Hamilton Lane’s investment practice spans the private markets – including private equity, real estate infrastructure, natural resources and private credit – so we view the infrastructure opportunity set and fundraising landscape within a broader context.
For example, over the course of 2015, we reviewed more than 600 private market investment opportunities, including approximately 40 infrastructure funds. Our clients typically allocate capital across several private market categories in order to diversify the sources of both risk and return. Within this broader context, we view infrastructure as an attractive building block of a diversified private markets portfolio.
Infrastructure has unique investment attributes suited for today’s institutional investors. These assets — roads, bridges, ports, pipelines — generally provide essential or irreplaceable services. Customers rely on them to provide fuel, water, electricity, raw materials and to move finished product. Without reliable infrastructure, our ability to conduct our lives and business is diminished. Furthermore, infrastructure generally offers stable cashflows, often secured by long-term contracts.
Infrastructure returns consist of both current yield and growth potential. Revenues may be directly or indirectly linked to inflation through regulated or contractual guarantees. Assets are readily financed, which serves to enhance value when capitalised with prudent amounts of leverage. Although infrastructure investors can bear certain risks – such as political, environmental, regulatory and liquidity – the asset class’ overall risk is lower compared to traditional private equity investments, given the essential services that infrastructure often provides.
Many large institutional limited partners (LP) have investment horizons that stretch out over decades. For these investors, infrastructure can play an important role in reducing a portfolio’s overall risk. In a manner similar to long-term bonds, the longer time-scale of many infrastructure projects aligns with long-dated funding obligations. They also provide sources of returns that are both bond- and equity-like.
Bond-like, because they often are regulated assets with long-term fixed-price contracts, resulting in low exposure to macro factors, such as GDP growth, commodity prices or global trade. Equity-like, because investors can benefit from improvements to the operations, financing or regulation of the assets while assuming risk of loss due to adverse developments.
In today’s environment, investing in infrastructure is particularly attractive to limited partners (LPs) owing to many factors, including governmental underinvestment, population growth with increasing urbanisation, energy and environmental concerns and new technological developments. Traditional municipal funding sources are increasingly unable to keep pace with the global investment need for new infrastructure.
Moreover, diminishing appetite or capacity for additional public debt may likely pose challenges in the foreseeable future. According to a recent McKinsey study, the world needs to invest approximately $57 trillion in infrastructure through 2030, just to keep pace with anticipated global economic growth. To put that in perspective, that’s equivalent to over three years of annual US GDP.
Many LPs prefer investing in core stabilised assets where downside is limited. These assets generally possess more modest yield and growth potential, but serve well as a core holding for a buy-and-hold portfolio. Outside of core assets, LPs are more selective, but willing to back general partners (GPs) that have demonstrated success with differentiated deal flow throughout a cycle.
A GP may have a focused approach in a particular sub-sector, which provides advantaged dealflow through established industry relationships. They may also possess operational capabilities or a differentiated view on certain geographies or sub-sectors. They may target only specific asset types such as distributed solar, hydro or gas-fired power assets. A targeted approach may provide opportunities for more extensive due diligence and the ability to add operational improvements post investment. Some GPs also build portfolios with a mix of both developmental and existing assets, in order to blend the current yield of existing assets and growth potential of developmental projects.
LPs favor GPs whose strategy encompasses a broader operational toolkit, including improving operations, reducing working capital and operating costs and enhancing existing management teams. GP strategies oriented towards value creation through either operational improvements or growth opportunities facilitate the creation of well-balanced portfolios of assets.
Other GPs differentiate themselves by selecting market segments and investment targets which fall below the threshold of strategic players, larger funds or other institutional investors. They may also seek the ability to partner with existing owners who are capital constrained or wish to redeploy capital into more core areas of focus.
In our experience, GPs who’ve demonstrated success in achieving these goals receive a welcome reception from a broad set of LPs.
