Seconds anyone?

In general, the market for secondaries – trading existing investor commitments to illiquid asset classes – is exploding. Little surprise there, with institutions looking to park money but nervous of doing new deals in such a volatile market. But not much is happening in the infrastructure market. And the question starting to be asked is whether this is because infra is simply too low yielding to interest secondary players very much. Or whether the quiet secondary market reflects no more than the sector’s youth – and will grow quickly enough when the sector grows up.

Look beyond infrastructure, and plenty is happening to suggest that secondaries will be the boom market the next year as the financial world licks its wounds. In February, SecondMarket, a brokerage, opened a new centralised market for trading secondary interests and attracted $500 million worth of commitments. In March, investment bank Houlihan Lokey launched a secondaries advisory business. And in April, Goldman Sachs sent ripples through the whole market when it closed its fifth secondaries fund on $5.5 billion. Secondaries advisor Cogent Partners recently estimated that the dry powder for private equity secondaries could nearly double from $32 billion to $65 billion this year if buyers hit their fundraising targets.

But the industry is unanimous that the secondaries boom will bypass infrastructure. In many ways that’s surprising. After all, plenty could come up for sale following the well-publicised problems at infrastructure managers such as Babcock & Brown, and end-investors like AIG.

Market insiders blame the asset class’s youth, low returns and buyers’ inexperience in ?valuing infrastructure interests. But they add that these aren’t insurmountable obstacles: so much money has recently flowed into infrastructure that it should eventually trickle down to secondaries. But not yet. And when it does, there are good reasons to say the market will be smaller than for some other asset classes.

size matters

Like infrastructure, commodities, property, debt and private equity all started off as primary markets only. When they reached critical mass, secondary markets developed alongside them to give initial investors liquidity without having to sell underlying assets. Apparently, infrastructure has not reached that point yet.

“It has only recently, over the last few years, grown to a substantial size,” says Craig Marmer, global head of secondaries at placement agent Probitas Partners. “It’s only in the current environment that you would see people have enough assets to want to consider a potential secondary.”
Data from Probitas, which keeps a close tab on infrastructure fundraising, shows that $86 billion has been raised for the asset class since 2004, when only $2.4 billion poured into the coffers of unlisted infrastructure asset managers. In January this year, Morgan Stanley put the number at about $100 billion more. But even at about $180 billion, infrastructure pales in comparison with the $1 trillion of dry powder held by its older cousin, private equity. So it’s simply too small to support much of a secondary market at the moment.

But it’s also true to say that differences in fund structures make infra a less obvious secondary punt than many of these sectors. Private equity is generally housed in closed-end vehicles, which usually ban redemptions until the fund matures. Therefore anyone wanting to sell out early has to do so through the secondary market. Infrastructure, in contrast, uses a mix of three types of fund:  closed-end; open ended; and listed investment companies. Investors can exit and enter the last two of these freely and so “you’ve got two other structures where the secondary market is not relevant”, says Marmer.
Investors in these structures have found liquidity in other ways. Last month, for example, the Canadian Pension Plan Investment Board bid A$1.37 billion (€710 million; $930 million) in cash to take private Macquarie Communications Infrastructure Group, at a 67 percent premium to its share price. It wasn’t the first Macquarie fund to go private, and market buzz is that it may not be the last. But the point is that deals like this don’t need a secondary market.

The small number of closed-end fund managers also means it’s harder to find a buyer in infrastructure than in private equity or real estate. Like attracts like, especially in an asset class with lower, more stable returns. Therefore fewer funds translates to fewer buyers for secondary interests. “When you think about who would be a good buyer of infrastructure assets, it would be another infrastructure investor,” says Marmer.

Returns matter more

That’s especially true since the asset class’ low returns are treated with some disdain by secondaries funds. Most secondaries funds want internal rates of return (IRR) in the mid-20 percent range, Marmer says, whereas infrastructure’s IRRs are typically in the low-to-mid teens.
“Secondary funds today are looking for equity-like returns,” says Todd Miller, managing director at Cogent Partners in Dallas. “Lexington, Goldman, Coller, all those guys are trying to find much bigger returns [than infrastructure].”

Adams Street Partners, a Chicago-based private equity firm with around $1.5 billion set aside for secondaries, can be added to the list. “Most of the universe of infrastructure is very fixed income-like both in terms of risk and cash return profile,” says partner Jason Gull. “It’s not something we would be interested in [except] at the right price. But I’m not sure that a seller would want to sell a fixed income return at an equity risk premium.” Limited partners (LPs) invest in Adams Street to grab equity returns that are above public markets, Gull says. “An LP shouldn’t expect infrastructure to derive those returns.”

So matching buyers chasing high returns with infrastructure’s stodgier universe is tricky. “I don’t think people change in the secondary world. They’re going to want a higher rate of return, which means a huge discount if they are to buy infrastructure funds on the secondary market. If you want a 20 percent IRR in the secondary world and you’re buying something that yields a 10 percent IRR, you’ve got a huge discount there,” Miller says. “Huge discount.” Cash-strapped infrastructure LPs are unwilling to take that discount. Miller, Marmer and Gull all agree that they’ve seen very little interest from sellers. And there’s no talk of any asset managers raising infrastructure secondaries funds. “I can’t imagine why someone would do that,” Gull says. “There’s nothing there.”

Experience wanted

A shorter term problem is that it is simply too young an asset class for either side to have developed the necessary expertise, making people wary of committing to secondary deals at the moment.
“Infrastructure is like real estate” says Miller. “It is its own animal. You have to understand it, so the buyers that are buying private equity, they have that expertise, but lack that expertise in the infrastructure space.” That’s especially true for pricing. “The specialist experts at dedicated secondary funds and funds of funds are often unfamiliar with the sector, so they are usually not aggressive on pricing positions that are coming their way,” says Kelly DePonte, Probitas’s head of research and due diligence.

So far, interest has been limited to quasi-infrastructure assets offering higher returns. “We’re starting to see that become interesting to people,” says Marmer, mostly in sectors such as energy. He has also seen some deals for funds that held highly leveraged core infrastructure assets. On the end-investor side, financial difficulties have made some LPs seek liquidity. Fallen American insurance giant AIG, which has backed several of Highstar Capital’s infrastructure funds, is known to be seeking liquidity for its positions. Other insurance companies and financial institutions that either needed to be bailed out by governments or are under steep pressures to deleverage have followed suit. But for the time being, the volume is not significant. And, says Miller, the market “probably [won’t gain steam for] at least three years”. Infrastructure is not private equity, and secondary markets will reflect that.