Written By: Emma Powell
Emma Powell looks at the outlook for infrastructure investment and finds compelling reasons for optimism in the resilience of some sectors during the pandemic and the role the asset class can play in fulfilling ESG goals
Government initiatives aimed at supporting the economic recovery, and renewed focus on sustainability have added fresh impetus for infrastructure investment as the UK emerges from the pandemic. Those factors, combined with low yields on offer from traditional fixed income, have driven more investors towards the asset class in recent months. More than half those surveyed by Preqin at the end of 2020 said they planned to increase their allocations over the next five years.
Investors may be cheered by the robust returns delivered by the asset class in the face of the pandemic, particularly against more volatile equity markets. “Overall the impact on infrastructure has been muted and infrastructure’s done what it’s intended to do, which is to produce a resilient, countercyclical opportunity for long-term investors,” says Hamish Mackenzie, head of infrastructure at DWS.
Indeed, UK infrastructure has outperformed equities not only in the midst of the pandemic, but also over the longer term. The FTSE Global Core Infrastructure index has delivered a total return of 41% over the past 12 months and 145% over the past decade. That compares with the 39% and 79% total returns generated by the FTSE All-Share over the same respective periods.
However, the infrastructure market has not escaped the pandemic unscathed, with some sectors suffering a more marked contraction in transaction activity and asset valuations. Passenger transportation, including airports and public transport, have suffered a heavy contraction in demand due to lockdown restrictions. Meanwhile weakened energy demand also weighed on power prices last year.
The long-term nature of infrastructure investment provides some insulation from dips in some valuations due to the pandemic, says Peter Bachmann, managing director of sustainable infrastructure at Gresham House. “Those valuations typically don’t need to be brought to bear or traded in the short term,” he says.
Conversely, the pandemic also acted as a catalyst for some broader trends such as digitalisation, which benefited asset valuations. “While digital infrastructure is an asset that has been supported in many ways by the crisis, it’s also an asset class that maybe has been made expensive by the crisis,” says Mackenzie. That was exacerbated by the shift towards more defensive areas of the market, as investors flocked back towards core and core-plus strategies and away from value-added infrastructure, according to DWS. During the first 10 months of 2020, funds focusing on core and core plus strategies secured over $45 billion of capital, according to the asset management firm, corresponding to around 59% of total capital raised in 2020 to date, up from 31% in 2019.
As economies enter the recovery phase with an increased level of certainty, entry prices for assets have already started to rise. Enterprise value/adjusted cash profit multiples attached to unlisted infrastructure deals in Europe have steadily recovered since hitting a post-pandemic trough in June, according to data from DWS, a trend that could continue thanks to the record levels of ‘dry powder’ in the core market. However, Mackenzie says: “I think the sorts of returns that investors are looking for should remain broadly consistent so long as interest rates and the outlook for interest rates remains the same.” The asset manager forecasts levered entry returns for core assets in mature European markets to be in the range of 7-9% this year.
Government support invites capital
The need to upgrade rail, roads and digital infrastructure has created an opportunity for infrastructure funds to potentially double in size to $2 trillion by 2025, according to forecasts by PwC. This follows a decade when private investment has fallen and created a $15 trillion funding shortfall needed to be filled by 2040, the G20 Global Infrastructure Hub has said.
Yet the call for investment has been given added urgency by the pandemic. The International Monetary Fund has called on governments in developed nations to increase public spending on infrastructure to help create jobs and spur economic recovery. In November’s spending review, the government pledged £100 billion in infrastructure investment to support the UK’s economic recovery. That included the launch of an infrastructure bank in April, with an initial capitalisation of £12 billion, aimed at accelerating investment in projects that would help the UK reach its climate goals.
Alongside investment in areas including waste, water and transport, the government hopes to attract private capital for projects that can help the country achieve net zero emissions by 2050. Indeed, with UK public borrowing hitting a record February figure of £19.1 billion, the highest since records began in 1993, it is unsurprising that governments increasingly recognise the need to encourage private investment into infrastructure projects.
“Government rhetoric around infrastructure isn’t new but it’s stronger,” says Mackenzie. The strain placed upon government budgets by funding pandemic support measures has created added impetus for policymakers to act as catalysts to encourage private capital to help “build back better”, he says.
The green agenda
The biggest opportunity for investors in the asset class over the next decade will be the transition to a decarbonised energy generation system, according to a Preqin survey of infrastructure managers at the end of last year. Mackenzie says that there is rising demand from investors for strategies that incorporate sustainability considerations. “If you look at the sustainability agenda, anything that we invest in now, to find a buyer at an attractive price in eight-10 years time, that asset has to be relevant to the sustainability agenda,” he said.
Growing awareness among pension scheme members could provide a further incentive for allocations to green infrastructure. The UK’s largest workplace pension scheme, Nest, has pledged £1.4 billion in renewable energy infrastructure investment over the next decade, after agreeing a partnership worth around £250 million with Octopus Renewables in March.
The scheme cited Yougov research that showed four out of five adults believed it was important the economic recovery from coronavirus should take climate change into account. The clean energy specialist will make direct investments in solar energy and onshore wind projects on behalf of the scheme.
Nest’s chief investment officer, Mark Fawcett, said that investing the pensions of the UK workforce in renewable infrastructure at home and abroad is a win-win for all involved. “All minds are focused on how to help ‘build back better’ from the pandemic and this move means millions of UK pension savers will be playing their part,” he said. However, there may be challenges involved in integrating ESG principles into infrastructure investment. The lack of quality and consistent environmental and sustainability data could provide a challenge to investors, with 71% of those surveyed by Preqin citing this as a challenge to implementing ESG.
More consistent government policy and mechanisms to support the construction of new sustainable infrastructure projects is also needed, says Peter Bachmann from Gresham House. “The UK has talked about net zero but it hasn’t talked about how it will implement the requirements to achieve net zero,” he commented. For renewable energy projects that could mean clearer frameworks in the planning process, for instance.
Sustainability opportunity aside, one of the core benefits of infrastructure in recent years has been the income stream on offer versus government bonds. However, expectations of a marked increase in inflation have risen following the huge levels of government stimulus and hopes of economic recovery due to successful vaccine rollouts. That has caused yields on 10-year government bonds to surge to their highest level in over 12 months. Could that dim the attraction of infrastructure investment in the near future? Not necessarily.
“One of the really big attractions of infrastructure as an asset class is, to a large extent, most of the revenues are inflation linked,” says Bachmann. That could include assets such as regulated toll roads or those generated by water companies, where revenue is explicitly linked to inflation. Nevertheless, as rates rise, there is a potential narrowing of the gap between the yields offered by government bonds and infrastructure returns.
Yet with the yield on 10-year Gilts still standing at just over 0.8%, the returns forecast for core infrastructure assets look compelling. The resilience demonstrated by some sectors throughout the pandemic, and the role the asset class can play in fulfilling ESG goals, should also provide a further boost to infrastructure inflows.