Off the beaten track

It comes across almost as a lament on behalf of infrastructure fund managers everywhere: “Investors are very clear on what they don’t want, but are still seeking the ideal structure,” says Marcus Ayre, head of infrastructure transactions in Europe at First State Investments. In other words, ‘please tell us what you really want’ (or something like that).

But First State believes that if you put together the right ingredients, you will come up with something that investors will find appetising. And that is precisely what it has sought to do with its European Diversified Infrastructure Fund. Surmising that investors have lost any affection they might have had for open-ended funds, First State has switched from an evergreen structure to a 15-year fund in which investors are given the opportunity to vote for five-year extensions. This, the firm believes, is the model that investors in infrastructure funds have been waiting for.

The background to so-called “hybrid” funds such as these is the long and ongoing debate about which type of fund model is right for infrastructure. In Europe, investors were long accustomed to the 10-year, closed-end private equity structure by the time the infrastructure asset class arrived on the scene. It was natural for investors to want to simply transfer to infrastructure a model that they were already familiar with. However, questions have been raised about whether this model is too much of a straitjacket on the long-term hold nature of many infrastructure assets – does it, in other words, impose an artificial timeline on the buying and selling of these assets?

Australian roots

For fund managers such as First State, which have their roots in the mature Australian infrastructure market, open-ended funds were the traditional choice. However, investor appetite for open-ended infrastructure funds in Europe appears to be diminishing. The Infrastructure Market Review and Institutional Investor Survey for 2011 by placement agent Probitas Partners found the percentage of investors interested in open-ended funds declining from 16.7 percent in 2009 to 13.4 percent in 2010 and just 5.0 percent this year.

Ayre has a theory on why the open-ended model has fallen out of favour. “When the global financial crisis came along, long-term investors thought they had liquidity mechanisms in their hedge fund and real estate fund investments but when they tried to exercise that liquidity, they found they couldn’t. Gating issues arose, with a long line of investors trying to get out. The conduct of some fund managers was not good and trust between GPs and LPs was broken.”

First State has gone in search of those magic ingredients that will win LPs over. One ingredient is what the firm describes as “circuit breakers”, which aim to offer genuine liquidity. One obvious example is the ability to opt for an orderly wind-down of the fund – either at the end of year 15, or at the end of any five-year extension that has been voted for. On top of this, investors can lodge redemption requests and undertake sales on the secondary market. In summary, says Ayre: “This is as much liquidity as we can give investors in what is essentially an illiquid asset class.”

Another ingredient is a wind-down period of sufficient length for assets to be optimally exited. This is topical at a time when some closed-end infrastructure funds have been requesting extensions. “We’ve had a lot of discussions with investors about tenor,” says Jeffrey Altmann, director of investment management at First State. “Some have a problem with private equity’s 10 years plus a two-year extension. For infrastructure businesses, two years is at best challenging. If you are going to extend, you want a sensible period of time to exit.” Hence, the five-year blocks offered by First State.

The firm also believes that its approach is a democratic and open one. The option to vote for a five-year extension will arise at various strategic reviews to be held by the firm, at which a two-thirds investor vote in favour would be enough for the extension to be agreed. These reviews will also include discussion of areas such as fees and general strategy. “It’s like an investment club concept,” says Danny Latham, head of infrastructure in Europe at First State. “It’s not ‘thanks for the money, see you later’.”

But what do investors make of attempts to adopt a position somewhere in between the traditional closed- and open-ended models? Richard Clarke-Jervoise, a director at fund of funds manager Quartilium in Paris, says: “Infrastructure is an asset class where any number of models work since the industry lends itself to many different strategies. Until the asset class has matured, you will see numerous different structures although I would anticipate that, in the long term, only a few will prevail as is the case for private equity.”

However, he has some reservations about what might be termed hybrid funds – for want of a better word. “As a closed-end fund-of-funds, a 10- or 15-year structure works best for us. Failing that, we’d rather invest in an evergreen or other very long-term structure. The logic is simple: the types of assets in which you invest should differ depending on whether you have a ten-year horizon or an indefinite one. But if, at the outset, you don’t know whether the assets will be held for, let’s say, 10 years or 30 years, you will fall between two stools and it will be difficult to work out the most appropriate model for crucial things like incentivisation schemes, liquidity windows and valuations.”

Wary of extensions

Clarke-Jervoise is also wary of fund extensions in certain circumstances. “In private equity, we’ve seen a series of fund extensions over the last few years and they don’t generally present a problem as they only delay a fund’s liquidation by a maximum of two to three years. The only real concern is ensuring the manager is looking to extend the fund life in order to maximise portfolio value rather than to prolong a fund’s management fees. Our concern for infrastructure funds is that, in some cases, those extensions may extend the fund’s life by ten years or so. Therefore, provided a pre-defined threshold of say 75 percent is met, investors who vote against an extension may find themselves locked into a 20-year fund rather than the 10-year structure to which they signed-up.”

He adds: “As a fund of funds, we’re aware that we remain a relatively small portion of the capital being invested in the asset class for the time being and that pension funds with a very long-term outlook will typically be driving votes in terms of volume. We’re therefore wary of investing in a fund where our own outlook may be different from that of the majority of investors and which could have significant consequences on our ability to provide our own investors with the liquidity they expect.”

The need to cater to different types of fund investor with different expectations – coupled with the very different risk-reward profiles of various infrastructure assets – means that structuring infrastructure funds optimally is exceptionally challenging. No wonder it’s such a talking point – and no doubt will be for a good while yet.