Doing what infrastructure should

“Infrastructure is a fantastic asset class that will get investors what they want when it’s done well.” And what do investors want? Characteristics typically associated with infrastructure include good risk-adjusted returns, cash yield, inflation protection, diversification, and a minimal J-curve. The problem is getting them.

The opening quote is volunteered by Andrea Echberg, a partner and head of European infrastructure investments at Pantheon, the London-based funds of funds manager. She is sitting in the firm’s headquarters at Norfolk House, St James’s Square, reflecting on the disappointments that some infrastructure investors have experienced.

“Infrastructure should deliver all these positive traits but it doesn’t where funds have overpaid, over-leveraged and moved outside their core investments,” she says. In the nascent infrastructure secondaries market, by contrast, she sees all the potential that infrastructure can offer:

“We can access cash flows where the supply/demand balance is very different from the primary market, where there is too much capital and too few deals. We see growth in supply, but also barriers to entry to being a good infrastructure secondary manager.”

She pauses before adding: “The portfolios you buy as a secondary investor are often around 75 percent-funded so they are known assets, you can see past any mistakes that may have been made, and there is immediate cash yield.”

‘Three pillars’

So far, so good. In the mind of the sceptic, however, a question will immediately form. If the market opportunity is so great, why is Pantheon one of only a handful of firms currently committed to the infrastructure secondaries space? Echberg refers to “three pillars” that support an infrastructure secondaries operation, without which – in her view – it would be very difficult to operate successfully.

First, is having an established secondary platform. This box is ticked by Pantheon, which has been operating in the private equity secondary space for more than 20 years. “It’s the origin of the business,” says Echberg. “It’s a capability which includes client service and talking to investors on a daily basis.” She adds that conversations about private equity opportunities can sometimes lead to a discussion about infrastructure – and, in many cases, to proprietary deals.

The second pillar is having a specialist infrastructure team. Herself a former senior infrastructure executive at the likes of Macquarie Group and Societe Generale, Echberg says: “To price assets well, you need to have a very good knowledge of the managers and their underlying assets. Sometimes as much as 50 percent of the net asset value (NAV) of a portfolio can reside in just one asset. You need to have insights into what drives the yield, whether there are cash sweeps and the existence of refinancing risk.”

Third: “You need to be a primary investor with excellent general partner (GP) relationships and be seen as a friend to GPs rather than a competitor. You need consent to be a player in the secondary market because you rely on information from the GP as well as from your own benchmarking.” Anecdotally, Echberg recalls an occasion when the firm was the only one invited to bid for a portfolio, such is the level of trust and confidentiality often required by sellers.

Opaque, inefficient

So, in Echberg’s view, the answer to the question about a lack of market participants is quite simple: there are not many firms that have all the ingredients required. Thus, it’s easy to understand why she is a believer that organisations with an existing secondary capability in areas such as private equity or real estate would be hard pushed to make a seamless transition into infrastructure.

“It’s a big market but also opaque and inefficient,” she points out. “And that makes it a difficult market for the likes of private equity specialists. You can get the same fund selling at a very different price within a very short timeframe. In one case, we got a 14 percent discount on a fund position and, in the same month, another position in the same fund was sold at NAV.”

There is another reason for the absence of private equity specialists: ticket sizes are simply not big enough for many of them. “Our sweet spot is $20 million to $50 million limited partner (LP) positions and that’s too small for the big secondary funds. Because of that, they don’t tend to invest in infrastructure teams. And, even once you have a team in place, it takes a long time to develop relationships.”

In spite of the modest ticket sizes, Echberg has no doubts about the size and potential of the infrastructure secondaries market. She believes the market has “emerged” since 2010 and that there has been a decent amount of primary fundraising since then. Extrapolating the same kind of primary-to-secondary turnover that has been seen in private equity, Echberg says infrastructure is likely to see a $4 billion to $6 billion secondary opportunity per annum over the next four years (based on conservative assumptions).

She adds that the upward trajectory of the infrastructure secondaries market is clearly demonstrated by the numbers. From just over $1.0 billion of deals in 2010 (where there was a known seller), the total rose to around $2.5 billion in 2011 and $3.5 billion in 2012. With just under $1.0 billion of deals done in the first quarter of 2013, around $4.0 billion is expected for the full year. Furthermore, Pantheon estimates that approximately 70 percent of these deals have been proprietary, with only 30 percent accounted for by sell-side auctions.

Of course, astute investors will not be attracted by the numbers alone. The big question is whether the quality of assets matches the quantity. Asked about this, Echberg has an intriguing response:

“At the moment, there’s very high turnover in the 2006 to 2008 vintages,” she says. “That’s interesting in terms of secondaries because they were peak fundraising years and pre-bubble. There was high leverage being applied and mistakes were made. But then you had the good years of 2009 and 2010. While the bubble assets have been written down or off, the 2009-10 assets have done well. Overall, the GPs and their funds may have done badly and their LPs want to get out – but that’s great from a secondary perspective because we get post-bubble assets with a great yield.”

Caution

If all this sounds too good to be true, Echberg is not shy of offering words of caution. “The big risk with funds that have under-performed is whether there is sufficient alignment to deliver a good outcome, or whether there is a perverse incentive to hang onto management fees as long as possible and not deliver value,” she says.

“Another risk is access to information,” she adds. “You don’t get the same level of information that you do with direct or co-investments so you do rely a lot on GP relationships and your own benchmarking.”

On top of that, there may be concerns about specific types of assets within portfolios. “We are nervous about subsidies and regulatory risk and we will adjust the price accordingly, or maybe decline to pay for a certain asset or assets,” Echberg says.

But this is merely the kind of measured assessment you would expect from a serious player and does not detract from what appears to be a viable and growing opportunity in the secondary market. In Pantheon’s view, it is no more or less than infrastructure “done well”.