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When you call your customers ‘debtors’, it is unlikely you’re thinking of customer service.” That quote, from a May 2017 keynote interview with Global Infrastructure Partners founder Adebayo Ogunlesi, is one of my favourites from a decade covering the emergence of infrastructure as an asset class.
I like it not only because it’s catchy – I’m a journalist, so catchiness is a professional hazard – but mostly because of the key themes it encapsulates, many of which are still playing out today. These include: infrastructure as a financial versus a public-service play; public assets as monopolies; end users as captive revenue streams; and what asset management actually entails.
For an asset class very much in the public eye, early practitioners had a remarkably laissez-faire approach to the projects they ran. As Ogunlesi recalled, the “buy-it-and-forget-it” approach was all the rage when GIP started in 2006. The prevailing wisdom then was that infrastructure assets ran themselves, that they were immune to economic cycles and that they generated strong cashflows and dividends.
Of those foundational myths, only the final one emerges fully unscathed 13 years later. The first seems almost comically off the mark in the age of ESG and active asset management. As for the second, the global financial crisis forcefully demonstrated that some assets correlated much more closely than expected with GDP.
Forged in the GFC
Hindsight is, of course, a great blessing, and the above isn’t intended as a facile swipe at infrastructure’s pioneers. Like every other asset class, the industry has had its growing pains and, in that sense, the GFC played a formative role in its development, by simultaneously exposing unsustainable practices while creating the conditions for infrastructure’s institutionalisation.
Excessive leverage, for example, was an early casualty. It’s true you could lever infrastructure assets to the hilt. But while this worked for some – think PPPs backed by availability payments – it proved disastrous for others.
The Indiana Toll Road, one of the US Midwest’s most important highways, is a good example of the latter. The holder of the $3.8 billion, 75-year concession that a Macquarie-led consortium had entered into in 2006 went bust after traffic fell because of the recession and the short-term debt used for its acquisition ballooned out of control.
The concession was eventually sold in 2015 to IFM Investors for $3.4 billion. Here’s what Julio Garcia, the manager’s North American infrastructure head, told us a couple of years after the deal closed: “Every year from when it was put into the long-term lease in 2006 until it went into bankruptcy, revenue grew, earnings grew and earnings margin grew. The problem with the ITR is that it had the wrong capital structure.”
Binging on leverage also proved disastrous at the GP-level, particularly when combined with an aggressive deal-making culture. That was epitomised by the spectacular fall of Australian manager Babcock & Brown. Reading through an April 2009 post-mortem from Infrastructure Investor’s then associate editor Cezary Podkul (click here to see where Cezary is these days), it’s striking just how comfortable everyone seemingly was with sky-high levels of debt prior to the GFC.
In 2007, a scant two years before its collapse, Babcock & Brown International – the firm’s main operating entity – was leveraged 83.5 percent. To make matters worse, most of its borrowings were concentrated in a A$2.5 billion ($1.7 billion; €1.5 billion), three-year facility owed to 25 of its senior bankers. That combination would prove fatal once the firm overextended itself and the GFC ground credit markets to a halt.
But Babcock’s collapse wasn’t just a cautionary tale about leverage. It also raised important questions on alignment of interests. As Campbell Lutyens co-founder John Campbell told us in that first April 2009 issue: “The Babcock & Brown experience should be a warning to any general partner who wishes to aggregate assets under management that you must really think through what is in the interest of the investors. If you put investors first, you will normally come out in the right position. But if you put the management company first, you will inevitably come out in the wrong position.”
A year after we published our Babcock retrospective, one of those investors was issuing his own warning about alignment and what LPs were looking for from the nascent asset class.
“If you have a €5 billion fund with an office of 50 people, then a 2 percent management fee is a profit generator,” Robert Coomans, then advisor to the board of Dutch pension fund administrator APG, told us in an April 2010 interview. “But if you run a €500 million fund with 30 people, then the story is different.”
A month later, delivering the opening keynote address at an early iteration of our Berlin Global Summit (click here for a look at 10 years of Berlin), Coomans shared more of his thinking on what pension funds wanted: “In infrastructure, [projects’] cashflows should be used as a barometer and not so much their internal rate of return. I think more emphasis has to be put on cashflows and maybe performance fees should start being paid against them.”
Fees are a perennially contentious topic to this day, though they have consistently moved away from the private equity model. These days, even value-add strategies charge an average management fee of 1.5 percent and have an 18.6 percent carry, with core ones charging much lower rates of 0.9 percent and 14 percent, respectively. Co-investment – now de rigueur – emerged partly as a way for LPs to cut down on fees.
Coomans’ reference to performance fees decoupled from IRR turned out to be prescient. Eight years later, Macquarie launched its €2.5 billion ‘super-core’ fund with a performance fee of 20 percent of the yield over a 4 percent yield hurdle per year (management fees were set at 50 basis points on uninvested capital, and capped at 65 basis points of the fund’s net asset value).
