PE Takes To The Highway: Infrastructure Finding Its Place In Private Equity

“If you believe that, I’ve got a bridge to sell you.” — The saying has become a tired line reserved for the fiscally naïve.

Perhaps sensing a contrarian opportunity, though, private equity groups are increasingly eyeing assets such as bridges and roads. And as these classic infrastructure plays drum up private equity dollars, the idea that an investor may one day buy the Brooklyn Bridge, and make a killing in the process, could turn the classic con (and trite punchline) on its head.

A typical investment in infrastructure is not sexy. Infrastructure generally covers what used to be, and still usually are, public works projects, encompassing investments in pipelines, airports, gas distribution networks, power generation facilities and of course toll roads and bridges.

The investment in North East Waste Services (NEWS) by AIG Highstar Capital could be considered standard for the space. The company specializes in the transportation and disposal of non-hazardous municipal solid waste. It operates landfills, transfer stations and both long- and short-haul collection operations, all of which collectively handle roughly 10,000 tons of solid waste each day

Sexy it’s not, yet many first movers are running to gain exposure to these types of investments.

“There’s been a significant amount of involvement [in infrastructure] from the limited partners. They’re looking for a different return stream, one that has a lower variance… We’re also seeing a lot of interest in creating new [infrastructure] products from the GPs,” says Erik Hirsch, the chief investment officer at institutional advisor Hamilton Lane.

Teachers’ Private Capital, the alternative investment arm of the Ontario Teachers’ Pension Plan, has been among the active players in infrastructure the past few years. The system, which makes direct infrastructure investments, started building its platform from scratch about four years ago. The pension, today, has plugged almost $5 billion into infrastructure deals.

Recent converts include Goldman Sachs, which is reportedly raising a multi-billion infrastructure fund, and JPMorgan Asset Management, having recruited Mark Weisdorf to head its new infrastructure program. The Carlyle Group has also rolled out ambitious plans. In March, the firm announced the formation of its new infrastructure arm and is reported to be raising an accompanying $1 billion fund.

Teachers’ Private Capital Senior Vice President James Leech, speaking of the recent newcomers, says, “It’s become the taste of the day.”

The stimulus for the infrastructure blitz has been a polygynous marriage of multiple factors. On the GP side, first movers, such as MacQuarie Bank and AIG Highstar Capital have proven the investment model out, while on the institutional side, LPs such as Baylor University’s endowment and the Ontario Teachers’ Pension Plan, among many others, have set aside substantial allocations to the budding asset class.

Perhaps most important, though—at least in the U.S.—has been the recognition from elected officials that private funding can fill wide gaps created by municipal budget deficits.

If there has been a landmark infrastructure deal in the U.S., the privatization of The Chicago Skyway, an elevated toll road that snakes from Southern Chicago into Indiana, would serve as the breakthrough transaction. Sydney-based MacQuarie Bank and Cintra, a Spanish infrastructure investor, took over a 99-year lease of the highway, paying $1.8 billion for the right to run the road.

Chicago Mayor Richard Daley celebrated the deal as a coup for taxpayers, and since the Skyway sale, other states such as Indiana, New Jersey and Delaware have either privatized toll roads or debated doing so. Most recently, New York Governor George Pataki even proposed leasing out the Tappan Zee Bridge, which sits just miles north of its famed Brooklyn cousin.

It’s not just toll roads and river crossings. City, state and federal funding deficits are expected to increasingly turn to private sector funding for an expanding pot of public sector needs. According to reports, it’s estimated that domestic infrastructure projects could run upwards of $1.6 trillion in the next five years, a number that some consider too low. Even if just a fraction of the anticipated projects get private funding, it would represent a billowing pool of opportunity.

Moreover, many view the need for infrastructure improvements as urgent. Famed investment banker Felix Rohatyn, who currently chairs the Bi-partisan Commission on Public Infrastructure, told a crowd at New York’s 92nd Street Y this past month, “Whatever you don’t do today, you’re going to have to spend 50% more to do it tomorrow.”

And this is just the opportunity set in the U.S. Most domestic groups are also keen to look at areas outside of the country for infrastructure. In emerging markets, such as Asia and Latin America, many governments aren’t just desirous of private funding, they need it to build infrastructure projects necessary for further development. In the developed markets, meanwhile, the opportunity is less greenfield and resembles the restoration needs seen in the U.S.

Low, Not No Risk

The collective investor enthusiasm from all sides has been driven by the idea that infrastructure represents a lower risk strategy. There are inflation-protective characteristics that all investors like, and the monopolistic nature of the assets ensures that there is little threat of competition. Moreover, infrastructure is more capital intensive than most private equity investments and gives limited partners a place to park capital for an extended period of time.

Management of infrastructure assets on the GP side is also generally more cut and dry. There isn’t the risk of obsolescence that one might find in a typical technology or defense investment, and there’s no need to guess a bottom, as cyclicality is a non-issue.

“These are cash flow positive businesses,” AIG Highstar Managing Director Jim Timmins tells Buyouts. “And in many cases the revenue streams associated with these assets or businesses have no correlation to commodity prices or to the other markets.”

Another factor that has buyout shops keeping tabs is the nascency of the asset class. While the level of activity has certainly picked up, and auctions can grow feisty, the pricing of assets isn’t nearly as efficient as the “traditional” LBO environment.

“The multiples of what is considered a traditional buyout deal have escalated to levels that are priced to perfection,” Norwest Equity Partners Principal Dorian Faust describes. “When we’re looking down the barrel of paying over 8x EBITDA for a basic low-growth, cyclical business, it leaves us scratching our heads.”

For that reason Norwest has explored and cinched infrastructure deals that three years ago may have been overlooked. Two of Norwest’s three platform transactions from last year could be deposited into the infrastructure bucket. The firm, in April, paired off with strategic buyer The Broin Companies to invest in two Iowa ethanol plants, and in November, Norwest co-invested with J.F. Lehman & Co. to launch Hawaii Superferry (see sidebar below).

“These aren’t your traditional buyouts, but as we penciled through the math, we determined that the risk of entering into infrastructure can be offset by a potentially better payoff relative to today’s risk/reward of a typical buyout,” Faust says.

Despite its billing as low risk, many GPs will often downplay this when discussing infrastructure. The most common worry lies not in the threat that the public will stop using toll roads or that the natural gas pipelines will run dry, but more in a firm’s ability to successfully wade through the bureaucracy of government.

In one AIG Highstar deal, for example, the firm had to gain regulatory clearance from 17 different states. Regulatory hurdles have also proved to be dealbreakers. Texas Pacific Group and Kohlberg Kravis Roberts & Co., for instance, were each unable to gain the necessary clearance for separate proposed buyouts of regulated utilities.

Of course, it’s these regulatory hurdles that become barriers to entry once an investment closes.

As the traditional private equity market continues to mature, many expect infrastructure to provide another avenue for LPs and GPs alike. The transition can’t yet be described as a sea change, but investor sentiment is clearly turning.

“Ten years ago, infrastructure was kind of a dirty word in the institutional investor dictionary. The perception was that although these investments represented a lower risk profile they also had a corresponding lower return profile, and that didn’t sit well,” Timmins says.

As many fear the private equity market may be hitting its peak, lower risk appears to be sitting better today.