Avoiding the crush

Ed Clarke, alongside fellow Infracapital co-founder Martin Lennon, is sat rather uneasily. This has nothing to do with any thorny question cast his way by Infrastructure Investor. It is entirely to do with Clarke, a towering individual, having been asked to perch precariously on the edge of a small glass table for photography purposes. But then, the two men appear to like making life difficult for themselves.

This much becomes clear when they reflect on their decision to target complicated, mid-market deals in order to avoid the influx of competition from sovereign wealth funds and direct investors at the large end of the market.

“Any market ebbs and flows in terms of where best value is,” says Clarke. “Pre-financial crisis there were relatively few investors looking to write very big cheques for infrastructure but there were a good number of medium-sized funds and the mid-market was heavily bid.”

“Post crisis, many banks reined back and a competitive group of medium-sized funds fell away while there was an increase in activity from sovereign wealth funds and larger direct investors from Canada and elsewhere, making the larger end more competitive. Many of these investors have a minimum equity ticket of $200 million to $250 million and need to be a minority, meaning that only the largest deals work for them.”

The middle way

To avoid the crush, London-based fund manager Infracapital – part of M&G Investments, the asset management arm of financial services giant Prudential – decided to head for the middle ground where deals “can be a bit more complicated”.

“We are hoping to earn up to an additional 200 basis points return through investing in situations that are a little more complex,” says Lennon. “The target may need to be separated out of a larger conglomerate, so, for example, we may have to create a new pension scheme for employees, or transition to a new IT system. To cope with these challenges, you need to have the resources and experience. But the plus side is that it can result in a less competitive field.”

Given this need to drive operational improvements, many infrastructure fund managers have taken steps to bolster their asset management resource in recent years. Infracapital is one such firm, having taken the step of hiring Stephen Nelson, the former chief executive of UK airport owner and operator BAA, in March this year.

“Buying infrastructure used to be seen as like buying a bond,” muses Clarke. “But now it’s recognised that these are proper businesses with a lot of customer interface where you can make real improvements.”

He cites the example of Calvin Capital, an owner and supplier of gas and electricity meters to British Gas in parts of England and Wales. Since Infracapital took full ownership of the business from United Utilities in July 2010, it claims that its commercially focused approach has trebled the firm’s EBITDA (earnings before interest, tax, depreciation and amortisation). “That demonstrates that you can deliver real upside through good asset management even in low business risk areas of infrastructure.”

New fund

That aim of combating high prices will continue to be Infracapital’s ambition as it goes about investing its latest fund, Infracapital II, which posted an interim close on £530 million (€625 million; $846 million) in September. The firm is hoping ultimately to raise £900 million, which would match the amount collected by its previous fund at its final closing in November 2008.

The new fund was deployed for the first time when Infracapital teamed with Morgan Stanley Infrastructure Partners to acquire Veolia Environnement’s UK regulated water business [renamed Affinity Water] in a deal reported to be worth £1.2 billion in June last year. Lennon says the deal made sense, given the firm’s determination not to overpay:

“You’d think that investing in UK water is always very competitive but this particular business [Affinity Water] was not big enough to really appeal to the direct investing heavyweights. Plus, most of our normal competition already had exposure to the water sector in their funds.”

Clarke explains how the deal came about: “Our investors said they really liked steady predictable yield and inflation linkage. So UK water was an obvious choice. We knew Veolia were considering their options so we approached them six months before they ended up launching a process. We got to know them, did our homework and were ready to go quickly in early 2012.”

He continues: “We felt that there was a real opportunity to support the management in seeking to improve the business and to put in place an efficient long-term capital structure. We secured long-term financing in January this year and we’ve got started on operational improvements. We appointed a new chairman [former energy industry veteran and John Laing chairman Phil Nolan] and we’re positioning the business for the next regulatory review.”

Punitive review

Some are anticipating that the regulatory review referred to – which takes place next year – will be fairly punitive, given criticism levelled at water companies by Jonson Cox, chairman of industry regulator Ofwat. Although Lennon sees political and regulatory risk as the “number one” risk faced by infrastructure investors, he has a pragmatic approach:

“It’s a double-edged sword. These are essential assets, which is positive but it also means that you have to care about the customer and you should be cognisant of the general environment. There is pressure on the purse and you need to be mindful of that.”

Arguably nowhere do you need to be more mindful of fiscal pressures than in Southern Europe. Lennon says the firm is “encouraged” by recent signs of greater stability in the South but says Infracapital is not “rushing back” there and is focused on northern countries for the time being.

“There are plenty of potential deals [in Western and Northern Europe] at the moment and we’re optimistic we can achieve a diversified portfolio as a consequence. On the other hand, we wouldn’t mind at all if the map grows once more into warmer climes!”

