Seeing growth in greenfield funds

Institutional investors jostling one another this year for a toehold in existing power plants or toll roads — in search of the steady, reliable yields sovereign bonds used to provide — might want to rethink their reluctance to invest in new ones instead.

That's the contention of some industry analysts, even as a growing number of investors focus on the bond-like charms of so-called brownfield infrastructure, with little apparent appetite for the added risks — in construction delays, cost overruns or uncertain demand forecasts — that can bedevil the new greenfield projects.

With demand for those core assets increasingly outpacing supply, that could be poised to change.

In a recent interview, Frederic Blanc-Brude, director of the infrastructure research institute launched in Singapore three months ago by Paris-based EDHEC Business School, said a soon-to-be-published EDHEC survey of roughly 90 asset owners and 90 managers of infrastructure assets suggests greenfield investments might be on the cusp of becoming more mainstream.

The survey found allocations to core, developed markets brownfield infrastructure remain the prime focus for asset owners and managers.

However, a substantial 30% of asset owners cited greenfield projects with long-term contracts or rates of return set by government agencies as “very attractive” or “rather attractive” investment targets — a level of interest greater than the managers surveyed had predicted, said Mr. Blanc-Brude. The research was sponsored by the Global Infrastructure Hub, established by the G-20 to promote investment in infrastructure and policy initiatives supportive of infrastructure.

Some analysts pointed to the prices investors have paid recently for exposure to high-profile brownfield investments in Australia and the U.S., at 30 times prospective cash flows, as evidence of overheating — with the caveat that that judgment could prove premature depending on how long the current low-yield environment lasts.

The growing ranks of institutional investors looking for “long-duration trophy assets” with cash flows to match their liabilities have left core brownfield assets significantly more expensive now than they were five to six years ago, said David Rae, Auckland-based head of investment analysis for the NZ$29.6 billion ($20.4 billion) New Zealand Superannuation Fund.

Those relative newcomers, focused on the “very bottom of the risk curve,” are pricing many veteran infrastructure investors in Australia — with average allocations of around 6% to 7% — out of the core brownfield market, said Peter Siapikoudis, senior consultant and head of infrastructure with Melbourne, Australia-based consulting firm Frontier Advisors.

In contrast to the private equity focus of earlier investors, the new actors buying infrastructure now want “something that won't tank when the next financial crisis comes,” Mr. Blanc-Brude said. And if valuations appear aggressive to many old-timers, “people who believe that interest rates will remain very low for a long period of time” can justify buying at these levels, he said.

That dynamic poses a unique challenge for Australian retirement funds — many with investment portfolios growing 20% a year on the back of mandated employer contributions in Australia of close to 10% of salaries — in maintaining their current levels of exposure to infrastructure.

Frontier Advisors and its clients have responded by “working hard to stay out of public auctions” as much as possible, Mr. Siapikoudis said. In a huge global infrastructure market, there are still “many, many opportunities outside of those auctions” that are small enough to be off the radar screens of bulge-bracket asset owners and in need of skilled managers to deliver on their potential, he said.

Most investors in the U.S. — newer to the asset class than their counterparts in Australia, Canada and Western Europe — look to infrastructure for steady cash yield and a lower correlation to other asset classes, said Jonathan Gould, assistant vice president and real assets specialist at consulting firm Callan Associates Inc., San Francisco.

“The societal needs are in greenfield, but investors are looking for brownfield as those are the assets that have the return characteristics investors are looking for,” he said. “Most of the greenfield investment are in niche strategies and derive a lot of their return from appreciation, which is not why investors allocate to the asset class.”

“Infrastructure funds are large in terms of the amount of capital they raise, but they might still only invest in 10 to 12 assets. If one or two assets do not perform, or one or two assets outperform, it could move the needle,” Mr. Gould said.

Paul Shantic, director of the inflation-sensitive portfolio at the $178.7 billion California State Teachers' Retirement System, West Sacramento, agreed. “There's less room for error in infrastructure in terms of ... underwriting of the assets,” Mr. Shantic said. “One or two investments that are bad can really drag down returns of your fund.”

That is why CalSTRS officials prefer infrastructure assets that are “big, plain and boring.”

“Infrastructure is not there to provide eye-popping, double-digit returns like private equity,” Mr. Shantic said.

For CalSTRS, infrastructure is a diversifier that provides income that goes up with inflation and modest return — more than fixed income, but less than private equity.

CalSTRS' infrastructure managers are allowed to take some construction risk as part of the balance between income and total return, Mr. Shantic said.

