Top 100 Hedge Funds
Hedge Fund 100: The Trillion-Dollar Club
Following a year marked by significant losses and redemptions, Alpha's annual ranking of the world's biggest hedge fund firms has a mix of new players and old favorites. The firms listed in 2009 Hedge Fund 100 oversaw a combined $1.03 trillion in assets. Although by most measures that is a kingly sum, it is nonetheless down substantially from the record $1.35 trillion the world's 100 largest firms managed at the end of 2007.
Corporate Bankrupcies Show Credit Default Swaps Should be Banned
Stock-Markets / Credit Crisis 2009
Apr 23, 2009 - 07:24 AM
Martin Hutchinson writes: For frustrated investors looking to justify the ban of credit default swaps (CDS), look no further than last week’s corporate bankruptcies of Canadian newsprint producer AbitibiBowater Inc. (ABWTQ) and U.S. shopping center developer General Growth Properties Inc. (GGP).
In both of these cases, credit default swaps became an actual bankruptcy catalyst - for the first time ever.
In the lead-up to both bankruptcies, the lenders who had debt outstanding - who would have the right to vote on any reorganization - had hedged their debt through credit default swaps and so stood to benefit from the company’s bankruptcy. That made it very difficult for both companies to get the majorities they needed for debt reorganization, making bankruptcy inevitable.
The CDS holders were in the position of seeing a 1929-vintage stockbroker balanced on a window ledge, and yelling “Jump, jump” - while simultaneously taking bets on the result.
In the AbitibiBowater bankruptcy case, holders of credit default swaps played two key roles:
They were spectators and potential litigants.
And they were the generator of lawsuits.
Let’s consider the first point.
When AbitibiBowater missed a bond payment on March 20, there were a lot of CDS derivatives outstanding that were close to maturity. Holders of these securities wanted to have AbitibiBowater immediately declared in default so that they could collect - a delay would allow their credit default swaps to expire.
However, non-payment of bond obligations generally does not become an actual “default” for several days (because the company is given a few days to come up with the money). Moreover, AbitibiBowater obtained a court order allowing the bond payments to be suspended while the company completed its debt restructuring. Thus, the CDS holders (to a value of about $500 million) were out of luck.
Or were they?
An International Swaps and Derivatives Association (ISDA) ruling on March 28 allowed CDS holders (as of March 20) to claim payment through a cash-auction system, as if a default had actually occurred.
The second role that CDS holders played truly was analogous to sadistic spectators placing bets at a suicide. Bowater (which had merged with Abitibi in an over-leveraged deal just two years ago) wanted to exchange its 9% bonds in order to improve its cash flow and to remove the likelihood of bankruptcy. To do this, it needed 97% acceptance from holders of bonds maturing in 2009 and 2010. The company was only able to get a 54% acceptance - largely because many bondholders also held credit default swaps, and so would actually benefit, rather than lose, from a Bowater bankruptcy.
General Growth, a shopping center developer with $27.3 billion in debt (real money even these days) - making it the largest default in U.S. real estate history - demonstrated the darkening cloud that’s hovering over the U.S. commercial real estate market. It also underscored the risks of being involved with credit default swaps.
General Growth’s mortgage debt had been securitized into mortgage-backed bonds, many holders of which had also bought credit default swaps, so debt restructuring proved impossible. Credit default swaps on General Growth’s vaunted Rouse unit were valued by auction on April 15, and were deemed to be worth 71% of par, so investors in them received $710,000 for each $1 million of CDS they held - a nice reward for voting “no” to a corporate restructuring.
Guess what? If busted insurance giant American International Group Inc. (AIG) was the writer of any of the credit default swaps on either AbitibiBowater or General Growth, we as taxpayers have paid the profits of the guys who forced those companies into bankruptcy.
A comforting thought, isn’t it?
The credit-default-swap rap sheet is becoming quite long. In the AIG case, CDS securities allowed an insurance company to write more than $200 billion worth of contracts, booking the premiums as income and reserving nothing against the potential losses, thus bankrupting itself at taxpayer expense.
Credit default swaps then allowed major banks - such as Goldman Sachs Group Inc. (GS) - to collect large sums through their holdings of AIG CDS contracts, while themselves having protection against an AIG bankruptcy, thus double-dipping at the expense of American taxpayers.
