Few things divide opinion more in the infrastructure investment world than a debate over the relative merits of open-ended and closed-ended funds. Advocates of the closed, private equity-style fund will frequently cite alignment of interest between general partner and limited partner as a compelling argument for their favoured model.
But here on the 10th floor of the imposing Tower 42 in the City of London, open-ended funds are celebrated. One reason why is that they can help avoid being at the mercy of self-imposed deadlines. According to resident firm Industry Funds Management (IFM), the Australian-headquartered international fund manager, the old adage is true – patience really is a virtue.
“It was two years in the making,” says Christian Seymour, IFM’s head of infrastructure for Europe, reflecting on the firm’s successful €800 million bid for the German grid of Swedish power company Vattenfall. The deal, which closed in March this year, saw IFM acquire a 40 percent stake in the grid, known as 50Hertz Transmission, while Belgian strategic partner Elia picked up the other 60 percent.
The auction for the asset, which had been launched two years prior, ended up with a Goldman Sachs/Allianz/RREEF consortium emerging as preferred bidder and entering exclusive negotiations. But the talks broke down in November 2009, with Vattenfall saying there had been disagreement on several issues. All the while, IFM had been an interested observer, waiting in the wings. Under no pressure to invest its capital within a specified timeframe, the firm could afford to bide its time.
“We sat out the initial auction,” says Seymour. “The regulatory framework [for 50Hertz Transmission] did not provide the certainty we required. But those uncertainties were addressed over the following 12 to 18 months. And then the other consortia fell away. We quickly formed a consortium with Elia, conducted due diligence and negotiated with Vattenfall.”
During this time, Seymour says, IFM had sought to develop a productive relationship with the regulator. “They had to get comfortable with us – that we were non-conflicted, offered good labour relations and didn’t want to strip the assets,” explains Seymour.
He adds: “In our talks with Vattenfall, we focused on the argument that we would develop the asset and that we had a good relationship with the regulator. It was very important to them that we could maintain the asset for the long term as they’re an electricity generator and they need a transmission network they can rely on.”
By pointing out that it has held some of its portfolio assets for as long as 15 years, Seymour says IFM was able to avoid the damaging “locust” label that has attached to private equity firms accused of seeking to exploit German assets for short-term gain.
Seymour claims that the deal was “the first true infrastructure investment by an infrastructure investor in Germany that was in core infrastructure rather than areas like service stations or metering solutions”. It was, he says, a “milestone” in that respect. And, having spent so much time on the sidelines, he is equally pleased to point out that the deal was completed in three months, with four banks providing the debt. “We’re looking for a take-out in the bond market over the next few months,” he adds.
For IFM, deals like this and its recent acquisition of a 40 percent stake in Dalkia Polska, the Polish utility, are vindication of its push outside its home market of Australia and into Europe and the US (for more on the latter see accompanying boxed item). IFM currently has 15 infrastructure investment executives based in Australia, 10 in Europe and 10 also in the US (a London office was opened in 2006 and New York the following year).
Seated alongside Christian Seymour is Kyle Mangini, IFM’s Melbourne-based global head of infrastructure. Reflecting on the history of the firm, he says: “Australia was the initial focus but we expanded in relation to the size of investors’ allocation to the asset class. The Australia fund has been going for 16 years, the international fund for six years, since 2004.”
The growth of IFM, including international expansion, has been primarily driven by the steadily increasing influx of capital from Australia’s superannuation funds. The company – which invests in private equity, listed equities and debt, as well as infrastructure – was formed in 1990 with the launch of the Development Australia Fund, created by the Australian superannuation funds to invest in growing Australian private and public companies and infrastructure. Infrastructure is the largest part of the business.
The firm is owned by 35 superannuation funds, which are also the major investors in the infrastructure funds. “There is no conflict between shareholders and investors because they are largely one and the same,” says Mangini. On the back of this substantial superannuation backing, IFM was ranked equal third in this year’s inaugural Infrastructure Investor 30, our ranking of the largest infrastructure investors globally. According to the firm’s website, it had A$23.4 billion (€16.2 billion; $21.5 billion) in funds under management globally on 30 June 2010 (across all strategies).
