Utter the phrase “fund structure” and chances are people will tune out and turn their minds to other, more exciting topics.
But in the world of infrastructure, fund structure is an exciting topic indeed. Witness a recent information for request put out by the Pension Consulting Alliance, advisor to some of the US’ largest pension plans, which asked managers to submit proposals for a fund “that addresses the unique characteristics of infrastructure investments” and warned that “particular emphasis will be placed on creative fee structures”.
Manager compensation is just one area where investors in infrastructure are pushing for innovation in terms of the types of investment fund they prefer, and the terms and conditions they want to see built in. Other examples are holding periods and the ability to redeem capital during the fund’s life.
The debate surrounding these issues is in part a sign of the times. He who has the money has the power, and infrastructure is not the only asset class in which investors are seeking to take advantage of the ways in which the credit crunch and the world economic crisis have changed the dynamic between fund managers and fund investors in favour of the latter.
But there is also another dimension to the issue. Unlike more mature asset classes such as private equity and real estate, which have both developed clear preferences for fund structures that are deemed appropriate given investor appetites and asset profiles, the jury is still out on what the perfect infrastructure fund should look like.
One segment of the market argues that open-end funds are the way to go. These funds have no defined lifetime and can perpetually cash out existing investors and bring in new money. Another segment of the market argues that closed-ended funds are the best way to invest in infrastructure. These funds, long the standard in private equity, have a defined lifetime, typically 10-15 years, and cash in and cash out their investors only at the beginning and the end of the fund’s life.
To get a better idea of the merits of each strategy, Infrastructure Investor magazine quizzed Ben Heap of UBS Global Asset Management, Henri Piganeau of Cube Infrastructure and Danny Latham of Colonial First State Investments of open- and closed-ended vehicles to see why they had structured their funds as they did. Here are their thoughts.
The case for closed: UBS Global Asset Management
At UBS in New York, Americas infrastructure chief Ben Heap gives the open-ended fund model credit where he sees it due. “An open-ended structure makes sense to everyone as an inherently sound structure to manage infrastructure. And that’s largely because you have a consistency between long-lived assets and long-term investor capital,” says Heap.
“The problem, which I think most people come upon, is that, at a practical level, the implementation is more complicated than that,” he adds. It’s because of these complications that Heap and his colleagues preferred a 15-year closed-ended structure for the $1.5 billion International Infrastructure Fund they manage.
In an open-ended structure, investors can look at the valuation of their interests at any time and decide to come in and out of the fund at their leisure. As valuations fall, some investors may get buyers’ remorse and exit, while others may choose to jump in opportunistically, creating volatility for an asset class that demands a patient, stable investor base. “Alone, the valuation issue is enough for us to prefer the closed-end structure,” Heap says.
Open-ended funds’ liquidity also creates problems, he Heap. “The reality is that to get liquidity in an [open-ended] infrastructure fund, you need inflows to match your outflows,” he says. In practice, this means that, should a large investor choose to exit the fund, the manager may be forced to sell assets to meet the redemption – an unsavoury proposition at best. “You create a conflict there. Do I sell the best asset to maximise the price? Or do I sell the worst assets at exactly the wrong time? It’s a complicated question.”
Far less complicated, he believes, are the shortcomings associated with closed-ended funds. To accommodate investors’ long-term horizons, managers can sell assets into an increasingly active secondary market, roll assets over into a successor fund once the fund’s current life is over, or do an initial public offering. Thus, UBS has to date only utilised closed-ended funds for infrastructure.
As the market grows and matures, though, that may change. More comparable transactions in the sector may make valuation easier and more willing investors will make liquidity easier to facilitate. “We would seriously think about an open-ended fund as we go forward,” Heap says.
The case for open: First State Investments
Open-ended infrastructure funds are nothing new in Australia, where asset managers have used them for years as a way to give their investors liquidity in an otherwise illiquid asset class. Last year, Colonial First State Investments, Australia’s largest fund manager, decided to bring the structure over to Europe, where a UK team led by Danny Latham, a former director at Deutsche Bank’s RREEF Infrastructure, launched an open-end fund for European infrastructure.
Latham declined to discuss the specifics of his fund or fundraising, but he is positive that infrastructure assets belong in an open-ended fund structure. They are often monopolistic, cash-generating assets with long useful lives that nicely match the investors’ holding periods and current cash needs.
“In the private equity world, the objective is to get in and out of these assets as fast as you can,” says Latham. “But in the infrastructure space, when people are buying these assets, they want to hold on to them.”
A fund structure should reflect and enable this basic investor preference. Closed-ended funds do not do so, Latham argues, because their performance fee structure encourages asset sales. Managers usually charge a fee on their investments’ performance, called carried interest, which is payable when assets are sold.
“You don’t want an alignment system that incentivises early disposal of assets,” he says. Worse still, some managers have used infrastructure funds as a way to generate fees for other parts of their investment banking businesses, he adds.
An open-end structure eliminates this conflict of interest, Latham says. Fees are charged on a net asset value, or the discounted cash flows of the fund’s investments, so there is no incentive to sell assets early. Instead, the manager is incentivised to maintain the performance of the underlying assets so that existing investors stay in the fund, and others enter it.
Just as important, an investor can leave the fund after a specified lock-up period, leaving others to enjoy the fund’s underlying assets without a forced exit.
“The investor comes and goes – not the asset,” Latham says.
Tried them both: Cube Infrastructure
Henri Piganeau is managing partner of the Cube Infrastructure fund in Paris, and has given much thought to both sides of the argument. Cube manages a €500 million fund that is backed by French investment bank Natixis, and which was originally structured as an open-ended fund with a goal of someday doing an IPO. That, Piganeau reasoned at the time, would provide investors liquidity and free Cube’s management from all the thorny issues surrounding valuation because “[public] market value is fair value by definition”.
But the plan proved untenable because Cube’s investors were afraid of exposing themselves to the volatility of public markets. “When we realised that, we decided to restructure,” Piganaeau says.
So earlier this year, Cube went from an open-ended fund to 12-year closed-ended fund with a possible three-year extension. Piganeau is very satisfied with the change. “A shorter-term horizon gives limited partners a better ability to evaluate the [investment] team. It puts more discipline in the creation of value,” he says, the reason being that closed-ended managers do not have an unlimited timeframe in which to prove themselves.
“An open-ended fund is a little bit like marriage but without really the opportunity to know your counterpart. You trust the team after two to three meetings and you are stuck with them for 25 years or more,” he says.
This is important, he believes, because infrastructure is not as much of a long-term investment exercise as others make it out to be. “It’s a short-term business to the extent that it is a daily exercise with the government to improve the contract. You really have to work on a daily basis. It’s not a buy-and-wait, it’s a buy-and-work [strategy], so I think to judge the quality of the team you want to have a shorter term,” he says.