These big financial institutions have now facilitated the largest real estate bankruptcy in U.S. history - as well as the bankruptcy of the world’s largest supplier of newsprint - by preventing creditors from agreeing to restructuring plans.
These same perpetrators were an accessory before the fact in the Lehman Brothers Holdings Inc. (LEHMQ) bankruptcy, because they provided the best-leveraged and highest-volume method by which hedge funds could benefit from a Lehman default - the CDS markets had much bigger volume than the stock-options markets, and better leverage and less risk than a direct short sale of Lehman’s stock. By buying credit default swaps and shorting Lehman stock, hedge funds caused a classic “run” on that unfortunate institution that would probably not have occurred otherwise - or even been possible.
In each of these cases, credit default swaps have imposed costs on taxpayers, on the U.S. and Canadian economies, and on society in general. And these costs are outside the terms of their own contracts.
If credit default swaps were just Wall Street gamblers’ playthings - used to “hedge” exposures and provide gaming opportunities for hedge funds - the securities might have some modest net social utility.
However, in the cases we’ve highlighted, the CDS market has proved to be a means of extracting rents from taxpayers and other outsiders. If AIG had been allowed to go bankrupt properly - causing huge losses to banks, investment banks and hedge funds - credit default swaps might well have died a natural death.
The rescue of AIG provided them with artificial life support - thanks to a U.S. taxpayer subsidy of more than $150 billion - a fact that has perpetuated their existence.
In terms of regulation, a moderate step would be to allow the purchase of CDS securities only by those with an “insurable interest” in a particular debt. Further provisions could be written, providing that voting rights on a debt were transferred as credit default swaps were written on that liability. You could even force CDS securities to be weighted 100% in bank risk capital calculations, as if they were direct loans.
However, even a CDS purchase to offload a direct credit risk can equally well be undertaken by a simple sale of the debt, which would at the same time transfer its voting rights in any bankruptcy.
Since hedging and transfer of a debt position is perfectly possible without the existence of credit default swaps, what valid economic purpose do they serve?
I’m one of the biggest free-marketers on the planet, but these things aren’t the free market, they only work because of bank regulation and the “too big to fail” doctrine. When I ran a derivatives desk in the 1980s, we looked at the possibility of credit default swaps - it was an obvious derivatives application - but we decided that they were impossible to hedge and their payout in default was too uncertain for them to be sound financial instruments.
We were right. The market for CDS securities only mushroomed in the late 1990s because - by that stage in the long economic bubble - bankers had stopped worrying about long-term soundness if it meant they could receive larger short-term bonuses.
Let’s ban them. Wall Street will scream about the loss of income, but that loss will be trivial compared to the amounts taxpayers have already paid to bail out Wall Street from its mistakes. The modest economic benefits of credit default swaps are dwarfed by the costs and distortions they impose.
Private equity investors, it is believed, have the expertise to understand the complex ways in which businesses operate. Retail investors have so
much faith in PE firms' domain knowledge that they favour companies that have high institutional holding.
However, nearly 50% mark-tomarket (MTM) losses on their India portfolio has shaken the market's faith in PE firms. In dollar terms, the losses amount to around $2.3 billion on total investments of $6.3 billion in India(for deals struck in the year 2007 and 2008).
The losers include the very best of PE fraternity, with names like Citigroup, Temasek, 3i, UTI Venture Funds, CLSA, Warburg Pincus and JP Morgan figuring in the list. Losses suffered by retail investors, who invested in companies with high institutional holdings, could be many times the losses posted by PE firms. Despite the fall in value of their investment, retail investors are still holding on their investments. Bogged by the ups and downs of the market, they are left wondering as to what should be their next step.
The extent of losses is huge. Less than 10% of the 93 private investments in public equity (PIPE) deals struck in 2007 and 2008 are in the black, because of high entry points. The two worst deals, in terms of notional erosion of value, are the investment by New Vernon in Prime Securities and Kotak's investment in Heritage Foods.
At the current stock price of the two companies, the MTM losses work out to be 93% and 91%, respectively. It is not only the loss suffered but an exit horizon is also not visible. Nalanda Capital's investment in Vaibhav Gems in the year 2007 has eroded its networth by 90% over a span of two years. A number of PE firms have invested heavily in unlisted companies. The losses could be huge, given the high valuations that many of such companies got then.
The average loss on investment for all private equity deals done in 2008 stands at 39%. The results of 2007 are not better either. Private equity investments struck in 2007 stand to lose $1.73 of their value at 35%.
