A funny thing happened in the latest edition of our annual European Asset Management Roundtable – we got to the end of our two-hour discussion and discovered that, probably for the first time, we had barely talked about regulation, that mainstay of infrastructure investment discussions. And there were actually positive developments on that front (more on that later).
There were good reasons for that, though. Brexit – the clever moniker for the scary possibility of the UK actually exiting the European Union – rampant populism, the radicalisation of both the Left and the Right in a near-term filled with elections, and shaky, anaemic growth that owes everything to the steroid boost of quantitative easing (QE) make talk around adjustments to RABs [regulated asset base] and WACCs [weighted average cost of capital] seem positively pointless.
And yet, infrastructure investors would be hard pressed to find a better investment destination than Europe, especially when it comes to the quality of the assets on offer, overheated pockets aside. Nor has there been greater appetite for Europe. Particularly when you compare the situation now with the height of the Eurozone crisis, when there was a real danger that capital markets would become regionalised, with US investors, for example, staying firmly on their side of the pond
So why the optimism around what looks on many fronts like a bleak European landscape? Because despite its problems, “Europe is still perceived as a coherent, safe area with a lot of good quality infrastructure. If you compare Europe with Brazil and the corruption scandals involving high level officials, I think investing in Europe is simply not comparable from a risk perspective. And if you compare Europe to Africa or Russia, then we are talking about different worlds,” summarises Antin Infrastructure chief executive Alain Rauscher, on the phone from Paris.
IT WAS THE BEST OF TIMES, IT WAS THE WORST OF TIMES
None of which minimises the very real high-level political instability on the horizon, which, some four years after the peak of the Eurozone crisis, makes it feel more like we are back in 1933 than back in 2007
“If you look at the roots [of the current instability] then you have the same kind of European retrenchment and a rise in nation state policies, with Brexit being a good example of that. Greece is another example of populism that goes against the trend of European integration. I think there's a lot of pressure for Europe around this and that's a serious question,” says InfraVia partner Bruno Candès.
That puts growth – the main bugbear our participants had with last year's European investment landscape – mostly in the shade.
“In relative terms, I don't think we can complain about European growth,” argues Ardian head of infrastructure Mathias Burghardt. “We have some countries, especially in southern Europe or even the UK, which are experiencing growth of around 2 to 3 percent, which in European terms is quite good. The problem today is volatility and the drastic changes in economic patterns around the world in a very short period of time.”
Not that growth worries are completely off the agenda. As Andy Matthews, Infracapital 's greenfield director, points out: “The level of quantitative easing (QE) in the US, the UK and Continental Europe means we should be seeing growth. The question is: what happens when the QE tap is turned off and we start to reverse it? I think there's a lot of nervousness about what that scenario will look like. So while the growth is there, it feels a little fragile.” Rauscher goes further and adds QE has created the conditions for another bubble to burst in the near future.
The good news, of course, is that volatility isn't all bad news and, “although it creates challenges for managers, it also creates opportunities for us as an industry,” points out Threadmark partner Bruce Chapman. One example of that can be readily seen in the energy sector, all participants are quick to highlight.
“I think the last trend that we've been seeing in terms of deal flow over the last couple of years, which is accelerating now, is oil companies disposing of assets,” says Burghardt. Adds Candès: “If we accept that Europe is a low-growth environment, then we have to accept that big oil companies not only have to manage their balance sheets, they also may unbundle their core operations from their non-core infrastructure.” That goes for other sectors too, like telecoms.
“There's a desegregation of assets trend going on with a view to finding infrastructure characteristics that guarantee the best price disposal – as opposed to private equity-type exits or trade sales. In that sense, we've seen some very creative thinking across various sectors and as an example the oil and gas industry is starting to consider how it extracts non-essential assets, like a pipeline, and make them attractive to the infrastructure investor.” says Matthews.
“We are definitely seeing a market that has embraced infrastructure as an asset class,” agrees First State Investments ' head of transactions, Marcus Ayre. “Particularly on the vendor side and the advisors to the vendors. A few years ago, infrastructure investors as a class were somewhat ignored by the large utilities, industrials and contractors when they were looking to monetise mature assets. We weren't the first obvious port of call and that is totally different today. Now, these vendors are packaging infrastructure assets of all shapes and sizes to cater specifically to infrastructure funds and direct investors to try and get the best price through this route to market.”
Sometimes, that embrace can become a bit too tight, like in the fiercely competitive auction-driven large-cap market. At other times, the eagerness to please the growing wall of capital targeting infrastructure can become counterproductive.
“A big trend I'm seeing is assets being brought to the market purposefully packaged to attract [direct] LP investment. Typically a deal where a lot of the work around restructuring and consolidating has been done and results in assets packaged in a way that mostly offers a dividend. I think this is an answer to the fact that LPs cannot get a return on bonds and have a growing share of money to invest in infrastructure, which they try and invest directly. So these assets are increasingly being pre-packaged in a way that will allow an LP to, say, get a 3 percent gross dividend,” says Antin's Rauscher.
