- 1 Global Infrastructure Industry Overview
- 2 Industry Outlook: What’s Ahead
- 3 Characteristics of Infrastructure Assets
- 4 Financial Characteristics of Infrastructure Assets
- 5 Key Infrastructure Sectors
- 6 Revenue Structures and Risk Profile
- 7 Risk Profile
- 8 Direct Investments, Co-Investments and Fund Investments in Infrastructure
- 9 Infrastructure and Inflation Protection
- 10 FX risk in Inflation
Global Infrastructure Industry Overview
Over the past decade or so, infrastructure has continuously emerged as a popular asset class and gained wider acceptance from institutional investors, who are now allocating a growing share of their portfolio to infrastructure. While infrastructure is considered with other private market asset classes such as private equity and real estate, what makes it different is its risk/return profile. Unlike private equity, where returns are generated by transforming businesses and achieving growth, infrastructure investments center around enhancing returns through core investment strategies that generate a long-term and often renewable stream of predictable cash flows, while reducing the risk of the broader portfolio. Another thing that makes infrastructure investing interesting is the variety of investment alternatives across the industry as well as different investment strategies and structures.
2017 turned out to be the one of the strongest years for the sector in history; 3,165 deals completed with an aggregate value of $916 B. Global AUM hit a record high of $418 B with an additional $150 B of available dry powder, also a new record for the industry. The strong financial performance of infrastructure made it the best performing private market asset class over one, three and five years. 2018 followed a similar trend, however, showed a slight slowdown from 2017 with the number of deals falling to 2,454. (Prequin 2018 Infrastructure Report)
Industry Outlook: What’s Ahead
2017 was one the best years infrastructure has had but the outlook looks even better. The 10-20 years outlook for infrastructure is extremely positive on the demand side, which is going to be driven by emerging markets; mainly India and China. Multiple forecasts have predicated a global requirement of $30-$40 Tn for infrastructure, of which more than 50% will come from emerging Asia. Increasingly, all the top global infrastructure investors are raising funds in India. Why is Asia so hot for infrastructure in particular? First, Asia is urbanizing faster than any other region in the world. Over 60% of the worlds’ population is in Asia, but currently only close to 50% of the Asian population lives in urban areas. This number is expected to grow to the 70% in the next 30 years, which will mean a greater need for urban infrastructure. Due to limited domestic capital, this demand will have to be met by private foreign capital. Another factor driving infrastructure demand will be environmental focus on clean air and water and increasing demand for renewable energy and modern and sustainable transport.
On the supply side, most investors are seeing the attractiveness of infrastructure and are not just below their target allocations, but are looking to significantly increase these allocations. Furthermore, infrastructure fundraising has also been at record high over the last 2 years, indicating that the supply side can continue to keep up.
However, despite the positive outlook, the industry does face a couple of major challenges, the main one being high asset prices. With increasing target allocations, new funds entering the market, and dry powder reaching record high levels, there is intense competition, especially for core infrastructure assets. With such strong interest and high returns, it would be surprising is asset prices are not high. The concern here is that entering at such high valuations makes it difficult for investors to make attractive returns. Another concern is the increasing regulation from the public sector as well as the increasing commitment to ESG principles, especially in emerging markets. With increasing private sector infrastructure investments in Asia, governments are now going to be taking a more proactive approach to regulate and oversee the sector, which will pose various challenges for private investors that we might discuss in another article.
Characteristics of Infrastructure Assets
Infrastructure assets are essential for the functioning of any inhabited region. These are some of the key features that define infrastructure and make the asset class attractive:
- Barriers to Entry: Strong barriers to entry is one of the biggest advantages of most infrastructure assets. Infrastructure assets are generally protected from competition for the asset’s users. This protection can come in various forms but most commonly arises due to some sort of agreement with the government. For example, monopoly granted by the government to a water or electric utility company or restrictions on granting new contracts for airports, toll roads, railways under concession agreements with companies that currently operate such infrastructure. Also, another reason it is difficult to enter the infrastructure space is due to the initial capex and time horizon required to get such assets started. Few firms are able to deploy such capital.
