Fri Apr 3, 2009 9:01pm EDT
Can private equity play the infrastructure game?
Until recently, aging infrastructure assets looked about as tantalizing to private equity investors as a bunch of trees. The comparison isn't far-fetched. The long-dated, low rates of return that infrastructure assets produce may be marginally better than the low single-digit returns that timberlands might yield after 40 years. Which is why U.S. buyout executives, hard-wired for high risk-reward bets, were less than enthused.
That mindset has changed the past few years. Five years ago, the city of Chicago sold a 99-year lease to Cintra, Concesiones de Infraestructuras de Transporte SA of Spain and Australia's Macquarie Infrastructure Group for $1.8 billion, giving the investors the right to operate the Chicago Skyway toll bridge. Many viewed the highway and bridge as a landmark event for privatization in the U.S., which has lagged Europe and Australia. Faced with crippling deficits and budgetary pressures, federal, state and local governments have increasingly turned to private capital to fill the funding gap for much-needed infrastructure improvements.
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Robust credit markets also whetted investors' appetites for steady, long-term investments that with financial engineering could yield better-than-average returns for infrastructure. Macquarie was the category killer that established the listed fund model at least a decade earlier.
Since then, the ranks of private infrastructure funds have swelled, drawing in Washington's Carlyle Group, 3i Group plc of London, Swedish private equity firm EQT Partners and several bank-sponsored and independent players. However, competition has also increased, and players have tried to boost investment returns by using more leverage.
"If you build it, they will come"
Funds raised globally for infrastructure investments
Year Funds raised ($bill.)
Source: Probitas Partners
With the global financial crisis and credit markets effectively stalled, infrastructure dealmaking -- often complex, multiparty transactions to begin with -- has become even more complicated. Political resistance is alive and well. The Pennsylvania legislature's recent rejection of a $12.8 billion turnpike concession sale underscores how American communities, and entrenched interests, are not eager to just hand critical assets over to private hands.
Lack of leverage also upended the debt-equity calculus. Listed infrastructure funds that relied on excessive leverage saw value vanish, leaving at least three Australian groups in receivership and the so-called Macquarie model in tatters.
Tight liquidity has derailed fundraising, not just for infrastructure vehicles, at least for the near term, experts say. New entrants, including New York's Kohlberg Kravis Roberts & Co. and Blackstone Group LP, both in the market with their first infrastructure funds, face recalcitrant institutional investors, many of whom are constrained by the denominator effect of sunken market values.
Moreover, experts believe leveraged buyout impresarios will need to offer more than financial alchemy to compete with project finance specialists. Of particular concern to limited partners is the matter of the PE model's economics -- 2% management fee and 20% carry -- broadly at odds with the less robust, low-return risk profile that infrastructure offers, observers say. That "long-term" investments for some PE funds may mean a holding period of less than five years has not have been lost on pension funds, either.
There are tensions between the low, steady-returns profile that institutional investors are attracted to and the classic PE fund structure, say investment bankers and placement agents. Thus, the PE model needs to evolve.
To some extent, that's now happening. KKR rocked the fundraising establishment by halving its fee and carry structure to 1% and 10% when it launched its fund last year. "To me, that tells you everything you need to know about returns expectations from infrastructure and where investors stand," says one fund manager who requested anonymity.
All this suggests private capital has a way to go. To be sure, the financial crisis may have only strengthened the impetus for privatization. There are those who note that after past excesses, lack of leverage may not be such a bad thing, particularly if investors focus on improving performance and enhancing asset value. Yet it remains to be seen whether private equity can play an effective, sustainable role.
If there are two people Chicago can point to as its biggest privatization advocates, they are Mayor Richard M. Daley and John Schmidt. Longtime Daley friend Schmidt, a partner at Mayer Brown LLP, had championed Skyway's privatization effort since 2002. Daley had in mind a concession sale of the Skyway system similar to Ontario's privatized concession to operate the 407 Express Toll Route for 99 years.
The Skyway is an eight-mile, six-lane, elevated roadway over the South Side of Chicago that includes a small steel truss bridge over the Calumet River. Opened to traffic in 1959, it had been a financial disaster and had been undergoing rehabilitation for years. For a time it enjoyed a reputation as a choice spot for gangland-style robberies, including a picaresque extortionist who held up tollbooths using different clients' vehicles from his backyard car repair service.
