A market on the move

Back in 2008, Swiss private markets investor Partners Group was pondering whether there would be such a thing as an infrastructure secondaries market – or at least, one of sufficient scale for it to make the firm’s participation worthwhile. It was a time when such deals were “few and far between” according to Michael Barben, a partner and head of private infrastructure at the organisation. “There was not constant deal flow but we began to engage actively and asked ourselves ‘will there be an infrastructure secondary market’?”

Four years on, and the answer to that question is a confident ‘yes’ – at least from Partners Group’s perspective. Since 2009, Barben says, the firm has bought 15 secondary infrastructure positions and is currently looking to add a 16th. In total, these transactions have been worth some $400 million.

By 2010, Barben points out, the global infrastructure fund market was worth around $160 billion. Given the experience of the private equity asset class that the secondaries market will tend to be worth around 1-2 percent of the primary market in any given year, Barben believes you have a market worth at least $1-2 billion.

This may not be much compared with the private equity equivalent – Professional Pensions estimated the private equity secondaries market to be worth some $24 billion in 2011 – but, to come back to the earlier point, there is a market. It’s of a material size and it’s growing.

Furthermore, Partners Group has bought from a wide range of sellers. The two big sources of deal flow cited by market participants are banks and insurance companies, but Partners has also bought assets from private individuals and family offices. In addition to the capital adequacy pressures on the banks (Basel III) and insurance companies (Solvency II) – which mitigate against holding equity investments on the balance sheet – Barben says “there are also people who made a foray into infrastructure as part of their private equity allocations and then the market turned and their commitment capacity decreased. Infrastructure was not seen as core, so they just went back to private equity”.

Heiko Schupp, head of European infrastructure investments at London-based private assets manager Pantheon, has identified other sources of deal flow. He points to “asset reallocations driven by portfolio valuations, where infrastructure may have outperformed private equity so the portfolio ends up heavy on infrastructure and hence – perversely – some infrastructure positions have to be divested”.

Schupp also points to limited partners (LPs) seeking to reduce the number of their general partner (GP) relationships – something being increasingly seen in the private equity universe – as a potential deal driver. “You’ve seen strategic relationships being formed where pensions want relationships with maybe three or four GPs rather than myriad GPs. Myriad relationships are difficult to monitor and cost time and money,” he says.

Look further ahead and there is another potential source of deal flow on the horizon: funds of funds deciding that they should liquidate their positions in long-dated funds. “In six to nine years’ time, you will have funds of funds looking at the investments they have made in 25-year [infrastructure] funds,” suggests Richard Anthony, chief executive of Evercore Private Funds Group, the London-based placement agent. He describes such a scenario as a “maturity mismatch” that potentially could be addressed through the secondary market.

DIFFERENT ROUTES

Richard Clarke-Jervoise, a director at Quartilium, the Paris-based funds of funds manager, has considered how these “maturity mismatches” may affect his own firm. “There are different routes [to liquidity] we could go down,” he suggests. “We could sell as a private equity kind of secondary, priced on a discount or premium to net asset value (NAV). Or, if a significant number of investors wanted to sell at the same time, you might be able to do a sophisticated intermediation process [led by an M&A adviser].” Either way, he believes “you would get people buying because they want infrastructure assets that are de-risked with contracts and yield.”

The kind of intermediated process referred to by Clarke-Jervoise is not new to the infrastructure asset class. Around six or seven years ago, a number of so-called “whole fund” secondaries were seen. These involved the establishment of listed secondary vehicles, such as HSBC’s HICL Infrastructure Company, which were designed to provide liquidity for investors in a primary fund. In the case of the 2006-vintage HICL – now managed by HSBC spinout InfraRed Capital Partners (see p. 18) – it acquired all the assets of the 2001-vintage HSBC Infrastructure Fund I, with proceeds returned to that fund’s investors.

For the kind of transaction referred to above – and indeed for any infrastructure portfolio containing a large number of assets – experienced intermediaries may well have a role to play in what can be a highly complex valuation process. “There is an important role for an intermediary as infrastructure assets are harder to price on account of the complexity of many of the underlying contracts,” says Clarke-Jervoise. “You may also have as many as 20 or 30 assets all of which means that the investors may not have sufficient resources to analyse them.”