The losses suffered by PE investors show the frailty of the India story, as no sector escaped value erosions. The worst affected sectors are real estate, information technology, banking and financial services, and healthcare. Clearly the perception that PE money is smart money remained just, a perception.
All hope is not lost yet. These investment honchos have managed to strike some good deals as well. A consortium of PE players like Saffron, Trinity, Barclays, T Rowe Price have made close to 50% profit on their investment in Phoenix Mills, a commercial and retail real estate developer. Nalanda Capital's stake in regional entertainment and news channel, Sun TV network has also grown by a credible 40% over its investment last year.
Nonetheless, there are some other positives also. Unlike portfolio investment, PE money could stay in India for another two-three years . Retail investors could, thus, avoid liquidating their portfolio. Recovery in equity market is not expectetd any time soon, patience would still prove to be a virtue.
The losses suffered by PE firms prove that the market spares none, not even the brightest of brains in the street. All valuation tools have been savaged at the altar of market volatility. Even the smartest guy in the street has been beaten down.
Though it is too early to comment on the investment rationale and valuations at which these deals were struck, the fact remains that PE firms are in no urgency to exit. This leaves a clue or two for the retail investor.
Note: It is assumed that the investments made during 2007 are still being held by the PE investors to arrive at current MTM value, for want of data.
Japan’s Hedge Funds Shun Trading Models to Find ‘Hidden Jewels’
By Tomoko Yamazaki and Komaki Ito
April 7 (Bloomberg) -- Hideki Wakabayashi sat through 500 meetings with company executives before settling on the stocks that produced a 13 percent advance last year for the long-short equity hedge fund he runs at Tokyo-based Finnowave Investments.
Toru Hashizume matched Wakabayashi’s performance with a 13 percent return for his Ginga Service Sector Fund by following a similar path. He said he sifted through 800 stocks before betting on about 70.
The Japanese hedge fund managers plan to beat benchmarks again in 2009 by shunning computer-driven trading in favor of company research. Their gains contrast with the average 19 percent drop of global hedge funds, according to data compiled by Chicago-based Hedge Fund Research Inc., and the 42 percent slump in the Nikkei 225 Stock Average during 2008, the index’s worst annual performance.
“When everything is sold right down and individual companies are in make-or-break mode, it is likely to be more of a stock-picking environment,” said Peter Douglas, principal of GFIA Pte, a Singapore-based hedge-fund consulting firm. “The hidden jewels of Japanese hedge funds will have a good year.”
The 10 billion yen ($100 million) Finnowave fund has extended its gains this year, returning 1.6 percent in January and 1.3 percent in February, compared with a 0.3 percent increase and 0.7 percent decline, respectively, by the Eurekahedge Hedge Fund Index tracking more than 2,000 funds.
Hashizume at Tokyo-based Stats Investment Management Co., which looks after 7.2 billion yen and advises the Ginga fund, has limited declines at his telecommunications and services- focused fund to about 2 percent this year, while indexes tracking those industries in Japan slumped 21 percent and 14 percent, respectively.
About 90 percent of the more than 200 hedge funds that focus on Japan are research driven, shunning the model trading strategies that account for almost half of the global industry, according to data from Eurekahedge Pte. and Hedge Fund Research. About 40 percent of funds that focus on Japan posted positive returns in 2008, compared with 27 percent in Europe and 38 percent in North America, Eurekahedge reported.
Japan’s independent hedge funds, those not affiliated with a financial institution, hold a fraction of the assets relative to global firms like Kenneth Griffin’s Citadel Investment Group LLC, which has $13 billion. They account for 95 percent of Japan-focused hedge funds and manage a total of $12.1 billion in assets, according to Singapore-based Eurekahedge.
“Japan-focused hedge funds are making money,” said Ed Rogers, chief executive officer of Rogers Investment Advisors Y.K. in Tokyo, whose $15 million Japan-focused fund of hedge funds, Wolver Hill Japan Multi-Strategy Fund, returned 6 percent in 2008. “The numbers just don’t lie.”
Finnowave mainly invests in stocks with a market value of at least 50 billion yen. The firm profited in 2008 by betting that shares of electronics stocks and export-driven companies would fall, and by acquiring shares of companies such as Nohmi Bosai Ltd. that benefit from an increase in domestic demand. Wakabayashi covered the electronics industry as an analyst at Nomura Holdings Inc.
