This article is sponsored by Threadmark
Q Which strategies and managers have emerged as winners with investors over the past 10 years?
We are in an incredibly benign environment right now and I don’t think the market has been sufficiently tested to be able to properly separate the winners from the losers. There have been one or two high-profile train wrecks, but those were mainly associated with the financial crisis. Since then, by and large, everyone that has managed to raise money has thrived.
Among OECD-focused managers, any losers have primarily been those that set out to raise a strategy that fell outside the scope of investor appetite, or where the manager’s profile was not strong enough to get the fund off the ground.
In terms of the scale of funds raised, a clear group of leaders has emerged. For firms like EQT, GIP, Brookfield and Antin, their timing was perfect. They didn’t have too much deployed at the wrong valuations ahead of the crisis. They then managed to scale significantly in the immediate aftermath to become real titans of the asset class.
Q Titans aside, how would you describe the appetite for the mid-market?
The appetite for the mid-market has always been strong among investors and offers the most exciting investment opportunities right now. There is limited capital, because as soon as managers become successful they seem to grow out of it. Don’t forget, the majority of large managers today started out in the mid-market. And there is an abundance of assets, many of which are available outside of auction processes. That means pricing is attractive and managers can really drive the structure of deals. That all becomes a lot harder to deliver up as you move up the size curve.
Q What ownership models do investors favour?
When the asset class first started gathering momentum, investors often favoured managers that were captive to larger organisations which had strategic interests and activities in the sector. It was felt they could help deliver dealflow and investors also hoped that if things didn’t work out – if there were significant departures in the team, for example – the parent would step in and ensure that the fund was successful.
But we have seen a massive rise in the number of independent players over time. In Europe, these managers typically have real estate backgrounds and in North America they typically have private equity backgrounds. These independent groups have now been around for some time and so investors are confident in the stability of the organisations. And while investors haven’t universally had bad experiences with captives, it has been sufficiently mixed that captive funds are no longer automatically favoured. There are still groups, such as Macquarie, that remain very successful in the fundraising business. But for more generic sponsors it has become challenging, although a number continue to retain teams and raise funds.
Q What skills are investors looking for in managers?
There is a very strong focus on value creation. Many groups that started out focused on core have moved up the risk curve. Investors have responded by demanding a greater focus on value creation within teams that have historically been dominated by project finance bankers. Operational experts with the technical skills to improve assets have been brought in.
I am always surprised, however, that there isn’t a greater private equity skill set within teams. Where managers are investing behind corporate enterprises rather than single assets, and where targeted returns depend on the manager doing something significant to develop that business, it surprises me that they haven’t tapped more readily into the private equity sector, which has those core skills of building businesses, incentivising management teams and monitoring growth.
It is hard to argue that some of these firms, with tens of billions under management, don’t have the resources to bring those individuals into their teams.
Q How seriously do investors really take ESG credentials?
Very seriously. We are seeing investors demanding that managers codify the ESG policies they have been pursuing for some time and incorporate that policy into their investment process in a more consistent and structured way. We are also seeing investors pushing for better ESG reporting – a statistical evaluation of the ESG credentials of each asset, measured regularly. They want to be sure that assets continue to be ESG compliant and ideally improve.
The other dimension here is appetite for conventional energy. Large investors are experiencing pressure from their boards, or ultimate stakeholders, to reduce or even eliminate exposure to certain types of fuel. If a manager’s strategy incorporates a focus on coal or nuclear, in the current environment that would be a hard fund to raise. When you look at oil and gas, there is a greater degree of flexibility.
But we are hearing rumblings that groups are being pressured to move their portfolios into other sectors. That could have a very meaningful impact, particularly in the US, and I think some high-profile managers could struggle to raise money next time around.
Investor reticence around conventional energy is the issue that has got me scratching my head more than any other right now. How do we marry this disconnect between conventional energy being both the essential bedrock of any energy generation system, and the largest investment opportunity in infrastructure right now – there are no big airports being sold or built in the US right now – and the fact that a large chunk of the investor base, particularly outside of the US, doesn’t want to increase their exposure?
There is a clear desire to transition completely to renewables, but unless we want to live in a world without a lot of the luxuries we enjoy today, we have to accept that until technology progresses, we need to rely on some level of fossil fuels in our economy.
Q What are investors looking for in terms of fund structures?
The major innovations took place early on. The Australians invested through listed open-ended structures from the 1990s, and PFI managers utilised long-duration closed-end structures from the mid-2000s. We have had 25-year term funds for well over a decade and it has become the accepted norm for core funds in many jurisdictions.
The big innovation we expect to come is the broad-based adoption of some form of open-ended structure. A couple of groups such as JPMorgan and IFM have had open-ended structures for some time, but generally the market has not gravitated towards the model. I think we will probably end up with open-ended funds for core and core-plus, with value-add and opportunistic funds retaining 10- or 15-year closed-end limited partnership structures. In other words, infrastructure will follow in the footsteps of real estate.
Shifting investor appetite
Typical of any emerging asset class, different groups of investors have developed their infrastructure portfolios in different ways and at different paces. Australian investors were very early entrants and largely achieved a level of maturity in the 2000s and have maintained stable allocations since. We don’t see substantial inflows or outflows from there.
The next groups to become active were UK pension funds, which focused on domestic PFI projects from the early nineties. Some stayed focused on the asset class as a liability match and primarily targeted sterling-based core strategies. Others started to broaden their currency exposure and expand beyond core. Some of those investors continue to be active in the same way today, while others found their pre-crisis exposure challenging and retrenched.
Continental Europe is also not a uniform picture. Nordic pension insurance companies started in the mid-2000s and have primarily continued to invest directly in core assets and supplemented that with funds in the value-add and opportunistic space. The Germans predominantly still view infrastructure as a liability match, or a form of fixed income surrogate, so for them it is largely about core strategies.
In Canada, the biggest investors got going early and now primarily invest directly, retaining just a few strategic relationships with the large managers at the opportunistic and value-add end of the spectrum. The mid-sized Canadian pension funds are very active through funds and have a broad focus, partly because the Canadian market itself is interesting but small, so they are forced to diversify early.
Unlike in private equity, the US investor market is still nascent from an infrastructure perspective. There are some large pension funds that go direct, with the odd fund commitment to gain access to co-invest. But many are still dipping their toes in the water. Some US insurance companies have gravitated towards infrastructure. But many prefer private credit for the risk-adjusted illiquid holdings in their asset allocation models. Meanwhile, the endowments, foundations and family offices that are significant investors in private equity are far less prevalent in infrastructure. I’m not sure that will change, because their return expectations are so far above what typical infrastructure can deliver.
Outside North America and Europe, the main investment markets are Japan and Korea. There are also some large pools of capital in Singapore and China. There are some Middle East accounts, but we don’t see much appetite coming out of Latin America or Africa yet, certainly not outside local markets.
Bruce Chapman is co-founder of Threadmark with more than 18 years’ experience of capital raising and corporate finance in private equity, infrastructure, energy and real estate