Is private equity still relevant? Or is it all about infrastructure now?
Private equity capital flows have been high, returns are cresting, leverage levels are falling, and the cost of debt is rising. These conditions are forcing private equity sellers to revisit pricing expectations; many wonder if the returns of the recent past are gone for good. To be sure, private equity funds will remain staples of asset allocation models in the future given their long, demonstrable history of performance; but investors are asking hard questions about infrastructure. Investors have voted with their pocketbooks, as 183 U.S.-based private equity funds closed on $196 billion in commitments in the last twelve months. Infrastructure is gaining ground with 19 funds closing on $31 billion in commitments in the same period; upwards of 80 infrastructure related funds are currently in or coming to market soon.
Infrastructure is on the minds of many investment committees. Investors are wondering what their exposure to these hard (real) assets currently is and how it can be increased. Given concerns over inflationary pressures in part due to the economic rise of China and India, many investment committees are looking for an inflation hedge. Hard assets and infrastructure in particular are viewed as one potential inflation hedging tool for some institutional investment portfolios. This has left some private equity sponsors wondering to what extent infrastructure competes with them.
What is infrastructure?
Infrastructure encompasses investments and assets from a number of sectors. These include energy/power, water, transportation, communications, and social services. There are greenfield (early-stage), expansion (mid-stage) and brownfield (lates-stage) infrastructure investment strategies, similar to the risk spectrum spanning venture, growth capital and buyout deals. These strategies involve buying or building assets or companies in either regulated or unregulated markets. The risk profile of an infrastructure project changes as the asset matures. For instance, getting a new bridge permitted and constructed involves risk, revenues take time to grow; but cash flows become quite predictable and leverageable as an asset gains widespread usage. This allows for refinancing, higher leverage levels and dividend recapitalizations for investors.
Infrastructure also shares common characteristics with real estate investing, such as the involvement of physical assets and the need for large outlays of capital. Nowhere is the real estate analogy more evident than in the case of seaports, airports, toll-roads, and toll-bridges. The capital intensive nature of large-scale industrial and office real estate and the need for long-term (anchor) tenants is closely akin to the capital intensive nature of communications networks, power and fuel distribution systems, and assorted water distribution and waste treatment facilities. One type of infrastructure deal, greenfield projects, can be likened to development real estate, although there is a subtle but very meaningful difference. So-called “spec. building” in real estate does not translate well into infrastructure asset investing. Most if not all Greenfield projects to date have been undertaken with end users effectively contracted to take the service, including public entities. The contractual “take out” is more akin to a build-to-suit real estate development than to “spec. development.”
Risk Return Profiles
The core, core plus and opportunistic risk-return profiles used in conventional real estate investing provides a useful framework to map infrastructure investments. Figure A depicts the conceptual return continuum in three dimensional space. Core properties generally entail lower vacancies and therefore more stable cash flows to support debt service. Opportunistic investments frequently require major capital expenditure, repositioning, and operational improvements; as a result they require more “active” management and more risk. Core plus (value added) strategies fall in between. So too it is with infrastructure investments.
Mature infrastructure investments (typically brownfield assets) can be compared to core real estate investments. Core infrastructure assets are often viewed as a buy and hold investment. These assets possess long-term (up to 99 years) contracts providing the basis for stable cash flow. There is often little operational improvement or additional leverage that can be added to amplify returns. Some investors regard these investments as a proxy for fixed-income investments and may place them within that allocation; a subset of these investors view infrastructure as an inflation hedge due to price inelasticity of the asset allowing for unit pricing to be increased ahead of inflation.
By contrast, development-stage infrastructure projects (often greenfield projects) require much more active management, analogous to a real estate development project or an opportunistic property investment. Active infrastructure management includes operational improvements, rate structuring and refinancing. Often the greenfield stage infrastructure investor shoulders risk akin with financing land development. The focus of the project is securing entitlements (contractual concessions) and concluding site preparation, thereby reducing risk before bringing in additional outside investors or selling the project outright. For shouldering this risk, investors earn opportunistic returns.
