Infrastructure’s quick rise as an asset class is creating increasing challenges for fund managers attempting to satisfy both an investor’s deal specifications and return expectations.
Growing competition for infrastructure is driving up asset prices and making good deals harder to come by, forcing managers to think outside the box when considering an investment. More capital means fewer assets to go around, which is leading to investments that are off the beaten path of core infrastructure, often in companies that are backed by physical assets, but make most of their money from rental and/or maintenance business contracts.
Some see the market trending to what is known as ‘infrastructure-like’ or ‘infrastructure-adjacent’ assets, many of them focused on the provision of services.
“A number of traditional limited partners would not consider something like that to be infrastructure,” Kelly DePonte, a managing director at US placement agent Probitas Partners, explains. “Some people call it opportunistic, some people call it infrastructure-like, and some people call it flat-out private equity.”
A handful of infrastructure fund managers have completed deals like this in the past year, and more deals seem likely as interest in the asset class heats up.
In August, Brookfield Infrastructure and iCON Infrastructure both announced investments in companies providing heating and air conditioning rental and maintenance services. Brookfield, based in Toronto, agreed to pay an enterprise value of C$4.3 billion ($3.31 billion; €2.86 billion) for a company called Enercare, while London-based iCON agreed to buy an 80 percent interest in Vista Credit Corporation for an undisclosed amount.
Other deals include New York-based I Squared Capital’s acquisition of European truck-trailer leasing company TIP Services, in May; last September’s acquisition of Canadian aviation-services company Skyservice Investments, by Toronto-based InstarAGF; and French manager Antin Infrastructure Partners’ purchase of Norway-based Sølvtrans, the world’s largest wellboat company for the transport of live salmon and trout, this September.
Along with increasing competition, DePonte says technology is being factored into the trend toward service assets. Innovations in how people travel and use power are changing how infrastructure is needed, he says.
“The basic problem is, you have the entire industry in fluctuation,” DePonte says. “There is downward pressure on core, and increased interest at the other end of the spectrum driven by an LP search for yield. Certain LPs are looking towards past definitions of infrastructure; others are looking towards future definitions of what they believe is becoming vital to society, with a number of LPs straddling the middle. There isn’t a single good answer.”
A ‘very distinct split’
When most people think of infrastructure, what comes to mind are images of winding roads, towering bridges and power plants billowing steam. For investors, that’s a picture of portfolio security.
Those assets are core infrastructure, which provides long-term, steady cashflows by capitalising on the revenue from tolls and electricity bills that the public cannot avoid paying. Investors have little to worry about competitors or disruption, because infrastructure typically forms natural monopolies in the regions they operate. Markets simply won’t support competing power plants or toll roads that run parallel.
Many times, these assets, which fulfill a vital public need, are government regulated, which means they’re insured to an extent to operate for years into the future.
Investors want exposure to core infrastructure to build into their portfolio returns of around 7 to 10 percent that will produce cashflows no matter the market cycle. That is why long-term institutional investors such as pension funds and insurance companies want exposure. It’s a play to gain insulated returns as the bedrock of a portfolio.
But that strategy is now entering the investment mainstream, and capital is flooding the market like never before. According to Infrastructure Investor fundraising data, 2018 has already topped last year’s total infrastructure fund commitments to become the biggest fundraising year on record. Managers raising a total of 43 funds have already pooled about $69 billion with three months left in the year, compared to just over $67 billion raised by 71 funds in all of 2017.
This wall of capital is creating a “very distinct split” among LPs in what they want from an infrastructure investment, DePonte says. Some investors want the steady cashflows associated with core assets, even if that means single-digit returns. “The flip side,” DePonte adds, is that newer entrants to the infrastructure market are coming in used to the private equity model.
In large commingled funds, a manager’s balancing act of varying appetites is leading to the expansion into ‘infrastructure-like’ assets.
“For many LPs talking to larger funds, they are hearing a traditional pitch, but with mention of some of these changes around the edges that will generate alpha,” DePonte says.
In I Squared’s deal for TIP Services, a “large portion” of the company’s business model is long-term trailer leases, Adil Rahmathulla, a partner at I Squared, explained in May. Renting truck trailers doesn’t exactly sound like infrastructure, though its business success seems highly dependent on a robust transportation sector.
Part of I Squared’s rationale for its investment being infrastructure, Rahmathulla explained then, is that the trailers are physical assets and are backed by long-term leases. Revenue may be generated in ways similar to some types of infrastructure, but some LPs wonder whether such assets will perform exactly like core over the long term.
Jang Dong-hun, chief investment officer of Korea’s $11 billion Public Officials Benefit Association, told us recently that the pension is not “comfortable” or “familiar” enough with these investments.
“The main reason is that there are a lot of these kinds of assets and each asset might have different characteristics and side issues,” Dong-hun says. “I am afraid that for these new, infrastructure-like assets, there might be a very short track record, and it is too much of a niche area to invest in.”
Still, other investors seem to be embracing the strategy. For example, The Washington State Investment Board made a $25 million co-investment alongside I Squared in TIP Services, allocating from its Tangible Assets portfolio.
Even with LP approval, DePonte says fund managers are sensitive about labelling these investments what they clearly are: related to, but not quite infrastructure. He says their reluctance is all about marketing and that it may not be so important.
“The real consideration is what does the entire fund look like, because the entire fund is going to be a portfolio of different projects and risks,” he says. “What many LPs are more leery of is funds that seem to be going all the way toward value-added or private equity-like, and don’t have a deep track record backing that.”
For Brookfield Infrastructure, an investment that, on the face of it, looks different may still provide key infrastructure characteristics many investors demand. Like I Squared’s TIP Services deal, physical assets underpin Brookfield’s investment in Enercare, with the company’s rental business forming “the backbone of its revenues”, according to Rene Lubianksi, BIP’s head of corporate development.
Lubianski adds, though, that BIP sees other key components to Enercare that makes labelling this deal infrastructure correct.
“It’s a high-quality and annuity-cut business that operates in an industry with hard underlying assets,” he says. The assets are contracted for years at a time, the industry has high barriers to entry and Enercare’s market share is very difficult to replicate, Lubianski explains.
Enercare’s origins come from regulated utilities, he adds, which is a niche but well-established infrastructure sector in Ontario that many consider core.
“This industry has firmly been within the definition of infrastructure for many, many years,” he says. “It’s our first investment in this space, so it’s new from that perspective, but I wouldn’t say it’s unique.”
All in the label
For investors in infrastructure, the return isn’t the only bottom line. Exposure to assets that are difficult to disrupt and protect that return is an equally important part of the equation.
So, what’s a fund manager to do? If assets are competitively priced, or there simply aren’t enough of them, they still have to put capital to work. That leaves them with a few options.
Fund managers can look for assets in developing markets, which adds several new risk factors, depending on the market. They can chase newer infrastructure assets, such as storage or data centres, and open up their LPs to less-proven technologies and business models, with higher potential for disruption.
They can embrace development and construction risk, and go into the business of bringing new infrastructure to life. Or they can look for assets that are closely aligned with core infrastructure, which is what an increasing number of managers are doing.
The flurry of deal activity seen in infrastructure-like assets is recent, and it’s too soon to know whether the pitch is true that these assets generate revenue in a way that is so similar to core infrastructure that it’s practically the same thing.
The one thing that is certain is that more capital is coming in to the asset class quickly, and fund managers need to communicate to LPs how that changes the equation. That could mean the erosion of core-only funds, or it could also mean infrastructure-like assets are accepted as close enough.
If the assets are behaving as they are supposed to, it seems likely both sides will find the debate is all in the label.