For example, in 2012, CalSTRS allocated $42.8 million for four projects as part of its investments in two funds — Meridiam Infrastructure North America II and First Reserve Energy Infrastructure Fund. Those included the construction of a portion of the Presidio Parkway transportation project in San Francisco; reconstruction of the Long Beach courthouse in Los Angeles County; operation of a gas-fired power plant near Oakland; and operation of a solar-electric plant in the Sacramento area.

Investors are careful to distinguish the higher-risk categories of infrastructure, which might offer some return but may take longer to provide the income they desire from the asset class.

Some U.S. investors assess the risks in their infrastructure portfolios much like they do in their real estate portfolios.

“Greenfield infrastructure should be viewed as opportunistic, as distinguished from core infrastructure, which more closely resembles core real estate in its risk-return profile,” said Girard Miller, chief investment officer of the $12 billion Orange County Employees Retirement System, Santa Ana, Calif.

OCERS has exposure to infrastructure through a new $100 million separately managed account with Los Angeles real asset manager Kayne Anderson Capital Advisors LP.

In the current environment, “you need to be an active sort of manager,” whether it's a matter of expanding, rolling up or disaggregating assets, said Ross Israel, who oversees an A$7 billion ($5.4 billion) portfolio of infrastructure assets as head of global infrastructure for QIC Ltd., Brisbane, Australia.

The difference between greenfield and brownfield investments is not always clear cut these days, said Brett Himbury, CEO of infrastructure money manager IFM Investors, Melbourne, in an e-mail.

“Investors in existing brownfield assets ... continue to make significant capital investments in what might be termed as greenfield expansions of these companies,” Mr. Himbury said. IFM Investors had $46 billion in assets under management as of Oct. 31.

IFM, for example is investing billions to expand the U.K.'s Manchester Airport Group; participate in Germany's energiewende, the country's program to increase renewable energy and remove nuclear energy; expand runways at Brisbane Airport and Melbourne Airport in Australia; and improve safety and service on American toll roads, Mr. Himbury said.

At CalSTRS, it is not uncommon for the pension fund's infrastructure managers to make value-added investments that need additional construction, Mr. Shantic said.

The infrastructure marketplace is experiencing polarization, with assets that have a high yield component enjoying relatively high multiples now, and those with a higher growth component commanding much lower multiples, said Boe Pahari, London-based global head of AMP Capital Investors Ltd.'s infrastructure equity business.

In this environment, “sourcing is the additional alpha,” Mr. Pahari said. A manager's experience in driving the business of an acquired asset, and its ability to focus on smaller deals and less central regions will all be key to adding value, he said.

Mr. Pahari said pension fund investments in greenfield projects could rise, in line with government efforts to provide those investors with greater protection when investing in new deals. But he predicted other institutional segments, such as sovereign wealth funds, will be better placed to boost allocations to those riskier long-term projects.

Still, the frothiness of the core infrastructure market is starting to push some investors into greenfield projects, said Kathryn Leaf Wilmes, San Francisco-based partner and global head of infrastructure and real assets at alternative investment manager Pantheon Ventures.

“We are seeing a change in terms in how people are looking to invest in the asset class,” Ms. Wilmes said. “Not that long ago, greenfield was a dirty word for investors in infrastructure. It was viewed as too risky, and inconsistent with investors' mandates.”

Investors thought greenfield projects took too long to produce cash yield, “which continues to be the holy grail for infrastructure investors,” Ms. Wilmes said.

Now, investors are “recalibrating how they view risk and return and where they find the best risk-adjusted returns,” she said.

“Overpaying for a core infrastructure asset and maximizing leverage to do so can be more risky than investing in a greenfield... project, for example. We are seeing more and more investor appetite for investing in earlier-stage infrastructure assets as the core market becomes more expensive,” Ms. Wilmes said.

This is positive for the industry because “if you dig into those numbers, a lot of the capital required is for new-build infrastructure,” she said.

“There's been a historic mismatch between where the capital is needed and where the capital is looking to invest, but the gap is being bridged,” Ms. Wilmes added.

Few infrastructure managers are focusing mainly on greenfield.

Most infrastructure managers have broader mandates with some greenfield around the fringes, said Cesar Estrada, senior managing director, alternative investment services, in the New York office of State Street Corp.

Even the relatively new sector of renewable energy is mostly brownfield projects, Callan's Mr. Gould said. “Renewables are starting to gather more traction in North America but remains well behind Europe.” However, “not more than 10% to 12% is in greenfield assets,” Mr. Gould said.

Meanwhile, veteran asset owners in the infrastructure space say they've been trimming their core holdings, and boosting allocations to more “core-plus” assets, including — in some cases — greenfield projects.

With the environment much more of a “cost-of-capital shootout than it used to be,” NZ Super has been a “net seller, rather than a net buyer, of brownfield infrastructure assets over the last few years,” Mr. Rae said.

