Inside the search for a manager

A Canadian foundation was seeking a comprehensive review of unlisted infrastructure managers, to allocate C$50 million ($40 million; €34 million) to an open-ended or closed-ended pooled fund.

A substantial number of managers are offering core/core+ strategies targeting 7 percent to 10 percent IRR in OECD markets. In this case, 26 were assessed at the longlist stage, following an analysis of the full relevant universe. Yet they are seeking to achieve this objective in very different ways. The first chart illustrates one such area of differentiation using two real-life managers targeting 9-10 percent IRR. Manager A adopts a more restrained approach from a bid IRR perspective, ensuring that many transactions sit within the 9-10 percent bracket, although bid IRRs in isolation can be misleading.

Manager B’s bidding pattern places a greater burden on that team’s ability to optimise assets. “In infrastructure, as in private equity, managers have undergone significant professionalisation as adding value has become more critical to delivering returns,” says bfinance senior director Anne Feuillen, who led the search. “A decade ago managers could buy assets, structure them appropriately and that was enough.”

Today it is more important – and common – to see strong operational expertise in-house.

Following an in-depth qualitative analysis and further refinement from the investor, the longlist of 26 was narrowed to a final list of four. Yet the latter stage was perhaps the most complex. The investor’s chief concern was determining whether the preferred manager – a North American fund – was over-paying for assets in a high-valuation environment.

“Investors are increasingly keen to understand the drivers of performance of predecessor funds,” explains Anish Butani, bfinance infrastructure specialist. “To what extent have valuation uplifts been driven by the reduction in risk free rates and more benign financing markets? In a ‘lower-for-longer’ environment, the ability of managers to generate ‘alpha’ is in the spotlight, making issues such as team specialisation and geographical coverage increasingly critical.”

In order to address this issue, bfinance scrutinised the manager’s successful and unsuccessful bids over the past three years and the evolution of pricing during those bidding processes. Conversations with co-investors, other LPs and financial advisors, as well as analysis of deal terms, helped to build a complete picture of the manager’s bidding approach.

This assessment resulted in the conclusion that, despite high prices and competition for assets, the manager had retained appropriate bid discipline.

The second chart, on the previous page, illustrates the divergence between bid and actual IRRs achieved to date for a global infrastructure fund, by way of example. Would this data imply that the manager has been over-paying for assets? There is a lot more to this question than assessing bid IRRs in isolation: a low bid IRR applied to conservative cashflows is the same as a high bid IRR applied to a more bullish business plan.

One final area of concern, flagged as a result of transaction analysis, was the degree of refinancing risk across the investments in the portfolio. Close examination of refinancing assumptions, such as whether investments had long-term hedging strategies in place or were potentially exposed to rising base rates in the future, proved to be significant.
This may also have strong implications for valuations and the performance of underlying assets.

COMBINING EXPOSURES

Another search saw a UK Local Government Pension Scheme engage us to conduct a search for one or two private infrastructure managers.

This project began with a detailed review of the institution’s existing infrastructure holdings, coupled with an analysis of the most attractive current opportunities in the infrastructure landscape based on pricing, size, inflation-hedging and more. The conclusions were used to design a tailored set of parameters for the mandate, which included a willingness to consider non-OECD exposure of up to 40 percent.

The focus on complementing existing exposures rather than analysing in absolute terms continued throughout the process.

Two managers, one US value-added and one European core/core-plus, were ultimately selected for allocations.

Another interesting feature of this search was its relationship with ongoing UK LGPS asset pooling. Even where private asset portfolios will not be combined for some time, savings can already be achieved. In this case, bfinance negotiated a bespoke fee sleeve for the selected managers, enabling the investor to benefit from aggregated fee discounts if fellow UK LGPS make commitments to them. Two other LGPS’s have subsequently decided to allocate to at least one of those managers, resulting in savings to the original investor.

Fees proved to be an interesting aspect of this search for other reasons too. The investor wished to avoid paying fees on committed capital – a view which did not fit well with one of their preferred managers.

In order to provide a fairer basis for assessment, we modelled the fee leakage of two different 15-year funds.

The second chart, on the previous page, illustrates a pure management fee only comparison, with ‘Fund A’ charging a 1.25 percent management fee on all committed and invested capital while ‘Fund B’ charges a blended management fee of 0.90 percent based on NAV, with NAV growth assumed at 6 percent per year. In both cases a four-year divestment programme is assumed, with NAV/invested capital declining by 25, 33, 50 and 100 percent from years 12-15 respectively.

Assuming target returns are met, fees paid to Fund A and Fund B would be broadly similar. This chart does not include performance fees, hurdle rates, catch-ups and other distinctions which make a large difference.

After negotiations with the relevant managers, the investor decided to pay management fees on committed and invested capital, concluding that the absolute fee leakage should be the
priority.

ENTERING RENEWABLES

This renewable energy-focused infrastructure search, conducted towards the later part of 2016, represented a serious step up in the ESG commitment of a European pension fund that had already shifted a third of its listed equity portfolio towards a low carbon index benchmark.

Although the investor had previously explored the topic with a large retained investment consultant, the lack of viable choices presented led the team to seek external specialist support for a full analysis of the market.

Aside from the renewables focus the remit was broad, permitting all strategies ranging from core to opportunistic, with a preference for OECD-only exposure.

Expectations for greenfield exposure were significantly higher than in conventional infrastructure searches, given the nature of this sector.

With 18 managers submitting detailed proposals for consideration, across various geographies and strategies, the process almost tripled the universe of funds available for this investor to consider. Some of these funds were not large enough to qualify for analysis by other consultants; others tended to avoid consultant ratings processes or RFPs since these have not been necessary for fundraising.

Since the nature of the renewable energy impact was a key priority for this investor, bfinance developed a bespoke tool permitting at-a-glance combination analysis of the various candidates in terms of their specific sub-sector exposures (wind farms, solar etc) and geography. This provided greater clarity in order to facilitate decision-making and communicate the nature of the environmental impact to the organisation.

After detailed qualitative analysis and due diligence, two managers were selected: one with a global OECD focus and the other with a US focus. One of these had never previously participated in any consultant selection process or RFP.

In many ways, renewable infrastructure provides an excellent example of the sub-sector specific private infrastructure managers that have recently proliferated, with specialist expertise proving more critical to return generation than has been the case in previous years. We expect this specialisation trend to continue.

As a result, many of these formerly ‘niche’ or ‘esoteric’ areas of the sector are often now broader and deeper than investors realise, opening the door to credible manager selection.

As countries, particularly in Western Europe, start meeting their renewable energy generation targets, the dynamics of investment are likely to change. We are already seeing the number of new projects in established technologies such as onshore wind and solar supported by generous subsidy regimes beginning to slow down. This relative scarcity has compressed returns to bond-like levels in parts of Western Europe.

Some managers are already targeting other segments of the renewable energy value chain, such as energy storage and generation capacity, that aren’t necessarily supported by long-term contracts and as such entail a greater level of risk. Investors should take note of the heterogeneous nature of renewable energy investment, the ability of managers to adapt their expertise to newer technologies and the implications for returns.