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January 11, 2024 | 22 min read
While private infrastructure has not always garnered the headline grabbing attention of other private market segments, it has offered investors access to stable, inflation-adjusted returns and diversification in the low yielding environment of the last decade. Despite recent historic inflationary pressures and rapid central bank rate hikes, the 1-year infrastructure return to December 2022 of private infrastructure was 15.9%, making it the only asset class to increase over 2022.1 Further, between 2007 – 1H 2023, private infrastructure has consistently generated higher absolute and risk-adjusted returns relative to its public counterpart.2 The question for many investors becomes how to allocate to private infrastructure and how to capture the many positive trends taking place across private infrastructure’s growing opportunity set when building an infrastructure portfolio today.
At HarbourVest we define infrastructure as the assets or services critical to the functioning of a region or country. These include utilities, transportation, communications, power, and social assets which provide essential services with monopolistic positions or high barriers to entry, low volatility of revenues, and cash flows which are often inflation linked. So-called “classic” infrastructure is represented by a variety of sub-sectors, including:
The asset class has expanded in response to increased demand from investors and changing global economic dynamics and, as a result, there is now a blurring of lines between infrastructure, real estate, and private equity. Newer infrastructure opportunities include energy transition technologies, logistics businesses, and various services businesses. Many of these private-equity type assets offer some similar characteristics to classic infrastructure like long-term contracts, defensive market positions, and relatively stable revenue streams. As private infrastructure evolves, investors are taking a more nuanced approach to the asset class, seeking different risk/return profiles and diverse ways to access the market.
Allocations to infrastructure range by investor type and objectives and depend on (i) the desire or need for annual cash yield, (ii) liquidity requirements and investment timeframe, and (iii) the return and risk requirements.
In our experience, investors with mature plans with long-term liabilities and greater desire for annual cash yield typically allocate higher amounts to infrastructure, often in the 5-10% range of total AUM. OMERS, a Canadian pension plan and long-term infrastructure investor, stands out with a plan to increase its infrastructure allocation to 25%.3 Anecdotally, we have witnessed clients continuing to grow their infrastructure allocations as they rotate out of other real assets / private markets to focus on more stable cash yields and lower correlated asset classes. Low-risk infrastructure assets can reduce the overall volatility of an institutional portfolio4 and during 2023’s market volatility, private infrastructure — particularly lower risk infrastructure — has been a diversifier within a wider portfolio. Given the often-strong inflation linkage and long-term capital structures of core infrastructure assets, infrastructure assets have frequently outperformed other asset classes in periods of higher inflation. It’s no wonder then that, according to one study, 57% of LPs are taking note and planning to increase their allocation to infrastructure.5
Source: Preqin 2023 Global Infrastructure Report
Source: Preqin 2023 Global Infrastructure Report
When designing an infrastructure portfolio, infrastructure investors should consider the trade-off between absolute returns, risk adjusted returns, and capital gains versus yield. Typically, lower-risk assets will generate steady ongoing cash flow whereby at least half the return is generated from yield and the remainder from asset value appreciation. Higher risk/return investing will typically generate most of its return from capital gain on exit. These investments tend to be shorter term in nature, exhibit more valuation volatility, and have a typical hold period of 5-10 years.
In thinking about infrastructure investments, the market typically categorizes them into three primary buckets: Core, Core Plus (including “Build to Core”), and Value-Add. These can be understood as:
Core
Core assets are typically operational, have limited volumetric risk and high margins, and annual yield is usually a significant portion of ongoing return. Revenues and cash flows are normally generated by regulated rates of return, availability payments (which provide for the payment of revenue as long as a facility is able to be used), or long-term contacts with creditworthy parties. Core assets tend to be long-term in nature, some with asset durations 100+ years in length.
Core Plus
(including Build to Core)
These assets have some similarities to core infrastructure but generally include a development or GDP-linkage component. There may also be an investment thesis focused on asset or contract optimization/de-risking.
Value-Add
These assets typically have some commodity price, growth, technology, expansion, or repositioning orientation and may include a greenfield (development) component. A significant proportion of ongoing return is typically generated from capital gains on exit. These investments will typically have a five-to-seven-year hold period.
When considering these options, infrastructure investors need to weigh their different risk and return targets. In our experience, infrastructure investors with a desire for less correlated returns and cash yield will typically allocate ~2/3 of an infrastructure portfolio to Core and Core Plus with ~1/3 being allocated to Value-Add. This allocation split also broadly mirrors the size of the market opportunity. Investors seeking higher returns while still seeking diversification from other private and public investments would allocate more evenly across the Core, Core Plus, and Value-Add segments.
In addition to the general classifications of Core, Core Plus and Value-Add, investors should think about their portfolio in terms of the different exposures (known as revenue drivers) at each level of risk.
