Private equity's big stake in infrastructure

The original version of this article was published by unquote" sister publication InfraNews

Infrastructure and private equity have been close bedfellows ever since infrastructure emerged as a distinct asset class in the early 2000s. But that relationship has often been fraught with difficulties and controversies. So much so, that private-equity-style approaches to infrastructure investment were one of the main reasons why returns on so many early deals fell below expectations.

Because some high profile private-equity-style infrastructure deals have performed poorly, there has been a broader impact on the infrastructure asset class in general. For example, LPs have become more active in infrastructure, leading to lower fund management fees and more direct involvement in deal origination and asset management. This has meant that infrastructure fund managers have had to develop new products, investment strategies and relationships with their LPs.

As the appetite for infrastructure has increased, and new investment strategies have developed, interest in the asset class has also grown from traditional private equity firms. This reflects the increased diversity of investment options in the infrastructure asset class. But there are concerns that this development could also signal a return to certain failed investment strategies.

This trend of private equity firms investing more in infrastructure is exemplified by the recent announcement by private equity behemoth Blackstone that it is launching a $40bn infrastructure vehicle.

Public Investment Fund (PIF) of Saudi Arabia will contribute $20bn to the fund, with the remaining capital to be raised from other investors. Taking into account additional debt leverage, it is expected that the fund will invest up to $100bn in infrastructure projects, mainly in the US but it is likely to consider opportunities in other countries too.

It is also expected that the fund will invest in both greenfield and brownfield opportunities, and across a range of infrastructure sectors.

A vehicle of this size is unprecedented and marks a major acceleration in the growth of very large infrastructure funds. To put the Blackstone proposal into perspective, infrastructure stalwarts Global Infrastructure Partners (GIP) and Brookfield recently raised the biggest two funds in infrastructure to date: $15.8bn and $14bn respectively.

One of the advantages that a fund the size of Blackstone's will have, even over the likes of GIP and Brookfield, is the size of equity cheques it will be able to write. This will clearly have an effect on the market, perhaps with others seeking to emulate the Blackstone fund.

The new fund is not Blackstone's first foray into infrastructure. It has already invested $15bn of equity in 40 different infrastructure-related projects globally.

Growing footprint
While not on the same scale, other private equity firms are also reigniting their interest in infrastructure. The Carlyle Group is this year expecting to hold the first close of its second global infrastructure fund — the $2.5bn targeted Carlyle Global Infrastructure Opportunities 1. The fund is the group's first foray in infrastructure fundraising since raising a $1bn infrastructure vehicle a decade ago.

Apollo also has a growing footprint in infrastructure, but currently has no dedicated infrastructure fund. Instead it invests in infrastructure through a large number of different funds, including credit hedge funds, mezzanine funds, distressed debt funds, and private equity funds, which form part of its "integrated model". This, says Apollo, involves collaboration across all of its fund disciplines.

Earlier this year Blackrock acquired the $3.7bn First Reserve Energy Infrastructure Funds, the energy-focused private equity platform, from First Reserve.

After the financial crisis, we saw most of the infrastructure industry taking private equity risks. We thought we could do it differently. We had no interest in taking private equity risk on infrastructure investments. We already had a private equity business. Infrastructure is a different risk class, and, we believed, needed to be treated as such" – Raj Agrawal, KKR

Fortress Investment Group has invested around $20bn in transportation infrastructure since 2002. These include in Global Signal, RailAmerica, Florida East Coast Railroad, the Jefferson Terminal, the Central Maine and Quebec Railway, the Repauno and Hannibal ports, and Seacube.

Elsewhere, other private equity firms with dedicated infrastructure funds are continuing to expand their footprints. EQT held a final close on a €4bn fund this year - its third to date - which reportedly drew investor demand four times greater than its proposed €2.9bn target.

KKR is also reported to be planning a third infrastructure fund of around $5bn. And earlier this year, Finnish private equity firm CapMan announced that it would develop a new infrastructure business to invest in the mid-cap space.

Renewed interest
So why are so many private equity firms entering the infrastructure space? It is partly to do with other funds holding hugely successful fundraisings, and also related to LPs asking fund managers to invest in the space.

The success comes from funds that have their roots in both the infrastructure space, and others like KKR and EQT, which are more firmly rooted in private equity. Both of these fund managers have track records in infrastructure that stretch back nearly a decade.

