Bullet train – 2006 to mid-2008

The market for infrastructure equity funds grew exceptionally quickly between 2003 and 2008. In 2006, more than $20 billion of equity capital was raised, up from less than $5 billion in 2004. This was followed by another big year in 2007, when about $35 billion was raised. By the middle of 2008, there were an estimated 70 funds in the market seeking to raise $70 billion. However, the flow of capital commitments slowed sharply as the credit crunch took hold and only about $30 billion was raised in 2008.

Source: Preqin Infrastructure Spotlight April 2009

It is also clear that much of the capital already raised has not been deployed. Mercer estimates that there over $30 billion of un-invested capital committed by limited partners (LPs) to major global and regional funds.

The attraction of this young, but reasonably well established, asset class is clear. Infrastructure assets are considered essential, either because they support economic growth, as in the case of transport infrastructure and utilities, or because they fulfil social needs, as with schools and health care facilities. They are long-lived assets characterized by the following features:

• Monopolistic position of underlying projects or high barriers to entry
  
  
• Captive customers
  
  
• Relatively predictable long-term cash flow

The quality and predictability of cash flows means that classic infrastructure assets can generate steady and attractive cash distributions to equity partners. However, this feature also means that infrastructure projects can accommodate relatively high levels of gearing.

The deterioration in the economic environment, and the virtual collapse of credit markets, have highlighted that infrastructure investing is not immune from economic and market influences. Recent events have highlighted a number of other less attractive features of the industry, specifically:

• The opportunity for investment banks and specialist players to tap into this market by raising funds with attractive (to the managers) fee structures attracted too many players to the market. This exacerbated competition. The initial purchase price of an infrastructure asset is a key determinant of the ultimate success of a project. It is now clear that some funds have overpaid for assets.
  
  This is a critical issue, especially in a weak capital-raising environment. If managers do not succeed in raising targeted amounts of capital, LPs are at risk of holding interests in inadequately diversified portfolios. The risk is compounded if the manager has overpaid for assets acquired in the early stages of the life of a fund, and/or acquired assets that are particularly sensitive to weak economic or market condition. This risk is further exacerbated when the companies remain listed on a stock exchange – see comments on Babcock & Brown below.
  
• Inexpensive and plentiful credit made it too easy to apply excessive leverage to projects, often in highly complex structures. This in turn increased the temptation for bidders to go the extra mile in trying to win deals in the expectation that they would still generate an attractive return on the equity component of the deal.
  
  
• Increased competition for “trophy” infrastructure assets, such as water companies, prompted some funds to stretch the definitions of infrastructure to include fringe assets. For example, car parks may be an essential component of an urban transport system, but are they infrastructure assets in the classic sense?
  
  
• Managers have used inappropriate structures to “package” infrastructure assets. Infrastructure funds listed in Australia are a prime example of that (see “Unwinding of Infrastructure” paper dated October 2008). Most unlisted funds have been structured copying the private equity approach without proper consideration given to the nature of the underlying assets.
  
  
• It is clear that many infrastructure assets, such as ports, airports and toll roads, are susceptible to demand risk linked to changes in the economic environment. That said, we would expect that given the ”essential” nature of these assets, the adverse impact of an economic slowdown should be limited. Nevertheless, while operators can adapt by reducing their cost bases, cash flows may be lower than expected in the short to medium term. This makes the return stream on such assets more volatile than had been expected.
  
  
• While other types of infrastructure assets (mainly utilities) have continued to generate steady income streams, in some cases this income has been retained as a liquidity buffer, rather than being distributed to the shareholders. Hence, distributions from the assets have been reduced when they were needed most.
  
  
• Some managers have not been adept at portfolio construction. A prime example of this is the Babcock & Brown European Infrastructure Fund outlined below.
  
