First movers

Some people just do everything before everyone else. Australian superannuation funds, for instance, were among the first to invest in infrastructure funds, eager to surf the privatisation wave rising Down Under in the 90s. As they gained experience, they started to shun managers in a bid to invest in assets directly, a move that saw them gain control of ports, roads and airports. But then some of them realised how expensive and time-consuming it is to do it all yourself – and so they got cold feet. Soon enough, they were back to investing in funds.

Whether the rest of the infrastructure industry will mimic this swing of the pendulum is too early to say, muses Philippe Taillardat, a partner at First State Infrastructure. The market – for now – seems to be stuck in the penultimate chapter, where the likes of pension funds and sovereign investors, with relatively small teams but lots of capital to spend, are ruling the large-cap market.

“What’s missing is enough time to test the direct investment model. Some institutions have developed the skills to originate and transact deals, but whether they are successful in managing assets is another question,” Taillardat explains.

One thing is certain, notes Marcus Ayre, a partner at First State Infrastructure: there are now limited instances under which funds are able to compete for big-ticket deals.

“Those direct investors want to deploy at least €500 million at a time, typically, but they want to own less than 50 percent of a single company. So they can only target assets worth north of €1 billion, and there’s not many of them. This segment is very congested.”

Fortunately that’s only half the story. Far fewer investors are daring to venture into the mid-market, Ayre says. The economics there are just too tough for them, he explains, as big teams are needed to deploy what remain relatively modest tickets.

“Big transactions are very visible – they’re easy to spot from a distance. But infrastructure is like an iceberg: 75 percent of the market lies below the surface. You need resources to create the network, understand a sector, canvass a geography,” adds Taillardat.

The competitive advantage of a firm like First State lies in the experience it has accumulated, argues Niall Mills, a partner at First State Infrastructure. Strength also comes in numbers, with 17 investment professionals zooming in on various corners of the European market.

An example of how stars can align nicely when skills and experience are put to work is the firm’s acquisition of Ferngas in December 2013. Formerly a subsidiary of German energy giant E.ON, the asset had “fallen through the cracks”, Ayre notes, at a time when utilities were much more focused on revamping their sales and trading activities than spinning off small grids. “E.ON had agreed to sell the asset to a neighbouring municipality-owned network. But when they got to the stage where the transaction had to happen, the municipality said it just didn’t have the money.”

That’s when First State stepped in, putting forward its ability to carry out due diligence and re-staff the company in a timely fashion. “Having secured that off-market transaction, we then used Ferngas as a nucleus to aggregate small networks in Germany.”

The firm then acquired EVG, a 1,168-kilometre gas grid, from E.ON and Verbundnetz Gas in October 2013. The sellers this time did run a limited auction to divest the asset – but the strong relation First State had with E.ON by then meant it was in pole position to acquire the company, Ayre explains.

“Consolidating small-sized networks is time-consuming, sure. But it allows you to convert what is a relatively modest investment originally into a meaningful one through aggregation. It’s a build-up story,” he adds.

Small is not what best describes the former Finnish power unit of Fortum – now known as Caruna – that First State acquired jointly with Borealis, the infrastructure arm of the Ontario Municipal Employees Retirement System, at the end of 2013 for €2.55 billion.

“Caruna is a really good story of why you shouldn’t be afraid to participate in auction processes if you position yourself very early and create a competitive advantage through excellent execution,” Ayre says.

Having unsuccessfully bid for the former Finnish unit of Sweden’s Vattenfall in 2012, First State already had inside knowledge of the market when Fortum first mooted a sale of its Scandinavian grids. Through sustained dialogue, First State persuaded the group that it would derive greater value from exiting its Finnish and Swedish businesses separately. It also hired a commercial consultant to have significant intelligence on the Finnish asset – the former electricity engineering division of Fortum, as it turned out – as well as most of the regulatory advisors with knowledge of the market well before the actual disposal process started.

That allowed it to develop a business plan for the asset with confidence and before anyone else. “We shouldn’t overlook the fact that Caruna is of a very similar size to Electricity North West, which we already owned. When looking at the asset there are a lot of things we’d previously experienced in the UK. We knew we could deliver,” Mills says.

This ability to transpose experience provides the firm with another competitive edge, Mills adds. Over the last few years, First State has run a variety of workshops to develop further know-how, share ideas and facilitate best practices. One of the latest fields explored by the team is fuel-cell technology. “Energy storage will be part of the future. Small to medium enterprises, households and emergency services would benefit a lot from facilities allowing for resilient, self-powered generation,” he argues.

Another workshop the firm ran over Christmas was focused on carbon reduction. “A couple of our assets are at the forefront of lowering carbon emissions. It’s very important for customers and the regulator, but equally it can also help reduce costs when designed properly.”

Yet such ideas can only bear fruit if assets are held for the long term, remarks Taillardat: “It’s about changing the culture. It takes time. Implementing such ideas can’t be done if your vehicle must flip the asset after just three years.”

Hence First State’s preferred fund structure, he says. The firm is about to start marketing a successor vehicle to its €2 billion European Diversified Infrastructure Fund (EDIF). Like the first vehicle, Fund II will be raised in successive stages, which First State refers to as ‘series’. The firm plans to launch three fundraising rounds for EDIF II, as opposed to five for its debut European fund. Each series will have a target of €700 million and a maximum size of €900 million.

Series Four and Five saw EDIF expand its investor base in Asia (including Japan, Korea and Malaysia), the Middle East and Canada. The fund was not licenced in the US at the time, but Taillardat hints that this may change for Series Two of EDIF II onwards. “We’re proud to have a number of pension funds from infrastructure companies supporting us. People who are experts in the field trust us.”

Taillardat believes at least half of Series One’s commitments will come from existing investors in EDIF. In other words, newcomers wanting to jump on the bandwagon this time around may be well advised to wake up early.