Managing Director,
Infrastructure and Real Assets
Principal, Infrastructure and Real Assets
Source: HarbourVest analysis
Not all infrastructure sub-sectors are created equal and understanding the revenue profile of assets is critical in investment selection. For example, one airport asset can be economic based and subject to passenger numbers, which are correlated to GDP, while other airport assets can have availability-based or regulated revenues which will not be subject passenger numbers and have more predictable revenues, subject to meeting minimum operational requirements. The main infrastructure revenue types are:
With the above in mind, investors might begin to think about how to apply some of these principles to their own portfolio. Benchmarking is a key step in that process.
A benchmark is a standard or measure that can be used to analyze the performance, allocation, risk, and return of a given portfolio. For infrastructure portfolios, however, there is not a widely accepted standard for benchmarking. Rather, institutions take varying approaches depending on their risk and return objectives, average target duration, base currency, and liability exposure (for example, CPI). HarbourVest has seen institutions take three approaches to benchmarking infrastructure: objective driven, peer group, and public market equivalent.
Description
Strengths
Limitations
Objective-driven
Compares portfolio with overall objective-oriented benchmark (e.g., CPI +3%, 7% IRR, 7% Time Weighted Return).
Aligns with overall objective.
Simple and intuitive.
Objective-driven benchmark is not an investable alternative.
Peer group
Measures performance metrics to a custom fund peer group or broad-based universe (Burgiss Global Infrastructure).
Intuitive to explain.
Ease of calculation.
Can be difficult to identify and specify the appropriate peer groups and/or universe.
Survivorship bias.
Public market equivalent
Compares performance relative to the public markets proxy.
Allows to compare PE performance relative to the public markets.
Allows for investments with irregular cash flows.
Does not adjust for different risk profiles (e.g., capital structure).
Assumes cash flows are reinvested at the same rate of return.
Objective-driven
Description:
Compares portfolio with overall objective-oriented benchmark (e.g., CPI +3%, 7% IRR, 7% Time Weighted Return).
Strengths:
Aligns with overall objective.
Simple and intuitive.
Limitations:
Objective-driven benchmark is not an investable alternative.
Peer group
Description: Measures performance metrics to a custom fund peer group or broad-based universe (Burgiss Global Infrastructure).
Strengths:
Intuitive to explain.
Ease of calculation.
Limitations:
Can be difficult to identify and specify the appropriate peer groups and/or universe.
Survivorship bias.
Public Market Equivalent
Description:
Compares portfolio with overall objective-oriented benchmark (e.g., CPI +3%, 7% IRR, 7% Time Weighted Return).
Strengths:
Aligns with overall objective.
Simple and intuitive.
Limitations:
Objective-driven benchmark is not an investable alternative.
Infrastructure can provide positive inflation linkage in a portfolio. However, not all infrastructure should be treated equal when it comes to the level of inflation linkage.
On the revenue side, inflation linkage can be contractual whereby revenues are contractually linked to inflation. For example, the tolls in a toll road may be linked to CPI, effectively growing annually at CPI. Furthermore, regulated monopolies like utilities can have explicit inflation linkage build into the remuneration formula. These examples offer the most direct inflation linkages as revenues will rise in line with the inflation escalator formula; however, some of the inflation benefits to revenue may be lagged.
Some infrastructure assets exhibit a strong but not direct linkage of revenues to changes inflation (correlated to inflation). This is the case with assets that have high barriers to entry and low-price elasticity of demand and protect their returns in periods of rising inflation. Examples of correlated investments include some transportation investments like ports and airports.
Investments to be mindful of are nominal investments that operate under fixed payments with no inflation linkage, and no ability to increase prices in an elevated inflation environment. Some long-term solar and onshore wind investments operate under long-term contracts with no inflation linkage.
On the cost side, infrastructure assets tend to have high operating margins. For example, it is not uncommon for toll roads to operate with 75%+ EBITDA margins. The high level of operating leverage reduces the impact of rising costs on cash flows. Furthermore, some infrastructure assets have contracts that allow rising input costs to be passed on to the counterparties, reducing the impact of rising costs.
In an inflationary environment as prices of materials and labor increase with inflation, replacement costs for tangible assets follow inflation and asset values tend to track these replacement costs.
In terms of capital structure, many infrastructure assets are financed by long-term fixed-rate debt that can be shielded from the impact of higher financing costs (caused by higher inflation). Furthermore, inflation can depreciate the value of nominal debt, enabling the assumption of additional leverage.
Once investors have decided on a long-term target to infrastructure and the risk/return and yield consideration highlighted above, investors then need to decide how to access infrastructure investment opportunities: primary investments, secondary investments, and direct investments. Like in other areas, the optimal portfolio combination of these can depend on an allocator’s liquidity requirements, diversification requirements, and team staffing/expertise.
