Infrastructure equity - Getting in on the ground floor

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Infrastructure equity has been big in Australia and Canada for a while, admired for its low risk, long-duration appeal. However, the sector's early success has led to a flood of new entrants, who are already driving down returns – and more are on the way. Is the market over-sold before it has properly begun? Claire Milhench reports.

Infrastructure equity has taken pension funds in Canada and Australia by storm in the last 18 months, but it is less well known outside those markets. However, Macquarie's decision to launch a global infrastructure index in conjunction with FTSE this summer, gave notice that it is hoping to change all that. The index launch followed the successful closure of Macquarie's oversubscribed European infrastructure fund, which attracted some j1.5 billion in investor commitments. European institutional investors such as Belgian pension funds KBC and Suez-Tractebel, Germany's HSH Nordbank, ABP of the Netherlands and the British Airways Pension Fund all put money on the table. But such interest, and the increasing number of participants bidding for deal flow, is already beginning to affect returns. Is this just the latest example of a firework asset class?

European pension funds like infrastructure because it is long-term, offers stable cashflows and a very long tail. But they are a long way behind the pioneers of the game – the Canadians and Australians. The Canadians in particular dominate the direct investment sector. Because these public schemes are so huge (the big six range from C$40 billion to C$100 billion in assets) it allows them to hire specialist staff and participate in bids themselves. "They are very aggressive and will back their own judgement," says Peter Salisbury, an industry expert with 20 years' experience in the sector. "They are constantly on the look-out for the next jewel. And when they find them they can write very big cheques. They have all made formal allocations to infrastructure in the last few years." However, although these pension funds have a gigantic appetite, there is just not enough deal flow in Canada to satisfy them, forcing them to look outside.

The Ontario Teachers' Pension Plan (OTPP) and OMERS are two of the biggest direct investors in Canada. Both have dedicated staff to conduct the required due diligence on deals and intend to grow their infrastructure commitments significantly. OMERS recently announced an asset mix strategy that will see it shift from 4% in infrastructure today to 15% over the next few years. Last year the asset class returned 31% and generated net investment income of C$292 million, compared with a loss of C$69 million the previous year. This was partly due to strong deal flow in 2004 with commitments of around C$900 million.

Paul Haggis, president and CEO of OMERS, says the plan's first commitments to this asset class were made by his predecessor Dale Richmond in the late 1990s, but in 2002 OMERS stepped up its involvement. In 2004 it purchased Borealis - its primary vehicle for investing in infrastructure - outright as part of a move to a new investment and business strategy model. This created four investment operating groups focusing on specific areas with specialist expertise – public markets, private equity, real estate and infrastructure.

New governance model

"In the past, outsourcing this asset management had been fine, but in 2003 we took the view that 40% of our assets would be going into illiquid assets in future and that required a different kind of governance model," explains Haggis. Borealis Infrastructure is now responsible for the origination and management of infrastructure assets for OMERS and its investment partners. It works with governments, constructors, and financiers in North America and Europe to develop and take on projects, although Haggis says this can be a slow process because of the scale of the commitments and the politics and bureaucracy involved.

The decision to switch to using more illiquid investments was arrived at after OMERS conducted a number of actuarial studies to see who made money in good times and bad. "OMERS did well in the 1990s but then the perfect storm hit and we went from a surplus to a deficit in short order," Haggis says. "When we looked at plans like Yale and Harvard, which had made allocations to private equity, they had done significantly better than other pension funds. Also, this switch is about getting off the merry-go-round of relative returns and moving towards absolute return strategies."

By going direct to market, OMERS can hold its investments for as long as it likes rather than being at the mercy of a fund manager who may be incentivised to sell out of an investment to get paid. "We're looking to hold these investments for the long term," Haggis says. "We don't need to look for an exit to realise cash, like you would with private equity – that's a very fund-driven view. The nature of these assets is that they provide a steady dividend to back our liabilities. It's a core part of our investment asset mix."

