Fund structure for infrastructure

And with some less than optimal results from prior infrastructure investing in the West to learn from, there are lessons to be learned about fund structure to avoid some of these pitfalls. Infrastructure, uniquely offers a means of getting better asset allocation from institutions to meet the liabilities of any long-term plan. Not surprisingly, the original models emerged in the West.

Roots of the model

John Campbell, the senior partner at UK-based Campbell-Lutyens, told AVCJ that decades ago the traditional diversification for institutions looking to move away from equities and fixed-interest bonds was real estate, with its intrinsic inflation protection characteristics and long-term predictable contracts like 21-25-year leases.

“That’s no longer true in real estate. With very few exceptions, the sector is now about short-term  less predictable lease income,” those he says. But infrastructure rose to replace it, offering regulated and contractually-bound predictable income flows, and not just for 20-25 years but for 30-60 years, and even longer.

“That amounted to an extraordinary opportunity for sophisticated institutions with the ability to play involvement in this asset class in a differentiated way – a chance to really build diversification and reduce correlation within their portfolios,” Campbell contends.

Major investors in the asset class, such as Canada Pension Plan Investment Board (CPPIB), Ontario Teachers’ Pension Plan (OTPP), The California Public Employees’ Retirement System (CalPERS), APG in Holland, and the Government of Singapore Investment Corporation (GIC) to an extent, are readily able to build teams and invest directly or define special allocations within funds to do deals they aren’t able to do themselves.

The fly in the ointment

Most of institutions have not had this option and have instead invested through co-mingled funds. This is where the problems emerged.

“The tragedy of the infrastructure sector’s development [in the West] is that the people who set up the first and second generations of infrastructure funds tended – with some honorable exceptions – to adopt a private equity model. They said to themselves, if we base our strategy on the capital gain-focused model of private equity, then in principle we can charge 2-and-20 of capital gain back to the first dollar of profitability, whereas if we base our model on long-term bond investing, we might be able to charge 20-40 or 50 basis points per annum for the service. So it’s obvious how they chose to operate, with 200 basis points or so per annum and 20% of all the gain [which might add up to another 200 basis points] over a fund lifespan of 10-12 years: a private equity look-alike.”

The “tragic” part, Campbell notes, was that this could, over the short term, be achieved. Institutional aspirations became focused on rates of return which were not appropriate in relation to the underlying assets. The returns realized in those early days came principally from the re-rating of the value of long-term streams of predictable income, which could be  translated into short-term high levels of capital gain. So, he says, if you were buying assets at, say, 13-14% for 35 years, and they were re-rated to 8-10%, you could with leverage create very significant rates of return, IRRs in excess of 20%, though only for a short period of time. But it was then possible to charge 2-and-20 back to the first dollar of profitability, delivering gross 20-25% and net 12-15%.

“Everybody was initially happy with this,” Campbell recalls. “The problem, though, was that after the first generation of funds, the asset agglomerators moved into the centre of the sector and it became impossible to continue producing those returns on what I would call conventional core infrastructure assets, because the re-rating had taken place. Many institutional investors failed to recognize that the game was changing; and the GPs didn’t go out of their way to point that out to them. So, in an era where the yield shift had taken place, and in a changed market environment when there was no longer the opportunity to re-finance assets and pile more debt ionto them – which should have been priced into the risk that was being taken, and therefore the rewards, though people often forgot to take these into account – the sector was predictably heading towards a traffic accident.” But Campbell believes there is a prescription to cure past ills.

In the futures institutions that are able to invest in infrastructure for the long term should organize co-mingled vehicles in which GPs offer their services, not on a 2-and-20 basis, but on an appropriate annual management fee basis. This should not create significant profit for the GP, he postulates. Rather, GPs should operate on low managment fees in most cases.

Similarly, the carry should not go back to the first unit of profitability, but should be based upon either a real rate of return, say 5% above the government bond rate.

The Asian difference

In Asia, Hong Kong-based Philip Jackson, who heads JPMorgan’s regional infrastructure team, says it is a completely different game. He points out that while the vast majority of private infrastructure capital to date has been targeted at the OECD, this is mostly a dividend yield story.

His firm’s version of this, the JPMorgan IIF Fund, is open-ended because the intent is to buy and hold forever. “But in an emerging market environment, such as ours in Asia, we think it’s more appropriate to look at the capital appreciation story, meaning putting capital in at a stage where the infrastructure is being built. This [translates into] a closed-end fund structure,” he tells AVCJ.

Under this umbrella there are different strategies, some more ideal than others. The riskiest is to essentially target greenfield opportunities, implying development risk, construction risk and early year ramp-up risk. For Jackson, this is not normally a preferred approach.

A second route is looking to buy privatized, existing assets, as in Australia and Europe. JPMorgan leans more toward this strategy in developed markets.

The challenge in going this way in an Asian context is that there are relatively few opportunities on offer where existing assets are being offered on a trade sale as opposed to an IPO. On those occasions where they do happen, an IPO can have a marked effect on the purchase price.

The private equity angle

Jackson hasn’t seen many governments looking to sell infrastructure via trade sales, though he believes this may develop. “If you’re selling something that is publicly owned to a single buyer, it can be quite controversial from a political point of view,” he cautions.

In taking a private equity approach to infrastructure opportunities in Asia, one way to invest is to operate in partnership with the target investees in taking a part, but not 100%, interest in their existing company. Such a comany may be adding new assets to an existing porfolio, “but they don’t have all their eggs in one basket,” he explains.

In this context, “[JPMorgan] takes a private equity partnership growth capital approach, as opposed to a buyout strategy. We always want to have a local partner next to us,” Jackson tells AVCJ.

Additional considerations include focusing on sustainability – in every sense. “We believe it’s necessary to focus on building things that the community needs at a price they can sensibly afford,” Jackson says. “If you build something that represents value for money that the local community wants, it’s going to get used and therefore be appreciated.”

Alternatively, he also sees room for more passive investors who “want to come to somebody else’s party.”

Risks and returns – right now

Because it is comparatively early days for the Asian infrastructure space, the risks are naturally greater. Comments John Campbell, “Generally you cannot rely to the same extent … on contracted flows of income. Yes, in India there is a rule of law. You can go through the courts to enforce your contract. But it takes a long time to get legal satisfaction. And in China, people question whether you can consider going to the courts; that you’ve got to rely on other methods to ensure that people you’ve entered into a contract with are really going to deliver.”

He believes that there is naturally less confidence in the consistency of regulation, but that regulators will behave in a predictable and fair way in many countries.

“The typical infrastructure investment that we’ve seen by institutions so far has tended to be in providing the tools for the mine workers, so to speak, rather than in just holding the long-term infrastructure assets themselves. So it’s about working out who the people are providing services to the infrastructure, whether it’s contractors or facilities managers or crane operators... That’s been by way of a proxy.”

Rob Petty, co-founding partner with Clearwater Capital Partners, who are indirect infrastructure investors, cites another risk. Noting that infrastructure funds are probably the longest funds outstanding in the markets today, he told AVCJ, “I’m not sure that people have really seen the full maturation cycle of 15-year infrastructure funds [in Asia]. But I do think the return profile for infrastructure funds when first committed to, is lower than a typical private equity fund – though obviously with that duration the multiples can still be pretty interesting.

“I also think it’s clear that the greater infrastructure industry is an enormous asset class. And I would say that, if you think about everything that is related to infrastructure, many – ourselves included – are involved in businesses that are components of an infrastructure transaction… Classic private equity funds will definitely be involved.” 

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