Infrastructure has never looked so good - so why are the capital markets dragging their feet?

With pipelines coming thick and fast around the world, investor sentiment has been a sore spot in the industry with fundraising having a very slow start to the year - why are they out of step and is it all to blame on larger forces?

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“Our members were more pessimistic about both equity and debt raising heading into this year than they have been for some time,” says Jon Phillips, chief executive of the Global Infrastructure Investor Association, although noting that “figures for the second quarter of this year are much more encouraging with fundraising and dealflow both trending positively.”

Aman Randhawa, principal at QIC, is seeing fundraising as a “challenging environment” right now, but he also believes there are brighter horizons coming next year.

The causes of these pains are multifaceted and worth unpacking. Much of what is making fundraising hard is what’s inspiring authorities to launch infrastructure projects.

While rate rises and inflation are having a sizable impact, the bigger part of it, Randhawa says, is “really how the portfolios at these pension funds have been performing and how as the listed market has contracted, the unlisted market has looked over allocated”.

He’s talking about the denominator effect: the artificial construct in a portfolio which dictates what percentage can be allocated to different sectors.

The percentage is static, and as a result, as global equities and bonds rise and fall in the markets, available funds for deployment are changed correspondingly - irrespective of their performance.

The denominator effect can put a lot of nervousness in people's minds as projects approach financial close, particularly in the lawyer’s offices, one investor barbs, causing a negative feedback loop in confidence.

“Infrastructure has held its value but because the overall denominator has shrunk it just looks overallocated,” says Randhawa.

Holding its value is crucial in thinking about the long-term of the asset class and what the future will hold - and the statistics are bearing this out.

Part of this has led to a rethink around infrastructure assets, with what’s deemed as truly essential coming fully into focus, helping to “sharpen origination”, according to one investor, on sectors such as digital - which wouldn't have been in that core sector before the pandemic.

Furthermore, as Phillips points out, infrastructure is, on the bottom line, a worthwhile bet: “If you look at the average performance of private infrastructure funds over the near and mid-term – say three months and three years – you see it comfortably outperforming real estate, listed infrastructure and bonds.”

Despite the denominator squeeze, infrastructure is still a “particularly favoured asset class for institutional investors”, according to Cornell University’s Program in Infrastructure Policy’s recent update on the markets, with many seeing it as a safe haven that can pass on rising costs. According to these figures, 43% of institutions are planning to increase the allocation over the next year.

Whether through new allocations or market reverses, many in the industry are seeing the denominator effect as something that will be short lived, but either way, as Phillips says, it will have “served to highlight the resilience of private infrastructure as an asset class.”

No doubt, there are some good reasons for portfolios to have such boundaries, but they shouldn’t be rigid; not when new evidence comes to light around a sector's performance.

“The events of the last couple of years have shown that infrastructure does have the inherent resilience to macro shocks,” says Colin Simpson, head of asset management at Local Pensions Partnership Investments, even pointing to sectors such as aviation which have now shown a strong recovery post-pandemic. “Pre-2020 we had this infrastructure playbook but we never had to live through the scenarios, but now, when infrastructure is providing a real essential quality for society, it has proven that.

“Looking from a cradle to grave perspective, I can see how these projects have shown their resilience, through Covid-19, the Ukraine war, high inflation and more. The intrinsic value of the assets is still there.”

This separation between investment performance and investor sentiment is causing frustration in the market, with many sources stressing the need for a rethink. If equity has a hard time, there’s just less capital in the overall pot, and that sentiment runs through the market.

“We manage a fully diversified portfolio for our client funds,” Simpson adds. “When equities rally, there might be some rebalancing to do. When I look at our infrastructure assets, they’re all performing to the initial investment case, which demonstrates that infrastructure can provide a level of portfolio resilience when you need it most.”

The reasons why infrastructure works to outperform these sectors in the midst of such stormy capital seas is worth delving into, as infrastructure is proving a rare quality of being a strong performer at both ends of the spectrum.

“When the rates were too low it was also seen as a way of improving returns with limited risks,” explains one veteran investor/developer. “The resilience of certain kinds of infrastructure is very strong. Looking back, you’re seeing it. Investors see that. Infrastructure has always been attractive, although never the main allocation for investors; it is getting more and more attractive over the years.”

This is even more prominent in hot economic environments such as the one we’re in today, he adds, pointing to more trade, more cars, more revenues on tolls as examples.

“There’s a very healthy natural hedge in many aspects,” he says. “It's very much linked to the economy.”

Some are concerned about whether there will be a ceiling for infrastructure’s protective qualities, particularly those that are passed on to the consumer.

Over the last two years inflation has been high and people are keen to see whether this asset class is able to produce revenues that match with the price of inflation. “For the most part the fairing is pretty okay but a sustained inflation environment probably leads to a pushback,” suggests Rhandawa. 

He points to the utilities sector, questioning whether in the long run customers and regulators would limit rises. “In that situation, we’ll have to see whether infrastructure can deliver that protection.”

Taking for instance the UK’s response to Russia's illegal war in Ukraine as an example, the British government supported the consumer for major hikes in prices of power, protecting the providers - but rumours of windfall taxes did circle.

But, so far, so good, an investor might think. And as a result, despite climbing interest rates, the combination of impressive performance and a potential for reallocation, many are heavily bullish on infrastructure going forward.

“We’ll continue to see a lot of money flowing into the sector. The rates we’re talking about right now, I would have killed for when I got into this business 30 years ago,” argues one investor developer.

“Equity rates are crazy low for quality projects,” he continues. “The reality is we are still in a very attractive market.”

So, where do P3s sit in this hot environment of future funds? Opinions are divided.

“Developers and funds, when they look at where to allocate their time and investment dollars, most of them are looking to do more akin to private investment than going through the procurement process of P3s, where you could end up spending millions for no guarantee,” says one long time investor, noting that there are huge opportunities in the green infrastructure space in the US as a result of the Inflation Reduction Act - and which don’t come with those tricky steps attached.

But for those willing to take the risk, the rewards are starkly there. More and more, people could be pushed into the risk-taking mindframe, with rising interest rates meaning investors are on the hunt for higher returns.

“Four years ago you could potentially offer a 6% return and it would be attractive but now the underlying base rates have risen you can’t take that to them; they might as well purchase a government bond,” said one international investor. “The important thing right now is to offer a new product to investors because they want higher returns due to the rise in base interest rates.

“You've got to offer new products that have returns in the mid teen range, so now you’re looking at things like greenfield P3s where you’ll attract those kinds of returns.”

This is why the infrastructure investors and developers are able to be optimistic about the future: as products change and new options become available, more and more money is set to come flooding in: the hope is that the capital markets aren’t pulling back; they’re gearing up.