Time to acknowledge the difference

The infrastructure asset class used to have its own version of the search for the mythical Holy Grail. The search for the standard fund model may not have had quite the same ring to it, but it was the subject of much excitable chatter among members of the infrastructure investment community some years back. Did it exist or not? For sure: If someone stumbled across it, what an exhilirating discovery it would be.

These days, true believers are hard to find. Jonathan Kandel, a partner in the private funds group in the London office of law firm Weil, neatly encapsulates today’s sceptical view: “Because of the different approaches that come under the infrastructure umbrella, it’s impossible to create a one-size-fits-all model,” Ed Gander, head of law firm Weil’s London private funds group, says. “Advisers have been barking up the wrong tree if they’ve been looking for that.”

The truth is, of course, that infrastructure offers many different types of investment across a broad swathe of the risk/return spectrum. But it can usefully be divided into two broad camps. One is at the private equity-type end of the scale. “The classic private equity-style model is still very popular,” says Jonathan Kandel, a London partner in the private funds group at Weil. “The manager offers a blind product for 10 years (with possible extensions) and makes its return from a mixture of primary and secondary assets and it looks and feels like a private equity fund.”

Mismatch

But then there are those transactions in core infrastructure assets which may involve long-dated government concessions, for example, and where infrastructure’s much-noted mismatch between the life of the assets and life of the fund comes into play. “Investors will look at you strangely if you’re a 10-year fund seeking to make those kind of investments,” asserts Kandel.

Hence, the second kind of infrastructure fund – a longer-term version which, unhelpfully, is itself divided into two types. One type is simply a longer-life version of the 10-year private equity fund, extending to anywhere between 12 and 20 years. The other approach is the open-ended, evergreen fund (with liquidity triggers to allow investors to exit if they wish to).

For those GPs offering longer fund lives, one of the difficulties they face is the ability to provide team members with appropriate incentivisation – an issue that has been taxing the minds of many a legal adviser working in the infrastructure space. “There has been a lot of work to bring forward the incentive payment dates,” says Kandel.

But making sure team members get compensated within a reasonable timeframe is only one aspect of the challenge. Another is trying to work out an appropriate formula for the basis upon which payment is due. As Kandel says: “With long-dated and evergreen funds, managers are not looking to be incentivised to sell assets: they are looking to be rewarded for generating long-term substainable yield” says Gander. “You need to incentivise based on an income return, rather than selling assets. And that’s where it gets complex. Making it work for the GP is hard but by no means impossible.”

“Another key to GP economics is scale,” Kandel continues, “as the management fee [as a percentage] will not be as high as it is in pure private equity. But if you have scale, and the assets throw off yield, then there are mechanisms by which you can share in the excess yield over a given benchmark. There are a lot of nuances and it’s something we spend a lot of time on because you need the team to stay put and be rewarded over the long term.”

The work being put in at the likes of Weil is in acknowledgment that the “infrastructure fund model” never really existed. Within the different types of model that do exist, many other interesting discussions have been taking place around structuring and economics. Below are some examples cited by industry professionals and advisers:

Management fees: Fees are still under pressure and falling. “There has been a lot of pushback on fees and carried interest,” says Kelly DePonte, a partner at placement agent Probitas Partners. “It’s nowhere near 2 [percent] and 20 [percent]. For a fund likely to make an IRR of around 10 percent that just doesn’t make sense.” But Deponte also stresses that there is no market standard – a point made by others too.

“Generally speaking, rates have dropped further in infrastructure than in private equity,” says Shawn D’Aguiar, a partner in the private funds group at law firm SJ Berwin, with the average typically around 1.5 percent [bear in mind this is the average of very different types of fund] with fee step-downs commensurate with the level of investor commitment.

But carried interest in infrastructure funds, while also under pressure, can be as high as 25 percent (or as low as 15 percent). “There is a lot of variety [in the carried interest rate] in infrastructure compared with private equity, which is nearly always 20 percent,” says D’Aguiar.

First close sweeteners: As a young asset class in which track records are still relatively slim, infrastructure funds feel a lot of pressure to get to first close – and will do what they can to drive fundraising to that all-important landmark. This could mean a variety of sweeteners for early or large investors such as reduced management fees, co-investment rights (some say you’d be hard pressed to raise an infrastructure fund these days without co-investment rights) and preferred secondary rights (first right to consider buying the interest of a fellow investor that is exiting the fund).

“Future proofing”: Clauses are increasingly being incorporated in fund documentation to cover the possibility of changes in the law that will materially affect the fund. For example, as a result of the European Union’s Alternative Investment Fund Managers Directive, it may be desirable to change a fund’s domicile from onshore to offshore. This is an example of so-called “future proofing”. Another example seen recently has been running a parallel non-Euro-denominated fund in tandem with the main Euro-denominated fund – with the idea that the main fund can effectively be replaced by the parallel fund in event of the collapse of the Euro (an eventuality that may now be looking a little less likely).

