Core private infrastructure outlook: Strong despite headwinds
The outlook for core private infrastructure remains strong despite various macro headwinds.
Katarina Roele, PhD
Significant attractive investment opportunities in core private infrastructure remain due to the structural tailwinds of the need to modernize, replace and decarbonize existing assets.
Global markets have been contending with a multitude of shock factors arising from both macro and micro drivers, creating volatility and ambiguity for investors. Core private infrastructure assets, while not immune, are resilient during such volatile and uncertain times due to the essential nature of the services provided, inflation protection, commodity cost pass-through and strong cash flow generation. Significant attractive investment opportunities remain due to the structural tailwinds of the need to modernize, replace and decarbonize existing infrastructure assets. While infrastructure had a positive year relative to most other asset classes, challenges exist in the form of a slower (though still positive) fundraising environment, higher financing costs, geopolitical risk and pressure on valuations. Investors must remain vigilant through the market turbulence, by focusing on EBITDA margin resilience, conservative leverage and strong inflation-adjusted cash flows in order to achieve the resilient returns expected from core private infrastructure.
2023 market outlook
The past year has seen the world in a continued state of flux, with geopolitics dominating headlines alongside rapid inflation and the sharp monetary policy response from central banks. Performance of core private infrastructure over the course of 2022 highlighted the resilience and “cycle agnostic” nature of the asset class and the importance for investors to diversify their portfolios. The Multiple on Invested Capital (MOIC) has remained resilient with Exhibit 1 showing the steady climb over the last decade, relatively unperturbed by macro shocks. 2023 is expected to bring much the same as the global economy contends with recession, continued monetary tightening, the cost-of-living crisis and dislocations across markets. Inflation is expected to be at an elevated level throughout the course of 2023, with labor shortages and pricing pressures likely to hamper opportunistic strategies involving large construction and growth plans.
Exhibit 1: Core private infrastructure has remained resilient through macro shocks
MOIC over the last 10 years
World economies are forecast to see slower – and, in some cases, stagnant – growth in the near term with many countries facing rapidly oncoming recessions. This will likely impact assets that generate little cash flow and rely too heavily on long-term growth or high-exit multiples and terminal values. Assets with a high contracted or regulated proportion of revenue and inflation-linked terms will be better positioned to weather a challenging economic environment, particularly if discount rates remain stable.
A core infrastructure sector that has recently been in the spotlight is contracted power generation due to intense spikes in gas and power prices. In many cases, merchant exposure led to upside from persistently high merchant power prices, resulting in the spectre of windfall taxes and revenue caps from governments looking to benefit from higher margins. However, the majority of core power generation assets have long-term contracts in place, which means there has not been a significant increase in revenue for most assets, resulting in stable expected median returns for 2023 as shown in Table 1. The rise in long-term forecast power prices does, however, provide a tailwind that is expected to remain as decarbonization through electrification continues across Europe and North America.
Table 1: Expected risk, returns and cash yields for various sub-sectors within the core private infrastructure asset class in the OECD region both for the long term and outlook for 20231
Given the essential services they provide, regulated utilities are expected to maintain stable yields and performance throughout the course of 2023, as also shown in Table 1. Their ability to pass through cost of debt increases and commodity costs as well as being able to forecast increases in the allowed returns during upcoming rate cases provides comfort in the current environment. Utilities have historically seen a strong correlation between allowed returns and inflation.*
Higher rate environment
The higher rate environment is expected to continue through at least the first half of 2023, albeit at a slower pace than last year. Rising interest rates put pressure on the cost of capital, including for infrastructure companies. As illustrated in Exhibit 2, the volatility of traditional asset classes has picked up in light of the macroenvironment, while core private infrastructure volatility has remained stable. The essential nature of infrastructure as an asset class has reduced the impact from recent macro-shocks, which has been illustrated by listed utilities performing strongly on a relative basis in 2022, albeit with higher volatility than private infrastructure, as seen in Exhibits 1 and 2. The impact of rate hikes is dependent on a number of factors but, most significantly, it is driven by the timing of refinancing, the level of fixed vs. floating debt and assumptions that were made on long-term interest rates and the long-term equity cost of capital. Possibly most importantly, underperformance hinges on the level of repricing of both debt and equity worked into valuations during the preceding period of low rates. Managers who used consistent long-term methodologies to underpin valuations will be in a much stronger position through this period of tightening monetary policy.
Exhibit 2: Volatility of core private infrastructure has continued to decline as the asset class has matured
5-year volatility vs. federal funds rate
Open-ended vehicles with long-term views on asset management and structuring are generally better placed to handle the squeeze from rate hikes. Furthermore, the underlying reason behind rate hikes, such as inflation and the labor market, must be considered when evaluating their potential impact. Ultimately, rates rise alongside and to combat high inflation, so strategies with positive exposure to inflation are benefiting through various mechanisms including, but not limited to, inflation-linked contracts, regulatory regimes, commodity cost pass-through and power prices.
Opportunities in the near term
The energy transition is expected to remain at the forefront of considerations for many investors and managers through the course of 2023 and over the mid to long term. The energy transition is likely to take longer, and cost more than many headlines might suggest.** Core private infrastructure has an important role to play on the ground at the grassroots level, working with regulators and supply chains to reduce total carbon. This has been highlighted recently by the emergence of scope 3 emissions reporting in 2023, which is a positive move for setting broader facts around the energy transition on the table.
Expectations are for continued focus on decarbonization, particularly in power generation as the search for clean energy security has accelerated, bringing further opportunities. This is supported by the Inflation Reduction Act in the U.S., which incentivizes multiple low-carbon energy sources and envisages an approximately 250% increase in wind and solar capacity by 2030. While there is not expected to be a material short-term impact from the Inflation Reduction Act due to the long-term nature of the tax credit system and the time required for construction, it signals clear medium- and long-term support for infrastructure investment in the U.S. focused on the energy transition, which is likely to create attractive opportunities.
Linked to the decarbonization movement is the need to fulfill energy security requirements, which presents a major opportunity for infrastructure. This is particularly true across Europe, where geopolitics is likely to remain center stage in 2023, with the war in Ukraine showing no immediate signs of abating. Significant investment is required in Europe to transition away from dependency on Russian gas. This creates an attractive investment opportunity from a risk/return perspective as governments align policy to encourage new development as well as repowering and overpowering existing brownfield sites. However, the security, safety and affordability of energy will also mean existing fossil-fuel-based infrastructure is likely to remain a key part of the global energy mix for decades to come. Importantly, there will also be investment opportunities to increase the efficiency of, and decarbonize, such assets.
The outlook for core private infrastructure remains strong despite various macro headwinds. The asset class’s built-in inflation protection, uncorrelated returns and consistent income remain highly attractive. Yields are likely to remain consistent and commodity-cost pass-through is expected to boost revenues for utilities. Core private infrastructure is proving to be cycle agnostic, in large part due to the essential nature of the services provided by the underlying assets, leading to low volatility and steady growth in MOIC. In addition, there remains a massive need for investment across infrastructure, requiring private capital to ensure the safety, reliability, affordability and sustainability of essential services. Valuations are also likely to be supported by continued fundraising inflows, even if at a slower pace than in 2021 and 2022. As a result, core private infrastructure is expected to remain resilient over the coming year, delivering diversified and consistent returns for investors’ portfolios.