Q&A: Paradoxes, paradigms and potential in private infrastructure Tamara Larsen, Senior Research Analyst, Alternatives Private infrastructure continues to benefit from strong investor appetite globally, and in certain geographies has benefitted from a long history of institutional investment (i.e., Australia, Canada). However, in certain ways, private infrastructure can still be considered a nascent asset class, with significant room to mature before catching up with the likes of traditional private equity or private real estate. This dynamic contributes to certain paradoxes and paradigm shifts as the industry evolves, but it also contributes to considerable opportunity for investors as well. These private infrastructure opportunities, as further discussed below, include different ways of thinking about co-investment opportunities, harnessing the potential benefits (and managing the risks) of emerging managers, as well as sector and thematic plays that appear to have a compelling outlook. Top-down and bottom-up shifts We continue to see wide institutional interest in making portfolio allocations to infrastructure, driven by the unique investment characteristics that the asset class may offer for investors portfolios (i.e., physical assets, typically with low exposure to GDP growth and corporate earnings). However, this asset class poses both opportunities and challenges for investors. Investors have opportunities in the wider array of investment strategies and vehicles that are becoming available. Key challenges involve identifying best ideas and managers in this broader pool, and also taking a thoughtful approach to questions of relative risk and pricing trends within a dynamic investing environment. Furthermore, western governments austerity programs since the financial crisis have made much more apparent some of the regulatory and political risks faced by investors in infrastructure. This is an important reminder that managers need to have the appropriate skills and diligence required to mitigate these risks. In this paper, I consider some of the questions uppermost in the minds of investors making new private infrastructure investments: What does core mean for private infrastructure? Is there a case for investing with boutique or emerging managers? Are managers changing the ways they approach political and regulatory risk? Are the general partners (GPs) responding to the interest in co-investments? Where are the current private infrastructure opportunities? We hope you find this helpful, and we would be delighted to address any further questions you have on current infrastructure investments. Russell Investments // Q&A: Paradoxes, paradigms and potential in private infrastructure NOVEMBER 2013 / 1
What does core mean in private infrastructure? This is one of the paradoxes. One might be hard pressed to find a marketing book for private infrastructure that does not reference a manager s focus on core infrastructure. However, despite the prevalence of the term in private infrastructure parlance, it can mean different things to different people. For example, the term is sometimes solely a reference to the expected essential nature of the services provided to the economy by the asset (i.e., its expected monopolistic features), rather than shorthand for the expected risk. Indeed, the actual underlying risk/return profile of a particular core private infrastructure investment may well be in stark contrast to what institutional investors who have been active in other real assets investing (such as private real estate) may associate with the term (i.e., relatively low risk, operational assets with limited leverage and low historical volatility to the cash flow stream). Thus, it is important for investors to focus on the potential risks to the expected cash flow stream associated with the target infrastructure investment, and how the manager works to manage and get compensated for those risks. This issue is further complicated because private infrastructure tends to fit different buckets (such as private equity or real assets) for different investors, depending on a variety of factors (including risk/return profile, inflation linkage, income versus capital appreciation drivers, etc). Thus, though widely used, the term core may mean what you think it means for private infrastructure - but not necessarily. Is there a case for considering boutique or emerging managers? Prior to the global financial crisis, the private infrastructure fund market tended to be dominated by bank-and private equity firm sponsored offerings. Since then, increased restrictions on banks and other financial institutions, as well as heightened sensitivity on the part of limited partners (LPs) to potential conflicts of interest, has contributed to the rise of step-out groups: independent, majority-management-owned shops led by teams whose members worked together at predecessor firms. Overall, the increased numbers of independent boutique managers may give infrastructure investors the opportunity to find advantage in some of the characteristics that make these smaller shops appealing to investors in other alternative asset classes as well. Forging strategic relationships with boutique managers in the private infrastructure space can offer key advantages. First: Smaller, independent managers tend to focus on niche investment strategies that may not be aligned to the well-oiled, scale-focused machines of larger shops. The amount of