OTPP has made a similar commitment to build its investment in this asset class. Teachers' Private Capital, headed by Jim Leech, is OTPP's specialist investment management unit devoted to managing infrastructure, venture capital and private equity investments. It currently has C$4.5 billion invested in infrastructure projects, 5% of the plan's overall funds. And Leech says that the group is looking to at least double this to 10%. "Most pension plans talk about allocations as if there is a limit on how much they can put in a particular asset class, but we don't operate on that basis," he says. "We can be quite flexible, after we have completed all our risk assessment."

He says the appeal of this asset class is that it provides a steady cashflow, with low volatility. "By infrastructure equity we mean investing in projects that are regulated monopolies or quasi/de facto monopolies. These are perfect for pension plans with long-term liabilities because they provide a hedge to inflation. We are only looking to pay out in 30-40 years so this is ideal."

Having made its first investment in infrastructure equity in 2001, OTPP now has 10 people in-house dedicated to this sector, and is hiring three more. "It's a growing area for us," says Leech. Skill-sets required range from risk, valuation and legal expertise to former corporate development officers from related industries such as the power sector, for example.

Lumpy investments

When assessing whether or not to bid for a project, Leech says his team will undertake months of due diligence, looking at the likely return for the risk taken, the currency risk, the economic climate, regulatory risk and overall supply and demand factors for the service in question. "There can be very long lead times, and that means these tend to be lumpy investments." The size is often imposing – C$500 million is
not unusual.

OTPP will also often look to form a consortium with its peers to make the bid, as well as working with an operational partner and a financial partner. "There's usually a consortium of three or four and the operational partner will be responsible for the day-to-day running of the business," Leech explains. "However, we will be involved at the board level and contribute to strategic development."

Like OMERS, only a negligible part of the portfolio is invested in Canada – around 2%. Some 40% is invested in New Zealand and Australia and another 40% in Western Europe, with the balance in the US. "The regulatory regime in Canada hasn't really caught up to that in Western Europe," says Leech. "There they are used to the privatisation of these kinds of assets and understand how to do it successfully. We see lots of opportunities there."

In 2004, OTPP participated in a consortium with Scottish and Southern Energy (SSE) and Borealis Infrastructure (OMERS) to purchase the C$7.5 billion UK gas distribution network from National Grid Transco. OTPP provided C$665 million in financing and holds a 25% stake in the entity. It also paid C$615 million for a 25% stake in the UK's Northumbrian Water Group.

OTPP has yet to dispose of an infrastructure equity investment, indeed, the whole point is to stick with it for a long time, says Leech. "It's not like private equity where you might look for liquidity in seven or eight years. There's no requirement for that here as long as the cashflow remains good. Indeed, it's one of our competitive advantages that we're such a long-term investor." He argues that pension funds participating in a bidding process on their own behalf can appear more attractive partners to management teams and regulators who are not keen to see assets flipped.

Coming to Europe

Yet Australian asset managers like Macquarie, Babcock & Brown and Hastings have built profitable businesses in this class, by targeting both institutions and retail investors. Having developed asset pools in their home markets, they are now arriving in Europe in search of fresh deal supply, and in some cases, new investors. A number of funds have been launched in Europe in recent months, and other houses such as Goldman Sachs are rumoured to be setting up their own infrastructure equity teams, now that a sustainable pipeline of transactions is on the way.

Supply is strong partly because government expenditure on infrastructure has declined in the last 40 years, so the old infrastructure is wearing out. "It's hitting the whole of the OECD countries at the same time," Salisbury says. New investment opportunities are expected to include the Dutch utilities, the French road network and Asian and Eastern European airports. Salisbury cautions that European investors still see the asset class as a bit exotic, but believes that as opportunities increase, it should become mainstream for European pension funds.

Whilst Macquarie is already established in London, Commonwealth Bank is understood to be recruiting in the City, and Hastings is also setting up a London office, under the direction of David Ridley. Hastings has been investing in infrastructure since 1994 and has about A$2.6 billion in the asset class, across several different funds, making it one of the biggest in the market.

The manager's first fund, the Utilities Trust, stands at A$1 billion, and still has many of its original investors on board. It has returned 10.78% per annum since 1994 and managed 13.72% in 2004. The firm's assets are split roughly 50/50 between retail and institutional investors. Ridley says that pooled vehicles tend to suit those pension funds that just aren't big enough to go direct to the infrastructure market, because of the sheer scale of the investments required. It's the difference between having A$100-200 million to invest in the asset class, and A$3-4 billion.

