Mark Twain once famously remarked “the reports of my death are greatly exaggerated” when confronted with a premature obituary.
Listed infrastructure fund managers may be tempted to say the same of their kind.
Over the past year, at conference after conference, delegates have loved to pillory listed infrastructure funds as destined for extinction. They point to their reliance on high leverage and rising asset valuations – along with fee structures that in many cases incentivised taking on fund-level debt and fleeced investors at every turn – as reasons for the decline.
The future, they say, lies in unlisted vehicles that focus on deriving value from operational improvements – not listed funds that rely on financially engineered dividends.
Their criticism is only half right. Yes – borrowing 15 years into the future to fund dividend streams today was not going to be a sustainable strategy, least of all in the current credit crisis. But they must not forget the myriad of reasons that have made listed funds an attractive investment over the years.
First, some perspective: listed investment companies (or LICs) are one of the oldest forms of managed investments. The first LICs in Australia date back to 1928, so small wonder that the listed infrastructure fund originated there some 60 years later. Unlisted private equity-style vehicles, by contrast, have only been around for about 30 years and unlisted infrastructure funds are scarcely older than the new millennium.
When Australian fund managers decided to package infrastructure in listed vehicles, they rightfully hit upon three important features that made it a good marriage: liquidity, diversification and cost.
Listed vehicles provide investors easy access to infrastructure assets that would be difficult to get directly. Investors can buy and sell shares of earnings from long-life assets as they see fit.
It is also arguably easier to build a diversified portfolio of infrastructure assets in listed infrastructure than in unlisted since the former is larger and more mature than the latter.
And while specialist fund managers in infrastructure do typically charge higher fees than mainstream equity portfolio managers, investing in a listed fund is still considerably cheaper than making direct investments in infrastructure assets. It is also very tax efficient, thanks to the stapled security model that has become the industry norm.
The misalignment of interests resulting from the external fund management model arguably dampened some of these benefits. As did the focus on leverage to derive returns, which is not surprising given that many listed funds calculated their base compensation as a percentage of market capitalisation and fund-level debt.
But unlisted vehicles are not without significant problems. The misalignment of tenor between asset lives and fund lives – not an issue in a permanent listed fund – is a fundamental problem that has yet to be resolved. And just like their listed counterparts, unlisted vehicles managed by investment banks paid their fair share of fees to other parts of their integrated organisations that provided services other than the pure management of the underlying assets. Most crucially, does an infrastructure GP really need a 2 percent management fee to cover the fund’s costs? Probably not.
Investors are taking notice. On the listed side, shares are trading at deep discounts to their NAVs, external management teams are being internalised and some funds, like Macquarie Infrastructure Group, are promising not to make any new investments until their shares recover. On the unlisted side, fundraising is tougher, the 2-and-20 fee structure is under siege and more investors are looking to open-ended funds as a solution to the problem of tenor misalignment.
Certainly, public markets remain as difficult as ever. But it would be better to view the listed-unlisted debate as a race to see who can get the alignment of interests right first – listed or unlisted fund managers – rather than an inevitable extinction of the listed fund.