Higher than the sun

When the I-35W bridge spanning the Mississippi River at Minneapolis collapsed last August, it provided a wake-up call about the dire state of the US roads network. Surprisingly, however the disaster – in which 13 people died and 100 were injured – did little to open Americans’ eyes to the merits of private sector funding of formerly state-owned assets. A US$234m replacement bridge, due to open this December, is being funded using conventional public procurement.

The US falls well behind other developed economies such as Canada, UK, France, Spain, Australia and New Zealand in terms of allowing the private sector to invest in its infrastructure. These countries started going down this route in the 1960s to 1980s and have in recent years experienced a boom in private sector investment in vital infrastructure projects, enabling both domestic investors and their public sectors to build up a wealth of expertise. Yet in America – despite its image as the powerhouse of global capitalism and pioneer of many recent financial innovations – this sort of thing remains largely off the radar screen.

There are two reasons for this laggardliness. The first is that the enormous municipal bond market in the US – on which the interest is tax-free – gives municipalities little incentive to enter public/private partnership deals. The second is that political opposition to the idea that municipal assets should be privately owned remains surprisingly strong in the US. For example a new toll road in Texas being developed by Cintra, majority-owned by Spain’s Grupo Ferrovial, has prompted howls of outrage.

But the US will, sooner or later, overcome its antipathy for infrastructure investment by anyone other than government. Already, pioneering toll road investors such as Cintra, Sydney-based Macquarie, Melbourne-based Transurban and Barcelona-based Abertis are putting some of the building blocks in place.

“North America is pregnant with opportunity. The US interstate road network was mainly built in the 1950s and has been allowed to deteriorate. The country is unusual in that, even though all their airlines are 100% private, their airports are owned by municipal authorities,” says Stephen Vineberg, who in January started as managing director of infrastructure at CVC Capital Partners, having previously carried out a similar role at Colonial First State. “I am a firm believer in the Hegelian dialect. There is a pool of capital available to fund these opportunities and there is a demonstrable requirement to invest in infrastructure.”

Vineberg draws parallels with Jonathan Swift’s character Gulliver. Currently, the shipwrecked giant is tied down, and the Lilliputians have constrained him with tax-exempt municipal bonds, government bonds and local politics. “One of these days, Gulliver is going to break free,” says Vineberg.

Even without full-blooded US participation, infrastructure has come of age as an asset class in the past couple of years.

There is plenty of scope to participate in economic and social infrastructure projects in more welcoming markets such as the UK, Canada, most of Continental Europe, parts of Asia and Australasia. And while not totally unscathed by the financial market turmoil in recent months, the area has been a comparative oasis, riding out the storms and squalls better than many other areas of investment.

Private Equity Intelligence estimates that €19bn was earmarked by global investors for investment in the asset class during 2007, almost double the amount raised in 2006. Globally, 48 infrastructure funds are looking to raise a further €31bn. Project Finance International puts the figures higher, saying that over the past 15 months 72 new infrastructure funds have been launched, and these are looking to raise more than €80bn.

“I think that in 10 years time infrastructure will be a bigger asset class than private equity,” predicts Michael Queen, managing partner and head of infrastructure investment at 3i.

Three forces have conspired to create the sweet-spot for the sector. The first is that institutional investors, particularly pension funds, have woken up to the merits of the asset class – and some regard it as a natural successor to commercial property and others seeing it as proxy for long-term bonds. They like the sector’s reliable cash flows, regulatory certitude and its value as an asset diversifier.

Because infrastructure assets tend to be either regulated monopolies or essential services with inelastic demand – people continue to become ill irrespective of where we are in the economic cycle – its cash flows are remarkably stable and are usually also inflation-proof through the cycle. The assets have a long life expectancy and can provide an inflation hedge thanks to their regulated charging structures. Taken together, these attributes make them a neat match for long-dated pension fund liabilities.

