December 15, 2022 |
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INFRASTRUCTURE IN INFLATION: THE COMING DISPERSION
December 15, 2022 | 8 Minute Read
Scott Lebovitz
Global Co-Head and Co-Chief Investment Officer of Infrastructure
Scott Lebovitz
Tavis Cannell
Global Co-Head of Infrastructure
Tavis Cannell
Key Takeaways
- Infrastructure is often viewed by investors as a broad hedge against inflation, but as the definition of infrastructure continues to expand, a more nuanced understanding of individual assets is required to appreciate if they truly possess the characteristics typically associated with infrastructure.
- The potential inflationary benefits of infrastructure assets are dependent upon the strength and adaptability of revenue streams, cost structures, and balance sheets.
- Inflation and rising rates are likely to lead to dispersion in performance across infrastructure assets, creating opportunities for more established and well-capitalized infrastructure companies, including acquiring and integrating smaller assets.
In an inflationary and rising interest rate environment, the infrastructure asset class is often turned to for its defensive and resilient return profile. However, given the amorphous definition of what constitutes an infrastructure asset, investors should avoid treating infrastructure as a homogeneous asset class with universal inflation-hedging properties. While infrastructure assets on average are less sensitive to inflation, the extent of the protection can vary dramatically depending on asset quality, sectors, and geographies. Additionally, the definition of infrastructure has broadened in recent years, expanding beyond traditional labels to now describe assets with a common set of characteristics: asset-intensive; defensive and contractual cash flows; resilient throughout the economic cycle; critical to society; and incumbency advantages. Amidst the evolution in infrastructure, some investors have sought out opportunities with higher prospects for growth and absolute returns that have lacked some of the fundamental infrastructure qualities that may provide insulation to inflation.
We believe building a balanced infrastructure portfolio of companies with resilient revenue streams, predictable cost structures, and defensive balance sheets should be top of mind in all economic environments—not just when inflation sets in. To begin focusing on the impacts of inflation and rising rates after they have taken hold is akin to shutting the stable door long after the horse has bolted. And in many ways, the inflation horse has already left the barn, with core inflation (excluding energy and housing) currently running at 4-6% in major western economies (ex-Japan) and expected to remain well above central banks’ target levels of ~2% throughout the coming year. But investors can still adjust, as the current environment may persist for a while as “progress towards policy makers’ comfort zone is likely to take time.”1
3Q22 Versus 2Q23 Core Inflation Forecast With Central Bank Target
Source: Goldman Sachs Global Investment Research
Revenues: In-Line or Ahead of Inflation?
Assets and businesses that have true infrastructure characteristics should continue to grow revenues in-line with, and potentially ahead of, any inflationary pressure. Many infrastructure investments feature pricing structures that have an explicit inflation-linked pricing mechanism (preferably uncapped). These pricing structures are particularly important in long-term contracts and are most commonly seen in highly regulated sectors. Without inflation-linked pricing, businesses with long-term contracts—a normally desirable infrastructure characteristic—are unable to re-price revenues and, therefore, will suffer from margin contraction in an inflationary environment. Hence, investors should seek a balance of price-escalating mechanics and contract length, rather than focusing on contract length alone.
For assets with shorter contract lengths, demand inelasticity is needed to implement customer price increases in-line with inflation. Many essential services and social infrastructure businesses often lack the 20+ year contract profile of more traditional infrastructure assets; however, they often have a customer base that is highly likely to recontract. The modular building sub-sector is a good example; contracts tend to be 5-7 years and are predominantly signed by municipalities for use in governmental business and services. The nature of these contracts enables the pass-through of price increases to adjust for the higher raw material costs, as has been recently evidenced. During inflationary environments, assets with shorter contract lives but inelastic demand can reset prices at a higher level upon contract renewal. However, much like investors shouldn’t take disproportionate comfort in longer contracts, we believe infrastructure investors should only accept shorter contract lengths if the underlying business is a true essential service with persistent and inelastic demand.
In addition to structuring contracts with broad inflation-linked pricing, asset owners can structure customer contracts to explicitly pass-through costs to avoid the adverse impact of specific input costs that are running ahead of inflation. Typically, these terms are focused on passing-through the larger—and often more volatile—variable inputs, such as energy, raw materials, or capex-related costs. This is often seen in data center assets, for example, where the level of energy usage is high.
Costs: Limiting Expense Growth to or Below Inflation?
Infrastructure businesses typically employ large labor forces and are asset-intensive, often requiring higher levels of energy and raw material consumption. This is especially true for those businesses that undergo periods of intensive capital expenditure. When inflation is driven by supply-side challenges, raw material shortages, a tight labor market, and elevated energy prices—as is largely the case today—infrastructure businesses may suffer from costs and expenses running ahead of headline inflation.
