Energy Transition, Digitalization, Transport
Infrastructure investment opportunities remain ample as the sector continues to prosper from what many have dubbed a super-cycle. This creates advantageous conditions for value investors, as many businesses, particularly those with large growth pipelines, are accessible at more appealing entry prices.
Against this backdrop, infrastructure fundraising and transaction activity is expected to accelerate this year. Given potential economic challenges, however, it will be critical for assets to exhibit downside protection and the flexibility to quickly adjust to changing conditions.
Connect Money spoke with Michael Underhill, CIO at Capital Innovations, who said the opportunity set remains intriguing, given the available pool of large-cap investors looking to put cash into new assets, as well as the greater returns on offer.
The energy transition and digitalization will continue to be important areas of capital deployment for infrastructure investors, but transport assets may see increasing activity as assets that have been off the market since the pandemic reappear.
Underhill also addressed investing in inflation-resistant assets now and why infrastructure, the risk/return profile of infrastructure funds, and if he has seen any with unique strategies or structures. He also shared his thoughts on ESG-focused strategies, the landscape of infrastructure M&A activity and his view on the overall sector for the next five years.
Q: Why invest in inflation-resistant assets now and why infrastructure?
A: Inflation is like soccer. It has been prevalent in emerging markets and almost nonexistent in the U.S. until about 18 months ago. Investors are seeing a pervasive inflationary regime due to various forms of stimulus, both excessive monetary policy and fiscal policy initiatives. Presently, inflation is higher than it has been in the last decade, and the Federal Reserve should take steps to reduce it but is walking a tightrope with complex dynamics.
The Personal Consumption Expenditures Price Index (PCEPI), which is the Fed’s preferred measure, grew at a continuously-compounding annual rate of 5.6% from November 2020 to November 2021. It has grown 3.4% per year since January 2020. Inflation has proven to be “sticky” and is following the trajectory of the 1970’s. (Chart below).
Infrastructure investments are typically viewed as an effective inflation hedge. As an asset class, infrastructure offers inflation protection due to the contractual or regulatory inflation protection on earnings that are passed through to investors through escalators in these contracts.
Infrastructure is the backbone of our world. From the roads we drive on and the energy that powers our homes to the digital networks that connect us, strong infrastructure is the foundation of a thriving economy and a high quality of life.
Q: Could you discuss the risk/return profile of infrastructure funds and how an investor can compare them to other assets in their portfolio?
A: Private infrastructure equity investments may provide stable cash flows and risk mitigation and with a risk focused strategy there is an evolving opportunity set of investments that are subjectively defined by their attributes.
Q: In terms of more liquid strategies, do you see any infrastructure funds with unique strategies or structures? (For example, is there a trend of infrastructure funds becoming more credit-like and paying out dividends earlier?)
A: Infrastructure debt can offer investors incremental risk-adjusted returns and other competitive advantages.
According to Realfin figures, “Capital raised by private infrastructure debt funds increased by 32.7% year-on-year to $19.88 billion in 2023, increasing its share of capital to 16% from 5.8% in 2022. The intensification of interest in infrastructure debt was also evidenced by the sharpest increase (51.1% year-on-year) in the number of investors describing their investment intentions for the asset class in 2024, according to data recorded in Q4 2023.”
We are seeing hybrid capital structure vehicles, interval funds and numerous pooled vehicles attempting to solve democratization of the asset class.
We engineered the world’s first Infrastructure interval and launched it in 2022.
Q: Investors are becoming increasingly interested in “green” or sustainable initiatives. What kind of ESG-focused strategies do you see in the infrastructure space?
A: Energy transition strategies have been increasingly popular investing across the span of renewables, energy efficiency, and low carbon to ensure our infrastructure is resilient against the impacts of climate change, cyber-attacks, and extreme weather events.
Millions of Americans feel the effects of climate change each year when their roads wash out, power goes down, or schools get flooded. Last year alone, the U.S. faced 22 extreme weather and climate-related disaster events with losses exceeding $1 billion each – a cumulative price tag of nearly $100 billion.
Q: Could you give an overview of the main themes driving infrastructure M&A? How would you describe activity levels?
A: Private markets General Partners raising large, pooled funds are challenged with excessive valuation in the large market deals ($500 million plus size deals).
Fund size (and relatedly, deal size) is a key variable in understanding performance trade-offs in private equity. Generally, investors expect smaller funds to offer greater excess return potential and larger fund performance to cluster around the asset class median. The law of large numbers.
This is, of course, contingent upon one’s ability to source, vet, and manage incremental idiosyncratic risk associated with smaller funds and/or emerging managers.
A few drivers are:
- Competition: larger deals tend to be banked and more competitive versus smaller deals where entry points are likely to be lower. Funds greater than $1 billion raised approximately 71% of all private capital inflows in 2023 despite representing only 9% of total funds in the market. Capital continues to consolidate with the top brands.
- Resourcing and Value Creation: you can only rinse and repeat the PE playbook so many times; there’s typically both lower hanging fruit and greater focus on value creation with smaller players.
- Alignment: are investments partners optimizing for incentive fees or asset gathering? With smaller funds it tends to be the former, and larger funds, the latter.
A bias to larger versus smaller funds is more a function of risk tolerance and the relative resourcing/access at your disposal – they’re not mutually exclusive.
Q: What general guidance would you give companies today about negotiating, arranging, funding, and closing infrastructure deals?
A: General Partners focused on infrastructure deals that will rebuild America’s roads, bridges and rails, expand access to clean drinking water, ensure every American has access to high-speed internet, and help tackle the climate crisis should see a significant opportunity from LPs and investors.
Q: What key areas must be addressed?
A: Infrastructure centered around three global megatrends:
- Digital Transformation
5G towers, data centers, fiber to the home, advanced robotics, artificial intelligence
[Underhill highlighted seven reasons why Capital Innovations invests in data centers].
- Attractive Returns: Data center REITs experienced a compound average annual return of 16.69% between 2015 and 2023, nearly 2X the REIT average of 8.6% based on the FTSE NAREIT ALL REITS index.
- Mission-Critical Infrastructure: Properties are “essential” to a tenant’s success and typically serve as a key asset in the tenant’s revenue generation activity.
- Creditworthy Tenants: Fortune 500 companies are often tenants paying the rent.
- High Renewal Rates: Lease-renewal rates are generally north of 95%.
- Historically Stable: Uncorrelated to the stock market. The usage of cell phones, credit cards, and the internet are considered essential by consumers and businesses.
- Tax-Advantaged: Investors may benefit from tax-sheltered income, capital gains, and investment through retirement and non-retirement accounts at preferred custodians.
- Skyrocketing Demand: Data usage is at an all-time high and continues to grow. The number of connected devices is expected to be 3x the global population by 2023.
- Energy Transition
Energy transportation & storage, renewables
- Enhancement of Aging Infrastructure
Tollroads, marine ports, roads & bridges, water treatment
Q: What are your projections for the infrastructure sector over the next five years?
A: AI’s paradox in the power sector. Artificial intelligence is rapidly transforming the power sector, offering unprecedented opportunities for efficiency and innovation.
