This article is sponsored by Ridgewood Infrastructure
Why is the lower mid-market such an attractive part of the US infrastructure industry?
There are several structural elements that make investing in the lower mid-market compelling.
First, valuations and portfolio exposures. With ample opportunity and relatively less capital availability, we’re creating investments in truly essential infrastructure at very attractive valuations, usually on a direct basis and avoiding investment bank-led sale processes. Capital sizing also enhances our ability to access unique investments, such as regulated utilities and long-term contracted assets, which aren’t as readily available for those that have to deploy much larger amounts of equity in any single investment. Second, value creation opportunity. We invest in companies with transformative growth potential and drive value in an operationally oriented, controllable and repeatable manner. The impact of our operational changes drives material value enhancement, given the scale of the businesses.
Finally, exit dynamics. As we harvest investments, we benefit from a healthy exit market comprised of both strategic and financial buyers seeking core infrastructure attributes in businesses which are then well matched for their desired investment profile.
Which sub-sectors are generating the most interesting lower mid-market opportunities?
Water and other regulated utilities, and select areas within transport, are currently areas of interest. For example, our buyout of the SiEnergy regulated natural-gas utility is an investment in a high-growth, regulated utility providing essential natural-gas services to customers in Texas. And we recently acquired Carolina Marine Terminal, which was our first investment through Ridgewood’s exclusive Transportation Infrastructure Partners joint venture with Savage, the largest privately owned transportation and logistics company in the US. CMT is a multi-modal marine bulk port that provides essential contracted transport, logistics management and product-handling services. We also continue to look at potential opportunities in renewables, other areas of the energy transition and parts of the communications infrastructure sector.
What is the approach to origination and due diligence in the lower mid-market?
Origination efforts are underpinned by an experienced and informed view about market fundamentals. With that starting point, we make targeted outreach to directly originate and bilaterally negotiate investment opportunities. We’re not participating in prescribed auction processes. Instead, we source opportunities through long-term relationships and deep roots in the marketplace. There are many benefits of getting to know and working with cities, industry-leading companies and management teams over time. Our approach to direct origination also creates more time for diligence, risk identification and mitigation, as well as value-creation planning. Throughout the investment origination and diligence processes, our investment and operating professionals use their experience and discipline to discern a deep understanding of both risk and opportunity.
How are deals at the lower mid-market typically structured and how do they differ from larger transactions?
Although there may be slight nuances, in general, I don’t think deal structures are all that different. There isn’t a one-size-fits-all methodology. We have a broad tool kit, which we use to create solutions that work for both us and our counterparties. Illustrative of this is the breadth of transaction types we’ve used, such as straight buyouts, project financings and joint ventures.
In short, we’re control investors with a focus on downside protection and upside potential. We’re openminded about how to accomplish that. It can be through employing instruments like preferred structures or sometimes by using earnouts to bridge valuation gaps.
We have a fairly conservative view on the use of leverage. We don’t use leverage to drive returns, but to enhance them. There are many other value drivers available to us from origination through to exit, so we can dial in a prudent and appropriate leverage level for each investment without amplifying risks associated with overleverage.
So what sorts of value-creation levers are best suited to the lower mid-market?
Our value-creation strategy is focused on repeatably and controllably scaling, stabilising and professionalising investments.
For example, our Undine portfolio company is focused on building a regionally concentrated, midsize, regulated water utility through the consolidation of independently owned, regulated water and wastewater utility systems.
The industry is highly fragmented. There are more than 65,000 utilities, and more than 90 percent of them operate at a level our larger competitors see as ‘sub-scale’. Undine has acquired more than a dozen of these utilities, with each typically serving fewer than 3,000 customers each. By growing the business, we are able to drive operational efficiencies and economies of scale.
Professionalising the business involves stewardship to improve management and operations, and standardising capital equipment to increase service levels in a cost-efficient and sustainable manner. Taken together, Undine has been positioned for eventual acquisition by strategics and core infrastructure buyers seeking to own scale-level, well-operated, regulated utilities generating stable cashflows with strong margins.
