Infrastructure: The risk/reward pay off

By Jayson Forrest

Infrastructure can provide great diversification benefits to a portfolio, but it’s not without its risks. Nick Schoenmaker (Drummond Capital Partners), Rob da Silva (da Silva Consulting), Rafio Khan (Innova Asset Management), and Nick Langley (ClearBridge Investments) discuss the opportunities available to investors with infrastructure.

IMAP Independent Thought Conference Infrastructure

Infrastructure assets can play an important role in adding diversification to a portfolio. However, before considering infrastructure, Nick Langley — Managing Director and Portfolio Manager at ClearBridge Investments — says it’s important for investors to understand that infrastructure assets fall into two categories: regulated and contracted utilities; and user-pays assets.

Regulated and contracted utilities — water, electricity, gas, and renewable utilities — characteristics of these assets include: the regulator determining the revenues that a company should earn on their assets; price increases are often linked to inflation, and long-term valuations are relatively immune to changes in bond yields; and demand for these assets is steady. Nick believes these characteristics lead to a relatively stable cash flow profile over time, which make these assets ideal for providing a portfolio with defensive qualities but higher income returns on the underlying assets.

User-pays assets — railways, airports, tollways, and ports — characteristics of these assets include: pricing is generally set by contracts, however, volume and revenue is determined by how many people use the assets; these physical assets move people, goods and services throughout the economy; and as an economy grows, develops and prospers, demand for these assets also typically grow. Nick says user-pays (long duration) assets provide growth but lower income to a portfolio.

“When you combine these types of companies into a portfolio, as an active manager, we get the ability to tilt our portfolio either towards defence — as we’re heading into recession — or cyclicality, as we’re coming through the recession and looking forward to some growth,” says Nick. “This allows you to protect capital in down markets, but also benefit from the upside as markets are rising.”

Nick Schoenmaker, CFA — Client Portfolio Manager at Drummond Capital Partners — classifies infrastructure as a growth asset, although he says this sector of the market actually behaved more like inflation-linked bonds last year. He believes infrastructure should be an asset class in its own right, adding that correlations support this, whilst the monopolistic nature of the assets — where there isn’t much competition and the earnings are more predictable — differentiates the return profile of infrastructure from the likes of listed equities.

Nick Langley — Managing Director and Portfolio Manager at ClearBridge Investments
Nick Langley - ClearBridge Investments
Nick Schoenmaker, CFA is Client Portfolio Manager at Drummond Capital Partners
Nick Schoenmaker, CFA i- Drummond Capital Partners
Rob da Silva is an Investment Consultant at da Silva Consulting
Rob da Silva - Investment Consultant
Rafio Khan is an Investment Analyst at Innova Asset Management.
Rafio Khan - Innova Asset Management.

When you combine these types of companies into a portfolio, as an active manager, we get the ability to tilt our portfolio either towards defence — as we’re heading into recession — or cyclicality, as we’re coming through the recession and looking forward to some growth. This allows you to protect capital in down markets, but also benefit from the upside as markets are rising.”

Nick Langley

There is the risk that maybe some green assets might get stranded over time. Energy transition is a very fluid and dynamic situation, which provides great opportunities but also high risks, making it a high risk/high return strategy

Rob da Silva

Themes and opportunities ahead

Moderating a session on infrastructure at the 2023 IMAP Independent Thought Conference in Sydney, Nick Langley says listed infrastructure is a secular growth story, which offers investors opportunities across a number of investment themes. These include: decarbonisation and energy transition; fracturing of the global economy (the increase in ‘onshoring’ and ‘friendshoring’); and the 5G technology evolution. 

In terms of energy transition, the global economy needs to spend approximately USD$200 trillion by 2050 in order to reach the net zero emissions target set by the Paris Agreement. However, according to Rob da Silva — Investment Consultant at da Silva Consulting — this transition will be fraught with risks.

“Whatever you think about climate change, there is unrelenting and urgent momentum for investment in decarbonisation and energy transition. However, there will be risks, as there always are with every transition,” says Rob. “That’s because there is more execution risk in energy transition than traditional infrastructure, like bridges and roads, which means not all emerging energy transition technologies are going to succeed.”

Rob adds that whilst disruption is good in any market or sector, disruptors can also get disrupted. This could well mean that the “latest and greatest” green technology being championed today, may well not be the technology that works in the future.

“There is the risk that maybe some green assets might get stranded over time. Energy transition is a very fluid and dynamic situation, which provides great opportunities but also high risks, making it a high risk/high return strategy.”

Nick Schoenmaker agrees, adding that many infrastructure assets rely on carbon intensive energy sources, meaning there will be a lot of disruption to this sector in the years ahead.

