The leap of faith

In 2007, infrastructure funds were like the latest faddish consumer item – with LPs jostling to snap up the best offerings while stock lasted. In the second half of 2008 and throughout 2009, the shelves were almost bare – and what little was on offer was often inspected with a contemptuous look and then put back in its place. This year, the shelves are again filling up and the casual browsers are back in number. Getting them to part with their money is not easy, however.

Berntsson: back
to pre-Lehman

In mid-March, Infrastructure Investor took the temperature of the global infrastructure fundraising market by holding extensive conversations with GPs LPs, placement agents, lawyers and other professionals.

The general vibe was positive – people are looking forward to a better year than 2009 (it couldn’t be much worse, after all) and some positive signals of intent are emerging. The recent announcement by the California Public Employees’ Retirement System to set aside $900 million for infrastructure funds in 2010 (with a further $400 million for direct investments) was one example.

Investors do have reservations, though, and capital is unlikely to start flowing freely any time soon. Vittorio Lacagnina, head of investor origination at US fund manager SteelRiver Infrastructure Partners, says: “LPs are cautiously optimistic and the fundraising environment will improve despite the continuing liquidity constraints. But infrastructure funds are competing for a limited pool of capital and it’s clear that GPs with a proven track record will have a much better chance of accessing that pool.”  

Below, we look at five key points that help define infrastructure fundraising in the first half of 2010. Within these five points you will find why enthusiasm is mixed with caution as investors try to make sense of a jumbled picture.

1. The asset class is in line for bigger allocations
“Pre-Lehman, infrastructure was high on investors’ to-do lists,” maintains Mattias Berntsson, a principal at London-based fund of funds manager Pantheon. Pension funds said ‘we need to have an allocation – probably a specific allocation – as it has its own characteristics’. When Lehman happened, all this was put on hold. Now people are getting back to where they were in planning and implementing their infrastructure investment strategy.”

In fact, in markets like Canada and Australia, some pensions boast infrastructure allocations of anything between 5 and 10 percent of their total portfolios. But in Europe, infrastructure investment is generally far more embryonic. This is especially true of the UK, where early adopters of infrastructure may have 2 to 3 percent allocations, but where the norm is less than one percent. The reason, says Danny Latham, head of UK and European infrastructure at asset management business First State Investments, is that the UK pension market is heavily influenced by consultants – and they have been advising their clients to wait for the emergence of longer track records and more data.

The good news is that the track records and data now coming through the pipeline are favourable. Says Latham: “The consultants have been waiting to see how infrastructure would pan out as a result of the crisis, and it has done very well. They are now out there recommending allocation increases.” Among UK and German pensions in particular, some observers note, there is a big debate about future inflation risk – and many are therefore likely to receive the consultants’ recommendations warmly.

The less good news is that, even once such a recommendation has been made and accepted, it can take a long time to get the capital into the ground. “There are new programmes but they can be slow to invest their new allocations, and they’re often not very formal allocations,” says one source.
2. Finding suitable recipients of the capital is difficult
Even those institutional investors that like the asset class may not like many of the proposals that land on their desks from those on the fundraising trail.

Kelly Deponte, a partner at San Francisco-based placement agent Probitas Partners, makes the point that a large proportion of infrastructure funds currently in the market are first-time funds. “Investors are worried about competence and whether you’ve worked together before, and it’s hard to get past that,” he says. In recognition of this, many funds sought bank sponsorship, “but over the last 18 months, many of the sponsors have gone belly-up”.

Many sources in the market express the view that there is a premium on independence. This is offered as one reason among others why New York’s Alinda Capital Partners raised $2.5 billion last year when less than $11 billion was raised by infrastructure funds globally. It also helps, of course, when – like Alinda – you’ve raised a fund before.

3. Fund economics are in a state of flux
In infrastructure, the equivalent of the leveraged buyout boom was highly leveraged brownfield investment for which private equity-style fees and carry were charged. Amid the poor post-crisis performance of certain funds and the conclusion of many investors that excessive leverage was used to artificially boost returns and justify the fee structure, the application of “2&20” to infrastructure funds is on the retreat.

