Inside the mind of a fund manager

The hunt for yield has led to an influx of capital in the European infrastructure sector, but will the increased appetite drive new projects? Jennifer Bollen reports

Why the flood of capital?

Infrastructure managers are not typically thrill seekers. Peter Hofbauer, head of infrastructure at Hermes Investment Management, talks of “sleep-adjusted returns” – those that give managers peace of mind beyond absolute or risk-adjusted returns.

The sector’s lack of excitement has led to a surge in appetite among risk-averse investors for European infrastructure funds. Data provider Preqin said 15 Europe-focused infrastructure vehicles completed fundraising in 2015, raising an aggregate €200m, compared with €9.6bn raised by 21 funds in 2014 and a record €10.5bn raised by 25 funds in 2013.

Colonial First State Global Asset Management and Copenhagen Infrastructure Partners raised the biggest infrastructure vehicles aimed at Europe last year, each garnering €2bn.

Significantly, when Preqin published an infrastructure report in November, all of the Europe-focused infrastructure funds raised last year had exceeded their initial targets, compared with half of such funds in 2014 and 32% in 2013.

It is not just European infrastructure attracting investment – fund managers are opportunistic and will consider most regions. However, SL Capital Partners says it has decided to target north-west Europe for a conservative geographic focus.

Figures from Preqin show a large concentration of completed infrastructure deals in the UK between 2010 and the fourth quarter of 2015 – 1,076, compared with 267 in France, which had the second-highest level of deal activity. In third place, Germany had 189 deals in that period. The figures include brownfield and greenfield deals.

Hofbauer said the rise in fundraising activity followed growing allocations to infrastructure among institutional investors, as they increasingly viewed infrastructure as a separate asset class from the broader alternative investments category.

“It is to do with in part some of the investment characteristics and attributes you can achieve investing in infrastructure, which attracts long-term investors,” he said.

These characteristics include a lack of correlation with equity markets, the ability to generate steady compounding returns in a low-interest-

“I have yet to meet an investor who is reducing their allocation to infrastructure. They are holding it or increasing it. The majority are increasing it.” Dominic Helmsley, SL Capital Partners


rate environment and a hedge against inflation, should it emerge.

Dominic Helmsley, managing director of infrastructure at investment manager SL Capital Partners, said that pre-crisis, traditional managers had typically split the investment universe into equities, fixed income and cash. Post-crisis, incumbent infrastructure funds had performed strongly, driven partly by low interest rates and operational value-add.

Increasing allocations

“Core infrastructure should be uncorrelated to listed markets, so clearly, investors are increasing their allocations to the broader alternatives, real assets bucket and specifically to infrastructure,” Helmsley said. “I have yet to meet an investor who is reducing their allocation to infrastructure. They are holding it or increasing it. The majority are increasing it.”

Karen Dolenec, global head of real assets at advisory firm Willis Towers Watson, added: “Infrastructure is still quite an immature asset class when you compare it with the other ones. It is structurally growing as investors become more familiar.”

Figures from Preqin suggest even greater sums will head for infrastructure in the coming years – it said 58% of Europe-based investors were below their target allocation to the asset class.

Pension funds and sovereign wealth funds dominate the infrastructure institutional investor base.

Abu Dhabi Investment Authority is the biggest infrastructure investor targeting Europe by current allocation levels – it has €14.2bn allocated to the asset class, according to Preqin. South Korea’s National Pension Service comes second, with €10.9bn, while Canada Pension Plan Investment Board comes third with €9.6bn.

Historically, Canada, Australia and the Netherlands have been the biggest infrastructure investors in Europe, but Asian investors are stepping up their presence. South Korea’s National Pension Service is one of the biggest investors in the region by allocation, while in October, energy company China General Nuclear Power Group agreed to invest in the UK’s Hinkley Point C Nuclear Power Station alongside EDF Group in an £18bn deal – the biggest in Europe since 2010, according to Preqin.

Meanwhile, in June, the £1bn Swansea Bay Tidal Lagoon named contractor China Harbour Engineering Company the preferred bidder for a £300m contract to supply marine works.