“I think this can be a potentially dangerous evolution for two reasons,” he continues. “One, is that it leads LPs to view infrastructure as bond-like investments and this makes them have no policy in terms of internal rate of return (IRR) and yield. It also makes LPs willing to take a hit on yield because the dividends are still better than what you'd get from buying a government bond. The second reason that I worry about this is this practice drives prices up big time and it also decouples the protection of value that comes from using IRR as a benchmark. Effectively, some LPs stop thinking about these assets in terms of IRR and start thinking about them in terms of a coupon,” he adds.
InfraVia's Candès, however, argues we need to differentiate opportunistic packaging from true value creation: “If we are talking about packaging assets just to capitalise on a very short-term opportunity in a buoyant market, that's probably dangerous over the long term. But one of the things we are trying to do at InfraVia is create platforms where we build scalable businesses, de-risk them and improve their long-term profiles and if you do that properly there is no reason why that value creation shouldn't be remunerated and returned to our clients, with a portion of this to be paid to the GP through carry and performance fees”.
Regardless of where you stand on the packaging threat, no one disagrees that the European large-cap market is mostly out of GPs' reach.
“I do think that the very large-cap infrastructure market in Europe has been taken over by very large direct investors and the role of fund managers in that market has diminished. Pricing there is incredibly tight because these investors have different underlying drivers. And to be brutally honest, what they believe they save in fees by not going through an intermediary they are paying to the vendors,” Ayre says.
IN MEDIO STAT VIRTUS
Still, there are pockets of the market where GPs can penetrate. “Everybody says that prices are pretty hot in infrastructure right now. I'd say that prices are high in any asset class and I'm not sure that infrastructure is really more expensive than real estate or listed stocks. Sure, some assets, like those sold in plain vanilla auctions, can be as expensive as in other asset classes. But a decent side of the market in Europe consists of mid-size assets which can still be bought at reasonable prices,” argues Burghardt.
But while the mid-market is mostly open to GPs and immune to the kind of low returns seen in a large-cap space saturated by direct investors with a lower cost of capital, it's not just business as usual anymore.
“We are seeing managers with a reasonably cheap cost of capital – people who set up managed accounts, or captive infrastructure managers – enter the mid-market. So some traditional barriers to entry, like size of transaction and long lead-up times, are no longer stopping some managers from underwriting a €100 million investment at 8 percent, which we thought was reserved for large-cap direct investments. If you're a mid-market GP wanting to earn a fee, you now need to deploy the GP's full gamut of solutions. Thinking you are safe because of what was until recently a relatively protected market won't cut it anymore,” argues Candès.
He concludes: “It's true, there is a tremendous amount of deal flow in the mid-market, but you need to add value.”
A BENIGN LANDSCAPE
When the conversation turns to fundraising, all participants agree we are in a much more benign fundraising environment.
“I think if you're talking about a relatively core infrastructure strategy then the flow of money from Europeans and non-Europeans will continue to be strong, even with some additional volatility. I think until infrastructure underperforms significantly as an asset class that trend will continue,” starts Threadmark's Chapman.
He continues: “I think the doors that are opening in this cycle pertain to certain strategies, like opportunistic infrastructure. If you tried raising an opportunistic fund two or three years ago that would've been really tough. We did a greenfield PPP strategy fundraising which we see as pretty low risk and it took us a few years to do that. Now, we think the market is turning for that sort of strategy.”
Chapman even goes so far as to suggest the market is benign enough to get first time funds off the ground, provided the teams behind them are experienced and the funds are not aiming for crowded areas of the market. However, somewhat akin to the situation in the mid-market, it's not just business as usual in the fundraising space.
“We are seeing a trend and we are in discussions with large construction groups that would've previously sold assets to funds or into the market and which are now looking into somehow organising capital around themselves,” says Chapman. “Globalvia is a good early example of that. But we are seeing a different range of options, including construction groups setting up their own fund management arms, or construction groups forming joint ventures with fund managers.”
It's not just the fundraising environment that is much more benign compared to a few years ago. Despite the high-level political tension, the regulatory environment for infrastructure is arguably much better than it used to be across the continent. “We went through a period over the last four years where the alternative investments sector was being beaten over the head and infrastructure got tarred with that brush. We are starting to see an understanding that private capital infrastructure investment is different to other alternative investment asset classes. There's always been that rhetoric, but now it's happening in terms of delivering on things like better treatment of infrastructure investment in Solvency II and some of the more concrete steps in the 'Juncker' Plan. So it's gone from the direction of having big multi-billion Euro plans that no one could fund to the beginnings of a regulatory environment that actually fosters infrastructure investment.” says First State's Ayre.
Matthews agrees: “As an established manager preparing to build a new greenfield focused platform we are very encouraged by the interest in the greenfield proposition. There is a global appetite from investors for European infrastructure assets, but investors at the same time want to see some differentiation in the product offering.”
It's Candès, however, that nails the momentum around European investment: “The good thing is that infrastructure is now the engine for growth for European policymakers and even if they don't deliver on everything they have promised, the market will create an environment that makes that possible.”