Is infrastructure an inflation hedge? Run the same concession at five inflation rates with full and partial indexation, then with index-linked debt, and read the real equity IRR.
Inflation indexation protects an infrastructure return only to the extent that revenue is indexed at least as fully as costs, and fixed-rate debt then turns that protection into leverage. On an illustrative 20-year concession with 65 per cent fixed-rate debt and fully indexed revenue, each point of inflation adds about 2.04 points of nominal equity IRR, and the real equity IRR rises from 8.01 per cent at 1 per cent inflation to 10.77 per cent at 4 per cent. With only 60 per cent of revenue indexed, the real return falls as inflation rises.
Worked in full in The Infrastructure Investment Analyst by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
"Inflation-linked cash flows" is in almost every infrastructure fund's marketing, and it is usually asserted rather than measured. Whether an asset protects its owner depends on three things that sit in the model, not in the brochure: the share of revenue that is indexed, how costs move, and whether the debt is fixed in nominal terms or indexed. Testing all three takes one model run at several inflation rates, read in real terms with the Fisher relationship covered in real vs nominal discount rates.
| Input | Value |
|---|---|
| Enterprise value at entry | 1,000 |
| Senior debt, fixed rate, 18-year annuity | 650 at 5.0% |
| Equity invested | 350 |
| Concession life | 20 years |
| Revenue, in today's prices | 115 |
| Operating costs, in today's prices, fully indexed | 30 |
| Share of revenue indexed to inflation | 100% or 60% |
Annual debt service is 55.61, against 85.0 of cash flow in today's prices: a coverage of 1.53 times before any inflation. Tax, reserves and lifecycle costs are left out so that the inflation effect stands alone; adding them changes the levels, not the pattern. All figures are illustrative.
Revenuet = 115 × (1 + indexation share × i)t; costst = 30 × (1 + i)t
Equity cash flowt = revenuet − costst − debt service (fixed 55.61 to year 18)
Real IRR = (1 + nominal IRR) / (1 + i) − 1
In Excel, nominal IRR =IRR(B10:V10), real =(1+B12)/(1+B2)-1 with inflation in B2.
Step 1, unlevered. With full indexation, revenue and costs both rise with prices, so cash flow is constant in real terms. The project's real IRR is 5.69 per cent at every inflation rate, and the nominal IRR moves one for one: 6.75 per cent at 1 per cent inflation, 8.33 per cent at 2.5, 9.92 per cent at 4. That is perfect protection, and it is the most that indexation alone can give.
Step 2, add fixed-rate debt. Debt service stays at 55.61 whatever happens to prices, so every point of inflation raises the margin above it. At 2.5 per cent inflation the equity earns 12.29 per cent nominal, 9.55 per cent real.
Step 3, run the inflation rates. The table below holds everything else constant.
| Inflation | Full: nominal | Full: real | 60%: nominal | 60%: real |
|---|---|---|---|---|
| 0.0% | 6.71% | 6.71% | 6.71% | 6.71% |
| 1.0% | 9.09% | 8.01% | 7.82% | 6.75% |
| 2.5% | 12.29% | 9.55% | 9.36% | 6.69% |
| 4.0% | 15.20% | 10.77% | 10.77% | 6.51% |
| 6.0% | 18.78% | 12.05% | 12.47% | 6.11% |
With full indexation the equity gains from inflation in real terms: 2.76 points of real IRR between 1 and 4 per cent inflation. The gain is a transfer from the lenders, whose fixed nominal claim shrinks in real terms. With 60 per cent indexation the nominal IRR still rises, by about 0.98 points per point of inflation, which can look like protection on a nominal dashboard, but the real IRR drifts down from 6.75 to 6.51 per cent and to 6.11 per cent at 6 per cent inflation. Costs indexed in full and revenue indexed in part is a short position in inflation, partly hidden by the debt.
Replace the fixed-rate loan with index-linked debt at the equivalent real rate of 2.439 per cent, its service rising with inflation. Now nothing in the structure is fixed in nominal terms, and the equity's real IRR is 10.16 per cent at 1.0, 2.5 or 4.0 per cent inflation alike. The equity gives up the inflation upside of the fixed-rate case in exchange for removing the downside if inflation falls below expectations. The level of 10.16 per cent is not directly comparable with the fixed-rate case, because index-linked debt service starts lower and rises, so the minimum coverage is 1.89 times rather than 1.53.
Reading the nominal IRR. The 60 per cent case shows a nominal IRR rising from 7.82 to 10.77 per cent as inflation goes from 1 to 4 per cent. In real terms the return drifts down over the same range, from 6.75 to 6.51 per cent, and sits below the fully indexed case in every row with inflation. Always restate the result as a real return before calling an asset a hedge.
Assuming the debt stays cheap. The fixed-rate gain depends on locking the rate for the whole tenor. A mini-perm or a short-dated loan refinanced into a market where rates have risen with inflation gives much of the gain back.
Confusing the IRR at entry price with value. Higher inflation usually comes with higher discount rates. The cash flows can rise while the price a buyer will pay for them falls.
The test is cheap: run the model at 0, 2.5 and 6 per cent inflation and read the real equity IRR. If it falls as inflation rises, the asset is not an inflation hedge for its equity, whatever the concession says.
The book's own cases, a toll road sculpted to a coverage floor and a regulated utility valued from eleven inputs, are in the free workbooks for the book, where these inflation runs can be repeated on its figures.
Only where revenue is indexed at least as fully as costs. In this illustration full indexation keeps the unlevered real return at 5.69 per cent at any inflation rate, and fixed-rate debt makes the equity gain from inflation. With 60 per cent of revenue indexed and costs fully indexed, the real equity IRR falls from 6.75 to 6.51 per cent as inflation goes from 1 to 4 per cent.
Because debt service is fixed in nominal terms while revenue rises with prices, so inflation shifts value from lenders to shareholders. With 650 of fixed-rate debt on a 1,000 asset, each point of inflation adds about 2.04 points of nominal equity IRR, and the real equity return rises 2.76 points between 1 and 4 per cent inflation.
It removes the leverage effect. When debt service rises with inflation too, the equity's real return is the same at every inflation rate, 10.16 per cent in this illustration at 1.0, 2.5 or 4.0 per cent inflation. The equity gives up the upside of inflation in exchange for not being exposed to inflation below expectations or to deflation.
This article is one calculation from The Infrastructure Investment Analyst. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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