"If you go direct you need a full in-house team with significant expertise because they need to be able to sit on the boards of the investments," he says. "It also means that you have to go through bidding processes and it takes time to build up a portfolio. But if you invest in a pooled fund you immediately gain access to a whole portfolio of assets."

Hastings offers two types of infrastructure fund – those that are listed on the Australian Stock Exchange, which can be accessed by retail investors, and unlisted funds which are aimed at pension funds and life offices. It also runs some segregated mandates for institutions. Although all the Hastings funds are open-ended, asset-raising for these two fund types is very different. Indeed, one of the main problems for a provider of such funds is managing the cashflow to support a bid for a new investment. In the case of the listed funds, once Hastings has made a commitment to a transaction, it has to take a bridging loan and then raises money on the back of this.

For the unlisted funds, Hastings takes indications from its institutional clients as to how much they want to commit in the coming year, which are then formalised in subscription agreements. Hastings then makes its commitment to the infrastructure transaction and subsequently draws down the investment indicated by its clients. "They might make those investments across two or three of our funds," he adds.

Accessing deals

Because Hastings doesn't have an investment banking division it must interact with governments, banks and other corporate advisers to make sure that it is plugged in to the dealflow. The fact that Macquarie and Babcock both have investment banks behind them means that they get good access to deals as a matter of course, but also lays them open to accusations of conflict of interest. However, investors may still choose to go with the bank-owned asset managers if they think the trade-off in deal access is worthwhile. And because the allocations are made via pooled vehicles, institutions can always sell out if they don't like the fees.

The market is beginning to get busier, however. In the last 18 months, competition for deals has intensified, with private equity firms also crowding the space. But Ridley says that such firms have higher return targets than infrastructure equity managers, giving the latter an advantage in terms of cost of capital. "That makes Europe attractive relative to Australia, where there isn't the same volume or range of assets."

Ridley is confident that Hastings will be able to continue to deliver good returns even though competition has intensified. "Quite a lot of return can be generated from our existing assets," he points out. And the manager's independence can also count in its favour in terms of getting access to deals, he adds. "But it doesn't matter if we don't win any new deals for a spell, or don't like the prices because we have critical mass. It's hard for other asset managers to start from scratch now; having a portfolio for 10 years means we have accumulated a lot of knowledge."

For the direct investors, Haggis agrees that the asset class has become so attractive that everyone is chasing the same deals. "It does seem like everything is an auction now." Whilst this means that prices are being bid up higher, Haggis says that OMERS won't be pushed into paying more than it thinks is wise just to secure a deal. "We have established return targets for this asset class and we will aggressively consider all the parameters when we examine deals. That means we have passed on a number of them. We don't get deal fever – we have checks and balances in place and if that means we lose a few, so be it."

He says there are many new deals in the pipeline in Canada and the US and, looking to the future, sees the involvement of private sector plans in the asset class, although this is likely to be of a different nature than that of the big public plans. "It may be that once the public plans have originated the asset they syndicate that to the smaller plans," he explains.

Leech is also bullish about the future, arguing that OTPP's size, knowledge, experience and global perspective should continue to count in its favour. "We're one of the early movers, but we're beginning to see more and more interest now, coming from all over the globe. The bidding list for Budapest airport was huge – you would never have seen a list like that two years ago." He says this is already hitting returns, but he hopes that increased supply will take the edge off this squeeze. "Also, the reputation we've earned should mean that we continue to rank as a preferred provider."

He sees the market expanding dramatically in the next few years as governments move to shed assets, although this will also encourage more new entrants to the market. "There are lots of copycats and wannabes coming along," he says. "It's important that we stay in front." He is concerned that some of the less sophisticated investors in the market have difficulties discerning the difference between infrastructure, and the more risky, private equity-like projects. "For example, a greenfield power plant built on spec with no supply contracts is a much different prospect to an established power plant with a contract to supply running for 25 years."

