Amarik Ubhi is Partner and Global Head of Infrastructure at Mercer
The Western (and now global) social convention of proposing
marriage with a diamond ring is actually only around 75 years old, while the
diamonds themselves have taken at least one billion years to form naturally.
In 1947, Mary Frances Gerety (a copywriter at N.W. Ayer
& Son) penned a now iconic strapline for De Beers Consolidated Mines
Limited, which transformed an otherwise declining industry: “A Diamond is
Forever.” It has been used by De Beers ever since and was even named the best
advertising slogan of the 20th century.
Since then, Marilyn Monroe, James Bond and even Inspector
Clouseau, among others, have contributed to the aura surrounding these little
pieces of crystal-structured carbon. That said, the aura is justified (at least
from a utilitarian, if not aesthetic, perspective); diamonds are the
hardest-known naturally occurring material, have the highest thermal
conductivity and can withstand extreme pressure.
In several industrial processes, nothing but diamonds can
endure the associated physical stresses and strains. If you want resilience,
you need a diamond. Global annual diamond sales now exceed US$130bn, but
unfortunately, success brings competition and even imitation. Cubic zirconia,
zircon, moissanite, spinel, rutile and even glass are some of the materials
typically passed off as the genuine article. How do we tell the difference?
There are several ways, but two extreme methods rely on the unique physical
properties described above; we scratch the diamond, however possible, and we
subject it to rapid heating and cooling. We test it to the breaking point,
knowing that a true diamond will not break.
Odd as it may seem, there are many parallels between
diamonds and infrastructure. The asset class has been around for thousands of
years, yet it only became truly commercial within the last 30 or so. For many
investors, infrastructure has become the jewel in their portfolios due to its
lower downside risk under the extreme, yet varied, economic scenarios of the
past decade. It, too, is now a multi-billion-dollar market, with ambassadors
for the asset class ranging from President Biden to President Xi Jinping, and
even Boris Johnson.
Unfortunately, these parallels also extend to imitation and
branding. The (commercial) success of the asset class over the past decade
appears to have resulted in certain assets and businesses being passed off as
‘infrastructure’ within portfolios. To the untrained eye, these counterfeits
may also seem identical, and, as with diamonds, may even pass some of the tests
when carried out in isolation or to a less-strenuous extent. And when being
bought and then sold by otherwise reputable infrastructure investors, does that
process itself not prove their authenticity?
What of the asset class’s iconic strapline? Although none are
as ingenious as that of Gerety, one in particular resonates just as strongly in
this specific context: “infrastructure provides inflation protection.” This
simple yet incredibly powerful slogan is as appealing to an investor in the
current market environment as a diamond’s carat, clarity, cut (and cost!) are
to a would-be fiancé. However, unlike De Beers’ catchphrase, this one is, at
best, incomplete and, at worst, inaccurate (particularly if “imitation”
infrastructure is considered).
To be clear, infrastructure investments can indeed provide a
degree of linkage to inflation over the medium to long term. However, the
degree of linkage (and the period over which it materializes) varies on an
asset-by-asset basis and may even be scenario-specific. This is because of the
complex interaction of several factors, all of which may be changing
simultaneously. Sadly, despite her marketing brilliance, even Gerety may have
struggled to encapsulate this accurate (if somewhat uninspiring) description
into something suitably elegant.
In the same way that the four Cs (carat, clarity, cut and
cost) described earlier are important to a would-be fiancé, the five Cs of
infrastructure are equally as important to a would-be investor seeking
protection from rising inflation. Many investors naively assume that if an
infrastructure asset’s cash flow is in some way inflation-linked, that is
enough. However, what happens if the asset’s counterparties don’t meet their
contractual obligations? Or the asset doesn’t have the pricing power predicted?
Or the regulator won’t allow for inflation pass-through as before?
That’s just the top line. Investors then need to consider
how an asset’s cost structure varies with inflation (which could actually be
growing faster than cash flow, at least in the short term). What about the
asset’s capital structure and the extent to which inflation linkage in cash
flows after the cost structure is being geared up (or down) by the quantum and
nature of the debt used to finance the asset? Typically, the realized gains
from an infrastructure asset during its holding period come from its coupons,
but the quantum, timing and inflation linkage of these are active management
(not automatic) decisions.
The unrealized gains come through an asset’s valuation,
which, for infrastructure, is typically done on a discounted-cash-flow (DCF)
basis. As all good scholars of Modern Portfolio Theory know, the key to any DCF
is the discount rate, in turn determined by the capital asset pricing model
(CAPM). However, what many good scholars struggle with, at least initially, is
that CAPM can be more (dark) art than exact science. Therefore, although an
asset’s projected net cash flows may indeed be positively linked to inflation,
an adverse change in the discount rate used may partially, or even completely,
offset this in the asset’s valuation.
So
what does this all mean for 2023 and beyond? Although a somewhat
controversial view, infrastructure potentially has an imitation problem, as
well as a (inflation) branding problem. What better way to test this view than
for the global economy to experience the highest
rates of inflation since the 1970s and, simultaneously, an associated
increase in risk-free rates not seen since the GFC?
These will be the two extreme methods we use to test the
unique investment characteristics of infrastructure as an asset class. We
believe true infrastructure will pass these tests, despite them being
unprecedented for the asset class given its relatively short commercial
history. However, investor expectations of inflation linkage may need updating
based on the experiences yet to come, and imitation infrastructure may finally
be pushed to its breaking point.
Key Takeaways
The magnitude of the link between inflation and private
markets depends on the asset-specific capital structure, cash flows and the
capital expenditures ratio. We believe true infrastructure will pass these
tests, despite them being unprecedented for the asset class given its
relatively short commercial history. However, investor expectations of inflation
linkage may need updating based on the experiences yet to come, and imitation
infrastructure may finally be pushed to its breaking point.
By Amarik Ubhi, Partner, Global Head of Infrastructure, Mercer