UBS Asset Management The infrastructure equity cycle Infrastructure white paper series Part 3 Institutional investor interest in the infrastructure sector is at record highs. This paper takes a closer look at the impact on valuations and examines where we are in the cycle. Declan O'Brien Alex Leung Real Estate & Private Markets, Research & Strategy
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 The infrastructure equity cycle: where are we now? This is the final installment of our infrastructure white paper series. Our first paper, The case for infrastructure debt (click here ), provided a closer look at the growing area of infrastructure debt. The second, Infrastructure and the economy (click here), explored how infrastructure returns might perform under various economic scenarios, particularly in a rising interest rate environment. This paper will examine where we are in the infrastructure equity cycle, in terms of investment style and valuations, and opines if the two are linked. Introduction Infrastructure equity is now an established asset class in institutional investors' portfolios making up around 3% 1 of total AUM. Fundraising in the infrastructure sector set a new record in 2016 of USD 66 billion, surpassing the USD 49 billion raised in 2013. This momentum continued in 2017 which saw USD 65 billion raised. Investor sentiment is at record highs: according to Preqin 2, 93% of investors surveyed felt infrastructure had met or exceeded their expectations; 90% expect to deploy the same or more capital in the next 12 months. Institutional investors' allocation to private assets has increased by 9% 2 p.a. (2010-2017); infrastructure was the asset class that recorded the strongest growth of 16% p.a. The attractiveness of infrastructure has been driven by its strong returns in a low-yielding environment. As with other private asset classes, the level of dry powder is at record levels as demand for high yielding assets exceeds investment opportunities. The step change in fundraising volumes in 2016 and 2017, and the rise of the mega-fund 3 has also contributed to the level of dry powder in the sector Chart 1: Growing infrastructure AUM (AUM, USD billion) 450 400 350 300 250 200 150 100 50 0 65 34 67 64 51 62 68 94 86 125 75 146 110 165 106 190 109 216 148 238 150 268 Unrealized value/ invested Dry powder Source: Preqin, 2018 Preqin Global Infrastructure Report 1 OECD (2018), Survey of Large Pension Funds and Public Pension Reserve Funds, 2016 2 Preqin, 2018 Preqin Global Infrastructure Report 3 Fund size of > USD 2 billion, Preqin Page 2 of 8
Evolving investment style The growth of the infrastructure sector means that investors now have a choice of managers across the risk-return spectrum. As the real estate nomenclature of core, core-plus, value-add and opportunistic is now firmly embedded in the infrastructure sector, we set out below an illustration of the typical return composition of each strategy. Chart 2: Illustration of typical return split by strategy Style Core Core-plus Value-add Opportunistic Income component Capital component Source: UBS Asset Management, Real Estate & Private Markets, 2018 Volatility of returns Note on the MSCI Global Quarterly Infrastructure Asset Index: The MSCI index is calculated in local currency and weighted towards Australia: 45% allocation as at December 2017. Risk-free rates in Australia over the past five years have exceeded the G7 average by around 1.5%, resulting in higher overall returns versus a USD-denominated index. Interestingly, while the one-year return profile in chart 3 provides a strong risk-reward relationship, chart 4 shows a weaker link over a longer period with higher-risk strategies demonstrating more volatile returns. Chart 4: Historical returns by style (Return p.a. %, local currency) 25.0 20.0 15.0 10.0 The illustrative returns above align well with the actual oneyear return composition from the MSCI index split by style below. 5.0 0.0 1yr 2yrs 3yrs 5yrs Low risk Moderate risk High risk Chart 3: Composition of historical returns by risk style (12-month return (%), local currency ) 25.0 20.0 Source: MSCI Global Quarterly Infrastructure Asset Index, December 2017 The rise of the mega-fund has contributed towards the record fundraising and dry powder in the sector. Many mega-fund managers were traditionally private equity players and this may also be a contributor to the increasing percentage of non-core strategies as shown in chart 5 below. 15.0 10.0 5.0 0.0 Low risk Moderate risk High risk Income return Capital return Source: MSCI Global Quarterly Infrastructure Asset Index, December 2017 Page 3 of 8
