Infrastructure investing: steady as she goes

To start, President Joe Biden wants his legacy to be defined by a rebuilding of American infrastructure. His $1,2 trillion infrastructure bill will see US roads, water pipes, broadband internet, and public works systems upgraded. The scale of that spending will be a boon for the kaleidoscope of businesses involved.

The pandemic is also providing strong impetus for global infrastructure spending – governments see it as a relatively uncontentious way to jumpstart their sagging economies.

Spending on infrastructure is also necessary for countries to remain relevant and competitive. As the world moves to address climate change, the economies that continue to use ‘dirty’ energy may find themselves shunned by increasingly carbon-conscious businesses and consumers. The transition to clean energy requires massive sustainable infrastructure development.   

These forces create an opportunity for businesses to design, build, operate, and maintain infrastructure assets. The purpose of the piece is to explore the resulting investment opportunity for individual investors, particularly in light of the Regulation 28 framework being updated to allow for a 45% allocation to infrastructure assets in South Africa.

What does it mean to invest in infrastructure?

Infrastructure is often touted as a new asset class when, really, it’s not. If you’ve owned MTN or Vodacom shares, you’ve had exposure to an operator of telecommunications infrastructure. Similarly, investments in any of the construction companies (Aveng, Group Five, Afrimat, etc.) would have given you exposure to infrastructure developers.

What has changed is that would-be infrastructure investors now have a much bigger opportunity set, making this alternative asset class suitable to a broader spectrum of individuals. There are four conduits through which you as an investor can get exposure to infrastructure:

1. Unlisted infrastructure funds (equity or debt)
2. Co-investment into unlisted infrastructure companies
3. Listed infrastructure funds (equity or debt)
4. Direct investment into listed infrastructure companies

The most suitable vehicle will depend on several factors including the amount you have to invest, your liquidity needs, your risk tolerance, and your experience of investing in infrastructure. Your portfolio manager, wealth manager, or financial adviser can help you assess the options.

But whichever strategy you pick, it’s critical to understand where the underlying infrastructure company or fund sits in the value chain. In general, there are three different stages to any infrastructure project:

1. Greenfield: Your investment will be used to fund the design and construction of an infrastructure asset that does not yet exist. Given the sheer number of unknowns at this stage, it’s an entry point suitable for investors with a high-risk tolerance and deep knowledge of how early-stage infrastructure projects are pieced together. However, the latter condition is removed when investing alongside a skilled investor. No cashflows are being generated by the asset at this stage, so investors must rely on the capital appreciation of the asset in question for their returns.

2. Brownfield: Your investment is used to repair or upgrade existing infrastructure. At this stage construction risk is lower, and the asset will usually be producing cashflows. That makes these projects less risky than those in the greenfield category. Here you could expect returns to have both income and capital growth elements.

3. Secondary stage: Here the asset is self-sustaining in that the cashflows it generates are sufficient to meet any maintenance or additional development needs. Not all infrastructure assets reach this stage, but those that do carry considerably less risk. In this case, the investor can expect reliable, fixed income-like returns.

When investing in an infrastructure company, it’s likely that they’ll operate in one of the above stages because each requires a nuanced skillset. On the other hand, an infrastructure fund may have exposure to a mix of projects or companies that straddle the different stages.

What are the benefits of investing in infrastructure?

It’s not just the fundamental demand for infrastructure that makes the thematic investment case interesting. The associated risk/return characteristics are downright seductive to 21^st century investors scarred by monumental volatility. The generally accepted benefits of investing in infrastructure are as follows:

1. Quasi monopolies – In most cases, governments must approve any proposed infrastructure development. Given that they stand to benefit from the success of these projects (both financially and politically) they are incentivised to restrict supply to only what is needed to maintain pricing power.

2. Inelastic demand – The success of some infrastructure will depend on the prevailing level of underlying economic activity. For example, the cashflow generated by a port is correlated to the strength of global trade. But others, like hospitals and toll roads, are less sensitive to economic cycles because people tend to use them regardless.

3. Quality cashflows – Limited supply and inelastic demand generate a stream of stable and attractive cashflows. In addition, the contracts handed out by government to the businesses who develop, operate, and maintain infrastructure assets are both long-term in nature (15+ years) and come packaged with inflation-linked price increases.

4. Low default, high scrutiny – Because of the above factors, credit agencies report low default rates for infrastructure projects. Given their large scale, they also require a high level of involvement from numerous stakeholders, increasing the level of scrutiny and promoting better governance.

Infrastructure assets with the above characteristics are likely to produce stable returns through the cycle, making them great for portfolio diversification. This characteristic will become increasingly valuable as investors seek steady returns to combat rising volatility and the anxiety it brings.

In addition, investing in infrastructure has the potential to create positive environmental and socioeconomic impact, something that many investors now believe their investments should achieve alongside the generation of attractive returns.

If I am to leave you with two points from this piece it would be that 1) the global demand for infrastructure looks solid and long-term in nature, but 2) it’s a heterogenous asset class in which the underlying companies and funds will have very different characteristics and risk/return profiles. In other words, the opportunity is real, but the right knowledge and research is required to make the most of it.