Probitas urges new approach to infra investing(5)

Amid a fundraising climate where a record 55 of 70 infrastructure funds in market are first-time funds seeking capital, limited partners should re-think traditional investment risk categories such as “brownfield” and “greenfield” and adjust their expected returns and investment fees accordingly.

That is the theory put forth by San Francisco-based placement agent Probitas Partners in a new white paper on infrastructure investing.

Probitas argues that investment categorisations – such as brownfields, or existing infrastructure assets, rehabilitated brownfields, or repair-intensive existing assets, and greenfields, or new construction projects – have fallen woefully short of correctly delineating risks for infrastructure investments.

“The notion that they categorically define risk has been proved a falsehood after the recent collapse of the financial markets”, Probitas argues, challenging the conventional wisdom of brownfields being less risky than rehabilitated brownfields and greenfields due to their additional permitting, planning and construction risks.

Brownfield vs. Greenfield: old school.

As evidence, Probitas points to “theoretically ‘safe’” brownfield investments in assets like toll roads, which have in practice proven to be riskier than rehabilitated brownfield or greenfield investments due to aggressive leverage.

The firm proposes a new risk-return spectrum to investors, which introduces leverage into the equation and differentiates between six categories of assets. These include conservatively-leveraged core brownfields on the low end of the spectrum and highly-leveraged brownfields and emerging market greenfield projects on the other end. Assets that depend on operational expertise to meet their investment goals, such as value-added greenfields or private equity-style infrastructure investing, fall in between.

Infrastructure risk-return spectrum: leverage matters.

 
Reflecting on this “more modern” view of the risk-return spectrum for infrastructure, Probitas also recommends that investors rethink their expected returns and, consequently, fees. Kelly DePonte, research director at Probitas, said many brownfield-focused funds were advertised to LPs with 18 percent to 20 percent internal rates of return (IRRs) and 1.5 percent management and 20 percent carried interest fees. Historical returns, though, have been more in the neighbourhood of 10 percent to 12 percent.

“A lot of LPs are pushing back and saying, ‘if I am going to be buying into a very long-term asset generating a 10 percent IRR, why should I be paying 1.5 and 20?’” DePonte said.

Still, LPs are unlikely to cut out fund managers all together and invest directly in infrastructure. Those that have done so have found that the costs of hiring a competent direct investment team were equivalent to approximately a 1.5 percent management fee, and many of the direct and co-investments have suffered lacklustre returns.

Instead, LPs are likely to press fund managers to lower fees. But Probitas cautions LPs against pursuing lower management fees and carry without regard for fund strategy. Funds with a heavy greenfield or private equity focus require more senior staff time to oversee investments. So a higher fee structure may be justified for those higher-returning strategies. And by investing with less-proven managers willing to accept below-market terms, LPs may actually be increasing their investment risk.

However, in the current market environment, LPs may not have much of a choice. Of 70 funds seeking approximately $99 billion that Probitas has identified in its latest list of funds in the market or about to come to market, 55 are first-time funds, DePonte says. He credits this to the relative youth of the asset class itself.

“There’s no way around just having a ton of first time funds. Logistically, that’s almost the way it’s got to be,” DePonte said.

And while the list of second and third-time funds does include funds with corporate sponsors, like Goldman Sachs Infrastructure Partners II, Probitas believes the market is likely to see more independent fund managers in the future. The benefits of sponsorship have diminished due to investor weariness over conflicts of interest and sponsors’ decreased ability to make large cornerstone capital commitments to funds, Probitas said.

The full Probitas fundraising list, re-ranked by target size and converted at spot rates as of press time into US dollars, is reproduced below.