THE GP CHECKLIST
What specific attributes should infrastructure investors consider when selecting GPs and fund opportunities? As with any investment type, LPs should seek infrastructure GPs who are good stewards of capital and manage their funds, with a view to maintaining consistent performance with attractive returns on capital. In this regard, we evaluate GPs on their ability to work effectively together, construct attractive portfolios of high-quality assets, add value post-close and ultimately achieve return targets that match expectations.
On the team side, we evaluate a myriad of factors such as investment approach, prior relevant performance, compensation philosophy, interpersonal relationships among team members and portfolio management skills. Regarding portfolio management, GPs must have a proven ability to source assets emphasising contracted cash flows and downside protection. They should prudently capitalise their investments using debt where appropriate and employ structural protections to mitigate risk.
In order to secure attractive dealflow, it’s also important for GPs to access opportunities from a variety of sources. They should maintain a flexible approach, with an ability to take either control positions or invest in joint or minority positions alongside like-minded investors. This flexibility creates more options on entry, and also allows for a greater variety of sourcing options.
However, in joint or minority positions it is important that a GP establish clear governance and effectively allocate responsibilities in order to maximise the probability of success. GPs should also have an ability to add value operationally and plan for multiple exit options. These options may include strategic sales or merger transactions, IPOs and dividend recapitalisations. Successful GPs will consistently monitor their portfolio to determine the optimal sale timing for each holding, including evaluating each asset within its competitive landscape and determining the potential to add incremental portfolio return.
Finally, investors should assess if the level of fees and expenses charged is appropriate to the strategy employed. Some funds may have a fee and carry level appropriate for a value-add strategy, when their approach may be core in nature. LPs may also be able to negotiate additional incentives owing to their size, or position as a first close investor.
SECTORAL AND REGIONAL OPPORTUNITIES
In today’s environment, falling energy and other commodity prices have imposed collateral damage on many infrastructure assets and the capital markets financing these assets. For example, after years of being viewed as a safe haven due to secure and stable distributions, some listed master limited partnerships (MLPs) have declined in value as investors worried about distribution cuts and potentially higher interest rates.
Associated private investments have similarly declined due to reduced real or expected cash flows as well as lower market comparables. Some previously announced midstream energy projects have been deferred or consolidated. Nevertheless, these disruptions may provide opportunities for GPs capable of maneuvering these challenges. New funds and existing funds with dry powder are anticipating opportunities in today’s environment that will create attractive future returns.
When evaluating funds from different regions, investors must consider several factors. First is the size of the market opportunity. On the surface, a particular region or geography may appear attractive, but have insufficient scale for institutional investment. A second consideration is overall growth and return potential. Current economic instability notwithstanding, many emerging markets have substantial long-term growth characteristics and a pressing need for capital supporting new projects and future population growth.
But this growth potential must be weighed against the stability of the regulatory and political environment. Investors inherently favour jurisdictions whose regulatory environment is not subject to abrupt changes associated with new political regimes. In that regard, OECD countries historically have provided more stable investment environments. In other countries and regions, an investor must pay particular attention to credit quality, political stability and the overall regulatory environment in order to be appropriately compensated for additional potential risk.
LPs need to consider portfolio construction within this broader context. A relatively narrow range of geographies or regions may make sense for many LPs. For example, a significant market opportunity already exists in North America, driven by the billions of dollars of investment necessary to improve and replace ageing transportation and water infrastructure, bring new energy sources to market and upgrade communications infrastructure.
North America also possesses deep financing markets, a generally stable regulatory and legal environment and active M&A market. Other OECD markets present similarly attractive characteristics. Australia, for example, is at the forefront of a privatisation campaign with an estimated A$100 billion ($69n billion; €63 billion) of expected future infrastructure privatisations and new greenfield projects. It also benefits from a stable regulatory regime and an established financing market.
Similar characteristics exist in European infrastructure and elsewhere. Attractive investment characteristics in these markets must be weighed against generally lower rates of growth and higher levels of competition among GPs and other investors, which may serve to reduce future returns.
In total, there is no right answer for evaluating opportunities and building portfolios, but a host of considerations driven by an investor’s willingness and ability to bear infrastructure specific risks in the quest for attractive returns.