  
• Governance models are often flawed. Funds may pay substantial fees to in-house groups for advisory and/or underwriting services. Managers may seek to transfer assets between funds. Policies governing the allocation of investments across internal funds may not be clear. Disclosure of these arrangements is not always sufficiently transparent.

Babcock & Brown – Off the rails

Babcock & Brown’s European Infrastructure Fund (“BBEIF”) serves as a good example of how a promising idea can go off the rails. At the time of its launch, BBEIF was one of the few players in the market that could claim to have genuine infrastructure experience and a successful track record. Babcock & Brown had developed strong capabilities in the sourcing, appraisal and execution of infrastructure investments. Based on the quality of the leading decision-makers, and the depth of resources available, we believed that BBEIF warranted our highest rating.

So what went wrong? At the corporate level, Babcock & Brown branched off into a range of other activities. It financed the business aggressively and employed complex structures within some of the listed investment vehicles sponsored by the firm. In the end, the company buckled under the debt when earnings fell and it became impossible to refinance existing facilities. The pressures created in Babcock and Brown’s other businesses have effectively put the firm into liquidation, of which private infrastructure fund management teams became a casualty.

This had a direct impact on Babcock & Brown's European infrastructure team. Corporate events were a distraction, not least because key executives saw their personal wealth wiped out as the Babcock & Brown share price plummeted. Project sponsors and potential long-term partners were put off by the uncertainty surrounding the company. This made it difficult for the manager to source assets and/or implement plans to enhance or protect the value of existing assets.

Fortunately, the fund had acquired several good assets before the problems at Babcock & Brown became acute. However, the manner in which the assets were purchased had constrained the fund management team’s ability to influence the day-to-day operations of the businesses owned by BBEIF. At the aggregate level, the Fund is also exposed to considerable “mark to market” risk through exposure to companies which remain listed and demand risk through investments in ports and road assets.

LPs are now faced with large (unrealized) losses, considerable uncertainty about the likely long-run return from the investment and the burden of having to go through the exercise of appointing a new management team (the existing team has bid to acquire the rights to manage the fund).

Infrastructure – Stuck in the sidings?

Does all this mean that the infrastructure story is stuck in the sidings? Let’s consider the evidence.

 “Classic” infrastructure assets are still attractive: they should generate relatively stable long-term cash flows which provide a good degree of indexation to inflation. There is also plenty of pent-up need for private sector involvement in the sector in all regions. Many governments have pressing needs to invest in new or enhanced infrastructure to support long-term economic growth, help cushion the economy in a weak period and help fulfill social needs. These governments may not be in a position to fund these investments directly.

Tougher times in credit markets make it considerably more difficult to finance projects. The days of aggressive structures and weak covenants are gone. This should help reduce competition and improve pricing discipline. Marginal players should also be forced out of the market. Distressed companies, such as construction firms (mainly Spanish) and banks (mainly Australian, Spanish and UK), should create a steady flow of secondary investment opportunities for equity investors with “dry powder.” These distressed players also represent a change in the industry dynamic as they have gone from buyers of assets to sellers, increasing potential supply at the same time as competition becomes less intense on the buy side.

Based on these factors, we were optimistic that 2009 would be a decent vintage for infrastructure investors. However, our confidence has waned of late. A key concern is the level of deal flow in relation to the amount of capital outstanding. There have been very few notable deals in the period since the Lehman Brothers bankruptcy. We estimate that managers of OECD-targeted funds have over $30 billion in capital that they have raised but not spent – and half of that amount is related to just 10 funds. On top of that figure, the managers in the market currently are hoping to add another $10 - $15 billion to that total in the next year. Additionally, there are many large direct investors – primarily large pension and sovereign wealth funds – that have available capital to invest in infrastructure, but those figures are not disclosed.

