09-Mar-22 Alternatives

More than just a potential inflation hedge

Investing in infrastructure is changing, creating some pitfalls but also plenty of opportunities.

  • When it comes to infrastructure investments, smaller deals often offer better value.
  • Benefitting from such opportunities requires a deep understanding of the sector and asset, particularly the underlying revenue, cost and value generation levers available to the business in question.
  • For investors willing to do their homework, trends such as decarbonization and digitalization can potentially generate additional upside.
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Even before Vladimir Putin’s latest war on Ukraine, accelerating price rises have been becoming a global phenomenon.[1] At 7.5%, the January jump in the US consumer price index (CPI) exceeded market expectations yet again, marking the sharpest year-on-year rise since 1982.[2] February has probably been even worse, at about 8%. Worse still, price pressures appear to be spreading from durable goods and energy to food and stickier service prices, such rents, dry-cleaning, veterinary care and haircuts.[3]

This highlights an additional challenge for investors. Aside from the general increases in goods and services prices, there has been plenty of variation in relative prices of both inputs (notably including wages for labor) and outputs. As we have repeatedly stressed, the key to protect against inflation is to focus on companies and sectors with high pricing power (for their goods and services), as well as strong cost control (for their inputs, including labor).[4] In Europe too, we have revised our inflation forecasts upwards for 2022, with 8% or so for the Eurozone. In the light of disruptions to supplies of energy and other commodities, the war adds additional uncertainties to the forecast in both directions.

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Against such a backdrop, infrastructure assets tend to stand out across all relevant dynamics: from revenues and costs to the valuation effects of changes in nominal and real interest rates. The quasi-monopolistic nature of most infrastructure assets means that demand often tends to be inelastic. In general, there is therefore a high probability that inflation can be passed on to customers through increased tariffs. Indeed, for regulated infrastructure sectors – such as water, power grids or toll roads – regulation generally features an explicit inflation-link, allowing tariffs to increase in line with inflation. Finally, infrastructure assets are typically long-standing and require large upfront capital expenditures but may need comparatively little in terms of annual maintenance or operating expenses, limiting cost pressures. Renewables, such as solar power plants, are typically a good example in this regard.

If this all sounds too good to be true, though, it can be. In recent years, competition among investors for large infrastructure acquisitions has been fierce. With high levels of dry powder in large-cap funds, a narrower universe of potential deals, and a shift to auction processes, competition for deals involving larger targets has driven up entry prices. Both Covid-19 and Putin’s war have also highlighted some operational risks and opportunities that may not have been so obvious before the pandemic – think of toll roads or airports during lockdowns. Or take the transportation and distribution of natural gas. Despite being regulated, such assets may face somewhat similar decarbonization challenges to those managed by their customers in the fossil fuel sector. In the meantime, the scramble for gas appears to have resulted in plenty of pricing power. Power generation offers another illustration of recent winners and losers. As in other segments, electricity may be contracted in the long-term and inflation-indexed, with some shades in between depending on the precise regulatory regime in question. Alternatively, merchant power plants sell their energy on electricity exchanges, so that revenues are determined by market conditions. For European power producers, the latter model has been far more attractive during the last couple of months as gas and, therefore electricity prices went through the roof.

All of which illustrates the importance of sophisticated strategic asset allocation and portfolio construction processes to mitigate the risks of increased performance volatility of individual assets and to help support solid portfolio long-term return generation. This includes thinking through potential political reaction functions in various countries in response to rises in the cost of living squeezing household incomes. 

Having spent heavily during the pandemic, governments coffers have been depleted with higher defense spending now looming as an additional drain on resources. As a result, private investors are likely to play a central role in providing the capital needed to support the transition to greener, decentralized and more innovative infrastructure platforms. “Just as decarbonization policies and technological innovation are reshaping the global economy, they are also rejigging the outlook for infrastructure investments” points out Gianluca Minella, Head of Infrastructure Research at DWS.  

