Key Takeaways

  • High-volatility and low-yield environment in the public markets require investors to rethink asset allocation to maintain stability and yield
  • Infrastructure investing is another tangible asset class that has drawn considerable interest from institutional investors
  • Infrastructure assets have stabilized demand with long-term, credit contracts in energy, power, telecom and transportation
  • Regulatory disruption creates the opportunity for high relative yield with lower risk and generally negative correlation to public market securities
  • Access to institutional level sponsors is a key benefit of investing at EquityMultiple

 

Investors in today’s capital markets are faced with a difficult “dual mandate” – the chase for yield and portfolio stabilization. While the equity markets have been facing extreme turbulence due to the disruption in global supply chains and other exogenous shocks caused by COVID-19, bond investors are faced with a massive flight of capital which has driven down yields seemingly everywhere in the public markets. Income-driven investors find few opportunities to source yield and sustainable-income streams, and fewer still in the public markets. While the U.S. has so far avoided the quagmire of negative rates unlike Germany and Japan, the U.S. risk-free rate is approaching the negative territory following three consecutive rate cuts in 2019 with two additional emergency cuts in 2020, leading to low yields across banking products and publicly traded markets.

The unique constraints that today’s market impose on investors require both institutional and individual participants to rethink their asset allocations and rebalance their portfolio appropriately. In search of yield and stability, diversification is key – infrastructure investing is a timely solution, and a  new asset class on the EquityMultiple platform.

From Real Estate to Real Assets

Together with real estate, infrastructure makes up a broader alternative investment category referred to as “Real Assets”. Both commercial real estate and infrastructure investments represent economic interests in tangible assets that can generate steady income streams due to the long-term nature of the useful life of the assets and corresponding preponderance of long-term lease structures to credit tenants. Infrastructure assets and contracts serve industries with stabilized demand and high barriers to entry such as energy, power, telecommunications, and transportation. As a result, infrastructure investments are less susceptible to exogenous shocks and market volatility and have the potential to perform in all market conditions.

An analysis by McKinsey Global Institute notes that global energy infrastructure requires $3.3T of investment annually through 2030, indicating a significant capital need to be bridged over time. In the private sector, the widening gap in the energy sector remains particularly notable as the demand for new infrastructure rapidly rises. The U.S. Shale Revolution has enabled the U.S. to outpace OPEC countries to become a key exporter of crude oil, refined products, and liquefied natural gas (LNG), driving up the capital demand for additional transport and storage infrastructure; as well as capital improvements. At the same time, there has been an accelerated focus on renewables due to regulatory burden, heightened environmental awareness, and the maturing of renewable energy technology and related infrastructure. The near-to-mid-term reliance on cleaner fossil fuels (natural gas) and a long-term shift to renewable energy sources together form a new set of demand drivers that should promote ongoing opportunity for infrastructure investors.

Yield and Total Return

From both a yield and total return perspective, infrastructure investments may help investors achieve better overall portfolio performance with reduced risk. With Infrastructure investments, issuers or sponsors generate service fees associated with certain infrastructure assets – such as energy transportation, refinery, and telecommunication towers – through long-term contracts with pre-defined lease rates and servicing volume. As a result, infrastructure investments have relatively low volatility and are less susceptible to market movements, contributing to a lower correlation with overall public markets. 

In global equity markets, infrastructure public equities outperformed the overall global equity market by more than 5.0% in 2019. Over a 10-year horizon, global infrastructure equity yielded an 8.6% annualized return, lagging slightly behind global equities. Infrastructure equities’ recent performance demonstrates that the asset class has been on an upward trajectory, garnering increased investor interest. 

On the debt side, infrastructure credit opportunities have long been favored by institutional investors focused on long-term steady cash flow. Infrastructure credits have delivered strong performance compared to other credit categories. According to Nuveen, infrastructure debt “historically has provided higher yields than similarly rated corporate bonds.” Compared to public debt, non-publicly traded private debt has offered a higher yield, pricing in the illiquidity premium as well as the supply/demand dynamics over time.. Recently, Basel IV regulations governing European commercial banks will restrict infrastructure lending by requiring increased risk weighting. European banks have been the predominant players in the infrastructure finance space to date. As was  observed in the aftermath of the Global Financial Crisis, a shortage of capital supply from regulated financial institutions enables non-bank lenders to increase volume and negotiate favorable terms, including credit-enhancing covenants. This dynamic is likely to play out in the infrastructure space as Basel IV is implemented.

In terms of risk management and portfolio construction, infrastructure as an asset class is known for its low correlations with public equities, bonds, and even commercial real estate. According to a report published by J.P. Morgan Asset Management, global core infrastructure is “the only asset class with a negative correlation to U.S. stocks (S&P 500) during periods of high market stress.” The low correlation between infrastructure and real estate compels investors to consider overweighting infrastructure to further diversify their alternative asset portfolio while potentially enhancing the portfolio’s risk-adjusted return potential. 

