Infrastructure investing in the digital age

• As the market cycle matures, we’re seeing private capital being deployed in uncommon ways, some of which we view as investments on infrastructure’s cutting edge, and others we see as lacking characteristics that discerning investors find desirable in the asset class.
• Physical characteristics of an asset represent only half the story for infrastructure investors; terms and the risk/return profile of a deal are every bit as crucial in determining the merits of an opportunity.
• As infrastructure investing continues to evolve, it makes sense to remain alert and open to new opportunities, emphasizing the importance of strong underwriting, which can help investors avoid overpriced trophy assets and hidden risks that plague more complicated projects.

As old as civilization itself, infrastructure has been the backbone of societies around the world. In 20 B.C., Augustus assumed the title of curator viarum, or superintendent of roads, and constructed a column listing “distances to all the major cities from the imperial capital,” establishing Rome’s Forum as ground zero for the empire’s vast system of roads, bridges, and ports.¹

While networks of prominent physical structures remain as integral today as in earlier eras, more recent interpretations of infrastructure include less visible networks every bit as vital to modern life. Here we explore infrastructure as an asset class, highlight newer areas of opportunity around its edges, and share our outlook on a selection of its subsectors.

A hybrid asset class, infrastructure typically blends some of the most beneficial characteristics from a range of other investment categories, including fixed income, real estate, and private equity. Specifically, infrastructure provides investors with an opportunity to pursue:

• Yield
  
• Inflation protection
• An illiquidity premium

While many asset classes, including stocks and bonds, are sensitive to changes in the business cycle, the infrastructure segment tends to demonstrate a greater degree of insulation against macro risks, such as economic recession or unexpected inflation. Such exposure tends to bolster portfolio resilience to market downturns, a particularly attractive feature in today’s late-cycle environment.

Infrastructure enterprises engaged in providing essential public goods and services—through electric, gas, and water networks; power-generation plants; highways, railroads, and ports; and telecommunications towers—may benefit from limited competition and stable demand from consumers. Investments in long-lived infrastructure assets can help generate steady cash flows, supported by either long-term contracts or regulated inflation-adjusted rates of return.

Over 60% of alternative asset holders believe we’re at the peak of the equity market cycle, and valuations across public and private markets have climbed in recent years.² When infrastructure investors were asked about the biggest challenges to return generation prospects in 2019, asset valuations rose to the top of the list.²

Especially in a late-cycle environment, disciplined underwriting and price discipline are key. Infrastructure’s favorable portfolio characteristics can get lost in deals priced to premiums and can leave investors more exposed to financial and operational leverage. Our analysis points to an alarming prevalence of poorly structured deals relying on overly optimistic assumptions that are unlikely to perform as investors expect. For example, certain toll roads encountered financial trouble after experiencing sharp drops in traffic during the 2007/2008 global financial crisis, ultimately demonstrating far more sensitivity to economic downturn than investors had expected. Best practices in underwriting call for thoughtful consideration of a prospective base case, a downside case, and an upside case, taking into account implications of a wide range of potential developments at both the macro and asset-specific levels. Prospective investors often focus on the upside case, but before proceeding, they need to be equally prepared for the consequences of the base case—and the downside case—no matter how prestigious the asset.

What do you see as the biggest challenge for return generation in 2019?

As the asset class continues to evolve, technological innovation, intelligent urbanization, and the rise of the network economy are reshaping opportunities for institutional investors. Current priorities at the Federal Communications Commission include “closing the digital divide in rural America and advancing United States leadership in 5G, the next generation in wireless connectivity.”³ Taxpayer and government resources are unlikely to meet the capital requirements to modernize existing digital infrastructure and develop needed new projects without growing participation from private enterprise.

Processing, storing, and transmitting data are playing more prominent roles in the infrastructure sector as society’s digital transformation expands the range of services we now regard as essential to our daily lives. Data infrastructure includes traditional cell towers, fiber optics, distributed antenna systems, and small cells for 5G technologies that will increase network speed and capacity, paving the way for artificial intelligence, machine learning, automated vehicles, and the Internet of Things.

Residing at the intersection of infrastructure and real estate, data centers represent a key expanding area. Companies continue to outsource information technology needs at a rapid clip, leading to extensive third-party ownership of infrastructure assets. Data storage needs are large, and the processing needs to take place close to the end consumer. We’re seeing growth of large-scale cloud deployments and numerous edge locations, and the demand for data centers is increasing.

Meanwhile, the entry of new financial investors in fiber optics is increasing valuations, so it’s critical to remain disciplined in finding the right companies at the right price. Across all areas of the segment, we believe it’s important to seek value in scalable platforms with attractive geographic locations, low churn rates, and credible counterparties, which helps manage risks in data infrastructure investing.

