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Infra Funds!

By Eric Peghini

Initially posted on the BSPEC blog

On a cold, gusty Saturday afternoon,

“Nation’s infrastructure is collapsing, MAGA!”

This was not a poorly executed haiku but rather a tweet attributable to the one and only infallible D.J. Trump and, never mind your opinion of the POTUS, a rallying cry that the population could stand behind.

Granted, one does not need a desk in an oval office to understand that infrastructure is important. However, from the outside peering in, infra may appear mundane to the modern-day civilian whose exposure is surely only limited to the daily commute down interstate sixty-whatever while lip-syncing Drake lyrics with an iced coffee holstered adjacent to the radio. But perhaps infrastructure is only uninspiring because we take it for granted until it all comes crashing down, *ahem* Italy.

From a financial perspective, infrastructure as an investment may also seem less attractive at face value due to the length of project construction periods and library of government regulations defining zoning restrictions, contracting requirements and subsidies – add to this the notion that the industry is predominantly a mature one which primarily grows with GDP.

But now is the time to divorce [some of] these prejudices.

What is true is that the infrastructure industry is incredibly significant, incredibly integrated within the context of global markets and the geopolitical landscape and offers a relatively new frontier of opportunities to investors.

Overview

Infrastructure represents real assets encompassing motorways, parking lots, bridges, airports, seaports, rail, midstream oil & gas (pipelines and storage) and power & utilities (including electricity generation, distribution and transmission, gas, water, and telecoms). Investments can be allocated into the following buckets:

  1. Core infra – Assets deemed as “essential” which are typically regulated and paying steady dividends. Because of this, IRRs will normally fall below 10%
  2. Core infra plus ­– While still brownfield, these projects demonstrate less certainty and require some growth Capex allowing for higher return potential
  3. Value add infra – Investments which require proactive redeveloping and with prospects for but no current pricing power or monopolistic characteristics (e.g. having the sole bridge connecting particular roads etc.)
  4. Opportunistic infra – Projects exhibiting the highest risk; think greenfield without state-backing. IRRs can go beyond 15%

Projects are not perpetually siloed according to entry risk profile. The investment may graduate from its initial bucket over the course of its lifespan. Because this sector is unexaggeratedly capital intensive, projects undergo development phases and operational phases ­– this adds variety. A pipeline of wind farms under development will sell for a lower EV/Megawatt Capacity than one that is under construction which will sell for a lower multiple than a similar farm which is operational. More subsidies for the farm and higher load factors also pump up multiples. These attributes allow funds to specialize or diversify holdings based on risk preferences. They also enable a fund to enter and add value at a unique stage. Because of their multi-stage lifecycle, assets will experience a number of changes in ownership; this implies more entry and exit points and increased M&A activity.

While historical returns may not embolden the case for infra investment (IRRs will not average 20%+), the benefit is risk hedged. You heard it from Trump earlier, demand for infra is a melody harped by politicians everywhere and backing investments with real, tangible assets allows for fundamentally sound returns. Further to, although indispensably embedded within the global economy, because infrastructure is so central – supplying transportation, water and power etc. – it is more insulated against market shocks.

What’s more to stuff portfolios is social infrastructure which is composed of schools, hospitals, courts, detention centers and the like. Perhaps unsurprisingly, these ventures are typically state-backed services yet they are operated by private contractors who bid for lucrative contracts (called tendering). Contracts are granted via government relationships, track record and pricing power with respect to the project which is under consideration. Sometimes these tenders are won strictly via auction, other times the government hand selects those contractors eligible to bid. Social infrastructure will include facilities management (FM) which is categorized as either “hard FM” (heating, plumbing, maintenance etc.) or “soft FM” (cleaning, security services, waste management and more).

Players

Pure infrastructure investing is a relatively new territory. Prior to around 25 years ago, private capital was not deployed for large infra projects; instead, governments would own and control the assets. This landscape has adjusted as the LP perception of infra thawed.