Nuveen’s report illustrates the diversification benefit of infrastructure investments by adding a 30% infrastructure allocation to a hypothetical traditional 60%/40% portfolio consisting of global stocks and bonds. The result shows that the new portfolio with the exposure to infrastructure gained 31 basis points in annualized total return while dropping the standard deviation (risk) by 102 basis points. 

Practical Considerations

No two economic cycles will look the same. Given the market’s recent responses to exogenous shocks, both institutional and individual investors are advised to strengthen their portfolio’s ability to withstand various scenarios and prepare for an extended period of price discovery in equity and bond markets. In today’s low-interest-rate environment, introducing high-yielding private credit strategies with a focus on a sector known for its stability can potentially enhance portfolio resilience through diversification without sacrificing income potential.

As with most alternative investments, one of the most crucial considerations when making private infrastructure investments is manager selection. Considering the breadth of the private infrastructure investing universe, the right manager must possess strong in-house expertise and a proven track-record with private project finance transactions.

Downside Protection and Resilience

Investors seeking stable, long-term income with an emphasis on risk mitigation should consider infrastructure debt. As with investments in commercial real estate, debt investments offer lower risk from both capital and operational perspectives. 

In comparison to similarly rated corporate debt, infrastructure debt not only offers attractive yields, but also tends to have lower default rates. Moody’s 2019 study of Project Finance noted improvements in default rates in the infrastructure industry, with the 10-year cumulative default rate down to 3.96%*. During the same period, the metric for corporate debt rated Baa (lowest investment-grade) is at 3.46% while Ba (highest speculative-grade) is at 15.70%.

Another important metric to consider alongside the default rate is the recovery rate, which measures how much of the loss would ultimately be recovered in the event of default. According to the same study, the ultimate recovery rate of infrastructure project-based debt is around 80%, with the chemicals production and power infrastructure recovery rate ranging from 80-100%. The distribution of the recovery rate shows that the losses on the majority of the default cases were repaid or fully mitigated through restructuring without economic loss. In comparison, first-lien leveraged corporate loans have a recovery rate of around 60%. 

In leveraged loans and private credit, covenants that provide lenders protections over additional indebtedness or early triggers in deteriorating conditions are not common. Amidst the low-default, low-interest rate environment of recent years, the public market has seen a surge in loans with low or no lender protecting covenants (so-called “cov-lite” loans). In deteriorating business environments, holders of cov-lite loans have little recourse but to watch their underlying credit deteriorate until an eventual default. Upon default, a loan can be sold at a discount or holders can band together and fight in court (generally Chapter 9 or 11 corporate liquidation or restructure).  First-lien infrastructure debt, unlike cov-lite corporate loans, generally entails robust asset-level covenants that give the lender clarity in the exercise of its rights at the early signs of a deviation in the business plan. The clarity in the rights of senior lenders both enables a direct path to the underlying asset and facilitates negotiations on effective resolutions, which maximize value recovery.

To further mitigate other idiosyncratic risks, infrastructure lenders can often build additional protections into the borrowing agreement. Construction risk can be managed by forcing borrowers to enter into turnkey construction contracts to mitigate the delays. For commodity risk, lenders can look for long-term supply contracts featuring predetermined price and volume targets to hedge against the commodity price fluctuation. 

According to a stress test conducted by JP Morgan Asset Management in 2018, private core infrastructure assets, given low correlations with equity and fixed income, “may mitigate the impact of an economic and market downturn on a diversified portfolio.” The researchers tested the asset class’s resilience by running multiple downside scenarios and found evidence of core infrastructure assets’ ability to hold steady performance during sharp energy price decline, high inflation, and a high-interest-rate environment when combined with other assets in the portfolio. 

Final Comment and Practical Considerations

No two economic cycles will look the same. Given the market’s recent responses to exogenous shocks, both institutional and individual investors are advised to strengthen their portfolio’s ability to withstand various scenarios and prepare for an extended period of price discovery in equity and bond markets. In today’s low-interest-rate environment, introducing high-yielding private credit strategies with a focus on a sector known for its stability can potentially enhance portfolio resilience through diversification without sacrificing income potential.

As with most alternative investments, one of the most crucial considerations when making private infrastructure investments is manager selection. Considering the breadth of the private infrastructure investing universe, the right manager must possess strong in-house expertise and a proven track-record with private project finance transactions.

 

*Based on cumulative default rates for cohorts 1990-2017 
By Charles Jin
Charles joined EquityMultiple in 2018. Charles provides solutions to clients and strives to enhance client experience while supporting the firm's investment and operations efforts. Charles received a B.A. in Economics and Mathematics from Vanderbilt University. Charles is a CFA Level III candidate.
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