Testing Times for Infrastructure Investment Resilience
Post-Q2 valuations have not yet emerged. However, the first quarter of 2020 saw core/core-plus infrastructure strategies demonstrating considerable resilience, although those funds with a greater exposure to volume-based assets (predominantly in transport and energy) were disproportionately impacted.
In order to gain a richer understanding of the impact of the pandemic on core/core-plus infrastructure we’ve taken a closer look at seventeen funds, including seven open-ended vehicles. Together they represent a substantial slice of the market.
We found that open-ended core/core-plus funds delivered median returns (Net IRR) of 0.1% in local currency terms in Q1 2020, and negative 2.6% in fund currency terms. Since their respective inception dates, these funds have delivered a median return (net IRR) of 8% in local currency and 6.2% in fund currency terms. The very pronounced difference between local currency returns (i.e. at the investment level) and fund currency returns (usually USD) illustrates the challenges of investing in global strategies with a high exposure outside of USD-denominated assets.
In terms of overall impact, Q1 performance typically reduced ‘since inception’ returns by around 50bps, with some funds expecting to deliver returns 300-500bps below their long term targets in 2020. Mean and median portfolio discount rates were 9.6% and 9.9% respectively at 31 March, with most fund discount rates broadly unchanged.
Meanwhile, by way of comparison, listed infrastructure shares were down by around 18% on average (GLIO Index to end-March) and listed infrastructure funds (invested in unlisted assets) were down around 10%. Of course this is not a like-for-like comparison: this refers to the fall in value of shares, as opposed to returns.
Although returns in Q1 appeared ‘flat’, this is potentially a little misleading. Unwinding portfolio level discount rates from 31 December 2019 to 31 March 2020 would have translated into total returns of about 2.5% for that quarter, meaning that the median return of 0.1% in local currency terms actually reflects a modest loss.
Analysis also indicated that 9% (median) of funds’ NAV was deemed to be exposed to COVID-19, although some had up to 65% exposure to affected sectors. Much has been made of the impact of COVID-19 on volume-linked assets, particularly in the transport sector. Transport assets were the most strongly affected portion of managers’ portfolios, although the valuation movements varied across sub-sectors. Airports in these managers’ portfolios returned -9.7% (median), Ports and Container Terminals -3.8%, Ferries -12% and Toll Roads -5.8%. Looking away from volume-linked assets, investors should also consider the potential impact going forwards in sectors such as renewable energy where a portion of revenues are linked to merchant power prices and equity upside is driven by long-term assumptions about energy prices.
One question on investors’ minds is whether COVID-19 may spell the end of ‘core-plus’ infrastructure and spur a flight to quality core infrastructure assets. Such a move would reverse the trend of the last few years, during which time the infrastructure asset class has migrated away from core territory. We do not believe that such a reversal is on the cards. However, this crisis has certainly highlighted the importance of contractual cash flows and strong counterparties; a dividing line may well emerge between contractual and monopolistic assets. Investors should continue to review manager portfolios at the asset level rather than following labels, with an eye towards the entire risk-reward spectrum within infrastructure equity.
In addition, it’s important to treat these valuations with an appropriate degree of caution. While many assets were impacted in Q1, the figures are based on what was, at that time, an uncertain outlook for businesses. Current indications from managers indicate that some assets, particularly in the airport space, are likely to be subject to further downward revisions during Q2 even though listed equity markets have rebounded.
When it comes to valuations, levels of transparency vary greatly between different asset managers. On the whole, open-ended funds tend to have have well-established valuation procedures in place that are subject to a degree of external scrutiny. On the other hand, closed-ended funds’ quarterly processes tend to be more varied and less well-defined: their performance tends to be measured by the annual yield that they deliver as well as the uplift upon the ultimate exit of assets, meaning that quarterly figures are not given as much focus.
Key issues for investors to consider
1) What is happening to new investor capital?
Some infrastructure assets may require recapitalisation or refinancing, which could be challenging if debt markets tighten. Some assets may therefore require further equity commitment and/or injections. Investors should probe to find out whether this will be funded from investor capital calls or by withholding dividends at the fund level.
2) Will increased asset management impact deal origination?
This is an important question as some funds may have to manage impaired assets over coming months. To what extent should managers be pursuing these new deals if there are significant performance issues in the current portfolio? Investors should assess whether their managers have adequate resources, not just to originate and execute but also to manage new deals.
3) Do funds that have been disproportionately impacted present a good buying opportunity?
While volume linked assets should improve over the long term as we return to a more stable and expansionary economic environment, investors should be watchful of the time lag between subscribing to a fund and capital being called. This often takes up to 12 months, by which time fund valuations may have recovered. Investors should consider whether they are looking to their core/core-plus infrastructure allocation to include such ‘higher beta’ exposures.
4) Should investors avoid transport assets at all costs?
There is much talk around the suitability of transport or aviation linked assets within infrastructure portfolios and it is easy to take a “glass half-empty” approach to this sector. A long-term approach is key and demand should ultimately return. Deals such as Gatwick Airport, acquired in 2009, went on to deliver spectacular returns to investors over the following decade and this crisis may well produce similarly strong opportunities.
So far, so insulated?
One thing is clear. 2020 will be a seminal year for the development of infrastructure as an asset class: the first real test since the explosion of institutional demand for this sector during the last decade. While Q1 figures suggest resilience and there is some hope that the worst of the pandemic may now be behind us, it is likely that economies are merely going through the first act of a multi-act downturn. Big questions are in the air. Will fundamental shifts in the way industries and societies function impact electricity demand and pricing? What about a prolonged trade war, while sectors such as telecoms and renewables are reliant on parts and equipment manufactured in China? If rail franchises are renationalised, what does this mean for rolling stock assets? Both 2020 performance and wider structural repercussions will have significant implications for how investors view infrastructure for years to come.
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