Institutional investor interest in the infrastructure sector is at record highs. Have valuations peak? And where are we now in the cycle? Find out.
Infrastructure equity is now an established asset class in institutional investors' portfolios making up around 3%1 of total AUM. Fundraising in the infrastructure sector set a new record in 2016 of USD 66 billion, surpassing the USD 49 billion raised in 2013. This momentum continued in 2017 which saw USD 65 billion raised.
Investor sentiment is at record highs: according to Preqin2, 93% of investors surveyed felt infrastructure had met or exceeded their expectations; 90% expect to deploy the same or more capital in the next 12 months.
Institutional investors' allocation to private assets has increased by 9%2 p.a. (2010-2017); infrastructure was the asset class that recorded the strongest growth of 16% p.a. The attractiveness of infrastructure has been driven by its strong returns in a low-yielding environment.
As with other private asset classes, the level of dry powder is at record levels as demand for high yielding assets exceeds investment opportunities. The step change in fundraising volumes in 2016 and 2017, and the rise of the mega-fund3 has also contributed to the level of dry powder in the sector.
Evolving investment style
The growth of the infrastructure sector means that investors now have a choice of managers across the risk-return spectrum.
Which investment styles are popular with investors?
Many commentators have incorrectly called the top of the market over the recent past. Rather than trying to predict when valuations might peak, we set out some late-cycle signals and critically assess the differences from previous cycles to provide some insights. The chart below shows the evolution of infrastructure valuations from 2004 – 2017.
Late cycle - Valuations expensive by historical standards but returns offer significant premium to bonds
Valuations appear to be close to 2007 levels; however, the risk-free rate in late 2007 was around 4% versus circa 1.5% today.
What are the implications for the cashflow of an infrastructure asset and the attractiveness of this asset class?
The infrastructure sector has proven itself as an attractive asset class by providing diversification and strong returns. We believe that infrastructure will continue to provide strong returns and play an important role in investors' portfolios.
However, the record fundraising in the sector has also led to an increasingly competitive market, fuelling rising valuations.
In our view, these inflows have also contributed to a change in investment strategies. The sector has become more focused on non-core strategies, many of which rely on capital growth to meet return targets. We believe that these strategies are more highly correlated to other private and public equities, meaning that investors will lose some of the portfolio benefits of investing in infrastructure.
There are warning signs that we are late in the cycle: managers are adopting riskier strategies and valuations look expensive by historical standards. However, we believe that some of the uplift in valuations can be justified by a lower rates environment. Additionally infrastructure still provides a significant premium over risk-free rates and looks attractive relative to other private asset classes.
These nuanced arguments highlight the risks around calling peak valuations with some worrying signals offset by other credible mitigating factors. So, while we can't pinpoint where we are in the cycle, we believe that if there is a market correction, income strategies would outperform capital-driven strategies as the income from stable infrastructure assets will continue delivering returns for investors.