The avuncular Schmidt, now in his mid-60s, was Daley's first chief of staff after his initial election as mayor in 1989. In late 2004, Schmidt, serving as Chicago's legal adviser, sat alongside other city officials and representatives of adviser Goldman, Sachs & Co. at the opening of bids for Skyway.
"They opened the envelopes, sort of in reverse order," Schmidt recalls. The first one, from Abertis Infraestructuras SA of Spain, came in at $505 million. The second, from an ABN Amro-led group, was $770 million. Both were considerably below expectations. Then the Cintra-Macquarie bid was opened; it was for $1.82 billion, $1.1 billion more than the next-highest offer. "I said, 'Let me see that. Are we reading it correctly?' " he says.
Schmidt calls it an emotional moment. "I knew something extraordinary had happened," he says.
Under the 99-year concession agreement, the winners received exclusive rights to operate and collect toll revenue from the Skyway and be responsible for maintenance. As Daley envisioned, the proceeds were to be used to pay off Skyway debt and create a reserve trust.
Even before the Skyway deal had closed, Indiana was considering a similar project for the Indiana Toll Road, a 157-mile highway linking the Midwest and East Coast, one of the most heavily traveled truck routes in the U.S. In 2006, the state awarded the same consortium a $3.8 billion concession to operate the highway for 75 years. Different deals have been struck elsewhere, including Florida's agreement in March to pay a group led by Madrid-based Actividades de Construcción y Servicios SA as much as $1.8 billion over 35 years to design, build, operate and maintain new toll lanes along Interstate 595. Florida will set toll rates and pocket the revenue.
Have the floodgates opened, or are investors and advisers indulging in wishful thinking? Opinion is split. In the U.S. alone, the amount of money needed to fix public works is breathtaking. The American Society of Civil Engineers recently warned that after decades of underfunding and neglect, roughly $2.2 trillion will be needed over the next five years to improve the nation's infrastructure to acceptable standards. Globally, according to a recent Overseas Economic Cooperation Fund study, $2 trillion is needed annually for electricity transmission and distribution, road and rail transport, telecommunication and water through 2030.
The Obama administration's stimulus package and other legislative initiatives, including the creation of a National Infrastructure Reinvestment Bank, have dangled the promise of federal support, but the dollar commitments to date appear to be a trickle compared with the need.
Political resistance hasn't disappeared. In October, a much-publicized bid to privatize the Pennsylvania Turnpike for a $12.8 billion, 75-year lease, won by a consortium led by Citigroup Inc.'s Citi Infrastructure Investors arm and Abertis didn't pass legislative muster, a major setback for the bidders. Members of the legislature and other opponents appeared reluctant to forge ahead, partly because many were convinced the winning bidders would need to hike toll rates to recoup operating expenses and the sizable lease cost to generate a return. There was also fierce opposition from the Turnpike Commission, which has been running it for 70 years.
Citi and Abertis said they're not giving up yet and will likely try again.
"Buyout firms will have to pay careful attention to aligning their business models to public policy and community interests," says one private equity executive. Infrastructure assets are "so core to many people lives" that heightened sensitivity is essential.
Dealmaking has also slowed because infrastructure assets are not immune from a downturn, as some might want to believe. While it's unlikely that a household will cut back on its use of water, drivers might well avoid toll bridges and roads, says Ben Heap, co-head of infrastructure at UBS. Toll traffic has fallen by as much as 10% in some cases, he says.
Making matters worse, price hikes are based solely on inflation, which hasn't been this low in 50 years. "So there's a little bit of a double whammy," Heap says.
In the U.S., privatization of large-scale structures such as toll roads, airports, seaports and bridges has been slow to gain adherents. For much of the past few decades, government agencies relied on tax-exempt bonds to build and repair structures. Except for some municipal water supply, sanitation services and telecom that have been turned over to private contractors, these assets have mostly stayed within the public domain.
In Europe, pieces of infrastructure have been fully or partly privatized since the '80s. The OECD estimates that privatized assets now exceed $1 trillion for member countries. Various forms of public-private partnerships have developed. Typically, the public agency owner and provider of services becomes purchaser and regulator, while the private sector provides finance and management of assets while generating returns. In the U.K., more than 900 such partnerships, valued at £53 billion ($76 billion) have been signed from the mid-'90s to the end of 2007, the study says.
