Take care with underwriting

As one of the founders of the private equity and real estate secondary markets, Landmark Partners is also playing an important part in the formation and development of the infrastructure secondary market. The maturation and development of limited partner (LP) active portfolio management in private equity took more than a decade. The institutional knowledge gained by selling private equity funds has accelerated the adoption of active management strategies in the real estate secondary market and, most recently, the private infrastructure fund market.

Over the last decade, most developed market economies have created initiatives to promote private infrastructure investing in order to help meet a global funding gap that the Boston Consulting Group estimates will reach almost $1.5 trillion over the next 15 years. To address this opportunity, institutional investors have committed more than $250 billion to infrastructure funds, which is almost 30 percent more than they committed to private energy funds over the same timeframe. Within the infrastructure market, 12 investment firms have accumulated more than 40 percent of total commitments to the asset class.

Like private equity and real estate before it, as the infrastructure market matures, investors are beginning to a) reassess their appetite for the asset class, b) refine their long-term strategy within the asset class, c) rebalance their portfolio positioning and d) reclassify general partners (GPs) as core and non-core relationships. These changing preferences, investor re-balancing goals and the large installed base of infrastructure create the foundation for a long-term sustainable secondary market for infrastructure. Like private equity and real estate, banking regulations and capital constraints, as well as redemption challenges for evergreen infrastructure funds should contribute to additional near-term deal supply.

Up to $12bn by 2016

As active portfolio management has become more common in the infrastructure market, secondary market activity has grown from $300 million in 2009 to almost $2.0 billion in 2012. Assuming the infrastructure market’s maturation curve is in line with our experience in the real estate market, Landmark expects infrastructure secondary volume of $8 billion to $12 billion from 2014 to 2016. The rate of maturation will largely be a function of buyer demand as the current base of infrastructure buyers is much smaller and less developed than the private equity and real estate secondary market.

We estimate that there are less than 20 institutions globally that have the focus, scale, and expertise to acquire a portfolio of private infrastructure funds. Within this market, the supply and demand dynamics for secondary purchases are not uniform and the market is bifurcated between Private Finance Initiative (PFI)/ Public-Private Partnership (PPP) funds and more volatile, opportunistic infrastructure funds.

Core PPP funds, like core real estate funds, offer investors attractive yields and fairly predictable cash flows that are typically discounted at lower costs of capital, especially in low interest rate environments. As a result, demand and pricing for PPP funds are very strong, and the supply is quite limited in the secondary market. In theory, the appropriate buyers for these funds would include pension funds, insurance companies and specialty secondary products.

More opportunistic funds, because of their sensitivity to economic cycles and their volatility, are typically priced to yield a total expected return of 13 percent to 18 percent. The typical buyer universe for these assets includes infrastructure funds of funds, infrastructure secondary specialists, pension funds and some insurance companies. While opportunistic funds offer higher overall returns, access to information and deep infrastructure expertise are critical to underwriting the underlying risks and return potential appropriately. Simply assuming the same risk profile as a primary infrastructure underwriting or asking a private equity secondary professional to underwrite infrastructure investments will lead to disappointing future performance.

Like all secondary markets, successful infrastructure secondary investing will be driven by expertise in deal sourcing, transaction due diligence, price/structure negotiations and portfolio construction. At Landmark, we believe that if you source secondary investments well, you will benefit from having more time and data to complete your due diligence, more attractive entry prices and a deeper set of investment opportunities, leading to the construction of a diversified portfolio designed to deliver strong risk-adjusted and j-curve-mitigating performance.

Ian Charles is a partner at Landmark Partners in Connecticut and Eddie Keith is a vice president