Making inroads: infrastructure secondaries

The majority of infrastructure investors still the lack internal resources and size to act as pure direct players, writes Partners Group’s Michael Barben.

Infrastructure secondaries represent a niche market within the broader private markets secondaries space. Until the early 2000s, there were very few dedicated, primary infrastructure funds in the market, but investor demand for stable long-term returns has contributed to the increase in infrastructure investing.

The emergence of infrastructure as a separate asset class gained traction in 2003/2004 and experienced a continuous ramp-up until 2007. The global credit crunch in 2008 significantly impacted the ability of fund managers’ to raise new money and, as a result, global infrastructure fundraising collapsed in 2009. While 2010 saw many funds that have been in the market for a prolonged period during the crisis close, the most recent economic uncertainties caused by the European sovereign debt crises have slowed down global fundraising.

With investors seeking liquidity due to changes in the regulatory environment and more active portfolio management in a growing number of infrastructure funds, the market for infrastructure secondaries grew accordingly. From experience, roughly between 3 percent and 5 percent of the funds closed between 2006 and 2012 are offered on the secondary market each year. Of this volume, only a fraction of deals will close, which Partners Group estimates to be in the range of $1 billion to $2 billion per year.

Currently, pension funds represent the largest share of infrastructure investors, followed by endowment funds, insurance companies and banks. While to date more than two-thirds of all infrastructure investors are based either in Europe or in North America, it is believed that more capital will be raised out of Asia going forward.

Historical secondaries infrastructure deal flow suggests that banks represent the main sellers of infrastructure fund interests, followed by endowment funds and pension funds. Pension funds, despite being the largest group of investors in infrastructure, are rather reluctant to sell infrastructure positions on the secondaries market. This is because pension funds face less financial pressure because their balance sheets are unlevered and revert to the secondaries market solely for portfolio rebalancing purposes. Furthermore, pension funds are still in the process of gradually increasing their exposure to the asset class, which results in the lower turnover of pension funds’ LP interests in infrastructure funds.

Infrastructure secondaries deal activity significantly increased between 2009 and 2011, which is partly explained by the overall growth of the infrastructure asset class. In addition, several current events and continuing trends, such as those described below, have driven infrastructure deal flow:

• European financial institutions continue to face pressure on capital requirements due to new regulatory frameworks such as Basel III, in the case of banks, or Solvency II, in the case of insurance companies. As a result, a large share of deal flow came from these financial institutions.
• The current macroeconomic outlook, especially across Europe, is calling for banks to have more robust balance sheets, creating an additional reason for banks to sell fund interests in the secondary market.
• Many early investors have been confronted with disappointing performance pat- terns that were not in line with the expected consistent and non-cyclical returns. Infrastructure managers, after a period of strong fundraising success between 2006 and 2008, deployed a substantial amount of money at the peak of the cycle. Transactions cleared at rich valuations and the economic exposure of infrastructure as an asset class has been underestimated.

It is true that investors are gaining experience in the asset class and increasingly consider different channels to gain exposure to infrastructure assets, but the majority of infrastructure investors still the lack internal resources and size to act as pure direct players. Therefore, capturing attractive secondary opportunities in the market can represent a viable option for infrastructure investors to access the asset class.

While resolving over-allocation issues and liquidity needs will continue to be a concern for large institutional investors, the secondaries market is increasingly expected to be used as an active portfolio management tool rather than just a pure liquidity solution. A larger portion of assets are likely to be sold going forward, resulting in a supply-demand imbalance in favour of buyers. Infrastructure secondaries are likely to continue to play an important role as part of a global and integrated approach to infrastructure rather than as a standalone investment strategy.

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Michael Barben is co-head of Partners Group’s private infrastructure unit.

This is an excerpt from a chapter Barben wrote for PEI’s book, The Private Equity Secondaries Market (Second Edition).