A safe pair of hands

Cressida Hogg and Neil King have a pleasant surprise awaiting them as they enter a meeting room in the Palace Street headquarters of 3i, near London’s Victoria rail station. On the table is a silver trophy for Asian Infrastructure Fund Manager of the Year 2010, as voted for by our readers, glinting in the rays of sunlight streaming through the windows.

As Hogg picks up the award, a joke is made about a famous incident a few days prior when a Real Madrid soccer player, taking part in an open-top bus celebration of his side’s Copa del Rey triumph over arch rivals Barcelona, dropped the trophy and watched helplessly as it was crushed under the bus’s front wheels. Reminded of the incident, she appears to clutch the award a little more tightly. 3i wants to be seen as a safe pair of hands and provide no opportunity for headlines suggesting anything to the contrary.

A 16-year veteran of 3i, which she joined from investment bank JP Morgan, Hogg was described as a “natural successor” by Michael Queen when she took from him the reins of the infrastructure business in January 2009, at which point Queen replaced Philip Yea as 3i chief executive. This was anappropriate description given that Hogg had been instrumental in the formation of the infrastructure team in 2005, which she joined as senior partner and chief investment officer.

Seated alongside Hogg is Neil King, an infrastructure partner. He also joined the team at inception in 2005, moving from Innisfree, the UK fund manager focused on Private Finance Initiative (PFI) investments.

Reflecting on this move, he says: “I had the opportunity to once again operate on the broader canvas that I had previously experienced in my banking career [15 years that included five years as head of WestLB’s London infrastructure team]. The PFI market is niche. I thought that the 3i brand would be an excellent way to access the infrastructure opportunity.”

As it turned out, that canvas turned out to be a little broader than initially envisaged.

3i’s experience of infrastructure investing through its long-established private equity operation prior to 2005 led it to believe that infrastructure deserved its own, separate treatment. Initially, says King, “we thought that the opportunity set was mostly PPP [Public-Private Partnerships] and PFI, but it quickly became clear that there was a wider opportunity in core infrastructure”.

Therefore, while the view remained that infrastructure had its own characteristics, it transpired that there was an overlap with private equity that could play to 3i’s strengths. “Core infrastructure was a better canvas for our private equity skills [than PPP/ PFI] because it called for similar operational judgements,” says King. “Our private equity heritage gave us origination and execution skills and our asset management capability is a huge advantage because these are living, breathing businesses.”

The significance of this should not be underestimated. At our recent Infrastructure Investor: Europe forum in Berlin, the concept of ‘asset management’ was referred to almost as a novelty. This was not lost on the forum’s chairman, Thomas Putter, who noted that, in private equity, the concept had been around for a long time.

Hogg adds that infrastructure management teams are increasingly attuned to what financial investors are able to offer.

“We can bring a well-rounded strategic view and a focus on things like governance and KPIs [key performance indicators]. You need board members who can really contribute.”

There is an implied theme: the growing tendency for institutions to invest directly rather than pay fees to fund managers. “The direct investing versus fund investing issue has some way to run,” says Hogg. “I can understand direct investing if you’re a very large organisation as it’s a way of doing things at lower cost. But most LPs [limited partners] don’t have the in-house skills or, perhaps, the appetite to invest directly.”

Hogg sees part of this asset management role as having the courage to support management teams through the tough times. “Many infrastructure businesses have critical performance moments,” says Hogg, pointing to the fact that, because they provide essential public services, there is a particular sensitivity around the performance of infrastructure assets. She points, as an example, to the pressure a water company would be under if there were an issue with water safety. This, she believes, means that infrastructure companies have a particular need for knowledgeable and supportive investors.

3i currently has two infrastructure vehicles, described by Hogg as “very distinct”. One of these, 3i Infrastructure plc, was listed on the London Stock Exchange in March 2007, raising £703 million (€796 million; $1.2 billion) in an initial public offering and then a further £115 million through a placing and open offer in July 2008. This is the developed world product, says Hogg, “with a long-term focus on core infrastructure in the European heartland”, although it also has a commitment to the 3i India Infrastructure Fund. Since inception in 2007, 3i Infrastructure plc has generated an annualised return to its shareholders of 9.9 percent and delivered its 5 percent yield objective each year to date.

One asset vital to 3i Infrastructure plc’s prospects is Eversholt Rail Group, the UK rail rolling stock leasing company (ROSCO) which it acquired from banking group HSBC alongside fund managers Morgan Stanley Infrastructure Partners and STAR Capital Partners in a £2.1 billion deal in November last year. 3i Infrastructure plc invested a hefty £151 million of equity in the business in what
can only be interpreted as a strong vote of confidence in its prospects.

King explains the background: “We first began looking at ROSCOs three years ago, when we looked at Angel Trains [which was sold to Babcock & Brown by Royal Bank of Scotland in June 2008]. That increased our knowledge of the sector and made us very keen to invest. We then saw Porterbrook [sold by Abbey National to Deutsche Bank, Lloyds and Antin Infrastructure in October 2008].”

He continues: “We had followed Eversholt for 18 months [prior to the deal] and knew that we wanted to buy it. There were not many potential buyers with a similar mindset. A lot of the money for large infrastructure assets comes from the US, Canada and Australia where rail markets are totally different. The UK train market has a balance of supply and demand and there is a robust regulatory framework – which made it an interesting asset.