work spent in underwriting small deals and conducting due diligence can sometimes rival that of larger deals, and it tends to orient GPs who have greater amounts of capital to deploy toward focusing on larger-scale transactions. In their efforts to deliver diversification within a more modest fundraise, boutique managers may be more oriented toward smaller transactions (those that may be under the radar of larger shops), where specialized skills may confer a competitive advantage. This is not unusual among first-time fund managers or step-out groups. Thus, these types of boutique managers may offer investors the opportunity to diversify their portfolios in a meaningful way whether as to deal size, risk, geographic profile or other differentiating features. Second: Investing with early-stage, independent managers can enable cornerstone investors to negotiate favorable economic and governance terms, whether for an entitylevel (usually minority) investment in the step-out company itself or as a first- or early-close participant in the new fund. By participating in the first close, cornerstone investors may be able to put an imprint on the legal documentation as well, so long as those terms are within market range and are not burdensome to prospective participants in the fund. Third: Smaller managers are likely to source off-market deals that may be attractive but too large for them to take down with their existing funds/accounts. Indeed, boutique managers tend to have a more limited roster of investment vehicles, due generally to resource constraints. By establishing a strong relationship early on in the life cycle of the company, investors have the potential to gain access to robust co-investment or direct investment pipelines from firms that, relative to the larger shops, do not have a lot of competing sources for capital. These co- and direct investment opportunities do pose certain risks and should be evaluated from a total portfolio fit perspective including implications for the portfolio risk profile. Additionally, care should be taken with regard to the GP s governance framework and platform scale for managing co-investment capital as well as commingled fund vehicles. It is important for investors to focus on the potential risks to the expected cash flow stream associated with the target infrastructure investment, and how the manager works to manage and get compensated for those risks. Forging strategic relationships with boutique managers in the private infrastructure space can offer key advantages. 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Fourth: More of the sponsor commitment in smaller, independent shops may derive from the personal wealth of key investment team members. In larger shops, it is not unusual for the lion s share of the sponsor commitment to be funded by the corporate balance sheet, and for a much smaller share of the commitment to be funded out of pocket by members of the investment team. Having skin in the game tends to support alignment with investors and keep the investment team focused on delivering on the mandate. However, evaluating these managers tends to be more complex, relative to the larger shop offerings. Track records are often an issue for newly formed independent shops, as the predecessor firms are often very restrictive and typically will not share non-public information on asset performance. Thus, the smaller, independent groups are often limited to providing more of a patchwork of updated performance track record data based on publicly available information. Other key issues to consider are whether the scale and staff expertise of the independent platform and the intended investment strategy are well matched, and, in turn, whether the skills and platform will fit the market opportunity over the investment horizon. Specifically for private infrastructure, there are also very important questions as to whether smaller firms have the expertise to appropriately underwrite regulatory risk and to navigate the regulatory and political environments in which the portfolio companies operate. The operational due diligence process also tends to be more resource-intensive for investors evaluating boutique managers, and the latter may need guidance on how to transition toward institutional-quality practices and procedures. In light of these issues, even large investors with significant in-house expertise in infrastructure may consider a manager-of-managers or separate-account solution to access emerging private infrastructure managers. Do you think there have been changes in how private infrastructure managers approach regulatory and political risks? There has generally been a reset in the paradigm for approaching regulatory and political risks in private infrastructure. Probably the highest-profile wake-up call on regulatory risk in infrastructure was Spain s series of changes to its feed-in tariff system for renewable energy (particularly the solar program) in recent years. Globally, there are numerous examples of changes in subsidy and tax regimes for renewables, or changes in settlements for regulated utilities, that have materially impacted the performance of private infrastructure investments. Though many private infrastructure managers showcase their roster of prestigious senior advisors or their executive in charge of handling regulatory matters on behalf of their platform, it is incumbent upon investors (and their advisors) to ascertain how well