As numerous macroeconomic trends continue their months-long decline indicating tough times ahead, a class of new investors that have been slowly gaining exposure to infrastructure could accelerate their push into the market at least in part as a hedge against market turbulence.

An expected spike in secondary transactions later this year is seen as the most likely entry point for US-based lower- and middle-tier pension funds and private wealth management teams who have not yet fully developed their allocations to infrastructure, said some of the investor and lender sources interviewed for this story.

Steady cash flows, long-term contracts, an uncorrelated position to swings in GDP and barriers to entry are testaments to infrastructure’s resilience, a trait that will be valued heavily if the global economy succumbs to recession.

“We still generally see institutional investors looking to maintain or grow their allocations to infrastructure, particularly given its lower volatility and inflation hedge characteristics in this macro environment,” KKR Partner and Global Head of Infrastructure Raj Agrawal said in an email.

The investor rotation that some expect for later this year could center around larger institutional firms tapping out their positions in global core-infrastructure funds, recycling that capital into more specialized, regional opportunistic strategies, said Vantage Infrastructure Senior Partner Nick Cleary.

Now that valuations have crested and with global core fund valuations susceptible to interest rate volatility, it could prompt investors to move money via secondaries into other vehicles like energy transition funds or core-plus funds.

Such asset class resilience will hasten a pickup in dealmaking activity later this year with investors eyeing not only core-plus but also transport, digital and in particular energy with opportunities in storage, transmission, distributed energy and clean mobility, DC Advisors said in its recent “Infrastructure Quarterly” report.

“A lot of money has been raised in global core funds (over the years) … so I think people are rotating out of those and into more specialized strategies to round out their portfolios,” Cleary said. “You’ll see more secondaries in funds that have probably been fully invested for a couple of years now … the value of those assets and value creation is a lot clearer (than funds deployed into the height of the market), so that means the bid-ask between buyers and sellers will be a bit narrower.”

He added US-based lower- and middle-tier institutions that are in the early stages of building out their infrastructure strategies could absorb those global core positions. Such buyers could find comfort in buying something “with no deployment risk and greater transparency and understanding.”

“Sovereign wealth funds, endowments, public pensions and other institutional investors have only funded 70% of their targets,” with the average institutional investors’ target allocation for infrastructure pegged at 6.6% compared to the current average allocation hovering at 4.6%, a February Cohen & Steers report found.

More broadly, the alternative investment industry is expecting an upswing in secondaries transactions, giving volumes of that M&A flavor a lift at a time when lenders are pulling back on financing riskier deals within the conventional auction market.

In 2022, secondary transactions exceeded USD 100bn while this year’s deal volume is estimated to reach USD 130bn to USD 150bn, according to a 24 March report issued by Bellevue Global Private Equity.

Denominator effect on secondary markets and dealmaking

The report cited the “denominator effect,” a buzzword of late that has echoed in all corners of global markets, as a culprit for potential future buying and selling of stakes in limited partnership structured funds.

For the past several months the denominator effect phenomena has caught the financial press’ attention with reports of LP investors’ public equities holdings declining in value vis-à-vis illiquid positions that held steady or outperformed, changing the risk profile of the portfolio as a whole.

This has had several knock-on effects, one infra investor said, that include LPs pulling back from making further commitments to newer infra fund launches, which in turn will affect asset managers' ability to gather assets that are beneficial to both their bottom line and that of their clients.

“That’s not really going to impact M&A activity in 2023 as those existing fund commitments are in place, it may have more of an impact on 2024 and beyond but there remains substantial dry powder,” said Morgan Stanley Infrastructure Partners Managing Director and Head of Americas Chris Ortega.

More controversial, some see institutional portfolio rebalancing possibly also forcing larger firms, such as Canadian and Australian pension funds, to sell off some of their direct investments.

In previous equity market downturns institutions largely held onto their direct holdings, figuring market conditions would restabilize within one to two years. Yet, this time might be different.

“For the first time in my career investment committees are saying ‘you need to rebalance now’ and that is crazy because that’s a more short-term outlook for a long-term investor who invests for 20, 30, 40 and even 50 years out. Now all of sudden they are making decisions that need to be implemented within the next six to 12 months,” said the infra investor.