Hedging is a primary tool for infrastructure business operators seeking to combat inflation. When infrastructure businesses have known future costs, the prudent course of action is either to hedge through futures contracts, such as in energy markets, or to acquire the necessary raw materials in advance to ensure new development or asset replacement costs are kept in-line with budgeted expectations. However, this may only be achievable for a limited time given the costs of storage and overall capital requirements.
Cost increases can also be mitigated by establishing and maintaining strong working relationships with multiple suppliers to avoid dependencies while ensuring access and priority when needed. This is particularly important for some raw materials and specialized tech hardware that may only be available through a few high-quality suppliers. Hence, working with these suppliers to allow them to manage their own business in an inflationary environment is critical to ensuring a strong partnership is formed and maintained. Ultimately, even if some concessions are made, we believe asset owners will reap the final benefit if the strong supplier relationship is able to reduce supply-side disruptions.
Some cost pressures are more difficult to mitigate, labor being a prime example. As inflationary pressure increases so too does the upwards pressure on labor costs. Short of seeking longer-term wage contracts, which if unattractive to current and potential employees may result in attrition of higher quality labor, it is difficult to inhibit labor costs. Some offset of labor costs may be gained by increased automation, but there is often a natural ceiling on the extent that can be achieved. As a result, we believe the best way to combat rising labor costs is accessing sectors and assets that inherently have lower labor needs or more orientation towards repetitive, standardized processes that are well-suited for automation.
Rates: Can the Balance Sheet Withstand Rising Interest Rates?
Higher inflation has typically led central banks to respond by increasing interest rates, which is being observed across most developed countries today. While the future path of interest rates is uncertain, the forward expected interest rate levels have frequently deviated from the realized level of interest rates, especially during uncertain economic and market conditions.
Forecast Versus Actual US Interest Rates
Source: OECD Economic Outlook: Statistics and Projections. As of October 2022
Given ongoing macroeconomic uncertainty and the specter of even higher rates, prudent debt levels are essential. In the event of an economic downturn, infrastructure companies should have manageable debt levels to ensure their debt servicing costs are well within recessionary cash flow levels and to limit any refinancing risk. Floating-rate products have been popular in recent years given the prolonged downtrend in interest rates, but they pose a risk in today’s market. With the historically low rates of recent years, prudent infrastructure investors should have sought to structure their outstanding debt at a fixed rate or implemented an interest rate-hedge.
As interest rates rise and the economic environment becomes less certain, the maturity and covenants of a company’s debt can become important. This is especially true for those companies that have elevated debt levels and/or exhibit greater cyclical exposure. It can be difficult to estimate when the cycle will turn, so often the only mechanism to defend against a stressed refinancing is to extend duration and add as many protective covenants as possible.
Opportunities From Inflation
Elevated inflation and rising rates pose a variety of risks, but they can also offer opportunities for well-placed businesses to enhance their market position. A weaker and more uncertain economic environment often sees smaller and less resilient competitors become acquisition targets at attractive valuations for the larger and more-established infrastructure companies. Add-on investments can be attractive in infrastructure providing two potential key benefits: i) they increase the advantage of size and incumbency, which may enable pricing power and stability of revenues; and ii) they provide an opportunity to identify synergies and reduced costs, particularly important in an inflationary environment. Similarly, as public markets have broadly declined, it has increased the opportunity for potential take-private investments in high-quality publicly traded infrastructure assets currently trading at depressed prices.
Even in the absence of inflation, owner-operators of infrastructure businesses should always be seeking to reduce costs and improve efficiency in the assets they own, but the benefit of such savings is keenly felt in inflationary environments. Cost and efficiency gains are difficult to achieve, requiring diligent planning informed by a depth of technical and sector expertise, as well as the time horizon to allow these changes to take effect. To that end, we believe private market owners are well-positioned to implement long-term, capital-intensive projects and strategic efficiency improvements due to the structure of their investment vehicles. Furthermore, private infrastructure investors are able to take a more hands-on approach relative to more passive strategies, allowing them to better leverage their significant resources and industry experience.
What Lies Ahead
The development of resilient, defensive infrastructure businesses requires constant and deliberate focus on the more granular—and what can be perceived as more mundane—attributes of asset management. Aggressive growth rates, new product rollouts, headline-grabbing capex, and new-build initiatives can quickly become overly optimistic in the face of a downturn. To continue with our horse metaphor, a shiny new saddle is of limited use if your horse is no longer in the stable. In stronger market environments, misplaced optimism and complacency is a key risk. Infrastructure investors that have sought absolute returns ahead of prudently generated risk-adjusted returns may find the coming years more challenging. As a result, greater dispersion in infrastructure investment returns may lie ahead.
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