To say that the current investment environment is challenging is an understatement. But private infrastructure – direct investments in physical assets that provide essential services to the economy – has been a rare bright spot in portfolios globally. Despite the economic and political shocks over the past year, infrastructure has remained resilient, with valuations and returns rising steadily throughout the past year. There are several reasons for that, according to a recent in-depth article from TD Asset Management Inc. (TDAM) called Private Infrastructure: A Rare Bright Spot in a Fractured World.

Hedge Against Inflation

The first reason is that infrastructure can provide a hedge against rising inflation, something the asset class demonstrated particularly well in 2022. Most private infrastructure assets offer essential services and require large upfront investments. As a result, underlying contracts typically have terms of 30 years or more, and they are often directly linked to Consumer Price Index measures, meaning that cash flows increase with rising prices.

Stable Discount Rates

The second reason for infrastructure's resilience is stable discount rates. Private infrastructure assets are typically valued based on a discounted cash flow model. Generally, these models consist of relatively easy to forecast cash flows, discounted by an appropriate risk-adjusted discount rate, which is derived using the capital asset pricing model (CAPM).

In general, as interest rates increase, discount rates are pushed higher, which in turn lowers valuations. However, CAPM hasn't been able to account fully for the relationship between interest rates and infrastructure discount rates over the last decade. During this period, private infrastructure assets have been valued with discount rates as high as 15%, well above what the CAPM formula would calculate. To explain the divergence, a buffer has been built into CAPM discount rates, known as an asset specific risk premium. As risk-free rates rise, this risk premium has room to compress, keeping the overall discount rate – and therefore valuations – relatively stable.

Influx of Capital

The third reason which drives the value of infrastructure is that the demand for high-quality assets in that space continues to set records, as investors progressively increase their allocation to the asset class. This influx of capital means more competition for infrastructure assets, keeping discount rates low and supporting valuations despite the rise in interest rates more generally.

Need for New Infrastructure

The last reason is the immense need for new infrastructure assets around the world.

The supply of new projects remains robust, driven by population growth, renewal of aging infrastructure, and the global shift to cleaner energy. For example, electricity demand is expected to triple in the coming years, as countries around the world seek to reduce their reliance on fossil fuels, while responding to renewed calls to strengthen energy security.

Looking Forward

In 2022, private Infrastructure proved itself as a strong addition to investment portfolios. TDAM anticipates that the inherent characteristics of these essential assets will continue to provide portfolios with stability, excess return and inflation protection well into the future.

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