Finnowave bought shares of Nohmi Bosai, a Tokyo-based maker of fire alarms and extinguishers, for about 600 yen each and sold them for more than twice that toward the end of the year.
Among other stocks that contributed to last year’s gain was Yokogawa Bridge Holdings Corp., a Tokyo-based bridge and steel tower builder. The fund invested in the shares on expectations that recent bridge collapses worldwide may boost demand for Japanese bridge builders that have among the best technologies in the world, Wakabayashi said.
In 2007, a Minnesota highway bridge collapsed, marking the worst such accident in 25 years, while in central China’s Hunan province a bridge collapse left more than 30 people dead.
Wakabayashi has switched gears and said he is investing now in export-driven stocks and selling domestic-demand shares, on the view that much of the negative news has been priced into shares of many exporters. He declined to name specific stocks.
He said he is also focusing on firms that may benefit from increased awareness of energy saving and environment-related issues, such as Sumitomo Electric Industries Ltd.
“The funds that are going to survive will be those that are doing the legwork and researching their companies -- craftsman-like funds,” Wakabayashi said.
Epic Partners Investments Co.’s Prowess of Japan Fund, a so-called market-neutral fund that favors stock picking, returned 17 percent in 2008 and extended its gain to more than 4 percent this year. A weakness of many computer-driven models is rigid stop-loss selling, said Tetsuya Abe, head of compliance at Epic, with 36 billion yen in total assets. A stop-loss order triggers the sale of a security when it falls to a certain price.
“In an environment where we had the market going up and down by more than 10 percent on a daily basis, you start to see irrational pricing on stocks,” said Tokyo-based Abe. “We don’t abide by the stop-loss rule, so our managers held some valuable investments.”
GFIA’s Douglas said Japan’s so-called lost decade in the 1990s, when asset prices declined and bank bailouts hobbled the economy, prepared Japanese hedge fund managers better than their overseas rivals to navigate challenging investment times.
The Nikkei 225 fell 60 percent during the past 15 years, while the Dow Jones Industrial Average in the U.S. rose more than 90 percent.
Douglas’s firm made an average 2.3 percent from its Japanese hedge fund holdings in 2008, while the MSCI World Index of 1,678 companies plunged 42 percent.
“You have a few skilled professionals who’ve grown up over the last 15 years investing in extraordinarily difficult markets,” Douglas said. “Tokyo managers have learnt how to roll with the not-inconsiderable punches thrown at them.”
To contact the reporters on this story: Tomoko Yamazaki in Tokyo at email@example.com; Komaki Ito in Tokyo at firstname.lastname@example.org
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.
The cost of capital of private equity is very high
The rising tide raises all boats but when the tide is going out, and there is no ambiguity that it is going out, a lot of PE firms who should not have existed in the first place will not existSanat Vallikappen Goa: With the booze, the beach and a magnificent setting on the ramparts of a 16th century Portuguese fortress, last week’s 2nd Biennial China-India PE Summit turned out to be a perfect place for stressed fund managers to loosen up after a very tough year. The meet was organized by Capvent AG, a private equity, or PE, fund of funds with $1.3 billion (Rs6,539 crore) under management. But no amount of this relaxed setting could make a difference to one man’s rather bleak outlook for the PE industry. Rahul Bhasin, managing partner of Baring Private Equity Partners (India) Pvt. Ltd, a PE fund that manages in excess of $1 billion in India, is well-known for his radical views. He was in peak form on Thursday when, one the sidelines of the conference, he talked about private equity’s woes in the context of its gigantic size, the gloomy outlook for global and domestic growth, the unpredictability of long-term outcomes, and the slow recovery in the West. Edited excerpts:
Straight talk: Baring Private Equity Partners (India) Pvt Ltd managing partner Rahul Bhasin. Harikrishna Katragadda / Mint The industry is five times too large.
We had $20 billion of investments in an $800 billion economy year before last (2007). That’s roughly 2.5% of our GDP (gross domestic product). The highest ever that the US reached was 1.4% of its GDP. Out of that 1.4%, more than 80% was taking public companies private, an opportunity that is not available in India. In China, the absolute investment numbers are similar, except that GDP is three-and-a-half times the size of ours.
The second issue is the explosion of private equity firms. There are 540 funds (active in India). I got this from one of my investors who tracked the number of people who tried to raise money from him, and includes private equity, venture capital and real estate funds. I don’t think it will be a significant exaggeration. Is the market deep enough for 50? I doubt it.