- Inelastic Demand: Infrastructure assets are essential for the functioning of society and thus the demand to use these assets fluctuates very little with changes in prices. The demand for infrastructure assets while inelastic, is not perfectly inelastic. In other words, the demand will change with an increase in price (except for absolutely essential assets with no substitutes), however, the degree of change will be relatively less compared to the price and will depend on how the demand curve for that particular infrastructure asset looks like.
- Economies of Scale and Low Marginal Cost: This is self explanatory; the marginal cost of each additional use of the asset is very low for the infrastructure company. For example, the marginal cost of one additional vehicle on a toll-road is almost negligible for the operating company.
- Long Life of Assets: While this may vary substantially from asset to asset, most infrastructure assets can be used for years with minimal maintenance capex relative to the initial construction and development cost. For most infrastructure assets, there is a long period before any major replacements / repairs are required.
However, there is one key risk to note here. In today’s fast paced world that is being driven by technology, new developments and innovations as well as other factors can change the dynamics under which the infrastructure sector has operated in the past, in which case, the above-mentioned competitive advantages of infrastructure may be minimized or compromised.
Financial Characteristics of Infrastructure Assets
While financial characteristics of infrastructure assets can vary by revenue model and sector, there are some financial characteristics that are common to most infrastructure assets, which can be helpful to mention during interviews.
Steady Revenue: Highly stable and predictable revenues due to regulation, concession agreements, or unchanging usage patterns. While regulated and contracted revenue models will have more stable and predictable cash flows than patronage and merchant structures, even the latter two are fairly stable due to high demand and unchanging usage patterns for such services. The different revenue structures are discussed in detail later in the article.
Low Operating Costs as % of Total Revenue: Most infrastructure assets have a negligibly low marginal cost for each additional use. Operating expenses comprise of a very low percentage of revenues and therefore EBITDA margins for infrastructure assets are commonly in the range in 50% – 80%, which is substantially higher when compared to many other businesses.
Capital Expenditures: Unlike a lot of other businesses that have consistent, ongoing capex needs, infrastructure assets have irregular and inconsistent capex needs that are mostly project based. However, while irregular and of varying amounts, capex for infrastructure assets is still fairly predictable as operators generally have an idea of when they might commission a new project.
Debt and Interest: Due to stable revenues and high EBITDA margins, infrastructure assets generally have high levels of leverage and interest costs. Leverage multiples such as Debt / EBITDA are generally higher for infrastructure assets when compared with other businesses.
Key Infrastructure Sectors
Infrastructure is so broad in nature that it can be classified into several dozen sub-sectors, however, most of the sub-sectors will fall under these 4 categories:
- Energy and Utilities: All transmission and distribution networks for gas, water, electricity etc. would come under this category. These assets usually enjoy a monopoly within a particular area, which is usually directly granted by the government or secured via a license or contract with some other regulatory body. However, since the companies operating such assets operate as a monopoly, they are often exposed to substantial regulatory oversight as well as partial government control in some countries. This is to prevent them from acting as a monopoly while securing supply by relieving the operator from competition.
- Transportation: Includes airports, railways, toll-roads, etc. Protected by concession agreements and geographical restrictions imposed by the government.
- Social Infrastructure: This subset of infrastructure includes assets that accommodate social services. These include, healthcare (hospitals and medical facilities), education institutes, housing, key utilities, general region infrastructure (bus stops, roads, parks), corrections and justice, etc. These assets are generally commissioned by the government based on need and private companies may play a role in operating these assets. These assets are also suited best for PPPs (public-private partnership) where the government provides the asset and the private party bears operates and manages the asset. However, in a lot of countries, private companies also own a percentage of the assets under PPPs.
- Communications: Whether or not to put communications under infrastructure is debateable. Broadcast and wireless network services require a lot of infrastructure in place to operate, which makes it difficult for players to enter the space. However, this sector, in particular telecommunications has significant competition, which sets it apart from other sub-sectors in infrastructure. The market structure for communications can be best described as an oligopoly as each geographic market is dominated by a handful of players.
