Institutions getting their hands dirty with infrastructure investments

More institutions are directly investing or co-investing alongside managers in infrastructure projects, moving away from commingled funds and redefining the sector in the process.

For institutional investors, taking a direct route allows for a more tailored investment, additional influence over the deals and greater return potential for the risk taken, according to fund executives and consultants.

For investment managers, having co-investors allows them to bid for larger projects without adding concentration risk, when a large portion of the portfolio is invested in one infrastructure project. In some cases, having a partner with specialist knowledge of certain sectors or regions can help managers to improve returns on the assets, said Anthony Stalker, London-based partner and chief operating officer of ADM Capital Europe LLP, an emerging markets specialist manager that offers infrastructure strategies.

Benjamin Way, senior managing director within The Macquarie Group's infrastructure and real assets division based in Beijing, said the company has been working with an increasing number of Asian institutions as co-investors. “We often target domestic money” when bidding for infrastructure projects to gain local knowledge, Mr. Way said. “It's not a prerequisite that you have to have a local investor such as a sovereign wealth fund as part of the consortium to win the deal, but (such an investor) can bring more credibility. ... It's just smart.”

Mr. Way declined to name the co-investors in recent deals, but said they include Asian sovereign wealth funds and pension funds. “Increasingly, the deals are getting bigger and need more equity, and (institutional investors) have more equity capital to deploy,” said Mr. Way, whose firm has about $92 billion in infrastructure assets under management.

While direct infrastructure investing is not new, the number of large institutions with co-investment programs has accelerated since the financial crisis of 2008-2009. At least 20 large institutions have implemented or are introducing direct infrastructure strategies compared with less than half that number five years ago, according to Ryan Orr, executive director of the Collaboratory for Research on Global Projects at Stanford University and co-author of “The New Era of Infrastructure Investing” published in May.

They include SWFs, insurance companies and pension funds — with Canadian and Australian funds leading the way but followed closely by European pension funds, sources said.

In the U.S., the $232.2 billion California Public Employees' Retirement System, Sacramento, began direct infrastructure investing in 2010, buying a 12.7% stake in London's Gatwick Airport.

“Certainly, our long-term objective is to focus on direct investments like the London Gatwick Airport transaction,” Clark McKinley, fund spokesman, wrote in an e-mailed response to questions. “We typically begin such programs with investments in pooled funds, then ramp up with more direct or co-investments with partners as opportunities arise and we gain more experience and resources to do that.”

The $154.6 billion California State Teachers' Retirement System, West Sacramento, made its first $150 million commitment in a commingled infrastructure fund in April and is seeking “to get into co-investments and direct investments,” fund spokesman Ricardo Duran wrote in an e-mail.

CalSTRS is planning to develop direct infrastructure capabilities in-house within the next several years, sources said.

Mark Weisdorf, managing director and CEO of J.P. Morgan Asset Management's infrastructure investments group, said institutional growth in direct infrastructure and co-investment reflects the increasing opportunities since the financial crisis. Under fiscal pressure, “governments around the world are interested in bringing in the private sector to invest in infrastructure projects. Corporations are also looking to sell non-core assets,” said Mr. Weisdorf, who is based in New York. J.P. Morgan has about $5 billion in infrastructure assets under management.

One of the firm's more recent deals was the purchase of Spain's Dragados ports and logistics business in December 2010, which also involved the e242 billion ($349 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands, as a minority co-investor.

Direct investment and co-investing in infrastructure allows institutional investors to “better control which infrastructure assets best fit into the investment portfolio” according to specific risk/return characteristics, said Robbert Coomans, adviser to the board of Algemene Pensioen Groep NV — the money manager for ABP. For example, in order to reduce volatility, APG might look at deals averaging around 50% to 60% leverage, vs. the typical level of 70% to 80%. Other considerations include targeting certain sectors or regions to diversify the overall portfolio.

