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1. Executive Summary
Private infrastructure faced challenges in 2023, with fundraising hitting a 10-year low and deal volumes dropping by 40% due to bid-ask spreads. The industry is grappling with high interest rates, a mixed economic outlook, and geopolitical tensions. Despite these obstacles, performance has remained relatively stable.
As we approach the end of 2023, there is growing concern about the validity of the bearish market sentiment. Many skeptics are questioning the current valuations and performance of infrastructure, suggesting that it may be wise to remain on the sidelines until a correction takes place. Specific concerns have been raised about the feasibility of onshoring in light of increasing global trade volumes. These doubts accompany the skepticism surrounding the hype of artificial intelligence in digitalization, while worries persist about the resistance against clean energy in decarbonization efforts.
Private infrastructure deal volumes have seen a decline worldwide in 2023 as caution prevails among buyers and sellers. Despite the industry having over USD 300 billion of dry powder, buyers are on the lookout for attractive deals while sellers are reluctant to offer significant discounts, resulting in a wide bid-ask spread.
Source: Preqin, November 2023.
2. Macro Outlook
The infrastructure sector is experiencing significant growth due to key factors such as decarbonization, digitalization, deglobalization, and demographic change. Despite the recent challenges of inflation and interest rate shocks, market expectations are anticipated to reset in the coming years. This provides a cautiously optimistic outlook for increased deal activity, especially considering the long-term investment themes that remain intact.
Source: Preqin, November 2023.
Critics have raised concerns about the current interest rate pressures impacting infrastructure discount rates, suggesting that valuations should decrease. However, recent performance in this asset class has remained positive, with no widespread write-downs observed.
When speaking to Investors we hear that they often focus on the significant increase in short-term yields, such as the 500bps rise in 12-month US treasury yields. However, when it comes to infrastructure assets, which are long-term investments with stable cash flows and useful lives of 20 years or more, it is more relevant to consider longer-term rates as an indication of the cost of capital. Interestingly, these longer-term rates have not experienced the same dramatic increase as short-term rates.
Source: MSCI, November 2023; RML Advisory
4. Market Timing
Investors seem to be cautious about private infrastructure valuations and are waiting for a better entry point. They see the potential for profit by timing their investments correctly, as demonstrated by the drawdown and rebound in listed equities. However, it's important to note that private infrastructure offers unique advantages, such as low volatility and low correlations with other asset classes. Recent data shows that private infrastructure has not experienced major drawdowns, unlike public equities.
Investing in private infrastructure offers a compelling long-term value proposition. Compared to public markets, accurately timing investments may result in limited upside potential, while the consequences of mistiming can also be mitigated.
Source: MSCI, Bloomberg.
Deglobalization is no longer viewed negatively in the business community. The shift towards onshoring manufacturing capacity and prioritizing energy security necessitates significant investments. Interestingly, this trend is also leading to the development of new facilities in rural areas that were previously overlooked. As a result, infrastructure investors now have access to untapped markets. Embracing deglobalization can bring about new opportunities for growth and development.
Source: World Trade Organization, October 2023.
The COVID-19 pandemic has underscored the significance of digital infrastructure, particularly with the increased adoption of remote work and education. The popularity of high-definition video conferencing has made high-speed internet a necessity. However, deal volumes for digital infrastructure investments have seen a decline since reaching a peak of almost USD 200 billion in 2022. Investors have become cautious due to over optimistic growth assumptions and debt-fueled investments. Nonetheless, the hype surrounding ChatGPT and generative AI has brought renewed energy to the sector, as evidenced by the increased stock prices of data center companies like Digital Realty and Equinix. It is important for investors to approach this opportunity with a balanced perspective, given the past disappointments of similar trends. Nevertheless, AI, supported by reputable hyperscale companies, may drive significant investment in AI-related infrastructure.
Clean energy continues to be a popular investment choice for infrastructure funds, driven by advancements in technology, political backing, and stable economics. While there have been some negative headlines regarding pushback against green energy, most renewable investors and developers remain confident in the industry's future. However, skeptics are raising concerns about potential risks from this opposition. With important elections approaching in the US and Europe, there is a possibility of policy changes that could impact the renewable energy sector. Despite these uncertainties, the International Energy Agency forecasts significant global green energy investments of USD 1.7 trillion in 2023 and beyond, demonstrating continued growth and potential opportunities.
8. A sensible investment strategy
Here is why investors should consider smaller infrastructure funds with a mid-market focus rather than larger funds. Risk profiles are complex, especially for larger projects with multiple potential points of failure. The mid-size infrastructure market tends to be underserved and, therefore, allows for attractive returns with well-mitigated downside risk. Larger funds with over 1.5bn euros face challenges in deploying their capital. Limited availability of deals compared to global capital deployment puts pressure on these entities to invest within their investment horizon. This may result in increased prices and higher risk tolerance. In the competitive landscape of larger infrastructure transactions, significant funds may adopt different strategies. However, smaller funds in the mid-market benefit from deal scarcity and abundant capital, allowing them to invest flexibly and reject unfavourable transactions.
We like managers that tailor the risk profile to align with their goals rather than relying solely on due diligence. In addition, where these smaller funds have a very strong proprietary deal sourcing network it brings the advantage of working on transactions before they hit the market, giving them a head start and less competition on price.
Well-established funds have the expertise to develop projects from construction to operations, creating a value inflection point. When investing in such smaller funds, there is potential for lower risk and better returns due to the time and effort put into developing the opportunity and structuring the deal. This involves creating contracts and collaborating with stakeholders.
The manager's active involvement and experience greatly benefit the contract terms with developers. Their hands-on approach and ability to develop trusted partnerships add value to the developers/vendors, leading to better opportunities for growth.
Smaller funds with a mid-market focus offer a practical investment strategy. These funds focus on mid-market companies with strong growth potential and less competition compared to larger companies. By investing in these funds, investors can benefit from the upside of mid-market companies while mitigating risks associated with larger, established companies.