The Bridge Ep. 04: How Infrastructure Really Fits Into a Modern Portfolio

The Bridge EP 04, Sadek Wahba, I Squared Capital – Transcript

Sonali:
I’m Sonali Basak. I’m the Chief Investment Strategist at iCapital, and today we are joined for the Bridge by Sadek Wahba. He’s the founder and Chairman of I Squared; a $55 billion asset manager focused on infrastructure investing. Sadek, thank you for joining us, because when people think about infrastructure, a common question I get is, where does this exactly fit into my portfolio? As an investor, a lot of investors understand the benefits of infrastructure, but they just don’t know how, how the risk profile, how the return profile matches with everything else.

Sadek Wabha:
First of all, thank you very much, uh, Sonali for having me here, and, uh, it’s a great pleasure. You are asking exactly the right question, which is, how does infrastructure fit in your overall portfolio construction? And to be able to answer that question, we have to basically ask first what actually is infrastructure? So, infrastructure is about investing generally in hard assets. So, it could be an airport, it could be a bridge, it could be, uh, a toll road. So right away you have an idea that it requires a physical component. It could be a data center, I’m sure we’ll talk about that. And with it is associated cash flows, which have, uh, a well-defined horizon, which is something that you can forecast, uh, because typically you have a regulatory framework around it. And it’s also typically linked to inflation. So, once you put all of these elements together, you can say, infrastructure allows me to get a steady return, will long duration, and a return that in real terms is positive. So, I can have a real term return that can be part of my portfolio. So that could be, for example, uh, fixed income extra or equity like, and so on and so forth. Then the next question is what kind of risk you want to take within infrastructure? So, you can take no different than real estate. You can take core, you can say core plus, or you can say value add and infrastructure replicates that in some sense. So, you can have assets that have very low risk because it’s 100% regulated. And by that, I mean the regulation says you will earn 6% return and that 6% is in real terms and you earn 6% return. Think of utility companies, or you can say, I’m going to build my own power plant mm-hmm . And I’m going to sell that into long-term contracts with a fixed price, a defined price, but some of that power generation, I’ll sell it in the open market. So, the price of power is high, I can sell it. If it’s low, I may not make as much as I want. So suddenly you have what you typically call merchant risk. Mm-hmm . Meaning demand and supply. Or you can take a bet on the market and say, I think power price is going to go way up. So, I don’t want to enter into long-term contract and fix my price because I think where I’m producing electricity right now is a constrained market, and I think data centers are going to buy that. And so, the price of power is going to go up.

Sonali Basak:
So, what you’re saying is that there is a spectrum here of the amount of risk you can take on, you can cap your downside by having a fixed return, or you can seek upside depending on how you engage with the asset class.

Sadek Wabha:
That’s exactly

Sonali Basak:
Right. But there’s something else that you said that really, I think is one of the biggest reasons a lot of people are asking about infrastructure right now. And it’s because of that linkage to inflation. We have been in an elevated inflationary world. We have been in a period where people are worried about inflation. Once again, even if you’re not concerned about an infa, an inflation spike or spiral, you might still be concerned that, uh, the inflation back to the fed’s target would be longer than one would expect. Which would, all, all of those scenarios, by the way, is good for infrastructure. Correct. And so, explain that dynamic. Why is this an investment strategy that has stood out? I think right now, one of the big things is a lot of other things are breaking down. So, it’s actually kind of standing out even more

Sadek Wabha:
That that’s true. And the, the reason is that infrastructure has the ability to pass that inflation through. I’ll give you a simple example. Uh, we own, for example, uh, a company that does industrial waste. Um, they collect industrial waste from automotive companies. Some of the automotive companies have said, I do not want any of my waste to go to landfills. I want my waste to be fully recycled. Ask yourself the question that industrial weight as a percentage of that total production, think of a unitary cost. How much of that is as a percentage of the cost of producing a car? Very, very small. Yet the need for it is very high. And so industrial waste companies have the ability to do all the work and charge inflation plus. And over the last couple of years, that company has been able to do exactly that. It has long-term contracts, and it’s able to do the recycling and increase the rates by inflation. Plus, for one reason is the cost of inputs have gone up, but then the cost of labor also has gone up, and you are able to increase by that and a little bit more. So that’s an example where there’s what I would call a basic need. You need to be able to do these kinds of services, and you are okay if you are able to increase, pay a little bit more because it’s a necessary that you want to have. And because you have very little choice to do that, and you want to do it right. So, these are the elements that you’re looking for when you make these investments.

Sonali Basak:
So, infrastructure is a broad category. One reason that a lot of investors like it is because they could explain it to their end client. They can explain roads and bridges and airports and energy infrastructure. People can understand it, feel it, see it. They can understand some of the mechanics behind it. What is your favorite area? What are a couple of areas that you find, uh, most satisfying to be investing in right now?