The sovereign wealth fund's latest monthly investment report showed a 4% allocation to infrastructure as of March 31, down from 6% as of June 30, 2013, the close of the fund's fiscal year, and 9.5% as of June 30, 2011.

“At the moment, we're only interested in assets that are a little more difficult” and probably on the smaller side, as such assets are less likely to be the object of cutthroat competition, Mr. Rae said.

The story at Australia's Future Fund is a similar one.

With the ranks of new infrastructure investors pushing up valuations, Future Fund “stopped deploying fresh capital into core offshore several years ago,” and instead moved to actively allocate capital to the higher risk — or opportunistic — part of the infrastructure spectrum, where valuations haven't run up as much, said Wendy Norris, head of infrastructure and timberland for the A$117.4 billion Melbourne-based fund.

That “core-plus” segment of the market covers infrastructure businesses that “need something done” — such as extending a contract or restructuring management — demanding more of an active management approach than an asset offering stable, bond-like returns, Ms. Norris said.

That has included some greenfield investments. Future Fund has invested in assets facing “late-stage development risk” as a limited partner in funds managed by Starwood Energy Group, a Greenwich, Conn.-based firm focused on building greenfield transmission projects, involving gas and electric utilities in the U.S., as well as wind farms and solar plants, Ms. Norris said.

Future Fund also co-invests alongside Starwood, she said.

Ms. Norris predicted Future Fund's infrastructure exposure could edge lower, as allocations to “core-plus” assets are balanced by reducing core holdings and putting some of the proceeds in cash — a broader trend that saw cash holdings jump to 22.9% of the portfolio from 20.6% in the three months ended March 31.

Infrastructure investments accounted for 7.1% of Future Fund's portfolio as of March 31, down from 7.4% and 8%, respectively, at the close of 2014 and 2013.

Superannuation fund executives say they're looking beyond core as well.

“We're broadening our horizon to look at greenfield opportunities,” including public-private partnerships, said Grant Harrison, investment manager, private markets, with Cbus Superannuation, the A$31 billion Melbourne-based superannuation fund for Australia's construction and building industries. Cbus sees those public-private partnerships as a “differentiated area of deal flow, in terms of underlying income streams,” Mr. Harrison said.

As a construction-related entity, Cbus is uniquely placed to evaluate things like construction risk, Mr. Harrison noted, adding that the fund might eventually consider broadening the business scope of its established property affiliate, Cbus Property, to pave the way for involvement in more greenfield projects, such as new hospitals or schools, where construction forms the core of the work.

Currently, Cbus is roughly at its targeted infrastructure allocation of 11%.

Some veteran infrastructure managers say they're recommending that asset owners add more greenfield to their allocation mix.

The yield compression on brownfield investments in recent years has pushed the pricing disparity between brownfield and greenfield beyond what the relative risks of the two would call for, said Andrew Kwok, a Singapore-based senior vice president on the infrastructure team of Zug, Switzerland-based private markets investment firm Partners Group.

While brownfield remains the focus, “if you do your homework,” investing in new greenfield projects can offer the “ability to generate a whole bunch of alpha,” Mr. Kwok said.

“To the extent you are going to invest in a significant portfolio (of infrastructure assets), greenfield should probably be part of it,” Mr. Blanc-Brude agreed. And “if you're investing to buy and hold,” for example, across a time span of 40 years or more, “then the greenfield period is actually a fairly short period of time,” he said.

Mr. Rae, meanwhile, said NZ Super “hasn't really done greenfield,” partly because of the risks presented by those projects in the past but also because some of the fund's particular circumstances aren't particularly conducive to current market trends.

Regarding the risks, Mr. Rae noted the past decade's history of toll-road concession sales by state governments in Australia that ended badly for investors. QIC's Mr. Israel likewise cited those sales as examples of “mishandling demand risk,” with “aggressive capital structures” used to build roads that then failed to see the demand needed to make made those investments viable.

That toll-road saga has proven a cautionary tale for asset owners, as the winners — in projects promoted by investment banks — were usually the bidders willing to make the most optimistic traffic forecasts, Mr. Rae said. That resulted in a “real winner's curse” that favored the second owners of those properties, he added.

Mr. Rae conceded that more recently, there's been much better risk-sharing between the ultimate buyers and the government promoter, with more direct negotiations between “some of the large players who expect to be owners for a long time, and the providers of the concession.”

However, in the stronger environment where the biggest asset owners have been more open to getting involved in those direct negotiations, NZ Super's modest size — in relation to its sovereign wealth fund peers — has proved an obstacle to partnering with them in those greenfield situations, Mr. Rae said. If NZ Super had the scale, it would be open to participating in a club deal for a good greenfield project, he said.