The Future of Infrastructure Investing?

Carl Winfield of Icons of Infrastructure reports, Infrastructure Investors Can Learn From Private Equity:

Investors will have to begin using a private equity approach to infrastructure as the market continues to evolve.

“Investors used to make money buying assets, but that assumes you can buy at multiples that are opportunistic,” Andrew Claerhout, senior advisor at Boston Consulting Group said at the 10th Annual CG/LA Infrastructure Leadership Forum. “Now, you need to develop a robust and creative value add plan to grow and reposition infrastructure assets.”

Claerhout, former senior managing director for infrastructure and natural resources for the CAD $180 billion Ontario Teachers’ Pension Plan (OTPP), noted that part of the reason for the shift to a private equity mindset is driven by increasing government deficits that compromise its traditional role in infrastructure delivery. Moreover, as investors have flooded the market over the last decade in search of traditional assets such as toll roads, airports and electrical generation facilities, they have cut returns by half.

Research from Boston Consulting Group and CEPRES shows that the multiple of capital for infrastructure investment dipped to 1.41x in 2016 from a 1.72x in 2006. That multiple fell further to 1.06x in the middle of 2016.

Flagging returns can be mitigated by looking beyond core infrastructure assets such as roads and bridges. But the pace of technological development is also playing a significant role in helping investors meet their return expectations.

“The infrastructure investing market is broadening to include a new class of smaller, distributed, tech-intensive infrastructure assets,” he said, referencing developments such as smart metering and ride sharing apps such as Uber Pool. “We are now seeing infrastructure-like opportunities from less conventional sources.”

Consumer demand for increased customization, responsiveness and innovation now requires investors to add a service component in order to realize return, Claerhout said. As a result, the need for active management of infrastructure assets has become more pronounced.

“Management teams, moving forward, will be given both capital and a mandate,” Claerhout said. “There is a sense of urgency, and we need to see capital as being transformative.”

Take the time to read the paper Andrew Claerhout co-authored, "The Future of Infrastructure Looks a Lot Like Private Equity." It is available here and it is excellent.

Let me just bring to your attention the two charts below (click on images):

As you can see, investors have been piling into infrastructure over the last five years and there's a lot of "dry powder" in the asset class looking to be deployed.

Not surprisingly, as capital has been piling into infrastructure, the returns have been declining over that time, making the asset class less attractive to investors.

The article discusses these challenges and the role technology is playing in this new era of infrastructure and how investors need to address these challenges.

Long gone are the days where you'd outbid other investors on an infrastructure asset, sit on it and resell it years later at multiples of what you bought it. You need to expand your horizon and approach and rework an asset and make sure you execute on your value creation plan, much like private equity.

In fact, I can say the same thing about private equity, long gone are the days where you buy a company, load it up with debt and then asset strip it to extract value. In a low-rate, low-return world, you need a value creation plan and you need people who know how to work an asset properly to extract value.

Anyway, Andrew also spoke with Drew Campbell, i3 senior editor, to discuss the BCG paper:

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:

1. 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?
2. 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:

1. Does it provide an essential or critical service?
2. Are there meaningful barriers to entry that limit competition now and in the future?
3. Is demand largely price inelastic, allowing for revenues to grow at or above inflation?
4. 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.

I've said it before and I'll say it again, Andrew Claerhout is one of the smartest and nicest infrastructure experts in the industry. When it comes to infrastructure, he absolutely knows what he's talking about and he was the person behind OTPP's new infrastructure approach.

I honestly felt Andrew should have succeeded Ron Mock as CEO of OTPP, but he left earlier this year to raise an opportunistic infrastructure fund to capitalize on an important shift in infrastructure which he sees taking place.

Anyway, I strongly recommend institutional investors reach out to him by contacting him through his LinkedIn profile here. His contact information is there and you can discuss a new approach to investing in infrastructure as this cycle matures.

Below, an older clip (October 2016) where Andrew Claerhout discussed why returns on OECD-based infrastructure have become competitive, making Asia a new opportunity.

Like I said, very sharp and nice guy who really knows his stuff. Every time I talk to him, I learn a lot and it's a real pleasure talking to professionals like him.