Kelly Deponte suggests: “If it’s not over-leveraged it means returns in brownfield should be around 10 percent net IRR and you won’t pay 2&20 for that.” There have been two main responses: one is push-back on fees and carry, with 1.25 percent for the former and 10 percent for the latter now often seen in the market; the second is larger LP groups opting to circumvent fees altogether by investing directly (of which more later).

Deponte adds that there may be “leniency” in the case of greenfield funds, while noting that the various different types of risk involved in greenfield projects make it difficult for LPs to assess appropriate fee structures.

Another area in which 2&20 may still be viable is opportunistic investment where, for example, projects may face regulatory difficulties or may have been poorly managed. But the fact that such investments tend to have short hold periods means they may be classed as private equity by some LPs or as infrastructure/private equity hybrids by others. This confusion over how to label the strategy only serves to cloud the issue of appropriate economics.

James Burdett, a partner and fund formation specialist in the London office of international law firm Baker & McKenzie, says investors’ focus on economics is leading to fund structuring innovations. For example: “On infrastructure funds, we are seeing pressure on how GPs fund the management fee. In some cases, investors want to see the management fee being funded out of cash flow after the end of the commitment period (rather than from further capital draw-downs) – meaning that, by the end of the commitment period, the fund must have assets that are generating sufficient returns to achieve this.”

4. LPs are struggling to diversify
As a representative of a fund of funds manager, it’s not surprising to hear Richard Clarke-Jervoise, a director at Paris-based Quartilium, say that LPs would be “well advised to become as diversified as possible by geography, strategy, vintage year, stage etc.” It’s precisely the same advice that would be offered by a fund of funds to any investor seeking alternative asset exposure.

And yet, infrastructure presents funds of funds with a tough challenge in getting that message across. Clarke-Jervoise says: “Investors are tending to take a purist definition of infrastructure in general and this is pushing many new entrants to stick to certain mainstream brownfield-only managers. Whilst most investors understand the attraction of a fund of funds, there are a number of barriers limiting commitments currently.

“For first-time investors, I think the biggest impediment to commitments to funds of funds is that many do not sufficiently understand the risks of direct fund investing while more sophisticated investors are currently making the most of their buying power to obtain the cheapest possible service at the same time as trying to maximise their co-investment programmes.”

There is currently a hot debate raging about what is an appropriate exposure to ‘esoteric’ strategies, including emerging markets. Michael Barben, head of the private infrastructure team at Swiss alternative asset manager Partners Group, says that “for a brownfield investor, the risk premium in somewhere like Mexico or Colombia is not so big that it would make sense for a European fund to invest there. Currency risk is a big contributor to volatility and the natural owner should be local pension funds”.

While greenfield investment in emerging markets is acknowledged to present some compelling opportunities, there is a view that it takes a lot of education before investors will get comfortable with strategies in this area.

5. Direct investing poses a limited threat to funds
“Direct investing [by LPs in infrastructure] is a trend – but only to a degree,” says Deponte. It’s a view that’s widely shared and reflects a belief that only the largest pensions with the biggest resources can do it effectively.

Even in these cases, there is some debate about whether the economics make sense. One source relates details of a conversation with a professional at a Canadian pension: “He said when he added up all the due diligence costs, staff costs and broken deal costs, it looked as if they were spending the equivalent of a 1.5 percent management fee to get the money in the ground.”

James Burdett does see direct investing as a “noticeable current trend” while not being of the view that the traditional infrastructure fund model will be usurped. He thinks investors will remain reliant on fund managers’ market knowledge and expertise.

“In addition to co-investments, we are seeing infrastructure funds leading consortia of institutional investors in large infrastructure buyouts as well as innovative ‘partnership’ or long-term cooperation arrangements between investors and fund managers which give the investor the benefit of the manager’s track record and deal sourcing expertise without the traditional fee structure associated with investment into a fund.”

In an asset class where a leap of faith is required, it’s no surprise that these kinds of arrangements have been growing in popularity.