The process infrastructure investors such as pensions undertake to commit capital to an investment manager is long and detailed. From the request for proposal to interviewing the top candidates to making a final selection and negotiating the terms of the contract and getting approval from investment committees and boards of trustees, these investors are careful and deliberate. But even the most careful and considered decisions don’t always go as planned, and in the current market, with high prices for a shrinking pool of investments, as well as investors that need to meet target allocations and investment managers with capital that must be invested or returned, that carefully considered process could become an undisciplined race to get capital invested.
This kind of environment can lead to style drift, or, in other words, investments with risk-return profiles that were not anticipated when capital was initially committed. If these investments don’t pan out, they become surprises for investors, and unhappy surprises if they are not communicated straightforwardly.
“Style drift is a critical consideration at this stage of the cycle,” says Peter Hobbs, managing director with bfinance. “There are variations in the extent and nature of style drift, but the uniqueness and scarcity of infrastructure assets means that pricing has become particularly aggressive and the drift more pronounced. This is arguably more apparent in infrastructure as a number of managers that raised funds around the onset and aftermath of the global financial crisis are coming back to market in a markedly different risk-reward environment.”
This issue is not exclusive to infrastructure investing — it is common across private asset classes. Strong demand for private investments has driven returns to historic low levels, and this has led many investors and managers to take on more risk in order to achieve the same level of returns as predecessor funds.
“New subsectors will always be questioned in terms of whether or not they are really infrastructure,” says Hobbs. “It’s a debate that has dogged the sector from the beginning.”
Hobbs points to motorway service stations in Europe, which 10 years ago were initially acquired by private equity managers and then later sold to direct investors once they had proven themselves as a good fit for the infrastructure asset class. Another example is today’s telecom sector — 20 years ago, telecom towers were not a core piece of infrastructure, but the explosion of the mobile phone has made those assets a core piece of infrastructure; it’s the same with fiber-optic cables.
Investors can take steps to protect against the risks that come with style drift before they turn capital over to a manager; for example, some larger managers offer dedicated separate accounts where there is direct control over the specific investments. But most infrastructure investors focus on commingled funds where discretion is with the manager.
“Given this discretion and the relatively long-term nature of these funds, it is critical that the manager and fund is thoroughly evaluated to ensure alignment with any investor’s interests,” says Hobbs. “When evaluating managers and their investment strategy, it is important to explore their discipline and alignment and experience through previous cycles, as well as underwriting their investment decision-making process. This underwriting should involve a review of IC [investment company] papers and decisions to understand the process behind the prices that are being offered for specific assets.”
The current environment is particularly susceptible given the strong demand for core and core-plus infrastructure investments and limited supply. But investors are not necessarily concerned by the name or type of asset whether it’s laundromats or cooking oil being pitched as infrastructure, though these are clearly stretching the definition in a new direction.
“When they’re looking at infrastructure, they’re looking at it from a risk perspective — will owning these assets achieve the desired outcome of the infrastructure allocation?” Hobbs explains. “As long as the downside risk is protected and this is seen as something that can demonstrate the stable, long-term characteristics of infrastructure investment with a credible exit strategy and returns being commensurate with risk being taken, then a certain sub-set of infrastructure funds will look at these types of assets.”