“CHEC has taken the strategic decision to enter the UK infrastructure investment and construction market, and we see the Swansea Bay Tidal Lagoon – a pioneering scheme that could bring the world a new energy option – as the cornerstone project in our business development strategy in the UK and wider Europe,” said Lin Yi Chong, president and chief executive ofChina Harbour Engineering Company in a statement at the time.

Manish Gupta, head of infrastructure corporate finance at advisory firm EY, noted: “China is still a marginal player in Europe, despite a number of state- owned entities looking at foreign markets, such as Africa, in line with government trade policy. However, as the domestic market slows down, we should be seeing more investment driven by exporting products and construction capability.”

Another growing theme in recent years has been co-investments with large institutional investors, particularly pension funds, as more investors seek to reduce the fees they pay by executing deals directly.

Helmsley said SL was keen to team up with investors for co-investment deals, although smaller investors might find such transactions challenging.

“It is about risk sharing on the pursuit of the asset and closing simultaneously when we find the asset, as opposed to us underwriting the deal, closing the deal and selling down the asset,” he said. “Co-investment is something we look at positively, but not all investors are equipped to do it. A lot of investors express a desire for it; not as many can tool up to execute it.”

What will be the impact on deal activity?
What impact will the buoyant fundraising market have on UK infrastructure deals? Managers are clear that deal opportunities continue to outpace fundraising and as a result, the market is far from overcrowded.

Hofbauer highlights that the capital flowing into European infrastructure funds covered a wide range of strategies and jurisdictions within the region, and that the equity held by closed-ended funds was earmarked for deployment over the next three to five years.

“The number is not actually that big,” he said. “What you are seeing more of is valuations related to the overall fall in returns in all asset classes rather than an imbalance between demand and supply of available capital.”

However, market participants have warned that deal activity and valuations for the most sought-after assets will inevitably rise. “Prices will go up, no doubt about that,” said EY’s Gupta, adding that the pipeline for transactions this year was limited.

“For the very large 
trophy assets we see huge competition and pressure on pricing. That is less the case at the smaller end of the market.”

Dominic Helmsley, SL Capital Partners

Helmsley of SL Capital Partners agreed, but said: “There is so much money seeking assets, we see a difference depending on where you sit in the spectrum. For the very large trophy assets we see huge amounts of competition and pressure on pricing – prices being pushed up and returns being pushed down. Increasingly those assets are being acquired by the direct pension funds, as opposed to the fund managers. That is less the case at the smaller end of the market.”

UK benefits from transparency

The UK, which relies heavily on private capital, remains a favourite market for infrastructure investors thanks in part to its transparency and regulatory regime, according to Hofbauer at Hermes. Large UK deals last year included the Thames Tideway Tunnel, London’s £4.2bn sewer, backed by a consortium of Allianz, Amber Infrastructure Group, Dalmore Capital Limited and DIF.

Meanwhile, CPP Investment Board and Hermes Infrastructure agreed in March last year to buy a third of ports operator Associated British Ports from GS Infrastructure Partners, an infrastructure unit of bank Goldman Sachs, and infrastructure firm Infracapital for £1.6bn.

Helmsley said investors continued to demonstrate strong appetite for low- risk investments, citing regulated assets such as those in the utilities sector and deals in the transportation sector among those attracting interest from SL.

Gupta said that while relatively few UK infrastructure assets were expected to come to market in the coming months, managers expected spin-off opportunities as a result of a restructuring of Network Rail.

The sales of London City Airport by infrastructure firm Global Infrastructure Partners and the M6 Toll road are also expected to be some of the highest- profile deals of the year.

Hans Holmen, a principal at consultancy Aon Hewitt, added that disposals of non-core assets by oil companies would also provide attractive deal flow. Brownfield assets continue to attract the strongest level of interest from funds and institutional investors, according to Holmen, thanks toestablished operating records and the promise of immediate yield. Such deals are particularly popular among pension funds, which must match their liabilities with low-risk, low-return investments.

“For greenfield assets you are taking on more risk on development and construction of those assets and will not generally get returns back until later,” said Holmen, who added that greenfield projects exacerbated the J-curve – the effect caused by negative cash flows in the early years of an investment.

Furthermore, many investors are reluctant to engage in the highly competitive public tendering process, which comes with potentially high abortion costs.

