Investors no longer want highly leveraged, private equity-style infrastructure products, and the market is slowly responding, writes Maha Khan Phillips

Dutch asset manager APG, in September, made its first ever inflation-related infrastructure loan, financing €80m of debt behind the reconstruction of a road. “This is the first time that a Dutch pension fund has provided debt financing for infrastructure,” says Harmen Geers, an APG spokesman. “It is also the first time that the Dutch government, although indirectly, has been involved in a financing situation where the compensation is inflation linked.”

The deal was put together by APG’s alternative inflation team, rather than its infrastructure division. But it is indicative of a growing trend. After highly leveraged funds got into difficulties during the financial crisis, institutional investors are looking for new ways to access infrastructure exposure.

Infrastructure fundraising peaked in 2007, but struggled in the following two years, largely because of an over-valuation of assets, over-leveraging of companies, and because of liquidity concerns. Although the asset class is back on the rise, allocations by pension funds are below target, according to Preqin, the data provider. Pension plans investing in infrastructure have aggregated assets under management totalling $8.4trn (€6.48trn).

Across the whole of Preqin’s sample, these investors maintain an allocation to infrastructure amounting to 3.3% of total assets, and have an average target of 5% of allocation.

Part of the problem is that new funds are finding it difficult to raise capital, leaving fewer opportunities for investors. “A lot of people are reviewing their business models. There are a lot of managers who have a model and a good track record who are still able to raise money. But if you are struggling to raise capital, you are going to have to do something differently,” says Michael Newell, partner in the London office of Norton Rose, the legal services firm.

Newell’s comments suggest that not all investors have found structures or opportunities that they are comfortable with, and it is easy to understand why. “A lot of investors geared up assets to what was, in retrospect, high levels,” says Toby Buscombe, a principal in Mercer’s Alternative Boutique. “We saw a number of investors bidding more aggressively for things and prices going up, with return levels falling. Then the tide went back out again, credit availability significantly reduced, the global financial crisis came in. Post-Lehman, the world found out which infrastructure funds were genuinely stable and which were more exposed. Infrastructure, which was heavily geared, was punished.”

Buscombe says investors are now going back to basics. “They are looking at assets that have a genuine monopoly position, predictable earning streams, with typically hard asset backing sitting behind them. Investors are more cautious about the level of leverage and we are seeing a smarter, more educated type of investor in the market.”

And managers, it seems, are beginning to pay attention. Martin Lennon, head of Infracapital, points out that his firm does not employ leverage at the fund level. “Funds that used leverage in this way to seek to grasp additional returns were largely found out in the recent crisis. Some investors may have tolerated that before, but now they are wise to the risks of such strategies, and I would be very surprised to see significant amounts of institutional money allocated to such debt laden strategies again.”

A more direct approach
Debt-laden or not, most investors prefer to make direct allocations, if they can afford it. “Investors are trying to emulate what the Canadians do and the big Dutch pension funds and one or two Nordic funds do and go direct and develop in-house resources. But it is only an option for some of the big funds,” says Georg Inderst, an independent consultant.

For less experienced pension funds, the solutions are not as simple. According to Preqin, funds invest via general alternatives, private equity, opportunistic and/or real estate allocation. The more experienced created separate infrastructure-specific allocations: 44% of active pension fund investors in infrastructure maintain a separate infrastructure allocation, while 19% invest via a private equity allocation, 15% via a general alternatives allocation, 13% via a real assets allocation, and a further 3% through an opportunistic portfolio. Buscombe suggests that having infrastructure sit in a wider alternative portfolio is one of the obstacles to the asset class’s growth.

The vast majority of pension funds invest in infrastructure by making commitments to third-party unlisted infrastructure funds: 96% actively invest in unlisted vehicles, while 19% make direct investments. Just 9% target listed infrastructure funds, according to Preqin.

All this is changing. For one thing, investors are no longer comfortable with private equity-type fund structures. “Traditionally, infrastructure was very much a private equity style product. To the extent that a lot of institutions will invest in a fund, they are looking for something that is long-term income-driven rather than capital return-driven as it was in the past,” says Newell.

Concerns about duration
Investors also want managers to deal with their concerns about duration, says Luba Nikulina, global head of private markets research for Towers Watson. In the past, investors would accept a private equity model where they would commit their capital, where managers would take an average of five years to invest, and then would start to look for opportunities to sell those assets because they had to generate returns and performance fees.  Now, investors want longer lasting deals.

