The infrastructure secondaries market is still small compared to private equity or real estate, but the market for them has taken root, is growing steadily, and shows clear signs of maturity. Industry watchers expect their use to grow further as investors search for effective ways to gain infrastructure exposure and as both general and limited partners provide a steady stream of fund assets for sale as they manage maturing portfolios.
Nadira Huda, vice president in Greenhill & Co.’s Capital Advisory group, and a member of the firm’s secondary advisory team, says there has been growing deal activity in recent years as investors work to fulfill infrastructure allocation targets. “We have seen significant growth in the market, especially over last few quarters,” Huda says. “Volume is now becoming meaningful and we expect more investors to focus on the asset class going forward.”
Greenhill & Co. estimates there were $4 billion to $6 billion in infrastructure secondary transactions in 2016. Not a massive market, but according to estimates made by Campbell Lutyens, the market has grown by a compound average growth rate of 23.6 percent since 2012.
Just a short time ago the market was more opportunistic, driven by special situations of overexposure, or distress, rather than part of a standard approach to portfolio management. There were fewer groups working with secondaries and many of the buyers were attracted more by returns — by alpha — than by a pure desire to gain exposure to infrastructure as an asset class.
Much of the supply of assets for secondary deals in the past came from early, dissatisfied limited partners. Some had taken on too much blind pool risk with initial investments or had lost patience with style drift. Others were simply trying to mitigate the damage of what they thought were unfavorable terms. There also was a one-time boost to the market as limited partners restructured following the financial crisis. But the motivations have shifted from opportunistic to a more normalized use of secondaries as a portfolio building block.
Demand for deals
It’s no secret that investors are scrambling for exposure to infrastructure. Aside from the portfolio benefits of infrastructure, returns of early infrastructure investments have been promising, which is driving even more to the asset class. Fundraising is stable at high levels and various industry surveys suggest investors continue to raise target allocations. Yet most still struggle to put capital to work.
Investing in secondaries offers a way to build exposure and to address many of the pitfalls that face would-be infrastructure investors.
“Many of these groups have looked at their portfolios and are trying to find ways to mitigate the J-curve, diversify their portfolio and achieve the strong cash flow yields that infrastructure can provide,” Huda says. “Secondaries can be an effective way to achieve those goals. They allow an investor to enter later in the fund’s term, when the assets tend to be “de-risked,” carry less leverage and when there is more insight into their performance. Some investors are also using secondaries to backfill vintage gaps in their portfolios.”
Demand for secondary fund assets comes from both traditional limited partner (LP) investors, the general partners (GPs) that invest on behalf of LPs, as well as from dedicated infrastructure secondary funds and funds-of-funds (FOFs); most deals are transacted by the latter two groups, however.
Evan Corley, a partner and member of the infrastructure and real assets team at Pantheon, says that the private equity market is a natural analog for the infrastructure market. Both markets are dominated by dedicated secondary funds and FOFs. “There are several institutions, including sovereign wealth funds, that have staffs dedicated to pursuing direct, secondary and co-investment deals,” Corley says. “Regardless, secondaries are labor intensive with demands on time associated with sourcing, due diligence and negotiations. Most institutions simply cannot do it on their own, so they tend to outsource.”
Gerald Cooper, a partner with Campbell Lutyens, agrees that most institutional investors are not structured to effectively originate secondary deals on their own. They simply do not have the resources, so it makes sense for them to supplement their deployment strategy with commitments to FOFs, dedicated secondaries funds or consultants on the buy side.
Corley says that while secondaries funds have been an attractive investment from a returns perspective, they are also an effective way for institutional investors to ramp up investment in the asset class.
“There are a few things that investors can achieve by using secondaries funds to jump start infrastructure exposure,” Corley says. “They can achieve target allocations with investments that deliver alpha and provide backwards vintage diversification. As they mature, investors tend to build the portfolio by layering on primary commitments.”
For the market to function as a viable option for investors, there needs to be enough supply of portfolio assets to acquire. There are many sources of secondary deals. Institutional sponsors can sell assets on the secondary market to capture capital gains and recycle the capital. Primary or greenfield funds can sell entire funds into continuation funds. And GPs nearing the end of a fund’s term can find buyers looking for de-risked, de-leveraged, yielding portfolios.
On a very basic level, the overall growth in the amount of capital invested in infrastructure will naturally boost the supply of secondary assets being sold.
“The amount of private capital being raised has increased, and there will be a natural churn of LP interests for secondary buyers,” Corley says. “Contributing factors associated with churn will predominantly include portfolio management. Overall, this process will help create ongoing supply for secondaries transactions.”
The market also might see supply come from larger LPs setting up shop to delve deeper into the direct market on their own. “Some institutional investors such as pension funds are in the process of building in-house capabilities to invest in assets directly both on the PE and infrastructure side,” says Huda. “As part of that process they are trying to consolidate their fund portfolios and employ fewer managers. Secondaries are a way to pare back their GP exposure, which has been one of the factors driving supply over last 18 months.”
GP vs. LP led deals
But it is GP-led transactions that are expected to play a larger role in building the market in the future. The funds created during the burst of fundraising from the mid-2000s through 2008 are maturing. Selling down the assets from these vintages are expected to drive more GP-led deals in the future. This is already happening in the market. Cooper says a majority of the estimated $3.5 billion in deals in 2016 were GP-led — versus LP-led — transactions.
