There are risks associated with investing in infrastructure. That much became evident before this interview began, with a last-minute change of venue from Miami to Phoenix as the increasingly threatening Hurricane Ian approached Florida and offered a stark reminder of climate risk.
In Arizona’s sunnier and less windy conditions, the perils of infrastructure can’t be found on the faces of Raj Agrawal, KKR’s global head of infrastructure and his team of regional heads comprising Brandon Freiman, Tara Davies, Vincent Policard and David Luboff. After this year’s $17 billion close of Global Infrastructure Investors IV, and 10 years after the $1.04 billion closing of its debut effort, the team now has about $49 billion of assets under management, up from the $13 billion it sat on when we last undertook such an interview with KKR in November 2018.
Despite having co-led the infrastructure business from 2007 to 2018 and been in sole charge since, Agrawal can’t feign disbelief about this level of growth.
“We did think we would be here, but I didn’t think we’d be here in 2022,” he concedes. “We entered this business because we thought it was a multi-billion-dollar, multi-decade opportunity and so it doesn’t surprise me that we have a leading European and North American business, a leading Asian business and a leading core infrastructure business. It does surprise me that we have the business with the leadership position and the scale that we have only 15 years into this.”
Agrawal credits several factors for this. His team, the strategy and their track record are those that gain immediate recognition, although Agrawal is cognisant of being part of the wider KKR machine.
“I don’t think we could do any of [our investments] without the resources that we have around us. If we were just an 80-person infrastructure team without the backing of a firm of over 2,000 people that are helpful to us in a myriad of ways, we couldn’t do the deals that we do. We migrate to deals that we believe only we – or one or two others – could pull off,” he states.
Then there’s other factors beyond his or KKR’s direct control. The growth of the market means he is no longer having to explain the role of infrastructure capital to either LPs or potential counterparties, as he admits he was doing even five years ago. And then, of course, there’s macroeconomic conditions that appear to be playing right into KKR’s hands.
As Agrawal posits: “When we talk to our investors, what’s on the top of their minds? It’s economic volatility, equity market volatility and inflation. How do you protect the real value of your assets and of your investments in this high inflation period?”
Managing ‘simple infrastructure’
Enter stage left the Diversified Core Infrastructure Fund – KKR’s latest product, introduced in December 2020. The open-ended vehicle has a 7-9 percent targeted net IRR, lower than the 12-13 percent targeted by KKR’s flagship series. It’s a fund that has thrived in the era in which it has operated, raising about $8 billion in less than two years.
“If you think about core assets, they tend to be closer to government policy, they tend to be monopolistic and therefore the revenues tend to be directly inflation linked,” says Davies, co-head of KKR’s European infrastructure business and head of the core strategy.
“Most of infrastructure is indirectly or directly inflation linked. I think in core that linkage is much stronger, and that’s certainly evident in our portfolio. If you look at investors and their biggest sensitivity at the moment, it’s inflation. So, if you can buy a product that is directly inflation linked, which effectively our strategy is, that’s a nice place to place your capital. When markets dislocate, I think there is a flight to quality. We saw that in infrastructure in the recession and I think you’re probably seeing that again in terms of where investors are thinking about placing their money at the moment.”
But, in December 2020, the world had other problems to think about and hadn’t even considered the rising inflationary period of 2021 and 2022. So what was behind the launch of such a vehicle?
“I think the genesis of the core strategy was a natural transition of the business,” believes Davies. “We speak to corporates a lot. We get really interesting dealflow from corporates but not all of that dealflow is super complex and something you can get a 15 percent return out of. In core, we are trying to buy simple infrastructure and hold simple infrastructure and by default, it comes with a lower risk profile and less volatility in the outcome and also, by default, lower returns. So, having the core capital alongside the core-plus capital allows us to prosecute a full spectrum of potential opportunities.”
The recipients of over $4.5 billion deployed from the fund so far we find electric utilities in Finland and Australia, renewables and district heating in the US, fibre broadband in Spain and PPP developer and operator John Laing, certainly giving credence to the ‘diversified’ element of the fund’s name.
There is, though, a wider significance to both the fundraising and deployment success to the DCIF seen so far. At a time when infrastructure GPs across the spectrum are launching new core products, KKR is several steps ahead of most on this. It will be interesting to see if this kind of momentum can be matched. Davies denies that KKR’s progress could be seen as a litmus test for such strategies but emphasises the importance of cash-generating assets.