Sadek Wabha:
Uh, so I’ll tell you that, that I find, um, you are very kind enough to put, uh, uh, my book in in front of you. Oh, I’m exciting to read it. And I, I, I wrote this book thinking precisely about the demand for infrastructure in the US and what the book did. It took me back to all the way to the early days of the Republic. And when people move to the US or to the Americas, uh, they would go to the governor and they tell the governor, listen, I’m starting a little community, and I need really to be able to distribute water. Right? And the governor said, no problem here. Here’s a, uh, concession. As long as you charge fairly, please go and build whatever infrastructure you want to distribute the water. I think the water sector is one of the most important thing. Uh, and I find that an extremely exciting one because from a public policy, it’s extremely important. It’s a basic need. You would need water and people take it for granted, but it has a big environmental impact. But at the same time, people don’t appreciate the amount of effort and infrastructure that goes behind water sector, the us I’ll ask you a question. How many water companies or water utilities do we have in the US?

Sonali Basak:
Oh, boy, I have no idea.

Sadek Wabha:
Okay. So, I, I put that in the, in a relative context, the United Kingdom back in the 1980s privatized under Margaret Thatcher, uh, prime Minister of England at the time.

Sonali:
Mm-hmm .

Sadek Wabha:
Privatized all of the water companies, which used to be owned by the government. And she said, I have no idea why the government is running these water companies. We need to privatize them. There was about 11 water companies. The US has 55,000 water companies, 90 plus percent of them are municipal owned. Mm-hmm . And even though the people who work on them know exactly what they’re doing, they staff for capital. Almost 40% of our water. And when I was on the President’s National Infrastructure Advisory Council, we did the study precisely on the water system. 40% gets, is leaked, leaked in bad piping, all that needs to be repaired. So, there’s a huge opportunity to invest in the water sector, for example, uh, when we talk about democratization of infrastructure assets so that a broader set of people can invest in, I’m thinking water sector, I’m thinking of airports exactly what you said, things that people can understand and recognize.

Sonali Basak
Well, it’s interesting because the water sector airports, something I think about a lot is, you know, to your point on the water and the municipalities, one thing I think about a lot is when we think about the fiscal situation of the United States, when we think about the fiscal situation of the states within the United States, how much money do they actually have to invest in infrastructure in the future? In my mind, that just creates this massive open hole for private capital to step in. This cannot be done actually without private sector help.

Sadek Wabha
Yeah, you’re, you’re exactly right. So, let’s look at some of the stats. 2% of our GDP has been invested in infrastructure. Um, okay. Is that high, low, uh, what about China? China’s invested over 8% of its GDP and infrastructure. Um, so, so that tells you right away that we have underinvested in our infrastructure over the last couple of decades. Uh, municipalities don’t have the tax basis to be able to continuously issue municipal bonds so that they invest in this. So, I think what we’re going to see over the coming years is greater involvement in the private sector through public-private partnerships to be able to make these investments in the water sector. Transmission power generation data centers, of course, is entirely done by the private sector. So, you’re going to see more and more of these collaborations over the coming years.

Sonali Basak
So, data centers, we have to go to data centers now. I mean, this is another thing that is complicated for a lot of people because when we think about infrastructure, we think about all of the other things that we had just talked about, the things that you need to survive every day. Correct. Enter data centers. Now all of a sudden, most investors on the planet, when they put infrastructure dollars to work, they’re thinking about data center infrastructure. But then there’s all these other considerations. How do I do it the right way? Is this being done responsible responsibly? Is there municipal risk? Is there energy risk? Um, how do you think about how infrastructure has changed now that we are seeing this enormous data center build out happening?

