Out with the old

Look at the headline figures, and it could have been far worse. Infrastructure fundraising fell by less than a third last year, an abrupt end to several years of rapid growth but far from a complete collapse.

In fact, things aren’t as stable as the statistics might suggest. The market has evaporated since September and shows little sign of springing back to life anytime soon. Scratch the surface, and some funds can still raise money. But there are murmurs in the market that investors will only touch those concentrating on safe investments. Some previously popular strategies are now well and truly out of favour. For example, the recent collapse of Babcock and Brown (see page 33, and problems at places such as Macquarie mean that the old strategy of borrowing heavily to turn around brownfield assets is dead.

According to research produced by Probitas, a fund placement specialist, global infrastructure fundraising was $24.7 billion last year, down from $34.3 billion in 2007 (see chart below). “Before September, I expected the total to be similar to 2007’s,” says Kelly Deponte, a Probitas partner in San Francisco. But only around $2 billion was raised between September and the end of the year. And: “I’m not sure that any infrastructure funds had a close during the first two months of the year [2009],” says Deponte. “Fundraising overall has fallen off a cliff.”

To blame, of course, is the credit crunch. The global crisis has made it difficult for institutional investors to make fresh capital available for new infrastructure funds.

The debt crisis also has put many investment projects on hold and “there’s [already] enough equity out there for the schemes coming to market”, says Brian Newman, of placement agent CP Eaton. However it is difficult, if not impossible, to raise debt for even the safest of projects at the moment, and certainly big deals look hard to do. As a result, the overhang of uninvested equity capital has been slow to diminish.

Several funds, such as Alinda II and Morgan Stanley’s infrastructure vehicle, are sitting on spare investment cash, according to Probitas, and in the short-term there’s no reason to fear the market grinding to a halt for lack of equity. But there’s consensus in the market that projects will be less highly geared in future, and that fresh equity will be needed to fund the plethora of infrastructure projects likely to emerge from governments’ attempts to spend their way out of trouble. The $2.5 billion purchase of Chicago’s Midway airport may be an extreme in terms of size (see page 16), but the fact even such a large transaction is being entirely equity funded does show how the market has changed. At the current run rate, more equity fund formation if a must if infrastructure groups are to continue making new investments.

Unsurprisingly, plenty of new funds are being organised to tap into this fast growing market. Probitas says there are over 70 closed-end funds in, or coming to, market, seeking over $92 billion in capital (see listing, page 41 And one fund manager who has studied his rivals’ portfolios says that “overall, most of them are pretty fully invested”. If they want to do more deals, they’ll have to raise more cash. That looks tricky, for the next six months at least. Fundamental Capital Corp’s Peter Luchetti
seems sanguine about his own fund’s current fundraising efforts (he says he is legally barred from discussing them) but splits institutional investors into three categories at the moment: those that say no; those that are waiting until the dust has settled on the current financial storm before committing money; and those “who see the current situation as an opportunity”.

Luchetti points out that funds launched at grim times like this have generated the best returns historically. But while some managers are licking their lips, the reality is that most are waiting for markets and valuations to calm down before taking the plunge.

Robert Coomans, who advises the board of Dutch pension giant APG on infrastructure investments, reckons the uncertainty probably won’t ease until the second quarter of this year, and that fundraising will increase “very gradually” after that. Others talk of recovery only in the final quarter, arguing even that might be optimistic.

So that’s the bad news: look at the headline figures and fundraising is all but impossible at the moment, and will remain so for some time. The better news is that some big new sources of funding are emerging, especially among pension funds, and that infrastructure’s relatively modest, but stable, returns on investment are viewed as increasingly attractive now that other asset classes have taken a bath.

To cash in on this expectation, fund strategies will change over the next year – and need to, because even those institutions keen to invest
may have a hard time doing so. Several market practitioners mention the ‘denominator’effect as one of the main constraints, where plunging portfolio values mean that existing infrastructure holdings can hog all of the available allocation because the total portfolio is worth so much less. That could dent one of the hoped for sources of cash – the fact that big funds must invest all of their allocation within a year and therefore will be looking for deals.

But it is also clear that many of the big institutional investors must rethink their allocations after the problems that clobbered everything from equity markets to property. And many will decide to divert money to secure, and adequately yielding, infrastructure.

APG, for example, allocated just 2 percent of its investment cash to infrastructure for this year. But that is being reviewed, and will increase “substantially”, says Coomans. Like other funds, the scheme is looking away from some areas, including private equity, that have market exposure. And the returns from infrastructure investment – not to mention the big government-led investment programmes that are brewing – are now looking very attractive.

That’s quite a big shift. Infra investments typically yield 10-15 percent, according to Probitas – very modest compared to the 20 percent plus yields investors were looking for pre-crash. Now the lower figure looks like “a good return”, says one pension fund manager. What is more, most infrastructure projects also generate cash, yielding regular rental or toll revenues rather than haemorrhaging money.