Clarke adds that Southern Europe should not be considered off limits to infrastructure investors. “The question is: What’s your risk appetite?” he says. “The underlying problems have not gone away, but that doesn’t mean there are no opportunities.”

‘Legacy of Thatcher’

Clarke relates that Infracapital’s ambition was to be pan-European when it raised its previous fund, which went on to make investments in the Netherlands (telecoms firm Alticom) and Spain (a portfolio of solar photovoltaic plants). However, the UK was the main focus given the “legacy of Thatcher” which meant that “a lot of infrastructure was in private hands, was open to private ownership and was tradable”.

While Infracapital has been managing third-party capital for 11 years, Prudential’s involvement in UK infrastructure goes back a lot further. Indeed, Lennon points out that it was doing Scottish hydro power investments as far back as the 1930s. Fast forward to the mid-to late-1980s and it was involved in financing the Severn Crossing and Dartford Crossing – two major transport projects considered to be forerunners of the UK’s prolific Private Finance Initiative (PFI).

Lennon, who had spent more than eight years in engineering, construction and project finance roles, joined Prudential in 1998. He was followed there by Clarke three years later, by which time the two men already knew each other well. Clarke had advised the UK government while at Hambros Bank on some early road PFI deals, with Lennon sitting on the other side of the table as a member of bid consortia.

The initial focus for Lennon and Clarke within Prudential was to source long-dated infrastructure debt for clients. To begin with, this revolved around private placements, bank loans and public bonds but they were soon handed responsibility for a “broader infrastructure mandate” which included unlisted equity.

Transition

Lennon says that the real “transition” of the business came around 2000/01. Reflecting on this time, he says: “We had correctly predicted that the infrastructure market was crying out for the means to recycle the equity held by boutique firms, construction companies and some banks. This was in effect 30-year cash yielding equity and there was an opportunity to create liquidity and match the product with the demand from long-term institutions.”

The upshot of this was a partnership with infrastructure fund manager Innisfree to create the Innisfree M&G PPP Fund, the first fund to be focused on the secondary public-private partnership (PPP) market in the UK. The fund, which raised £225 million, was open-ended, prompting a recollection – and subsequent laughter – from Lennon that one of the assets in the portfolio has the option for a 65-year extension. He doubts he will be around to see that contract come to an end should the option be exercised.

The PPP fund was consistent with Prudential’s strategy to increase its client base. However, by the time the mandate had been fulfilled, the market had moved on. “By 2005, there was quite a dramatic change in the infrastructure market,” relates Lennon. “The asset class had registered in the thoughts of many in the international investment community and owners of infrastructure assets had begun to appreciate what they had.”

This made the broader opportunity to buy and sell stakes in infrastructure assets and companies increasingly attractive compared with the UK PPP market, which was getting “very competitive” in Lennon’s view.

Track record

Since then, Infracapital has gone onto build a long track record in infrastructure investing – something which other infrastructure fund managers must view enviously given that this is a young asset class where experience is highly valued by investors.

Aside from track record, there is another reason why Infracapital believes it has an appeal to the limited partner (LP) community. “We’re set up in a similar way to an independent boutique, but we have the benefit of the support of a major international financial institution behind us,” Lennon points out.

“Our investment committee powers reside solely with the directors of Infracapital and no one else [outside the team] has a veto over decisions. But being part of the wider group has benefits in the shape of enhanced deal origination, reach into corporate Europe [the group is a major investor across European markets] and relationships with policy makers and regulators.”

Given that one of the initial rationales for the launch of Infracapital was to expand the client base, it’s no surprise that this remains a focus for Lennon and Clarke. “We want to develop a broad network of LPs by geography and type,” says Lennon.

“Insurance companies and pension funds remain key and there is still growth potential in this area. But in addition there are sovereign wealth funds and funds of funds managers and we’ve got Asian and North American investors coming in. Europe continues to account for the bulk of the investor base, but it’s becoming a bit more balanced.”

Growth and expansion is also being seen in the financing arena, and this gives Clarke much encouragement. He acknowledges that the banking market is now of a “three- to five-year” duration, but “they are comfortable lending as long as there is a good take-out” [in the capital markets].

He points to the proliferation of private placements “of all shapes and sizes” that “couldn’t be done five years ago”. He also says the market is benefitting from debt funds needing to get assets on board. “We’ve also seen project bonds and UK government guarantees, which are good additions to the toolkit,” he adds.

Hence, the discussion ends on a note of optimism. And with £530 million in its pocket and what Infracapital sees as a niche position in the market, why wouldn’t it?