Real Asset Fundraising: Rocky Road, but Short-Lived
The infrastructure sector has fared well in the face of this year’s market turmoil, and secular trends like digitalization and decarbonization are projected to drive the need for fundraising in the years to come.
However, recent pockets of weakening macroeconomic conditions remain a risk for 2024. Given the current higher-for-longer interest rate environment, the days of relying on low-cost credit to boost returns are long behind us.
Looking ahead, added diligence in investment and asset management methods is likely to be required to produce results. For all combinations of high inflation, low inflation, strong GDP growth, and weak GDP growth, for example, more stringent sensitivity and scenario analysis may be required to stress test an investment.
This is especially critical for infrastructure assets due to the level of leverage that is frequently applied. Even if the underlying fundamentals are robust, a down cycle could easily cause financial trouble if leverage is large and refinancing assumptions are overly optimistic.
Still, a modest but long-lasting recession is an underappreciated risk. Given that infrastructure investments have a lengthy asset life, 1-2 years of earnings contraction usually has little influence on valuations (as long as there is no financial crisis).
A protracted and shallow recession, on the other hand, may cause investors to incur higher write-downs, as a deterioration in the cash flow picture over a longer time has a significant influence on valuations.
Surprisingly, infrastructure investors have not raised their hurdle rates despite rising funding costs. Despite public market underperformance, deal valuations remain stable.
Some might argue that adjusting discount rates based on short-term changes in interest and inflation are impracticable due to the long investment horizon of these assets, especially since infrastructure project valuations do not fluctuate substantially from month to month.
According to Preqin, $330 billion in dry powder supports values and keeps hurdle rates low. Essentially, valuations are being propped up by competition. Preqin states that many infrastructure funds in the market are currently focusing on core and core-plus strategies.
Much of next year could still be difficult for fundraising. Infrastructure cash flows may be as resilient as projected, and values may remain steady due to no change in the discount rate or profitability, but the opportunity cost remains a concern, according to UBS.
When a 10-year US Treasury yields nearly 5%, a super-core approach with limited inflation protection that provides a (hypothetical) 7% net return appears less appealing. Based on real returns, a higher risk/higher return strategy, or one with a strong inflation pass-through, would appear more appealing, the bank added.
By the end of this year, infrastructure will have been put through a complete cycle of economic stresses, putting the asset class’s defensive attributes to the test. The market has slowed, as expected, as the lag effect of halted investments during the peak of uncertainty in 2022 feeds through to fewer transactions concluding in 2023, although infrastructure’s financial performance has remained strong.
According to global asset manager DWS Group, given the sector’s strong year-to-date performance and stronger-than-ever tailwinds in terms of policy support, the slowdown in fundraising and transaction activity should be relatively short-lived, with the 2024 outlook likely seeing a return to positive trends.
Meanwhile, according to Coller Capital’s Global Private Equity Barometer (Summer 2023), 3x as many LP’s surveyed intend to increase their allocation to alternative assets over the next 12 months compared with those who expect to decrease allocations. This increase is largely expected to be in the infrastructure (42%) sector.
The defensive nature of infrastructure also makes it relatively attractive compared with other asset classes during uncertain times, especially when investors are looking for safe havens.