While paying too much for high-quality assets represents one way infrastructure investors can go wrong, taking on projects with long, complicated paths marked by multiple contingencies along the way represents another. In the race to gain exposure to promising ventures, prospective owners often make erroneous assumptions that cost them dearly.

For example, development risk—including entitlement, permitting, and escalating construction costs—can be difficult to quantify. Mispricing the probability of something going wrong, or the magnitude of losses if it does, may raise an investor’s overall risk profile beyond the intended level.

"Technological advancements and declining costs have solidified wind and solar power as economically viable alternatives to fossil fuels, but infrastructure investors need to be selective."

When wind farms were first developed, for example, initial energy production forecasts exceeded realized output by a substantial margin. Now established, renewable energy can pose new challenges. Fiercely competitive and quickly changing, renewable energy represents great promise with great expectations, which may already be priced into the market. If realized growth rates don’t meet those now envisioned by the consensus, renewable energy investors could be exposed to future valuation risks. Technological advancements and declining costs have solidified wind and solar power as economically viable alternatives to fossil fuels, but infrastructure investors need to be selective. Falling costs, while good for consumers, squeeze profits for producers, heightening the importance of each prospective assumption and leaving less room for forecasting errors.

Moreover, long-term purchasing power agreements (PPAs) with traditional utilities are on the decline as less favorable corporate PPAs become the norm. From an infrastructure investor’s perspective, this shift introduces new risks. Corporate PPAs are more likely to call for common delivery points. If a renewable energy project holds assets that don’t reside near a preferred common delivery point, the project owner may be assuming risks of congestion along transmission lines connecting the site of generation with the site of delivery. Known as location basis risk, we’ve observed unprepared renewable energy investors encountering such challenges, particularly in Texas.

While the need for sustainability lays a long runway for renewable power generation, the segment’s great momentum has created a crowded and hypercompetitive market. Transactions involve multiple, continually shifting factors that require thoughtful review. We believe it’s wise to begin by casting a wide net and to choose only high-quality projects with best-in-class operating partners known for rigorous cost management practices. Geography also matters immensely: Investors should aim for projects residing near end customers or common delivery points, which decreases location basis risks that can weigh down a project’s profitability with unanticipated congestion costs.

As the asset class continues to change with the world, we believe legitimate opportunities exist on infrastructure’s cutting edge. Data centers and digital infrastructure, parking lots, land registry software services, nursing homes, and even crematories can all be fair game for infrastructure investors who take a rigorous approach to selecting and underwriting transactions. The tactical opportunity set of assets may evolve over time, but when infrastructure investing is done well, the favorable combination of predictable yield, inflation protection, and an illiquidity premium endures.

While the asset class faces challenges, including cyclical valuation risk and limited availability of private investment opportunities, those challenges are in many ways outweighed by emerging roles for alert infrastructure investors in areas involving technological innovation, intelligent urbanization, and sustainability solutions. Renewable energy and the systemic shift toward greater data needs by institutional and individual consumers, for example, present promising prospects for infrastructure investors with robust underwriting practices.

"Far from the cutting edge of technological innovation lies a highly unusual yet equally intriguing investment idea almost beyond infrastructure’s periphery: the funeral industry, one of the least sensitive to the economic cycle."

Far from the cutting edge of technological innovation lies a highly unusual yet equally intriguing investment idea almost beyond infrastructure’s periphery: the funeral industry, one of the least sensitive to the economic cycle. However constant death may be, the way we deal with it has been changing in recent years. In fact, being buried isn’t as popular as it was only a few years ago, and cremation rates are on the rise. There were 31,521 burials in New York City in 2016, down nearly 14% from 2008; by contrast, there were 19,883 cremations there in 2016, an increase of over 40% since 2008.⁴

The premium required to occupy more space in death, as in life, is part of what’s driving the shift away from the cemetery and toward the crematory. Storing cremated remains, or cremains, calls for only a tiny fraction of the space occupied by a coffin. One cemetery in Queens is quickly running out of space for burials and has built its first mausoleum containing 168 crypts and 3,400 niches over an area that would have held only a few hundred graves—a move that “will extend the life of the cemetery.”⁴  

Why can a crematory be considered infrastructure? An unceasing part of life, dealing with the logistics of death is an essential service, and doing so improperly would have public health implications. While all crematories are regulated and must be licensed, each country and state has its own rules and barriers to entry governing cremation business practices. Finally, the need for cremation services remains relatively inelastic, as modest changes in prices don’t much alter the quantity demanded.

1 The Roads of the Romans, Romolo Augusto Staccioli, 2003. 2 Preqin investor survey, November 2018. 3 Almost Daily Comment, Grant’s Interest Rate Observer, May 20, 2019. 4 “Real Estate for the Afterlife,” the New York Times, March 15, 2019.