“We have seven portfolio companies but a look through to 68 different assets and in its simplest form, diversification should reduce the volatility of the returns over the medium term. So, despite the fact that the strategy is new, you are getting immediate benefits of diversification in terms of coming into it at scale,” says Davies.
What other managers finding their feet in the core space might also look to KKR for is the intrigue as to how that relatively high 7-9 percent range, as stated in fund documents, is reached. Operating renewables, such as DCIF’s maiden deal Neon Renewables, and Northumbrian Water in the UK, will need careful management to reach those targeted returns.
“Every deal we’ve underwritten has been in our target range [of returns]. Some are at the lower end of the range – typically the utilities – and typically the platform deals are at the higher end of the range,” adds Davies.
This perhaps places a greater emphasis on asset management. But how does this differ for a firm that has been investing from the outset in infrastructure in 12-year fund terms, with views to exits, rather than the open-ended approach of the DCIF?
“We approach our investments with a thesis and if our thesis, for example, is to incrementally invest into a platform, we need to control our platform and we need 100 percent ownership,” says Davies.
“To underwrite into those deals where it’s a bit more of a passive thesis for an existing operational steady-as-she-goes asset, then we can take a view on a significant minority interest.
“So our thesis does need to align with our ownership stake. The transformation isn’t as much a focus as our core-plus strategy, but it’s still relevant. We actually have a performance fee that is incentivised from increasing operational cashflow and so there is a focus to align us to that value creation on those assets.”
It may have sounded like bluster, but Agrawal’s earlier comments of KKR owning “a leading core business” are justified by the numbers, as was his assertion that it also runs a leading Asia business. Head of Asia-Pacific infrastructure Luboff joined KKR in January 2019 from Macquarie Asset Management, which at the time of writing, holds the gong for the largest Asia-Pacific infrastructure fund, with the $4.2 billion close of its latest vehicle in May.
However, that may be about to change. After closing its maiden Asia-focused effort on $3.9 billion 18 months after Luboff’s arrival, fundraising is back in full swing. KKR revealed in its Q2 2022 earnings that $4 billion had been raised to date for Asia-Pacific Infrastructure Investors II, which will surely see it surpass the latest Macquarie vehicle.
Asia, though, would have been a natural step for Macquarie, which runs other segmented funds focusing on Europe and the Americas. KKR, however, has raised $28.5 billion from a global strategy. So, why the need for the separate vehicle?
“When we started Asia, we’d been investing in North America and Europe through our global fund series for 12 years,” says Agrawal. “We told our investors this is a North America, Europe, developed market strategy. We make a big deal out of sticking with what we tell our investors, and so we did not want to stray into Asia with the capital that had been entrusted to us.
“The second reason is that there’s a lot of Asia, frankly, that looks very similar to other developed markets. But there’s a portion of Asia that looks dissimilar, in terms of currency volatility, hedging and reliability of regulation. In our minds, because of that, this is actually a premium product in terms of premium return potential and a slightly higher risk as well. We wanted our investors to be able to make their own allocation decisions.”
That being said, some industry figures have told Infrastructure Investor that investment in Asia no longer displays that significant return premium. Luboff, though, does not believe this is comparable, raising the example of KKR’s May 2019 investment IndiGrid, an operator of 14 electricity transmission assets that operates through the public infrastructure investment trust (InvIT) model.
“We have developed Asia and developing Asia within our fund, and what we try and do is get a blend between the two to give a mid- to high-teen gross return to our investors, for which we’re very much on track,” Luboff says.
“IndiGrid is very core infrastructure as a 30-year take or pay contract effectively backed by an Indian government’s subsidiary. So the credit risk is very low and the volatility of cashflow is very low with margins above 90 percent. It’s the type of asset that the core fund would love to get its hands on in Europe or the US, but you can’t because that entry point would be so high. We are currently marking the asset at 1.8x.
“It was a particularly good find and the market opportunity was there and that IRR is north of 20 percent in US dollars. So it’s very difficult to say what’s the premium because the type of assets that we’ve been able to buy are different to the type of assets that a comparable core-plus fund would buy in Europe or the US. A core-plus fund in those markets wouldn’t buy a contracted transmission asset.”