The model for infrastructure funds was pioneered in Australia by Macquarie, whose antecedents were in merchant banking. In the '90s, it capitalized on capital flows from Australia's pension schemes, known as superannuation funds, and set up infrastructure funds, many of which were publicly traded entities.
In Canada, pensions also began investing in infrastructure but went a step further, embarking on co-investments and direct investments. The Ontario Teachers' Pension Plan began investing in 2001, mostly as a direct investor. It had C$8.8 billion ($7 billion) in its global infrastructure portfolio as of end-December 2007, out of a total C$108.5 billion.
The Ontario Municipal Employees Retirement System established a subsidiary, Borealis Infrastructure Management Inc., in 1998. The unit, now with C$5.2 billion of assets, aims to have as much as $10 billion in its portfolio, with 60% of the capital in Canada, the rest primarily in the U.K., Western Europe and the U.S.
"The natural owner of an infrastructure asset is a pension or endowment fund that intends to hold the asset indefinitely," argues Leo de Bever, CEO of Alberta Investment Management Corp., in a recent essay in Infrastructure Investor, a PEI Media trade publication.
De Bever is one of the more outspoken apostles for direct infrastructure investments, recently publishing a book on the topic. AIMCo of Edmonton, Alberta, was established in 2008 to manage C$70 billion in pension assets.
Infrastructure is only now emerging as a distinct asset class. For pension funds, it's a perfect way to match long-term funding liabilities with long-term cash flows that infrastructure assets typically generate. "Money wants to find a home, and infrastructure is one of those areas offering investors legitimate gains," says Tony Perricone, a partner at Jones Day.
Last year, the California Public Employees' Retirement System, which used to lump its infrastructure investments with other alternative assets such as private equity, said it would allocate up to 3%, or about $7.2 billion, for infrastructure, with a net target return of 5% above inflation over five years. "We hope to generate stable, attractive investment returns with low to moderate risk as we deploy capital to meet a reported need of $1.6 trillion for U.S. infrastructure projects over the next five years," Rob Feckner, CalPERS board president, said at the time.
The California State Teachers' Retirement System also has a new policy in place, though it has yet to make an investment. Other states including Alaska, California, Oregon, Texas and Washington appear to be diving in as well.
Despite transactions having mostly been private-to-private deals to date, the surge in interest in infrastructure has sparked a fundraising frenzy. Even with liquidity constraining many large pension funds, private infrastructure pools raised nearly $25 billion last year. The total fell short of the record $34.3 billion raised in 2007 but still outpaced 2006, according to investment advisory firm Probitas Partners.
About 77 infrastructure funds globally are seeking an estimated $92 billion of commitments from institutions. The pace has been glacial, bankers and lawyers say, and raising all of it isn't a sure bet. "Fundraising has slowed tremendously, though unlike megabuyouts, there's still a fair amount of money going into infrastructure," says Kelly Deponte, managing director at Probitas. "Pension funds are looking at the demand side of the equation."
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Top 10 infrastructure funds now in the market
Rank Fund Fund manager Manager country Size ($mill.)
1 GS Infrastructure Partners II GS Infrastructure Investment Group U.S. $7,500
2 Macquarie European Infrastructure Fund III Macquarie Funds Group Australia 6,691
3 Macquarie Infrastructure Partners II Macquarie Funds Group Australia 6,000
4 Citi Infrastructure Partners Citigroup Infrastructure Investors U.S. 4,000
KKR Infrastructure Fund Kohlberg Kravis Roberts & Co. U.S. 4,000
5 Alinda Infrastructure Fund II Alinda Capital Partners LLC U.S. 3,000
6 aAIM Infrastructure Fund aAIM Infrastructure U.K. 2,982
7 Fondi Italiani Per Le Infrastrutture F2i SGR Italy 2,704
8 CVC European Infrastructure Fund CVC Infrastructure U.K. 2,676
9 Santander Infrastructure Fund II Santander Infrastructure Capital U.K. 2,007
10 Gulf One Infrastructure Fund I Gulf One Bahrain 2,000