Das Yield

The Germans are coming! Just as German football clubs Bayern Munich and Borussia Dortmund upset the established order with their Champions League semi-final victories over Barcelona and Real Madrid, so German institutional investors are staging a similar takeover of infrastructure.

You might have heard some noise about the increasing prominence of German institutional investors in the asset class. Maybe this came from fund managers fresh off the fundraising trail, speaking in slightly awed tones about this new source of capital; or perhaps from headlines about the significant cheques being written by Rhineland insurers you never even knew existed.

What you may not perhaps have realised is just how big the German opportunity can be for infrastructure as an asset class. With about 0.5 percent of total institutional investor portfolios currently allocated to infrastructure, with an appetite to increase that amount to 2.0 percent by 2016, the opportunity is potentially huge.

How huge? Close to €35 billion, according to a survey earlier this year produced by the Research Centre for Financial Services at Steinbeis University Berlin, with the support of DekaBank.

According to the survey – entitled Risk and Return Profiles in Equity and Debt Capital Investment in Infrastructure – German institutional investors had around €7.5 billion in equity capital committed to infrastructure in 2012. However, come 2016, that amount is predicted to rise to €25 billion, with an additional €9.5 billion committed to debt – or just under €35 billion in aggregate.

As Andre Hesselmann, former head of alternatives for a German insurance conglomerate and a founding member of fund manager YIELCO Investments, puts it: “German limited partners (LPs) are on the brink of investing in infrastructure. Nearly everyone in the [German] institutional investor market is doing due diligence on infrastructure.”

The reason why German institutional investors are finding themselves increasingly drawn to infrastructure is pretty much the same as for other institutional investors across the developed world: 

“With fixed income accounting for by far the largest share of their portfolios and, given the zero interest rate policy of central banks and the low yields associated with this, many institutional investors are in search of alternatives to meet the steady flow of their payment obligations, which they have little means of influencing,” Susanne Wermter, senior fund manager, renewable energies, at German asset manager Aquila Capital, told Infrastructure Investor.

But the story in Germany comes with a twist because of the country’s unique position as Europe’s economic powerhouse.

Martti Salmi, head of international and EU affairs at Finland’s Ministry of Finance, told Reuters – hopefully not too gleefully – that “as an unintentional consequence of the crisis, Finland has benefited enormously. We have not lost a cent so far. The same as for Germany very much holds for Finland”.

The “unintentional consequence” Salmi colourfully refers to is the flipside of the European Union’s sovereign debt crisis: while weaker southern members on the receiving end of ‘taxpayer bailouts’ saw investors rush for the exits, northern European countries, perceived as ‘safe havens’, were opening their doors to them and watching their funding costs plummet.

INFLOW

That inflow of capital over the last three-and-a-half years has benefitted northern European countries immensely – not least Europe’s economic behemoth, Germany.

According to a study by German insurer Allianz, cited by Reuters, Germany has saved €10.2 billion in borrowing costs between 2010 and 2012, as yields on the country’s 10-year bonds plunged from 3.39 percent to the current 1.18 percent.

“If we add up the interest rate advantages gained in the period 2010 to 2012 and those that Germany will benefit from in the years to come, we arrive at cumulative interest relief for the German budget of an estimated €67 billion,” the German insurer pointed out. Those savings are “enough to slash around 3 percentage points off Germany’s government debt ratio,” Allianz added.

A second report, produced by Jens Boysen-Hogrefe of the IfW economic institute highlighted that low interest rates and safe-haven capital inflows saved the German federal budget €8.6 billion in 2011, €9.6 billion in 2012, and at least €2 billion this year.

Unfortunately for Germany’s institutional investors, that savings bonanza has created a veritable yield drought.

Thus, while Salmi reckons northern European sovereigns might just get away with guaranteeing their debt-ridden southern brothers “without getting our feet wet, or with getting our feet wet only a little bit,” German institutional investors have been left with no choice but to take the plunge and diversify their portfolios to meet fixed liabilities.

BARRIERS TO ENTRY

The question – once the premise has been established and we accept that infrastructure has been identified by German LPs as a suitable means to diversification – is just how do these institutional investors plan to invest in the asset class?

Crucially, the factors shaping that answer are unfolding right now, with consultants, general partners (GPs), and LPs all bringing their ideas to the table. As YIELCO Investments’ Hesselmann neatly summarises it: “Everybody [in the institutional investor market] has their finger on the trigger, but nobody’s pulling it just yet.”

There is, however, some tentative good news, at least for GPs: German investors have already shown their willingness to invest in the asset class through infrastructure funds.