In between core and opportunistic lies core plus or value-added strategies. According to Ross Israel at
The leverage levels differ between greenfield and brownfield (mature) infrastructure projects. Greenfield development projects that have not been stabilized can support limited debt service and thus have lower leverage levels (20%-40% loan-to-value, or LTV). Whereas mature infrastructure assets with stabilized cash flows can be leveraged up to 90% LTV between senior and mezzanine financing. Much like a highly leveraged buyout deal or office building, most of the attributable value for the equity holder in the core infrastructure transaction is derived from attractive acquisition pricing and from the leverage.
Return parameters generally match the core, core plus (value added) and opportunistic strategies in real estate. Core infrastructure can produce 9 percent to 12 percent gross IRRs at the project level. Core plus infrastructure can produce 12 percent to 15 percent gross IRRs, while opportunistic infrastructure can produce 15 percent to 25 percent IRRs. Note: these are general parameters and vary considerably by vintage year and by project sector. This then is a key departure from traditional private equity where returns hover in the 18 percent to 25 percent range. The vast majority of infrastructure deals fall into the core and value-added space and thus have a lower return profile than private equity transactions.
A second key distinction from private equity results from the fact that infrastructure assets exist in many cases as a regulatory concession and take time to mature. These concessions, however, can last up to 90 years, far longer than the typical private equity transaction. The early construction period is more analogous to real estate development than private equity. However the ability to increase prices over the life of the concession is the attractive inflation protection feature that appeals to investors. Equally, the predictability of the long-term concession is well suited to large public pension programs that have time-specific liabilities to which they are attempting to match assets of a similar duration. This liability-driven investing approach is gaining favor with some institutional investment programs.
As a result some U.S. public pensions are beginning to incorporate infrastructure into their longer-term asset allocation models. Here is where infrastructure may come into indirect conflict with private equity. The allocation pie is a zero sum dynamic; for allocations to increase to one area they must decrease in others. Historically, fixed-income allocations have fallen as alternative strategy allocations have risen, with private equity being a chief beneficiary. The question is, with the adoption of more inflation hedging strategies by some programs, will the rise in hard asset allocations (encompassing infrastructure, timber, etc…) pull allocation percentages away from fixed income? Or if private equity returns fall, will the allocation come out of the private equity bucket?
The more subtle but perhaps equally important source of competition at this level may be competition for the mindshare and bandwidth of the investment committee. At the end of the day, most institutional investment programs utilize a committee-based approach to approve commitments to long-term, closed-end fund vehicles. To the extent there are more of these vehicles to evaluate, there are more funds competing to get on the staff’s calendar for review and on the investment committee’s calendar for approval.
Investor adoption of infrastructure initially came from Australia and Canada, while European and Middle-Eastern investors followed over time. Fund sponsors have been marketing in the United States given recent high-profile U.S. transactions (e.g. Chicago Skyway). As U.S. private equity firms begin to reach abroad for institutional investor dollars and as foreign infrastructure funds market here, there may be a marginal pinch on allocation dollars.
A separate impact for some private equity fund sponsors could come in the form of deal competition. Depending on the metric used, nearly half of the “infrastructure” investments completed over the past ten years were in the energy sector. Many conventional private equity funds have been straying into the energy sector, drawn by the fundamental demand growth and supply constraints. It may be that groups that previously operated in distinct segments may begin to bump into each other on deals. This could have an impact on pricing as more sources of capital pursue the same transaction. Anecdotal reports for fund sponsors pursuing large brownfield transactions in the United States suggest that a rising number of players pursue an already limited amount of deal flow. This, in turn, is causing slowdowns to the intended pace of capital deployment for fund sponsors.
Clearly, private equity will remain a standard for mature institutional portfolios, but for many of the reasons discussed here, infrastructure/ real assets will increasingly be incorporated into the strategic planning for asset allocation in the future.
Bruce Pflaum is a Director of Real Assets & Private Equity at Sterling Stamos Capital Management LP. Excerpts from this article first appeared in Institutional Real Estate Letter in an article co-authored by Bruce Pflaum and Bob Moreland from BerchWood Partners.