Raj Agrawal, global co-head of KKR's infrastructure business, explains why his firm first entered the asset class and sheds some light on how private equity views infrastructure. "In the early 2000s, we saw very interesting investment opportunities, but we could not invest in them because they did not meet our existing private equity fund criteria."

These included regulated interstate natural gas pipelines, which Agrawal says would have fallen below the firm's target risk and returns but still represented a very attractive risk-adjusted investment.

Realising that they had turned down a good opportunity helped spur the firm's infrastructure effort; as did taking notice of the post-crisis investing environment.

"After the financial crisis, we saw most of the infrastructure industry taking private equity risks," says Agrawal. Ports and toll road businesses, for example, began to suffer due to traffic volatility and high leverage.

"We thought we could do it differently. We had no interest in taking private equity risk on infrastructure investments. We already had a private equity business. Infrastructure is a different risk class, and, we believed, needed to be treated as such."

There are other factors, according to EQT's Stefan Gleven. He points out that LPs want to invest in the asset class, and there is also a strong general push towards investing in alternatives. "There is inflation protection and long-term stable contracts," says Gleven.

"There is also an actual real hard asset as with real estate, so the business itself is not going to go away."

But interestingly, the growth of the infrastructure industry is itself having a multiplier effect. Capman's Villa Poukka explains: "There are a growing number of people who advise funds that are available to join private equity houses to work on infrastructure," he says.

This is helping to intensify the interest in the asset class.

Private equity purists?
However, there are some traditional private equity funds that have not invested in infrastructure, have only done so on a fairly limited ad hoc basis or with energy related infrastructure. For example, Ares Management has four funds that invest in energy related infrastructure and five related co-investment vehicles.

For Bain Capital neither infrastructure nor energy infrastructure form a core part of its strategy, so its investments in these areas have been very limited.

"As I look across the private equity industry, we hear a lot of talk about infrastructure, but we aren't seeing models like ours," says Agrawal.

"Some of the bigger private equity firms are talking about becoming involved in infrastructure but aren't necessarily there yet, while there are smaller firms getting involved, but through generally differing strategies."

Gleven points out that some big firms have not yet firmly established themselves in infrastructure because they do not necessarily have the people with the right skill sets, or networks. Another reason is that private equity deals are where they feel most comfortable.

Private equity strategies
Despite the crossover between the strategies of infrastructure funds and those with private equity backgrounds, there are important distinctions to their approaches.

"Even with the same asset, what makes a deal infrastructure or private equity depends on what you want to do with the asset," says fund-of-funds investor, Golding's Matthias Reicherter. "It depends on the underlying business plan and the risks you are prepared to take with the transaction.

"With private equity and value-add infrastructure funds it boils down to the underlying structure of your fund, and the necessity to go for an earlier exit compared to infrastructure. There's always an advantage of going for an infrastructure fund if you are comfortable with the risk return profile of having a deal at the lower end of the risk-return spectrum."

However, Reicherter says that he welcomes the entry of private equity. But he believes that private equity funds should target specific infrastructure sectors or industries rather than simply diving wholesale into the asset class.

"This is more theoretical than practical," he says. "If it is a private equity fund going for a deal you need to assume a private equity-style investment business case, and therefore it wouldn't be an option for us."

There are very few infra managers doing mid-cap infrastructure in the Nordics but there is a demand for origination and execution," he says. "Most European infra managers are headquartered in London or Paris. We have offices in the Nordic capitals, so we can attack that market" – Villa Poukka, Capman

Agrawal argues that having separate infrastructure and private equity businesses allows KKR to distinguish between infrastructure and private equity risk profiles. Others, without that kind of diversity, he says, may have a greater tendency to "stretch the definition of infrastructure."

"If an asset doesn't have an infrastructure risk profile then we would look at it with our private equity business," he says.

However, for firms like EQT and KKR, their approach still bears some of the hallmarks of private equity. For example, both tend to invest in assets that have an added degree of complexity.

"We have an entire private equity toolbox that we can use," says Gleven. "That includes add-ons, additional investments, team expansion and business development.

"We have an operational angle where we invest and transform. I wouldn't call that a private equity approach, though. We are an infrastructure fund with an industrial approach."

The advantages of private equity
Poukka argues that because there are many more private equity managers than infrastructure managers, they bring more tools and boast a wider range of geographies.

"There are very few infra managers doing mid-cap infrastructure in the Nordics but there is a demand for origination and execution," he says. "Most European infra managers are headquartered in London or Paris. We have offices in the Nordic capitals, so we can attack that market.

