Unlisted infrastructure investments have traditionally been structured in line with the private equity fund model. A new model must be adapted to reflect institutional investors' requirements, writes Elliot Bradbrook
The majority of infrastructure investors are looking for a stable and predictable long-term return as well as a degree of portfolio diversification. However, as an asset class born out of the private equity mould, infrastructure (as a separate entity) remains at a crossroads. On the one hand, investors and appreciate the benefits of investing in infrastructure assets, but on the other, there is a tension between the long-term nature of these assets and the short-term focus of the private equity fund model.
As a result, industry professionals continue to debate the best way to access infrastructure opportunities and question the suitability of the private equity fund structure when applied to an asset class with a lower risk-return profile and a longer investment horizon.
A conservatively managed infrastructure portfolio presents a unique opportunity for institutional investors, such as pension funds, to satisfy their long-term liabilities. As shown in figure 1, the various types of pension plans account for 41% of the total number of infrastructure investors worldwide. Public pension plans are the most prominent type of infrastructure investor, representing 19% of the global total, while private sector pension plans account for 16%. Superannuation schemes account for a further 6% of infrastructure investors, many of which are based in Australia. Other significant investor types include insurance companies (8%), banks (7%) and asset managers (7%).
To satisfy these long-term liabilities, institutional investors rely on infrastructure assets to generate a steady and predictable yield over a number of years, usually as part of a lower risk strategy that is uncorrelated to market volatility. Private equity funds, however, usually pursue a more revenue-seeking, higher risk-return strategy with a far shorter holding period. Despite these inherent differences, infrastructure fund managers continue to follow the private equity model when raising infrastructure funds, with 82% of investors currently gaining their exposure through commitments to such vehicles; 8% invest through listed funds, and 31% consider direct investments in infrastructure assets.
Although interest in direct investment is growing, only a limited number of investors realistically have the resources and expertise to complete and handle these investments in-house. These investors tend to have significant assets under management and higher percentage target allocations. In reality, 64% of the current investor universe has under $10bn in total assets under management and 52% have less than 5% of total assets allocated to infrastructure opportunities. Most investors are therefore smaller in size and will continue to rely on third-party infrastructure fund managers.
These smaller players also tend to be the most inexperienced investors, hence the reliance on fund managers. They are still undecided as to where infrastructure fits within their investment portfolios and choose to make opportunistic investments through previously established allocations, rather than reserving capital specifically for infrastructure investment.
Of the current infrastructure investor universe, 28% still invests via a private equity allocation, while 14% invests via an allocation to real assets. A further 8% invest through a general alternatives allocation. Less than half (43%) of investors maintain a separate allocation dedicated to infrastructure, but these tend to be the larger and more experienced investors.
The fact that fund investments will continue to be the main route to market for investors in future suggests that a closer alignment of interest is needed between limited partners and general partners when investing in infrastructure. This alignment not only applies to the structuring of the fund but also to manager terms and conditions. Investors are now largely unwilling to buy into the traditional 2/20 private equity fee structure when investing in lower-risk infrastructure assets that are forecast to produce lower returns. However, the current market does not reflect this investor sentiment.
Figure 2 shows the management fee charged during the investment period for infrastructure funds currently raising capital and vintage 2010/2011 funds closed. Of these funds, 62% still follow the 2/20 structure, charging a management fee of 2%. More than a third (38%) of fund managers are beginning to adjust their fee structures by reducing the management fee charged according to investor demand, but more needs to be done to satisfy both parties.
The debate over fees can, in part, be attributed to the limited amount of data available to create meaningful performance benchmarks for the infrastructure industry due to the relative youth of the asset class. However, the performance of older infrastructure funds provides a good indication of what investors can expect from younger funds.
In comparison with other strategies, infrastructure funds have performed well, with the median net internal rate of return (IRR) for funds of vintages 1993-99 at a similar level to private equity (buyout and venture capital) and real estate. The standard deviation of net returns of infrastructure funds is also much less than these other strategies. This suggests that infrastructure funds are less risky than other strategies but are able to produce attractive returns for investors even when compared with asset classes that shoot for higher returns.
Although infrastructure is now widely regarded as a separate asset class, the industry is still structured according to private equity principles. As such, the characteristics attracting institutional investors to the asset class are being overshadowed, with infrastructure assets being applied to fit the pre-existing private equity fund model rather than the reverse.
Most infrastructure investors are looking for long-term exposure to a portfolio of lower-risk assets providing a steady income stream, which is the opposite of what is traditionally available through a 10-12 year private equity-style fund with a 2/20 fee structure. There is consequently a mismatch between why investors look for exposure to infrastructure assets and the current financing models being marketed by infrastructure fund managers.
To overcome these issues, the fund model must be adapted according to the characteristics of infrastructure assets, meaning longer fund lifecycles and a reduction in fees according to the level of risk exposure being targeted. Growth of the unlisted infrastructure industry is reliant on a resolution to these key issues and will require greater cooperation between investors and fund managers to improve alignment and increase the flow of capital to infrastructure assets in future.
Elliot Bradbrook is manager of infrastructure data at Preqin