Most private infrastructure funds are sponsored by large financial institutions through their investment banking units, according to industry data. Goldman Sachs completed the first bank-sponsored fund in the U.S. in 2006, raising $6.5 billion, of which $750 million came from the investment bank. It is now campaigning for a successor fund, which industry reports say is capped at $7.5 billion, though a source says the actual target is well below that mark. Goldman Sachs declined to comment on the fund.
Its first fund was used for the $22 billion LBO of oil pipeline company Kinder Morgan Inc. and to purchase seaport facilities operator Associated British Ports Holdings plc, which a Goldman-led group bought for £2.8 billion in 2006.
Morgan Stanley Infrastructure Partners began investing in 2006, closing two major investments before it wrapped up its first fund with $4 billion in May 2008. The fund, which targets transportation, energy, utilities, social infrastructure and communications assets, surpassed its $2.5 billion goal despite a difficult environment.
It has a fund life of 15 years, looking to invest in assets highly correlated with inflation that can generate returns of 12% to 15%, says Sadek Wahba, Morgan Stanely's infrastructure head.
Last year it teamed with Ontario Teachers' to buy Saesa Group, a Chilean electric distribution, transmission and generation subsidiary of New Jersey electric utility Public Service Enterprise Group Inc., for roughly $870 million, plus debt. And in December 2006, Morgan invested in a $563 million purchase of Chicago Loop Parking LLC, the largest underground parking system in the U.S.
UBS closed its $1.52 billion infrastructure fund in October to invest in mature assets involving utilities and transportation, among others, aiming for returns of 10% to 13%, says Heap. Its first investment, in 2007, was a $348 million purchase of a 50% stake in Northern Star Generation LLC from another infrastructure fund, AIG Highstar Generation LLC. UBS was also part of a consortium that purchased British water and sewage company Southern Water Capital Ltd. from Royal Bank Investments Ltd. for £4.2 billion in 2007.
Citigroup launched Citi Infrastructure in 2007. It lured Felicity Gates, who previously led a Deutsche Bank AG affiliate's North American infrastructure business, and Juan Béjar, formerly head of infrastructure at Spain's Ferrovial Infraestructuras and former CEO of Cintra. Citi is still marketing its first infrastructure fund and wouldn't comment. Reports pegged the target at $5 billion.
Carlyle joined the fray with a $1.15 billion fund completed in November 2007. That year, it bought biosolid recycler Synagro Technologies Inc. for $772 million. And in May 2008, it took a majority stake in ITS Technologies & Logistics LLC, an intermodal facilities operator that helps move goods through North America by transferring containers from rail to trucks.
Carlyle says it aims to improve assets by making them more efficient through incentives or building them out through acquisition and expansion. Generally, "the most appropriate use of funds is for projects or assets with some level of existing operations," says Barry Gold, Carlyle's co-head of infrastructure.
What might help counter community resistance is to deploy capital into projects that benefit the public or provide "essential service" in a way sensitive to needs of all stakeholders, says Gold.
That means staying flexible, he adds.
Carlyle plans to look at the transportation, water distribution-wastewater treatment and social infrastructure sectors, which are public benefit assets that would serve users even in dire times, he says. But the firm won't rule out making greenfield investments that make economic sense, such as a shovel-ready road projects designed to relieve traffic congestion.
KKR launched its infrastructure initiative in May 2008 with a big splash. It poached energy investment banker George Bilicic of Lazard to spearhead the effort. Bilicic sat across the table from KKR when the buyout house, along with TPG Capital, acquired Texas utility TXU Corp., now Energy Future Holdings Corp., in the largest LBO on record. In informal discussions with LPs, KKR had talked about a $10 billion fund with limited partners, according to a source. Not long after Bilicic rejoined Lazard and assumed his old position as head of global power and utilities, KKR came out with a prospectus targeting a $4 billion fund to be led by Marc Lipschultz, who heads its energy and natural resources group.
Not to be outdone, Blackstone also aims to raise a fund reportedly targeting between $2 billion and $5 billion, though details are sketchy. Reports said the fund has not yet begun fundraising. According to Preqin Ltd., the New York firm will invest in a range of developed infrastructure assets in the U.S. and Europe. The firm recently hired Trent Vichie and Michael Dorrell from Macquarie Capital in New York as founding partners of Blackstone Infrastructure Partners.
KKR, Blackstone Group executives and Bilicic all declined to comment.
