Not All (Core) Infrastructure Is Created Equal

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As an asset class, infrastructure has demonstrated its resilience throughout economic cycles. These assets can offer investors a compelling combination of income, diversification, inflation protection and downside risk mitigation.

Yet not all infrastructure is created equal. Historically, the cash flow stability and performance of some infrastructure assets classified under the same risk profile category have varied during periods of market volatility. Depending on the magnitude and nature of the variability, the value of some assets has been affected as well.

Across the infrastructure universe, investors have a wide range of risk profiles to choose from. Such strategies can focus on specific geographic or regulatory regimes, sectors or stages of development. We believe investors should closely evaluate the infrastructure strategies available to them to truly understand the underlying risk profiles—and whether the target returns are an appropriate reflection of those risks (see Figure 1).

Figure 1: What’s in a Name?

Not All-Core-Infrastructure_v3-Figure1

The Infrastructure Universe

Infrastructure assets are the networks and systems that provide essential services, facilitate economic activity and enable the movement or storage of goods, water, energy, data and people.

They include, among others:

  • Utilities: Electric, gas and water networks
  • Renewable power: Hydro, wind and solar generation
  • Transport: Seaports, airports, toll roads & bridges, rail networks, export facilities and container networks
  • Midstream: Pipelines, processing and storage
  • Data infrastructure: Telecom towers, data centers and fiber
  • Social infrastructure: Hospitals, schools and public facilities

Infrastructure assets also tend to exhibit similar key characteristics. They are capital-intensive with high barriers to entry, have steady demand and long operational and useful lives, and generate relatively stable long-term cash flows, often with built-in inflation protection through adjustable pricing.

And yet, despite these similarities, virtually no two infrastructure assets are exactly the same. They span the globe, cover many different sectors, are at different stages of the project lifecycle and vary widely regarding revenue frameworks, cash flow profiles and risk profiles.

Defining Core Infrastructure

“Core” infrastructure includes lower-risk, essential assets that have long-term visibility of cash flows. These assets have specific attributes that make them resilient in most economic environments while generating income and the potential for capital appreciation, creating attractive risk-adjusted profiles (see Figure 2).

Figure 2: Risk Attributes of an Infrastructure Asset

Not All Core Infra Equal_v2-Figure-2

In our view, a core infrastructure asset should offer the following key characteristics:

Essential Services or Goods
Plays a critical role in the economy in an industry with high barriers to entry and benefits from relatively inelastic demand.

Long-Term Useful Life
Has a long productive life under perpetual ownership or long-term concession agreements.

Stable Cash Flow Profile
Has predictable revenues supported by regulatory frameworks or long-term contracts with highly creditworthy counterparties that mitigate price or volume risk.

Includes direct or indirect inflation escalators, cost pass-throughs or embedded growth.

Lower-Risk Countries
Primarily in developed markets, such as U.S., Canada, Western Europe and Australia, with stable and dependable regulatory regimes.

Operational Maturity
Has an established operating history with less inherent operational complexities.

Capital Structure Stability
Is a conservatively capitalized business with nonrecourse financing and investment-grade credit metrics and limited or no restructuring requirements.

Current Yield    
Has sustainable, high operating margins supporting a majority of the returns from current yield.

The Portfolio Benefits of Core Infrastructure

Core infrastructure shares key benefits with fixed income, such as predictable long-term cash flows and limited market risk. These assets tend to be resilient, with consistent performance at all points of an economic cycle. This is true when times are good, but it is more evident in times of market disruption.
Not All Core Infra_v4_Figure-3

What Are the Key Risks?

Given the characteristics of core infrastructure investments, two key risks are regulatory risk (for regulated assets) and counterparty risk (for the long-term contracted assets).

To mitigate these risks on the regulatory side, investors can look for a track record of a stable and transparent regulatory environment that fosters economic activity. For counterparty risk, identifying highly creditworthy counterparties can help ensure a higher likelihood that the contracts will be honored. Focusing on lower-risk countries that have a long-established rule of law is another way to potentially mitigate counterparty risk.

These are important mitigating factors because they act as the first line of defense. Ultimately, however, the protection is the essential nature of the infrastructure asset itself. Lower-risk core assets are critical infrastructure that simply cannot be shut off without a functioning alternative. This means that regardless of what might happen to any single consumer in the supply chain, other market participants should step in and utilize the infrastructure so that the economy continues to function.

A Cornerstone Long-Term Investment

The demand for lower-risk core infrastructure continues to be very strong as investors view the characteristics of these investments as providing several portfolio benefits, a good match for their liabilities and the potential to deliver attractive risk-adjusted returns.

Governments and corporations continue to seek private sector solutions to ever-increasing debt loads as borrowing costs normalize from historical lows. Many traditional utility and telecom operators, for example, are inviting institutional investors to invest alongside them in highly contracted or regulated assets. They use the proceeds to meet capital requirements, such as reinvesting in older operating assets, or to help them meet decarbonization targets.

Across the infrastructure universe, we expect traditional operators to look to partner with investment managers that can provide capital and operating expertise to meet their goals. All this means that core infrastructure can be a cornerstone investment in portfolios for many years to come.

When considering an allocation to infrastructure, we believe that investors should look to identify investment strategies that are consistent with their risk and return objectives. They should also consider whether the managers behind those strategies have operating expertise in a variety of sub-sectors and regions—as well as intimate knowledge of various regulatory frameworks. This will help them to underwrite and, later, manage these assets. Considering today's uncertain economic and political outlook—and concerns about historically high equity valuations—we believe core infrastructure is an attractive diversifier in investment portfolios.

The bottom line? A lower-risk core infrastructure strategy should deliver a consistent cash yield with attractive risk-adjusted returns—regardless of economic cycles.

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Originally posted March 18, 2022