A key problem relates to the lack of debt financing available at this time (the opportunities this presents to long-term institutional investors are discussed later). Based on feedback from managers, it has been very difficult to assemble financing packages in excess of $1 billion in the last 8 months . Even smaller deals are now financed by much larger bank syndicates (more banks are now involved in debt financing) which on its own introduces a new level of complexity for executing the transaction. Given that the large funds were previously buying $5 billion assets with 60 - 70% gearing, and they are now constrained to $2 billion deals at the outside, we can see why capital is not being invested. And while expectations now appear to be more realistic, managers are also telling us that sellers are reluctant to divest assets at lower prices unless they are compelled to do so.

As a result, we are concerned that competition for good assets will remain strong – if not quite as feverish as in some recent auctions. The offset to this is that managers cannot use as much leverage as they have in the past few years so any given deal is likely to have a considerably higher equity allocation than those completed in the last four years. We note too, that some of the equity commitments which have not been invested to this point will be needed to pay down debt in underlying assets when financing facilities begin to mature. However, we remain to be convinced that managers will still be disciplined when bidding for assets.

Yellow signal – Proceed with caution

This does not imply that the rationale for investing in the equity of infrastructure assets is fatally flawed. However, we believe that investors should be especially selective when choosing their partners. Ten to fifteen years is a long time to rue a decision.

Good managers will have sensible and achievable fund-raising targets which will be aligned to their investment strategy in terms of transaction sizes and number of assets targeted.

The winners in today's market will be investors who pay sensible prices based on realistic assumptions for future growth and inflation and appropriate discount rates, and who can strike the optimal capital structure for an asset. The easy gains to be made from financing and refinancing assets are no longer available. The aggressive use of debt structures at asset (and perhaps even portfolio) level is not appropriate. Underlying leverage needs to be more prudently managed.

We also believe that success in this market requires a superior ability to manage assets effectively once they are acquired. In our view, achievement of return targets will depend on a manager’s ability to implement incremental operational improvements over the life of an investment. These managers are best placed to keep their funds on track to deliver the stable returns that LPs expect over the long-term.

We would also highlight that the opportunity set is evolving from the traditional equity like investments in the primary market to alternative approaches. For example, opportunities in the market for infrastructure debt. Access to public markets is limited to the highest rated utilities. The debt syndication market is constrained, forcing equity investors to rely on a relatively small group of banks with project finance expertise, many of whom are severely limited in their ability to lend. Primary debt is not only difficult to source, but is also more expensive and available over shorter tenors. We believe that this creates opportunities for alternative suppliers of long-term debt capital, such as pension schemes and other institutions.

We note too that the market for secondary debt is interesting. Banks, insurers and construction companies may need to sell positions to bolster their balance sheets. This creates opportunities to acquire high quality positions at attractive prices.

Our analysis of the opportunities in infrastructure debt is at an early stage, however, we think that the opportunities are compelling enough to warrant more in-depth research which we are in the process of undertaking.

Next steps

We encourage investors to use the challenges faced by managers today in raising capital to press them on fund terms. By and large, fund terms are skewed in favor of general partners/managers. This has persisted because prominent infrastructure funds met and exceeded their fund raising targets with relative ease in the boom period from 2006 to mid-2008.

Now is the time to go back to basics. There is no single “right” formula, but we believe that LPs should expect:

• More equitable management fees. These typically range from 1% to 2%. The median is 1.5% for the funds we rate. Management fees are often charged at the same level on capital committed but not drawn down. We see no justification for 2% management fees. Incentive payments paid for long-term success (see below) should be the key driver of rewards. We think that management fees should move down to the lower end of the current range, and that lower fees should be charged on uncalled capital.
  
  
• Incentive fees need to change. The de-facto industry standard is that the manager receives a 20% share of returns in excess of a preferred return of 8%, usually based on the net asset value of the fund. This is imported from the private equity world. Long-term cash flows incorporating a degree of indexation to inflation are a key attraction of infrastructure investments. It may be sensible to link incentive fees to hurdles based on premiums to inflation. Another idea would be to link incentives to unlevered returns to discourage the aggressive use of debt. The hurdle should represent the required cash return to investors. This will ensure that payments are loaded to the latter stages of the life of the fund.
  
