Boe Pahari summarises the market drivers that have created a strong environment for investing in infrastructure, and how investors can navigate challenges and take advantage of opportunities being created.

An overview of the macroeconomic Context

Valuations and leverage increased steadily from the aftermath of the GFC until the end of 2021 due to (i) the global liquidity cycle (quantitative easing, low rates), (ii) an overall stable environment (low inflation, global growth, shrinking risk premium) and (iii) more capital flowing into private markets.

However, following a series of interrelated issues such as, supply chain congestion, rising cost of materials, the conflict between Russia and Ukraine, spiking energy prices, and a burgeoning food crisis, the macroeconomic backdrop has gradually changed into 2023 with high inflation, rising interest rates, and reduced GDP forecasts. In this environment, we are seeing valuations come down from their previous peaks. We expect this to have a negative impact on existing infrastructure portfolios; as a new manager we perceive this environment as optimal for acquisitions and establishing a portfolio of new assets.

As the macroeconomic environment seeks to revert to its new normal, we envisage that significant volatility and uncertainty will continue to be observed over the near term in this journey. However, we believe that this will also present unique opportunities, however, as investors are able to price risk appropriately and successfully allocate capital to sectors and assets that are well placed to capitalise on the global megatrends as well as ‘fill the funding gap’ where there is significant market dislocation.

In response to the macroeconomic environment, debt markets are widely expected to slow down with liquidity and lending to generally tighten, possibly resulting in increased credit margins. Assets with greater levels of leverage in place today, particularly in the Core and Core+ space could be susceptible to refinancing risk, if base rates and credit margins move unfavourably, and leverage reduces. The Infra PE strategy involves a conservative level of leverage. Furthermore, we believe that the risks associated with the debt slowdown will largely impact established portfolios with legacy debt issues.

We believe our Infra PE strategy is well positioned to be both insulated over this period, and to be able to capitalise on opportunities. In our view, assets with inflation-linked revenues will be able to bed used to offset higher costs and preserve real returns. In particular, assets with defensive characteristics, such as barriers to entry, contractual revenues, significant market presence and those that are essential to modern living are well protected from a sharply rising inflationary environment. Whilst wage growth has also experienced a sharp increase, unemployment continues to remain low and we expect the continued upskilling of the workforce coupled with automation will provide an opportunity to drive improved profitability. For example, education and healthcare are strong defensive sectors, yet are also sectors that we believe present a significant opportunity in terms of transitioning to technology- centric businesses as opposed to the conventional labour-intensive model.

Significant market dislocation has occurred in various sectors as a result of the pandemic and ensuing economic environment. We believe that this, presents unique opportunities as capital is allocated in a disciplined way over the investment horizon period as these assets return to their prior long-term average in terms of profitability and valuation levels. For example, within the aviation industry, sub sectors such as ground handling have been significantly impacted yet remain an integral part of the industry, business models such as ground service equipment pooling and leasing not only free up the balance sheet for ground handlers and provide a more demand driven cost profile, they also provide access to latest generation of equipment and access to automation that can alleviate some of the labour shortage challenges.

However, following a series of interrelated issues such as, supply chain congestion, rising cost of materials, the conflict between Russia and Ukraine, spiking energy prices, and a burgeoning food crisis, the macroeconomic backdrop has gradually changed into 2023 with high inflation, rising interest rates, and reduced GDP forecasts. In this environment, we are seeing valuations come down from their previous peaks. We expect this to have a negative impact on existing infrastructure portfolios; as a new manager we perceive this environment as optimal for acquisitions and establishing a portfolio of new assets.

As the macroeconomic environment seeks to revert to its new normal, we envisage that significant volatility and uncertainty will continue to be observed over the near term in this journey. However, we believe that this will also present unique opportunities, however, as investors are able to price risk appropriately and successfully allocate capital to sectors and assets that are well placed to capitalise on the global megatrends as well as ‘fill the funding gap’ where there is significant market dislocation .

In response to the macroeconomic environment, debt markets are widely expected to slow down with liquidity and lending to generally tighten, possibly resulting in increased credit margins. Assets with greater levels of leverage in place today, particularly in the Core and Core+ space could be susceptible to refinancing risk, if base rates and credit margins move unfavourably, and leverage reduces. The Infra PE strategy involves a conservative level of leverage. Furthermore, we believe that the risks associated with the debt slowdown will largely impact established portfolios with legacy debt issues.

