This article is sponsored by Stafford Capital Partners and appears in sister publication Infrastructure Investor’s Annual Review 2019.
With all the talk these days about the compressed returns in the core infrastructure space, why are secondaries investors smiling? Knowing the assets in a fund upfront and turning back the clock in terms of vintage and pricing are increasingly attractive features of the growing infrastructure secondaries market, say Ingo Marten, William Greene and Matthew McPhee, partners at Stafford Capital Partners.
How is Stafford approaching the infrastructure secondaries market?
Stafford celebrates its 20th anniversary this year and secondary investments have been an important part of the firm’s investment strategy from the very beginning.
Our founders were pioneers in the secondaries business on the private equity side since the late 1980s and we have built upon this knowledge and experience since then, exploring the secondary market in new asset classes like infrastructure, timberland and sustainable private equity.
Secondaries provide the benefit of being information-rich for those who know how to gather and analyse data efficiently. Our databases and proprietary analysis systems have been developed over the last 10 years and are instrumental in giving us an informational advantage and asset analysis around risk, pricing and sourcing.
What is the current status of the infrastructure secondaries market?
Healthy with great prospects!
As a data-oriented company, we track carefully every aspect of the secondaries market to identify pockets of value. Overall, in the last few years, the secondaries market volume has been tracking at about 10 percent of the primary market commitments raised, lagged by five years; this has been the historical trend in the more mature private equity market.
What type of transactions and pricing trends are you seeing in this market?
As such, in terms of infrastructure secondaries, in 2015 we had approximately $50 billion to $60 billion of primary commitments in infrastructure, resulting in current secondary dealflow at about $5 billion to $6 billion a year; in 2019, there were approximately $100 billion of primary commitments in infrastructure. Therefore, our latest infrastructure secondaries fund will benefit from the continued growth in infrastructure secondaries, effectively doubling in the coming five years to $10 billion and more capacity per annum. Generally, it is our perception that the market is growing in line with or more quickly than the demand for such transactions, ensuring that infrastructure secondaries remain a buyer’s market for specialist players. Because of our proprietary information, systems, people and relentless focus, we expect to be very well placed to take advantage of this forthcoming step-change in the size of the secondaries market.
“We see an increasing pricing differential between infrastructure on the direct asset side compared to the secondary side”
We are generally seeing a split into three groups. The first is large portfolio trades, where infrastructure can be a subset of the larger portfolio across all private equity and private markets. The other group is general partner-led transactions where a GP is seeking to extend its term or add additional capital to the portfolio. The third group is individual transactions where limited partners are seeking liquidity for positions within an overall portfolio at a low cost and with a light degree of complexity.
We seek to be a provider of liquidity to LPs on those individual transactions, so we are not overly prescriptive about size. We can do small transactions or multiple transactions with a size of around $30 million to $100 million. It is also important to have the right fund size for the market opportunity at hand. As such, our fund size is increasing in line with the market but staying below the $1 billion mark.
In terms of pricing trends, the returns on primary infrastructure assets since the 2010 to 2011 timeframe have been clearly under pressure. On the secondary side, however, we have not seen much pressure. Offered discounts may have come down from 10 percent to 5 percent at an average over the last eight years, but for specialist buyers such as Stafford, with ever-improving processes, discounts have actually increased from 8.8 percent for our first vehicle to 13 percent today.
In particular, there are good value opportunities in the small to mid-size segment and we believe we have the systems and processes in place in order to execute on those efficiently: we have seen offered discounts on average at over 10 percent for the zero to €20 million range of transaction – ie, over twice the discount of larger €80 million-plus transactions.
Turning back the clock
What are some reasons you view infrastructure secondaries as more attractive in today’s climate than primary deals?
It is increasingly difficult for new primary funds to access traditional core sectors at a favourable return. Record levels of dry powder create a risk of primary funds loosening their pricing discipline or undergoing mandate drift, moving away from traditional infrastructure assets with steady cashflows towards higher-risk assets or regions. In terms of a fund, which has largely deployed over the past five years, a secondary transaction effectively allows investors to turn back the clock and gain access to those traditional core infrastructure assets while also benefitting from diversification.
