Infrastructure returns: resilient and supported by income
Hello, everyone. Thank you very much for the time today. My name is Nick Moller. I am an Investment Specialist at JPMorgan in the Infrastructure Investments Group. And today, we're going to talk a little bit about the private infrastructure market and specifically what we saw in 2020 and the outlook for 2021 and beyond.
So, turning over the page, first, we're going to really fit the backdrop in terms of, what do we think about infrastructure as an asset class in terms of the definitions? Prior to 2020, one thing we were talking a lot about was, what's the definition of core?
And in our view, we were seeing some creep in that definition, whether it be geographically or sectorally. But how do we think about the asset class? So really to summarize, infrastructure is essential. We think of core infrastructure as being defined by regulated utilities, long-term contracted assets, so think 10-year plus contracts. And then the GDP sensitive end of the equation, toll roads, airports, ports, et cetera, really being the core plus because you have more volume metric exposure.
What we saw prior to 2020 was expansion of that definition to include, well, transport assets being core, emerging market assets being core. And what was really fascinating about 2020, we in no way predicted COVID, but I think it was a good test of the asset class to be able to see, well, how do these sectors perform on a relative basis?
And what we're always keeping in mind when we think and talk about private infrastructure is, what are the goals and objectives? And we always bring it back to what we call (unintelligible), diversification, inflation protection, and yield. And the real key here is to get a different outcome i.e. diversification from other more traditional assets, you need to mitigate the factors that drive that, whether it be commodity prices, growth, any of the other factors that drive more traditional assets.
Contracted and regulated assets, which are effectively monopolies or monopoly by contract, and essential services, are critical elements of providing them.
So if we turn to over the page and think about, what happened in 2020 for some of these different sub-sectors? Now, we would like to think what happened is exactly what you'd expect to happen. On the very far left of the chart, you can see natural gas consumption and electricity consumption.
Now, this should be intuitive. Even though many of us were working from home for an extended period, we still needed to heat our homes. We still needed electricity. Water is not on here, but we still needed water. These are all the essentials of daily life that were needed despite the pandemic. And this really reflected the contracted or regulated end of the spectrum.
As you move further to the right on that graph, you see increasing sensitivity to what happened in 2020, whether it be volumes at ports, albeit less sensitive than many expected, the amount of road travel, and obviously amount of aviation travel, and also what happened to the energy markets.
So, what you see is, those core plus assets being much more sensitive to a more challenging economic environment. Again, I think conceptually, as we would have expected, but not necessarily however one was approaching the asset class prior to COVID.
On the right hand shot, what you see though is, prices of many of these infrastructure assets were very different. And I think that's what's also key in thinking about the definition of core. Not only should it be in a central asset where demand is very stable, but the contractual and regulatory structures typically mitigate the price risk by either fixing it or passing it to customers.
So really, that is the definition of core in our minds. As we look ahead, it will be certainly very interesting to see how these dynamics play out. But I think the punchline is, infrastructure as a relatively “young asset class” didn't necessarily have good, strongly accepted definitions of what's core and what's not. We think 2020 really has provided some of that clarity for investors and investors alike.
Turning to the next page, one other key theme of 2020 and beyond the asset class was ESG. And now, this might seem obvious. Everyone’s talking about ESG now. But really the way we think about ESG in this asset class is GES, governance comes first. Control is key. Having strong relationships with your regulators and customers is key. And obviously the E, people are very, very familiar with in terms of the energy transition, resilience, et cetera.
This is something that is inherent and fundamental to the asset class. If you're not doing ESG, whether you called it that or not, that's directly impactful to risk adjusted return. And I think what was important about 2020 is, this really got highlighted.
Having control positions was critical to dealing with some of the very challenging situations of COVID. For example, regulated utility and essential service, many employees on the front line that had to work in person, literally to keep the lights on and the water flowing.
From a social perspective, dealing with customers and regulators in this period was obviously critical. Having strong relationships with your regulators in terms of how you treat some of the impacts of COVID for customer bills, might have near term impacts, but in terms of long-term value, is absolutely critical.
And clearly, in terms of the E, as it's very much being talked about, the focus on the energy transition and what that means for infrastructure as a whole, both the risks and opportunities that creates for different types of infrastructure, have very much come into focus. So, it certainly was an interesting demonstration of how ESG just is very much critical and integral to this asset class.
So if we turn over the page and start thinking about, well, not only how did infrastructure perform return and income wise in 2020, but what happened over an extended period? And what we're seeing on this chart is some of the data that is available on the private side, in terms of returns and specifically income.
What you see in this chart in earlier periods is, even during the financial crisis, global financial crisis back in ’08, ’09, infrastructure returns were pretty resilient, driven by the returns really being based in income. Fundamentally, if most of your return is contracted or regulated, i.e. probably little growth, most of it is coming in income.