We believe our Infra PE strategy is well positioned to be both insulated over this period, and to be able to capitalise on opportunities. In our view, assets with inflation-linked revenues will be able to bed used to offset higher costs and preserve real returns. In particular, assets with defensive characteristics, such as barriers to entry, contractual revenues, significant market presence and those that are essential to modern living are well protected from a sharply rising inflationary environment. Whilst wage growth has also experienced a sharp increase, unemployment continues to remain low and we expect the continued upskilling of the workforce coupled with automation will provide an opportunity to drive improved profitability. For example, education and healthcare are strong defensive sectors, yet are also sectors that we believe present a significant opportunity in terms of transitioning to technology- centric businesses as opposed to the conventional labour-intensive model.

Significant market dislocation has occurred in various sectors as a result of the pandemic and ensuing economic environment. We believe that this, presents unique opportunities as capital is allocated in a disciplined way over the investment horizon period as these assets return to their prior long-term average in terms of profitability and valuation levels. For example, within the aviation industry, sub sectors such as ground handling have been significantly impacted yet
remain an integral part of the industry, business models such as ground service equipment pooling and leasing not only free up the balance sheet for ground handlers and provide a more demand driven cost profile, they also provide access to latest generation of equipment and access to automation that can alleviate some of the labour shortage challenges.

Supportive government policies for infrastructure investing

Governments continue to recognise the importance of infrastructure in order to stimulate growth as well as to minimise social division. During the Covid-19 pandemic, the wellbeing of societies was severely impacted with healthcare systems significantly stretched and a greater push towards working from home creating an instant need for improved digital connectivity. Furthermore, the energy transition agenda is of increasing importance for governments and requires substantial investments in order for aspirational targets to be met.

In recent years, several governments have announced economic stimulation packages, many with a dedicated focus on infrastructure and its importance in relation to economic growth and energy transition. In the European Union, the European Green Deal (Sustainable Europe Investment Plan) was launched. This seeks to mobilise at least EUR 1 trillion in sustainable investments over the next decade and create an enabling framework to facilitate sustainable investments. The US has approved its USD 1.2 trillion bipartisan Infrastructure Investment and the Jobs Act and the Inflation Reduction Act which includes a USD 0.4 trillion budget for energy and climate change projects. Other countries across the globe are also announcing similarly ambitious economic programmes.

Infrastructure has historically provided compelling returns (see section 3.3.1) and can offer a high degree of downside protection. Despite the shifting rates, VE1 believes that infrastructure investments are well positioned for a resilient performance through macroeconomic cycles.

As a result, we see this as a once in a generation opportunity to acquire companies in relevant sectors, at attractive valuations given the current environment in the equity and debt markets, as well as the macroeconomic scenario.

A maturing asset class with historically strong performance

Historically, infrastructure as an asset class has provided attractive and resilient returns for investors. Due to its essential nature and structural demand, infrastructure investment can offer a high degree of downside protection, attractive cash yield, and low volatility. Since 1998, unlisted infrastructure has provided an annualised return of 14%, which compares favourably to global equities and listed infrastructure with an annualised return of 7% and 5% respectively. During the last ten years, unlisted infrastructure has delivered an annualised return of 12%, while global equities have returned 13% on an annualised basis. However, the annualised volatility of unlisted infrastructure was lower compared to that of global equities and listed infrastructure thus supporting an attractive risk-adjusted return profile. The slightly lower ten-year return compared to the return since 1998 suggests that infrastructure as an asset class is maturing and being increasingly adopted by investors. 1 As such, many infrastructure assets are increasingly exhibiting a commoditised risk/return profile and becoming core infrastructure. Higher risk-return strategies, such as Infra PE or Infra Growth, typically invest at an earlier stage in the cycle and thereby enable the potential of additional alpha to investors compared to core infrastructure.

Attractive Asset Pricing

As more capital has flown into private infrastructure, the asset class has matured, and consequently, asset pricing has levelled. Some assets in certain sectors have experienced substantial price increases, whereas others have been more stable. According to ‘Preqin Investor Outlook: Alternative Assets’, as of June 2020, 64% of the surveyed investors cited asset valuations as the key challenge for return generation in the next 12 months. As of June 2021, this number was down to 41% of the surveyed investors. Further, 68% of the surveyed investors also stated that they considered asset valuations were fairly valued or undervalued as of June 2021, up from 53% as of November 2018.

Insufficient Private Infrastructure Capital Available

In 2021, infrastructure managers globally raised an aggregate amount of capital of USD 123 billion 2 , which exceeded the previous record of USD 118 billion raised in 2019. Despite the increasing capital inflows, deployment remains robust with dry powder (capital available for deployment) at a stable level of around 36% of assets under management during the last five years 3 . A substantial share of the capital raised is utilised for making acquisitions and facilitating mergers of infrastructure businesses 4 . In 2020, private investment in infrastructure in secondary markets totalled USD 412 billion. 5 However, with an annual demand of USD 4 trillion 6 from both public and private sources, the amount raised in 2021 still seems far from sufficient to close the gap.