As the institutional experience of the last decade has made clear, the level of risk and degree of return on different infrastructure investments can vary fairly dramatically. Accepting this reality, investors and asset managers now readily differentiate between so-called core, value-add and opportunistic investments based on detailed asset-specific analyses, rather than relying on sector-level generalizations.
In this more nuanced view of the asset class, one salient trend is particularly clear — core infrastructure exposure is increasingly prized in institutional portfolios. And importantly that's reflected in the price.
Core infrastructure can be defined on the basis of expected cash flow performance: the long-term cash flows to equity should be predictable with a low margin of error. In other words, core assets should operate in a consistent and transparent regulatory environment; avoid heavy exposure to any one commodity price; experience a mature demand profile; have inflation protection, preferably through revenue indexation; and employ prudent leverage, especially through long-term fixed-rate debt.
Given these characteristics, the appeal of core infrastructure is no surprise. Predictable, inflation-adjusted cash flows appeal to pension plans' endless need for secure income in order to meet future obligations. Meanwhile, infrastructure assets' monopolistic characteristics protect against downside scenarios, while stable yields match institutional investors' long-term liabilities.
As inflows to core infrastructure have risen, we estimate discount rates for core infrastructure investments have declined by approximately 4% from 2010 to 2016. This reduction is partly attributable to the lower cost of debt, as central banks have provided record levels of liquidity to the global economy. However, growing investor interest and the asset class' gradual institutionalization also have created a secular trend in valuations that is independent of interest rate fluctuations. In all likelihood, that is only going to continue. We expect the equity risk premium — loosely defining it as the difference between the expected return on equity and the cost of debt — to decline further for core infrastructure assets over the next three to five years.
This gradual regime change in expected returns has meaningful implications for core infrastructure investments and investors.
First and foremost, regulators and policymakers are closely watching the growing investor appetite for core infrastructure investments and their predictable cash flows. In return for maintaining stable and transparent regulatory frameworks, regulators will expect that rate-payers also benefit from the declining cost of capital. Regulated businesses' allowed returns on equity and weighted average costs of capital will remain under pressure.
Policymakers also have recognized investors' heightened interest in stability through the demand for regulated assets, and are beginning to extend the regulated return model to infrastructure sectors beyond utilities. A regulated allowed return based on asset valuation framework can potentially open up greenfield development projects for investors targeting core-like returns and predictable cash flows.
For example, Spain's new renewables regime and a few U.S. transportation development projects have implemented modified versions of this model. These frameworks have had considerable success in attracting private capital because investors are able to avoid exposure to fluctuations and forecast errors in electricity prices and traffic. The model can bridge the gap between institutional investors' focus on core investments, which overwhelmingly need established and mature assets, and the policymakers' focus on green field projects or capacity enhancements.
We expect the regulated return model to be increasingly implemented in new sectors and jurisdictions, and become more prevalent in the core infrastructure space overall. The much-hyped national and regional infrastructure development plans, including the Trump plan in the U.S. and the Juncker plan in the EU, will provide a testing opportunity for our thesis through the next five to 10 years.
The investor approach to leverage is another topic that can potentially go through a regime change. The end of the interest rate supercycle might affect decisions on leverage. Many infrastructure managers overperformed in capital structures and refinancing activities, as interest rates kept declining below foreseen levels. Going forward — and assuming the 30-year downward trajectory in interest rates has ended — there will be a clearer trade-off between yield and total return. We expect some investors to opt for lower loan-to-value ratios in infrastructure investments, especially when they are particularly interested in yield.
Infrastructure, while still growing in institutional portfolios, is no longer an emergent asset class. After a full economic cycle including the Great Recession, investors and asset managers have ample experience to assess and analyze the risks of infrastructure investing. The next phase should bring substantial rigor and a heightened focus on ESG principles embedded in the infrastructure asset class — given its inherent focus on sustainability — while evolving frameworks and end-user needs will continue to provide investors with new opportunities.
Anton Pil is managing partner, J.P. Morgan Alternatives, based in New York and Serkan Bahceci is head of infrastructure research with J.P. Morgan Asset Management (JPM)'s global real assets group in London. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.