Economic turmoil over the past 12 months has proved to be a major headache for infrastructure investors. Negative performance and volatility across public markets have left many LPs overexposed to illiquid private assets – the so-called “denominator effect” – while strict allocation guidelines have forced investors to rethink their liquidity positions.
Limiting overexposure to private infrastructure assets has become a growing priority over the past year. But rebalancing portfolios also comes with its own potential risks, not to mention the challenge of predicting how long the denominator effect will even last.
“We have seen investors take a wait and see approach over the first half of 2023,” explains Irene Mavroyannis, managing director and global co-head of business development, infrastructure at Partners Group. “It has been a more challenging capital raising environment, and because of the macroeconomic issues and the challenges with portfolio rebalancing, investors have become far more critical in terms of where they put their funds.”
Infrastructure fundraising has been hit particularly hard over the first half of 2023. In Q1, capital commitments dropped by 94 percent year-on-year, reaching $3.6 billion against $65.2 billion the year before. Justin DeAngelis, partner and co-head of sustainable infrastructure at US-based Denham Capital, warns that the tight fundraising environment could last until the first quarter of 2024 when he “expects a significant amount of new capital to be committed absent a material macro shock”.
In response to the denominator effect, LPs overexposed to private infrastructure assets have been eyeing the secondaries market as one potential route to address to their liquidity concerns. A survey from Coller Capital, published in June, found that 83 percent of LP respondents intend to use the secondaries market to rebalance private equity portfolios, up from 77 percent in December. Rebalancing portfolios was also the only response that had increased over the past six months.
“What we have seen in the market is a five-year record high of LPs considering rebalancing their portfolios,” adds Mavroyannis.
A rebalancing act
Tapping the secondaries market is one way to address overexposure of illiquid assets. But recent research from Morgan Stanley points out that this could actually increase potential risk versus allowing a certain degree of over-allocation.
“LPs who look to rebalance less mature vintage funds via secondaries may be selling at times when portfolios have [yet to] mature, and therefore [could] take lower returns,” explains DeAngelis.
So Yeun Lim, global head of infrastructure research at advisory firm Willis Towers Watson, adds that the right strategy also depends on the type of LP.
“If we are talking about a growing pension scheme or other types of LPs with a lot of capital coming in, even if they do have a bit of denominator effect, there is time for them to rebalance. However, a closed pool with no or limited contributions might need to work around what is happening on the risk side and may need to think about selling assets.”
Some investors have had little choice but to rebalance their portfolios, even if that means missing out on attractive entry points for high-quality private market assets, because of their tight governance and allocation limits. Under-allocation could equally result in investors lagging peers that are at target or overweight when private markets overperform.
Morgan Stanley research suggests that, where possible, LPs should focus more on performance and temporarily relax portfolio guidelines rather than rushing to secondaries. The lag and smoothing effect between public and private markets could ultimately prove the denominator effect to be more temporary or even illusory, highlighting the benefit of a ‘wait and see’ approach.
Jason Cheng, chief executive and managing partner at private equity fund manager Kerogen Capital, says: “Investors have been managing through the denominator effect in a number of ways including postponing deployment by a few quarters, temporarily reducing ticket sizes, using secondary transactions to increase liquidity and obtaining special approval to breach allocation limits rather than making structural changes to allocation strategy.”
Cheng points out that infrastructure and sustainability allocations have been less impacted by the denominator effect than many other asset classes. Strategies like core have suffered more from the wider macro and interest rate environment over the past year while LPs continue to gravitate to core plus and value-add strategies.
“Investor appetite going forward looks more focused on higher return strategies within infrastructure as well as growing the sustainability and energy transition secular thematic,” he adds.
Others argue that investors are underexposed to infrastructure. Despite the worst first quarter for private infrastructure fundraising since 2009, a report from advisory firm Hodes Weill & Associates and Cornell University’s Programme in Infrastructure Policy found that institutions are underinvested by an average of 98 basis points versus target allocations. In the Americas, this was the most prominent at 152 basis points, while private pensions are only two-thirds on track to hit their target allocations.
“In contrast to other private market asset classes, investors are typically underweight compared to their target allocations for infrastructure and have headroom to continue to make meaningful allocations to the asset class,” says Nick Colley, global portfolio strategist at CBRE.
“While the denominator effect has led to a general pause on allocating new commitments to private markets, investors are forward-looking and can see that infrastructure offers unique risk-return characteristics that are accretive to their overall portfolio objectives.”
Investor appetite for the energy transition is another important factor. In the same Hodes Weill & Associates’ report, roughly 40 percent of LP respondents reported that they were planning to increase allocations to renewable energy and storage over the next few years. The “new energy transition”, which includes green hydrogen and carbon capture, was the second most popular investment strategy with 39 percent expecting to increase allocation.
“Importantly there is fiscal and political support from governments, while investment strategies that offer solutions to societies evolving needs – whether that is energy security, digital infrastructure, renewable energy or clean transportation – offer attractive risk-adjusted returns with inflation protection,” says Colley. “There are a number of structural tailwinds for the asset class that should support capital flows.”