Infrastructure and inflation protection - Putting theory to the test

To put our infrastructure investing experience with inflation mechanisms to the test, we recently tested our assumptions with a survey to each of the managers in our infrastructure secondaries funds, SISF II and SISF IV. Our survey ultimately represented data from 294 assets using data from the managers models that formed the base case of their investment. As a Core infrastructure manager our dataset is heavily biased to Core, relative to the broad range of infrastructure sectors. Nevertheless, the range of responses was illustrative of how sensitivities can vary even within the Core group of infra managers.

As not all assets react in the same way we decided to split our sample in three main categories outlined in Figure 5, based on the assumed inflation mechanisms that different groups of revenue offer. We anticipated that Core assets, with contractual agreements would be better positioned against an inflation increase as their revenue streams usually adjust for inflation through a pre-agreed formula. Following them, Core Plus/Value Add assets with monopolistic elements may not directly benefit from inflation, however they are typically in position to increase their prices given their strong bargaining power. Finally, the Opportunistic assets, being strongly GDP-linked, were expected to respond well to inflation only when driven from the increasing demand during higher economic activity.

Methodology

Since inception, the SISF investment strategy has focused on Core infrastructure with its strong claim to offering inflation protection. As part of our core strategy, we look to acquiring assets with strong inflation sensitivity. Therefore, more recently, we tried to analyse the trends in our portfolio to see if there are any shortcuts, such as focusing on specific sectors or specific industries.

We ran sensitivities based on the asset models received from the managers of the various funds. Our dataset included a total of 294 assets across the infra universe. Our goal was to measure how much the project life IRR of an investment moved, for a 1% increase of inflation every year going forward, beyond the base case. Additionally, as part of our due diligence, we assign DCF rates to our assets based on their riskiness to proxy how “Core” an asset is. For each asset we compare the DCF rate to the inflation protection it offers.

Results

A summary of the key outputs is depicted in Figure 13 which verifies our expectation that Core assets tend to offer higher protection to inflation. This aligns to the investment targets for the SISF strategies across a well-diversified portfolio. In addition, assets with contractual agreements or multiple inflation protection mechanisms, also provide higher protection to inflation.

Our survey indicates that each asset reacts uniquely to inflation movements. Our results show a wide spectrum of sensitivities, even spanning negative territories. This idiosyncratic behaviour explains the high volatility that is translated into a low R2 of approx. 0.1. Despite that, a well-diversified portfolio of assets can effectively tackle this volatility, resulting in the formation of a portfolio that keeps track of inflation.

We performed an additional analysis at a sector level to understand if the dynamics around inflation are uniform. Once again, on average, any of the sectors offered a min. of 0.5% inflation protection, but individual results were rather scattered within each sector. For example, transportation assets (Figure 14) show the broadest range of results. This does not take us by surprise given the broad range of 18 assets in this group and is further explained through the example of three ports that SISF II has invested. The first port is NCIG, an Australian port with long term take-or-pay agreements but revenues to our investment mostly come from non-indexed subordinated debt, that offers no protection against inflation. The second one is Flinders Ports a Southern Australian port operator, with limited contractual protection and limited explicit capacity to pass through inflation, that has less than 0.5% sensitivity. Finally, Peel Ports a strategic asset in UK with strong ability to pass through inflation to clients and substantial leverage that has a 2.5x inflation sensitivity.

The survey revealed for the entire SISF series portfolio of assets a 0.98% sensitivity to inflation meaning that for a 1% increase in inflation above the base case Gross IRR is also increased by 98 bps, which illustrates that SISF infrastructure program offers a strong protection against inflation surge.

Inflation protection – key issues to consider

Overall, our asset level analysis has confirmed our views on the appeal of infrastructure investment as a source of inflation protection. We also see that within the broad range of infrastructure opportunities, core assets, with long-term debt profile and clearly defined contractual agreements, offer the strongest protections. Their indexation to inflation typically tend to perform better in an inflationary environment. We also know that during periods of increasing inflation, being fully invested is critical to sustaining returns.

However, there are no shortcuts to understanding inflation sensitivity for individual assets. While we have identified some basic mechanisms across types of infrastructure assets, each asset is highly dependent on offtake contract terms, exposure to various commodities and debt structures and geographies. As ever, diversification is contributing positively to balance out the intricacies of each asset assisting in the formation of an overall well-protected portfolio.