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Careful what you leave on the table

How much of your upside scenario do you factor into your base case when trying to win bids in a competitive market?

There are two legitimate concerns investors have when looking at the increasingly crowded infrastructure space. Firstly, how aggressive are managers when bidding for assets that in many cases are generating diminished returns? And secondly, is this pressure leading to style drift, with managers chasing assets that blur the lines between infrastructure and other asset classes?

We’ve written about the latter topic quite a bit recently, but it’s interesting to revisit the former too. The classic fear about aggressive bidding is that managers are packing unrealistic expectations to justify the multiples they are prepared to pay in relation to the returns those assets are then expected to generate. This is particularly true for core infrastructure assets. A typical worst-case scenario is one where managers are backing an overly optimistic business case that is then found to be fairly dependent on factors outside of a manager’s control, like robust economic growth or a favourable exit environment.

Here’s how Ian Simes, senior vice-president for Brookfield Asset Management, elegantly put it to us at our recent debt roundtable, when touting the merits of mezzanine debt versus core equity:

“We’re seeing core infrastructure equity at sub-10 percent IRRs and that doesn’t seem to put very much return on risks like regulatory changes or exit multiples. If you’re a 10-year closed-ended equity fund and you buy something today at a very high multiple, and you’re expecting to sell it in 10 years’ time for that same high multiple, if discount rates are higher and general values have come down for whatever reason, then you may not achieve the IRR you were expecting.”

But there’s a flipside to that argument and it’s this: in a competitive bidding environment, how much value are managers prepared to leave on the table? Or put differently: how much of the upside should managers bring to their base cases to have a reasonable chance of winning a bid?

In a recent conversation with a senior member of a well-known infrastructure manager – one with a fairly conservative risk appetite and a traditional view of what qualifies as infrastructure – the manager explained to us that he was instructing his team not to leave any value on the table these days. That is, the manager is now telling his team to include elements previously reserved for the upside scenario in their base case if that’s what it takes to win a bid.

While, at first glance, this may raise alarm bells, the key here is which elements of the upside are being brought into the base case and whether managers are being reasonable in assuming they can deliver on them. In our conversation with this specific senior professional, the picture that emerged was that of a prudent manager that had historically preferred to add the gravy firmly on top. None of the upsides mentioned seemed unreasonable; and all appeared anchored in the kind of value creation that particular team had been able to deliver in the past.

But of course, it’s not hard to see how, depending on manager discipline, what may have started out as an ambitious but ultimately deliverable return target can easily end up sounding like a hail Mary pass.

So what does it mean when your gravy starts getting baked in? Two things come to mind: firstly, that in this cycle managers are having to work harder than ever to extract value from core assets; and secondly, if what used to be the upside is now increasingly normal, what will the new upside look like?

One thing is certain, though: in the current market, it’s hard to imagine how competitive a manager without strong value-creation skills can actually be. 

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