The focus for many institutional investors appears to be shifting to independent funds partly because of uncertainties over continuing support from financially stressed institutions, according to industry executives.
AIG Highstar, a private equity fund that invests in infrastructure, has dropped AIG from its name, although it remains tied to the embattled insurer in so far as AIG is a limited partner.
Founded in 2000 by Christopher Lee, a former Chase Manhattan Corp. and Lehman Brothers Inc. executive, the firm is in the market for its fourth vehicle, after raising $3.5 billion for its third in 2007.
Another large group, Global Infrastructure Partners of New York, is a joint venture between Credit Suisse Group and General Electric Co.'s infrastructure division, launched in late 2006. Credit Suisse sought to capitalize on its and GE's project finance expertise, a source says. Each contributed $500 million to a $5.64 billion fund that closed last March, having the advantage of raising money before the crunch hit.
GIP's team, mostly consisting of investment bankers, is led by Adebayo Ogunlesi, chairman and managing partner and a former CS investment banking chief. The fund, together with AIG affiliate AIG Financial Products Corp., acquired London City Airport, the U.K. capital's fifth airport, in 2006 for a reported $1.4 billion in October 2006.
How has that portfolio holding performed? "Better than OK, even in this environment," says a source.
Except for energy infrastructure specialists, some of which have been very successful, most U.S. players are first-time funds, and it's too early to judge performance. Those with exits may have an edge. Alinda Capital Partners LLC boasts the first independent infrastructure fund in the U.S. Launched in 2005 by ex-Citigroup project finance experts led by Christopher Beale, the firm completed a $3 billion fund in 2006.
Alinda began fundraising last year for a successor vehicle with a $3 billion target and has pretty much raised that amount. It helped that it has had partial realizations, including the sale of airport assets in Australia and in the U.K. divested by portfolio holding BAA Ltd., the British airports operator owned by Spanish construction group Grupo Ferrovial SA.
Alinda, GIP and other bank-sponsored funds now fundraising declined to comment.
Charting the risk-return profile for infrastructure and setting benchmarks remains a work in progress. Funds entering the market come up with a structure and strategy for investment vehicles, targeting returns that generally assume some leverage on the underlying portfolio. Early studies pegged net returns for most managers at between 9% and 12%. But those numbers predate the credit boom. They also vary depending on the underlying assets. According to J.P. Morgan Asset Management, toll roads may get 10% to 12% and airports may get 15% to 18%, against an average of 10% to 15%. For instance, Alinda Capital, focused mostly on brownfields, generally targets a base return of 12%, but it may gain a further 3% through operational enhancements and a potentially lucrative exit multiple, according to sources.
In general, brownfields investments with well-established cash flow tend to produce the lowest returns, with a target internal rate of return of about 10% to 12%. Depending on how much capital is invested, rehabilitated brownfields -- assets that are built but that may need capital improvements or expansion -- may offer 15% returns.
For greenfields, or projects that need to be built, investors may hope for 18% to 20% returns because they take on design, construction and operating risk. Most private infrastructure funds appear to have multiple investment targets, typically a combination of brownfields, greenfields and secondary investments, according to Preqin Ltd.
Even before the credit crunch, heightened competition fueled by the proliferation of funds eroded return expectations from double to single digits, the OECD reports. "The first-mover advantage typical for new asset classes has run out," it says. Macquarie's earlier funds were reporting IRRs of around 20% because "it had the market to themselves," says one New York fund manager. But as the market became more liquid and efficient, pricing has become more aggressive, with target IRRs relying on increasing amounts of debt and equity.
Critics have pointed to recent auctions such as the concession sale, announced in October, for Chicago's Midway Airport, the first privatization of a U.S. airport, saying bidding was quite aggressive. The winning group, Citi Infrastructure in partnership with Vancouver International Airport Authority and John Hancock Life Insurance Co., bid a little more than $2.5 billion.
"The whole market was appalled," says a fund manager familiar with the auction. The bid was all equity, the source says, but even without debt, bidders were targeting a 15% IRR.
The unsuccessful privatization of the Pennsylvania Turnpike also drew what many viewed an aggressive bid from Citi-Abertis, whose $12.8 billion offer, said to be 60 times projected Ebitda, was well above the next highest bid of $12.1 billion from Goldman and Transurban Group, Australia's second largest toll-road operator. Macquarie bid $8.1 billion, which fell below the threshold, and was shut out from the final round. Citi declined to comment on the auctions.