Revenue Structures and Risk Profile
- Regulated: Assets under this structure are subject to significant government regulation. While the operations and management of the assets may be handled by private companies or by both the government and a private company, the government plays a greater role in determining consumer prices, quality of service and economic returns earned. Regulated assets generally operate as a monopoly. Depending on the structure of the agreement between the government and the private sector party, the revenue from the asset can solely go to the private sector party or be shared with the government under a PPP agreement. This agreement can depend on several factors and varies drastically with sectors and geographies. Water and energy utilities are generally regulated.
- Contracted: Contracted assets benefit from strong stable cash flows underpinned by long term contracts. These assets are generally contracted by the government / regulatory bodies to private sector companies with minimal government supervision once the contract is in place. Due to minimal government regulation and regulatory oversight, these assets face significant counterparty risk, in particular, counterparty credit risk. Due to the long-term nature of contracts, cash flows for these assets tend to be more predictable and therefore may have a lower discount rate. However, we will discuss this a little later.
- Patronage: Revenue for these assets varies with usage. Most common examples of such assets include transportation assets such as toll-roads, airports, seaports etc. Assets such as toll-roads and railways levy charges for each use, whereas some assets, such as airports do not levy charges for each use but earn revenue through rent and service revenue. Cash flow / financial performance of assets following this structure is most correlated to economic indicators such as GDP and population growth rates. However, usage levels of some assets are less sensitive than those of others. For example, metropolitan airports are exposed to only limited fluctuations in usage levels under a number of different scenarios, whereas, smaller regional airports face a lot more fluctuation. These assets are also exposed to market cycles and trends more so than other assets. For example, usage of airports can be driven by trends in leisure travel industry or tourism industry.
- Merchant: Revenue generated from these assets is dependent on the current market price of the services. Revenue from these assets is most variable due to their dependence on market prices. Uncontracted power generation is a good example of the merchant model.
The revenue structure of an infrastructure asset plays a key role in determining its risk profile. In general, all else being equal, assets with regulated and contracted revenue structures will see slightly lower discount rates when compared to assets that have patronage or merchant structures. However, revenue structure is not the only factor that drives risk and therefore there can be cases where patronage assets might have lower discount rates than that of contracted or regulated assets in the same sector and geography.
Other factors that drive the risk profile for infrastructure investments include:
Leverage: Just like in any other business, leverage is a key risk in infrastructure. Unlisted infrastructure investments will generally have higher interest rates and can pose substantial risk for investors if leverage levels are not aligned with the assets revenue generation abilities.
ESG, Political and Regulatory Risks: Before going through with any infrastructure investment or infrastructure project, it is absolutely essential to diligence these risks in detail. Typically, all the mid-sized and large infrastructure funds would work with an ESG advisor to diligence these risks. Certain infrastructure projects may involve a lot of construction, which may cause a harm to the environment and social community of that area. It is important to diligence the environmental and social impact of the infrastructure project as there can be massive fines in case of any violations. Shifts in policies and regulations might pose opportunities but can also pose significant threats in case there are adverse changes in regulations, concessions and tariff agreements. Therefore, it is important to understand the current governments’ or the potential governments’ (if applicable) stance towards regulations in a particular sector. All these factors play a significant role in determining the risk profile of an asset. An infrastructure investment in emerging markets like Brazil and India will have much higher political and regulatory risk when compared to an infrastructure investment in the US or Canada.
Risk profile can be further broken down based on stage of development:
Greenfield Projects (Early-Stage): Greenfield projects are those for which plans have not been drawn out or only a basic outline of plans has been made. However, the decision to proceed with the project has been made. This type of project has significant risk. Some of these include construction risk, capex overruns and approval and regulatory risks. Furthermore, setting up a revenue structure and various agreements with different stakeholders involves several steps and a significant amount of time, which adds to the uncertainty. Projects in this stage are the riskiest projects.