The rising tide raises all boats but when the tide is going out, and there is no ambiguity that it is going out, I think a lot of private equity firms who should not have existed in the first place will not exist. May be it’s five times too large and this means that 70-80% of the funds that exist today will not exist five years from now.
Lower GDP growth pares returns.
In India, all returns are driven by growth... The challenge is that the cost of capital of the private equity industry is very high. Investors expect that you (the fund) will offer them at least a 25% dollar return. The growth (of GDP) used to be 9-9.5% in real terms,15-16% in nominal terms, 22% in currency appreciated terms (the currency was also appreciating in 2007) and, if you picked the sectors right, you could get 5-10%. Finally, if you picked the companies right, you could get another 5-10% on that, which theoretically brought you to almost 40% returns. Assuming that we made some mistakes, still it was possible to get 30% return.
Now, the GDP growth is likely to be around 5% and, in the short term, even lower. We think this year will be closer to 4% largely because manufacturing is going to have a tough time recovering, and industrial production growth will be infrastructure-related. Agriculture has had four spectacular years in a row and it’s very tough to repeat that kind of growth.
The other reasons for lower growth.
Investable savings will come down rapidly, largely because the extra-normal profits of the resource industries in India—responsible in a large way for the jump-up in savings rate—have vanished as resource prices corrected. My own guess is savings rate will go down from 33-34% to 25-26%. We will have a lot of debt from the banking system globally, which is due for repayment, getting repaid this year. Debt will not get rolled over and, therefore, the net investable savings in the GDP will go down. It’s very tough to see how more than 13-14% of GDP can be invested this year, against 37-38% last year.
Topline growyh of portfolio companies to go for a toss.
The topline growth is going to be significantly lower in the companies private equity funds invested in. Besides, your cost of capital has not come down because risk perception has gone up. Because of high risk perception, a lot of assets all over the world are giving you very high returns. So you have to generate those returns to attract capital into India.
No margin expansion either.
If you can’t get it (returns) from (topline) growth, the second place you can typically get it from is margin expansion. We’ve been working very hard with our portfolio companies to reduce working capital cycles and expand margins, but we have not succeeded. We have helped them maintain their margins.
If you look at the cycle around 2001-02 (bottom of the cycle) profits after tax as a percentage of revenue of the Indian corporate sector was around 1.7%. Last year (at the peak of the cycle) it was 6.7%. So if you assume that the cyclicity will get repeated, you would assume that the profitability of the private sector can get hammered.
Capital structure efficiency not easy.
When topline growth goes away, margins growth is very hard to come by. The third thing that private equity can do is capital structure efficiency or balance sheet efficiency, which often means the ability to take away resources from a business which it doesn’t need, or bring in resources where it needs them and make that more efficient.
Here, you have a lot of structural bottlenecks, as the cost of bringing in or taking out an asset is very high because of stamp duties. The cost of bringing in or taking out labour from a business is also very high. On capital, you can bring in or take out, but you have dividend distribution tax.
P/E expansion then?
If you see where price to earnings (P/E) multiples are over the long-term (last 10 years’ average), and you look at where they are today, markets are still trading at a premium over the long-term. The last two to three years were a bubble. It’s not a reality. If you’re trading at a premium to the long-term reality, then no returns are going to come from there.
Only hope: special situations.
Special situations are alive and well. These happen when a business is being particularly badly run. Then you (an investor) get in, intervene and you fix it. That will happen when there is a corporate governance arbitrage, where the owners have not been fair to their shareholders, and you come in as private equity, and just be fair.
All drivers of growth together, but….
The last option is if you can get a conjunction of some components of all these drivers, that would be an opportunity (to invest). But then again, when you’re looking for four or five drivers of returns to meet your cost of capital, then the opportunity set available comes down sharply.
No predictability of long term outcome.
To be able to invest long-term capital, you need some amount of predictability of longer term outcomes. If you look at longer term outcomes, we are running a huge fiscal deficit. Is it an Indian problem? No, the US is doing it, the UK is doing it, and there is no guarantee how many more countries won’t do it.
Make the darn cake larger.
In a country like India, financial engineering is overrated. Here, you have to focus on making the cake larger. Trying to find sophisticated financial ways in which you can make your share of the cake larger is setting yourself up for disputes. Make the darn cake larger; stop fighting about share of cake. If it’s larger for everybody, everybody wins. Make the companies larger, make them more profitable, and there’ll be enough to go around.
