Playing Offense: How We Approach Value Creation in Infrastructure
We often talk about infrastructure investing in terms of defense —how it offers the potential for smoother returns in times of economic volatility, with roots in real assets that are essential to society, and the potential to invest in businesses with inflation-linked, long-term contracts.
That is all very true, but infrastructure investments are not just big, heavy assets. They’re real businesses with operations, employees, physical plants, land, revenues, costs, capex, and profits. As we acquire infrastructure businesses, both large and small, we have a fiduciary obligation to actively and sustainably manage them for the long term. We benchmark our businesses to others in the same sectors, as well as other relevant global reference points, to ensure that each individual business focuses on achieving its highest potential, both by operating as efficiently as possible and by setting and achieving ambitious goals for growth and sustainability.
Focusing on growth, sustainability, and efficiency has the potential to improve the value of the business, and therefore the value of the investment. This, in turn, provides the potential for upside participation that we believe is so attractive for infrastructure equity investors, even those who are initially attracted to the asset class for its more defensive properties. We believe value creation has helped support the solid historical absolute returns for private infrastructure alongside its deserved reputation as a “shock absorber” (Exhibit 1).
EXHIBIT 1: Private Infrastructure Has Had Attractive Risk-Adjusted Returns
Annualized Quarterly Returns (Q12012-Q32023)
Derisk and Rerate
The infrastructure assets we typically pursue generate healthy, steady cash flow before we invest. They are often underpinned by long-term contracts and have strong market positions within their industry. In many of our infrastructure strategies, however, we also try to find assets that have some level of complexity. By cultivating strategic optimization and growth in areas others might overlook, we have the potential to unlock value that was previously hidden. Complexity comes in a variety of forms, some of which are detailed below:
- Streamlining: Companies might be involved in tangential businesses that dilute their core infrastructure mission. We would look to streamline and refocus these businesses to clarify the company’s purpose and enhance operational efficiency.
- Optimizing Operations: We often identify businesses that could benefit from operational improvements through additional investments in their assets, implementation of best practices, and more focused or adept management. This could involve spinning off a division with untapped potential into a standalone infrastructure business.
- Strategic Shifts: We support companies undergoing fundamental strategic shifts that unlock opportunities in a changing environment. For example, one of our portfolio companies, Albioma, is transitioning from coal-fired power plants to renewable energy production from biomass. We see this as part of a structural shift aligning with the global trend toward decarbonization, which is playing out with particular speed in Europe, where Albioma is headquartered.
- Capital Infusion: When a company needs incremental investment to unlock potential, we can provide capital solutions that allow firms to capitalize on growth opportunities without the burden of expensive external financing. This may involve funding an acquisition, building solutions that are less costly than external acquisitions, or pursuing opportunities in new markets, to name a few examples.
- Expanding Access to Capital Markets: When companies want to raise external financing, we support them in identifying the appropriate sources of capital and executing those transactions at the best terms. This is an important element of many of our businesses that are growing strongly on tailwinds in digitization and decarbonization.
The specifics of the problems and solutions vary by sector, jurisdiction, and idiosyncratic factors, but our general approach is the same as in many other equity strategies at KKR: We use a toolkit to help businesses unleash value that KKR has developed over more than 40 years. We want to derisk the asset, solving for the features that make it complex, which in turn allows it to rerate, so that the same stream of revenues is worth more when we sell it than when we bought it. Put simply, we seek to deliver a business with less risk, higher EBITDA, or both.
To bring this to life, let’s review an example of an investment that checked our defensive infrastructure boxes but also had and has significant upside potential.
A Corporate Carveout that Needed to Narrow its Focus
Viridor, a company that operates waste-to-energy plants in the United Kingdom, has strong infrastructure characteristics. It is backed by hard assets that provide an essential service to local municipalities. It benefits from long-term inflation linked contracts with government counterparties which in turn provide a high cash flow visibility.
On top of that solid foundation, we saw an opportunity to derisk and rerate the business. The company didn’t start out as a company, but rather as a division of a larger water utility. It processed less waste and created less electricity than comparable standalone waste-to-energy companies in its sector. It also managed waste collection, recycling and landfills, and some of those businesses either weren’t essential to what we saw as the core infrastructure opportunity or attractive given the push to decarbonize waste-related businesses.
Carving out a division from a larger company is difficult. Operators must choose a management team, ensure continuity of everything from supply chains to IT, and create a cohesive culture quickly. However, all these challenges are also opportunities—to hire talented executives, make back-end systems more efficient, empower the work force with aligned incentives and set clear goals for moving forward.
With the help of KKR Capstone, our operational specialists, we separated Viridor from its parent, divested the waste collection and landfill businesses, made incremental capital investments that increased the plants’ capacity, made operations more efficient, and split the company into two parts: an operating company that runs the existing plants and a development company that works on developing new businesses that relate to the circular economy. With the help of KKR Capital Markets, we strengthened the balance sheet of Viridor by raising long-dated fixed interest rate investment grade debt.
Today, Viridor is building two more waste-to-energy plants and recently signed a long-term partnership with the British government to capture and store the carbon produced at one of the company’s facilities. We have sold a portion of the operating company and are working on new initiatives related to the circular economy with the development company, including converting used plastic back into raw materials that can be recycled into new plastic. These initiatives can both create value and enhance sustainability for the business, ensuring that Viridor is well positioned to stay ahead of both regulation and public opinion in the United Kingdom. For example, Viridor is poised to become a net-negative carbon emitter, meaning that running the business puts less carbon into the atmosphere than its recycling and energy creation businesses keep out.
Investing Ahead of Tailwinds
Infrastructure investments have another source of upside potential: the ability to invest behind structural growth themes. We see infrastructure sectors like digitalization and decarbonization as forces that are fundamentally reshaping society and businesses. Both require material investment into infrastructure (Exhibit 2), whether that infrastructure comes in the form of fiber-optic cables, data centers, renewable energy assets, batteries, smart meters or the widely varied businesses and assets associated with electrification. As an investor, we want to be positioned to capitalize on trends with such powerful tailwinds behind them.
EXHIBIT 2
2023 Investment vs. Required Annualized Spending to Reach Net Zero
The combination of investing behind broad themes that have significant growth potential and investing in specific businesses that we know we have the skills, experience, and connections to improve are two important ways we create value. We often say that capital preservation is our most important objective as infrastructure investors, but the point is never merely to come out even. Choosing the right businesses and using the right techniques to put them on a path to greater success can help infrastructure investments play offense as well as defense.
