We received this request from one of our readers:

“Hi guys.
Enjoy reading your post.
I have an interest in investing in infrastructure (5 in’s in a row… that must be a record!!). Could you consider providing an article on infrastructure investing in listed and unlisted funds, and also look at the effects of rising interest rates on these funds. Thank you.”

Global stock prices plunged in January as US stocks suffered their worst month since the start of the pandemic in March 2020. US stocks fell mainly because the Federal Reserve warned that it would raise rates to counter US inflation, which hit a 40-year high of 7% in 2021. For the month, the S&P 500 index lost 5.3% in US dollars (and 2.3% in Australian currency), its worst January from the GFC.

Consumer Price Index (CPI) in the United States – January 2020 to December 2021

Source: Refinitiv

Inflation protection in infrastructure

As inflation picks up around the world, many investors are turning to stocks known for their inflation protection, especially infrastructure and utilities stocks.

The discussion here assumes that companies defined as infrastructure companies meet two criteria.

First of allthe firm must own or operate assets that behave like monopolies.

Second, the services provided by the company must be essential to the proper functioning of a community. These companies have predictable cash flows that make them attractive defensive assets.

The main inflation protection for utilities stems from the fact that they are regulated at the time of earnings. Their regulators set the price for the service provided by the utility in such a way that the utilities get a “fair” return. When inflation raises input and other costs, including the cost of capital, regulators allow utilities to raise their prices to ensure that their returns fairly compensate shareholders over time for the capital invested to deliver their services. . If the regulatory process is working effectively, accelerations or decelerations in inflation and related changes in interest rates should have a limited influence on the financial returns of regulated utilities.

The same is true for most infrastructure assets. The prices charged for services by infrastructure assets such as toll roads or airports are usually linked to inflation through regulation or contract. The value of the company is thus somewhat protected from variations in inflation. Inflation can even increase the value of infrastructure assets over time, as these assets typically enjoy higher customer base as population and wealth increase.

Listed and unlisted infrastructure assets are inflation proofed to the same extent because the structure through which the assets are held does not change the economics of the assets. The business model of the assets will reflect the demand for the service provided by the asset, the regulatory framework the asset faces and the underlying cost structure for the service provided.

Listed versus unlisted

Investors who can see the inflation-hedge benefits of owning global infrastructure and utility assets face an early decision: choosing between listed and unlisted infrastructure assets. Many might lean towards the listing as it has some key advantages over the unlisted.

1. An ability to invest quickly

While investors can take many years to find available assets and invest their capital in unlisted infrastructure, hundreds of millions of dollars can be invested in days in the world’s best listed infrastructure companies.

2. Easy diversification

The publicly traded global infrastructure and utilities universe tracked by Magellan contains more than 130 companies from 22 countries and 10 industry segment classifications (as defined by Magellan). This choice means that investors can build a well-diversified portfolio of listed infrastructure stocks on a regional and sector basis.

In comparison, it is not uncommon for unlisted infrastructure funds to hold a concentrated portfolio of 10 to 15 assets that are generally skewed towards one sector or region. Ultimately, the portfolio composition of unlisted funds is highly dependent on the assets available at the time the fund is invested.

3. Greater transparency

Listed securities are transparent, unlike private infrastructure funds which can often require ‘blind engagement’ in what can be a portfolio of low quality assets.

4. No costly failed offers and related costs

Unlisted infrastructure funds typically start with a sum of money and then make an offer to buy assets. These offers often fail and incur costs. Each offer may involve significant expenses for legal, tax, accounting and advisory services, which are ultimately the responsibility of the investors, whether the offer succeeds or fails. Even the most experienced infrastructure managers are not successful with every offer.

5. No forced sale

Listed infrastructure assets are not subject to any forced asset sales. Most private infrastructure and unlisted funds are “closed” with fixed periods until termination. At the end of the term, the assets must be redeemed (unless there is a vote to extend the term) and this could result in the sale of assets in sub-optimal market conditions. The open nature of listed assets means exposure can be held indefinitely.

6. An ability to switch between regions and sectors

Once investors have built a well-diversified portfolio of global listed infrastructure stocks, they can easily adjust holdings across sectors and regions to take advantage of different market conditions. This ability can improve the risk-return profiles of listed infrastructure portfolios. Unlisted infrastructure funds are limited in their ability to perform medium-term shifts between regions and sectors during the life of the fund due to the illiquid nature of the unlisted infrastructure investment universe .

7. More liquidity and live pricing

The listed market is liquid enough for investors to easily gain and reduce their exposure to global infrastructure companies. Live pricing allows portfolios to be valued immediately, unlike the unlisted market where valuations are infrequent and opaque.

Managing illiquid assets within an overall asset allocation framework can make it difficult to maintain proportionate weightings. Acquiring assets in private markets takes time and a significant recovery or downturn in public markets can upset the balance of a portfolio and potentially exacerbate the cyclical nature of portfolio returns.

8. More opportunities for pricing errors

The analysis suggests that over the past decade, listed infrastructure investment opportunities have traded at a significant discount to similar infrastructure assets in the unlisted market.

In theory, private market infrastructure assets should be priced at lower prices than their exchange-listed equivalents due to their illiquidity. This discount should provide investors with generally longer investment horizons the opportunity to exchange liquidity for higher long-term returns.

However, the opposite has happened in recent years.

The supply and demand dynamics for private market infrastructure have changed such that many of these assets have historically been acquired at valuation premiums to their publicly traded alternatives. This partly reflects the intense competition for many assets in unlisted markets, driven by the sheer weight of capital in the sector. Data provider Prequin estimates that total capital awaiting deployment in unlisted infrastructure funds is $300 billion, up nearly 300% from a decade ago, and this does not include large institutional investors, such as pension funds and sovereign wealth funds, which also invest in these assets.

Gerald Stack is Head of Investments, Head of Infrastructure and Portfolio Manager, and Ofer Karliner is Portfolio Manager at Magellan Asset Management, a sponsor of Firstlinks. This article is general information and does not take into account the situation of an investor.

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