Infrastructure assets can usually support 50% to 75% debt in the capital structure, says UBS' Heap. But using too much leverage can backfire, as it did for Australia's Babcock & Brown Ltd. and Allco Finance Group Ltd., both of which emulated the Macquarie model and are now bankrupt. Analysts say it didn't help that some of their debt structures were provided on a short-term basis, a mismatch to the longer time frame for underlying projects.
"When times get tricky, it's possible to have plenty of breathing room at the operating level yet still be unable to meet debt service at the holding company level," says Heap. Their analysis didn't factor in the global financial crisis, which have forced such firms as Babcock to sell assets at fire-sale prices. "Infrastructure projects can handle more leverage than private equity projects in normal economic cycles, but not overly excessive leverage," says Mark Weisdorf, global chief investment officer of J.P. Morgan Asset Management, which has its own fund as well. "If a project's cash flows decline when an asset is 90% levered, it could cause problems."
The bankruptcies have hurt Macquarie, whose listed funds are down about 40% for the year amid continuing worries over asset valuation. Macquarie has considerably more resources than its bankrupt imitators, but the listed infrastructure fund model it pioneered has understandably taken some hits from critics who argue that it's "broken."
Last year, institutional advisory firm RiskMetrics Group Inc. issued a scathing critique of the complex structures of the model, which it argued was flawed, in part because of the danger of overpaying for assets. A spokesman for Macquarie says the firm addressed the report in detail at the time, including making various corrections. It has also made corporate governance changes in its listed funds since the report was published, he adds. In recent months, the firm has tended to take on the role of adviser rather than acquirer, sources say.
Under prevailing conditions, investors being pitched by PE-style infrastructure funds may need a lot more convincing. For one thing, the typical 2%-20% fee/carry structure is less compelling. Canadian pension funds have long argued that if infrastructure funds are pitching low- to midteen returns, the standard 2%-20% economics makes no sense, which is why they've tended to invest in assets directly. With limited leverage, there's even less justification for it, they say.
Still, most infrastructure funds retain 2%-20%, with a hurdle rate averaging 8%. There are variations: The management fee might be a sliding scale, and the hurdle rate could range anywhere from 6% to 12%. Carlyle came in early in the cycle with a 1.5%-20% structure and a 12-year life, plus a two-year extension. The fund is targeting returns in the upper teens, a source says.
KKR's diminished rates are a big departure," says a large LP in KKR's buyout funds. "That does say that some of the pension funds aren't prepared to pay 2% to 20% on products that have a lower risk profile in a class where they are or can be more direct participants themselves."
Another concern is the risk that PE funds might stretch the definition of infrastructure. As one disgruntled pension fund manager explains: "You can have two different power plants. One fully contracted for fuel supply and providing electricity for 50 years. That's an infrastructure plant by our definition. On the other hand, another plant may buy fuel in the spot market and sell electricity in the spot market. That's a merchant power plant, and there's lots of them around. In theory, the first will have much lower returns and won't sustain a 2% to 20% structure." Says one Canadian investment officer: "If private equity looks into it, they'll start pushing into the second type. It's in their DNA."
Moreover, pension funds with long-term funding liabilities to worry about seek a very high return of capital to cover those liabilities. Buyout shops normally have a holding period of about five years, but that's not usually long enough for pension funds and other investors.
"IRRs are only one snapshot of performance," says one fund manager. "Sophisticated investors look at how much capital comes back in 10 years or more." Alinda Capital and others have a 10-year holding period, but some funds may have shorter holds and exit within five years, sources say.
Investors are also leery of the lack of infrastructure expertise among traditional private equity firms. "There are LPs out there saying that other funds might have more or deeper expertise in infrastructure than KKR or Blackstone," says one investment adviser. To be fair, KKR has been hiring project finance experts as part of the investment team, as have others, but there's a shortage of truly seasoned infrastructure executives, industry observers say.
All things considered, private equity funds with appropriate structures might still get the benefit of the doubt. For pension funds that are increasingly attracted to the asset class, the advantages of improving social and economic infrastructure assets may outweigh concerns over low returns.
At the same time, public-sector authorities will need to adapt their own management models to reward employees for efficiencies, cost savings and making the asset work better for users, says Gold. Accountability will be important, and revenue sharing is one way of achieving that, he adds.
And while financial engineering may ultimately help boost fund returns, it isn't the only factor, experts say. Fund managers can just as well focus on operational changes to get multiples of return on capital. In that respect, the LBO folks might yet make a good stab at outperforming their peers.