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The Evolving Risk-Return Spectrum in Infrastructure
Capital Call - a bi-weekly newsletter from LPs for LPs, covering the latest and greatest from across the private markets
Calling all LPs! Thanks for joining me (John Bailey, Co-Founder at OneFund) for another edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs.
The mission of Capital Call is to deliver concise, top-notch insights and updates from the private markets tailored to what matters for LPs.
This week we will be looking at:
The Evolving Risk-Return Spectrum in Infrastructure
The Supply Chain Recovery
Fundraising updates and VC/PE reports
GP Perspectives from Scott Nuttall & Michael Arougheti
About OneFund
OneFund is democratizing access to Private Equity and Venture Capital for everyday investors. We partner with the world's top PE & VC funds to offer investment options without the million-dollar minimums.
If you would like to follow what we are doing, get more regular updates directly from the team, or become a member, schedule a call!
Industry Insights
The COVID-19 pandemic in many ways fundamentally altered society’s approach to infrastructure and supply chain, changing critical infrastructure use habits, digitalization trends, procurement strategy, and more. However, recent data shows many negative pandemic impacts reverting, and infrastructure and supply chain emerging stronger than ever on various measures.
In this week’s newsletter, I’ll analyze the changing dynamics within both these sectors and discuss potential opportunities for LPs to capitalize.
The Evolving Risk-Return Spectrum in Infrastructure
Infrastructure has shown to be resilient through economic uncertainty thanks to its fundamental characteristics and strong secular tailwinds. Overall, it has navigated high inflation, rising interest rates, geopolitical tension, and political uncertainty. Looking at data from UBS below, most infrastructure sectors were resilient throughout the pandemic and are now outperforming pre-COVID revenue levels (with airports being the understandable outlier).
Despite performance data within the sector remaining strong, infrastructure GPs are dealing with rapidly changing return expectations as a result of historic interest rate hikes. In the near-zero interest rate environment prior to mid-2022, it was easier for funds to employ a strategy of levering up on debt to boost returns of infrastructure and supply chain investments. Today, however, thanks to the changing interest rate environment, value-added and opportunistic strategies are gaining attention. The mid-single-digit returns of core infrastructure were appealing when interest rates neared zero, but the current 5.5% U.S. rate forces LPs to pivot to strategies focused on double-digit returns.
As seen in the analysis and prediction from J.P. Morgan above, highly defensive segments such as regulated utilities and contracted power generation are not providing a significant return outperformance over treasury rates. LP interest is shifting towards more opportunistic sectors, especially merchant (uncontracted) renewables / traditional power as well as digital infrastructure. These sectors, J.P. Morgan expected, may return 10%+ in 2023 and benefit enormously going forward from the long-term secular trends of digitalization and energy transition.
Another value factor for LPs interested in infrastructure is that power generation and digital infrastructure feature sizing flexibility. GPs can acquire local wind and solar assets or regional telecom or fiber networks, but sizing for airports and nationally regulated utilities can only be done at scale. This better suits the trend of acquisitions shifting toward the middle market.
Agile, middle market GPs operating across renewables and digital are attractive, but LPs should keep in mind these sponsors still require strong operational expertise. Despite smaller sizing, these investments typically require navigating strict regulatory and environmental approvals, merchant risk, contract management, and municipal government relations. GPs in this space cannot merely be financial buyers and must ensure they have adequate operational staff to support investment teams.
Supply Chain Recovery may Shift Procurement Strategies
Procurement managers have rapidly shifted their supply chain strategies through the pandemic disruption, often using near-shoring and other initiatives to improve flexibility at the expense of higher costs. However, this remains situation remains incredibly fluid given potential geopolitical concerns and that supply chains have more than recovered from COVID-19 disruptions.
As seen in the chart above from S&P Global, generally supply chains now have the fastest lead times since 2009 due to the debottlenecking of logistics networks. S&P predicts we’ve reached peak efficiency, and numbers may revert slightly to March 2023 levels, but pressures on supply chains remain light moving forward.
Additionally, the soaring shipping coasts of 2021 and 2022 have fully reversed as current prices are below pre-pandemic levels. Prices peaked at $18,000 per FEE (Forty-Foot Equivalent) in September 2021 and have since dropped to $1,000 per FEE. S&P notes that the direction for shipping rates is a function of capacity discipline and that the Journal of Commerce reports
that capacity could increase by 19% year over year by the end of August. This means rates should hold low or even drop as the shipping supply increases.
What low shipping rates and efficient lead times mean for sponsors and LPs is that applying overly conservative supply chain strategies does not need to dampen deal returns anymore. Sponsors would often pursue non-Asian procurement strategies and local OEMs during the disruption, reducing underwritten IRR due to higher costs, but can now design supply chains more akin to pre-Covid strategies. Industries that heavily rely on Asian components, such as computer chips, solar panels, and batteries, should also benefit from reduced shipping costs.
LPs should evaluate how their sponsors are rethinking supply chain strategy, and ensure they are adapting to the changing environment.
Updates from Across the Ecosystem
Fundraising
Reports
GP Perspectives
Private equity’s optimism has improved over recent months, and many are hopeful it will persist to fix the challenged fundraising environment. Discussing KKR’s Q2 results, Nuttall states, “It’s too early to declare a return to normalcy, but there’s no doubt it feels like the markets are thawing a bit. The new deal pipeline and activity is up.”
If markets continue to improve, an uptick in deal activity can be expected as KKR feels pressure to deploy their $100b in dry powder and other sponsors follow suit. LPs can expect new fundraising to happen through the rest of 2023 and 2024 but should also be wary that current sentiments are fragile and can reverse at any sign of bad news.
Michael Arougheti (Ares, CEO)
Ares Management’s CEO, Michael Arougheti, is confident in the resilience of its 3,000-company middle market strategy. If the economy worsens, Ares has had time to improve PortCo's balance sheets and may benefit from the expected lowering rate environment. He doesn’t want to write off the possibility of slowing growth but notes the figures from Ares PortCos are coming in and are demonstrating continued strength.
About OneFund
OneFund is democratizing access to Private Equity and Venture Capital for everyday investors. We partner with the world's top PE & VC funds to offer investment options without the million-dollar minimums.
If you would like to follow what we are doing, get more regular updates directly from the team, or become a member, schedule a call!
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