It’s not usual to hear an audible gasp from the audience when something surprising or shocking is unveiled in public. But usually it’s the stuff of magic shows or comedy acts, rather than infrastructure conferences.
At this year’s Infrastructure Investor: Europe 2010 forum at Berlin’s Radisson Blu hotel, however, one could indeed hear a collective “ooh” as an audience poll revealed that delegates had changed their minds on whether the private equity model works for infrastructure or needs to be replaced by something substantially different.
It was just one of the many timely reminders of the trends shaping this rapidly evolving asset class heard by delegates in Berlin during the two-day conference, which has become a vital diary entry for all those involved in infrastructure investment.
Here, in no particular order, are our top ten Berlin takeaways, based on insights shared at the event:
1. Think more than just jobs. Everyone knows that infrastructure development can create jobs. Not surprisingly, then, job creation has been at the top of the agenda in many countries to get pensions involved in infrastructure. But the argument for job creation may have been oversold. “If that’s all you want to do, you could build pyramids,” said Richard Little, director of the Keston Institute for Public Finance and Infrastructure at the University of Southern California. Little’s right: there has to be a greater incentive for infrastructure investing than just spurring job creation – otherwise, the pensions have every reason to sit out the opportunity. “We can’t invest in infrastructure just because it’s good for the economy,” said Robbert Coomans, adviser to the board of APG Asset management, the €240 billion Dutch pension.
2. Ignore BABs at your own peril. Build America Bonds, the new type of municipal security that was introduced last year in the US’s $787 billion stimulus package, could be transformational for the country’s nascent infrastructure market. The market is beginning to realise that the regulations for this new type of municipal security are written so broadly that there is room for a lot of creative structuring – and private equity firms and investment banks are going to be taking full advantage of it. Here’s just one infrastructure fund manager, Peter Luchetti of Table Rock Capital, talking about how he’s structuring his BAB deal: “What happens is your equity goes in as sub debt, and the senior tranche is a tax-credited tranche, and the sub debt is a tax-credited tranche. And if it’s done in a concession format, there’s no FIRPTA [Foreign Investment in Real Property Tax Act] implication. So it’s extremely powerful. And it’s just getting started in the US.” The buyers are noticing: a sovereign wealth fund investor in the audience said he’s following the developments in the BAB market and may invest in them in the future.
3. But take advantage of the debt markets now. That’s because even if the worst of the crisis is now over, its aftermath will continue to cast a shadow over the debt markets in the form of refinancing. As is well known, many infrastructure assets were over-leveraged in the run-up to the crisis. And in the next few years, the survivors will have to refinance. This means there are bound to be some “difficult discussions” ahead between bankers and borrowers, said Chris O’Gorman, the head of infrastructure at Mizuho Corporate Bank, and “the banks are just going to insist on that leverage coming down”. So if you were thinking of talking to your bankers about taking out that new loan or refinancing one of your assets, now may be a good time to do so before the next wave of refinancing sours their appetite. A silver lining: there will be a requirement for new equity to help bring leverage down, so opportunities for recapitalisations of the Brookfield-Babcock variety are bound to continue for some time.
4. Watch out for the regulators. And it’s not just one type of regulator – with a number threatening to impact infrastructure-related capital flows and performance, it’s hard to know where to look. There’s the politically motivated Alternative Investment Fund Management Directive that one speaker claimed might “kill the ability to raise funds on an international basis”. Then there’s regulation relating to financial institutions that many fear will make moving capital off balance sheets and into infrastructure such a costly operation that it may not seem worth it. In these kinds of instances, infrastructure may find itself inadvertently caught in a trap set for others – be it financial institutions or private equity firms. But on this top of this, infrastructure investors are also at the whim of industry-specific regulators, whose actions may sometimes be surprisingly punitive. In any event, best be prepared – perhaps taking a lead from its private equity cousin, the infrastructure asset class needs to get organised and make sure its views are heard when it comes to issues that might hurt it.
5. Co-investing: lot of talk, little walk. LPs are very keen to get close to the action. One obvious way is through co-investing – the appetite is unquestionable and (for many) unquenched. But will this thirst ever be slaked? A view frequently expressed was that co-investment was already a notable theme in infrastructure and getting bigger. Alain Rauscher, head of Paris-based fund manager Antin Infrastructure Partners, said that “only a tiny fraction” of investors are “able to deliver”. He noted the many obstacles that stand in the way: governance, human resource, constitutional issues and the need for rapid decision-making among them. Have these requirements perhaps been underestimated? The same scepticism was expressed with regard to direct investing: it’s a serious undertaking that requires a serious resource. For many, planned participation may be a lot of talk but little walk for some time.
