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.