Sadek Wabha (00:13:15 -> 00:16:31)
So, two things you asked me about portfolio construction and how does infrastructure fit in that portfolio construction? And then we said, well, it could be a little bit less risky, a little bit more risky. Within infrastructure, one of the sectors, one of the verticals you can invest in would be what I would call digital infrastructure. And digital infrastructure includes fiber optic, it includes data centers, it includes cell towers. So, you can see that within digital infrastructure, uh, you have multiple sub-sectors. So, data center is one of them. So, infrastructure fits within a portfolio and within infrastructure, you want to be able to then create a diversified portfolio that includes some transport, some digital infrastructure, maybe some fiber optic and some data centers. If you want to take a higher risk, then you say, I’m going to make a big bet just on data centers.
And you can do that. But that’s a different risk profile. So, what, for example, we do at I Squared Capital, we only invest in a broad, within your portfolio. I Squared Capital builds a portfolio, diversified infrastructure investments across different sectors and different regions. And so that, that creates, if you want the diversification that you want. So, data center, data center comes in different colors. You can build a data center, and you’ll be a developer and you build that. So, you take development risk, construction risk. You can have a data center that’s already operational with a long-term lease agreement with one of the mag 7s. Um, that data center could be doing AI related, uh, uh, computation. It could be training or it could be inference or it could be the cloud. We all use the cloud in one form or another, but the cloud is really, uh, hundreds and hundreds and thousands of data centers around different parts of the world. And that’s ultimately where you keep your cloud if you want. And so that data center could be what you call co-location. You use some of it, some another company use some of IT enterprises rent some of these pieces. Think of a hotel. Yeah. And that’s where the data center is. So different models, we have focused on what we call the traditional data centers, where you basically, uh, rent out the space, uh, co-locations to different people. Have we looked at this new type of data centers for ai, uh, computation inference training and so on. The answer is yes, but we are very careful about that because right now there’s great excitement, understandably so. Uh, but we are not looking for home runs. We are looking for singles and doubles. And that’s why you have to be a little bit discerning and careful, uh, and really say, what do they tell you? Location, location, location. So where is that data center located? Um, what’s its residual value? What’s the niche of the contract? Who are you entering into a contract with for how long? All these details you have to analyze.

Sonali Basak
I think what the biggest part of what you’re saying also too, is that, um, you know, when you’re looking at the data center investments, there are these big, concentrated risks. Yes. At the end of the day. Correct. And it, generally speaking, you’re looking to diversify your exposure. And so, you can do that, it seems like within the AI theme, quite meaningfully without ever investing directly in a data center at all, actually.

Sadek Wabha:
Yes, absolutely. So, We are building power generation. So, data centers need a lot of power, and we are reading this every day. So rather than go straight into the data center, we are doing something else. Well, in addition to, we look to build power generation, and we have several billion dollars allocated to that. And we are building right now a power plant in let’s say Illinois. And that power plant is going to produce electricity with, by the way, carbon capture, because that’s what Google wants. And we entering into long-term power agreement with Google. So, Google buys the power, and then Google decides, I’m going to use it for my general operations, for my data centers. That’s their decision. So, it’s no longer linked to a particular data center. It’s linked to Google that needs the power anyway. They may need it today for their, uh, AI data centers, or they may need it for something else, but that’s their decision.

Sonali Basak
How are you thinking about that broader market of power, utilities, even energy right now, just given everything that’s going on in the world, the increased demand for power, given the data centers, but also all of the disruptions that we’ve seen geopolitically frankly or otherwise.

Sadek Wabha
So, for the last 20 years, the demand for power was basically flat. In the last couple of years, it went from essentially zero to two and a half, 3%. Now you think that’s not much, but that’s huge. The real challenge is not that we don’t have power in the us, is that the power is not properly allocated. If I look at demand and supply, there’s really a good match. The problem is two things. The data center is in one location and needs power there, but that power is not there. Where there is excess power, you don’t need a data center. I go back to what I told you earlier. How much did we invest in infrastructure in the last couple of decades? Less than 2%. So, our transmission and distribution lines. So, transmission would be high voltage, cable distribution would be, you know, the lines, the electric lines that come to your house. At least a third of our high voltage cable need to be replaced. At least 45% of our distribution cable needed to, to be replaced. And that’s, by the way, nothing to do with the new demand for power. That’s, that’s extra.

Sonali Basak
What does it look like with a new demand? ? Oh, oh, if you can max exponentially more. Right.

Sadek Wabha
The east side of our grid is still not connected to the west side. I worked on a project 25 years ago to connect the east to the west. What happened to that project?

Sonali Basak
Vanished in thin air,

Sadek Wabha
Vanished in thin air. So, there are fundamental challenges that we have, uh, but I’d like to say fundamental opportunities.

Sonali Basak
Well, there’s a, there’s a great optimism isn’t there, to investing in real estate and infrastructure and, and all the things that power our society most because it, it requires this immense degree of collaboration with everything you said about the underinvestment that you’ve seen in infrastructure. Why are you finding it such a promising area for private capital investors to get in? Do you need, um, more investment as a group to be able to be successful?

Sadek Wabha
Uh, absolutely. So, to go back to what you said, you, you brought up a very important topic. You said municipalities under stress, we have deficit. So, take our deficit. A deficit is in the US is about 10%, uh, probably expected to go up, especially if I look at the new budget that’s being proposed, easy to 15%. Our debt to GDP is about 120%. But that excludes the indirect obligation. So, if you include the commitments that the government has made to all of us in terms of social security and so on, that number goes well over 300% of debt to GDP, that number is expected to climb. So, so you need to be able to deal with that issue. And the capital from the state is not sufficient, and the only way to do it is to bring in the private sector. But by the way, what I’m telling you is not, is not revolutionary. UK in the 1980s, privatized half of the airports approximately in Europe are either publicly listed or privately owned, but with a, with a regulation. Right? 99% of our airports in the US are not private. So, I’m not telling you tomorrow we need to privatize everything, but I think you need to bring, inject capital. You need to inject, uh, new methods, new technologies, uh, forget about the technologies and the softwares that are going to come up from AI that we need to put in, into all of our systems. So, all of that will require a huge amount of capital and huge opportunities.

