The structure of things

Last May, in the depths of the Rayburn House Office Building in Washington DC, Mark Florian found himself in unusual circumstances. As the head of North American infrastructure investment banking at Goldman Sachs, Florian spends much of his time advising municipal governments on the potential benefits of selling their toll roads, parking lots and public utilities. But on that day in mid-spring, Florian was not advising elected officials; he was testifying before them, part of a congressional hearing on the issues surrounding the privatisation of the nation's highways.

Hosted by the Subcommittee on Highways, Transit & Pipelines, the hearing was meant to highlight the benefits and pitfalls of recent trends in toll road public-private partnerships. But it also served to highlight something else: the extent to which infrastructure has increasingly become a topic of conversation – not just among institutional investors, private equity firms and municipal governments, but federal congressmen as well.

As Florian noted in his prepared statement, “seemingly overnight large amounts of money are being pooled into a variety of funds to solely invest in infrastructure”. Private investment in these types of assets – toll roads, ports, airports, utilities and more – has been prevalent for decades, primarily outside the US, but it has gained new prominence in recent years as a growing cadre of private equity investors and their well-heeled limited partners have entered the sector.

As pension funds have shifted more of their allocations to alternative investments such as private equity and real estate, they have becoming increasingly enamoured with infrastructure, which has not only generated attractive returns (see chart titled “Solid performance”), but has also delivered them over a long period of time, which has the added benefit of matching the long-term liabilities of most pension funds. In his testimony, Florian estimated that US pension funds have allocated $50 billion (€38 billion) to infrastructure in the past few years; Standard & Poor's recently noted that $100 to $150 billion has been raised overall.

While pension funds and other institutional investors have boosted their demand for infrastructure assets, owners have been increasingly willing to sell them. One factor has been funding: facing limited sources of money and rising capital requirements for infrastructure and other public needs, local governments have been looking at creative options to monetise their holdings. Yet another equally important factor has been the substantial liquidity in the market, which has allowed sellers around the world, both private operators and government entities, to receive high prices.

“Until the amount of money chasing [infrastructure] became a critical mass, it wasn't immediately feasible,” says Dana Levenson, chief financial officer of the city of Chicago, which, in 2005, leased the Chicago Skyway for 99 years to a consortium of Macquarie Bank and Cintra for $1.8 billion. “When Skyway took place, it came at a time when funds such as Macquarie were looking. In any market, you need a buyer and seller.”

Just about everybody that talks about infrastructure has Australian accents

Chuck Leitner

The confluence of these supply and demand trends has generated some significant deals over the past 12 months, from the $3.8 billion privatisation of the Indiana Toll Road in the US to the £10.3 billion acquisition of BAA in the UK, one of the largest infrastructure deals ever. In fact, since 1998, six of the largest eight infrastructure deals took place in 2006 (see table titled “Living large”). All told, there was $145 billion worth of infrastructure transactions in 2006, according to Standard & Poor's. An equally impressive statistic: private equity firms accounted for almost 50 percent of that total (see chart titled “Private equity restructures”).

Judging by current trends, more activity lies ahead. Goldman Sachs, for one, recently raised $6.5 billion for its debut infrastructure vehicle, one of the largest pools of capital ever dedicated to the sector. Other investment houses, including The Carlyle Group, JP Morgan and Morgan Stanley, are each raising dedicated infrastructure vehicles, while regional private equity firms such as Dubai's Abraaj Capital and India's IL&FS are each raising capital for investment in their home markets.

ASIA: WHERE IT ALL STARTED
The current craze for infrastructure probably sounds like yesterday's news for most Australians. In their country, private investment in the asset class has been around for more than a decade, spurred by the government's forced savings programme, which was initiated in the early 1990s to provide billions of dollars to Australia's pension funds. Several of the largest investment firms in the asset class hail from Down Under, such as Babcock & Brown and Macquarie Bank, which is widely considered the market leader and the biggest player in the sector. As the Australian infrastructure market matured, investors such as Macquarie began exporting their knowledge and capital overseas.

Or, as Chuck Leitner, the global head of RREEF, the real estate and infrastructure arm of Deutsche Bank, puts it: “Just about everybody that talks about infrastructure has Australian accents.”

Contrasted with the mature infrastructure market in Australia, the developing countries of Asia, particularly China and India, are also witnessing a boom in infrastructure as their surging economies necessitate vast new networks of roads, tunnels, ports etc.

According to a report last year in the Wall Street Journal, China is planning to spend up to $400 billion on infrastructure through 2010, while consulting firm McKinsey has estimated that India needs over $250 billion in infrastructure investment.

“The single most important bottleneck is infrastructure,” Aashish Kalra, managing director of Trikona Capital, which is partnering with IL&FS for a $100 million infrastructure joint venture, told PEI's sister publication Private Equity Real Estate last year.

US: A NEW MARKET
Despite the size of the infrastructure market in the US – the Bureau of Economic Analysis has estimated it at $5.6 trillion – the sector is relatively immature in terms of private investment. This is primarily due to the municipal bond markets, which have provided governments with robust financing for public infrastructure projects. In recent years, however, as the country's infrastructure has aged and the ability to raise capital via taxes has diminished, more and more public entities are looking to the private sector.