the GPs are able to use their marquee resources, and other resources, to manage regulatory and political risk and drive value. Regulatory and political risk may be inherent in infrastructure investing, but there are ways of approaching portfolio construction and active management that can help manage those risks. It seems that there has been a surge in interest in co-investments in recent years. How have GPs responded? It s a paradox there seems to be a lot of demand for co-investment pipeline on the part of limited partners (LPs), even though many of them are not necessarily positioned to actually execute transactions. In response, managers are increasingly setting up co-investment clubs (with priority rights and discounted costs), where membership is based on minimum fund commitment thresholds (i.e., US$100 or $200 million) or on first-close participation, in order for LPs to be offered access to co-investment pipeline. The process can be so complicated and the sums of capital so large that fund managers are increasingly dedicating senior resources to managing co-investment relationships. Co-investments typically involve deals requiring equity checks that would trigger the commingled fund concentration limits. GPs tend to offer LPs the balance of the required equity as a co-investment. At larger sizes, side-by-side investments may be structured as direct investments by LPs, with board representation and voting rights accorded. At the lower end of the size range, the co-investment stakes tend to be passive and structured to tag along with the commingled fund. Investors get the opportunity to put more capital to work and to strategically re-weight their portfolios toward particular asset profiles, typically at a lower cost, due to the fee breaks often offered on co-investments. Having skin in the game tends to support alignment with investors and keep the investment team focused on delivering on the mandate. It is incumbent upon investors (and their advisors) to ascertain how well the GPs are able to use their marquee resources, and other resources, to manage regulatory and political risk and drive value. Russell Investments // Q&A: Paradoxes, paradigms and potential in private infrastructure / 3
However, because participation in co-investment transactions tends to take place at the live deal stage, there is usually a quick time frame for underwriting a transaction, getting to a decision and getting the appropriate internal approvals in time to meet closing deadlines. Since the fund manager is counting on the co-investment capital in order to fund the equity, delays and problems on the part of the co-investment LPs can complicate or imperil the deal. Thus, specialist expertise and an internal decision-making framework that can accommodate a short timeline is required. A different set of complications can arise when fund managers raise so much capital for coinvestment vehicles that the size of the commingled fund is dwarfed, potentially creating a dynamic wherein the fund manager is largely sourcing deals that fit the co-investment vehicle mandate (rather than the fund). In such a case, investors in the commingled fund may be essentially along for the ride (led by the co-investment vehicle). Though some managers have identified ways to balance competing interests and execution abilities on the coinvestment issue, it remains an interesting dynamic within the industry as a whole. Another paradox associated with co-investments is that much of the focus has been on infrastructure equity opportunities. There has been much less focus on opportunities to use GPs to access infrastructure debt pipeline directly, particularly when GPs are refinancing portfolio assets that have been largely de-risked. Though there has been a significant increase in infrastructure debt offerings via dedicated commingled funds, it has been to varying degrees of success in fundraising. Matching up current pricing trends, investor expectations for infrastructure debt returns, and the management fees associated with running a commingled debt fund vehicle can complicate the economics. Some GPs have elected to focus their infrastructure debt efforts on behalf of managed accounts, or clubs of managed accounts. Another alternative is to take a page from the insurance investors playbook and use GPs in one s existing private infrastructure portfolio to access infrastructure debt deal flow directly. However, this option may be somewhat resource-intensive for those investors who do not yet have in-house expertise for underwriting and managing private debt investments. What are current themes for potential opportunities in private infrastructure globally? North American energy plays. The North American energy market is continuing to undergo profound transformation. Multiple factors are contributing to market shifts and distortions that offer opportunities in private infrastructure. These factors range from surging domestic oil, gas and liquids production, to the shift among producers from dry to liquids-rich basins, to bottlenecks in transportation and processing and storage infrastructure, to regulatory pressure to retire coal plants. The expectation is that these shifts will continue and, as well, offer a potentially attractive investment horizon for some time. Mid-market transactions globally. Despite how tough the current path is to raise capital for private infrastructure commingled funds, there continues to be significant capital