After a long period of low inflation, 2022 is seeing an increase in consumer prices across the globe, and fears from investors regarding the erosion of real returns. Inflation in the USA accelerated to 8.6% in May 2022, the highest since December 1981. Similar trends are seen in the emerging markets. Inflation in India, for example, reached 7.79% in April 2022, an eight year high, and well beyond the Reserve Bank of India’s target range of 2%-6%.(1) The sudden increase in inflation is likely driven by a number of factors, most notably the after-effects of the Covid-19 pandemic and the war in Ukraine. Covid-19 related fiscal stimulus entering the market has increased demand for goods and services on the one hand. On the other hand, Covid-19 and war-related disruptions to global supply chains are constraining supplies, impacting food availability, and the cost of energy amongst other things, and consequently having a marked impact on inflation.(2)
With rising inflation as a backdrop, according to a Prequin survey, infrastructure investments in 2022 look set to become the fastest growing alternative asset class, in terms of fundraising. At the time of the survey, infrastructure funds constituted circa 20% of private markets capital raised, as opposed to circa 10% per annum, in the prior 8 years.(3)
Does this indicate that infrastructure is a good hedge against inflation, and could this be driving investors to increase their exposure to infrastructure in 2022 and beyond? We believe yes. The cashflows that underpin infrastructure investments are either inelastic or indexed to inflation providing a pass-through of rising costs to the end user. When considered from the perspective of a lender, loans are made on floating rate basis, or if fixed rate, can be swapped back to floating, to ensure that the cost of debt flexes according to inflationary changes.
Infrastructure as an inflation hedge
Infrastructure assets, on the whole, can provide a level of protection against rising inflation. These assets are often monopolistic in nature, offering a level of price inelasticity of demand and therefore an ability to maintain revenue and profit margins. Inflationary price increases can be passed through to the end user through increased tariffs, ensuring the underlying investors returns are protected.
Not every infrastructure asset is structured in the same way, and therefore one needs to ‘look under the bonnet’ to truly understand the level of inflationary protection afford by an infrastructure investment.
3 categories of infrastructure assets
Infrastructure assets can be divided into three broad categories on the type of service delivered and their broad contractual structure, when considering inflation:
- Regulated infrastructure assets
Regulated infrastructure assets typically provide an essential service to communities of users, and operate in a natural monopoly.(4) The tariffs, that are governed by regulation given the monopoly, are reset annually taking into account a fair return for the investors, capex and maintenance requirements amongst other things, and would typically be indexed to inflation. Since the tariff is reset annually, there is a timing lag in the inflation protection. This type of asset includes electricity transmission and distribution infrastructure, and contracted renewable energy power plants, as examples.
- GDP-linked infrastructure assets
The revenue of some infrastructure is linked to the economic growth of the host country. The greater the growth, the higher the infrastructure utilisation. The greater economic growth will also be contributing to the inflationary increases. Increased costs may therefore be passed on to the end consumer, where possible. However, these cost adjustments are not regulated or contractually guaranteed, but are opportunistic in nature, and may be influenced by the competitive landscape. The ability to pass through costs would have to be negotiated with the contract counterparts and may not endure for the life of the contract. Examples of growth-linked assets include commercial and industrial power plants, toll roads, and digital infrastructure.
- Public Private Partnerships
Assets that have been contracted via a public private partnership (PPP) are built by the private sector and utilised by the public sector. The private sector typically bears significant risk and responsibility and is remunerated based on performance.(5) In this model, revenue can be based on the payment of an availability fee, independent of the number of users of the facility. Cost increases can often be passed through to the end user under the PPP model. Examples of such infrastructure include hospitals, schools, and prisons, amongst others.
In summary, the revenues of infrastructure assets are typically protected contractually against inflationary pressures, particularly in markets where the assets are regulated or where a public service is delivered by the private sector.
Are debt providers receiving any of the inflationary protection?
Commercial banks and private debt providers typical apply a variable income strategy in the infrastructure sector. They offer debt for infrastructure investments priced using the US Dollar secured overnight financing rate (SOFR) plus a margin spread, creating a variable floating rate debt instrument. With a floating rate loan instrument, as inflation pushes up the base lending rate, in this case SOFR, the loan instrument is repriced, and is therefore only subject to the effects of inflation for short periods of time. In certain instances, fixed rate loans are offered to borrowers. In this instance, the fixed interest rates may be swapped back to a floating rate, which may offer the lender protection from inflationary increases.
Consequently, deploying a variable income debt instrument provides protection from inflation at two levels; namely, at the project company level, where the underlying revenue stream is typically indexed to inflation or there is inelasticity of demand, and secondly via a floating rate debt instrument, where the yield is protected from inflation through increases to the base rate.
Evaluation of the inflation hedge
When a lender evaluates an investment opportunity, it would typically consider how exposed the underlying cashflows are to variability, including that of inflation. A key consideration is whether tariffs or revenue streams are indexed to inflation, whether the hedge is perfect or only partial, and the extent of the coverage. Furthermore, where indexation is possible, the borrower’s ability to pass through the cost of inflation and higher cost of debt to the underlying customers would be considered.
Even though there may be a level of elasticity of demand in the underlying asset financed or service provided, it is also recognised that the possibility to pass through inflationary costs is not infinite and will eventually result in breaking point and reduced usage.
Lenders would work closely with hedging service providers to offer solutions which can mitigate the impact of inflation, as described above, at a price point that makes sense for both the borrower and the lender. Offering a borrower, a fixed rate debt solution, which is swapped back to a floating rate, can often achieve the desired impact by protecting the borrower and underlying users against the effects of inflation in the cost of debt, while simultaneously providing the lender with the benefits of inflation protection, at a reasonable cost.
Sources:
(1) Trading Economics https://tradingeconomics.com/ (Accessed: 15 June, 2022)
(2) Tsoneva, T., Staab, M., Boing, R. (2022) Inflation as a hedge – look no further? CBRE Investment Management Insights March 2022. Available at: https://www.cbreim.com/insights/reports/infrastructure-as-an-inflation-hedge
(3) Private Equity Wire Insight Report (2022) Pricing Power: How Infrastructure Funds Are taking On Inflation, May 2022. Available at: https://www.privateequitywire.co.uk/pricing-power-how-infrastructure-funds-are-taking-inflation
(4) Law Insider. Available at: https://www.lawinsider.com/dictionary/regulated-infrastructure-assets
(5) Public Private Partnerships Reference Guide, Version3, 2017, World Bank. Available at: https://ppp.worldbank.org/public-private-partnership/library/ppp-reference-guide-3-0-full-version
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For further information, please contact:
Tahmina Theis
+41 44 441 55 50
tahmina.theis@blueorchard.com
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