Going after the big beasts

If you’re the kind of investor that likes to throw your weight around with big-ticket commitments and demands for co-investment rights, this could be your kind of year. Asked for cutting-edge developments in infrastructure fund formation, many asset class professionals refer to a bias towards limited
partner (LP) groups with heft.

One market source offers the following observation, which appears to be widely shared: “The thing that’s becoming a novelty is how much infrastructure is playing into the hands of very large investors with tickets of, let’s say, €200 million to  €500 million. Very rapidly, the industry has been tailored
around them and the economics are made to work in their favour.”

'Disproportionate influence'

One reason is the concern of fund managers that large institutional investors will opt to fund infrastructure assets directly rather than through funds – thus denying them a major source of capital and providing tough competition for new deals. Hence they are being offered co-investment rights as well as discounts on management fees and carried interest.

Says another market observer: “They [large investors] have a disproportionate influence on the industry. You’ve got fees and carry structured massively in favour of those investors.”

One manifestation of this is the tiered fee structure which sources say is becoming so common that it is almost market standard in both the US and Europe. This sees the largest investors charged the lowest fees (and sometimes also with less carried interest paid out to the fund manager on their portion) while the smallest investors pay the highest fees (see accompanying boxed item on p. 15 for an example of such tiering).

Although fee tiering is also seen in more established asset classes such as private equity, fund formation experts say it is seen more regularly in infrastructure ‘main fund’ documentation. In private equity funds,
tiering will more likely be found in separate co-investment vehicles rather than the main fund. In other words, the infrastructure asset class makes the phenomenon more explicit.

Growing up fast

There is an interesting historical aspect to this, some market sources point out. The private equity industry started small and gradually evolved to the point where very large limited partners (LPs) emerged.
The infrastructure asset class, on the other hand, has been growing to maturity in a market where the dominance of the larger investor is well established. Unlike private equity, the smaller investor is arguably not etched into its DNA.

The embrace of the larger investor is part of a trend for those raising funds to put a concerted effort into the first close. “Given the weakness in the fundraising market, teams are focusing much more heavily on achieving a first close,” maintains Richard Clarke-Jervoise, a director at Quartilium, the Paris-based funds of funds manager. “A year or two ago, GPs came out with their new funds and talked to the entire universe of potential LPs. As a result, many of the fundraisings stalled. Now, GPs want to complete a first close of more than 50 percent of the final target size. This will include their largest existing
and new investors.”

Terms and conditions are reflecting this rush to get to the all-important first close in a fundraising environment where the headwinds are still perceived to be strong. Although last year was the highest global infrastructure fundraising total since 2008 at $20.8 billion, this was still well below the $39.7 billion pre-Crisis peak in 2007. Shawn D’Aguiar, a partner in law firm SJ Berwin’s private funds group in London, says that early-bird discounts are increasingly becoming available for those prepared to commit at the first-round phase.

In the rush to first close – and the courting of large investors that this involves – there are hidden dangers. One is that the same larger investors may change strategy in future – for example, moving away from infrastructure in general or perhaps away from funds and towards direct investing. The risk in this case, as one market source describes it, is of “over-concentrated relationships”.

Or, another way of putting it: if you neglect a substantial portion of the investor base, you shouldn’t be shocked if those investors bare their teeth at you when you eventually need them.

Aside from “going large”, Infrastructure Investor has discovered plenty of other key fund formation themes. Among them:

Re-ups rule (and innovation is a victim): No longer does the debate rage about the appropriate time horizon for an infrastructure fund. “It’s now accepted that there are different models depending on what does or doesn’t work for the GP’s strategy and the target LP base in question,” says Clarke-Jervoise of an issue that has attracted considerable intellectual curiosity. In Clarke-Jervoise’s view, this year’s pipeline of funds coming to market will move away from first-time funds (where the opportunity to innovate is arguably greater) and towards existing managers raising second funds such as EQT Infrastructure and Global Infrastructure Partners. And most of these funds, says Clarke-Jervoise, “will more or less stick to whatever structure they had for their first fund, making a few tweaks where necessary”.

Broader key man clauses: “There is a lot of negotiation around key man [provisions], including when it gets triggered, the consequences and the lifting of any investment period suspension,” says D’Aguiar. A staple of private equity fund clauses, the key man provision dictates what will happen in the event that key executives leave. Recent examples of management teams launching spinouts from sponsored funds have made investors jittery according to market observers. Some want the clause expanded to cover more executives.

Risk fears evident in documentation: In a volatile macro-economic scenario, investors are focused more than ever on risk. And that means putting tight wording in the documentation when it comes to the likes of geographic and currency risks. For example, investors are sometimes asking for wording which allows European funds more flexibility to invest outside the region, given the problems in the Eurozone. According to D’Aguiar, some investors are also seeking to avoid over-exposure to certain types of asset, such as ports or logistics for example – and are ensuring wording is included to this effect.

Yield built into the economics: Around a year ago, the idea of incorporating yield into infrastructure fund economics was a hot talking point. As with fund time horizons, there is no right answer. One objection to yield-based compensation was that it might dissuade fund managers from making the level of capital investment that an asset required. Consequently, the approach is more generally accepted where funds have less capital-intensive and more long-term strategies.

How to invest in debt? The jury’s out: “Infrastructure debt will become an investment space of increasing size,” says Clarke-Jervoise. “More and more LPs we talk to are very focused on private debt and infrastructure is seen as pretty attractive.” But, while there has been much focus on the debt funds that have launched into the market, it is not at this point clear how the bulk of infrastructure debt product will be sold into the market. Some think funds will only play a relatively small part in this process.

The tiers are flowing

Tiered management fees, which are designed to reward those investors making large commitments, have become increasingly commonplace in the infrastructure fundraising market. Here are two unnamed examples that have been circulating:

Example 1    Example 2   
 Commitment Management fee (currency not specified) Management fee   Commitment Management fee (currency not specified) Management fee
 Less than 75m  1.75%  More than 100m  0.8%
 75m to 150m  1.5%  Less than 100m  1.0%
 150m to 225m  1.25%    
 More than 225m  1%