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An investor's guide to essential services

nvesting in infrastructure equity is increasingly an attractive option for institutional investors with long-term liabilities. The asset class "infrastructure" has been defined as those essential services that a society cannot do without, split into (1) ‘transport' infrastructure such as roads, bridges and airports, (2) ‘regulated' infrastructure such as water, electricity and gas distribution networks fees, and (3) ‘social'
infrastructure such as schools and hospitals where governments pay an availability fee over a 20 to 30-year term.

The class has recently become attractive because the growing realisation that the nature of these returns fits with asset liability management and expanding liability driven investment strategy trends of pension funds.

Notwithstanding a few large funds capable of setting up their own funds in-house or through a subsidiary, most institutional investors prefer to invest in an infrastructure vehicle through specialist infrastructure fund managers.

This is due to a lack of expertise, the perceived risk of such assets, the long-term management intensity of infrastructure purchases, the ability of some ‘local' infrastructure fund managers to win deals, and both the capital leverage and co-investment opportunities alongside trusted experts.

More specifically for infrastructure, specialist fund managers can tap into a large deal flow through the extensive global networks of advisory and investment executives in their respective
financial institutions. With a number of specialist infrastructure funds being raised in various investment banks, ranging from $1bn (€768m) to $3bn, pension funds need to consider their own aims and objectives regarding this new asset class, and select fund managers accordingly.

How infrastructure products are structured, managed, and how they perform relative to third-party defined benchmarks cannot be determined directly from the market.

This information can generally only be obtained from the vendor, who will have objectives that might not correlate with the investors.

Specialist infrastructure fund managers' motives should be known and reliable since institutional investors need to carefully select between managers who ‘fudge' data, those who misrepresent the situation for short-term reward, and those who are looking to create an alignment of interests.

Few institutional investors have been able to develop routines to evaluate claims about past performance. This creates a further complication in the selection.

When outsourcing to experts, investors build up relationships with intermediaries that will last for the term for which the infrastructure fund was set up.

It is also important for investors to be knowledgeable about the product designers' reputation, since these providers, rather than the market, are the dependent factor. An independent approach to selecting is preferred, for which communication and instinct are vital.

Those fund managers that are selected need a track record of winning deals, which shows that they know, and have been active in, the market. Size of fund, expertise in M&A and predicted returns are also important. Once specialist infrastructure funds have been pre-selected, pension funds need to consider various potential tensions in the long-term governance of these investment relations.

Most specialist infrastructure funds are set up in private equity fashion, driven by managers looking for
compensation. Despite infrastructure as an asset class having been promoted as a perfect long-term investment over three to 50 years, the infrastructure fund managers' pay structure is often focused on an upfront payout, with additional profits arising if there is money left over from the sale of assets at the termination of the fund.

Figure 1 describes how most providers are seen to churn capital to reap short-term rewards, showing opportunism rather than long-term commitment, since generally only10-year closed-end funds are offered.

Large risk-averse funds and smaller funds without the opportunity to create an in-house team acknowledge this time horizon conflict but do not know how to deal with it. Many decide that the 10-year span is far enough in the future to allow them to come up with a good termination option. They are investing their money now and planning to deal with the inconvenient facts later.

 

nfrastructure assets are fundamentally different from the usual 10-year private equity fund since these assets are desirable over the long term rather than over the usual three years. Institutional investors should look to find the right specialist infrastructure fund managers for their investment aims. Longer-term funds are desirable and some pension funds are attempting to find providers which will try to create 20 to 30-year funds. The success rate is low, with these investors opting to set up their own competing teams.

Other experienced investors that have dealt with specialist infrastructure fund managers over the past
few years, are now trying to negotiate exit strategies that accommodate their interests. This continues to be difficult since providers' business plans are aimed at selling the asset with maximum profit.

Some pension funds, though, are devising plans to own their part of the asset independently from the provider prior to signing the contract for the equity allocation to the specialist fund investment. In addition, new smaller specialist managers are opting to provide
more flexible investment mandates that accommodate this time horizon tension.

The fee structure of these types of infrastructure vehicles is composed of different elements (management, performance, transaction and so on).
Some of the specialist infrastructure fund managers make most of their money from upfront transaction fees rather than through shares of the performance fees (see Figure 2).

This is because most specialist funds execute three distinct functions: acquiring, managing and selling the assets. Investors are looking for asset managers, but most specialist infrastructure funds are set up in an investment banking fashion, with the goal of generating transactions.

Some claim that such an incentive structure is the only way to win deals since investment banking ‘is the business for deals'. This does not fit with asset management, since the ‘deal team' in these cases is not responsible for the long-term management.