Investment into fund managers as a Limited Partner. Primary investments typically have a longer holding period of 10-14 years.
There are broadly two types of secondary opportunities:
The holding period for secondary investments can vary. Typically, secondaries have a shorter holding period of 3-5 years; however, some GP-led secondaries (notably in Core infrastructure) can be structured to have a long-term hold with no planned exit.
Direct investments are investments into infrastructure assets involving a change of control in the underlying investment. Holding periods for direct investments can vary from a 5-year hold to a long-term hold with no planned exit. Direct investments or co-investments require an experienced team with a nimble investment approval process.
Direct investments are typically significant minority or majority (20-50% ownership) transactions into an infrastructure asset. Direct co-investments involve investing alongside an infrastructure fund or strategic investor in a deal. Direct co-investments are typically minority (<20% ownership) transactions and may involve certain governance rights.
In addition to the above, when considering fund investments an investor should consider which kind of fund to utilize, as well as the benefits those funds offer. These can be thought of in the following ways:
Bespoke fund of one vehicle for a single client which can take the form of a closed-ended vehicle or sometimes an open-ended vehicle.
Committed capital is locked-up for the fund term which is typically 10 with extensions which can be up to 4 years (14 years total).
Typically, there is no fixed term; there is typically monthly or quarterly subscriptions and redemptions. Commitments may be subject to a lock-up period. Institutions requiring liquidity optionality may prefer the open-ended fund format.
Bespoke fund of one vehicle for a single client which can take the form of a closed-ended vehicle or sometimes an open-ended vehicle.
It is more common to find core plus and value-add infrastructure vehicles in the closed-ended fund format. Typically, more than half the return comes from capital gain from exiting investments before the end of the fund’s term.
It is more common to find core infrastructure in the open-ended fund format. Typically, there is an emphasis on delivering ongoing income and growing NAV. Typically ongoing income will comprise at least half of the total return. Assets may be held in perpetuity or to the end of the concession.
Bespoke fund of one vehicle for a single client which can take the form of a closed-ended vehicle or sometimes an open-ended vehicle.
New money is exposed to the J-curve.
New commitments are invested in the entire portfolio, providing ongoing cash yield. Open-ended funds can be used as a tool to kick-start an infrastructure allocation, proving immediate diversification with “J-curve” mitigation.
Bespoke fund of one vehicle for a single client which can take the form of a closed-ended vehicle or sometimes an open-ended vehicle.
Valuations are typically triangulated using a range of approaches including public and private market comparables, precedent transactions and asset-based valuations. Investors’ returns are based on cash flows and final asset sales at market value.
Valuation is typically based on a long-term discounted cash flow analysis, valued by third party valuation firms. Investors invest / redeem based on unrealized asset values. Investors in the same vehicle may achieve different holding period returns depending on the timing of commitments and redemptions.
In summary, the decision around where to allocate (Core, Core Plus, Value-Add) and how to allocate (Primary, Secondary, Direct) will lead to different optimized outcomes across the various investor objectives. These can be understood through the below chart which visualizes the risk return profile of these options.
Primary
Secondary
Direct Co-Investments
Primary
Secondary
Direct Co-Investments
Source: HarbourVest analysis.
To understand and illustrate the impact of a more multi-dimensional approach and the various portfolio construction choices, we developed a hypothetical example based on discussions with potential new infrastructure investors. Critical metrics in the quantitative analysis included measurements across return, risk, liquidity, and time horizon that we believe are crucial to assessing and targeting an exposure’s overall risk/return profile and optimizing an infrastructure allocation strategy.6
The primary goal was to develop a 10-year tactical investment plan for a public pension fund to reach and maintain a 5% infrastructure allocation in OECD developed markets with an emphasis on renewable energy and energy transition investments. As a second order, the portfolio had a stated return objective of capital appreciation targeting an overall 10% – 12% net return with 3%-4% annual yield.
The final objective was to create a long duration portfolio of Core and Core plus, and value-add infrastructure investments diversified by strategy, stage, vintage, and geography that was comprised of non-cyclical, stable cash flow investments with low variable costs. Liquidity was not a current concern; rather the goal was to slowly scale the program to target 5.0% allocation within 5-7 years with consistent investment pacing and capital committed over multiple cycles to gain exposure.
