Like students after an exam, we are all conducting a post mortem on the current crisis before the results are known. But as the end results might not be clear for another 5-10 years, at least, it is inevitable (and desirable) that we try to work out the impact of the current financial meltdown.
As infrastructure managers we need to consider what the future is for our business. What can we learn? And are we prepared to learn the lessons of this crisis? Can we implement changes quickly enough to maintain investor confidence and secure the future for infrastructure as an independently-managed asset class? Some lessons are likely to be painful and some institutions may take longer to learn them, at their peril.
In the race to institutionalise an emerging asset class, fund managers borrowed technology from real estate and private equity to offer a product for institutional and retail consumption that delivered growth, yield and stable cash flows. Cheap debt, and expectations that it would remain cheap and plentiful indefinitely, prompted fund managers to reduce their cost of capital by increasing leverage and paying back equity to shareholders (or by paying more for assets).
Low interest rates drove asset prices up and, in some instances, debt was used to pay for growth, fund acquisitions and enhance distributions to shareholders. Shareholders did well in the short term but the result was over-geared assets. These are now in the process of deleveraging as global credit contracts and assets return to more conservative capital structures.
In 1996 Macquarie Infrastructure Group heralded the birth of listed infrastructure and ushered in a golden period for infrastructure investors and managers. Performance in the listed sector was astoundingly good until the middle of 2007. Listed infrastructure delivered low volatility coupled with good yield and capital growth. By the end of 2007, there were 23 listed funds in Australia with a market capitalisation around A$45 billion (€25 billion; $33 billion). By March 2009, these funds’ market capitalisation had more than halved to A$21billion.
Unlisted infrastructure funds were developed because wholesale investors wanted to avoid listed funds’ daily mark to market. These funds expanded rapidly as investment banks and private equity firms followed dedicated infrastructure managers into the asset class. The greatest change occurred between 2005 and 2006 when the number of unlisted funds more than doubled (to 27) and the aggregate capital increased by 240 percent to $22.5 billion, according to Preqin.
As the weight of capital bore down on a limited pipeline of deals asset prices were driven up. Definitions of infrastructure broadened (‘core plus’, ‘infrastructure like’) and gearing increased as infrastructure fought for attention against other institutional asset classes such as private equity.
When global equities hit a wall in late 2007 listed stocks in every sector, including infrastructure, crashed. This was not supposed to happen. Infrastructure was supposed to provide insulation from the turbulence in a bear market. What happened to stable cash flows, essential service revenue, regulated monopolies and long-term contracts?
In fact, true infrastructure businesses have generally delivered as promised during this recession. Revenues have been stable or slightly down. Disappointing performance, particularly in listed infrastructure, has come from assets carrying too much debt. Listed stocks also suffered when investors seeking liquidity sold any stocks perceived to be overly geared or complex.
So, although operating cash flows have held up well, free cash flow has been squeezed as debt is repaid and interest costs have increased. The lack of free cash has become even more critical where assets, such as toll roads, are exposed to the economic cycle and operating cash flows have dipped. In some instances shareholders are being asked to help the deleveraging process by injecting more capital.
In essence, an over-geared infrastructure asset started to look more like a call option on GDP rather than a defensive asset that could withstand an economic downturn.
While managers were busy growing their funds through 2006 and 2007, governance structures began to face scrutiny. Externally-managed funds operated with fee structures which were a blend of investment banking, real estate and private equity models. Managers were incentivised to execute transactions and grow funds under management while at the same time delivering value to shareholders. These goals did not always sit well together, particularly when banks started to demand repayment of their loans.
A combination of low-cost debt and fee structures which encouraged growth in funds under management incentivised managers to compete for a relatively small pipeline of quality infrastructure assets. This pushed up the price of infrastructure, especially in the OECD where transactions could readily access more liquid and sophisticated bank debt and capital markets.
In emerging markets, deals moved slower, had less debt, were harder to find and were more dependent on long-term relationships with governments and industrialists. In addition, emerging market investors rightly demanded higher returns to compensate them for increased political and economic risks. This discouraged traditional financial investors and the market was largely left to experienced industrialists and niche funds.
As a consequence, deleveraging is likely to be more painful in developed than in emerging markets. Political and economic risks remain in emerging markets. However, assets will benefit from higher growth in population, urbanisation, GDP and productivity which will help assets out grow any deleveraging that needs to take place.
Despite the recession core infrastructure has continued to deliver stable cash flows that are insulated from broader economic cycles as cash flows are underpinned by either regulation or inelastic demand. Infrastructure investors should take solace from the fact that ‘new infrastructure’ and ‘old infrastructure’ will not be fundamentally different.
Changes will occur at fund, rather than asset, level. Managers will need to pick and choose the changes to make in order to sustain investor confidence — and investors are likely to vote with their feet where managers make the wrong decision. Among the changes that funds in the market are considering are:
• Clearer demarcation of the different classes of infrastructure in fund mandates. 2006-07 saw some creative interpretations of ‘infrastructure’; this trend is likely to be reversed. Non-core infrastructure has a place in investors’ portfolios somewhere between core and private equity but should not be sold on the same returns as core infrastructure.
• Less leverage and limited use of gearing to generate distributions to investors.
• More conservative acquisition assumptions taking into account new‘downside’ assumptions.
• Stronger alignment between fund staff and investors. Incentives are likely to be paid over a longer time frame and be referable directly to investors’ returns. Reporting lines will not be blurred between the fund and the sponsors and fund staff dedicated solely to the fund.
• Re-evaluation of fees to reflect more accurately the services provided. Passive managers should not charge the same as active value-add managers and fees should not incentivise growth for growth’s sake or encourage excessive risk-taking.
• No lock in of a sponsor as preferred M&A advisor to the fund.
• Re-balancing of portfolios to include allocations to emerging market assets
with less leverage and more natural growth possibilities.
With all of these changes and, as assets delever, the question remains: will expected returns for infrastructure increase, decrease or remain the same? To a certain extent this depends on where global debt and equity returns settle but some observations can be made about the likely outcome.
New infrastructure will have less inherent risk as prices fall, debt is paid down and managers adopt more conservative acquisition assumptions. Even without overall returns changing real returns have already increased as inflation falls. As infrastructure fund managers change their fund governance and pay down debt it is likely that they will also emphasise infrastructure’s bond like characteristics, playing to investors’ risk aversion and need for predictability.
The market is short of liquidity at the moment and this presents a buying opportunity for managers with cash. But these higher returns are more likely to be a short term spike. Medium- to long-term the likely outcome is that returns will be stable or fall slightly but assets will be substantially less volatile and capital structures much more conservative.
Andrew Jones is executive director, infrastructure at Challenger Financial Services Group in Sydney