  
• Compensation paid to the team responsible for the fund should be aligned to the incentive fee structure outlined above – rewards should be linked mainly to long-term success, measured in cash terms.
  
  
• The other key driver of rewards should be appreciation in the value of capital committed by the fund management entity, and the management team, on the same terms as the LPs.
  
  
• Transaction fees should be avoided. Funds should source advisory and underwriting skills on an unrestricted basis. Where the payment of transaction fees is ingrained into the business model, they should be based on market rates which are reviewed at least annually by the Fund Advisory Board. All fees paid for advisory and underwriting services should be disclosed to LPs on a quarterly basis.
  
  
• Portfolio construction guidelines are generally not very stringent. They should be tightened up to restrict the manager’s ability to take excessive single asset, sector, geographic, foreign exchange or mark to market risk. The use of fund level leverage should be limited in amount, and used only to fund a transaction pending a call of LP commitments.
  
  
• We think that the quality and frequency of dialog between the general partners (GPs) and members of fund Advisory Boards should improve. Also, smaller LPs should be represented on the Advisory Board by a nominee of their choosing. The members of the Advisory Board should have access to an experienced independent advisor.
  
  
• Rules covering potential conflicts of interest should be clearly defined, and subject to oversight by the Advisory Board. Transactions such as the transfer of equity interests between funds controlled by the same manager, or between the sponsoring company and funds, should be subject to the approval of the Advisory Board. Their decision should be based on independent valuations and access to technical reports prepared by third-party experts.
  
  
• LPs should always have recourse to a “no fault” divorce clause to remove the manager. Where these clauses exist, they are often triggered only if 80% of the LPs (by value) agree. If the clause is triggered, the manager will be entitled to compensation in the form of two years’ worth of management fees. LPs are not going to go to the trouble of removing a manager unless there is a strong reason to do so. We think a hurdle for approval of two-thirds of LPs is sensible, with less generous compensation terms (no more than one year).
  
  
• Key person clauses should be in place to give LPs the ability to suspend commitments, and if necessary, terminate the management agreement, in the event that key executives were no longer able to fulfil their duties to the fund.
  
  
• Asset valuation policies should be clearly defined and subject to oversight by a qualified auditor and/or third-party valuer.
  
  
• Reporting needs to improve. LPs have the right to know more about the assets they have acquired. Managers and Advisory Boards should develop templates that describe the key features of any new investment made and that would be distributed to all LPs. In addition to quarterly valuations, managers should provide a quarterly update of key risks relating to underlying investments and the portfolio itself, such as currency, interest rate and refinancing risk, regulatory issues and so on, and steps taken to mitigate those risks.

Whether investors succeed in securing better terms or not, one thing that won’t change is that the lawyers will retain the upper hand in drafting placing documents and partnership agreements. The documents are lengthy, complex and at times, rather tedious. However, there is no substitute for a careful review of all of the documents, with input from qualified external advisors, including lawyers and tax specialists.

Conclusion

The infrastructure model has taken some knocks, but it is not broken. We are hopeful that the market will adjust to a tougher environment over the course of 2009, and that investors will succeed in establishing new, more equitable, benchmarks for fund terms. We believe that this will position the infrastructure market to yield good returns in 2010 and beyond.

Investors should be especially stringent in selecting the GPs with which they choose to work. We believe that managers who have realistic fund-raising targets, disciplined approaches to asset pricing, strong relationships with banks and proven expertise in the management of critical, and relatively complex, assets are best placed to deliver the steady long-term returns that should be expected from this asset class.

We also recommend that close attention is paid to fund terms, and that investors seek to redress the balance between LP and fund sponsors. Compared to investment in traditional assets, investing in infrastructure is time-consuming and expensive in terms of due diligence, but worth the effort in our view.