Last year there was a marked rise in secondary trading of infrastructure fund units. Christopher O’Dea asks whether the market will get even bigger
It has been seven years since the global financial crisis. A sharp increase in infrastructure secondary market activity in 2014 suggests this is how long it takes for infrastructure fund investors to become sufficiently dissatisfied to exit close-ended vehicles.
Secondary transactions involving infrastructure fund units increased by 177% in 2014 over 2013, to $1.9bn (€1.7bn), according to the 2014 Volume Report compiled by Setter Capital. While this is a small share compared with the private equity interests that dominate the secondary market, the 2014 increase brought infrastructure funds rapidly into the same frame as real estate, which saw a 32% increase in secondary volume to $6.8bn.
It is not entirely surprising, given the increased appetite for infrastructure among pension funds. But infrastructure projects carry new risks, often stemming from operational or technological factors – and, like any newly popular asset, a high entry price can detract from financial performance.
The impact of those risks is fuelling the nascent secondary market. Two key features stand out: the source and likely supply of secondary fund units by vintage year, and the supply of units based on the underlying type of asset.
“This is a newer asset class, compared to the secondary market for real estate or private equity interests,” says Marc Meier, a vice-president in the private infrastructure team at Partners Group. “It’s fair to say we see the market getting more mature and there is certainly growing interest in the asset class.”
The result of interest in secondaries is predictable. “There is an effect on pricing and valuation,” Meier says. With infrastructure in general being a top priority for yield-seeking pension fund investors, “most sellers have pretty high pricing expectations, especially compared to four years ago. Most offerings tend to be pretty fully priced.”
Partners Group generally avoids participating in the broad bidding processes through which many secondary investments are marketed. During 2014, Meier says, none of its secondary investments came from a full auction; instead they were derived from limited bidding by one or two other parties or on an exclusive basis.
Lofty price objectives for secondary units being sold today are the result of the land-rush mentality that characterised the first wave of investment in infrastructure, according to the head of the secondary unit at one major investment firm. Investors simply overpaid, in the belief that their assumptions about returns would prove correct, he added. Some investors simply “had to have it” when infrastructure funds started being marketed in meaningful volumes. Others over-leveraged to make financial projections work, while in other cases assumptions about key factors turned out to be incorrect, such as over-optimistic traffic forecasts for some toll-road projects. “A lot of money went into things that didn’t work out,” he says. But in fairness, he adds, “in 2006 and 2007, people were fairly optimistic about everything”.
This has created a significant opportunity for institutions to enter the infrastructure market today, or for those aiming to tailor their holdings. Much of the secondary interests are from funds with vintage years between 2006 and 2009 – Preqin says the reported value of infrastructure assets in those vintages is $82bn, providing a significant potential supply of secondary-market volume. And most of that supply is seasoned assets containing properties that have passed their J-curve hurdles, the secondary unit head said. Those operating records enable secondary managers to accurately value the fund interests.
In terms of composition, the interests being offered are primarily from diversified infrastructure funds, so the underlying assets span encompass toll roads, ports and shipping, airports and power generation. Acquiring interests on a secondary basis enables institutions to buy proven, cash-flowing assets – the brownfield infrastructure in developed markets that investors prize. According to Preqin, high prices on established assets are one reason why institutional allocations to infrastructure remain below target levels.
Institutions can also access infrastructure secondaries on an aggregated basis. Pantheon, for example, has raised $1bn to invest in infrastructure funds on the secondary market. Highlighting demand for the asset class, the firm said the fund was oversubscribed and double the size of its 2009 offering. The new fund, which will also invest in new funds and co-investments with Pantheon’s network of general partners, drew interest from new geographic markets, with investors from Asia backing the fund, in addition to North American and European clients. As of March, Pantheon said it had invested capital in seven transactions, worth 19% of the fund’s capital, and had three other transactions close to completion.
The growth in fund secondary trading alongside ‘primary’ infrastructure fund investments reflects the underlying infrastructure asset market, where investors have been steadily increasing demand for secondary projects to avoid as much of the pre-operating risk as possible. Preqin says 64% of total deals completed since 2008 have been in secondary-stage and operating brownfield projects. Some infrastructure funds now integrate secondary-market acquisitions in their investment remits, according to Preqin’s 2015 Global Infrastructure report.
Hermes GPE, for example, will invest in primary and secondary interests, as well as direct investments. Its new fund raised £704m (€980m) by January and is targeting £800m, which would make it the largest fund of funds in the capital-raising stage, according to Preqin. The €1bn Partners Group Global Infrastructure 2012 also opportunistically acquires fund stakes on the secondary market, Preqin says.
Even the largest infrastructure investors are seeking to buy assets with proven cash flow – and they can execute customised transactions beyond the reach of fund-based investment programmes. In March, Canada Pension Plan Investment Board (CPPIB) and Hermes Infrastructure agreed to invest approximately £1.6bn to acquire a stake of at least 30% in Associated British Ports (ABP) from Goldman Sachs’s GS Infrastructure Partners and Infracapital, a unit of M&G. A portfolio of 21 landlord ports in the UK, ABP’s business is underpinned by long-term contracts with a mix of blue-chip customers.
An active secondary market has also developed in bank project finance loans, as banks try to reduce balance sheets, says David Cooper, head of the EU debt business at infrastructure manager IFM Investors. “We see quite a lot,” he says. In a similar way to equity fund interests, loans acquired on a secondary basis are attached to seasoned assets and do not expose investors to construction risk, Cooper says. “Secondary loans can offer a better credit profile than deals that are in the market day one,” he says.
Market participants say infrastructure debt fund units are not ideally suited to secondary trading because many include hedging transactions that could be technically difficult to transfer to new ownerships. But Cooper expects the expansion of the infrastructure debt market to lead to a need for secondary trading of fund units. As of January, Preqin says, there were 31 unlisted debt funds seeking capital, targeting $22.7bn in total – a record in terms of the number of funds and the amount of capital sought by managers. “Large debt funds will create the need to give LPs a way to exit a fund and find liquidity,” says Cooper. “It’s inevitable.”
Although participants expect the infrastructure secondary market to grow quickly with the asset class itself, the key feature of the nascent market is reconciling sellers’ price objectives with current perceptions of the value of seasoned fund units. Meier sees sellers seeking to obtain “an optically good price”. These days, sellers are reluctant to accept prices at significant discounts from fund NAV, he says. Accounting conventions used to calculate fund NAVs can also play a role in secondary-market pricing, he says. Some funds may use cost-basis accounting to calculate their NAV, for example, so the price of a secondary-market offer for fund units can be close to NAV, but potentially represent a significant implied discount to the fair market value of the assets. Such factors place the onus on buyers to dig deeply into the economics of the underlying projects. “It only works if you can identify the recovery value on a bottom-up basis by looking at each transaction asset by asset,” Meier says.
While investors sort through the secondary-market offerings from funds raised about seven years ago, the next crop of potential secondary units is being sown by managers eager to satisfy pension funds’ hunger for the steady, defensive income streams that infrastructure can provide. The ongoing robust increase in infrastructure assets under management will ensure a supply of secondary units.