Investments in private infrastructure have experienced steady growth in the past few years.
Following a relatively short-lived slowdown in fundraising after the global financial crisis (2009–2012), infrastructure fundraising returned to the pre-crisis levels of $40 billion-plus per annum from 2013 onwards. With the increased stock of private infrastructure funds, the secondaries market became an established part of the infrastructure investment universe. While the cyclical drivers, such as deleveraging pressure and change in regulation, which kick-started the market in 2008–2011, have become less pronounced, the overall maturity of the sector, growth in the number of managers and portfolios are providing continuous support to the dealflow. Secondaries has therefore become an alternative way for investors to access the infrastructure space and it offers unique benefits and challenges.
Compared to primary investments, secondaries opportunities allow investors to evaluate an existing portfolio before making an investment decision and therefore minimise the blind pool risk. Secondaries investments can also complement an institutional investor’s infrastructure portfolio by increasing the diversification across vintage years and mitigating entry valuation risk.
Portfolio benefits are particularly pronounced at the outset of a new programme, as secondaries investments provide immediate diversification and allow for an increase in the investment level. When acquired at a discount, they provide an immediate valuation uplift, mitigating the J-curve effect. The relatively small size of the industry and the unique nature of infrastructure investments result in certain complexities in the secondaries investment process, implying that a successful secondaries infrastructure investment strategy goes beyond simply acquiring assets at a discount to their stated net asset values.
Infrastructure-specific challenges arise from complicated valuation methods due to asset peculiarities, lack of public comparables, limited track record of fund managers, as well as limited dealflow when compared to the other segments of the secondaries market.
In spite of the recent growth, infrastructure remains a niche segment of the broader secondaries market. Based on Partners Group’s experience, infrastructure dealflow represents between 5 and 10 percent of the total secondaries dealflow volume. In contrast, private equity accounts for around two-thirds and real estate for around a quarter.
When compared with activity in the primary market over the past seven years (2009-2015), infrastructure secondaries dealflow corresponds to around 20 to 30 percent of the yearly fundraising volume (that is, typically $4 billion to $8 billion). Only a portion of the dealflow actually reaches closing. Over the past three years (2013 to 2015), we estimate that only between 20 percent and 25 percent of the deal flow (by volume) transacted. For 2013 to 2015, this represented an effective market size of around $1.5 billion to $2 billion per year.
Until 2015, the infrastructure secondaries market was dominated by traditional LP stake transactions, most of which transacted as single lines. In the second half of 2015, a new infrastructure sub-market emerged, as the funds raised pre-GFC (in 2006-2008) started considering extending their maturities with the view to holding fully built out portfolios for the long term instead of selling the assets in the market. To facilitate liquidity to those LPs not interested in a long-term continuation, GPs started running liquidity offerings, or tail-end liquidity solutions, which are discussed further below. A number of such liquidity offerings are expected to actually reach closing, which will result in a significant increase of the market size in 2016 and 2017. Based on Partners Group market intelligence, three to four funds were expected to complete liquidity offerings in 2016, with a total transaction size of between $1.5 billion and $2 billion. The outlook for 2017 is very similar, bringing the total volume of infrastructure secondaries closed in those years up to $3 billion to $4 billion.
MARKET PARTICIPANTS AND DYNAMICS
Given the relatively small size of the market, it is not surprising that the number of market participants active in the infrastructure secondaries space remains limited. According to Preqin, the overall number of investors targeting infrastructure secondaries is about 150. Partners Group market intelligence suggests that not all of them are transacting regularly on the market. The breakdown of the investor universe in the infrastructure secondaries space is presented in the adjacent chart. Pension funds represent the largest single group (41 percent) of potential secondaries investors. This reflects the generally high interest of pension fund capital in the infrastructure asset class. Specialised market players, such as funds of funds, asset and wealth managers, are the second-largest group. Combined, they represent 30 percent of infrastructure secondaries investors. It is worth noting that this number includes not only dedicated infrastructure secondaries specialists, but other secondaries players that occasionally participate in the infrastructure market. We estimate that where only dedicated infrastructure secondaries specialists are included, the number of specialised market players would shrink to about 15 to 25 organisations. This is consistent with what we observe as initial competition in broadly marketed infrastructure secondaries transactions. The amount of capital raised in the last three years by specialised market players with a significant allocation to infrastructure is estimated at around $6 billion.
Taking into account the estimated annual market size of around $1.5 billion to $2 billion observed and the fact that other market participants (pension funds, for example) have additional dry powder to deploy in the space, it is not surprising to see competition increasing, especially for straightforward transactions, such as single fund LP stakes.
The supply-demand dynamics in the infrastructure space have changed since secondaries market activity started eight to 10 years ago. In 2008–2011, a significant number of sellers (in particular, those driven by liquidity or regulatory factors) and only a handful of professional buyers were capable of evaluating infrastructure secondaries transactions. From 2014 onwards, the number of motivated sellers has shrunk and, at the same time, new secondaries players have entered the market. For the two reasons given below, this dynamic should not come as a surprise:
Most investors seek to increase allocation to infrastructure.