At year-end 2010, ABP reported a 23.5% return on its infrastructure portfolio, which totaled 0.3% of the entire fund. Fund officials are targeting a 2% exposure to infrastructure, according to data provided by ABP.

APG made its first direct infrastructure investment in 2007 on behalf of ABP, and Mr. Coomans expects the majority of those investments in the future will be co-investments, rather than commingled funds.

At CalPERS, fund officials said advantages of direct infrastructure include more influence in how the assets are managed. For example, CalPERS nominee Sir Roy McNulty was recently appointed to Gatwick's board of directors. Furthermore, CalPERS also received a cash dividend of about $70 million, which was related to the airport's successful bond refinancing, according to Mr. McKinley. “Such returns are potentially greater than from investments in pooled accounts,” he said.

Institutions also save on fees, which typically mirror private equity for commingled infrastructure funds, several sources said. The amount of cost savings varies according to such factors as the terms of the direct investment and how much is being spent on additional internal resources to implement such investments in the first place.

Peter Lykke Thomsen, head of socially responsible investing and secretary in the investment department at Pensionskassernes Administration, Hellerup, Denmark, said about 3.2% of the 140 billion Danish kroner ($27 billion) fund is committed to infrastructure. Of that, about two percentage points are in infrastructure funds while the remainder is in direct infrastructure. PKA's target for the asset class is 2% to 5% of fund assets, and officials are looking to increase the allocation to direct infrastructure.

“We will still invest in funds; we don't believe that (direct infrastructure) is a substitute but more complementary to (infrastructure) funds,” Mr. Thomsen said. “Funds have characteristics that are more similar to private equity, targeting projects in the early development stages and often striving for a higher risk/return profile. In comparison, direct infrastructure tends to target assets that are more developed and less risky, with more consistent income streams to better match pension obligations.”

But direct infrastructure also brings additional burdens for co-investors, partly due to the long-term time frame of the investments themselves, sources said. Investors need to have the necessary corporate governance structure in place, resources to conduct due diligence and the ability to monitor the investments over their lifespan of 25 years and beyond.

APG, for example, employs about 10 investment professionals to manage the infrastructure portfolio, which includes a combination of direct investments and commingled infrastructure funds. “We have to do the due diligence and make the investment decisions (on infrastructure co-investments) within a very short period of time,” Mr. Coomans said.

Advantages include steady cash flows, long duration and some downside protection, according to Ashby Monk, research director at Stanford's CRGP and co-director of the Oxford SWF Project. Mr. Monk, who is based in Palo Alto, Calif., is also co-author of “The New Era of Infrastructure Investing” report.

Robert Gardner, founder and co-CEO of independent investment consultant Redington Ltd., London, is advising U.K. insurance companies and pension funds to co-invest in domestic infrastructure assets on an unleveraged basis in order to benefit from the potential for “the stable, long-dated, inflation-linked cash flows.”

“The old model of infrastructure investing as a proportion of alternatives no longer applies,” Mr. Gardner added. “Many pension funds are now saying that infrastructure should be part of an illiquid, liability-matching portfolio (accounting for) maybe 10% to 15% of the total fund. ... In this case, they're looking for real returns of about 4% to 5%, rather than the 12% to 13%” internal rate of return.

The presence of an increasing number of direct infrastructure investments is changing the sector's landscape, said Boe Pahari, head of European infrastructure at AMP Capital Investors based in London, which has about $5.8 billion in infrastructure assets under management globally.

Large pension funds are focused on lower risk and lower returns, but higher cash yields with less leverage, Mr. Pahari and others said. As a result, many infrastructure managers have lowered the average leverage levels of strategies offered to institutions, sources said.

Mr. Pahari added that the development of co-investments has led AMP to offer separate managed accounts and co-investment arrangements. In the past year, the SMA business grew about 20% in terms of AUM.

Jeffrey Altmann, director of European infrastructure investment management at First State Investments based in London, added: “Co-investment arrangements often present a better alignment of interests between LPs and GPs, compared to a mandate to invest alongside a fund.”