Infrastructure private equity – overview
The concept underlying infrastructure private equity is in no way different to any other type of private equity, with the general pattern being raising capital from investors, investing in assets, managing or restructuring said assets and finally selling for a profit. It comprises investments in essential utilities or services, as shown in the figure below.
Infrastructure as a private equity class has only been around since the 2000s, but has grown significantly in these past two decades. Indeed, about twenty years ago this asset class did not attract much private capital, being confined mainly to public investments. Most infra assets belonged to governments or to corporates who once built them. However, led by a worldwide movement of privatizations, many investment opportunities started arising in infrastructure assets. Countries such as Australia and Canada pioneered the attraction of private capital for both construction of new infrastructure and monetization of existing assets, with Australian bank Macquarie being credited as the first-mover in infrastructure private equity.
Nowadays, infrastructure is one of the most important asset classes in private equity, accounting for a major portion of committed capital. The main investors range across different categories. The most important players are summarized in the following table:
When classifying different types of PE, infrastructure investing is usually considered as an independent group, due to its unique characteristics which stem from the structure of the markets they operate in, with transport or social infrastructure being indispensable services to the community and the utilities or the communication sectors being often highly concentrated or characterized by natural monopolies. The assets that infrastructure PEs focus on share similar features:
- They are relatively low risk, with stable cash flows and low volatility. Because these assets provide essential services and often have monopolistic positions, they have a more inelastic demand compared to other asset classes
- They have strong cash yields. The infrastructure market is a stable and solid market with low but steady growth. It provides key services for society, and the governments often provide an extent of incentives which translate to a secure stream of returns. These assets hence have a constant divided yield and PE firms do not necessarily need to depend on exit strategies to gain returns
- Their performance is often closely linked to that of macroeconomic indicators, especially inflation. This leads to these assets being considered “inflation hedges”
- Their returns are not much correlated with those of other classes. This makes these assets an effective diversification tool for investors’ portfolios
Although generally infrastructure assets are low risk, there is no uniform level across all types. A popular classification is based on the relation between return of the asset and its risk.
- Core infrastructure assets are those with the lowest level of risk (but naturally also lowest levels of return). They are brownfield investments for which we can safely forecast cash flows and maintain a small margin of error. Generally, they are assets operating in heavily regulated sectors and serving economically and demographically stable areas. Examples include utilities and transportation with lengthy concession agreements
- Core Plus infrastructure assets are slightly riskier but with better growth prospects (there are partly market-based cash flows). While there is a degree of risk, it is limited by factors like long-term contracts and high entry barriers. Examples include renewable energy and not heavily regulated transportation.
- Value-add infrastructure are assets with better returns that are generated from a degree of greenfield investing, restructuring or significant managerial involvement. Naturally, this entails higher risk as well. Examples include purchasing social or transport infrastructure with the aim of expanding its operations and scope.
- Opportunistic infrastructure are the riskiest type of assets, so much so that some experts would rather classify them as traditional PE investments. They have very limited dividend yields and often require significant contributions to R&D. An example could be investing in a firm which is developing a new way to transport or store energy.
Note that the distinction between greenfield and brownfield investments is the following: while the former consists in investments in plants and infrastructures that have not yet reached an operating status, the latter are instead investments already producing cash flows. As a consequence, greenfield investments are riskier and are normally carried either by industrial sponsors or by a consortium of funds and industrial sponsors or sector experts, driven by the need of specifical sectorial knowledge. On the other hand, brownfield investments are less risky and are normally preferred by Infrastructure private equity funds, as they can provide cash flows to repay debtholders straight away.
As of July 2020, the infrastructure private equity market has more than 330 funds operating worldwide, with the largest 10 funds shown below.
In terms of regional exposure, funds tend to operate multi-regionally, with regionally focused funds present mainly in Europe. Moreover, capital raised worldwide in 2020 is focused mainly in energy, followed by telecoms and social infrastructure:
Infrastructure Private Equity – Development
Infrastructure Private Equity has developed tremendously in the past years, due to a series of reasons. In particular, the market has experienced a steep increase in capital raised during the last two decades, while the number of funds closed has decreased sharply in the past three years, bringing consolidation to the market. This is visible from the average fund size, which went from approximately $400 million in 2012, to the current $1.4 billion.
There are several reasons behind this growth, and they can all be traced back to the peculiarities of the asset class:
- A decade-long environment of low interest rates making traditional investments less attractive, which has led to a difficulty finding sufficient and appropriate income generating assets
- An increasing emphasis on the environmental, social and governance (ESG) aspects, which materialized both with more investments in infrastructures, and with National incentives for green energy, with the latter boosting the investments in renewables
- The search for diversification on alternative asset classes, characterized by low correlations with traditional asset classes
- The inability from Governments of OECD Countries to finance infrastructure projects due to their balance sheet constraints and the rising debt/GDP ratios, which will be even more visible in the future years following the abovementioned crisis
Starting from the first point, it is visible how there is a strong, negative correlation between the interest rates levels and the infrastructure investments. The graph below compares the interest levels from Europe (using German Bund as proxy) and US governments, the two major markets for infrastructure, with the levels of capital raised and dry-powder available for fund managers.
While the infrastructure funds have risen almost monotonically during the past 20 years, it’s visible how the interest rates levels have followed a contrarian path, reaching values close to zero in US and negative in Europe (Germany). This trend can be explained by the fact that institutional investors such as pension funds or insurance companies looking for stable and safe long-term investments, have turned to more profitable forms of investment. Given the characteristics of infrastructure assets, they show potential in line with the needs of these investors, yielding stable cash flows, low volatility, and good returns in the long term.