Secondly, the supply of debt to the sector appears to have been relatively unaffected by the credit crunch. “Access to debt financing to fund future transactions is likely to remain relatively open,” says Standard & Poor’s managing director of infrastructure Mike Wilkins, “as long as credit risks are in line with investors’ and lenders’ requirements and properly reflected in the pricing of infrastructure debt.”

The third trend is that governments increasingly recognise that, unless they start investing about 3.5% of GDP in their creaking infrastructures – including new roads, railways, ports, airports, energy transmission networks, energy utilities, schools, hospitals, government accommodation, water and wastewater – their economies could well grind to a halt. And, because most are running fiscal deficits, most accept the need for external funding.

Queen says that, after 20 years of neglecting their infrastructure, developed countries, particularly in Europe and the US, had little choice other than to take the bull by the horns. This is partly because the old-fashioned public procurement method rarely set aside sufficient funds for long-term maintenance.

And Queen says that emerging economies such as India and China are going to find it impossible to sustain their high rates of economic growth rates if they make heavy investment in their infrastructures. “A rough rule of thumb is that if GDP is growing 8% a year, then they need to spend about 8% of GDP on infrastructure.”

In January, Morgan Stanley predicted a whopping €15trn of infrastructure investment is needed in the emerging markets over the next decade. It said that urbanisation is creating demand for basic infrastructure such as power, electricity, water and transport. Morgan Stanley said 43% of the requirement is in China, with 13% needed in India.

Separately, India’s central bank has identified “infrastructure bottlenecks” as the biggest constraint on the Subcontinent’s economic growth and recently launched an investment vehicle in London that will use US$5bn of foreign exchange reserves as a contribution towards a major €335bn investment plan over the next five years in roads, railways and airports. This galvanized several players including 3i, GE and local bank ICICI to launch Indian infrastructure funds of their own.

Among recent fund raisings targeting developed markets, Washington DC-based Carlyle closed its first infrastructure fund last November, raising US$1.2bn in 18 months. London-based CVC Capital Partners has poached the Australian-born Stephen Vineberg from Colonial First State as its first managing director of infrastructure and has announced plans to raise a dedicated infrastructure fund, the group’s first to specifically target infrastructure investment.

“We’re looking to raise a €2bn fund, focusing on Europe,” says Vineberg. “We’ll get out into the market in the second quarter and I am optimistic we will have raised this by the end of the year.” He will be tapping pension funds, endowments, insurers and sovereign wealth funds and expects that some of the commitments might previously have been in real estate. The fund will look at investing across Western Europe and might also look at opportunities in Turkey and Czech Republic.

“We intend it to be a value-added style fund with a higher return profile,” says Vineburg. He believes that defining factors in superior performance will include the selection of assets – he calls it “buying well” – highlighting the importance of CVC’s European network of offices is unearthing opportunities ahead of privatisations and asset sales. Post-purchase he highlights the importance of stewardship and stakeholder management. “This is one of the skill sets that successful infrastructure investors need to have. Buying assets is important but how you look after them is even more important”.

Yet infrastructure remains a relatively immature asset class and there is still much debate about what sort of vehicles are most appropriate for investing in it. Michael Queen is critical of some of the closed-end funds seen in the sector with limited shelf-lives and which incorporate carried interest type management fees. He says: “Our fundamental belief is that the GP/LP model is totally inappropriate for investing in infrastructure. Infrastructure assets typically have a life of 10 years or more, however private equity type funds are working to a shorter time horizon, and tend to want to flip their asset within three to five years.”

For developed markets his preference is for fully transparent, listed vehicles such as investment trusts – indeed 3i Infrastructure was the UK’s second largest investment trust launch of 2007. “A listed vehicle has the advantage of providing you with perpetual capital and the ability to hold assets for 25 or 30 years. There is no need to flip the assets or to liquidate the fund. Also the political sensitivity of PPP deals is far greater than for private equity deals. This is another reason why listed vehicles – with their greater transparency – are the right way to go.”

Queen at 3i stresses that listed vehicles are common in Australia, the world’s most developed infrastructure market. Macquarie Group runs 11 listed vehicles including Macquarie Airports and Macquarie Infrastructure Group. Most are listed on the Australian Securities Exchange but others are listed in London, New York, Toronto, Seoul and Singapore. Rival firm Babcock & Brown has four funds listed on the ASX and one London-listed fund.