There is still a lively discussion on whether infrastructure is best served by a capital gains approach with a yield component, a heavily focused yield play, or whether it is best treated as a pure bond-like substitute after a decade of historically low interest rates.
Wall of money
In a January 2016 roundtable, Antin Infrastructure Partners’ chief executive Alain Rauscher railed against what he saw as the opportunistic packaging of infrastructure assets as bond substitutes to cater to the growing wall of money descending on the asset class.
“This can be a potentially dangerous evolution for two reasons,” he said. “One, is that it leads LPs to view infrastructure as bond-like investments, and this makes them have no policy in terms of internal rate of return and yield. It also makes LPs willing to take a hit on yield because the dividends are still better than what you’d get from buying a government bond.
“The second reason … is this practice drives prices up big time and it also decouples the protection of value that comes from using IRR as a benchmark. Effectively, some LPs stop thinking about these assets in terms of IRR and start thinking about them in terms of a coupon.”
The good news is that this discussion doesn’t necessarily need to be settled, with the asset class demonstrating it has enough depth and breadth to accommodate a range of approaches.
When it comes to investor preferences, though, a few key themes have been coalescing over the last decade. LPs want a solid yield component from their infrastructure strategies, regardless of whether they are more (or less) capital-gains focused.
They also want their managers to be stocked with industry experts – and not just financial wizards – capable of managing these assets. And they want GPs to approach infrastructure assets with a long-term mindset, even if the vehicles housing them often don’t go beyond 10 years.
The debate about asset management has become particularly interesting. On the one hand, any unlisted manager worth its salt will eagerly talk about its asset management prowess, gamely explaining which levers it can pull to extract value out of its assets or to mitigate the damage from a downturn. Considering how returns are compressing in certain markets, the ability to build platforms and execute carve-outs has also become a staple of managers’ toolkits.
On the other hand, apart from a few well-known champions, there is scepticism about the value managers can actually add. Speaking at the 2019 Global Summit, Tom Masthay, director of real assets for the Texas Municipal Retirement System, said that while managers are quick to sell their operational expertise, in practice they are mostly just bringing capital to the table, often through syndicated deals or minority positions where the operational value they claim to be able to add is simply not achievable.
It’s not just LPs that are being wary. In this historically low interest rate environment, managers are not averse to admitting that the asset class (like others) has benefited from some fair winds. Here’s what JPMorgan Global Alternatives managing partner Anton Pil had to say in a November 2017 keynote interview: “The question is, when values have been rising, have they been rising because of discount factors or the underlying business dynamics? I’m a lot less interested in assets that have gone up simply because you’ve changed the discount factor or their future cashflows. That is much less interesting than businesses where we can see clear synergies or improvements.”
Or as one LP, who asked to remain anonymous, dryly put it: “Everyone’s a hero these days.”
What there’s little argument about, though, is the decisive role the low-interest rate environment played in turning infrastructure into a much more appetising asset class. Starved of yield thanks to years of quantitative easing, institutions started to flock en masse to alternative assets, with infrastructure one of the main beneficiaries.
A case in point: in 2009, when Infrastructure Investor started publication, a total of $11.63 billion was raised; in 2018, the figure had climbed to $90 billion – though, to be fair, 2009, in the immediate aftermath of the GFC, was a particularly bad year for fundraising.
Know your customer
As the asset class grows in the 21st century it stands on the cusp of unprecedented opportunity. This year alone, unlisted fundraising is expected to top the $100 billion mark at a time when governments around the world remain starved of cash to fund new infrastructure.
Of all the challenges the asset class faces – including the very clear and present danger posed by the climate crisis – the biggest is probably to be careful what it wishes for. As more assets make their way into private hands, investors and managers have found themselves under intense scrutiny – all at a time when populism is rocking the globe.
Thomas Putter, the former Allianz Capital Partners chief executive, was particularly prescient in predicting this tension. “[Infrastructure investors] are now part of a mechanism that will force these assets to be paid for,” he told a conference in 2011. “We’d better be very careful about how we explain this.”
It’s no surprise that environmental, social and governance criteria have moved from being a box-ticking exercise to making or breaking reputations. According to a survey by sister title Private Equity International, LPs active in infrastructure are more likely than their counterparts in the other main alternative asset classes to give major consideration to ESG when carrying out due diligence into prospective managers. The elusive ‘S’, perhaps the hardest of the three components to measure, will continue to grow in importance in tandem with the asset class’s increased footprint. As infrastructure, particularly in developed countries, moves from a freely available entitlement to a visibly paid-for service, practitioners will have to excel in delivering value to customers directly. Government, once the preferred – and perhaps only – interlocutor, should no longer be seen as the main piece of the public puzzle.
If there is one lesson imparted by tech giants such as Amazon or Apple it is that great customer service is necessary to keep users on side, even when the companies appear to be monopolies in the making. As the asset class confidently marches into the 2020s, it would do well to keep that in mind. Here’s to the next 10 years.