6. Private equity model is not yet dead. And it may not be for a while, since there are some salient features of it that work well for infrastructure – most notably, having your team be incentivised over the short-to-medium term. This may seem like sacrilege in infrastructure, where everyone knows we’re talking about long-term assets. But, as one panelist put it during a debate over fund structures, the long-term nature of infrastructure assets need not imply a long-term investment structure for investing in them. After all, if people aren’t compensated for their work today for 10, 12, 13 or 15 years, where’s the incentive to try their best each and every day or to not go to another shop if a better opportunity with more frequent bonus pay arises? These were undoubtedly some of the issues that went through the audience’s head as it voted on a resolution that the standard private equity model has failed for infrastructure and needs to be replaced with something substantially different. Going into the debate, 56 percent agreed, 44 percent disagreed. After the debate? A 51 percent to 49 percent victory for the private equity model. One thing’s for sure: the debate will go on.
7. Marriage counselling. If there was one buzzword coming out of this year’s conference that word was “alignment”, namely, the need for greater alignment between the needs and wishes of limited and general partners. Just how badly more alignment between the two parties is necessary was brilliantly – if anecdotally – illustrated by a vote taken during the LP panel discussion that started the conference on day two. When LPs were asked if they received all the information they needed from their GPs, a resounding 62 percent said “no”, with only 38 percent satisfied with the quality of the information they were getting. Funnily enough, when GPs were subsequently asked if they felt they provided their LPs with all the information they needed, the result was inversely proportional, with 62 percent answering “yes” and only 38 percent feeling they should provide them with more information. Clearly there is work to be done in ironing out this disparity but the good news is that all the participants are committed to their relationship, with the word “marriage” frequently popping up to describe it. And like in any successful marriage, both sides are clearly aware that the most important thing is not to be overwhelmed by the bumps in the relationship, but to recognise the problems, seek some counselling and move on.
8. ‘T’ is for transparency. Continuing with the marriage metaphor, any good counsellor will tell you that without trust, no relationship can ever withstand the test of time. And in this relationship, LPs are clearly having trust issues with their GPs. In Berlin, LPs overwhelmingly called for more transparency on everything from fees, to asset valuations, to general information on the day-to-day running of the funds they invest in. GPs understandably raised the concern that calls for more information and/or more LP participation might seriously impede the decision-making process (one person even asked LPs anonymously why bother to invest in a limited partnership at all if you just want to “interfere” with everything). They also made sure to stress that their expertise is the reason LPs hire them and that they should therefore trust their management skills and the information they provide. But the fact that LPs are being quite vocal about the issue means that GPs will increasingly be pressured to address the elephant in the room.
9. The economy is relevant, after all. Apparently, there’s no such thing as a free lunch. When some infrastructure investors began pumping leverage into projects as a way of generating high-teens returns and justifying quasi-private equity fees, it almost seemed like a safe bet. Even in the event of an economic downturn, it was considered that the likely impact would be manageable. And why was this not a reasonable assumption? In the past, the correlation between infrastructure and the economic cycle was limited – you might see a small deterioration for around six months and then everything would be back to normal. Not this time. The “GFC” was no normal downturn – and it didn’t have a normal impact. Toll roads saw huge declines in traffic more or less overnight, ports and airports suffered heavily as well, and one clear message from Berlin was that infra/GDP linkage deserves re-evaluation.
10. It’s the inflation, stupid. To all those who are staying up at night wondering how to get pension funds to channel even more significant amounts of money into infrastructure, APG’s Coomans offered a timely reminder of why pension funds invest in infrastructure. According to him, stable, long-term cash-flows are what pensions want to match liabilities like inflation. It’s this, more than a project’s internal rate of return, that will satisfy pension funds. And if you need further proof of just how important the issue is, consider Coomans’ following statement: “Maybe performance fees should start being paid against them [cash-flows]”. Note also: important as inflation is to infrastructure, it may only become more so, as Henning Eckermann, the chief economist of Partners Group, warned of a spike in inflation in developing countries in the near future.
One final thought for those sampling Berlin cuisine: beware of “all-you-can eat” schnitzel bars that charge only €5 for a meal. They may be delicious, but in the aftermath one might feel much better off with the €5 note firmly in pocket. Take our word for it.