"It is easier and there is less risk starting a team within an established private equity firm."

Agrawal says that KKR has positioned itself as a "problem solver" for businesses.

"We work as a solutions provider," says Agrawal. "We listen to a potential business investment and then come up with a financing and operating structure that is most responsive to their needs."

Those kinds of very active approaches, while not exclusive to funds with a private equity background, tend to be their hallmark.

"We are very hands on," says Gleven. "We talk about industrial value creation, how to grow, how to launch a new product, add-on acquisitions, integrating management teams and carve-outs.

"When we do a financing we don't look at dividend capacity but how will the company have the freedom to grow and invest. We would also have less leverage, so we have the freedom to build and grow the business."

Private equity has typically earned higher returns than infrastructure funds, hovering around the late teens and early 20s. It is generally unrealistic for funds to earn those kinds of returns from infrastructure investments, but more active approaches do tend to drive greater value.

KKR, for example, targets gross returns in the low to mid-teens, in investments which Agrawal describes as being very low risk. EQT was generating a net IRR of 26.9% as of a year ago.

Private equity fees
The issue of fees is, of course, obviously closely linked to performance. Private equity has tended to charge higher fees than core infrastructure, but the fees universe is as diverse as the level of expected returns.

"If a fund generates premium returns they can charge higher fees," says Gleven. "If a fund has expected yields of around 3% then you would expect investors to push for lower fees."

Poukka takes a similar view: "Private equity wants to create value rather than just being an allocation manager," he says. "The more you can create value for your investors in risk-adjusted returns, the more you warrant your incentives and fees."

For example, KKR has management fees and carried interest of 1% a year and 10% of returns over 8% a year respectively. EQT charges a management fee of 1.6% (1.5% for first close investors) plus a performance fee of 20% over a 6% hurdle rate.

The risks
But the past problems of infrastructure fund managers applying private equity type approaches to infrastructure assets remains a risk. How likely are fund managers from private equity firms to make those same mistakes?

"If they did a copy and paste from private equity that would be dangerous – it would become private equity risk," says Reicherter. "But LPs have learnt from the events during the financial crisis.

"We have high valuations now and the amount of leverage has increased but the lessons have been learnt."

Even with the same asset, what makes a deal infrastructure or private equity depends on what you want to do with the asset. It depends on the underlying business plan and the risks you are prepared to take with the transaction" – Matthias Reicherter, Golding

Agrawal and the experiences at KKR confirm Reicherter's view on the risks being taken by private equity. "We have learned from the industry's mistakes of the past," says Agrawal. "We've constructed our portfolio accordingly and thus far, that has worked very well for us. It's not that our strategy is necessarily better than a private equity strategy; it's just different, as it should be for a different type of risk-return profile."

Agrawal adds that much of the industry takes a more private equity approach, meaning that fund managers take on volume risk and competitive risk with the aim of making returns in the mid to high teens. "But we have a separate private equity business for that," says Agrawal.

The points made by both Reicherter and Agrawal are important, and suggest there are efforts being made to avoid the exuberance and risk taking of a decade ago. The danger is that in an increasingly congested market, firms may be tempted to take inappropriate risks.

What next?
More traditional private equity investors in infrastructure will undoubtedly create more competition. But Reicherter argues that it will also increase choice and specialisation.

"People need sophistication," he says. "There is a trend towards complexity and diversity. But more complexity means more risk, so you need sophisticated advisers and in-house teams."

Poukka takes a similar view, saying that private equity managers will be able to provide infrastructure investors with new and different tools. "We are trying to do things with local asset owners and are aiming to be more flexible with our structures," he says. "But a lot of asset owners don't even know that they have suitable assets for infrastructure investors. There will be more opportunities."

Agrawal is excited by the prospect of the infrastructure fund universe growing. "The whole infrastructure ecosystem is starting to expand and mature," he says. "We are starting to see different investment strategies and styles. That's a good thing and will help the industry continue to grow."

The growing interest from traditional private equity firms in infrastructure is not likely to abate anytime soon. There will be more risks, but also more opportunities for LPs.

How fundraising goes for Blackstone's new $40bn fund will help to determine the future direction of infrastructure, and test LPs' demand for such a huge proposition. If other private equity firms and infrastructure fund managers follow Blackstone's lead, then the infrastructure space is likely to change dramatically in the years to come.

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• Topics
• Infrastructure
• Infrastructure
• KKR
• EQT
• Carlyle Group
• Apollo Management
• CapMan