That is a big advantage in wooing investors likely to be highly conservative after the money-grubbing disasters of recent years. And of course many other asset classes, from property to private equity, look a lot less lucrative now than they did a year ago. Infrastructure compares well. So institutional investors will divert money away from the wobblier markets, and also rethink the activities of some of their individual funds. Several fund managers suggest privately that their private equity investments will become increasingly focused on infrastructure, for example.

So there’s a fair amount of money out there that will be diverted to infrastructure. But there’s also a big pot of cash squirreled away that has been only lightly tapped so far. “It’s a natural for pension funds,” says Michael Barben of Partners Group, a Swiss alternative investment group and fund of funds. With many banks and insurers in meltdown, it’s the big pension funds both industry and government are urging to get involved with infrastructure. Certainly, the likes of the World Bank have gone on record to say that global infrastructure can only be developed with private cash – and that the key lies in tapping the big pension funds, both state and private. So far, they’re taking a cautious peek. Many European pension funds now invest directly into infrastructure, along with Canadians such as CPP Investment Board in Toronto (for details of CPP’s infrastructure effort, see page 18). But US pensions are conspicuous by their absence, although most expect that to change over the next year. And the Europeans generally have so far allocated little more than APG’s 2 percent. This pool of money is coming out of hiding, but slowly.

BIG PRIZES, TOUGH CUSTOMERS

“Everything has changed now,” says Fundamental Capital Corp’s Luchetti, citing President Barack Obama’s $787 billion economic stimulus package in the US. As well as tax cuts and job creation, this promises heavy infrastructure investment – with an upfront pledge to increase the use of private funding. Some $46 billion will be thrown at transport; $31 billion at federal buildings; $21 billion at schools and $6 billion at water – with more investment likely to flow from the pledge to develop renewable energy.

Governments in Europe and elsewhere plan similar action, and the pension funds have taken note. “The [US] public pension funds will look for deals that create jobs,” says one US analyst, clearly sniffing a social agenda here. And that’s no bad thing if it unlocks large amounts of new capital.

Trouble is, the big US pension funds have little experience of infrastructure, and certainly lack the staff and expertise for direct investment. So they’ll toe dip when they do come in, and they’ll likely act as financial, or portfolio, investors initially. And, say some, they’ll demand a very different sort of investment from the highly leveraged fare offered by the likes of Babcock & Brown and Macquarie.

In the US, word is that brownfield investments, and anything bearing market risk, are out. Instead, funders will “probably insist on project finance structures”, says Luchetti. Investments must be conservatives, revenues certain and there must be a clear understanding of the risk-reward balance.

In terms of funding, this means some of the larger existing managers specialising in infrastructure will find it hard to get cash. Probitas says the 10 largest infrastructure funds are heavily focussed on brownfield (see table), and slams some of these from an investor’s point of view. The ‘Macquarie model’ is “over-leveraged, with unrealistic operating assumptions, indifference to market risks and over-priced”. It makes similar criticisms of leveraged buy out deals. Some of these big funds, including ones run by Goldman Sachs and Macquarie, are out to market at the moment. They may find the going tough.

All of which suggests that as an asset class, infrastructure is in flux and still emerging, rather than a market that has stalled for lack of cash. There’s a growing consensus that the real problem is many of the funds out there are, or were, doing the wrong thing. From now on, financial leverage must fall (to 60-70 percent, from 80-90 up to now); returns must be matched to risk; and fund lengths must be matched to project lengths: in recent years several funds were structured with a 10-year term, which fitted ill with project lengths of around 30 years.

For a correctly structured fund, fundraising has “certainly not” stalled, says John Campbell, founding partner at placement agents Campbell Lutyens in London. “Rumours of the death of infrastructure investing fundraising are false. Those comments tend to be promoted by funds which no longer have a strategy or structure that is relevant to the more sophisticated institutional investor community now emerging.”

The handful of successful fundraisings in recent months do seem to bear this point out. Take Bank of Scotland, which successfully sold a 49.9 percent stake in its portfolio of public private partnerships at the end of last year. Most, but not all, of the projects were in the UK, and there was a decent split of projects, ranging across health and education in particular. Consequently the risks were spread, and with most of these deals operational already, they were also quantifiable.

Most importantly, the fund came with a 25-year term, so that funding matched the duration of the projects. With strong and safe cash flows and a modest fee structure of 50 basis points (in contrast to some of the more aggressive funds out there at the moment), Bank of Scotland was able to show that the new pool of pension fund money exists in reality, as well as on paper. Four UK pension plans committed between £40 million and £77 million apiece, and the 49.9 percent stake garnered total commitments of £434.3 million. If the fund is structured correctly, there is money to be had even in this market.