New developments are riskier

“Most of our clients are pension funds that have liabilities of some description and are looking to match those liabilities,” said Hofbauer.

“Therefore they are looking for safe, steady, predictable returns... so new developments do not naturally fit within that because there are higher risks – execution risk, construction risk, a lack of yield and there is probably a lack of opportunities, other than in the very large economic infrastructure projects.”

Recent research from Aurium Capital Markets has revealed a 36% increase in the number of pension schemes investing in infrastructure during a 12-month period over 2014/15.

Online analysis by the investment house found 136 pension schemes with direct investment in infrastructure projects in 2014, rising to 185 last year. Pensions identified as investing in infrastructure last year included Australian Government Future Fund, Canadian Forces Pension Plan, John Lewis Partnership, Pensionskasse Post, Ontario Municipal Employees Retirement System and The Pension Protection Fund, the company says.

Aurium has also announced that it has raised £270m to help fund UK renewable energy projects, including over £100m from institutional pension funds. The attraction of renewables to investors is growing significantly, the company says, as falling costs in the sector coincide with government looking to phase out coal-fired power stations. Green energy is increasingly seen as a good bet, despite the phasing out of government subsidies for onshore wind and solar power.

“Green energy projects are very attractive for pension schemes. They improve the green impact of pensions’ portfolios and pay attractive returns.”

Steven Blaze, Aurium

Aurium partner Steven Blase said: “We are seeing more and more pension schemes investing in infrastructure, and we believe green energy projects here are very attractive for pensions. They improve the green impact of pensions’ investment portfolios, they can pay an attractive return and there is very little correlation with mainstream asset classes.

“We have already raised £200m to build and acquire a portfolio of major biomass and EfW (energy from waste) plants in the UK and we are looking to raise funds for more projects in this area.”

However in February, the chief executive of Suez UK’s recycling and recovery division, David Palmer-Jones, expressed concern that if we were to leave the EU this sector might become less attractive to investors, because EU recycling targets might no longer apply.

New projects and risk

Activity in the greenfield market rose last year – there were 25 UK infrastructure project finance deals worth a combined $8.9bn, according to data provider Dealogic, up from 14 totalling $7.4bn in 2014.

However, project finance levels remain low compared with the top of the market – in 2007, there were 71 UK infrastructure project finance deals worth an aggregate $22bn, the highest number and total value of such deals of the past decade. By 2009, as the credit crisis took hold, the figures had fallen to 55 and $11.5bn. The following year they had slumped to 48 and $5.7bn.

The need for private capital for greenfield projects and the high risk profile of such investments has led to growing discussion around how to solve the risk problem for investors.

“There is a desire to invest in greenfield; the gap you see between that desire and implementation is due to the risk profile and whether projects can be structured in a way that is beneficial to investors,” said Willis Towers Watson’s Dolenec. “This is an area where we see governments focusing more attention.”

Fund managers cite the Thames Tideway Tunnel as an example of how the government can significantly lower the risk profile of a greenfield project. According to a spokeswoman for Thames Tideway, a government support package provides cover for insurable events above the amount the market is prepared to provide and means the government would act as insurer of last resort should the market not be able to provide pre-agreed cover.

The government would also act as lender of last resort should the capital markets close for a significant period and may provide equity to fund the shortfall should the project’s costs exceed a 30% overspend.

“When the project started three or four years back, the government was keen to show pension fund money coming into infrastructure,” said EY’s Gupta. “It will need to be done on a case-by-case basis... It can only be done for large projects.”

And Dolenec warned: “All governments are talking about it, but for every project that has gone well I could give you an example of a project that has not had investment go into it.”

Top 10 infrastructure investors in Europe by current allocation

1. Abu Dhabi Investment Authority – €14.2bn – United Arab Emriates

2. National Pension Service – €10.9bn – South Korea

3. CPP Investment Board – €9.6bn – Canada

4. All Pensions Group – €8.3bn – Netherlands

5. Ontario Teachers’ Pension Plan – €8.1bn – Canada

6. AustralianSuper – €6bn – Australia

7. Future Fund – €5.9bn – Australia

8. PGGM – €5.4bn – Netherlands

9. Public Sector Pension Investment

Board – €4.6bn – Canada

10. Hermes GPE – €4.2bn – UK

Source: Preqin