However Queen acknowledges that LP/GP structures may be appropriate for emerging markets such as India where the returns from infrastructure funds can reach private equity levels and where there is more chance that individual projects can be floated on the local stock market.

Not everyone shares Queen’s views, however. CVC’s Vineberg says: “Listed vehicles provide permanent capital, transparency, accessibility for retail investors, and the ability to sell to other institutional investors when you want to. But the flipside of listed companies is that they bring exposure to the fluctuations of the stock market. Our investors would rather invest in unlisted funds as they take out that market volatility”.

“As with Henry Ford, it used to be you could have any type of infrastructure fund as long as it was black. But now the market has fragmented into a kaleidoscope of different types of funds. That matches where investors are coming from. So there are low-risk, annuity-style funds, which suit defined-benefit pension schemes seeking liability immunisers. These sorts of funds are unlikely to invest in emerging market deals. There are also funds offering a proxy for property and other specialised vehicles aiming to achieve higher risk-adjusted returns.”

Are fees justified?

Alarm bells have also been sounded by some investors about the fee structures on certain infrastructure funds. At the London Terrapinn conference last October, one speaker claimed that some infrastructure funds were charging private equity type fees for running wind farms. He asked: “On what grounds? Could they make the wind blow harder?”

Jane Welsh, senior investment consultant at Watson Wyatt, says fees for some funds mirror private equity levels: a management fee of 1% to 2% and a performance fee of 10% to 20%, which usually kicks in should annual returns exceed an IRR of 8% to 12%. Welsh says: “That does seem high, given that there should be less work involved than in private equity.”

Paul Woodbury, co-head of infrastructure at Henderson Equity Partners, says: “There is some validity in what she’s saying – particularly where low-risk funds are concerned.” He believes that some bank-style funds have “muddied the picture” for other managers because of their low charging structures. They can charge low fees on infrastructure equity funds, making up for it with charges on transactions and debt.

Another area of concern is that the wall of money coming into the infrastructure sector is causing asset prices to lose touch with reality. For some time, rating agency Standard & Poor’s has been warning of a dot.com-style bubble in the infrastructure market, due to excessive leverage and overvaluations, and exacerbated by a shortage of mature assets in which to invest. The warnings reached a crescendo when London City Airport was sold for €750m in November 2006 to Global Infrastructure Partners (a joint venture between GE and Credit Suisse) and AIG, and when Macquarie paid £8bn for Thames Water in October 2006.

CVC’s Vineberg accepts that bubbles emerge whenever an asset becomes available and its ticket size is accessible to a broad spectrum of infrastructure investment players. “It is probably fair to say that, in some parts of the market, there is too much money chasing too few opportunities”. Some commentators have gone as far as saying that investors are having to make do with recycling past privatisations.

Vineberg stresses CVC’s new fund will steer clear of over-heated auctions such as recent ones of UK airports and water companies. “We will seek to avoid the risk of overpaying in hotly-contested tenders by steering clear of things on the front page of the FT,” says Vineburg.

Queen says another issue for the sector is a looming skills shortage. “There’s the lack of qualified people capable of assessing potential deals,” he says. 3i currently has 30 infrastructure executives based in London, Frankfurt, Mumbai and New York but Queen wants to double this within three years. When I spoke to him he was spending two days interviewing in New York. “Getting experienced individuals into the team is critical. Any decision they make can be very expensive if it goes wrong.”

So what are the long-term prospects for the sector? Vineberg says it is a hugely exciting time for infrastructure investing, which even now remains one of the Cinderellas of global finance, even though new horizons are opening up. “Infrastructure is where private equity was 10 years ago. There are still only about 100 groups directly involved in Europe. Institutional investors are still waking up to it. And North America is still waiting in the wings”. He believes the theme tune for the asset class should be that old favourite by The Carpenters: “We’ve only just begun”.