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A Paradigm Shift: Infrastructure Equity 2.0
By: Mina Pacheco Nazemi and Addie Sparks, Barings
Historically viewed as a yield-oriented and inflation-protected (but lower returning) asset class, infrastructure equity is transitioning to assets that could drive alpha in an investor's portfolio.
This is an excerpt from NCPERS Summer 2024 issue of PERSist.Historically viewed as a yield-oriented and inflation-protected (but lower returning) asset class, infrastructure equity is transitioning to assets that could drive alpha in an investor's portfolio.
Infrastructure Equity 2.0: The Evolution from Toll Roads to Carbon Capture
Infrastructure investing is changing. For decades, the asset class has been characterized by assets that provide essential services that are highly regulated—including toll roads, utilities, and ports. However, over the past 10 years, the opportunity set has evolved into a new version of infrastructure. Compared with the toll roads of the past, “Infrastructure Equity 2.0” includes companies and projects that are more distributed in nature (i.e., typically fixed assets that are distributed spatially), smaller in scale, and composed of multiple assets. These companies and projects are typically characterized by:
- More conservative capital structures (often with modest or no leverage),
- Fixed-rate debt with medium- to long-term maturities,
- Inflation protection,
- Contracted cash flows.
There are a number of secular tailwinds driving growth in both supply and demand for these assets over the coming years—from the exponential increase in data consumption globally, which is driving the need for enhanced digital infrastructure, to global efforts to meet climate goals, which is increasing demand for infrastructure related to the energy transition. These trends are shaping attractive investment opportunities in the next generation of infrastructure, particularly at the lower end of the market (i.e., enterprise values of $200-500 million).
Given that these trends are likely to persist and possibly even accelerate, we believe this segment of the market has the potential to outperform over the next decade—which is supported by the historical outperformance of the middle market, generally, over market cycles. Specifically, we see these opportunities across four key sectors (Figure 1):
Record-level Fund Sizes are Emerging in Infrastructure
Infrastructure is currently experiencing trends similar to those that have characterized the private equity industry over the last decade. For one, there are fewer funds raising record-breaking fund sizes in the market. At the same time, there is a desire by limited partners (LPs) to consolidate their fund commitments with larger checks to fewer sponsors. In short, LPs are aggregating their capital to fewer and larger managers with 81% of the capital raised in infrastructure for the last five years funneling to funds over $1 billion.1 This dynamic has led to a dearth of capital being raised in the lower and middle market.
Are Middle Market Funds Positioned to Generate Stronger Returns?
As investors in the asset class for over 10 years, we have observed that as
infrastructure funds have grown larger and more established, performance has historically reverted to the mean (Figure 2). Alternatively, smaller infrastructure funds have historically outperformed their mega fund peers due to a number of reasons—including relatively attractive valuations, a wider opportunity set, and expanded exit environment.
The middle-market, value-add segment of the market looks particularly attractive today. In addition to less competition, because funds in the middle market tend to be smaller in size, they allow managers to be more nimble and invest in less-efficient corners of the financial markets. As a result, smaller managers are well-positioned to identify companies that could potentially outperform and have historically benefited from more attractive valuations and capital structures.2
Emerging Managers: Potential to Generate Outsized Alpha
In addition, the performance of larger, established managers has historically been trending toward the median (Figure 3). For the largest and most mature funds (Funds IV and higher), data shows that performance has declined over time, with more of these funds falling into middle quartiles. There are a number of reasons why, including the fact that larger GPs are often overseeing funds in various lifecycle stages (fundraising, investing, portfolio management, and exiting), while emerging managers can typically dedicate the majority of their time and attention to investing and managing a smaller portfolio with fewer assets. Also, emerging managers tend to be more strongly aligned with their investors, both financially and psychologically, as their long-term success is predicated on making strong investments out of the gate.
Key Takeaway
We believe the opportunity appears most attractive in the middle market, where smaller infrastructure funds have historically outperformed their mega fund peers. That said, given the number of potential challenges that could impact private markets going forward, we believe disciplined manager selection and maintaining active portfolio management are key factors for success.
Endnotes:
1 Source: Barings, Pitchbook Q1 2023 Global Real Assets Report. As of March 31, 2024.
2 Source: DealEdge. As of October 4, 2023.
Bios: Mina Pacheco Nazemi is the Head of the Diversified Alternative Equity team and serves on the investment committee. She is responsible for originating, underwriting and monitoring GP relationships, direct/co-investments and continuation vehicle opportunities for private equity and real assets. Mina has worked in the industry since 1998 with experience as a general partner and limited partner investor in private markets and focused on underwriting direct/co-investment opportunities. She is also a board member of the Pan American Development Fund and serves on the investment committee for the City of Hope and Cal State Los Angeles. Additionally, Mina is a current Finance Fellow for The Aspen Institute. Mina holds a Bachelor of Arts with honors in Economics and Political Science from Stanford University and her Master of Business Administration from Harvard Business School.
Addie Sparks is a member of Barings' Diversified Alternative Equity team and is responsible for originating, underwriting, and monitoring of private equity and real assets and co-investment & continuation vehicle opportunities in North America and Europe. Prior to joining the firm full-time in 2019, Addie interned on the Barings' Global Business Development team. Addie holds a B.S. in international business and finance and a minor in Chinese studies from the University of South Carolina.
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