So, as we saw in the financial crisis, this asset class isn't immune to what goes on in the broader markets, but the resiliency, supported by the income, is critical. As we move left to right on this page, you certainly see there was some capital appreciation in interim periods as we went through the last decade.
But I think really what draws the attention is, well, the financial crisis was a long time ago. A lot of investors have only entered the asset class in more recent years. How did the infrastructure perform? And we really did see on the core end, and data's still coming out, but fundamentally, I think things went, again, as hoped and as expected, as I alluded to on the prior chart.
Infrastructure wasn't immune. We did see some challenges for ports and other asset types, but fundamentally core assets remained essential. So the returns we saw from infrastructure being very resilient. So despite it being most traditionally an equity asset class, the volatility we saw in returns for infrastructure versus other asset classes, whether it be public or private, being much lesser.
And really the punchline here is things broadly went as expected. Now, as I've alluded to, those that focused more on core plus, had a much tougher time. But at least for the core part of the asset class, investors were generally pretty happy with where things ended up.
So if we turn to the next page, really thinking about, well, what has this created in terms of capital raising demand? And this shows a number of different private asset classes in terms of capital raising. Probably the question I get most frequently right now is, is there too much money chasing too few deals?
And frankly, that was the question pre-COVID as well. We have seen a material pickup in the amount of capital raised in this asset class, but what I would really caution or remind people is, it's off a very low base relative to other asset classes.
So yes, capital has been raised, and in some cases it represents pretty material increases. However, I would note, and as we'll get to, the opportunity set of this asset class is broad. We’re very much in the early stages of the opportunity set for infrastructure.
Where maybe we do see some trade-offs is those that focused on closed end higher risk infrastructure, where historically you perhaps were able to get double digit net returns while also investing in core, core plus assets. That certainly is harder going forward. You really do have to take risk, whether that be emerging markets, developments, other sub-sectors, to get your return. Or some of those larger high profile trophy assets, typically privatizations, continue to see slightly different dynamics, but as a whole, and as I'll get into, plenty to look at and invest in this asset class.
So, as we move to the next slide, really thinking about the sustainable underlying need for infrastructure. Now, this really is typically intuitive to folks. Part of the reason we are seeing infrastructure continue to develop and exist as an asset class in investors’ portfolios, really is this chart.
Fundamentally, whether it's a good, poor or other cycle, this is still something we need in our daily lives to support humanity. So the need for infrastructure is strong. We'll see what happens going forward, but in terms of the asset class growing and becoming a standard part of investor allocations, in the same way with the real estate or other alternative asset classes grow, this is the driver behind that.
That does also bring up a little bit of the question of, well, what does this mean for a infrastructure plan? One of the other most frequently requested questions I get at this point in time. So I think the prospects of an infrastructure plan, specifically here in the US, are probably better than they have been for quite some time.
It's become - it became a bit of a running joke that every week was infrastructure week during the prior administration, but to be fair to them, it felt like that has been the case as long as I can remember. So, we'll see what happens.
There is no doubt that for the economy, an infrastructure bill is likely very helpful in terms of further stimulus. I would just caution that most infrastructure bills focus on shovel-ready projects, which frequently in the past, have meant State and local government projects will ultimately deploy a lot of the decisions, or employ a lot of the decisions with respect to capital and infrastructure in the US.
All this being said, whether an infrastructure bill happens or not, we don't expect it to materially change the opportunity sets that we're seeing in the asset class. And as I'll get to towards the end, we do see quite a lot of opportunity with respect to where we can put capital to work.
So, turning to the next slide, what we see here is sort of the implications and follow-on of as the asset class has grown. Obviously, a lot of intention and focus on, what do we expect going forward with respect to returns in the asset class?
Now, data is not easy to come by. And what we're showing on this chart is the - our estimates of the expected return for private infrastructure over time. The first thing you see is, they’ve certainly come down. That's probably not too surprising. We've largely seen that for most asset classes over time.
I think what's interesting is, you can see that the spread, if you will, to the risk-free rate, in many ways has stayed relatively consistent over time. So, while returns have come down, which is challenging for those that are targeting double digit net returns, on a relative basis, we would argue, returns still look pretty attractive.
I'm certainly the infrastructure person at JPMorgan, but with respect to what we're seeing in other asset classes, whether it's traditional fixed income, traditional equities, real estate, private equity, I don't think any asset class has been immune to the trend over time of expected return.
So, while returns have come down, from our viewpoint, an 8% expected return for the relatively lesser risk that was demonstrated during COVID, still seems attractive to many investors, from an asset allocation perspective. It's just that the asset class is being more thought of as a complement in our expansion of real assets now, rather than being sort of a lower risk form of private equity.
In many ways, what we're seeing is, the infrastructure market develop in the same way we're seeing real estate, where we have both core and higher risk opportunities and strategies in different fund formats. That's really what we're seeing of all moving forward. So, while returns have come down, I certainly don't expect that to change investor appetite. And that's exactly what we're seeing in terms of our investors acting as they look to allocate capital moving forward.