“Estimates suggest that the US needs $1.6 trillion over the next five years just to repair and build highways, bridges, dams, airports, railroads and other infrastructure,” Dale Anne Reiss, the head of Ernst & Young's global real estate practice, said in a recent statement. “The annual tab to maintain the nation's 50-year old highway system is $176 billion alone. With real estate capital flows at their highest levels ever, I would not be surprised to see more pension funds and other long-term investors move into private funding of key infrastructure developments.”

In recent years, the most prominent examples of US infrastructure investments have been toll roads. From the greenfield development of the San Joaquin Toll Road in California in the 1990s to the recent privatisation of the Chicago Skyway, widely regarded as a landmark transaction in the sector, local governments across the country have followed suit. And given the current state of the nation's infrapage structure, as highlighted by Reiss, many experts predict that privatisation of existing toll roads will accelerate. (See chart for a list of projects that are currently being considered in the US).

Infrastructure has become red-hot, almost too quickly, because it's become fairly competitive pretty quickly

In addition to toll roads, water and gas distribution companies have been drawing significant interest from private investors. Since late 2005, Macquarie has made three different acquisitions in the US, including Pennsylvania power company Duquesne Light Holdings, Hawaiian gas utility Gas Co and Northeast US water supplier Aquarion. A significant number of firms have also raised funds in recent years to focus specifically on the energy infrastructure space, including ArcLight Capital Partners, Energy Capital Partners and First Reserve, which raised a $7.8 billion energy-focused fund last year, one of the largest in the sector.

“There's a lot out there,” First Reserve chief executive officer Bill Macaulay said at the time of the fund closing. “We've underspent on infrastructure in the US and Europe since the last boom, which ended in 1982 – a lot of years that have to be made up for.”

Similar activity has been seen in Europe, where the acquisition of UK water utility Thames Water by (who else) Macquarie was one of the largest investments ever in the infrastructure sector.

EUROPE: BY SEA AND BY AIR
Europe generally has a more developed market for infrastructure assets due primarily to the lack of municipal bond financing, which has forced governments to seek alternative sources of capital. Airport operator BAA, for example, was privatised by the British government in 1987, one of the first and most successful examples of such an initiative. (By contrast, the upcoming privatisation of Midway Airport in Chicago, scheduled for later this year, will be the first large airport privatisation in the US.)

Private investment in airports, according to one industry consultant, was popular throughout Europe until the late-1990s, when stock markets collapsed and the spectre of September 11 slowed down passenger travel. Today, as passenger numbers have bounced back and infrastructure investors have found themselves flush with cash, airports are back in favour.

Perhaps there was no greater endorsement of that than Ferrovial's massive acquisition of BAA, owner of Heathrow and Gatwick airports among others. Several months after the announcement of the BAA deal, a consortium including Credit Suisse and GE Infrastructure paid €750 million to acquire London City Airport, further cementing the sector's resurgence in the financial community. Though airports have accounted for a relatively small percentage of the total infrastructure investment in Europe (see chart), they have certainly generated some of the brightest headlines.

Another sector that has drawn pages of ink (and plenty of private equity dollars) is ports, particularly in the UK, which saw Associated British Ports, PD Ports, Peel Ports and P&O Ports all fall to private investors in the past two years. Investors have been drawn to ports as global shipping continues to rise and the world economy grows at a healthy rate.

STRUCTURAL CHALLENGES
Yet even as infrastructure heats up around the globe, significant concerns, both political and financial, have been raised. If the congressional hearing last spring demonstrated that US federal politicians are increasingly interested in the topic, the discussion also highlighted that not all of them are comfortable with it. A number of congressmen questioned the panelists, among them Governor Mitch Daniels of Indiana and Governor Tom Kaine of Virginia, on the potential loss of public control over public assets, the substantial profits that the private investors stand to earn and the fact that many of the firms acquiring US toll roads were foreign entities – echoing some of the controversy surrounding the Dubai Ports deal in 2006.

In addition to the political challenges confronting the asset class, infrastructure investors are also facing financial hurdles. As in the broader real estate market, the flood of capital entering the infrastructure sector has led to skepticism and, occasionally, alarm. One infrastructure investor recently told Private Equity Real Estate: “[Infrastructure] has become red-hot, almost too quickly, because it's become fairly competitive pretty quickly.” Late last year, Standard & Poor's went even farther, warning of an impending “bubble” in the sector due to cheap financing and private equity migration into the asset class.

“With debt-to-EBITDA multiples in recent deals ranging from 12x to 30x, it is clear that, as a result of rampant demand, the infrastructure sector is in danger of suffering from the dual curse of overvaluation and excessive leverage – the classic symptoms of an asset bubble similar to the dotcom era of the last decade,” S&P analyst Michael Wilkins wrote in November.

As you would expect in these heady times, however, few firms seem to be slowing down. The market is vast, the returns have been strong and the need for infrastructure, which provides the most basic of services to the entire population of the world, will only grow as the economies of the world develop and evolve.

“I think the fundamental drivers are in favour of infrastructure privatisation over the longer term,” says Felicity Gates, the chief investment officer for infrastructure at RREEF. “The drivers globally are all going in one direction.”