2010 2011 2012 2013 2014 2015 2016 2017 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Chart 5: Changing investment style (Capital raised by primary equity strategy, %) Chart 6: Composition of returns by risk style (Quarterly return, %) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 8% 17% 24% 51% 16% 23% 45% 16% 7% 49% 32% 12% 9% 7% 4% 15% 18% 10% 20% 24% 51% 65% 46% 39% 22% 23% 30% 18% 39% 39% 21% 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 (1.0) Core Core-plus Value-add Opportunistic Income return Capital return Source: MSCI Global Quarterly Infrastructure Asset Index, December 2017 The impact of the growing share of non-core strategies in the infrastructure sector can be seen in the 2017 total return from the MSCI index which consisted of approximately 60% capital return and 40% income return. Source: MSCI Global Quarterly Infrastructure Asset Index, December 2017 This suggests that the infrastructure sector is moving more towards the core-plus, value-add style than core. This may also indicate that the sector is experiencing some style drift, with managers seeking riskier transactions to meet stated return targets as returns have compressed. Correlation with other asset classes As outlined in our previous white papers, one of the key features of the infrastructure asset class is a historically low correlation with other asset classes as shown in chart 7 below. Chart 7: Low historical correlation between infrastructure and other asset classes (Correlation coefficients (4Q07-4Q17) Equities Government Bonds Corporate Bonds Listed Infrastructure Private Infrastructure (2Q lag) Equities 1.0 - - - - Government Bonds -0.4 1.0 - - - Corporate bonds 0.5 0.2 1.0 - - Listed infrastructure 0.8-0.1 0.7 1.0 - Private infrastructure (2Q lag) 0.3-0.1 0.0 0.3 1.0 Source Equities: MSCI WORLD ; Government bonds: JPM GBI GLOBAL ALL MATURITIES; Corporate bonds: ICE BofAML Global Corporate Index; Listed infrastructure: DJ BROOKFIELD GLB INFRA (USD); Private infrastructure: MSCI Global Quarterly Infrastructure Asset Index. Page 4 of 8
The overall private infrastructure sector shows a historical correlation coefficient with listed equities of 0.3, once we apply a lag of two quarters. Public markets price daily based on market fundamentals whereas the private market relies on semi-annual or annual valuations. Therefore, we believe that by applying a lag, the results are more closely aligned with reality than showing the unlagged correlation coefficient with equities of 0.02, noting that both methods have limitations. While we don t have robust data for core strategies, we believe that an income stream from low-risk, stable assets would have an even lower correlation with traditional asset classes. From a diversification perspective, adding low correlation assets to an existing portfolio improves riskadjusted returns, as measured by the Sharpe Ratio. However, as infrastructure investors become more aggressive with their investment style, the riskier "infrastructure" investments perform more like public or private equity investments, where capital appreciation tends to make up a large part of returns. Riskier infrastructure investments therefore become correlated with other risky assets, which means an investor loses some of the diversification benefits from investing in infrastructure in the first place. Valuations Many commentators have incorrectly called the top of the market over the recent past. Rather than trying to predict when valuations might peak, we set out some late-cycle signals and critically assess the differences from previous cycles to provide some insights. Chart 8 shows the evolution of infrastructure valuations from 2004 to 2017. Chart 8: Late cycle - Valuations expensive by historical standards but returns offer significant premium to bonds (EV/EBITDA multiples) (Bond rate,%) 18x 10% 16x 9% 14x 8% 12x 7% 10x 8x 6% 5% 4% 6x 3% 4x 2% 2x 1% 0x 0% Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Trailing 12M Avg EV/EBITDA (left axis) Trailing 12M Median EV/EBITDA (left axis) 10-year bond (G7 average, right axis) Source: UBS-AM Proprietary Database, Mergermarket, InfraNews, Infrastructure Journal, Infrastructure investors, Bloomberg; August 2018 Page 5 of 8
Looking at the EV/EBITDA multiples in chart 8, valuations appear to be close to 2007 levels; however, the risk-free rate in late 2007 was around 4% versus circa 1.5% today. This has implications for both the cashflow of an infrastructure asset and the attractiveness of the asset class. Infrastructure assets are typically highly leveraged so the impact of lower rates on an infrastructure company's cashflow can be material. However, as EBITDA is calculated pre-debt service, the EV/EBITDA multiple does not adjust for the impact of lower rates making the over-time comparison less meaningful. The low yield environment has contributed to the attractiveness of private markets with investors seeking to capture the premium which private markets can offer. Infrastructure has further benefitted from its strong performance (see chart 3). The increased interest in the asset class has led to return compression; however, relative to riskfree rates, which have also been falling, infrastructure continues to provide an attractive premium. High valuations are a topical theme across all public and private equity markets as cheap money has driven up asset prices. Private equity data published by McKinsey 4 show that EV/EBITDA valuations