He cites the electric vehicle market, where there is a push by the U.K., Japan, and China to phase out internal combustion engines in vehicles by around 2040. “As more electric vehicles get rolled out, battery technology will improve,” says Nick. “I believe we will see a significant increase in the number of residential houses using batteries to source and store their electricity from the power generated from solar panels. So, this could be very disruptive for electricity grids, but it would be positive for rooftop solar.”

Nick also believes the infrastructure sector will be impacted by ‘populist politics’, which could potentially lead to declines in the regulated returns of infrastructure. “There are a lot of cross currents in infrastructure, which will still take some time to play out.”  


With infrastructure, we definitely prefer active management because we believe there will be disruption in this sector of the market. We think good active managers that are able to navigate stranded or impaired assets, will add alpha to a portfolio

Nick Schoenmaker, CFA

Allocating to infrastructure

When allocating to infrastructure, Rafio Khan — Investment Analyst at Innova Asset Management — says Innova looks at infrastructure as a sleeve on its own. “For us, it’s about growth exposure, but we also recognise that infrastructure has idiosyncratic risks that can impact portfolios.”

According to Rafio, when Innova compares listed and unlisted infrastructure opportunities, the main question it asks is: ‘Why would we pay more for assets of similar quality and illiquidity?’

“We’ve seen unlisted assets trading at a premium to listed assets, creating a situation where a consortium of buyers can take out an asset. Their justification for paying so much for the asset is they’re better at pricing than retail investors,” says Rafio. “However, we argue that the listed market should command a premium because of the liquidity it provides, and the unlisted market should be at a discount. But commonsense doesn’t prevail.”

From a strategic allocation, Drummond Capital Partners is currently overweight listed infrastructure to global property due to concerns with commercial real estate and their valuations.

“With infrastructure, we definitely prefer active management because we believe there will be disruption in this sector of the market. We think good active managers that are able to navigate stranded or impaired assets, will add alpha to a portfolio,” says Nick Schoenmaker.

“We also like valuations in infrastructure compared to the broader listed equity market,” he says. “When adding infrastructure to a portfolio, advisers should also be looking at the fundamental return drivers over time — including revenue and interest rates, GDP growth, and credit spreads — and have a view of where you think those factors are going to move over time, compared to core equities. We also seek out opportunities in the unlisted space and private markets, such as in areas like distressed debt.”

Technology redundancy will happen… As wealth managers, when allocating to infrastructure, we need to work out the likelihood of what technologies are going to fail, so we can disregard companies that are reliant on them from the portfolio

Rafio Khan

Technology redundancy

Nick Langley acknowledges that the issue of technology redundancy in the infrastructure sector, particularly in relation to energy transition, is a key consideration for any portfolio. As an example, he points to the telecommunications infrastructure of the National Broadband Network (NBN), which is under pressure from the likes of Starlink and 5G.

“However, we’re not really worried about technology redundancy in our portfolios,” he says. “That’s because unless we can see 15 plus years’ worth of cashflows being generated or a regulated return being generated from that particular investment, then it’s not going to make it into  our portfolio in the first place.”

Rob accepts there is a vast array of infrastructure projects with risks attached to them. However, he believes investors can take a conservative approach when investing in infrastructure. They can do so by waiting for the likes of the big super funds or institutional investors to finance the riskier projects. He says these larger investors are better placed to absorb failed projects when emerging technologies are unsuccessful.

“So, as an adviser or retail investor, you need to think about the level of risk and whether it’s appropriate for what you want to do. Some of these technologies will work and by taking a punt, you can get a big pay-off. However, many of these emerging technologies won’t work. You need to recognise the risk/return pay off when you’re thinking about it,” he says.

Rafio adds that because we’ve come out of an extended period of ultra-low to zero rates, capital has been easy to access. But now that capital is more expensive, the internal rate of return (IRR) — which is a metric used to estimate the return on an investment — needs to be higher for infrastructure projects.

“Technology redundancy will happen,” says Rafio. “But I also believe a lot of this emerging technology will impact the world in 10-20 years down the track. As wealth managers, when allocating to infrastructure, we need to work out the likelihood of what technologies are going to fail, so we can disregard companies that are reliant on them from the portfolio.

About

Nick Schoenmaker, CFA is Client Portfolio Manager at Drummond Capital Partners;

Rob da Silva is an Investment Consultant at da Silva Consulting; and

Rafio Khan in an Investment Analyst at Innova Asset Management.

They spoke on ‘Infrastructure asset class view’ at the 2023 IMAP Independent Thought Conference in Sydney.

The session was moderated by Nick Langley — Managing Director and Portfolio Manager at ClearBridge Investments.

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