In an inflationary era, with rising interest rates and a war in Europe, investors can be forgiven for questioning their conventional methods and definitions of investments within their portfolios. Many investors, even before the economic turmoil of a pandemic, were already anticipating market corrections and, according to a McKinsey & Co. article titled “Institutional Investing in the Time of COVID-19,” they were embracing risk-factor approaches to portfolio construction. The article notes, “Those who implement these approaches do so largely because they believe that the promise of diversification failed in the last crisis, and that diversification across macro risk factors — equity risk, inflation and rates, for example — is the right way to diversify.”
For investors, that diversification can come in many forms, and for our purposes it comes in the form of infrastructure investments. However, what was once considered core (bridges, airports and roads) is changing and evolving. The diversification of the portfolio, even within infrastructure, is expanding to many other areas. One important effect of this, and this has been true for infrastructure investing and things such as private equity, is that competition is growing for these assets. With competition comes even further expansion of the definition of infrastructure to meet new needs, as well as rising prices.
Managing risk is a main driver for institutional investors seeking to “proof” their portfolios. According to the Natixis 2022 Global Institutional Investor Outlook survey of 500 institutional investors from 29 countries, 69 percent of investors say inflation is a top portfolio risk for 2022. Interest rates, valuation, volatility and ESG issues round out the next four reasons for policy risks, according to investors.
With definitions within portfolios changing and risks shifting with world affairs and economic cycles, how can investors and managers navigate the current market and keep portfolio objectives on track?
EVOLUTION VS. CHANGE
Although the definition of infrastructure is changing, it has been doing so at a gradual pace. Some say it is more of an evolution than a drastic change. “With new technologies and business models gradually maturing, we anticipate growing interest from private infrastructure investors in emerging infrastructure sectors,” notes Jane Seto, partner, portfolio manager and head of asset management at DWS Infrastructure. “This will lead to an expansion of the asset class across a broader set of strategies and risk/return propositions aimed at complementing existing infrastructure portfolios of core and core-plus infrastructure. We already notice acceleration in fundraising for thematic infrastructure funds in sectors related to energy transition with focus on sectors such as renewables, energy efficiency, hydrogen, sustainable transport, and smart cities infrastructure,” explains Seto.
“Nevertheless,” she adds, “from our perspective, although the asset class may be broadening, and more emphasis may be required at the portfolio level rather than for individual assets, our definition of infrastructure does not change fundamentally.”
Interestingly, the evolution of infrastructure as an asset class and the demand for the diversified characteristics infrastructure offers are creating an influx of capital in the sector, says Gregory Smith, president and CEO of Instar Asset Management. At the same time, this evolution is creating greater opportunities to meet shifting societal and environmental needs. Despite higher capital and infrastructure rates more broadly, when contrasted with the risk-free rate during the past two decades, infrastructure is still competitive and offers attractive risk-adjusted returns. “There is definitely more liquidity in the marketplace, and we are definitely seeing rising prices, but in a lot of areas we are still seeing good value opportunity because the equity risk premium is better today than it was 20 years ago,” says Smith.
With that, Smith adds, infrastructure over the same period of time continues to evolve as an asset class, helping businesses operate and adapt through macro conditions impacted by government policy, technology, regulators, climate change and more. In the early days of infrastructure investing — around the beginning of the 2000s — investors would invest in areas heavily concentrated with regulated assets, such as transmission lines. But infrastructure has to be allowed to evolve, Smith argues. For example, as policies, public sentiment, technology and environmental concerns shift in real time, we have seen the most attractive renewable resources for investors evolve, from wind power to solar energy, and now to opportunities found within bioenergy.
Declan O’Brien, head of infrastructure research and strategy at UBS Asset Management, agrees. “Clearly what the market was then was a lot of PPP, regulated utilities and large monopolistic assets, but that kind of infrastructure is not being built in the same manner that it was back then,” he notes. “The composition of assets has changed, but that’s not to say that the risk is higher or the features are different … where we used to invest in utilities, and now invest in subsidized renewables, we can generate stronger returns than a big gas-fired generator, in our view.”
WHAT IT MEANS
Jan Mende, a senior vice president in Callan’s real assets consulting group, says that portfolios are changing to expand into other sectors, and more capital is chasing more opportunities, which may be driving prices up with increased competition for assets. It used to be investors would have transport, energy, renewables and utilities investments; now they have added a communications bucket to the mix, and are spanning many more sectors (e.g., energy transition) than they did before. The interesting thing is that some funds are being very specific.
“We’ve had some funds focus only on digital/communications-type assets, where they are sector specialists, or a lot of funds only focused on renewables,” says Mende. “So, we’re seeing more funds come to market with a specialist strategy than we did 10 years ago, but investors are also continuing to deploy capital with diversified managers that can construct a portfolio based on the best risk-adjusted returns.” She adds, assets that are involved in the digital/communications sector tend to be more growth-oriented, and some managers are more bullish on that and expect a higher return from the associated growth in the sector. Other managers see that sector as too competitive and, therefore, some core managers are not active in that sector because it does not benefit from the same defensive characteristics as other core investments.
Smith agrees and says 20 years into the asset class being more mature, there is more definition among the managers, similar to real estate funds, which can include focuses on commercial, mixed-use, industrial or residential real estate. “Infrastructure is going to increase in its level of complexity,” he stresses. “Over the last few years, sector-specific funds have already begun to emerge, separating into sectors like water, digital, mid-market, core-plus or value-added. The nature of what infrastructure is investing in, and the nature of those managers, will become more defined, and you’ll see more specialization as you see infrastructure evolve as an asset class.” He goes on to say there will be a more robust selection, as all investors allocate more capital to infrastructure investments.
Other investors see the change in policies and attitudes, and they utilize their experience to meet new opportunities. Seto says, “What we see now is that European regulation is contributing to changing the investment landscape, with decarbonization policies deepening the investment pipeline further, while also providing investors with solid long-term regulatory visibility on emerging infrastructure sectors, compared with several other geographies … so, although our European strategic proposition is not changing, the investment landscape within our target market is broadening across emerging infrastructure sectors.”
As changes occur in Europe and elsewhere, investors seem to have more of a risk appetite and understand that infrastructure is more exposed to secular trends in the economy, according to O’Brien. Trends such as decarbonization, digital transformation and demographic change are shaping and reshaping investor behavior. “These are important sectors of the economy that are seeing good returns and provide good solid fundamentals.”
While most investors are still focused on infrastructure equity as an investment, Mende says there is a trend developing where some investors are now enquiring about infrastructure debt as an asset class. For example, there are funds that offer access to investment-grade 20-year debt investments, or subinvestment-grade assets that are higher risk/return and have five- to seven-year terms. This is still in its infancy.
BOTTOM LINE
It would appear that 10 or more years after infrastructure has taken hold as an asset class for institutional investors, the definition is still evolving. What started out as basic core investments in transportation and energy is evolving into digital and emerging growth technologies. A post-COVID investor, reeling from current events, will have to make the best selections based on their long-term objectives and risk-adjusted strategies. They will also have to contend with greater competition as more projects come online and more investors get in the game.
Joel Kranc is director of Kranc Communications in Toronto.