In addition, the team that acquires the asset does not and often cannot (due to legal reasons) manage it: those who know the deal intimately usually disappear to win the next deal for the fund. Questions have thus arisen over what the correct model for asset management/ governance of infrastructure might be. There are some leading banks trying to manage the assets, or ‘milking the assets' as described by some, but their capabilities are stretched doing this. Important also is the alignment with the larger financial institution that is offering the infrastructure vehicle.

With the investment banking nature of infrastructure bidding and the 10-year focus, some large investors are now trying to enhance the asset management focus.

Paradoxically, many do acknowledge that the current transaction-based incentive structure is the only way to win deals since investment banking ‘is the business for deals'.

A compromise solution to this problem can be seen in placing specialist infrastructure funds between investment banking and asset management within large financial institutions. Some progress is being made towards this, since the long-term asset management issue has only recently become the more pressing matter in the infrastructure field.

In infrastructure investing, financial service providers have dominated the fee structuring. Figure 3 shows
how institutional investors would like to see a transparent structure with dependent managers, but many providers aim to keep their managers as independent as possible, with fee structure explanations being made at their discretion.

This initially proved successful, but institutional investors have recently argued that the fees associated with specialist funds are too high and are unsustainable, since they resemble private equity fees whereas infrastructure assets have lower risks, and therefore lower returns.

Now that infrastructure returns are decreasing with the disappearance of early ‘mispricing' and increased global competition, some leading specialist infrastructure fund managers take proportionately larger chunks of fees out of the returns compared with private equity.

 

n alignment of interest can be ensured by demanding that directors have significant ownership stakes or ‘skin in the game', but some providers want to keep their stake small or get the larger financial institution within which they are embedded to cover the ownership stake. Other providers are more committed since they consider infrastructure a good investment opportunity for their own money.

Effective governance structures can have considerable influence. Funds perform stronger when ensuring that mutual fund directors have significant ownership or ‘skin in the game'. Since institutional investors are becoming more knowledgeable about this new asset class, they are positioning themselves better to negotiate a secure
alignment of interest with the providers winning and managing infrastructure assets. Pension funds should aim to demand a transparent structure with dependent managers.

An alignment of interest in the infrastructure sphere can be forced through a substantial investment by the fund management, payment of fees to the larger sponsoring financial institution at the end of the fund life, and limiting the total amount of fees by the fund to the larger institution. In addition, a performance target should be set for the provider. In this way it is hoped that the infrastructure fund will perform.

Many of these governance issues can be dealt with through contracts. Fees can be discussed and put in place, the fund manager's ownership and commitment can be secured, a clear description of types of infrastructure assets and specific geographic regions can be given, and an alignment of interest can be created through setting out commitments for all. Some large pension funds like to be seed investors, or founding partners in order to secure the above prerequisites but negotiations can be long and hard, with lawyers generally only brought in after an initial informal agreement has been reached. One difficulty, however, is the opportunistic aspect of infrastructure investing in general. An institutional investor will, for example, not demand that its money be invested if there are no good investment opportunities.

Some financial service providers instead offer a flexible structure for the investors they are trying to entice. Since institutional investors like to invest in a special investment vehicle tailored to their needs, those providers that can be flexible receive a lot of interest and raise a large amount of capital. For others it is difficult to create a flexible structure since traditions within financial service institutions' culture are strong. Material conflict of interest occurs.

Despite attempts by investors to eliminate the situation whereby fund managers use their parent organisation as the preferred advisory partner through their contracts, it is generally accepted that it cannot be disposed of entirely. Figure 4 shows how while investors prefer clear-cut and hard structures, especially for the fees, (preferably tailor-made to their needs), and demand a firm alignment of interests between fund management and the performance of the fund, providers find ways to negotiate a more flexible structure.

 

enerally, the latter contracts are vaguer on the long-term interests, with alignment of short-term interest over performance fees. At the same time, institutional investors do not want too much flexibility, because board meetings that are created to offer flexible input slow down the decision-making process.

The investment mandate is crucial: investors acknowledge that a balance needs to be struck between setting strict limits while still maintaining manoeuvring space for a specialist infrastructure manager so that time and money are not wasted on extra meetings to approve execution.

These contracts discuss the fee structure, how the fund manager is committed, a visible alignment of interest that both the fund management and the larger organisation are committed, a definition of the kinds of infrastructure that the fund can be exposed to, with restrictions on certain risks (with a set minimum requirement and one on an individual asset basis), and specific directions regarding asset selection, purchases and regions.

Morag Torrance completed a doctorate in 2006 at the University of Oxford on Institutional Investing in Infrastructure. This article is based on some of her research findings. She now works at Capital Partners, which specialises in infrastructure and equities

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