The West is not going to recover in a hurry.
The probability of a recovery in the West in short term is low. Fundamentally, the West is living beyond its means. If you want to re-establish equilibrium, you have to get them to live within their means, which means they consume less. Whichever way you look at it, it’s not going to recover to where it was, suddenly. And if it doesn’t recover, then that incremental demand fillip for exporting your way out of a domestic problem is not available.
Back to basics.
Private equity essentially brings an organized, efficient managerial paradigm, to young companies. It helps them attract talent, identify long term opportunities, right resources, align the incentive structures against those resources, maintain good governance practices, and so on. The focus on basics has to increase dramatically because it’s easy to jump in when P/Es are expanding because that’s going to give you returns.
Private equity will go through a natural process of cleansing. You will also see a lot of pain and cleansing of international firms, who were very big in the leveraged buyout business. There is so much leverage in their portfolio companies.
Driving returns by simply increasing leverage is a fantastic thing to do in a bull market. You don’t ever face the cost of the consequences of that cost. In a bear market, you get leveraged loss also.
Leveraged buyout shops from the US to India. Why?
I find it quite amazing (that they are setting up here). When I read articles about their intents, etc., my summary of what they seem to be saying is that “we have problems in our home markets, there is a crisis, there is an issue with our business model, therefore we will go to India”.
I wouldn’t call it a positive vote on India. It’s more like saying “I don’t know what’s going on in my home base, let me go to some other market.”
Private equity will not get capital, but India may.
The GDPs in the West are shrinking. If you look at relative returns, India might actually be a better place (for investments).
For private equity, will India be more attractive? Yes. Will private equity as an asset class get more capital? No. Because the LPs (limited partners) will look at debt and say they can get 25% debt of some municipal corporation of some part of the US, so why would they put money in private equity? The asset allocation there will shift out of private equity into distressed debt. The likes of pension funds and endowments have prioritised their relationships. They’ve decided on who they want to stick with and who they don’t. I think we (Baring) have the good fortune at this moment of being on their priority list. We are not facing any issue (redemption pressures, etc). But can I sit here and say that there won’t be an issue tomorrow or day after? If there is a global contagion of this nature, you have to assume that you will get hurt somewhere.
APRIL 5, 2009, 8:01 P.M. ET
Financial News: Barclays Cleared For Spinoff Of Buyout Arm
Barclays Private Equity, the top-performing, in-house buyout division of Barclays Bank, has received approval from its third-party investors to spin off from its parent before its fourth fund is raised next year.
However, the U.K.-based bank, which also started exclusive talks to sell its exchange-traded fund manager iShares to buyout firm CVC Capital Partners last week, has yet to agree a deal. A Barclays spokesman declined to comment.
Roger Jenkins, chief executive of the investment banking subsidiary of Barclays Capital's principal investments arm, has been leading the negotiations with regional co-heads of Barclays Private Equity Paul Goodson (UK), Gonzague de Blignieres (France) and Peter Hammermann (Germany) representing the three offices planning the spinoff.
Jenkins and Goodson reportedly met with third-party investors in Barclays Private Equity's funds in late December to discuss strategic options for the group but a source with knowledge of the talks between the bank and its funds' external investors said an indicative agreement to support a spinoff had been given within the past two weeks.
A large investor in the arm's first three funds said: "Barclays Private Equity contacted us and our understanding is there is a general willingness to go down this route, but the hows and terms have not been agreed."
Barclays Bank has been contributing less of its balance sheet to supporting Barclays Private Equity funds, having moved from committing about half the total raised for its first fund to EUR650 million of the EUR2.4 billion in fund III closed in August 2007. External investors in Barclays Private Equity Fund III are some of the world's leading managers of funds of funds. All those contacted declined to comment.
Japan Venture Capital Funds Facing Mergers as IPOs Disappear
By Patrick Rial and Kotaro Tsunetomi
April 6 (Bloomberg) -- Japanese funds that buy stakes in start-up companies are struggling to survive amid the worst market for initial offerings in 17 years, Kazuhiko Tokita, chairman of the Japan Venture Capital Association, said.
Only 49 companies went public last year, the fewest since 1992, depriving venture firms of the source of 45 percent of revenue and 90 percent of profits, based on data from 2007. The investors are likely to pool their holdings to create bigger stakes so they can pressure companies to merge or buy back stock, Tokita said.