Below is an introduction of the key investment houses in the space:

Other notable participants include Stonepeak, North Haven (Morgan Stanley) and other investment banking arms, the Canadian pension funds (OMERS, Teachers, CDPQ etc.) sovereign wealth funds (GIC, CIC, Wren House etc.), and the usual suspects: KKR and Apollo.  Strategies include both majority and minority holdings. Investments are regularly acquired via consortiums due to the relative size of the assets  and the levels of development demanded by the project entered. Management fees will diverge from the golden 2 and 20 structure circling 1.5% instead as vanilla infrastructure investments require longer retention periods.

Execution

IRRs are produced via the leverage effect and/or multiple arbitrage. This is necessary because revenues are fixed and margin improvement is difficult to realize. As such, according to some sources, investments may observe leverage to equity ratios of 8:2. Many of the “lower risk” or more publicly-supported projects can reach even higher altitudes; for instance, a school could sustain upwards of 90% of transaction value in leverage. Through this, preferred returns are certainly within reach yet at such levels of debt, operational risk, construction risk and market risk must be adequately considered.

Alongside sourcing assets, financing is also central to infra investing. LBO’s, the traditional PE method, are widely employed within infra investment. Oftentimes projects will experience Public-Private Partnerships (PPPs) in various formats in which the government will pay the investor a certain hurdle rate to develop an asset. A more granular example includes Private Financing Initiatives (PFIs) involving a private investor financing a publicly demanded infrastructure project and leasing it to the public sector in order to smooth the patron tax burden. Some greenfield projects will typically require Project Financing where loans are non-recourse and secured by the projects’ cash flows whereby the venture’s assets are used for collateral. Many infra funds will issue private capital to public institutions under these types of arrangements.

Modeling

For those seeking increased technical exposure within finance, infrastructure can be an enticing area because most assets require models for valuations. This is due to the fact that not all assets are perfectly comparable on a relative basis (as locations are fixed and vary), brand value has no impact on EV and levered free cash flows are predictable with relative feasibility – projection periods oftentimes exceed 10 years. Many prospective investments have operations and maintenance (O&M) contracts which detail the terms allowing for increased modeling visibility. “Win rates” can also be applied to forecast cash flows as contractors typically have established order-books or committed future revenues for the services to be provided from tenders won.

Here’s a high school diorama of an infra model. Using toll roads as an example, the owner, say Ferrovial (a major global concessionaire), may retain a concession for a road. During the expected life of the asset one can make top line assumptions: toll fees may grow with CPI and traffic will expand with expected population increases and/or auto sales. A safe bet is assuming that commercial traffic is likely to expand with GDP. Combine these two to forecast sales volume, then deduct Opex (based on historical margins), interest according to the tranches of debt raised, taxes and maintenance Capex to forecast the medium-term cash flows. If the entire concession life is not modeled, then one may assume an exit multiple in the year following the projection period based on a regression of the asset’s remaining life to EV/EBITA (or EBITDA) of precedent transactions.

Similarly, one can effectively replicate power cash flows using take-or-pay generation or baseloads, forecasted prices of electricity and consensus forecasts of input expenses (whether that’s the cost of coal, natural gas, nuclear or renewable installation expenditure). One can also go ahead and value seaports based on expected shipping traffic and concession life. Really, it’s all model-able and a model is actually expected. The general disclaimer is that in reality, infra funds will blend copious additional layers of minutia into their valuations.

Having glanced over these simplified models one can ascertain how interconnected infra is with the global economy. The asset class is one that drives and enables the continuity of several other industries. It is therefore critical for societies to finance and issue projects to the professionals who can properly implement and maintain the infra assets. Such opportunities are ripe for investment. For more insight follow us on twitter for live updates.

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Bocconi Students PE Club
The Bocconi Students Private Equity Club (BSPEC) is a student-led organization at Bocconi University. The club publishes articles related to private equity and venture capital, conducts interviews with active PE professionals and hosts events featuring funds and advisors. BSPEC is one of the oldest and most active student associations at Bocconi University and its alumni are currently employed at top tier investment banks and PE funds. Learn more at https://bspeclub.com/

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