Last month, Infrastructure Investor was surprised to receive a call from a US-based investor an hour before the agreed time. While grateful to see him honour his promise, we kept wondering why he was honouring it so early. The explanation never came, hinting that our interviewee had simply miscalculated the time difference. The mistake is very much excusable (your correspondent is certainly no stranger to arithmetic confusion). Equally, it may also suggest the LP in question was not speaking to European GPs on a daily basis – a reminder that while infrastructure today is a global market, in some respects it remains very local as well.
This is not entirely surprising. Many pension funds and insurers have their assets and liabilities denominated in a given currency; most of them are also looking to minimise risks, and therefore not so keen on exposing themselves to foreign exchange volatility. “If we can keep ourselves in the US then we do. It’s where we want to be after all. We want to stay close to home,” says Paul Shantic, director of inflation-sensitive investments at the $193 billion California State Teachers’ Retirement System.
Of course, investors also value infrastructure for its diversification benefits and their strategies tend to explore a wider set of geographies as they build up exposure. While they may be anchored somewhere, LPs move around to pick the funds and assets they like in what they believe are promising markets. They are, therefore, not immune to geographic trends. “A number of LPs are now looking at the US, where the dealflow had until recently proved disappointing,” says Uwe Fleischhauer, an executive board member at YIELCO Investments, a German-based fund of funds. “There are also discussions about emerging markets, where they understand risks have often been overestimated.”
This relative flexibility has a reason. As far as alternatives are concerned, LPs can be somewhat opportunistic; notwithstanding strong appetite for the asset class, they do not always have a specific target allocation for infrastructure. Time and again it will be part of a broader bucket, the name of which will often vary. At CalSTRS, infrastructure is covered by the ‘inflation-sensitive’ team; at the Washington State Investment Board, some infrastructure funds come under the ‘tangible assets’ portfolio, explains Chris Phillips, director for institutional relations and public affairs at the $108.5 billion pension. In other cases, it will be part of the real assets or fixed-income strategy.
GOING, GOING, GONE
What really unites most LPs today are the attributes they continue to seek in infrastructure. “The asset class will continue to increase in popularity as yield still remains scarce and due to the defensive, inflation-hedging characteristics of many of the infrastructure concessions,” says Roland Winn, senior investment strategist for external investments and partnerships at the New Zealand Superannuation Fund, which manages NZ$31.9 billion ($22.9 billion; €21.4 billion).
“It is anticipated that [tangible] assets will have a large portion of the return attributed to annual distributions of income generated by the assets, with the remainder due to capital appreciation commensurate with inflation,” echoes Phillips.
Given the attractiveness of such characteristics at present, it is no surprise LPs are keen to increase their exposure. For big, established investors, this quest is likely to translate into a “thoughtful, measured” approach to the question – as CalSTRS’ Shantic describes it – with new funds and assets steadily added to the strategy. “We’re realising that over time we want to build a portfolio that’s diversified not only in terms of geography and asset type but by vintage years as well.” He adds CalSTRS does not really have an allocation target, but still, in the mind of the team, infrastructure should ideally represent $3.5 to $4 billion (it had about $2.2 billion committed to the asset class as of 31 March 2016).
But if the pension is patient in its fund selection, it’s also because it takes some effort to find “the funds and fund managers that we feel comfortable partnering with,” Shantic explains. “There’s plenty of folks trying to raise a fund out there. The question is who are you confident with in terms of how they underwrite and do their due diligence and whether their view of infrastructure aligns with ours.” Key to this assessment, he adds, is how managers value the downside case when considering an investment. “We’re not looking to have two or three misses and then a big payout. That’s more private equity-like, and not the model we subscribe to in infrastructure.”
While smaller investors no doubt share similar views on the asset class, they differ from their larger cousins in that many are still in the ramp-up phase. “Most started only recently and the majority, so far, haven’t met their target allocations. There may be lots of talks about growing competition and high entry prices but that’s not really changing LPs’ allocation behaviour, especially as they do not really have an alternative for this type of investing,” says Fleischhauer.
Since 2015, however, increasingly large vehicles have been raised in ever shorter periods and the window left for getting aboard has seriously narrowed. “For LPs, allocating to the funds they would like to allocate their money to has become a new challenge.”
THERE’S A PRICE FOR EVERYTHING
A trend that’s been well documented in recent years, including in our pages, is the decision by a number of GPs to adjust their return targets in the face of heightened competition. Is the same sort of pragmatism being observed at the LP level? “Expectations have not really changed, but they’re probably a bit more realistic,” says Fleischhauer. He says investors are now happy to get about 5 to 6 percent net on core, and up to 10 percent on core-plus transactions. Opportunistic, PE-like or greenfield strategies, unsurprisingly, are still expected to reap double digits.
Competition is not the only factor shaping anticipations of future returns: past performance also matters. On that front, Fleischhauer thinks few investors have been disappointed. “In some cases we get the feedback that the yield component was slightly below what they expected, but that they were quite happy with the total return. Exit valuations, on the other hand, have often been stronger than what was in the books, because they’ve been less dependent on public markets and exit strategies.”
Limited access to the top funds may well have shifted the pendulum towards managers when it comes to negotiating fees. Or has it? Bar a few possible exceptions, this is not what we hear. “Folks we already work with know we are sensitive to fees and are trying to be accommodative. And those managers that might be trying to attract our attention will certainly try to lower fees for us. So it’s always a discussion, always a concern. And that’s why we’re also trying to get an idea of what their co-investment opportunities might be and why we continue to explore separately managed accounts,” says Shantic.
Fleischhauer notes that terms and conditions have improved compared to five or 10 years ago, with more flexibility also offered on fund duration. He says infrastructure vehicles now have an average tenure of 12 to 15 years; other models, such as 10-plus-10-year offerings, are also emerging. And while competition for funds is rising, he concludes, infrastructure has a card up its sleeve.
“We haven’t seen any inflation so far but that might change: in Germany, for example, we’re expecting about 2 percent. So infrastructure might soon be playing an interesting role as an inflation hedge.”