We previously discussed private equity strategies in the realm of private companies: buyout, venture, and growth equity. Now we look at strategies related to assets, such as infrastructure and real assets.

With infrastructure private equity and real assets, managers look to invest in hard assets, which for infrastructure includes bridges, tunnels, roadways, airports, and ports. Real assets include physical commodities/natural resources, and land & buildings.

Exposure to infrastructure and real assets can be used to provide investors diversification and inflation hedging protection since the strategies invest in tangible assets.

Infrastructure private equity targets assets that provide essential utilities or services. Sectors include:

• Utilities: gas, electric, and water distribution
• Transportation: airports, roads, bridges, rail
• Social infrastructure: hospitals, schools
• Energy: power plants, pipelines, and renewable assets like solar/wind farms

Infrastructure can be further broken down into the following categories:

• Core: assets with established, predictable cash flows and little growth potential, often referred to as brownfield
  • Examples: regulated electricity distribution assets, such as power lines, with the government setting the rate
  • Risk: limited revenue risk
  • Target Return: <10%
• Core-Plus: assets needing moderate improvements, presenting additional growth potential or stabilized assets in emerging markets, often using slightly more leverage (typical loan-to-value 50+%)
  • Examples: established metro system in Mumbai, India
  • Risk: moderate, presented in improvement risk or operating geography
  • Target Returns: low teens
• Value-Add: assets requiring significant operational improvements or re-positioning, potential returns are generated from capital appreciation due to improved cash flows versus core and core-plus, which depend on cash flows to generate yield.
  • Examples: aging power plant in need of significant capital to be optimized
  • Risk: moderate to significant risk
  • IRR expectation: mid-teens
• Opportunistic: constructing new assets in uncharted territory, representing significant development risk since the utility needs to be established with the construction of the new asset, sometimes referred to as greenfield
  • Examples: new toll road construction
  • Risk: significant
  • Target Returns: 15+%

From a portfolio positioning standpoint, asset managers generally look at Infrastructure private equity as fitting in a fixed income bucket for investor portfolios.

In fact, since late 2020, J.P. Morgan’s Private Bank has been revisiting client portfolios to discuss new fixed income allocations.

Given today’s low yield environment, Kristin Kallergis, J.P. Morgan global head of alternative investments, notes clients could potentially use alternatives to provide diversification and stable returns traditionally found in fixed income.

Infrastructure assets can serve the following needs in portfolios:

• Relatively Low Volatility: given these assets serve as providing a greater good for society, the assets are less likely to experience disrupted performance from market volatility
• Inflation Hedge: infrastructure assets are linked to population growth, GDP, and other macro factors that change the demand for infrastructure, which can serve as inflation protection
• Low Correlation: given the performance drivers of infrastructure relate to the consumer demand for a public good, the correlation between infrastructure and other assets, such as traditional PE, equities, fixed income, or even real estate, is low

Dispersion of Returns by Strategy & Geography

10-Year Asset Class Risk-Adjusted Performance

Source: Hamilton Lane, June 2021. “Catching the Wave: Infrastructure Performance.”

Infrastructure private equity funds differ from the strategies discussed in our earlier edition of buyout, venture, and growth equity. Typically, infrastructure private equity funds carry longer terms, since infrastructure assets usually need more time for development compared to companies. Return expectations for infrastructure private equity are often lower, given that the funds invest in assets with prices often set by the government. This lower return is partially offset with a lower risk given the government’s involvement in the asset.

Risks

Whereas investors in buyouts, venture, and growth equity undertake risk in the targeted company’s performance, within infrastructure, investors expose themselves to the performance of the asset. Depending on the level of development needed for the asset, investors are exposed to the risk of an asset’s completion. Additionally, the public utility bears significance on an asset’s value.

Government involvement in infrastructure can also be a risk. What one administration deems as suitable infrastructure spending can be reversed by the subsequent leader. Specifically, with international infrastructure projects, investors can be exposed to currency risk if denominated in the local currency.

• Target Investment: assets to provide a societal benefit, i.e. airports, hospitals, power plants
• Need: serve public need for improved or new asset
• Target Returns: 7-15%
• Risk: Development Risk, Government Intervention, Currency Risk
• Term: 10+ years

Sources:
Mergers & Inquisitions. “Infrastructure Private Equity: The Definitive Guide.”
Barron’s, August 2021. “Future Returns: Investing in Private Infrastructure Assets Could Rise.”
CAIA. “Risk, Return, and Cash Flow Characteristics of Private Equity Investments in Infrastructure.”

The Chartered Alternative Investment Association defines real assets to include Real Estate/Land Equity & Debt, Farmland, Timberland, Mining Land/Rights, Physical Commodities, and Intellectual Property (Copyrights, Trademarks, Patents, Trade Secrets, etc.).

Real assets can provide the following for portfolios:

• Diversification: real assets show a little-to-negative correlation to traditional public equity markets, which helps protect capital in market downturns and maintain exposure to gains during a bull market
• Inflation Hedging: since real assets are often used in consumer products, real assets have been shown to protect against inflation
• Value Appreciation: real assets are physical assets, which have a fixed or limited supply. As the population increases, the demand for these assets will increase at a time that when supply will not be able to meet demand, leading to the potential for value appreciation

Correlations of Real Assets, commodities and REITs (1992-2020)

Performance of Real Assets, Commodities and REITs (1992-2020)

Source:
Nuveen, May 2021. “Resiliency and diversification from uncorrelated market exposure.”

Real assets can be accessed through private equity, which also differs slightly from the buyout, venture, and growth equity strategies previously discussed. Private equity investing in real assets usually carries a time horizon that is slightly longer, ranging from 7 to 15 years, since extraction and/or development of real assets takes a longer time than company turnaround. Historically, real asset private equity returns have been moderate and typically range from 7% to 15%.

Risks

Real assets private equity strategies may expose investors to similar types of risks as found in infrastructure since this strategy also revolves around a tangible asset. With real assets, performance is contingent on the mining and development of the targeted asset, as found in infrastructure. Real assets can be exposed to geopolitical risks, which could result in prohibiting the extraction of the targeted assets or nationalizing the supply of it. From a pricing perspective, while real assets typically experience inelastic consumer demand, meaning that consumer demand will remain unchanged if the price goes up or down, the pricing could change if public sentiment changes. For example, if a real asset is deemed unethical and as a result experiences a drop in demand, then the price will be impaired, following supply/demand economics.

• Target Investment: non-financial asset, representing a physical good
• Need: supporting inelastic consumer demand
• Target Returns: 7-15%
• Risk: Development, Geopolitical, and Consumer Demand Risks
• Term: 7-15 years

Sources:
Investopedia - Real Asset Definition (investopedia.com)
CAIA, August 2015. “An Overview of Real Asset Investing.”

In discussing the merits of infrastructure and real asset private equity investing, we find common themes between the two strategies, as both provide diversification from other assets and inflation hedging. Both infrastructure and real assets target investment in physical goods and services that cater to either inelastic consumer demand or public utility. Infrastructure and real assets private equity strategies offer investors an opportunity to lower correlation amongst their portfolios and provide protection against rising prices.