The resilience of infrastructure: Understanding valuation considerations

In recent years, infrastructure has emerged as a resilient asset class, particularly during inflationary periods. The prevailing assumption is that inflation leads to higher interest rates, which can positively influence revenues while having a less detrimental effect on interest expenses, capital expenditures (capex), and maintenance costs. However, this article contends that the resilience of infrastructure investments is not an inherent quality; rather, it necessitates active management and value creation, akin to other alternative investment asset classes. Therefore, it is crucial for investors to comprehend how periodic valuations are constructed and to identify the key drivers influencing these valuations.

The unique challenges of infrastructure as an asset class

The infrastructure landscape is vast and has evolved significantly over the past few decades, establishing itself as a distinct asset class. This sector encompasses numerous industries, each with its own dynamics, regulatory frameworks, and correlations with overall GDP. Some sectors may be regulated or incentivized with public funding, while others may present varying risk profiles.

For instance, transport assets such as airports and toll roads faced considerable challenges during the COVID-19 pandemic, as their returns are closely tied to economic growth. In contrast, data centers and energy assets are driven by different factors, particularly the long-term trend of increasing connectivity and sustainability considerations. A thorough understanding of these sector-specific dynamics is essential for grasping the valuation intricacies.

Moreover, not all assets within a sector are created equal. In the energy sector, for example, environmental, social, and governance (ESG) trends impact conventional and renewable energy assets differently. Additionally, the energy infrastructure sector is often characterized by regulatory influences, particularly in the case of electricity grids or publicly subsidized renewable assets.

In recent years, there has been a noticeable shift towards infrastructure assets with higher risk profiles, moving away from supercore and core assets in pursuit of higher yields. Some investments now resemble private equity-like structures, such as renewable development platforms with ongoing operational features. Articles like “Pipeline or Pipe Dreams? Valuing Renewables Platforms” by Infrastructure Investor highlight the distinct risk considerations associated with such assets.

The valuation process for infrastructure assets

The appeal of infrastructure investments lies in their stable and predictable cash flow streams, often coupled with inflation-protection features. Investors typically utilize discounted cash flow (DCF) techniques to estimate the value of these assets based on forecasted cash flows. However, the process of valuing infrastructure assets is far from straightforward.

Determining cash flow forecasts is a complex endeavor that demands advanced modeling skills. Most infrastructure assets require intricate financial models for various purposes, including valuation. These models must integrate a multitude of factors, such as operational, regulatory, financial, accounting, and tax considerations. It is not uncommon for these models to comprise dozens of spreadsheets containing thousands of unique formulas, all crafted by financial experts specializing in this area.

Recognizing the significance of these complex models, supervisory authorities often recommend independent annual model reviews, as evidenced by the CSSF feedback report 2023 on ESMA's Common Supervisory Action on valuation.

Once cash flows are established, the next step is to determine the discount rate at which these cash flows will be discounted to present value. This requires a deep understanding of the asset's characteristics, cash flow model, and external environment. Given the precision needed in cash flow estimation, the discount rate must also incorporate asset-specific considerations, often manifested as risk premiums that supplement the base market-derived discount rate. These risk premiums may account for construction, commercial, and regulatory risks, among others.

Insights for investors

Given the sensitivity of infrastructure asset valuations to asset-specific factors, investors are eager to comprehend how asset managers or valuation professionals derive their valuations, and which standards are applied. In this context, adopting well-recognized valuation standards, such as the International Valuation Standards, is a welcomed practice.

Valuation bridges, sensitivity analysis, and discount rate analysis are valuable tools that can help investors understand the underlying dynamics and drivers of infrastructure asset valuations.

• Valuation bridges: These break down changes in valuation compared to previous exercises, distinguishing between cash flow forecast changes, capital operations, cash flow timing, and changes in discount rates. For example, the spike in energy prices in 2022 or ongoing technical improvements in wind farms have significantly impacted cash flow forecasts in recent years. A valuation bridge illustrates how such factors can influence valuations.
• Sensitivity analysis: This provides insights into the impact of key valuation drivers, allowing investors to assess the main risk factors. For instance, a 50 basis points change in risk-free rates can significantly affect valuations, particularly for highly leveraged assets. A sensitivity analysis may provide an answer to questions such as, “What if there is such a 50 basis point change?”
• Discount rate analysis: This offers a glimpse into how various components have evolved over time, such as changes in asset-specific risk premiums. In cases of significant discount rate fluctuations, further inquiry into the asset's background and market environment may be warranted.

Current valuation trends

According to the EdhecInfra index Infra300, as of Q3 2024¹, the index has shown positive performance in the high single digits in recent years, with a notable 16.99% return over the last 12 months, supported by interest rate cuts that have reduced discount rates.

As 2024 valuations are being finalized, several trends are emerging:

1. Stabilization of discount rates: After increases in 2022 and 2023 due to rising risk-free rates, discount rates in 2024 have stabilized at slightly lower levels, excluding asset-specific considerations.

2. Volatility in energy prices: Although energy prices have decreased from their 2022 peaks, they remain volatile, complicating financial forecasts and impacting valuations of energy infrastructure assets.

3. Capex requirements: Significant capital expenditures related to decarbonization, and electrification introduce volatility in the valuations of various infrastructure assets, such as energy grids. Adjusting discount rates in line with capex progress remains a subjective area requiring expert judgment.

4. Future financing needs: Assets with upcoming refinancing requirements, such as renewable development platforms, have valuations which are particularly sensitive to macroeconomic uncertainties.

The resilience of infrastructure funds has been underscored by their performance amid economic challenges, including the COVID-19 pandemic and geopolitical tensions. Their long-term investment horizons and the essential nature of their services maintain consistent demand, providing stable cash flows. Government support and favorable regulations further enhance their appeal, driving increased allocations from institutional investors.

Despite challenges faced by clean energy funds in Europe, which have underperformed conventional energy assets due to supply chain issues and inflation, the demand for cleaner energy remains strong. Asset managers' experience is crucial for value creation as investments shift toward higher-risk options. Infrastructure valuations are negatively impacted by high interest rates but are supported by inflation, indicating that long-term infrastructure returns remain positive, albeit with variability.

While this list is not exhaustive, it underscores the importance of understanding the drivers behind valuations. Despite the overall positive market performance, asset-specific considerations can vary widely.

Conclusion

Infrastructure is rightly considered a resilient asset class, particularly in light of recent challenges such as the pandemic, rising inflation, and geopolitical uncertainties that have adversely affected other alternative investment classes. However, this resilient performance should not obscure the significant differences that exist between various infrastructure sectors and even among assets within the same sector.

Investors must therefore continue to scrutinize asset valuations closely. The quality of valuation models and reports is essential for enhancing investors' understanding of the infrastructure landscape and its inherent complexities. By doing so, they can make informed decisions that align with their investment strategies and risk appetites.