In Europe, recent initiatives by the European Union under its proposed new policy framework are likely to spur technological innovation in infrastructure and create several new investment opportunities.[5] For example, the directive on the deployment of alternative fuels infrastructure provides EU member states with responsibility to ensure the provision of e-charging stations on major highways every 60 kilometers, and hydrogen refueling stations every 150 kilometers.

As technologies mature and reach a late-stage of development, we expect more opportunities, particularly for small- and mid-market core plus and value added infrastructure in sectors such as alternative fuels and related refueling infrastructure, green hydrogen or energy efficiency.[6]

The market also remains very active for greenfield and development opportunities in established infrastructure sectors such as networks, rolling stock and renewables, with institutional capital particularly attracted to sectors where regulation underpins cash flows visibility and growth.

Look at our forecasts to see our 12-month outlook in numbers.

The EU Commission also proposed to increase the target for renewable energy to 40% by 2030 (up from 32%), with specific renewables targets for transport, heating, cooling, buildings and industry, and more ambitious targets for bioenergy. With power prices expected to rise over the coming decade, we anticipate renewables to increasingly achieve grid parity across Europe. This factor, alongside the continued growth of the European long-term power purchase agreement market, is expected to support the growth of renewables capacity in Europe and continued interest from institutional investors.

As a result of these measures, we expect further growth in the energy efficiency services sector and an increased volume of public tenders and public-private-partnerships focused on improving the energy efficiency of government-related infrastructure within the EU. For example, the reform identifies specific measures to accelerate building renovations that contribute to energy efficiency. Moreover, the package incorporates an obligation for the public sector to reduce energy consumption for public services and requires the public sector to renovate government buildings at an annual rate of 3%.[7]

The EU Commission also proposed to increase the target for renewable energy to 40% by 2030 (up from 32%),

Needless to say, we are keeping a close watch as the Commission's various proposals make their way through the legislative process. And, while all EU law is directly applicable across the EU, much can in practice depend on how proposals are implemented in various member states. Still, the ambition and direction of travel of this “European Green Deal” is clear, namely nothing less than the “transformation of EU economy and society to meet climate ambitions”.[8] In addition to environmental concerns, this has the benefit of boosting energy independence from Putin’s increasingly erratic regime.

More broadly, we believe that infrastructure looks set to play a pivotal role in the achievement of a more sustainable and inclusive global economy, and the asset class is expected to contribute to the realization of up to 72% of the UN Sustainable Development Goals (SDGs).[9]However, ambitious decarbonization policies, stronger public investment and robust renewables growth may not be sufficient: achieving net-zero emissions may require significant transformational changes and larger private investments in late-stage technologies.  As infrastructure evolves, the investment pipeline is broadening, with transaction volumes in the middle-market and small-cap segments well positioned to capitalize on the stronger flow of projects in sectors such as renewables, energy efficiency solutions, transport electrification, battery storage and digital infrastructure. While many of these new projects are supported by regulatory or contractual features underpinning cash flow visibility, and may be attractive for core plus strategies, others may still be in a maturing phase and may be better positioned for higher risk/return strategies. Over the medium term, we expect standardization of regulatory and contractual frameworks to play a pivotal role in supporting the maturation of late-stage technologies and accelerate private infrastructure investment.

Already, we are observing a stronger volume of transactions in the lower-middle market and small-cap segments, in the late-stage infrastructure technologies and renewables sectors, with average ticket sizes increasingly in the range of EUR 50 million to EUR 150 million. Market data already indicate that the average transaction size has reduced to EUR 227 million in 2021, from EUR 344 million in 2017. As infrastructure fundraising continues to grow and sustainability-linked strategies spread, we anticipate a stronger demand from long-term investors for strategies focusing on sustainable infrastructure assets in the small-cap and middle market. These strategies appear well positioned to provide potential portfolio diversification from more traditional core infrastructure, while also contributing to supporting sustainability targets.