So turning to the next page, another key factor obviously is yield. I talked about yield earlier in terms of for core infrastructure. If you're mitigating many of the risks that drive capital appreciation, both for the positive or negative, that leaves most of your return coming in income.
Now, I will say again, it's as much a sign of risk from our perspective. Yield is a sign of where your return is coming from. Obviously, for many investors, the lack of yield in more traditional sources is a challenge. So, I also get the question of, well, what are yields going to be like moving forward? How possibly can yields and infrastructure be set?
Well, the first part is what I already said. It's really structurally the returns mostly coming in form of cash. And certainly as what we're seeing right now is returns staying at a fairly material premium, or I should say yields staying in a fairly material premium to where we see other different asset classes.
Now, certainly, at the end of the day, this is not fixed income. It's still an equity investment strategy, albeit lower risk equity. But for those clients that do need some income or are viewing this as a de-risk form of traditional equity investment, typically that income component can become very critical.
So turning to the next slide, one of the key questions I'm getting at the moment is, well, you've told me your assets are long-term. You just told me the income component is high. I'm starting to get very worried about what might happen with inflation and or interest rates. As we recall, not too long ago, there had been a bit of a spike in the treasury rates, which has really raised this in investors’ attention again.
Now, again, I'm not the macroeconomist, so I'm not going to necessarily predict where inflation will go from here. Really, what I'm going to remind people is, what does it mean if it comes back for infrastructure? Now, we haven't seen much, but inflation is a positive for this asset class.
Many regulatory structures and contracts explicitly or implicitly, pass through inflation in order to ensure they're covering their costs. So if we see a rise in inflation, even if it's a modest one, that is a positive. So, in many ways, we hope for inflation.
Now, if I take that in terms of, well, what if we see a rise in interest rates? Those answers really go hand in hand. If we see a rise in interest rates alongside a rise in inflation, as in theory, we should, that's great. You might see a change in discount rates, but you're seeing a consequent increase in revenues that offset some of that impact.
I think we can all say that a material rise in interest rates, without a follow-on increase in inflation, that's not necessarily good for an infrastructure as an asset class. But frankly, what is, other than cash or very short term fixed income?
So look, the asset class isn’t immune, but at least if we see over the medium to long term, interest rates rising in the way they would expect it to be, i.e. if there's inflation, we're pretty bullish on what that means for infrastructure. And that's certainly another driver we're seeing in terms of how investors are allocating their capital.
Many clients thinking about, well, maybe my commodity allocation didn't quite go as planned over the last decade. Well, my chips allocation, that protects me against inflation, but in the absence of inflation, return expectations aren’t very high for chips.
So, people looking at infrastructure as an asset class where they can get inflation protection, but still a reasonable rate of return and yield. So another factor we're seeing for the expansion of the real asset allocation within people's portfolios.
So turning to the next page, really to wrap things up, what is the transaction outlook? And I alluded to this earlier. We have seen a lot of capital raised. Returns have come down, albeit - I've already highlighted why we think that is with respect to what's happened to all other asset classes.
I think the other systemic fundamental transition we've seen coming out of COVID is, what that's done to corporate balance sheets. Now, there's a few stats here, but really what we're thinking about for infrastructure is, we have seen a material pickup in the number of transactions from corporate entities looking to sell assets.
Now, there's a couple of factors here. One is COVID. That - so, many folks have to increase the amount of debt on their balance sheets, albeit temporarily, and selling assets is one way to pay that down. The other factor is really just capital management.
The way I like to think about it is, why does no company own its real estate anymore generally other than headquarters? It's mostly a capital allocation decision. You can sell that real estate to an investor at a “lower” rate of return, and that allows listed businesses in particular, to reinvest in the high growth opportunities that their public shareholders are typically looking for.
The exact same dynamic applies within infrastructure. So whether it's pipes, wires, storage, take your physical infrastructure that supports many listed businesses, that same dynamic is occurring, as they think about ways to optimize their capital allocation going forward.
And I think this is in its very early stages. One can pretty easily think of the many large corporate typically listed businesses across the broad infrastructure spectrum. So far, it's a relative drop in the bucket in terms of the amount of private capital investing in these sort of businesses.
Now, maybe getting a private equity like return out of that will be more challenging, but for those that invest on the core end of the spectrum, really this is creating a lot of opportunity, and we're really seeing more transactions than we have seen in in many, many years.
So with that, that's really the conclusion of my comments today. Really appreciate everyone's time. Thank you for listening. As always, please do reach out if you have any questions. Your JPMorgan representative will be happy to get me and us in touch with you, should you wish to learn more. Thank you so much.
Nick Moller, Investment Specialist in the Infrastructure Investments Group, discusses the private infrastructure market, how it performed in 2020 and what to expect in 2021 and beyond.
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