Greenfield Projects (Late-Stage): This category is also called greenfield but includes projects that are in a further stage of development. These projects include those for which plans have been developed and approved by the necessary stakeholders. This reduces the risk slightly. Typically, projects in this stage have also gone through the process of setting up revenue agreements / structures. However, there is still significant construction risk and ramp-up risk associated with these projects.
Brownfield Assets: Brownfield assets are those that are currently operating and generating revenue. These assets might have scope for further expansion but will require significant capex. In terms of risk profile, since brownfield assets are already operating and generating revenue, they tend to be viewed as the least risky and therefore might have lower discount rates than greenfield projects.
Direct Investments, Co-Investments and Fund Investments in Infrastructure
Direct investing simply means the purchasing of ownership in an infrastructure project / asset / company by an investor. Direct investing involves making investment into a specific asset. On the contrary, investing as an LP into a fund is different as the fund might invest in 10 different assets and thus the LP’s exposure would be diversified by all the assets in the fund’s portfolio. Direct investing requires the most involved execution and full exposure to the performance of a specific asset. These investments can vary in terms of amount of ownership acquired. In infrastructure, direct investors with majority ownership would typically take responsibility of operating the asset by either hiring management teams or keeping the existing management teams in place. Direct investors typically have high operational expertise and know how.
Co-investments can be broken down into two categories: direct co-investing and LP co-investing. Direct co-investing basically means investing with another investor or group of investors. In other words, it is just another way of executing direct investments. Such deals are also known as clubbed deals. Clubbed deals are pretty common in infrastructure as cheque sizes to acquire substantial infrastructure assets can be quite large. Furthermore, a lot of investors prefer to acquire minority stakes along with other investors to reduce their exposure as well as benefit from the knowledge and expertise of other investors. LP co-investing can get a little more complicated, but at a high level, it means that a fund’s LP makes a minority investment alongside the fund, directly into a transaction. Generally speaking, only LPs with the largest commitments or strong relationships with the GP are offered this option.
Fund investments, as already stated above, involve investors investing into a fund as LPs and the fund executing transactions using the capital contributed by the LPs. Fund investments provide LPs with exposure to all assets in the fund’s portfolio and are therefore a good route for investors that are looking for diversification. Increasingly, fund investments are also being used as a vehicle by institutional investors to access new markets. It is easier for institutional investors to invest in a fund that already has experience in a market they’re trying to enter vs them trying to make direct investments in a new market. This way, investors can get a sense of the new market and benefit from the knowledge and expertise of the fund, before making direct investments themselves.
Infrastructure and Inflation Protection
Infrastructure assets have an additional benefit in that they offer inflation protection to investors. Most infrastructure assets offer inflation protection but the degree of protection varies by asset. Regulated and contracted assets have an explicit link to inflation in the form of regulation and concession agreements respectively. Other assets may not have an explicit link to inflation but often have the pricing power to deliver a similar or better outcome.
Contractual provisions allow asset owners to pass through inflation through higher rents, toll rates, etc. This is possible as the demand for these assets is generally not very sensitive to price. Regulated assets also generally allow for price increases that are tied to inflation. However, not all infrastructure assets are equally effective in providing inflation protection. Unregulated sectors such as airports and trade and transportation sectors that experience demand fluctuations due to economic cycles are not as effective as regulated and contracted assets when it comes to providing inflation protection.
FX risk in Inflation
FX risk is another factor that global infrastructure investors need to keep in mind. Ultimately, all returns will have to be converted back to the investors home currency and the value of assets will also be calculated in the investors’ home currency. However, an investor might have investments around the globe. Changes in exchange rates with the investors’ local currency will impact the returns as well as the value of assets which are denominated in other currencies. This is a significant risk and can have a major impact on returns in case of any major exchange rate fluctuations. Of course, investors can protect themselves against this risk by hedging. However, protection through hedging comes at a cost and therefore investors need to analyze the benefits of hedging vs its cost. To do this, investors need to be on top of macroeconomic trends to understand the exchange rates between their home currency and the other currencies they are exposed to.