Sonali Basak
You know, it’s interesting because how do you think about this even on a, um, size level on when to go for the big swings and when to focus on actually the smaller ones, the middle market?

Sadek Wabha
What we’ve done over the last 15 years is actually focus on the mid-market. Uh, mid-market is defined anywhere between three to 400 million enterprise value to a billion plus. When I talk to you about the industrial waste company, perfect example of a mid-market company that has grown substantially over the last couple of years. So, we like to identify mid-market opportunities where we have an ability to grow, where we have an ability to create operational value in a much more flexible way. And where you have much more degrees of freedom than if you are a very large company. So, in many cases, we’ve started what we call platforms where we take, for example, power generation. Uh, we started the platform in the hydro sector. So, we started with one asset, five megawatts. We had a team of 10 who was led by a fantastic person who, um, she had been involved in, uh, hydropower for years and years. And that company with five megawatts over the span of three, four years became almost 400 megawatts. And one asset became something like 20 assets.

Sonali Basak (00:23:23 -> 00:23:27)
You probably learned so much along the way from that’s seeing all of these projects start to take off

Sadek Wabha (00:23:28 -> 00:23:53)
A and you, you learn and you are able to retain that learning because you have, at least in our case, an operational team, engineers, uh, lawyers, uh, specialists in renewables, especially in X, Y, and Z. All of that is within the firm. So, they tend to get involved very intensely with the management team. It makes sense to me, and that makes a big difference.

Sonali Basak
It makes sense to me that a lot of opportunities are happening at the mid-market level because of what you said before that the local matters a lot in this business.

Sadek Wabha
Yes, the, the local matters because you have community issues, you have local regulatory issues, you have NIMBY issues. You see more and more people who are not keen on having a data center next to them. Uh, we built a data center in Ireland, and we use our own power renewable among other things. Uh, it was going to be built within what you call” inside the fence” ’cause we have a power plant and we’re going to build next to it. A lot of people were very skeptical, said, I I’m not sure I want a data center next to me. So, it took us a year to be able to work with the community, the regulator, to explain what we were doing, the fact that that data center was not going to increase the prices on the community. So, there’s a lot of work that needs to be done, and that’s what we like because we’re able to control our destiny if you want.

Sonali Basak
It is interesting. I feel like a lot of people can’t figure out, um, how to make renewable work in so many places, but it seems like you’re cracking the code on a larger scale.

Sadek Wabha
Yes. And the key thing with renewables is you want to understand the domestic regulation. Uh, you want to understand, uh, the type of technology. So, for example, we will never, uh, big proponents of offshore wind, uh, in the US at least because we felt it’ll be too expensive. It wouldn’t make, um, economic sense. Uh, and we’ve seen the administration, uh, clearly change their mind on that. Uh, which doesn’t surprise me, but we are investing in solar where it makes sense. Texas is a big, uh, state where you have huge amount of renewables, both wind and solar. We have other markets where we’ve invested, uh, in renewable Europe is big, uh, consumer of renewable power. We invest in Asia. We, for example, one of the largest install of batteries right in, in Asia to support the and the Japanese grid. Uh, so these are the kinds of things that we do. So, where while most of our investments are in the US, we invest in Europe and a little bit in high growth economies to ensure that we have the kind of diversification you want to have.

Sonali Basak
So, from an infrastructure investor then today, what is your sense of the biggest risks out there from where you sit?

Sadek Wabha
I think the biggest risk is concentration. So, you, you don’t want to find yourself, uh, investing in a sub-sector. Not because that sub-sector has inherently, uh, risks that you want to avoid, but because there is uncertainty that is built up in the system today. So, inflation, is it going to be three or four or 5% interest rates? Are they going to go up or not? Um, we’re at this inflection point. There are too many variables happening and you want to be able to go back and look at fundamental assets that give you that base return plus the kind of value add we talked about in a diversified way. So that I think is the, for me, the key thing to do day.

Sonali:
Yeah. A lot of uncertainties every day.

Sadek Wabha
Yes. Everyday work on diversifying your portfolio.

Sonali Basak (00:27:15 -> 00:27:32)
Sadak, it’s been so nice to have you here at iCapital.

Sonali Basak (00:28:08 -> 00:28:17)
That was Sadek Wahba. He is the founder and chairman of I Squared for the Bridge at iCapital.

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