As Mathias Burghardt, head of infrastructure for newly independent asset manager AXA Private Equity (AXA PE) told us in last month’s keynote interview, “the largest number of LPs [in AXA PE’s third infrastructure fund] comes from Germany, comprising over 25 percent of the fund. Before this fundraising, we had no German investors […] now they are the number one investor base”.

Considering AXA PE raised €1.45 billion for Fund III with a further €300 million earmarked for co-investments, German LPs went from zero to more than €437 million of the €1.75 billion the French fund manager recently raised.

Wim Blaasse, managing partner at Dutch fund manager DIF, also highlighted the prominence of German LPs in his firm’s third infrastructure fund, which closed recently on €800 million, pointing out that “around one-third of the capital in Fund III is coming from Germany – basically from pension funds and insurance companies”.

According to Wemter, “at Aquila Capital, we are seeing significant interest from institutional investors in our renewable energy investment solutions, which include photovoltaic, wind and hydropower projects”. Aquila Capital has more than $2 billion of equity invested in renewable energy.

Wemter sees this interest as natural, since “investments in renewable energies offering long-term stable cash flows make this an attractive investment for the asset-liability management of insurance companies and pension funds”. She also believes “renewable energies such as photovoltaics, wind energy and hydropower are developing comparatively stably as real assets”.

But Hesselmann, which is raising a fund of funds and managed accounts, while optimistic, is somewhat guarded about the ability of German institutional investors to adequately capitalise on the infrastructure opportunity.

“To be honest, most of these investors don’t have the appropriate teams to invest in either funds or to go directly,” Hesselmann argues. He’s speaking from experience. During his past life as head of alternative investments for a German insurance conglomerate, he has seen many colleagues who did not have big enough teams to invest in anything other than funds of funds.

Hesselmann believes the same applies to practically all of Germany’s mid-sized insurance companies, which he expects to go large on infrastructure. This team deficit is, in his opinion, a non-negligible barrier to entry and one with the potential – together with a lack of diversification – for unpleasant consequences.

“In infrastructure, there will always be bad investments, like the motorways in Spain, for example. If you don’t go widespread and something goes belly-up, the whole asset class will get blamed,” Hesselmann points out.

Hesselmann is also somewhat wary of another trend taking root in the German institutional investor market: the emphasis that is being placed on direct infrastructure investments, like Amprion (see accompanying box).

“The problem is not so much the low returns” some investors are willing to accept, he argues. “The problem is that if something goes wrong and you have to hire external expertise, then your costs immediately go up while returns slump and additional workload rises exponentially. LPs need to be educated about investing in the asset class.”

Still, nurturing a potential €35 billion of fresh capital sounds like a nice problem to have.

THE AMPRION SCARE

It’s hard to remember just how much of a stir the acquisition of a 74.9 percent stake in Amprion by a Commerzbank-led consortium of German institutional investors caused in late-2011.

It’s not just that here was a group of investors including the likes of Munich Re, ERGO, MEAG, Swisslife and Talanx plonking down €1.3 billion to run Germany’s fourth-largest electricity network; it’s that, the day after the deal closed, the German regulator announced it was considering reducing allowed returns for the electricity and gas sectors by a little over 1 percent.

For many GPs – already over-eager to point out the basic unsuitability of a team of institutional investors to run an 11,000-kilometre network with considerable capex requirements – this development seemed like the cherry on the cake – the perfect ending to a grim cautionary tale about the dangers of direct investment.

It didn’t help that, when contacted by this magazine shortly after the watchdog’s announcement, a spokesperson for consortium leader Commerzbank reacted with “surprise” to the proposed cuts. Some claimed the proposed returns reduction was entirely predictable. Whether they were right or wrong in this analysis, the situation looked genuinely worrying.

As Vincent Gilles, head of European utility equity research at Credit Suisse, said shortly after the announcement, Germany’s allowed rate of return for the electricity and gas sectors, “post taxes […] is probably close to 5.5 percent, i.e. below the cost of capital of most large utilities in Europe, which in turn explains why RWE and E.ON have been sellers of their respective high-voltage power grids”.

For a moment, it almost looked as if seller RWE had successfully divested the majority of its stake in Amprion in the nick of time. To make matters worse, Amprion came with a 10-year, €3.3 billion capex programme attached, which, in the words of ratings agency Moody’s, posed “significant execution risk”.

Fortunately, the regulator’s proposed returns cut did not materialise, leaving the story, for the time being at least, with a happy ending.