Based on the defined above objectives, the investing path included two distinct phases:
Illustrated in greater detail below, the ramp up phase included a 50% allocation to a mix of Core and Core plus infrastructure secondaries and direct commitments. Core and Core plus holdings represent a solid anchor for new portfolios, bringing stability along with income that can contribute to earlier cash flows. We also believe secondaries can play a crucial role in the life of a new infrastructure program, including the ability to acquire assets at a discount to fair market value and potential J-curve mitigation – which can create the opportunity for positive returns earlier in the life of a program. Secondaries also can bring important vintage year diversification, accelerated deployment, and a shorter timeline to exit while also exhibiting lower return dispersion, all which support improving the overall risk/ return profile of the program in the early years.
Initial ramp phase
$1.4 billion annual commitment for 5 years (2023-2027)
Portfolio construction:
Build out phase
$700 million annual commitment for 5 years (2028-2032)
Portfolio construction:
Target NAV achieved
During ramp up, in addition to secondaries, we believe direct co-investments provide attractive return profiles as well as a high degree of visibility into underlying assets. While they can be more concentrated in nature, investments into direct assets gives investors the greatest capacity to tailor exposures and customize targeted objectives. In this instance, important aspects of the ramp up phase included:
Finally, in the build out phase the percentages clearly shift not only across infrastructure strategies but also transaction types, with 50% of the portfolio migrating into stable Core and Core plus primaries. As illustrated, the shift included a 30% allocation to higher growth diversified primaries and 20% allocated to value add direct and secondary transactions which believe can be additive to cash flows and the return profile of the portfolio in the later years.7
When building an infrastructure portfolio there is no one single approach. Allocators need to consider their target return and risk profile including a requirement for ongoing yield compared to capital gains, desired inflation linkage, required liquidity, and time horizon. Investors must also consider their risk tolerance, deployment timeline and size and expertise of the team when selecting how to access the market.
While the allocation should be long-term, we also believe it is important to update approaches to the constant evolving market opportunity. As allocators increasingly focus on infrastructure assets, and the opportunity set continues to expand with growth opportunities, how investors construct their portfolios is taking on greater importance. In fact, we believe the how of infrastructure portfolios is increasingly linked to optimizing portfolio construction, including the potential level of downside protection offered and the excess return generated. At HarbourVest, we believe that taking advantage of market opportunities when combined with systematic diversification across several risk dimensions including transaction types, geographies, vintage years, revenue-types and infrastructure sub-sectors can improve both the risk budget and return profile of an infrastructure portfolio, and help allocators achieve their targeted objectives while optimizing their outcomes and performance.
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(i) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and
(ii) whose funds are managed by an entity mentioned in sub‑paragraph (c);
(e) a bank that is licensed under the Banking Act 1970;
(f) a merchant bank that is licensed under the Banking Act 1970;
(g) a finance company that is licensed under the Finance Companies Act 1967;
(h) a company or co‑operative society that is licensed under the Insurance Act 1966 to carry on insurance business in Singapore;
(i) a company licensed under the Trust Companies Act 2005;
(j) a holder of a capital markets services licence;
(k) an approved exchange;
(l) a recognised market operator;
(m) an approved clearing house;
(n) a recognised clearing house;
(o) a licensed trade repository;
(p) a licensed foreign trade repository;
(q) an approved holding company;
(r) a Depository as defined in section 81SF of the SFA;
(s) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere;
(t) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors;
(u) a designated market‑maker as defined in paragraph 1 of the Second Schedule to the Securities and Futures (Licensing and Conduct of Business) Regulations;
(v) a headquarters company or Finance and Treasury Centre which carries on a class of business involving fund management, where such business has been approved as a qualifying service in relation to that headquarters company or Finance and Treasury Centre under section 43D(2)(a) or 43E(2)(a) of the Income Tax Act 1947;
(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;
(x) a Service Company (as defined in regulation 2 of the Insurance (Lloyd’s Asia Scheme) Regulations) which carries on business as an agent of a member of Lloyd’s;
(y) a corporation the entire share capital of which is owned by an institutional investor or by persons all of whom are institutional investors;
(z) a partnership (other than a limited liability partnership within the meaning of the Limited Liability Partnerships Act 2005) in which each partner is an institutional investor.
An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:
(i) an individual —
(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;
(B) whose financial assets (net of any related liabilities) exceed in value $1 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount, where “financial asset” means —
(BA) a deposit as defined in section 4B of the Banking Act 1970;
(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or
(BC) any other asset as may be prescribed by regulations made under section 341; or
(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;
(ii) a corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by —
(A) the most recent audited balance sheet of the corporation; or
(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;
(iii) A trustee of a trust which all the beneficiaries are accredited investors; or
(iv) A trustee of a trust which the subject matter exceeds S$10 million; or
(v) An entity (other than a corporation) with net assets exceeding S$10 million (or its equivalent in a foreign currency) in value. “Entity” includes an unincorporated association, a partnership and the government of any state, but does not include a trust; or
(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or
(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.
Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).
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