So, from a trend perspective, we see an increasing pricing differential between infrastructure on the direct asset side compared to the secondary side. On the primary side, we have seen core infrastructure assets that were trading eight years ago at 10 percent IRR, trade at 6 or 7 percent today. Meanwhile, our funds continue to track at over 11 percent on average, through the effect of discounts, quality performing assets and strong premiums on exit. We are convinced that today, more than ever, our strategy is extremely competitive in terms of returns to a direct strategy, but with the benefits of swift deployment and unparalleled diversification.
For whom are infrastructure secondaries attractive and what are the key risks?
Three benefits stand out from a well-executed secondaries approach: very competitive – and measurable – risk-adjusted returns, immediate yield and unmatched diversification.
The first type of investor who joins our fund is one who is starting an infrastructure allocation and sees a diversified, well-priced core infrastructure investment programme as an ideal entry point, allowing them to ‘jump start’ their infrastructure programme. In our most recent portfolio, we have successfully completed 20 separate transactions across 18 funds, as well as several co-investments. We have a broadly diversified portfolio across 14 vintage years with 248 underlying investments in total. We have been able to offer immediate yield, no J-curve and swift deployment (88 percent deployment within 18 months of final close).
“The market is growing in line with or more quickly than [demand], ensuring that infrastructure secondaries remain a buyer’s market for specialist players”
In terms of risks, knowledge about the assets in the funds to be acquired and the ability to transact fast are key. We like to say that you cannot do a secondaries deal successfully if you do this as a hobby. We are 100 percent focused on secondaries and have built the team, systems and process to source, due diligence and execute successfully. This allows us to source proactively, understanding pricing and risks before a transaction is even active.The second type of investor we see typically has a long experience investing in infrastructure and is concerned about pricing levels and risk creep in the primary market. That investor thus appreciates the pricing advantage and risk consistency of a core secondaries strategy as a hedge against the risks they see in their primary portfolio. A few years ago, many of our discussions with investors involved explaining the benefits of infrastructure secondaries from a ‘standing start’, whereas for our current offering, Stafford Infrastructure Secondaries Fund IV, we are having discussions with sophisticated large institutional investors that come to us having already concluded internally that secondaries must be a key component of their infrastructure programmes.
If you have not built a track record of being able to close transactions in the secondaries market at a fast pace, you are at risk of overpaying to true asset value – focusing for instance on headline discounts – and underdeploying on lower-quality assets.
At Stafford, we are convinced that we have those risks well under control so that we can benefit from the market.
Looking ahead, where do you see the future deals coming from? Do you anticipate shifts in geography or transaction types?
The secondaries market is quite healthy. As noted, the overall size of the secondaries market is expanding quite rapidly. Several institutions are seeking to deploy further capital into infrastructure, which is positive, and that is providing an extended level of liquidity for the infrastructure sector and its assets.
There is an enormous amount of capital coming into primary funds and, as a result, there is significant dry powder in the marketplace. This is currently estimated at $180 billion, underpinning a lot of the valuations. So, while there is sure to be volatility in the short term for the primary market, the underlying conditions of the infrastructure asset class remain very healthy.
As a liquidity provider across the core infrastructure market, what we have seen over the past five years is a lot more allocations into this sector throughout North America. They are getting to a stage where they’ve moved beyond initial deployment to looking at the structure of their portfolios and to fine-tune their portfolios in the secondary market as well.
So, we are seeing a burgeoning of opportunities, not just in the number of funds that have come into the market, but also through broader geographic participation in the secondary market overall. Opportunities within the sector are very strong.
The infrastructure secondaries market is a bit behind private equity. However, while private equity secondary markets took a long while to learn and adopt the use of secondary transactions and tools for active portfolio management, the infrastructure secondary market is much faster in its growth trend. This is partially because the technology is known, allowing a much faster ramp-up of the secondaries market compared with the long years it took the private equity market to mature.
At Stafford, we have almost $6 billion in assets under management with a strong focus on secondaries. Our well-resourced and growing team of investment professionals with direct operating investment experience is a large benefit as we seek to tackle the opportunities of this growing market.