Commentary: Infrastructure as an inflation hedge

Infrastructure touches every aspect of our lives. From access to water, energy, transport and data, its tangibility and necessity have long reinforced the idea that the asset class provides a strong hedge against inflation. While true, it is not straightforward. With inflation running at levels higher than at any earlier point in the existence of the private infrastructure fund market, the veracity of this notion is particularly relevant.

Infrastructure is a diverse asset class and there are many approaches to investment. This diversity means that labeling all investments as having counter-inflationary protections is an oversimplification. Each infrastructure subcategory has unique characteristics, primarily how the assets are built, operated and generate income. Location adds a further level of complexity as individual markets feature divergent regulatory regimes, political dynamics, and economic and social demand.

The underlying notion of inflation protection is fundamentally sound — investment in assets that provide essential services usually feature revenues that are protected through contractual or regulatory mechanisms. So far, so simple. However, a combination of asset complexity, in addition to the end-user reliance on services can complicate matters.

A comprehensive understanding of the inflation sensitivities of assets, their contractual and regulatory mitigants and the limitations of these protections is essential to effective investment. By way of a simple example, the contractual revenues of an asset may be secured through an inflation-linked mechanism, with a periodic review and/or true-up. However, this does not account for operating costs, inputs, feedstock (fuel and other inputs such as biomass), staffing and maintenance that may not be contracted on the same basis, resulting in adverse impacts on returns, despite revenue-inflation linkage. In another, more extreme example, following a sustained high inflationary environment, services might no longer be affordable. If the end users are the public and the essential service is water, the issue is no longer a simple IRR calculation.

Successful approaches to infrastructure investment employ a strategic approach based on deep sector expertise, underpinned by long-term fundamentals and flexibility to invest a portfolio diversified by sector and geography, as well as across the risk spectrum. Additionally, there are three principles in asset selection and management that can provide an additional measure of protection against inflation:

Over the next 20 years, we will continue to see a shift into renewable energy and decarbonization solutions, increasing data connectivity and high-speed internet access requirements. These will remain fundamental building blocks of society, while an aging population will change the way we think about health and social care. These themes will stand the test of time — investment to resolve long-term societal needs, whether through renewable energy projects, fiber networks or better health-care technology and provisioning. They will be supported by long-term demand that will outweigh periodic inflationary pressures. Moreover, political will to deliver on these commitments is enshrined in public opinion or written into law.

Investing and building infrastructure businesses in growth sectors playing into broader societal themes requires deep sector-specific knowledge, a hands-on entrepreneurial mindset and the operational expertise to develop and execute investment opportunities. It also requires an understanding of an asset's role in future value chains and how this develops over the long term in a growing market segment. Managers with proven capabilities in these areas can be one step ahead and focus, influence and adapt to add significant value.

Managers with global capabilities across multiple jurisdictions can adopt best-in-class insights across a range of markets and geographies, optimizing opportunity and risk exposures by allocating where the best risk-adjusted returns are available and mitigating specific risks that may arise in other geographies. Current examples of this include the U.S., where managers seeking to navigate inflation are benefiting from the roll-out of the Inflation Reduction Act that has turbocharged renewable energy opportunities. Where the reverse is true, when conditions change or economic headwinds impact assets, global managers can identify relative value and redirect capital allocation to manage exposure to protect and optimize returns.

The infrastructure investment market is very different to that of 20 years ago. The same will be true in another 20 years. Identifying the ideas that will shape societal progress is central to good infrastructure investment, as well as contributing to a cleaner, healthier and a more connected future society.

No hedge is perfect. However, taking a highly specialized approach to long-term infrastructure demand taps into political, social and economic trends that extend well beyond short-term inflationary pressures. It requires presence across global markets, deep sector knowledge and a manager that rolls up its sleeves and takes an active approach — adjusting course when necessary to mitigate risk and capitalize on opportunities.

In a world where persistent inflation is likely, seeking resilient long-term investments that deliver value through investment cycles will become even more important. Allocators should take a considered and nuanced approach to infrastructure — the future of our portfolios and society may depend on it.

Vincent Gerritsen is head of private markets Europe at Morrison & Co. and is based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.