increased by 1.9x from 2009-2017 versus a 1.2x 5 increase in infrastructure multiples. This makes infrastructure look attractive on a relative basis. Our proprietary database is robust containing more than 1,000 data points. The availability of data in private markets is limited so we have created an aggregate index to show the overall trends. The limitation of an aggregate index is that the data could be skewed by changing sector composition over time; however, this would only have a meaningful impact if the change concerned a switch to or from assets with above or below average multiples. Conclusion The infrastructure sector has proven itself as an attractive asset class by providing diversification and strong returns. We believe that infrastructure will continue to provide strong returns and play an important role in investors' portfolios. However, the record fundraising in the sector has also led to an increasingly competitive market, fuelling rising valuations. In our view, these inflows have also contributed to a change in investment strategies. The sector has become more focused on non-core strategies, many of which rely on capital growth to meet return targets. We believe that these strategies are more highly correlated to other private and public equities, meaning that investors will lose some of the portfolio benefits of investing in infrastructure. There are warning signs that we are late in the cycle: managers are adopting riskier strategies and valuations look expensive by historical standards. However, we believe that some of the uplift in valuations can be justified by a lower rates environment. Additionally infrastructure still provides a significant premium over risk-free rates and looks attractive relative to other private asset classes. These nuanced arguments highlight the risks around calling peak valuations with some worrying signals offset by other credible mitigating factors. So, while we can't pinpoint where we are in the cycle, we believe that if there is a market correction, income strategies would outperform capital-driven strategies as the income from stable infrastructure assets will continue delivering returns for investors. Attractiveness of the asset class The attractiveness of the asset class is an important consideration in the trajectory of valuations. The infrastructure asset class is around 4x larger now than in 2007 and these flows have contributed to asset price inflation. There is a growing secondary market for infrastructure assets, which has supported the strong overall performance of the sector. As capital-growth strategies are reliant on successful exits to meet return targets, a healthy secondary market supported by strong liquidity from new inflows is paramount. While the outlook for the sector is very positive, with sentiment for the asset class at record highs, markets face headwinds with the ongoing withdrawal of quantitative easing and rising rates. We have already seen some consequences of this with a return of volatility in the public markets. Capital-growth strategies that are more correlated to the public markets could be less attractive in the event of a market correction. 4 McKinsey Global Private Markets Review 2018 5 UBS-AM Proprietary Database Page 6 of 8
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Infrastructure Research and Strategy Declan O' Brien Alex Leung For more information please contact UBS Asset Management Infrastructure Research and Strategy Declan O' Brien +44-20-7567 1961 declan.obrien@ubs.com Follow us on LinkedIn www.ubs.com/infrastructure This publication is not to be construed as a solicitation of an offer to buy or sell any securities or other financial instruments relating to UBS AG or its affiliates in Switzerland, the United States or any other jurisdiction. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any errors or omissions. All such information and opinions are subject to change without notice. Please note that past performance is not a guide to the future. With investment in real estate (via direct investment, closed- or open-end funds) the underlying assets are illiquid, and valuation is a matter of judgment by a valuer. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. A number of the comments in this document are considered forward-looking statements. Actual future results, however, may vary materially. The opinions expressed are a reflection of UBS Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Asset Management account, portfolio or fund. Source for all data/charts, if not stated otherwise: UBS Asset Management, Real Estate & Private Markets. The views expressed are as of March 2018 and are a general guide to the views of UBS Asset Management, Real Estate & Private Markets. All information as at March, 2018 unless stated otherwise. Published September 2018. Approved for global use. UBS 2018 The key symbol and UBS are among the registered and unregistered trademarks of UBS. Other marks may be trademarks of their respective owners. All rights reserved. Page 8 of 8