The case for active ownership

Institutional investors are continuing their march into the infrastructure projects market, with direct and indirect investment in both debt and equity growing. Direct investment, particularly in greenfield infrastructure, requires infrastructure investors to build certain skills, but what types and what activities will likely produce the best results?

As financial close on an infrastructure project approaches, it is tempting to believe that technical advisers or project managers can look after the business-related details of construction and operation.

Unquestionably, external advisers are needed for the most specialised expertise, such as geological surveys, for example, but generally they are not the most skilled at determining how a project – as a business – should be run.

For that, investors needs to look elsewhere to make strategic decisions about best business practices, such as hands-on decisions about project execution and determining how best to run an operational asset to maximise returns.

Infrastructure projects are complex. It is not enough to simply look at the financial model and weigh up risks and premiums. A deep understanding of how projects work is essential, not merely to minimise risk of failure, but to optimise every stage over the 50-year life of most infrastructure assets.

The private equity market provides a valuable model to try and understand how infrastructure investors can better deal with the strategic, operating and capital decisions that can maximise the value of an asset over the long term.

Many of the larger private equity firms and institutional investors with in-house direct investing capabilities have broadly embraced – or are moving towards establishing – operational capabilities in their portfolio management groups.

At its best, their approach can teach infrastructure investors a lot. To understand why, it’s first worth considering the challenges.

Investing for life

The construction costs of many infrastructure projects may be secured with fixed-price contracts, but could this put quality at risk if a contractor’s costs escalate?

Lenders may have security over a project, but the chances of finding new sponsors to take on a stricken asset, or to attract a good price for it, are limited. Many infrastructure contracts do not perform well under pressure and some construction contractors, which may seek to flip their equity early on, are not always working to optimise the project for low life-cycle costs.

In fact, the construction sector has shown none of the productivity growth of other industrial sectors in recent years, as McKinsey’s analysis makes plain.

Unnecessary costs are not the only threat to rates of return. As more institutional investors pile into direct infrastructure investment, competition to finance assets has increased and in developed markets there can often be too many financiers chasing too few assets with too inflated a value. The result is that returns are getting squeezed.

With this and other challenges in mind, we would argue that direct infrastructure investors – be they GPs or institutional investors – increasingly need to arm themselves for active ownership.

McKinsey studies of leading practices in building and operating infrastructure projects have yielded a toolkit of techniques to make productivity and efficiency savings in design, construction, ramp-up, maintenance and operation.

Following design-to-cost principles prevents over-specification in project design and results in the lowest cost means of achieving the required performance; standardisation and modular construction eliminates some recurring project costs; and lean construction concepts shorten delivery time and have been proven to further reduce costs.

According to our studies, merely delivering the assets more efficiently without optimising operations can reduce whole-life investment in infrastructure by 15 percent.

But globally such techniques are not universal – in fact, they are not even common. The increased sophistication involved demands genuine expertise to implement them. And productivity drivers should not be limited to the construction phase when a project has a useful life of 50 years. The same thinking around lean operations, procurement, maintenance practices, and cost management needs to be brought to portfolio companies and assets to maximise their value.

Unfortunately, not enough investors are equipped to grapple with this task. Financiers with deep understanding of debt and equity capital markets are well represented as portfolio managers – experts in operations, logistics and engineering less so, although this trend is changing.

Knowledge is not the only obstacle for portfolio managers to really drive improvements in their infrastructure investments. Expertise needs the right structures, incentives and support. Capex and operations specialists need to be as valued as deal originators if assets are to perform optimally over a 30- to 50-year lifetime.

Active ownership works

In seeking to draw up a model for what a hands-on asset manager should look like, the private equity portfolio management or operations group offers close parallels.

Over the last 10 years, private equity firms have increasingly valued an active ownership approach. McKinsey studies into active ownership have demonstrated that, more than just a badge of honour, these firms have delivered their best risk-adjusted deals when this approach was consistently applied.

In the vast majority of these deals, private equity deal partners drew up a value creation plan, monitored it using key performance indicators (KPIs) and reviewed it constantly. This technique can only succeed if the plan is well researched and informed by dialogue with management.

The most successful deal partners engage heavily in the initial stages of a deal, where, just as in infrastructure projects, returns are at their most negative. They spend most of their time during the first 100 days working directly on a company and meeting company executives.

It is vital, however, to employ the right people for this task. Our research indicates that the best results are produced when the senior members of a deal and operations team spend the bulk of their time interacting with management in the first 100 days. Having more senior representatives of the investor on the board of a portfolio asset tends to also produce better results.

Success lies beyond just a core of deal partners.

Separate McKinsey studies have found that leading private equity portfolio groups employ dedicated operations teams to introduce productivity-boosting techniques. These teams look beyond financial metrics to the whole range of operational and strategic techniques on a regular basis. In the leading groups, they are integrated with the deal team and with comparable compensation.

In the first 100 days of an infrastructure project, debt is drawn down and considerable costs are sunk. We would argue that infrastructure investors should have a performance management plan ready at financial close to map out these 100 days, covering everything from cash flows, to human resources, to regulatory issues, with leading practices in construction and operation in mind.

It’s not hard to see why an infrastructure project, with a tight set of covenants and a matrix of KPIs to meet every month, would benefit from this approach.

The matrix of skills required to closely manage a portfolio of projects of different types is huge. Investing in capability, however, need not imply a vast increase in fixed costs for an asset manager. It will always be necessary to complement in-house expertise with an ecosystem of external advisers to provide the most specialised knowledge.

Whether a particular role is to be delivered internally, externally or in partnership with a co-investor depends on the investor’s strategy and objectives. But it is imperative they use project knowledge to set their agenda.

Infrastructure projects are an excellent investment proposition and their risk of actual failure is low, as ratings agency studies demonstrate. But when it comes to optimising performance over their life cycle, infrastructure investors can and should make a difference.

Their structure and capabilities must be built around the asset. Returns, in the form of decreased costs, better operating performance and increased IRR, should more than justify going to the trouble of not just investing in your project, but managing it too.

Toronto-based Robert Palter is global co-head of infrastructure at McKinsey