Sources were divided on this point as some said while they have not seen institutional investors sell direct holdings as of yet, they agreed it could happen.

Numerous pension funds and other institutional investors did not respond to messages seeking comment.

“I think it is affecting private equity and real estate more than infrastructure, because again a lot of pension funds remain under allocated so they are not likely to dispose of assets, although they may slow down,” said a second infra investor, adding that fully allocated investors will unlikely unload directly held assets because of their steady performance.

Yet, if such a scenario were to occur, institutions would be more likely inclined to rebalance their portfolios through selling direct stakes in low-hanging fruit, such as certain struggling real estate assets.

The infra investor believed that fiber-to-the-home players in certain over-built markets whose debt is trading in dangerous high yield territory could be sold from institutions to distressed debt buyers or sector investors. Indeed, certain providers in Europe have encountered financial difficulties while their American counterparts have clawed back ambitious forward guidance numbers on fiber passings for this year.

An institutional lender source said aging data centers dealing with obsolescence issues and which are vulnerable to customer churn, especially in challenging economic conditions, could represent monetization opportunities for long-term investors. Panelists at the recent DCD Connect conference in New York said data center activity could slow down because capital costs and construction expenses have risen, though plenty of money is chasing the asset class as demand remains elevated.

Economic headwinds and rate volatility

Yet, a tide in denominator-related monetizations and secondaries could be held at bay if interest rates taper off and the Federal Reserve halts or reverses its quantitative tightening initiative, the first investor said.

Sources were also divided on how significant of an impact the Fed’s serial, year-long rate increases of what has amounted to a 4.49% hike have had on dealmaking, whether it's trading in secondaries or conventional M&A.

Since the Fed began its rate hiking mission last March, credit has contracted and with it the broader M&A market – though most sources said such conditions have only had the effect of sidelining “frothy” deals for infrastructure assets as those transaction volumes have held steady since the second half of 2022.

“Despite the more challenging environment in the second half of the year, we saw capital deployment into infrastructure deals reach a high-water mark of USD 186.2bn in the fourth quarter of 2022,” Agrawal said citing Infralogic’s Q4 M&A report. “At KKR, our pipeline for global infrastructure opportunities is as active as it’s ever been.”

Sources said they expect credit spreads to continue widening into the year for investment-grade credits, possibly impacting some infrastructure asset valuations that are sensitive to interest rate movements.

Not only are the Fed rate hikes responsible to some degree but also credit fund flows, which year-to-date have seen significant net outflows leaving high yield bond funds and collateralized loan obligation funds, Ortega said.

“Larger banks are becoming more selective … and potentially could be even looking to sell some of their (loan) book in order to free up some lines,” said the institutional lender.

“The high yield market is the quietest it has been since the pandemic started,” Ortega said. “We were previously in an environment where you could get any deal done that you wanted, but you needed to be really careful about valuations. Now we're in a market where valuations are more interesting, but you need to be more thoughtful and creative in terms of how one gets that deal done.”

This has left dealmakers trying to find other ways to structure transactions, such as forming joint ventures, obtaining seller notes, over-equitizing deals or acquiring secondaries, sources said.

Adding to global core fund uncertainty, soaring interest rates will put pressure on those vehicles, sources said.

“People’s attention will be more focused on where they think there are better values, so… the rotation out of global-core could come from various reasons: One, because that is where investors are more heavily invested; two, it’s a sector that is more vulnerable to a higher interest rate and inflation environment that we are in because those assets have been priced pretty richly; three, you get maturing of strategies and it makes sense to rotate out; and four, there are better opportunities in other parts of infrastructure or the greater investment landscape,” the second infra investor said.

While sources had mixed opinions on what the Fed would do, market observers have pointed to the inverted US Treasury yield curve – especially the front end of the curve – and Eurodollar futures as indicating something is more systemically wrong with the global economy than several recent bank failures in the US and Europe. For the first time since the Great Depression in the 1930s, M2, a measure of the monetary stock, has decreased. Commodities and the US Manufacturing Purchasing Managers' Index have continually sunk for months while movements in precious metals and fund flows to money market funds are all pointing to a recession.

Usually, the Fed cuts rates when economic performance begins to sputter.

A slew of new institutional money is willing to wait to find out how volatility in interest rates and the drying up of credit will affect infrastructure.

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