According to a 2011 survey by consultant Towers Watson, infrastructure is now the fourth-largest externally managed alternative asset class for pension funds, after real estate, private equity and hedge funds.
Furthermore, a recent Preqin survey showed that 82 percent of institutional investors currently gain their exposure to infrastructure through commitments to unlisted infrastructure funds.
Despite this, patchy data can make it difficult to gain a clear picture of activity in the unlisted segment. To overcome this, First State Investments’ (FSI) unlisted infrastructure research team have developed a proprietary database of ‘core’ infrastructure M&A activity over the past decade.
Our intention here is to explore a number of questions about the unlisted market, the answers to which have previously relied heavily on anecdotal evidence. For example, how have the forces of supply and demand for infrastructure played out? What does historical activity reveal about institutional investor preferences? What implications are there for future opportunities?
TRACKING INSTIUTIONAL INVESTMENT INTO 'CORE' INFRASTRUCTURE
The database focuses on activity by institutional investors, such as pension funds, unlisted infrastructure funds, sovereign wealth funds and the largest private equity funds. Only deals exceeding $50 million were included.
In line with the core infrastructure focus, the database focuses on brownfield assets across the energy, transportation, water and waste sectors. It does not include social infrastructure, communications, or ‘peripheral’ assets such as service businesses or upstream energy assets (e.g. oil and gas exploration).
Applying these filters, we estimate that approximately $291 billion of activity has taken place over the decade to the beginning of 2012.
DEAL FLOW OVER TIME: SPORADIC AND UNPREDICTABLE
Figure 1 shows the breakdown of institutional infrastructure investment by sector over the past decade. The most salient observation through this prism is that no two years look the same in terms of sectoral mix.
Why is this?
Firstly, the pipeline of brownfield infrastructure opportunities is somewhat de-linked from the broader economic cycle. For example, while privatisation opportunities can be driven by economic factors (such as the International Monetary Fund’s bailout package conditions in the Eurozone), they can also be triggered by political or regulatory changes, which are less correlated across countries or jurisdictions.
Secondly, the participation of non-institutional investors also diminishes the available opportunities for institutional investors. For example, large toll-road construction companies such as France’s Vinci and Spain’s Abertis have held concessions for toll roads beyond the greenfield stage.
Finally, the prevailing strategic and financial environment may prompt an M&A wave in an industry. For example, major vertically integrated energy players such as E.ON are seeking to redeploy capital from lower-margin regulated assets into higher-margin generation or exploration segments. The broader availability of financing will also affect the level of deal flow.
The opportunistic, and therefore sporadic, pattern of deal flow is instructive for institutional investors. Specifically, it underscores the difficulty in achieving a sectorally diversified exposure to unlisted infrastructure from scratch.
It also highlights the narrow window of opportunity that exists to invest in prized assets. In absolute terms, water and waste assets have attracted more institutional investment than any other sector over the past decade.
However, investment in the sector has been sporadic. Over a 16-month period from 2006 to early 2008, institutional investors, including FSI, invested nearly $43 billion in regulated UK water utilities. Yet there was virtually no institutional investment for the following three-and-a-half years.
As the institutional investment space becomes more crowded, we anticipate that existing portfolios – offering the ability to generate a return on committed capital immediately – will become more highly sought after.
Institutional preferences: not all infrastructure assets are created equal
Figure 2 shows the split between institutional and non-institutional investment in each sector. The figure in parentheses indicates the percentage of deal flow accounted for by institutional investors, or the ‘penetration rate’.
The striking degree of variation across the sectors is interesting in its own right, but can also provide clues about future investment trends in the sectors.
Airports have enjoyed a healthy level of institutional participation over the past decade. However, the flip side of this is that availability – and therefore pricing – may be an issue for investors over the next decade.
While demand for airports has been strong, supply in the form of privatisations has not kept pace. This has created intense competition for assets. Earlier this year, Infrastructure Investor reported on Brazil’s auction of three airports, attracting 28 bidders. The eventual sale price was almost five times the minimum amount specified by the Brazilian government. More recently, Edinburgh Airport was bought at an EV/EBITDA multiple of 16.7x – higher than the expected 12-13x.
On the other hand, the lower institutional presence in the rail sector stands out. Here, there are two possible takeaways for investors.
Firstly, it is a reminder that non-institutional investment can crowd out institutional participation in a sector. Berkshire Hathaway – which made a $36 billion takeover of railroad company Burlington Northern Santa Fe (BNSF) in 2010 – is not classified as an institutional investor in our database.
However, it is also worth noting that the rail sector is less of a pure play than other transport sectors – track and rolling stock is often jointly owned, unlike airports and airlines. This, in addition to the often large size of former government enterprises, arguably make deals in this sector more suited to the wider investment focus of conglomerates than to the more specialised focus of core infrastructure investors.
Turning to energy, institutional investment patterns reveal a clear hierarchy among the various types of energy assets, based largely on the level of associated risk.
Electricity and gas transmission and distribution (T&D) assets are typically regulated (being natural monopolies), and offer relatively predictable revenue streams. Pure conventional generation assets, on the other hand, are usually unregulated, and exist in a more competitive market. Investments in this sector are therefore viewed as riskier from a core infrastructure investment perspective, and instead tend to appeal to specialist energy-focused or smaller private equity funds.
This is supported by the results shown in Figure 2. Despite there being a vast opportunity in generation ($372 billion), institutional investors account for a much smaller percentage of activity in this sector (6 percent) than in electricity T&D (19 percent), and oil and gas (18 percent).
Regulatory pressures such as the European Union’s Third Energy Package will also continue to create opportunities for institutional participation as transmission and distribution assets are divested by vertically integrated utilities. This unbundling will improve investors’ ability to select the segments (e.g. generation, transmission, distribution) that match their risk and return profile. In turn, this should pave the way for greater institutional participation in the lower-risk transmission and distribution segments.
Finally, renewable energy assets (8 percent) have also been perceived as being too risky for inclusion in a core portfolio, appealing instead to specialised investors such as smaller private equity funds with a thematic or sector focus. However, larger deal sizes as well as lower technological and regulatory risks are set to make the sector more attractive to institutional investors. We anticipate these shifts will increase the level of penetration over time.
Ritesh Prasad is an analyst at First State Investments in Sydney
All references to First State Investments experience and capability in relation to infrastructure refers to both First State Investments and Colonial First State Global Asset Management in Australia