Drew Campbell, i3 senior editor, spoke with Boston Consulting Group’s Andrew Claerhout about the firm’s recently published white paper, Infrastructure’s Future Looks a Lot Like Private Equity.
Many infrastructure investors want to invest for the long-term (15, 20 years or more) and infrastructure asset life cycles are long term (40-100 years), but the fund vehicles used to invest in these assets and companies are generally shorter to medium term (10-12 years). Are there enough vehicles, fund or otherwise, for investors to make long-term infrastructure investments?
Typically, the type of vehicle used depends on the investment strategy the manager intends to pursue. As the infrastructure market has grown and matured, it has been segmented into various risk-return strategies, including super-core, core, core-plus, value-add and opportunistic, where risks and expected returns increase along a continuum as you move left to right, from super core to opportunistic.
As mentioned in the BCG white paper, a decade ago infrastructure was quite narrowly defined, and investors tended to focus almost exclusively on assets that are now considered super-core or core, such as municipal water works, commuter toll roads, landlord seaports, electricity and gas distribution networks, etc. For assets, which are expected to perform in a stable and predictable way over a long period of time and where value creation is incremental rather than transformational, a long-term, or open-end, fund is generally most appropriate. For investors with core-plus, value-add or opportunistic strategies, there is typically a greater focus on growth — organically or via acquisition — improving operations, and reducing the overall risk profile of the investment to change the market’s perception of the asset to mainstream infrastructure. Once complete, an exit allows the investor to more effectively crystallize the value of these improvement efforts.
Effectively, there are two distinct infrastructure markets. One which is mature and lower risk, where open-end funds are most common, and the other, which is more nascent, offers potential for outsized returns, where closed-end funds are most common.
Is there a potential resolution between the shorter-term nature of the closed-end model and investors’ desire for longer-term holds?
One predicament that long-term investors frequently struggle with is that due to the shorter duration of closed-end funds, LP’s are unable to maintain exposure to certain desirable assets following the winding up of the fund. One potential solution, which some funds have successfully employed, is providing LPs the option to continue to own some or all of the fund’s investments either directly or through an alternate long-term vehicle managed by the investment manager. Another option considered by certain managers is a distribution “in kind”. These approaches allow the investment manager to crystallize the value they created, while providing LPs with continuing exposure to the underlying assets.
While this sounds straightforward, successfully transferring assets from one vehicle to another is quite complex, as it requires agreement on a number of difficult issues. For example:
- At what valuation should the transfer occur? I expect most people would agree that fair market value should be used, but how should FMV be determined in the absence of a competitive auction?
- What if some, but not all, of the LPs in the closed-end fund want to continue to hold the asset? Is the decision made by the majority of the capital or is an over-allotment mechanism used to provide an exit to those LPs that want liquidity?
These are just two of many questions that would need to be answered before such a transfer could occur. Ideally, the process used for an orderly transfer would be part of the fund’s limited partnership agreement as opposed to something negotiated before an imminent exit.
You say that in some infrastructure assets, value creation is incremental rather than transformational. Why is this?
Core and super-core infrastructure assets typically are, by their nature, large single assets with limited levers to pull to create material value. As mentioned before, examples are municipal water works, commuter toll roads, landlord seaports, electricity and gas distribution networks, etc. Investors in these core assets are looking for a certain risk-return profile — and typically over a very long-term horizon — which does not require the asset to be transformed, but maintained and incrementally improved. Accordingly, core assets tend to fit better in open-ended vehicles. Conversely, core-plus and value-add assets require investors to prove out a thesis and deliver a business plan within a set time frame. Exiting the investment validates the delivery of that thesis as a third party is willing pay for this value upfront.
How do current high valuations challenge unlisted infrastructure managers?
There are several risks to watch out for in today’s market. The first is overly optimistic business plans. In late-cycle economic expansionary periods like today’s market, investors that are hungry to deploy capital can often unconsciously underwrite business plans that are unlikely to be achieved. When I was at Ontario Teachers, although we tried to avoid cost of capital shootouts, on multiple occasions we bid on — and lost — in auctions of marquee assets. Based on the valuations paid, it was clear that the winning bidder both underwrote a very low rate of return and assumed an extremely optimistic business plan. When an investment is priced to perfection, actual returns can only be lower than underwritten returns — i.e., the upside is already fully reflected in the base case, so only downside risks remain.
What are some of the other risks in today’s market?
Another risk is investing in businesses that don’t sufficiently satisfy the definition of infrastructure. It is the risk profile, as opposed to the sector, that determines whether an asset is infrastructure or private equity. For example, long-term contracted power generation is infrastructure whereas merchant power is not. As expected returns on core infrastructure have declined, investors have worked hard to identify assets that offer higher risk-adjusted returns. Some of these assets are new, previously under-appreciated forms of infrastructure. We invested in some of these when I was at Ontario Teachers. They included crematoria, liquid bulk storage, energy storage, etc. Others are private equity with an infrastructure return target. A standard list of questions can help determine if a company is infrastructure as this provides a consistent approach that can be applied against every opportunity, for example:
- Does it provide an essential or critical service?
- Are there meaningful barriers to entry that limit competition now and in the future?
- Is demand largely price inelastic, allowing for revenues to grow at or above inflation?
- Are margins high and the resulting cash flows stable and predictable?
A final risk in today’s market, is not having an ambitious, but realistic value creation plan for the investment, including the capabilities to deliver it. In the past, it was possible to buy well and reasonably expect that you could sell the business at a higher multiple of earnings — or lower discount rate — in the future. I expect most people would agree that this would be a very aggressive assumption to make today. Accordingly, investor returns need to come from transformational value creation — from growing, improving and repositioning the business ahead of an exit.
If infrastructure investors increasingly move to private equity strategies to generate value, do PE fees become an issue — are PE managers lowering fees to match this low-return environment?
When I entered the private equity industry in 1999, target annual returns were 30 percent. Since then, return expectations for all private asset classes have consistently declined. In private equity, they dropped to 25 percent, then to 22 percent, then to high-teens, and finally to mid- to high-teens, which is where we are now. Target returns for infrastructure have always been lower than private equity, reflecting the lower risk nature of the asset class, but they have followed the same consistent downward trend. As gross returns have compressed, the private equity managers I am aware of largely continued with 2 percent and 20 percent economics and an 8 percent hurdle, with mega-funds reducing management fees slightly to account for the fact that they were managing very large pools of capital. Large core infrastructure managers offer lower fees than private equity, but they do this on a large base of capital and tend to have a lower hurdle rate before performance fees kick in — often 6 percent. So based on history, I don’t see fees behaving dynamically as expected returns fall or rise.