Another relevant insight is that the dry powder, i.e. the capital available for fund managers to invest, has increased sharply in the past years. This implies that the competition in the market is now stronger than ever, with more funds seeking the same assets and deals, hence pushing infrastructure prices upwards.
Regarding the second point, the following graph compares the investment in clean energy worldwide with the total number of ESG Investments:
ESG investments have increased from $11.3 trn in 2012 to $30.7 trn in 2020, with clean energy also increasing rapidly, especially in Asia. This is part of a global transition towards green energy, and a growing attention towards ESG factors by investors. Green energy is, and has been, one of the main drivers of growth for infrastructure private equity.
It is indeed clear how the energy and renewables allocation has gained an outstanding share throughout the years, going from ~34% of the global investments’ allocations in the 2014-2016 period to ~67% in 2020. This trend has been boosted by national regulation giving incentives for green investments. Moreover, technology advancement for photovoltaic and wind power plants has improved efficiency, decreased costs, and increased useful life, making them even more attractive investments for fund managers.
A report from Lazard has compared the levelized cost of energy for both solar and wind technologies between 2009 and 2020. Levelized cost of energy is defined as the total costs over lifetime over the sum of electrical energy produced over lifetime.
The decrease in cost per unit of electricity produced is evident for both technologies. The technology improvements have made these two energy sources among the cheapest in term of LCOE, which suggests that in the future they will spread further, including in emerging markets, without the need for strong national incentives.
In terms of diversification capabilities, we can look at a study carried out by Credit Suisse Asset Management, highlighting correlation among major asset classes between the years 2000-2010:
Infrastructure is displaying a low correlation with other asset classes, in particular to equities (0.44) and Bonds (0.32). Infrastructure investments can therefore provide a good enhancement to portfolio’s performances in terms of risk/return. Moreover, it has been shown that historically, global infrastructure has disproportionately outperformed in down markets compared with global equities. In up markets, global infrastructure has kept about 81 per cent of the upside, while in down markets, it has only seen 61 per cent of the downside. Once again, this shows how infrastructure investments have proved to be a great addition to portfolios worldwide. An internal study by MBA GLI between 2006 and 2019 has also shown good performances in terms of Sharpe ratios for infrastructure investments.
Coming to the last reason why infrastructure investments have experienced such a growth in the past years, we should look at the debt to GDP levels of advanced economies.
We see that the Debt/GDP ratio for advanced economies has increased by around 50% over the past 20 years. This further shows the importance of private capital’s injections to sustain the economy and the infrastructure needs.
All in all, we can see that infrastructure investments have experienced an outstanding increase in the past 20 years, due to a mix of economic and social factors. Moreover, it is clear how infrastructure PE is one of the few asset classes that is able to combine very good returns with a tangible and immediate contribution to the whole society’s well-being and growth.
The outlook post-Covid
A report by McKinsey has outlined the infrastructure investments needed to fuel future growth in developed economies already in 2016 . They found that while trillions of dollars in annual investment will be required just to keep up with expected rates of growth, a pattern of underinvestment has produced a growing shortfall and allowed many foundational systems to deteriorate.
Research by Oxford Economics has also outlined how the current investment trends do not keep up with the spending needed to sustain GDP growth:
Emerging markets account for about 60% of those needs. Furthermore, the report by McKinsey points out how since the great financial crisis, infrastructure investments have actually declined as a share of GDP in 11 of the G20 economies. This is particularly important if we consider the further impact that Covid-19 will have on developed economies, in particular in terms of a sharp increase in Debt/GDP ratios.
The consulting firm also outlines how institutional investors and banks have $120 trillion in assets that could partially support infrastructure projects. Some 87 percent of these funds originate from advanced economies, while the largest needs are in middle-income economies. Matching these funds with projects requires solid cross-border investment principles. Impediments that restrict the flow of financing, from regulatory rulings on investment in infrastructure assets to the absence of an efficient market, have to be addressed. The most important step, however, is improving the pipeline of bankable projects.
This is particularly important if we look at how infrastructure investments are able to sustain economic growth. MGI estimates that infrastructure typically has a socioeconomic rate of return of around 20 percent. In other words, one dollar of infrastructure investment can raise GDP by 20 cents in the long run. Moreover, BCG estimated that infrastructure can help create at least 10,000 total jobs for every $1 billion invested. With these numbers in mind, governments can support the infrastructure industry not just for its own sake, but also as part of the larger post-pandemic recovery effort.
The infrastructure outlooks seems even more directed towards private capital if we look at the forecast of Debt/GDP ratio set out by the IMF in October 2020. In fact, all the macro economic areas in the world are going to experience an increase in debt/GDP ratio, due to both more spending to sustain the economies, and a decrease in GDP. This would mean that balance sheet constraints for governments around the world will be even tighter, and that the public investments in infrastructure are likely to decrease.
To conclude, infrastructure investments will be needed all around the world to sustain economic development and to accelerate the shift towards a more environment-friendly economy. At the current state, it seems that the infrastructure needs will not be covered by the current outlook of both public and private capital, with the former being particularly affected by the current economic crisis. On the other hand, this can be an opportunity for private equity funds to generate long-term cash flows for their investors in an uncertain economic state, while creating welfare across the globe and sustaining economic growth. It is therefore more important than ever that the public and the private sector collaborate to raise funds and invest in infrastructure projects, with several opportunities arising all over the world.
Iacopo Dante Giachetti