“This is very short-term for investors because they are thinking about much longer-term exposure to the assets,” Nikulina says. “There is no sense having an early exit when they can stay invested and get the cash yield. How do you overcome the duration issue? Investors want either a much longer-life, closed-ended vehicle with some mechanisms for [them], or they want open-ended structures where it is documented from the start that, if they find a buyer for their stake, they should be able to exit whenever the need arises, but that nobody can force them to exit.”

Investors are also negotiating on fee structures. “The vast majority are looking for lower volatility and lower risk, and lower returning investments can only support lower fee structures, which are more aligned with the level of expected returns,” says Peter Hofbauer, head of infrastructure at Hermes GPE. While fees were typical of private equity structures of “two and 20”, infrastructure funds promised high returns in exchange.

Now, says Hofbauer, if there is one set fee structure that is prevalent, it would be “one and 10”. “We believe that fees should be aligned with returns. The lower the volatility and return, the lower the fee, whereas on more complexity add and alpha seeking returns a higher fee is more appropriate,” he says.

Managers say that investors can use co-investment structures as a way of maintaining control of many of these issues. In an opinion paper, Mercer’s Buscombe points out that larger pension schemes in Australia have eschewed pooled funds in favour of direct investment club structures.

These involve “a consortia of like-minded pension scheme investors” who come together to buy the assets outright or make significant direct investments. “Such structures have afforded more control to investors over investment portfolio composition – and on-going investment management – than could be achieved via a pooled fund structure.” It also allows costs to be spread between all parties.  

Hermes GPE has invested in 197 funds and approximately 47 co-investments globally, with assets of £4.2bn. Hofbauer says the firm’s co-investment approach benefits everyone. “We recognise that different institutions will have the ability to participate in different ways, but in our view there are very real benefits from being in the wholesale rather than retail [part of the business] where you do have significant capacity to co-invest. We have greater governance, and greater capacity to look at investments and make sure they comply with client aspirations.”

Hofbauer points to the firm’s relationship with large pension funds. “These organisations clearly have the capacity to be co-investors. Separately, we have a range of smaller clients. What we have done is established a pooled investment vehicle that sits side by side with our larger client in terms of the co-investment, so they are getting the buying power and market positioning that they otherwise might not be able to obtain,” he says.

Debt and other emerging strategies
Managers are also becoming specialists. “There are more targeted funds now, who say we just focus on core infrastructure, not opportunistic sectors, or that we just focus on renewable sectors, and so on,” says Annabel Wiscarson, executive director, business development for Europe, for Industry Funds Management (IFM). The $35bn fund manager is owned by 32 major Australian superannuation funds.

One of these specialist areas is debt. In September, IFM appointed David Cooper as a director of debt investments, to lead the expansion of its infrastructure debt capability in the UK and Europe. It followed on from Allianz Global Investors’ announcement in July that it would also offer clients infrastructure debt investments. Allianz poached a team from Trifinium Advisors, led by Debora Zurkow, to spearhead the operation.

“For investment managers to effectively fill the funding gap created by the retreat of banks from this area of investment, it is critical to have deep expertise in the field of infrastructure debt and the risk profiles of different projects,” says Andreas Utermann, global CIO.

Fund managers are collectively aiming to raise $10bn in unlisted infrastructure debt funds this year, according to Preqin. In May Aviva Investors Hadrian Capital Fund 1 announced its first close, while AMP Capital raised €400m from a range of international investors for its fund.

“Debt is a very interesting area. Banks have less risk appetite and there is a big opportunity for pension funds to fill the gap in the debt area. We have a global infrastructure debt fund and we’ve been very successful in that first launch. Now we’re launching our second fund, so clearly there is plenty of opportunity,” says Boe Pahari, head of infrastructure in Europe for AMP Capital.

Last year saw the highest aggregate capital raised in infrastructure debt, although 2012 is lagging behind. “Debt is still a very small market, and there are very few funds out there,” explains Inderst.

Other areas, like renewable energy and utilities, are also proving popular. Investors are still looking to beef up allocations to infrastructure, but available opportunities, liquidity constraints, fatigue with the private equity model, and the fact that infrastructure is often part of a wider alternatives allocation all play a part in creating challenges, according to Buscombe. However, he is optimistic about the future.

“It is important for investors and analysts in this market in particular to remind themselves that there is a longer investment story out there,” he says. “Things did get choppy and a bit racy over that three-year period in the lay up to the financial crisis, but over the longer term the industry has really developed. We are seeing a lot more investment products coming through that are tightly focused on sectors, and a lot more focus is built into fund offerings. So ultimately investors have a lot more confidence about where their money will be invested and where on the risk spectrum they’ll be. There are still core plus higher risk funds out there, but managers are being honest about what they are targeting.”