Moreover, the prospects for those funds under management swelling further over the coming years look good. Since 1992, Australian employers have been forced to pay a percentage of their employees’ salaries into superannuation funds. When the scheme started, this percentage was 3 percent. This rose to the current level of 9 percent in 2002, but will climb further to 12 percent by July 2019.
“The Australian superannuation funds are in growth mode as they have large net capital accumulation,” says Mangini. “It’s a young system and there will be many years before there is net cash flow out. At the moment the focus is on growth and asset accumulation.”
One counter argument to any assumption that even larger volumes of capital will continue to flow to infrastructure investors from superannuation funds is the bad experiences that some investors had when the Crisis struck. But Mangini makes an important differentiation between experienced investors and those that were relatively new to the game:
“Some investors have been in the asset class for some time and they understand it and allocate to it within a portfolio approach that reflects that understanding. But new investors have come into the asset class, and there have been some significant and public failures. They thought it was safe and stable and they’ve had a bad experience. It will take time to get them to return to the sector.”
At this point, the conversation turns back to the appropriateness or otherwise of certain types of model. Says Mangini: “The model that was applied created instability. The issues [around deal and project failures] were balance sheet related, not related to the income statements. Revenues were constant and cash flows were relatively stable. The stress was around the balance sheet due to high leverage and the use of accretive interest rate swaps. It meant that small operational dislocations pushed business plans over the edge. There was no room to manoeuvre.”
IFM chooses to avoid those areas of investment that might be termed “quasi-infrastructure” – or, more parochially, the racy end of the market. “We focus on core infrastructure with a tie to GDP where there are high barriers to entry and low demand elasticity,” says Seymour. “Thus we are represented in airports, toll roads, electricity transmission and distribution – and we also have a portfolio of public-private partnerships. It’s very much core; it’s not ferries and metering companies and things like that.”
Given current market conditions, it could be argued that IFM’s self-proclaimed patient approach is in tune with the times. Even those feeling rather more pressure to get capital invested may well struggle to do so. “The dynamics [of the deal market] have changed,” says Mangini. “In terms of demand for assets, a number of buyers are out of the market and some may find it hard to raise capital. That should be positive for active buyers. But, from the supply side, vendors think the market will improve and are therefore holding back. There’s a lack of motivated sellers. It’s an environment where you’re more likely to have negotiated deals rather than auction processes.”
Where assets do end up the subject of negotiation, IFM’s view is that obtaining debt funding is less problematic than might be imagined. “Credit was widely available before the Crisis, then it was difficult to obtain any credit at all, and now it’s moving towards equilibrium,” says Mangini. “We’ve found the debt market fine for assets in the portfolio that are high quality. There’s a bit of work around refinancing, but we’ve not experienced execution problems.”
On the financing of new deals, Seymour observes: “You can still finance core infrastructure assets. There has been a genuine pull-back from the banks from providing long-term debt. But they’re happy stretching to five years with a view that the proper long-term source of finance is the bond market.”
Mangini expresses the view that “capital is like water; it finds its level”. He sees capital flowing into the infrastructure market from various sources, including debt funds – and points out that IFM has its own infrastructure debt product run by the firm’s fixed income team.
A US national, Mangini is asked how he sees infrastructure investment evolving in his home market (see also accompanying boxed item). “There’s disconnect in the US,” he says. “There is an obvious need, a glaring need for infrastructure investment. Government deficit issues mean that public capital for infrastructure development is limited. Institutional capital is available and could be well used to improve everything from bridges to the provision of drinking water. The need exists, the capital is available, but you can’t get the two together.”
He continues: “It’s a matter of what people are used to. In America, people are not used to paying the private sector for providing toll roads, for example, but they are used to paying the private sector for electricity. Over time, people will accept private provision of public services if it delivers better results. The private sector will not have an easy ride – it will be held to a higher standard [than the government itself] at similar or lower cost.”