Investment thresholds: It’s always been common to find in infrastructure fund documentation limits to the amount of capital that can be invested in particular sectors. These days, with sovereign risk prominent, you are likely to find at least as much attention paid to the amount that can be invested in particular territories.

The growth of investment clubs: It’s either fund investing or direct investing, right? Well, not necessarily. Increasingly, large infrastructure assets are being acquired by groups of investors – often diversified by type of investors and countries of origin. An example was the €3.2 billion acquisition of German transmission network Open Grid Europe in May last year by an investor group comprising Macquarie, British Columbia Investment Management, Abu Dhabi Investment Authority and insurers Munich Re and ERGO. And then there’s the launch of the UK Pensions Investment Platform. Expect more of these investment clubs – some formal, some more opportunistic.

The emergence of the pledge fund: Seen before in private equity, one relatively new emerging trend in infrastructure is the pledge fund. This sees investors make a loose commitment of capital to a manager to make investments within certain parameters. Each transaction put forward by the manager must be approved by the investors, who will decide whether to pursue the transaction independently. D’Aguiar says pledge funds are often associated with “first-time managers who ultimately want to raise a fund but perhaps it’s not the right time so they put a pledge fund or club in place instead. Among other things, it can help you to build a track record prior to raising a fund”.

Fund extensions and terminations: Some infrastructure funds offer investors votes on whether the fund life should extend beyond a given time period. So, for example, at the end of a 10-year period, a vote may be held to see whether investors wish to extend for a further two years. Then, if the two-year extension is voted for, a subsequent vote might be held regarding a further two-year extension at the end of year 12. Equally, if a fund has failed to deliver a pre-agreed level of return by a given point in time, investors may be given a vote to decide whether the fund should automatically stop new investments and go into a realisation phase from that point on.

Insurance companies: How to ‘future proof’

“Solvency 2” – a word and a number designed to strike apprehension into the hearts of insurance companies everywhere, especially those charged with making investments on their behalf. And this is despite being a year from coming into effect.

For those in need of a reminder, Solvency 2 is a European Union (EU) Directive that codifies and harmonises EU insurance regulation. The most highly publicised aspect of this is the effect it will have on the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. The Directive, which needs to be approved by the European Parliament, is scheduled to come into effect on 1 January 2014.

Insurance companies wanting to invest in infrastructure debt are today looking at ways in which they can “future proof” themselves from likely Solvency 2-related developments. A key consideration is that even though debt investments may be low risk, if they are made through a fund they are likely to be considered high risk by Solvency 2. There will likely be a single capital weighting for all investments in unlisted funds and this will be set at the highest level, as for direct unlisted equity investments.

Therefore, says Richard Clarke-Jervoise of Paris-based fund manager Quartilium Funds of Funds: “Little or no allowance is made for the specificities of the actual underlying assets on a look-through basis. Thus, private equity, infrastructure and mezzanine debt funds are generally speaking treated identically despite the very different risk reward profiles of each underlying asset class. Furthermore, fund investments do not derive any reduction in capital weighting on account of their risk diversification compared with individual equity investments in single assets.”

Because of this, insurance companies and their advisers are seeking ways to reduce the capital weighting requirement of investing in infrastructure debt by investing directly in the individual assets rather than through a fund structure.

One example of a customised programme by which an insurance company is the direct owner of debt paper nonetheless managed by a third party was the recent structure unveiled by French banking group Natixis where it is acting as custodian for an infrastructure debt platform in which Dutch-Belgian insurance company Ageas has joint investment decision-making responsibility.

The platform has been structured as a type of debt securitisation vehicle called a Fonds Commun de Titrisation by EuroTitrisation, a French asset manager.

No room for complacency

Global infrastructure fundraising increased for the third year in a row in 2012, but it’s not all good news for those seeking capital.

Last year was, on the face of it, a decent year for infrastructure fundraising. The $23.5 billion collected globally meant that the $20.8 billion raised in 2011 was comfortably surpassed. It also meant that global infrastructure fundraising has increased each year since the post-Global Financial Crisis low of $10.7 billion was recorded in 2009.

However, Kelly DePonte, a partner at placement agent Probitas Partners – which compiles the figures – cautions against any sense of complacency at the findings. “It’s still a difficult fundraising market,” he insists, pointing out that Global Infrastructure Partners raised around $2.4 billion in the first quarter of 2012 alone – and that, without the help of the New York-based fund manager’s record-breaking $8.25 billion vehicle, the 2011 total would not have been beaten.

DePonte estimates that around 125 infrastructure funds are currently in the market – looking for an aggregate of more than $85 billion – and that “a number have been out there for 18 months to two years and they are still below target”. Around 25 funds recorded a final closing during 2012.

DePonte says fundraising in the US – a major market for private equity fundraising – has been somewhat stymied in an infrastructure context. “The states are under stress but they’re really caught up in political infighting,” he says of the lack of deal flow. He adds: “We see more funds being launched in Asian greenfield. There is beginning to be as much activity in Asia as in the US – and that’s despite the Indian market treading water.”