European infrastructure: Bubble at the core

Serving 655,000 customers in the steadfastly middle-class commuter towns that extend south from London, Sutton and East Surrey Water Group (SESW) is a classic core infrastructure asset: a stable customer base, a transparently regulated industry, and predictable inflation-linked revenue streams. Japan's Sumitomo Corporation paid GBP164.5 million ($252 million) in equity plus GBP140 million in debt for the company in February. The EBITDA multiple was said to be 10.5x.

Sumitomo is not the only Asian investor to seek refuge from volatile global markets in UK and European water in the last 18 months. One of the losers in the SESW auction, Beijing Enterprises Water Group, has gone on to buy Veolia Environment's Portugal-based water assets. In early 2012, China Investment Corp. (CIC) picked up a minority stake in Thames Water.

Cheung Kong Infrastructure (CKI) is also an active investor, with a portfolio that includes Northumbrian Water and a minority interest in Southern Water.

"UK water is a great barometer for what is going on across European core infrastructure," says Andrea Echberg, a partner at Pantheon. "There is a huge amount of interest from sovereign wealth funds, direct institutional investors and infrastructure funds and valuations are creeping up. Sumitomo reportedly paid 1.46x the regulated asset base for SESW, while the average is just 1.3x."

Put in context, UK water utilities have traded between 1.2x and 1.48x over the last decade, with the peak coming just before the global financial crisis and the trough just after it.

High entry prices

Escalating valuations aren't confined to the infrastructure space. According to a report released in May by valuation specialists American Appraisal, Asian buyers - principally those from China, Japan and India - paid an average of 9.9x EBITDA for European companies in 2012, up from 5.7x and 3.3x in the two previous years.

The assets in question range from food to technology, but infrastructure stands out due to deal size. If Asian investors, driven by strategic interest and a low cost of capital, have misjudged the risk and return profiles on their deals, it is airports, toll roads and utilities that will potentially see the biggest write-downs.

The fundamental desire for developed market infrastructure exposure is broadly the same for Asian investors: diversification and yield.

"These LPs' inherent concern is yield versus absolute returns foregone," says Vincent Ng, a partner at Atlantic-Pacific Capital who is currently marketing a European infrastructure fund in Asia. "The guys who need yield are typically the ones with a lot of asset liability matching considerations - insurance companies and pension funds, both of which need cash flow for distributions. Sovereigns are active because a lot of them are backed by national reserves that fund certain programs."

A desire for low risk and cash flow generation is also taking a growing number of investors into infrastructure debt, which ameliorates the J-curve effect on a portfolio, although equity remains more popular.

The appetite for diversification and yield is reflected in a survey of institutional investors by AMP Capital in the first quarter of 2013.

Asked how their allocations had changed during the three-month period, nearly half of respondents said they were deploying more capital in direct infrastructure deals. Asian respondents specifically expressed an interest in government bonds, mezzanine debt and listed and direct infrastructure holdings. The primary structural changes they expect to make in their portfolios involve asset and liability matching and expansion into new asset classes and markets.

Of the more mature LP markets, Australia, Japan and South Korea are generally cited as the most interested in infrastructure, with Singapore and Hong Kong trailing. Australia-headquartered AMP Capital opened a Hong Kong office last autumn with a view to broadening its investor base within the region, which is currently dominated by superannuation funds.

Kerry Ching, AMP's Asia managing director, adds Southeast Asia to the list of markets in which there is interest in infrastructure equity and debt as well as in listed vehicles, although the client base is still relatively small. Investors are also open to European exposure due to the perception that assets might be undervalued as a result of macroeconomic concerns.

However, a lack of familiarity with the asset class breeds conservatism. "Investors in Asia tend to assign more value to liquidity," Ching says. "Many groups we talk to, if they have any hesitation about real assets, it's whether they will be able trade their position and whether they would have to absorb a big discount. Demand does seem to be picking up, though, and you see there are global managers trying to develop capabilities and build their own teams."

Going solo

The question is how large can these teams become and does it mean the institution no longer has need of a third-party manager. Partners Group, for example, has infrastructure mandates ranging from EUR10 million ($13 million) to EUR900 million and those towards the upper end of the scale in Asia tend to be corporates and mid-size pension funds.

The region's sovereign wealth funds are treated as potential collaborators rather than clients, although industry sources note there are still younger players that require GP relationships to generate co-investment opportunities. Until about 18 months ago, CIC was still making allocations to infrastructure funds.

On the other hand, Government of Singapore Investment Corp. (GIC) has been active in the space for some years - and is ranked alongside the Canadian pension funds among the most sophisticated operators - while strategic investors such as CKI, Sumitomo also feature independently or as part of club deals.

"The guys who have been at it for a while are very good at what they do and have large in-house teams," says Kyle Mangini, global head of infrastructure at Industry Funds Management (IFM), a global asset manager owned by 30 Australian non-profit pension funds. "They are smart, have depth and can be fleet of foot. The sovereigns are still growing and as long as they are growing they will be active."