As the firm’s commitment of resource to the US market would suggest, it is confident that the teething troubles will eventually be overcome. In emerging markets, however, it’s a different story. “You have so many different issues to deal with such as the evolving regulatory structures, the [possible absence of] the rule of law, and the tremendous amount of capital targeting these markets,” says Mangini. “It’s hard to deliver the returns you need in light of the relative degree of difficulty.”
There is an exception to this emerging markets caution. Mangini adds that the opportunity in Chile, where IFM has a portfolio of hydro-electric assets, is “terrific”. For the most part though, emerging markets may require too much patience even for this very patient investment group.
The platform investor
Alec Montgomery, the head of IFM’s US operations, is bullish on the North American infrastructure market. But it’s not PPPs that are giving him optimism, finds Cezary Podkul
As the old adage goes, actions speak louder than words. If so, judging by IFM’s latest move, the firm thinks the US market for infrastructure is going to double in size in ten years.
IFM recently signed a ten-year lease on a new Midtown Manhattan headquarters for its US staff, where it’s rented out not one but two offices, side by side. On a sunny Thursday morning visit in August, one office was still being set up for IFM’s 12-strong US team, while the other was being sublet.
But this is a temporary state of affairs. Alec Montgomery, the man in charge, expects eventually to fill up the other office once the market picks up and there’s enough demand to add more firepower to his team.
“We’re relatively optimistic,” he said. In the last quarter, activity has picked up: more pensions and institutional investors are requesting interviews for allocations and inquiring about infrastructure.
That also was the case two years ago, before the fall of Lehman Brothers in September 2008 ground things to a halt. IFM had just established its US office, hired Montgomery and – as evidenced by a story from Infrastructure Investor in October 2008, was looking to add to its US team.
“We had a lot of momentum coming into 2009,” Montgomery recollects. But, in retrospect, 2009 was “obviously a pause.”
Despite the pause, the firm managed to get its US operations off the ground. IFM attracted $550 million in commitments from 20 US investors. Most of the investors were Taft Hartley funds: a type of pension scheme for labour unions that came into existence as a result of the eponymous Taft-Hartley Act.
The $550 million accounts for only about one-sixth of the total commitments in the firm’s global fund, which covers investments in North America and Europe. But given the dearth of institutional capital available in the US in the last 18 months, it’s nothing to sneeze at.
Which begs the question: what’s the secret ingredient? In part, it may have been jet fuel.
One of the firm’s flagship US infrastructure assets is the Colonial Pipeline: a 5,519-mile system of pipes that transport refined petroleum products through 12 states, from the Gulf Coast up to New Jersey. IFM bought a 15.8 percent interest in Colonial in 2007 for $641 million and considers it as core an infrastructure asset as any.
“When Hurricane Katrina hit and there were power outages down in Louisiana, the call came in from Washington [DC] to power utilities in Louisiana saying ‘get your electricity up and running to drive Colonial’ because Colonial’s shipping all the jet fuel to the East Coast,” Montgomery said.
“That’s pretty important,” he added.
IFM’s other US investments have been what Montgomery calls “platform businesses”. These are businesses that provide not only the kind of stable revenue streams one might expect from Colonial but also provide some potential to grow the business organically or through acquisitions.
Montgomery places IFM’s other two US investments in the platform category. These are North American Energy Alliance, a northeast power utility IFM bought from Con Edison in 2008 for $1.47 billion, and Duquesne Light Holdings, a Pittsburgh utility IFM took private alongside Macquarie in a 2007 deal valued at $1.6 billion.
One notable omission in the portfolio is any sort of public-private partnership, like a toll road leased from a government. That’s not by accident but by design.
“I think the PPP opportunities . . . are just less attractive to us because of the amount of capital required and very competitive returns that those have been bid historically,” Montgomery said, adding: “They have a place in the portfolio, but they aren’t as attractive to us as platform investments that have good regulatory frameworks and some optionality on growth.