Alma Recurrent Energy Infrastructure Income Fund

Market Review and Outlook

Infrastructure investing has surged in popularity in recent years, even while many investors have avoided energy infrastructure or “midstream” assets. This has led to a sizeable valuation gap between midstream and other types of infrastructure, despite similar investment characteristics. What explains the divergence? Poorly-defined ESG criteria have certainly contributed, even as other types of infrastructure – airports, power plants, highways and railroads – face many of the same ESG risks as midstream. In conversations with allocators, we notice how some investors cite midstream’s greater energy transition risks, even as this claim has been undermined by continued growth in midstream cash flows. Other investors suggest that non-energy infrastructure assets have more exposure to AI-related growth, despite the fact that midstream will service these AI-levered assets (while bearing less of the costs), a point we discussed 2 months ago. Below, we examine how the “global infrastructure” category has captured the imagination of many allocators, despite midstream offering very similar economic characteristics at cheaper valuations.

Investment Discussion
Since COVID, “infrastructure” investing has soared in popularity, but midstream has been quietly excluded
In recent years, the popularity of infrastructure investing has soared, as investors in a world of increasing uncertainty and volatility have been drawn to “toll road” assets with low cash flow volatility, strong contract profiles, and lifespans measured in decades (note how similar this sales pitch is to the midstream sales pitch of a decade ago!).

Only 20 years ago, infrastructure assets were viewed as a niche backwater in the global investing landscape, but global infrastructure-dedicated AUM has grown to >$1 trillion over that time, with BlackRock recently announcing its largest-ever M&A transaction in a $12bn acquisition of Global Infrastructure Partners (GIP), one of the world’s largest infrastructure managers.

All of this infrastructure fundraising should bode well for the midstream energy infrastructure space, but the energy infrastructure sector has largely been excluded from this exuberant environment. Long time readers of this note will recall that energy infrastructure and midstream-dedicated public funds are coming up on 8 straight years of fund outflows – as fundraising in other infrastructure subsectors has soared!

Below, we examine the fundamental drivers driving the exclusion of midstream energy infrastructure from the infrastructure fundraising boom. We compare publicly-listed midstream infrastructure assets, such as the oil and gas pipeline and storage companies where we invest, with the financial performance of global listed infrastructure companies, including North American railroads, global airport and highway operators, as well as non-electric utilities, such as wastewater and sewage treatment operators.

It may come as some surprise that the underlying financial performance of midstream has not meaningfully lagged the broad infrastructure space. During the buildout of the 2010s, midstream returns declined as much of the midstream sector’s invested capital was tied-up in construction activities, but other than the 2010s, midstream returns have actually been superior to the returns of the broad infrastructure category! This is despite a massive downturn in commodity prices and the impacts of COVID, which fell disproportionately on the energy and transport sectors.

Could the lack of interest in midstream assets be the reflection of a lack of growth opportunities in the oil and gas spa
Prior to COVID, the midstream sector fell victim to the trend of externally-financed rapid asset growth. Undertaking a huge number of simultaneous projects, midstream companies had significant amounts of their balance sheets tied-up in “fallow capital” – non-cashflow generative construction activities – and as returns waned and energy prices fell, midstream companies found their external financing sources increasingly scarce.

Since then, investor concerns have moved in the opposite direction – could the energy transition mean that the midstream sector is headed toward inexorable decline, with a permanent lack of future growth opportunities?

Today’s midstream fundamentals simply do not reflect a slow inexorable decline – in fact, midstream asset growth has been comparable to the growth rates of the broad infrastructure space in recent years, despite the near-complete cessation of new projects during and immediately after COVID. This asset growth has driven mid-to-high single digit earnings growth for the last 5+ years in the midstream space – moderate growth, and a far cry from the declines cited by midstream skeptics.

A valuation gap has emerged as investors have bought into the idea that midstream is inferior to other types of infrastructure
Midstream growth rates reached unsustainable levels during the early days (1990-2010) of intense M&A and consolidation as integrated oils disposed of pipeline assets, followed by comparably intense organic growth in the Shale-driven years of 2010-2020. Since then, we have seen asset growth across midstream settling into a very typical infrastructure growth rate ranging between 4% and 6%. The growth rates shown above suggest that midstream today is arguably more “infrastructure” than it’s ever been in the past, with returns that actually exceed all infrastructure sub sectors except for certain North American railroads (a subcategory which trades well above midstream valuations).

The midstream sector now trades at a significant (~30%) enterprise value discount to broad listed infrastructure companies, despite superior returns and comparable growth. Since we measure valuation on an enterprise value (debt+equity) basis, the discount is even more dramatic when measured on a levered basis: midstream equity values would need to increase by 50% simply to match broad infrastructure valuations.

What are investors to make of the significant midstream valuation discount, in light of fundamentals that appear comparable or superior to the fundamentals of the broader infrastructure category? Is there a real risk to midstream that is not apparent in any adjacent industry? Is midstream’s leverage to AI less real than other infrastructure asset classes, despite midstream assets being physically connected to sources of AI demand? Are natural gas power plants likely to support AI-driven growth, but somehow exclude the pipelines delivering fuel to those plants? Are airport revenues likely to remain stable and growing, as the delivery and storage of aviation fuels potentially falls?

If these downside cases for midstream seem unlikely, then perhaps the discount for midstream assets is simply the result of savvy marketing by broad infrastructure fundraisers, and the source of future alpha for midstream energy infrastructure investors.

Fund

Performance review

During the month of June 2024, the Alma Recurrent Energy Infrastructure Fund returned 0.26%. On a year-to-date basis the Fund has risen 14.90%.