What are Infrastructure Investments?
Infrastructure investments are a form of “real assets,” which contain physical assets we see in everyday life like bridges, roads, highways, sewage systems, or energy. Such a type of asset is quite crucial in a country’s development. Often, investors invest in infrastructure, as it is non-cyclical, and it offers stable and predictable free cash flows.
Financial Characteristics of Infrastructure
After learning about infrastructure, the question comes down to why invest in infrastructure and not just public companies? The answer comes down to the attractive financial characteristics of infrastructure.
1. Stable and steady cash flows
The potential for steady cash flows is one of the main attractive features of infrastructure. It creates steady and predictable cash flows, given that the asset often comes with a regulated and contracted revenue model.
For example, a newly-constructed sewage system could include a government contract to run for the next decade. So, unless the government goes bankrupt (a slim chance in developed markets), the cash flows are quite predictable.
While the small Italian restaurant at the corner of the street may go bankrupt during a long economic recession, that same risk does not apply to infrastructure assets. As mentioned before, infrastructure assets – such as bridges and roads – are crucial to a country’s development, which also means that they will still be heavily used regardless of what stage the economy is in.
3. Low variable costs
Infrastructure comes with extremely small marginal costs per use, which is completely negligible. Using a bridge, for example, every car that drives on it will bring extremely small variable costs.
4. High leverage
Leverage is the amount that is taken on. Given that infrastructure provides stable and predictable cash flows, it can take on high levels of leverage, which results in high-interest costs.
Risks of Investing in Infrastructure
Although leverage is a common characteristic of infrastructure, it still poses a risk. High amounts of leverage result in high amounts of interest to be paid. If the revenue-generating abilities are enough to match the interest, then that would be a huge risk for the asset.
2. ESG risk
ESG risk – also known as environmental, social, and governance risk – is always an important part of infrastructure. For example, when building a large highway or bridge through a certain region, it may disrupt the social community of the area. In addition, the construction phase may cause a lot of pollution and environmental hazards that need to be taken care of.
The political factor plays more of a macro effect on infrastructure. Different governments will have different stances on developing infrastructure and how to regulate it. Assets in emerging markets – such as Brazil or India – will face higher political risk than a country like the United States.
Infrastructure Stages of Development
1. Greenfield (Early-stage)
Greenfield early stage means that the developers have already decided to carry out the project, but only very basic plans have been made. These types of projects face the largest amounts of risk – mainly in construction, regulatory, and execution. In this stage, it is also crucial to set up relationships and agreements with various stakeholders.
2. Greenfield (Late-stage)
Greenfield (late-stage) means that the developers are further along than the early stage. At this point, plans have already been developed, and everything is confirmed with various stakeholders. The risk here is less than early-stage, but still faces construction risk and possible CAPEX overruns.
3. Brownfield assets
Brownfield assets are assets that are already operating and generating revenue. An example would be a bridge that has been completed and has cars running on it. Such a type of asset would be the least risky because it comes with a usually established revenue stream already.
As one of the financial characteristics of infrastructure is stable cash flows, the discounted cash flow (DCF) valuation method is often used. However, there are some things to be noted when using a DCF for infrastructure investments:
1. Discount rate
Often, people use discount rates that reflect the approximate lifespan of the asset. In the case of infrastructure, which is built to last a long time, the 30-year Treasury bond is usually used. The discount rate should also reflect the illiquidity risk that is associated with investing in the asset.
2. Unlevered free cash flow
It is common to use unlevered FCF to value infrastructure, as most infrastructure has the financial characteristic of being highly levered. When using UFCF, make sure that WACC is used for the discount rate to reflect both debt and equity in the capital structure.
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