Stabilising an investment might mean undertaking a transformative repositioning, such as taking an asset through construction. We worked with the City of San Antonio and its municipal water authority to construct, own and operate the 142-mile Vista Ridge water pipeline, which supplies approximately 20 percent of San Antonio’s fresh water, under a 30-year take-or-pay contract.
The Vista Ridge project is an essential component of the city’s infrastructure. It diversifies San Antonio’s water supply and will provide meaningful relief to the local ecology. We oversaw the construction, led the process to select the long-term operator of the water pipeline and recently completed a large private placement to replace the project’s construction facility with long-term financing. Vista Ridge is very well positioned for continued, strong operations and, eventually, we expect a long-horizon owner will have interest in owning the asset.
From these examples, you can see it’s possible to have a disproportionately positive impact on assets in the lower mid-market compared with other size stratifications. Assets can be transformed significantly quicker than at the multibillion-dollar end of the spectrum.
What are the most likely exit routes?
There are multiple ways to win on exit. Our investments are deliberately positioned to be acquired by both strategics and financials. The consistent theme is that we’re able to invest in these assets at a point that longer-horizon, lower cost-of-capital buyers can’t or won’t, perhaps because it’s too small for them or because they’re not equipped operationally to drive the value at this stage. But they’re thrilled to own these assets once they’re repositioned and are a better fit for a longer-horizon owner. That’s all part of the value-creation strategy.
After our period of ownership, investments are well matched to the desired investment profile of a broad buyer universe. Competition has increased materially in the part of the market we exit into, which helps to drive further value.
You say you source deals bilaterally. But what sorts of competition do you typically face?
Some infrastructure managers are dipping their toes in the lower
mid-market, but there’s no one we see with any repetition. Institutional-scale family offices are sometimes seen evaluating investments in the space, but their resourcing capacity is usually very different. It would be naïve to think there’s no competition, but there’s certainly less of it.
How do ESG challenges differ at this end of the spectrum?
In the lower mid-market, there’s more opportunity to be impactful on ESG. It’s culturally important to our business and it creates value in the portfolio. Although the companies we deal with may be taking some of the action required, generally they will not have a formalised approach to ESG. So, when we invest in them, we make it a priority. That will involve, for example, implementing policies and procedures to ensure best practices, and elevating discussions on ESG in order to make material differences.
What is the current level of LP appetite for investing in the lower mid-market in US infrastructure?
Appetite for investing in the lower mid-market is growing as LP knowledge of infrastructure continues to mature. LPs like that we’re able to provide a differentiated portfolio of essential infrastructure assets which truly has those long-term, high-quality, non-correlated cashflows and that delivers very strong risk-adjusted returns. They also like how we create value in a repeatable and controllable fashion using relatively low levels of debt. And, given the smaller fund sizes, they appreciate the strong GP-LP alignment.
SiEnergy, Texas: Scaling up at the lower mid-market
SiEnergy is a regulated natural gas utility servicing around 30,000 customers in the Houston, Dallas and Austin metropolitan areas of Texas.
It fulfils Ridgewood’s criteria of being a truly essential asset with high-quality, uncorrelated cashflows. Through its industry relationships and experience, Ridgewood formed a relationship with the company’s chief executive and together they approached the counterparty, for which SiEnergy was considered non-core.
The investment required deep sector expertise in order to work with regulators and community stakeholders. Together with the CEO, Ridgewood continues to focus on scaling and professionalising the business, bringing in a chief financial officer and enhancing systems and management reporting. The firm also prioritised enhancing its emphasis on ESG. One tangible example of this is that SiEnergy has achieved approximately £10 million ($13 million; €12 million) of carbon emissions avoidance over the past year by supplying compressed natural gas to one major customer alone.
SiEnergy has generated 20 percent organic growth in the past year, which Ridgewood’s Ross Posner describes as virtually unheard of in the regulated utilities sector. And although there is no imminent exit on the horizon, Posner says that financial and strategic buyers alike are watching closely. “There is a lot of runway left for us and the management team,” he says. “The company only gets more attractive to potential buyers as we continue to achieve our objectives.”