“The process went pretty quickly as we were the only credible bidder but it took a while to close as these are quite complex businesses. Since we completed the deal, we have put in a new chairman and refinanced the business in the bond market. We have a good view of its long-term prospects and we’re very happy.”

Adds Hogg: “It [Eversholt] is absolutely in our sweetspot. It’s the sort of deal that’s not obvious if you’re an investment committee on the other side of the world. There were complex due diligence issues and, if you’re flying in and out, it’s a big challenge to get your head round those issues.”

Indian ambitions

The second of 3i’s infrastructure vehicles is the 3i India Infrastructure Fund, an unlisted, closed-end ten-year fund which posted a final closing on $1.2 billion in March 2008. 3i has a team of investment professionals based in Mumbai and Delhi, dedicated exclusively to sourcing investments for this fund. The aim of the fund is to take advantage of India’s rapid growth by delivering private equity-type returns from lower risk assets in the port, airport, road and power sectors. As at 31 March 2011, it had posted a gross money multiple of 1.3x.

Hogg neatly encapsulates the aura that surrounds India from an investor perspective: “It has population growth, demand for new build and re-build, urbanisation, economic growth, a huge demand for power. In toll roads, ports and airports, we’re seeing explosive growth. And you have a government committed to working with the private sector and successful entrepreneurs and promoters
being encouraged to build infrastructure.”

Take a look at Google Earth, says Hogg, and “you can see the building of a continent”.

She points to Krishnapatnam Port, a private sector port in which the 3i India Infrastructure Fund invested $161 million for a minority stake in February 2009. The port is now, she says, “as large as major European ports – and, not so long ago, there was nothing there”.

Despite this, arguably the most notable investment from the India fund to date was the $228 million it pumped into Adani Power in September 2007 (a further $15 million investment followed in June 2009). This deal may, indeed, have played a major part in the award of the Asian fund manager trophy now in Hogg’s possession.

3i worked with the power developer to increase planned capacity from 2,640 megawatts at the time of the investment to 16,500 megawatts by the end of September last year. When Adani undertook an IPO valued at $4 billion in August 2009 – in what was the first major IPO in India in more than 18 months – it was more than 20 times oversubscribed. Since then, it has continually traded above the offer price.

But while 3i has taken encouragement from its dealings in the Indian market, it knows better than to get hubristic about the opportunity. Hence, it’s unsurprising that Hogg has a balanced view.

“There’s inflation, interest rates are up, and the government has faced challenges which have slowed [deal] approvals. The 2G telecom licence scandal [in which licences were sold at rates far below their value, leading to criminal charges against a government minister] was a watershed. Plus, with more funds focusing on India, there is more competition.”

Her caution extends to India’s much-hailed growth story. “In India, there’s a tendency to think that things will always grow in value. You need some realism to understand the downsides. Will traffic always grow at 5 to 10 percent per annum? There will come a time when it plateaus, and there has to be a buffer in financing structures that allows for this.”

Successor fund

But for all this no-doubt sensible pragmatism, India will remain central to 3i’s infrastructure strategy in the forseeable future.

And, with the current fund around 70 percent invested at the time of going to press, thoughts have naturally turned to a successor vehicle. In a call following the release of 3i Group’s preliminary full-year results to 31 March, chief executive Michael Queen confirmed previous reports that the firm would be seeking to raise a second India fund with a target of up to $1.5 billion.

“We’re starting a dialogue now with investors in Fund I,” says Hogg. The fundraising process will be officially launched later in the year.

Still on the subject of fundraising, Hogg indicates that, at some future point, 3i may look into raising an unlisted fund for developed markets. “Some investors read our reports, appreciate the transparency and like the track record, but say ‘you don’t offer a product that suits us. Why not do an LP product?’.”

Hogg does not rule out the possibility of such a fund, which might invest alongside the listed vehicle, saying that “we’d love to be able to take more of the equity on larger deals”. However, it’s clear that such an idea, while theoretically attractive, is not one for the near term.

In a European context, a more immediate concern is to work out where the best investment opportunities lie in the period ahead.

King highlights five interesting areas, one of which is the deleveraging being undertaken by the likes of utilities, oil and gas companies and construction firms, which is leading them to divest non-core activities.

For oil and gas companies, for example, this is seeing them move out of midstream activities that they don’t feel the need to own, such as pipelines and storage facilities.

Other developments noted by King with the potential to deliver deals to infrastructure funds include: government activity, including fiscal pressures leading to more public-private partnerships in continental Europe; funds selling assets over the next few years (as they look to provide proof of valuations); and more agreement between buyers and sellers on the appropriate valuation of assets as the economic situation continues to stablise.

He believes that the transport sector, in particular, could benefit from the latter of these developments, saying: “The market has now priced GDP corrections into transport deals much more effectively and we think it will become more attractive going forward.”

He adds that there will also be “a lot of activity” in the airports sector over the next six to 12 months” and that “we’ll be interested in that”.

Wary

On renewable energy, King is more wary. He says: “We’ve constantly looked at renewable energy but we’ve done nothing significant and long term. We’ve struggled with the risk-adjusted return and the tendency for people to overpay for these assets. We won’t chase sectors for the hell of it.” That said, he also believes that certain subsets within clean energy, such as smart grids, have the potential to see “huge activity” within the next five to ten years.

With two vehicles investing in the space, 3i can afford some confidence that it will be around to see that opportunity materialise.

It may even hope to claim another award or two along the way.