For investors within the Local Government Pension Scheme, infrastructure looks like a good investment due to its long-term time horizon, but how does it hold up in times of high volatility and inflation? Aysha Gilmore reports.
Global markets have experienced a double challenge of high volatility and inflation over the past years. In 2020, amid the Covid pandemic, the VIX index surged to the highest levels since the 2008 crisis.
Whilst UK inflation has now fallen to 3.4%, it peaked at 11% in October 2022, with the Bank of England now predicting that inflation will return to its 2% target in the coming months but will pick up again after that. Overall, this represents a challenge to the Local Government Pension Scheme (LGPS), whose benefit payments are linked to inflation.
Investors are therefore increasingly on the lookout for assets to help them navigate this uncertain environment and infrastructure appears to be ticking these boxes.
Infrastructure assets suit investors within the LGPS due to their in-built and long-term revenue contracts, spanning 10-20 years.
So, in light of recent economic uncertainty, how are infrastructure assets keeping up with inflation?
Asad Rashid, senior investment research consultant at Hymans Robertson, suggests that infrastructure is an asset which performs well during times of volatility, with it tending to do “better than most asset classes in an inflationary environment”.
“A good portion of infrastructure assets can pass on 100% of inflation, and even assets without explicit inflation linkage often offer some implicit protection,” he explains.
Development vs operational
Infrastructure investment can be broken down into two broad phases – the development and construction phase and the operational phase. Operational infrastructure assets, have a “strong ability” to pass through full inflation to end consumers, “for example, our electricity, mobile and water bills have all gone up recently in line with the high inflation we have seen in the past two years,” Rashid explains.
“Part of the reason for this price hike is that the inflation-linked payments are passed on to the infrastructure owners, i.e. those who own the fibre/telecom networks, power generation assets and water infrastructure underlying these services,” Rashid says.
For example, GLIL, a £3.6bn infrastructure investment platform, designs its assets to be inflation-linked, offering returns of UK CPI + 4-6% over a rolling ten-year period.
Speaking to Room151, Ted Frith, chief operating officer at GLIL, explains: “High inflation is likely to increase our operating costs as the price of materials and wages rise, such as in our ports business and in our construction projects, but the flip side is that the price of product sales also increases.
“In the most recent inflationary spike, our portfolio of electricity generating assets has profited materially from the significant increase in the price of power.”
Frith states that operating costs are likely to be the most significant drag on returns in an inflationary environment. “Managing costs, therefore, is a key part of maximising returns from our infrastructure investments.”
However, inflation may be a potential risk in the development and construction phase of an infrastructure asset, Rashid explains as this could cause higher than budgeted labour or construction costs, impacting the profitability of a project.
Frith notes that managing these costs through sensible contracts is key to mitigating these impacts. “We minimise short-term costs by trusting our management teams to have a keen eye on cost management and on optimising their operational process.”
“Additionally, we favour fixed price contracts wherever possible for significant capital expenditure projects,” he continues.
Also, construction cost inflation can be positive for assets that have been already built. “As new assets become more expensive to build, the capital value of existing assets rises as they are now more attractive on a relative basis,” Rashid explains.
Significant inflows into infrastructure
But despite these short-term challenges, appetite from LGPS funds to invest in infrastructure has been significant.
According to the LGPS Scheme Advisory Board’s annual report for 2022/23, investments in infrastructure continued to see positive flows, much of which went into green or renewable investments. In total, it highlighted that £6.6bn (18.5%) of the £369bn pension scheme has been committed to the asset class.
It also highlighted that infrastructure investments delivered an average return of around 5%, below the return of other alternatives but broadly in line with benchmarks.
GLIL, committed to three projects in 2023 alone: the acquisition of a minority stake in Cornerstone, a mobile tower joint venture, a deal worth £360m; the acquisition of a 25% stake in the M6 toll road; and establishing a UK-focussed Lyceum Solar portfolio, which included an investment of £200m in solar energy assets.
Frith states: “First hand, we have seen GLIL’s members continuing to allocate capital to our UK core infrastructure portfolio. Our fund now has commitments approaching £4bn from our seven pension fund investors.
“Elsewhere, whilst 2023 was somewhat quieter, the last decade has seen significant inflows into the sector as a whole from pension funds, insurance companies and sovereign wealth funds.
“The greater predictability, lower volatility, and the inflation-linked cash-flows from investing in infrastructure remain attractive to investors, especially those that have long-term time horizons and can manage the lack of liquidity that comes with these types of investments.”
Outside of GLIL, eight LGPS funds backed a £450m investment in Gresham House’s British Sustainable Infrastructure Fund supporting vertical farming, broadband expansion and habitat banks alongside other local sustainability projects. The fund currently has a pipeline of £2bn and aims to deploy the additional £450m across its existing platforms.
From an investment pool perspective, in early 2024, ACCESS, which has 12 partner funds, confirmed two infrastructure fund vehicles managed by IFM Investors and JP Morgan. While ACCESS did not disclose the amount of individual transactions, it said that the deals “brought £1.5bn of infrastructure funds into ACCESS pool alignment”.
Resilient to market cycles
Rashid explains that the large appetite for infrastructure over recent years is due to returns on the investments being resilient to market cycles, due to the “monopolistic position that some infrastructure companies enjoy and the essential nature of the assets and services they provide”.
“The essential services provided by infrastructure assets mean returns can be fairly predictable and relatively resilient to economic stress and market cycles. We think the attractiveness of infrastructure lies in the asset class’s ability to provide high-income streams with long duration and inflation protection.
“The fundamental reasons for investing in infrastructure remain firmly in place and the asset class remains as attractive as in previous years.
“Asset valuations went through a correction in 2022/23 and are now showing some signs of stabilising. The sharp rise in short-term interest rates has not had a significant impact, as most infrastructure assets are financed with long-term debt,” Rashid continues.
Financing pressure
However, higher interest rates which were put in place in order to contain inflation may have an impact on financing infrastructure investments. Despite UK inflation cooling down, the Bank of England has maintained the base interest rate at 5.25%. This can make financing for projects more expensive and less accessible as lenders will likely prioritise high-quality assets and experienced counterparties.
Rashid explains: “Infrastructure fundamentals have held up relatively well so far, but slowing growth is a potential risk to some cash flows, particularly gross domestic product-linked assets.
“Across the asset class [infrastructure] as a whole, we expect to see a divergence in performance between assets and strategies which can pass on inflation and have already secured low-interest costs, and those that cannot.
“In the current tough economic environment, demand for the best assets is likely to remain strong, with assets requiring a significant amount of work or capital likely to be repriced to lower levels.”
The appetite for investing in infrastructure should remain strong throughout 2024 and going into 2025, with the main reasons for this being that it offers predictable income streams and is supported by secular trends, Rashid explains.
Adding to this is the desire for pension assets to deliver positive social outcomes, Frith states: “There is a sense that investing in infrastructure can be a social good; providing an engine for growth for the economy, assisting in the energy transition and providing the new infrastructure that our communities and society crave. And at the same time producing an appropriate risk-adjusted return for the portfolio.
“I see, therefore, infrastructure remaining an attractive place to invest in today’s market.”
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