It is commonly stated that infrastructure helps protect portfolios from inflation, but Justin Webb, associate director of Access Capital and member of the Investment Management Consultants Association & Mike Wright senior associate at Access Capital Partners believe this claim does not always stand up to close scrutiny.
It is often claimed that infrastructure investments provide investors with protection against inflation. And that they successfully navigate through a high inflation scenario by passing on this inflation to end users. At an operational level I agree with this claim, albeit noting the magnitude of the inflation hedge differs substantially across infrastructure sectors. In the case of regulated assets, the level of inflation running through the economy is often a direct input into pricing and revenue. In other cases, high pricing power and strong profit margins (reflecting the monopolistic and capital intensive nature of these assets) means investments are well placed to pass on higher costs to consumers.
However, those making this claim are only telling half the story. While it is true that many of these assets have the ability to pass on higher costs, inflation spikes are typically accompanied by an increase in interest rates, reflecting the response from central banks and from bond investors who demand higher returns to compensate for inflation. Rising interest rates can have a direct negative impact on cash flows due to higher debt servicing costs (depending on the financing structure of the asset and the extent to which debt is fixed). Importantly, higher interest rates are also likely to have a negative impact on the current value of infrastructure assets in the eyes of investors. Given the long duration of many of these infrastructure assets, this negative impact could be material.
Exploring this concept a little further through a simple example, imagine two infrastructure assets, one a regulated asset in which all of the CPI increase can be passed on to end-users, the second an airport or port, which would likely be able to pass on a significant, though not full, amount of the CPI increase to customers and with revenues affected by GDP given passenger numbers (airports) and container throughput (ports) are impacted by the real economy. Under a high inflationary scenario, both assets are likely to see to their net operating cash flows rise, which is the basis for commentators to proclaim these assets to be inflation proofed.
However, Figure 1 and Figure 2, depicting the net present value impact as a result of an inflation shock, simplistically illustrate what is often left unsaid. That is, under the inflationary scenario, the effects of net operating cash flows, higher capital expenditures (including debt servicing), and discount rates (as a result of a higher risk-free rate) greatly impacts what investors ultimately care about – this being equity distributions and the value of their investment. In both cases, the discount rate effect (being subject to a higher discount rate in valuing the investment) outweighs the inflation proofing of each asset at the operational level – in our specific example, Asset 1 and Asset 2 fall in value by 8 per cent and 18 per cent respectively.
At an operational level, assets such as regulated utilities are likely to fare better than GDP linked investments such as airports and ports in a high inflation scenario, given that these regulated assets have the ability to pass on a higher amount of inflation to end users and are less sensitive to economic conditions as a result of inflationary changes. However, such regulated assets are likely to carry more leverage than their GPD exposed counterparts and therefore be subject to a lower applied discount rate in their valuation. This is likely to translate to a greater negative effect on value than for GDP linked assets due to the higher discount rate effect in a high inflationary environment. Despite this greater fall, from an investment value’s perspective, the net effect is that regulated assets are likely to hold up better under our inflationary scenario.
It is important to note however, that while we can make broad remarks about how these asset classes will fair in such a scenario, ultimately the individual characteristics of each investment will dictate how it will stand up to such an inflationary shock.
A further consideration which is often neglected relates to the earnings multiple (typically measured by enterprise value/EBITDA) that infrastructure investors are willing to pay may fall in a high inflationary environment. Similar to a price to earnings (P/E) ratio in listed markets, EV/EBITDA is a valuation multiple widely used to measure the value of infrastructure investments. In figure 3, data from the S&P 500 Index since 1900 illustrates that lower P/E ratios have generally been observed during higher inflationary periods. Specifically when inflation was between 6 per cent and 10 per cent, the average P/E ratio was 13 times,
and when inflation was over 10 per cent, the average P/E ratio decreased to 9 times.
Given that infrastructure is a relatively new asset class it has not experienced a period of sustained high inflation and therefore it is not possible to analyse data on valuation multiples through such economic conditions. However, given the evidence in equities throughout these periods as well as the correlation between listed markets and listed infrastructure it is not unreasonable to assume that there may be downward retreating in valuation multiples for unlisted infrastructure in a period of high inflation.
When it comes to inflation proofing, infrastructure assets are not a silver bullet. On the whole, these assets can benefit at the operational level during a period of high inflation. However these gains are likely to be more than offset from a revaluation perspective due to the effects of capital structure issues and higher applied discount rates as a result of a subsequent period of higher interest rates. Furthermore they are unlikely to be immune from lower valuation multiples in a high inflationary environment.
While their level of inflation proofing is not perfect, infrastructure investments still play a very important role as part of a diversified portfolio of superannuation assets in an inflationary environment. We believe that such assets are likely to fare better than fixed interest and equity investments when subject to the same inflationary environment and offer prospective returns higher than cash and inflation linked bonds, which are required by superannuation funds in order to meet the return objectives.
For investors seeking to maximise the inflation proofing qualities of infrastructure investments, this is best achieved through building a diversified portfolio of infrastructure assets that have direct linkages to CPI in their revenue, high operating margins and capital structures not susceptible to interest rate rises.