities, operate within in a system of periodic regulatory reviews. Regulators establish the quality of the infrastructure to be maintained, which impacts company expenditure, and regulates the prices paid by customers. Any changes in regulation can also threaten the viability of future projects.
Project valuations are based on models which discount future cash flows, inflation and interest rate movements, sometimes over decades, into the present. They are sensitive to small changes in long-term assumptions. If any assumptions at acquisition prove too aggressive, investors may find themselves locked into a disappointing return. This makes initial due diligence critical. It is especially important to consider how the investment thesis may change in difficult or stressed scenarios.
Why consider infrastructure for a multi asset portfolio?
Within a multi asset portfolio, a strategic allocation to infrastructure can provide significant diversification benefits and, in a world of record low interest rates, an attractive level of income that may be relatively stable compared to other asset classes. In addition, its tactical appeal has risen in the current economic context. Nonetheless, as with any asset class, it is important to scale positions intelligently and understand the risks associated with the underlying investments. Given how varied the space is, allocating within infrastructure can be as critical as allocating to infrastructure.