in the market chasing core deals specific assets characterized by predictable cash-flow streams and no hair on the deal. Infrastructure funds under pressure to transact, as well as large pension plans and sovereign wealth funds, continue to be major players in the market. GPs focused on smaller, mid-market transactions, particularly those sourced on a proprietary basis, may offer opportunities to avoid the cost of capital shoot-outs and aggressive pricing associated with infrastructure assets sold at auction. Given that so many of the larger players are focused on the scale benefits of putting large sums of capital to work in any given transaction, smaller deals and those with more hair may fall under their radar offering GPs the opportunity to acquire mid-market assets on an attractive basis; to reposition, recapitalize or re-contract them through active management and de-risking strategies. There is the potential to aggregate mid-market deals to a scale that would attract the larger players on the exit. Even without the aggregation play, smaller transaction sizes tend to support a broader exit buyers pool. Infrastructure debt in Europe. In response to increased capital requirements associated with Basel II and III for long-term loans held on balance sheet, there has been a retreat among European banks (which had previously held a dominant position) from the infrastructure lending market, particularly in Europe. This has created an opportunity for There has been much less focus on opportunities to use GPs to access infrastructure debt pipeline directly, particularly when GPs are refinancing portfolio assets that have been largely de-risked. GPs focused on smaller, mid-market transactions, particularly those sourced on a proprietary basis, may offer opportunities to avoid the cost of capital shoot-outs. Russell Investments // Q&A: Paradoxes, paradigms and potential in private infrastructure / 4
alternative capital providers, including institutional investors, to step into the gap. The potential to access infrastructure assets with monopolistic features and attractive credit profiles on a long-term basis may offer an attractive option for institutional investors grappling with long-term liabilities and the yield outlook for traditional fixed income portfolios. Clean energy. Clean energy, one of the more visible option demonstrating the potential for a compelling double bottom line in infrastructure, continues to be a focus area for GPs and LPs. Yet there has been a reset on regulatory risk, with many feed-in tariff and subsidy programs up for change or recently undergoing change. While some managers include renewables as one part of a broader infrastructure investment mandate, there are also managers who focus exclusively on clean energy. Though energy program and regulatory change can bring opportunity, navigating the relevant regulatory frameworks, as well as the economic and technical aspects of renewables investing, takes expertise and is not a static undertaking. Emerging markets. Even with the recent cooling off in much of the emerging market economies, the long-term growth of the middle class in those markets is expected to have massive follow-on effects associated with the build-out of infrastructure, ranging from power generation to mass transit to wastewater management. However, the macro considerations for foreign investors, such as regulatory and political frameworks and the environments for private sector investment, are as critically important to evaluation of opportunities in these markets as are the micro considerations, which include counterparty and joint venture partner risk and realistic options for monetization and repatriation of value creation. While the field of private infrastructure fund managers is not nearly as crowded in emerging markets as in developed markets, identifying institutional-caliber investment-ready managers in the space can still be challenging. Nevertheless, for investors who have built out their anchor portfolios of infrastructure investments in developed markets, opportunities to invest in private infrastructure in emerging markets may have appeal, due to the potential for enhanced yield profiles (via approaches incorporating appropriate risk-mitigation measures), diversification benefits and long-term growth prospects relative to developed markets. Favorable investment horizon It is fair to say that, globally, the private infrastructure market has been quite dynamic of late, offering investors the opportunity to take advantage of new trends, shifting relationships and compelling market forces for the benefit of their portfolios. Finding the right opportunities continues to be key, as is investment discipline and active portfolio construction. Our outlook for private infrastructure investing continues to be favorable, and we welcome the opportunity to further engage with our clients in conversations about the asset class. Navigating the relevant regulatory frameworks, as well as the economic and technical aspects of renewables investing, takes expertise and is not a static undertaking. Opportunities to invest in private infrastructure in emerging markets may have appeal, due to the potential for enhanced yield profiles, diversification benefits and longterm growth prospects relative to developed markets. Russell Investments // Q&A: Paradoxes, paradigms and potential in private infrastructure / 5
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