The infrastructure fund landscape is still relatively narrow and does not lend itself towards regular portfolio management exercises by LPs, which would support a higher transaction volume.
EMERGING INFRASTRUCTURE SECONDARIES CATEGORIES
The most notable development in the infrastructure secondaries space in the last two years has probably been the emergence of liquidity offerings, or tailend liquidity solutions, which have been driven by the different expectations of existing LPs in established funds with fully formed portfolios, and by the desire of new groups of investors to enter the asset class.
From the perspective of existing investors, a number of LPs that committed to the ‘first generation’ infrastructure funds in 2006–2009 have a strong expectation of the liquidity events coming through, as the funds approach the end of their originally set terms. The preference for liquidity is explained by the fact that some investors (for example, certain banks that were significant LPs back in 2006–2009) discontinued their engagement in the asset class and other investors changed their approach (for example, many large pension funds established direct infrastructure investment programmes).
Not all LPs are targeting liquidity in their infrastructure portfolios. Certain LPs tend to be more interested in maintaining their exposure to the asset class, perhaps because there is a lack of investment alternatives in the current market environment, or they desire to eliminate friction costs created through the sale and purchase of assets, or because they prefer yield over capital appreciation typically generated by asset sales (bearing in mind that building a yielding portfolio usually requires substantial time). In addition, in certain occasions, extending the holding period can maximise value recovery for those assets that were highly levered at entry and therefore disproportionally impacted during the GFC.
Based on those considerations, a number of managers have launched organised processes with the view to providing liquidity to LPs without necessarily selling the underlying assets. Although these transactions are usually seen in the secondaries context, it is worthwhile noting that they exhibit the following different characteristics to typical secondaries transactions:
Longer duration, sometimes as long as 25 years.
Typically, no or very low upfront discount to NAV.
For those reasons, such transactions might be challenging for players with typical closed-ended funds seeking to frontload infrastructure returns via secondaries transactions.
An additional benefit of an organised tail-end liquidity solution is the opportunity to restore the alignment in the group of investors and to secure a group of LPs willing to support the GP and the fund over the long term. On many occasions, these transactions also serve to rebalance the economics for the GP by:
adjusting the management fee to a longer asset management period with limited asset selection, due diligence and execution work; re-basing the performance fees from acquisition costs to the most recent fair valuation marks; and occasionally crystallising the payment of the performance fees accrued.
While tail-end liquidity solutions serve valid purposes and are usually conceived with the aim of satisfying the needs of the different participants, they inherently pose a number of conflicts, which need to be carefully managed. Here are just three of the possible conflicts that can arise:
The GP often acts on both buy and sell-side. GP interests, on many occasions, are more aligned with the remaining (and incoming) investors, which are poised to support the GP in the future, as opposed to the exiting investors. Especially, in cases where no performance fees can be crystallised after the initial period, the GP can be less interested in maximising the price of the liquidity offering, as a higher price would translate into a higher base for computation of performance fees for the extension period.
The information disclosure in a tail-end liquidity solution process is often less granular than in a ‘normal’ asset disposal and, as such, can result in less value obtained compared to an organised asset sale. In addition, secondaries buyers could (and to some extent should) expect better pricing versus a direct asset acquisition to account for the more complex structure, less control over the asset and value impact of the GP economics.
The typical control mechanisms present in the fund investment environment are less relevant for the tail-end liquidity solutions. For example, key-man clauses leading to a suspension of the investment period are not really applicable to the fully built out portfolios.
All in all, the complexity of tail-end liquidity solutions and the need to carefully navigate different conflicts result in a fairly small number of those processes effectively reaching completion. As mentioned before, we expect three or four funds to have achieved completion on the liquidity solutions in 2016. Probably, the most widely publicised transaction of this type is the sale of 21 LP interests in the 2007 vintage €2.17 billion Arcus European Infrastructure Fund, totaling over €700 million. The transaction was led by APG, the Dutch pension fund manager, which acquired a €440 million commitment out of €700 million sold.
Other advanced liquidity solution situation, which was signed in 2016, involved a portfolio acquisition of seven assets in the 2007 vintage €1.1 billion Eiser Global Infrastructure Fund by 3i, APG and ATP.
Even within the limited universe of infrastructure secondaries players, only a few are capable of leading a tail-end liquidity solution. Besides the ability to evaluate a secondaries transaction, such a role requires a significant amount of capital (typically, at least between €100 and 150 million is necessary to act as a cornerstone investor), the ability to lead a complex documentation process and, more importantly, the appetite to lock in capital for a period of up to 25 years. The latter requirement, in particular, cuts across the expectations of secondaries investors, which often focus on providing early cashflows from an infrastructure portfolio and have underlying investment vehicles with a life span of 10 to 15 years.