“We think infrastructure will continue to be a growing segment in the secondary market,” Cooper says. “Both the number and the size of infrastructure funds grew dramatically during the mid-2000 to 2008 time frame. And we are coming up on the period where the natural fund life is expiring for many of these vehicles. We expect many of these more mature assets will find their way into the secondary market.”
But a shift in deal profile might create some challenges.
“Sales of LP interests tend to be more straight-forward, with a single seller and usually a minority position in the fund,” Huda says. “GP-led transactions, however, are inherently more complex. These newer transaction structures can range from straight tender offers — where the GP facilitates the sale of multiple limited partner stakes — to a full restructuring, where assets are moved into a new vehicle and additional capital is potentially raised. GP-led deals can also have potential conflicts that need to be navigated and many more moving parts.”
Another sign of maturity, and a development that is expected to help grow the market further, is the widening universe of players in the market. Cooper says the number of groups working in the infrastructure secondaries market has grown steadily. The FoFs and adviser/consultants have raised increasing amounts of capital to go into infrastructure as they recognize that there is meaningful demand from LPs that like the asset class for diversification and stable returns. Dedicated secondary fund groups also have become more interested in the market as a good number of infrastructure GPs have delivered above target returns, in some cases delivering IRRs in excess of 20 percent.
“Some of these investors are delivering attractive returns and, in some cases, buyout level returns,” Cooper says. “When you have infrastructure funds targeting mid-teens returns, but delivering 20 percent plus, with lower risk assets, you are going to see growing demand for investment.”
Huda adds, “Historically, many of the larger secondaries houses were reluctant to invest in infrastructure secondaries due to the lower return profile associated with the asset class. However, as returns for private equity secondaries have fallen — the average high bidder for PE secondaries is now underwriting at around 10 percent to 12 percent — a number of these groups have been diversifying their mandates by raising dedicated pools of capital for infrastructure secondaries.”
As the secondary market has shifted from a more opportunistic opportunity, and competition for the underlying assets has risen, pricing has tightened. There can be significant price dispersion in bids for the same secondaries asset, but it is clear valuations have risen steadily in recent years. “If you asked me a couple of years ago, many deals were pricing at a 15 percent to 20 percent discount to NAV,” Huda says. “Now some core and core-plus OECD funds are at par or even premium territory.”
One measure of pricing tracked by Toronto-based adviser Setter Capital illustrates the overall trend. The Setter report is based on a survey of “most active global buyers in the secondary market for alternative asset funds.”
Bids among these players for infrastructure fund stakes reached higher than any of the other strategies tracked by Setter in the past five years. Average top bids for infrastructure funds on the secondary market, according to the firm’s most recent report, reached 96.9 percent of net asset value as of the end of November 2016, a 3.8 percent jump compared with a year earlier. The firm priced 42 infrastructure funds as part of the analysis, which were generating an average internal rate of return of 8 percent.
Setter makes note that they receive more price data from buyers of more “salable” funds, meaning that they have higher liquidity ratings, which suggests deals that are inherently closer to par. But, again, the direction of the trend is telling. Infrastructure was the only strategy to have consistently increased in its average top price year-on-year, with no decreases. Bids have risen 33 percent from 73.1 percent of NAV since 2011, according to the report.
“We definitely see better pricing in the market,” Cooper says. “Even though there’s not a huge amount of capital looking at secondaries, there is far more than three to four years ago, and today’s buyers have more reasonable return expectations. They are pricing on a risk-adjusted basis and not expecting to squeeze PE returns from it. We are routinely seeing funds sell in the single-digit discount and par range.”
Corely adds, “We’ve seen discounts evolve from solid double-digits to low double- and single-digits. They are beginning to look like more traditional secondary market returns. Obviously, it is nice to enter the market at deeper discounts,” he continues. “But what we have found from many of the deals completed to date, is that there are still significant returns generated, a lot of value creation, by holding the assets to collect yield and benefit from value creation initiatives being put in place by GPs.”
Buyers always face competitors, says Huda, but there will likely be even more in the future. “On the direct side, valuations for core trophy assets have soared,” Huda says. “And given the long concessions, those investors are not going to sell those assets anytime soon, which is creating a supply issue. As a result, we’re finding that secondaries buyers are increasingly paying up to access assets they were unable to acquire through their direct platforms. This supply imbalance will also serve to keep pricing strong for the foreseeable future.”
The increasingly competitive market and rising infrastructure valuations will challenge dealmakers to set appropriate expectations. “Transactions that price at or close to the GP’s reported NAV tend to find significantly higher support from existing LPs, and a higher proportion of LPs that elect to sell,” Huda says. “Setting appropriate pricing expectations upfront both with the GP and with the LPs is vital to ensuring the success of the transaction.”
But for now, industry watchers expect the competition to feed into other positive news to grow the infrastructure secondaries market. “Once you have some competition and there are more options to invest, and there is more history of transactions, it leads to more supply,” says Corley. “We expect, as these transactions are more commonly accepted as portfolio management options, there will be a virtuous cycle with more completed transactions.”
Tyson Freeman is a freelance writer based in Sebastopol, Calif.