Luboff raises an additional example of a more recent deal, its August investment in Pinnacle Towers in the Philippines, which joins India and Korea as a key investment destination for KKR, stating that the asset has cashflows and contracts that would look like a core asset outside of Asia, but can capitalise on the need for growth of telecom tower infrastructure in the country. But, when it comes to the macroeconomic environment, Luboff argues these still look more like core assets.
“If you look at the rupee, it’s falling relative to the dollar, but by far less than most other currencies,” he says. “So, yes, we’re seeing inflation, we’re seeing interest rates going up, we’re seeing leverage ratios going down. But the reality from our perspective, we largely hedge our currency. We’ve always taken prudent levels of leverage. And really importantly, our portfolios are performing really well because we’ve had this inflation passed through.”
What Luboff does admit is that in some ways, the APAC journey has been a back to basics one for KKR. Despite KKR’s and the team’s experience in the region, he says investors saw it as a first-time fund. Seemingly, from the rapid second round of fundraising, many of those concerns would have been alleviated.
Brown to green
Away from new strategies, a cursory glance at some KKR portfolio companies might give the feel of many large infrastructure funds in market today. There’s fibre – and plenty of it, be that in Italy, the Netherlands, the US, Chile or Colombia. Then, of course, there is CyrusOne, the mammoth $15 billion data centre deal closed alongside GIP in March. However, there’s certainly no sense of following the crowd, according to Policard, co-head of European infrastructure, who recalls KKR’s 2015 investment in Deutsche Glasfaser, builder and operator of fibre networks in Germany. The asset was sold to EQT and OMERS in February 2020.
“In 2015, nobody knew what fibre was. Nobody cared and that was great. That gave us the opportunity to go and do it,” he recollects, somewhat tongue-in-cheek. “On the flipside, we have been historically very much underweight in transportation. Most GPs buy commercial airports and ports but we haven’t got into those because we felt those assets are quite correlated to GDP, which is inconsistent with our strategy.”
Freiman, head of North American infrastructure, adds: “I think what we’ve found is the intersection of large deals that are also complex is a place where it’s not uncompetitive, and we’ve actually really thrived in that space. If you look at a lot of the deals we’ve done in the last five years, they’ve been cheques for $2 billion-$7 billion of equity. They are businesses that are not simple, they’re businesses that require an operational transformation, a complex carve-out, a complex partnership, a reimagining of management and of business plans.”
That reimagining is now leading KKR back to transportation deals, while keeping in mind Policard’s reservations about GDP correlation. This has included its investments last year in Norwegian shipping group Ocean Yield and fixed-base operator Atlantic Aviation.
“There is a big decarbonisation trend in the aircraft sector, in the shipping sector and the urban mobility sector,” says Policard. “We see a big trend towards decarbonisation of transport, and towards ammonia hydrogen down the road. The paradox is we end up doing a lot more transport these days – in subsectors where we see less volatility or some contracts – because that really participates in the decarbonisation trend.”
That ties in with KKR’s efforts in the energy transition space these days, too. While that side of the strategy was once about buying into renewable energy businesses, it is now about decarbonising wider energy portfolios, as recent take-privates of thermal generators Albioma and ContourGlobal attest.
“A few years ago, the narrative around energy transition was incredibly unsophisticated and I think there’s just a greater appreciation now that there would be a tremendous amount of human suffering in the world if all natural gas production were to shut down,” believes Freiman. “I think the reality is [the war in Ukraine] clearly just shines a light on the need for more energy. That energy needs to be produced in a way that’s consistent with an energy transition that works for the world. That clearly means a lot more renewables.”
With all that said and KKR’s increasing segmentation in infrastructure, would we likely see a separate strategy around the energy transition thesis?
“We think the opportunity in energy transition and renewables is tremendous. The question for us is whether there is a tremendous opportunity there that’s incremental to what we’re doing today?’ Frankly, our hypothesis is yes,” says Agrawal. “But that’s something that we would need to prove out and gain a lot of conviction before we decide to go build a business, because we’re motivated by building something that would be incremental. We’re always considering opportunities, so it’s one of the few things that we think is interesting.”
The growth train, it seems, shows little sign of stopping.