The LP paradox

Limited partners, especially pension funds and life insurers, will readily tell you that they like infrastructure because of its long-term, stable cash-flows. So why do they prefer infrastructure funds with 10- to 12-year life-cycles?

If you are a limited partner (LP) looking to invest in infrastructure because you’ve just heard about all the great things the asset class provides – such as stable, long-term cash-flows, inflation protection, etc… – would you take kindly to a pitch from a general partner (GP) running along these lines:

“I’ll take two or three years to start building a portfolio, during which time there will be practically no yield. Then I’ll provide you with a stable 3 percent to 4 percent yield for four to five years. And then I’ll make it up to you when we exit these assets. Assuming conditions are right at the time of exit [this last part probably mumbled].”

If you are an LP lured to infrastructure by the long-term benefits the asset class can provide you, it’s likely that the above has just put you off from investing – right? Actually, wrong, because the above, in slightly caricatured fashion, is the sort of closed, 10- to 12-year infrastructure fund structure LPs tend to favour.

What’s paradoxical is that, in theory, that fund structure – favoured by a significant portion of LPs – denies “access to the really nice characteristics which this asset class can offer a pension fund,” Henk Huizing, head of infrastructure investments at Dutch pension asset manager PGGM, told Infrastructure Investor, in an interview to be published in the September 2011 issue.

Reflecting on PGGM’s increasing focus on direct investments, Huizing said: 

“What pension funds like about infrastructure is the long-term stable cash flows of these assets. What we try to achieve is 25 to 30 years of very stable cash flows. If you invest through a fund, there’s no yield in the first two or three years because they are still in the build-up phase. Then you have a period of three to four years where you have a sort of stable cash flow, but it’s certainly not 9 percent or 10 percent yield, it’s more like 3 percent or 4 percent. And then there’s this huge exit return, which means there’s certainly not a long-term, stable cash flow and your total return is dependent on your exit return, which is dependent on the conditions at the time a fund exits.” 

But if long-term, stable cash flows are what pensions – and presumably other long-term investors – want out of infrastructure, why is the closed-ended fund model so popular? Huizing is at a loss to explain this paradox.

“Is it because infrastructure is still a relatively new asset class?” he muses. “For us and our clients, it’s not an issue; they clearly understand that these are very long-term, illiquid investments. So if they decided to quit infrastructure it could take many years before they would see their money […] these are not investments for five years, but for 25 years. But when you get a return, it’s a long-term stable cash flow for 25 years. If investors don’t want these benefits, then I don’t know,” he answers.

Or maybe some LPs are just happy with getting a low double-digit return in 10 years’ time. The real question then becomes whether infrastructure is the best way to reach that goal, or if its true benefits are only for those with their eyes on the distant horizon.