This is a key point about infrastructure secondaries – they’re not for the unitiated. This helps to explain why many private equity secondaries specialists have not yet ventured into infrastructure – at the current time, they simply don’t have the resources to value the assets accurately. (Though as the market grows in size, it wouldn’t be a surprise if they found ways of adding this resource).

“There is no benchmarking for infrastructure [valuation] as there is in private equity,” says Schupp. “Infrastructure assets are valued on discounted cash flow (DCF) models and you can’t benchmark because the discount rate is anyone’s choice and it’s not made public. We re-value at the asset level because we know we have a team with direct experience of investing in these kinds of assets. We go in and we re-value them and then arrive at a combined valuation of the portfolio. It’s quite difficult to do and not many can do it.”

Schupp emphasises that the assets in a portfolio can vary greatly. Some may be regulated assets, others availability-based, others linked to gross domestic product (GDP) – and they may be based in different
geographic markets. “If you’re not able to go to the asset level [in order to reach a valuation], it’s a bit of a stab in the dark,” he concludes.

At Partners Group, the pricing of a portfolio is “the outcome of a valuation exercise asset by asset”, according to Barben. “We model each asset individually and apply a discount rate commensurate for the risk we are taking on. Then we overlay the fund structure to arrive at our purchase price for the portfolio,” he says.

The significance of an accurate valuation is highlighted by the dramatic differences in pricing that have been evident in the infrastructure secondaries space. Barben says Partners Group’s deals have typically involved discounts [to the latest available NAVs] ranging from 15 percent to 40 percent, with an average of around 25 percent. But, at the extremes, Partners has done one deal with a 3 percent discount and one with an 82 percent discount.

Explaining these differences, Barben says: “For the seller, the important thing is whether he has to book a loss – and how much of a loss. One of the best secondaries we did was buying at a 3 percent discount. This was not at all because there was a lot of competition, in fact there was none in this case. But it was just perfect timing to buy the portfolio. The portfolio was at the trough of the J-curve, it was 70 percent invested so it had high visibility, costs were factored in, it hadn’t been written up and there was a lot of embedded value in the assets that was not yet reflected in the NAV. That meant we could offer an attractive price to the seller but it was still a good deal for us.”

He adds: “The 82 percent discount was in desperate times in 2009 where the seller was getting rid of unfunded commitments where they couldn’t afford to pay in any more. It was an extreme example.”

BUYER’S MARKET

As the discounts referred to by Barben would suggest, infrastructure secondaries is seen as a buyer’s market. But the fact that discounts are being paid does not mean it’s a market where extreme caution has to be exercised about the quality of the assets up for sale. As Schupp says: “I think one of the most important things [about this market] is that we don’t believe sellers are being driven to sell by dislike of the asset class or disappointment at its performance.”

Schupp does acknowledge, however, that there is a lot of work to be done in isolating the transactions that make sense. “The general market is very lumpy, it’s not steady deal flow. It’s a bit like London buses – you wait for ages and then three come along at once. I think a lot of that is down to the numbers being quite difficult. We did a study in 2011 and found that if we funneled the market down to what we were prepared to look at, it was quite small. Those deals which merited detailed analysis were a lot less than the total universe.”

Richard Anthony does not believe that secondaries will ever be as large a proportion of the infrastructure investment universe as in its private equity equivalent. “It’s such a ‘buy and hold’ strategy, so you won’t ever see infrastructure secondary positions being traded in anything like the volume that you see in private equity,” he says. “The positions get locked away.”

However, others have different views. Clarke-Jervoise points to the existence of LPs which may have an 8 to 10 percent target allocation to infrastucture but are currently only at 1 to 2 percent. In other words, the asset class has a strong growth trajectory ahead. Moreover, he points to the high proportion of bank-sponsored funds in infrastructure – a source from which secondary activity might be expected to arise.

Schupp says infrastructure secondaries – while smaller in absolute terms than private equity secondaries – “may be even more active because of infrastructure’s long-term nature”. He points out that, when you’re talking about 15-year funds with long asset-hold periods, “there is a lot of need for liquidity along the way”.

What’s clear is that an infrastructure secondaries market of a material size is sustainable – and it’s not too long ago that this was not being taken for granted.