In addition to the diversification and yield imperatives that draw many LPs into infrastructure, the sovereigns' approach is influenced by the fact they have to deploy huge amounts of capital each year, so a fund program alone might not suffice.

Industry participants say that the combination of unbundling initiatives, strategic divestments by utilities, state-led privatizations and the general need for the infrastructure base to be refreshed means there should be sufficient opportunities in Europe. In the core space alone, gas, electricity and oil assets have gone on the market in addition to water and wastewater services, and transportation assets, notably airports in the last couple of years.

The EU estimates that infrastructure investment requirements in member countries across the transport, energy and digital broadband sectors total EUR2 trillion over the next decade. Private investors should also be able to capitalize on a post-global financial crisis sea change in the financing market, now the commercial debt that once underpinned much of project finance has become harder to obtain.

Brandon Prater, managing director for private infrastructure at private markets investment manager Partners Group, argues that for investors from nations such as China there is a legitimacy factor to investing in European infrastructure. The asset class is perceived as extra safe - an investment-grade bond - and a desirable counterbalance to the economic swings in Asia.

Having said that, he is concerned that prices are being bid up so much that they no longer reflect the risk that still resides in the businesses.

"These are great assets and UK water is probably the most transparently regulated space you can find in infrastructure, and that is why people pay extremely high prices to get into it," he explains. "But there is always a risk of changing regulation. OFWAT [the UK water regulator] has been clearly guiding the market that it will take a more conservative view on regulated returns in the next determination."

The extreme example of this lies in Norway, where institutional investors pumped billions into the country's pipelines only for the government to announce that it would cut tariffs on gas transport for new contracts - in some cases by 98%. The investors' return expectations were rendered meaningless.

The scenario for UK water is less dramatic, but it could still eat into revenues. It involves OFWAT not only reducing returns as entry multiples get higher, but also changing its approach to oversight to focus more on quality of service and payment for performance. This approach could be mirrored in other utilities.

A sovereign wealth fund, for example, that pays a 40% premium on the regulated asset base and targets an 8% base case IRR could see a 1% cut in the regulated return reduce the IRR to 4%.

"There is political risk, a regulatory and tariff risk, and a taxation risk as well," adds Pantheon's Echberg. "Given the environment that a lot of these European governments find themselves in - they are looking to find ways to save money or increase revenues - these infrastructure assets are to a degree vulnerable."

Spanish solar have also been hit by retroactive tariff cuts and additional taxes.

Mitigating risk

Two broad strategies exist for addressing these kinds of risks. First, be comfortable with different regulatory regimes within Europe and price appropriate levels of risk-adjusted return in case the investment deteriorates. Late last year Portuguese airport operator ANA was privatized as part of the country's bailout agreement with the EU and IMF, and IFM participated in the bidding.

The asset went to France's Vinci but IFM spent a significant amount of time understanding the Portuguese market - the legal system, access to local debt, changes taking place in the industry and various potential macro situations. This included mapping out what would happen if Portugal left the euro and there was a substantial devaluation in the domestic currency. It concluded that airport assets might actually benefit from such a development because Portugal would become cheaper and more attractive as a tourist destination.

"Any market we go into we need to be comfortable that the rule of law will be applied," adds IFM's Mangini. "If you put $1 billion on the ground, you can't pick it up and move it. So our first question is: ‘Can we enforce a contract?' Then we ask: ‘How is the industry regulated?' and ‘What is the country's regulatory history?' We like an established regulatory system where you can see consistency in terms of how assets are regulated."

Second, spread your risk. While core infrastructure is inherently appealing because it is stable and regulated, investors aren't compensated for overconcentration. Industry participants put forward numerous alternative approaches: social infrastructure developments in healthcare, niche and less niche energy strategies such as energy-from-waste and Northern European solar, and greenfield road projects in France and Italy.

There are even high hopes for conventional gas-fired power in the UK given that much of the existing coal-fired capacity is scheduled to be taken offline.

For those without the inclination to pursue these often smaller-scale opportunities on their own, the caveat is finding a capable manager. According to Preqin, 39 Europe-focused infrastructure funds raised a total of $29.6 billion in 2007-2008; over the following four years 53 vehicles attracted commitments of $20.9 billion. Activity has picked up in 2013, with $11.1 billion raised so far, but Macquarie's latest infrastructure offering accounts for nearly one third of this.

For many, performance has been patchy, particularly where capital was deployed speedily and without discipline in the years preceding the global financial crisis.

"There have been a few funds that have come through the first cycle of the European infrastructure (2005-08) without many problems in their portfolios," says Partners Group's Prater, "but a lot that did have problems and are having trouble fundraising their successor funds."

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• Topics
• Infrastructure
• Infrastructure
• Infrastructure
• Europe
• Asia
• Europe
• Infrastructure
• Sovereign wealth fund
• CIC
• Japan
• China
• Industry Funds Management
• AMP Capital Investors
• Partners Group
• Pantheon