Average Private Infrastructure Equity Transaction Size, Europe

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Source: Estimated based on DWS proprietary database of European unlisted infrastructure deals, including publicly available transaction information from Infrastructure Journal, InfraNews, Pitchbook, Bloomberg, Preqin; as of 12/21

As for inflation's impact on more traditional financial assets, a good starting point is to think of a bank deciding whether to grant a new loan at a fixed rate of, say, 2% for 10 years. All else equal, higher than expected inflation is good news for borrowers and bad news for lenders and savers. The same basic logic holds for bonds, or indeed any promise denominated in nominal terms. Many bonds are structured just as a simple loan, with regular interest payments via a coupon and repayment of the bond's face value when it matures. As recent decades, especially after the financial crises in 2008 and 2009 showed, such obligations to pay specific amounts on specific dates in the future are not a one-way bet. Lower than expected inflation, or even deflation – falls in the general level of prices for goods and services – make the fixed interest and the final repayment more valuable. The bank would be able to sell its loan or a similarly structured bond at a higher price. Provided, naturally, that such disinflation or even outright deflation does not impair the economic prospects of the borrower to an extent that makes a default seem increasingly likely. 

Average Private Infrastructure Equity Entry Prices, Europe

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* Enterprise Value / Earnings before interest, taxes, depreciation and amortization
Source: Estimated based on DWS proprietary database of European unlisted infrastructure deals, including publicly available transaction information from Infrastructure Journal, InfraNews, Pitchbook, Bloomberg, Preqin; as of 12/21

Decarbonization aside, infrastructure in the middle market and small-cap segment also appears favorably positioned to capitalize on other megatrends such as digitalization, supporting value creation via organic expansion, platform strategies and M&A. This is frequently opposite to core large-cap infrastructure strategies which tend to focus on mature assets providing yield, and with limited capital appreciation potential.

Of course, some small-cap and middle market infrastructure deals focusing on late-stage technologies may be in a higher risk/return spectrum compared with traditional core or core plus infrastructure. While potential for long-term return generation is higher, these returns may be also more exposed to the ability of managers to successfully deliver on business plans and growth initiatives. Still, we believe that selectively adding late-stage technologies may be an attractive way to support portfolio valuations through an element of resilient earnings growth, with core infrastructure valuations somewhat exposed to a rising interest rate environment. In short, infrastructure certainly comes with its own risks particularly for those with limited previous experience. Putin’s war is highlighting the risks of braving erratic jurisdictions in search of higher yields. In these uncertain times, however, we believe it may also offer potential opportunities for investors willing to do their homework.

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1. https://www.ft.com/content/088d3368-bb8b-4ff3-9df7-a7680d4d81b2

2. https://www.ft.com/content/7a0213d2-ad59-485f-bcc9-fc0e10a11988

3. https://www.bls.gov/news.release/cpi.htm; https://www.ft.com/content/34298da7-e4b0-4ce3-98ae-968da78d3381

4. https://dws.com/insights/cio-view/cio-view-quarterly/q4-2021/inflationary-paradigm-shifts/?setLanguage=en

5. For further details, see: https://www.dws.com/capabilities/alternatives/infrastructure/infrastructure-matters/eu-fit-for-55-and-infrastructure-investment/

6. Core plus describes strategies that offer greater risk and greater potential returns compared to the investment characteristics of traditional infrastructure investments. They can thus be added to a core portfolio to augment returns (hence, core plus).

7. European Commission, "Proposal for a Directive on energy efficiency (recast)", 14 July 2021.

8. European Commission, "European Green Deal: Commission proposes transformation of EU economy and society to meet climate ambitions", 14 July 2021.

9. University of Oxford, “Infrastructure needed to achieve 72% of Sustainable Development Goal targets”, 2 April 2019, citing Nature Sustainability, “Infrastructure for sustainable development” (2019).

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