“The industry needs to gather its power during this ice age, and that means combining,” said Tokita, a former director of Mitsubishi UFJ Financial Group Inc.’s venture capital unit. He predicts funds will lose money this year and possibly next. “When this is finished, what’s left standing will be the real venture capitalists.”
The country’s three biggest firms saw two years of profits wiped out since April 2008 as Japan’s economy shrank at a 12.1 percent rate in the fourth quarter, according to data compiled by the Venture Enterprise Center and Bloomberg. Japanese funds, which together manage 1.04 trillion yen ($10.6 billion), get more than twice as much revenue from IPOs as U.S. and European firms, according to Venture Enterprise.
Tokita’s group will hold a meeting for more than 100 members this month to facilitate merger negotiations and collaboration on investment stakes, he said.
The inability to take companies public is reducing new investments, starving start-up businesses of capital. Smaller companies, which employ about 70 percent of Japan’s workforce, said financing is the hardest to get in at least 23 years, according to a survey published by Shoko Chukin Bank on Feb. 25.
Of the 936 companies that went public in Japan from 2002 to 2008, 62 percent were backed by venture funds, data from the JVCA shows.
“The drain on available funds is a real concern,” Venture Enterprise wrote in a report. “Venture firms are Japan’s drivers of industrial competitiveness and economic activity.”
The venture units of Shinko Securities Co., Dai-Ichi Mutual Life Insurance Co. and asset manager Diam Co. merged in February 2008. Meiji Capital was acquired by Yasuda Enterprise Development on April 1.
“Funds that can’t break even in this environment will be forced to exit,” said Shinichi Fuki, executive managing director of Jafco Co., the largest venture investor. “There’s been talk that some players will be pushed into mergers, and I’ve got a strong feeling that’s what’s going to happen.”
IPOs slumped as the deepening global recession dragged the Nikkei 225 Stock Average to the lowest level in 26 years.
The 49 IPOs last year was less than a third of 2006’s level, according to data compiled by Bloomberg. This year, no companies listed in January or February for the first time since at least 1999.
Profitability of IPOs is also declining. The first four companies that sold stock this year priced shares at an average of 7.9 times annual earnings, compared with 15 times in 2008.
The IPO “business model is dead,” said Hiroshi Matsumura, director of the VEC. “Those who can’t successfully diversify their exit strategies won’t survive.”
Jafco, Daiwa SMBC Capital Co. and Japan Asia Investment Co., the country’s three largest venture firms, reported combined losses of 25.6 billion yen ($260 million) for the first nine months of the fiscal year ended March, compared with total profit of 22.9 billion yen for 2006 and 2007.
Jafco lost 851 million yen in the period. Daiwa SMBC reported a 5.1 billion yen loss in the same period, while Japan Asia Investment suffered a 19.6 billion yen decline. Their shares slumped more than 10 percent this year, trailing the Topix index’s 3.2 percent decline.
Besides IPOs, venture funds make money when companies they invest in merge, repurchase stock, or sell units to other funds or companies. Management buybacks, where executives repurchase shares from venture capital firms, and liquidations made up 37 percent of Japanese venture fund revenue in 2007, VEC data showed.
Mergers accounted for 16 percent of revenue and 1.9 percent of profit, with other strategies making up the remainder, according to the VEC.
Stakes owned by Japanese funds are too small to force acquisitions, the JVCA’s Tokita said. Pooling holdings would give them new ways to profit, he said.
“Our industry is in a race for survival on a global level; we’ve been hit by a giant tsunami,” Fuki said. “VC firms that aren’t able to raise funds and continue investing when prices are low aren’t going to make it. The need for fund consolidation is not something I can deny.”
To contact the reporters for this story: Patrick Rial in Tokyo at email@example.com; Kotaro Tsunetomi in Tokyo at firstname.lastname@example.org.
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.)
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 $92 billion of commitments from institutions. The pace has been glacial, bankers and lawyers say, and raising all of it isn't a sure bet. "Fundraising has slowed tremendously, though unlike megabuyouts, there's still a fair amount of money going into infrastructure," says Kelly Deponte, managing director at Probitas. "Pension funds are looking at the demand side of the equation."
Braving the economic turmoil
Top 10 infrastructure funds now in the market
Rank Fund Fund manager Manager country Size ($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