Salisbury is also concerned that less sophisticated investors and newer entrants will bid up prices and so force down returns. To date, returns have often been well in excess of expectation, given the level of risk involved. However, returns are already being eroded in areas like the Australian toll road sector, where there is now a much larger number of participants. "Utilities have always been crowded, but now airports and toll roads are crowded, and the opportunities just aren't there," Salisbury warns. He says that in the beginning returns were high because of the information arbitrage – very few of the world's big investors were focused on the asset class because it was so new. "That meant the promoters had to give a big yield to encourage investors to get on board. But that's likely to be eroded as time goes by and more people are bidding."

The other contributing factor to this erosion is that governments are now much less likely to underestimate what they are selling off. Returns have been good to date because governments have poorly calculated these values. "This is not likely to continue as they get wise to the true value of these long-term projects, which can continue to pay out for 50-100 years," Salisbury argues.

The retail dollar

Macquarie's solution to this problem has been to build up its retail client base by launching a series of publicly-listed infrastructure equity funds. "Retail investors are willing to accept lower returns and it also means you don't have one big investor looking over your shoulder who might complain if they think your fees are too big," says Salisbury. Ridley says that infrastructure funds appeal to Australian retail investors who are keen on stable, yielding investments that offer some capital growth. "There is a big listed property sector in Australia and infrastructure is the next wave," he explains. "It's quite normal for Australian retail investors to have infrastructure equity in their portfolios – they don't hold fixed income much."

Salisbury adds that he expects to see a lot of failed entrants to this sector in the next few years but there will always be opportunities for a premium player. "That means someone with an M&A team that has good relationships that allows them to do deals. The opportunities are still there but they are different from those of 10 years ago." As a result, he expects to see the market polarise between the boutiques and the megabanks, which won't suit mid-tier players like Macquarie. "How will they cope with the reduction in fee levels? And the megabanks will be able to provide more facilities. Outside Australia, Macquarie is not a significant M&A player, so they will be at a disadvantage when some of the big investment banks start to focus on this. Strap yourself in, it's going to be an interesting ride!"

Where does PFI fit in?

Donald Duval, chief actuary in the employee benefits group at Aon Consulting, says that the indifference or antipathy of UK pension funds to infrastructure equity has a lot to do with its history. "In Canada and Australia, the infrastructure needs relative to the size of the economy are big, and pension funds are used to investing in very long-term asset classes." He cites the example of agriculture or mining in Australia. "The UK hasn't had this tradition of development – it has tended to be done by companies or the government."

Duval says that pension funds have invested in companies involved in PFI, but this hasn't always been successful. He points to examples like Eurotunnel, Railtrack and Jarvis, and adds that where such initiatives have worked, there has been criticism for ideological reasons. "So the UK is very antagonistic towards private involvement in infrastructure projects. The nationalisation of the infrastructure in the mid-20th century has left a big legacy." He strikes a note of optimism by adding that this may change with the 2012 London Olympics, which will require a big injection of private monies, and is likely to arouse some patriotism.

Some UK fund managers haven't been deterred by the underwhelming reception to date. Henderson Global Investors offers a £330 million secondary fund targeting government partnerships or PFIs, and Jane Welsh, a senior investment consultant at Watson Wyatt, says that she is now seeing interest in the secondary phase of PFI from UK investors. "This is when the hospital is up and running, the government is paying you to use it, and those payments are inflation-linked, so there is a steady stream of revenue," she explains. Henderson's fund includes a portfolio of five projects providing public swimming pools and other leisure facilities for local government bodies, and a 30-year concession contract to treat wastewater in Scotland.

Capacity constrained

"There is quite a lot of interest from pension funds in this type of investment because a lot of the risk is taken out, but there is not a lot of it about," says Welsh. Whilst investment tends to be via a pooled fund, these are opened and then closed again like private equity funds, so it can be difficult for investors to get access. "It's something different for pension funds, but unfortunately it is capacity constrained, so it is not something you can put a lot into," she says.

If European interest grows in infrastructure equity, she believes that investment will most likely be via a pooled vehicle, rather than going direct to market. Even giant Dutch fund ABP is using funds at present rather than trying to bid on its own behalf. "Going direct requires too much diligence, and besides, we are seeing a lot more infrastructure funds out there now, both in Australia and the US," says Welsh.