Europe has, for some time, been the sweet spot for institutional investors seeking infrastructure exposure, but with so many investors chasing the same deals, supply-demand pressures have depressed returns in the asset class there. As such, some market participants are questioning why more North American institutional investment officers aren’t seeking newer or less-trodden paths to more attractive infrastructure investment opportunities in markets in their own backyard.
The North Dakota Retirement and Investment Office (NDRIO) is forging down that path. “European opportunities appear to be more challenged in the infrastructure sectors we’re considering,” declared David Hunter, executive director and chief investment officer at the $13.8 billion pension fund. “There are good opportunities, but so many assets appear to be more fully valued at this point,” he said. “It’s difficult to be overly optimistic about European infrastructure.” That’s why NDRIO is looking more closely now at North America for infrastructure deals. “There appears to be a better opportunity set of proper risk-adjusted returns in the U.S. and Canada” he said.
The North Dakota fund has dedicated 4% of its portfolio, or about $550 million, to infrastructure investments. Over the next couple years, it plans to increase that to 5%, Hunter said. Regarding returns, “three percent of our portfolio is core to core-plus bringing in returns in the six percent to eight percent range. The fund is currently seeking lower double digit returns for valued added opportunities. Its infrastructure portfolio is seeking 7% to 8% net returns, overall.
“Managers are paying higher than they would like to for infrastructure deals in Europe,” asserted Patrick Adefuye, head of real assets products at research firm Preqin, which recently published its quarterly report titled the Preqin Quarterly Update: Infrastructure Q2 2018. “While fundraising has been strong, we have seen dry powder rise to record highs, potentially indicating that fund managers are wary of deploying capital into overvalued assets,” Adefuye said. “Ultimately, with the market remaining crowded and with capital still plentiful, fund managers will have to find ways to effectively deploy funds into available assets,” Adefuye said, adding that the highest level of deal activity still remains in Europe, while levels for the U.S. and Asia remain flat.
“Infrastructure deal activity overall slumped in Q2 2018, with the quarter seeing five-year lows for the number of deals completed and for total deal value,” Adefuye said. In total, there were just 569 infrastructure deals completed in Q2, worth a combined $49 billion, according to the Preqin report. This represents the record lowest aggregate deal value for the industry, the report said. The previous lowest quarter in the last five years was $57 billion in Q1 2014. “Europe was primarily responsible for the slowdown, as activity in the region fell by 72%,” said Adefuye. Deal activity in Europe fell from $63 billion in Q1 to just under $18 billion in Q2, Adefuye noted.
Deal activity will have to pick up significantly in the second half of 2018 for the industry to come close to levels seen in previous years, Adefuye said. Going forward, as Preqin gets more data, the aggregate deal value for Q2 2018 could rise by up to 10%,” he said.
European opportunities appear to be more challenged in the infrastructure sectors we’re considering.
John F. Freihammer, portfolio manager at Chicago Teachers’ Pension Fund, with $10.5 billion in assets under management (AUM), said the fund currently invests primarily in North American infrastructure assets, but that it does have exposure to Western Europe and to Australia. “There is good demand for assets in Europe, so our portfolio has benefitted from that as valuations continue to increase. Managers have remarked that competition and bidding for assets in Europe remains fierce, so that has certainly helped to increase valuations as well,” Freihammer added. The market values of assets are influenced greatly by recent comparable sales of similar assets. As prices paid for recent sales increase due to competitive bidding, so do the valuations for comparable assets, even if they are not on the market, he explained.
Political and regulatory hurdles stymie deals
Regarding investment opportunities in Australia, North American, Canada and the U.S., Freihammer stated that “Australia and Canada have had a big head start with respect to institutional investment and private/quasi-private ownership of infrastructure assets, due to earlier adoption and acceptance of these transactions, and are thus much further along than the U.S. in terms of widespread acceptance of infrastructure as a viable institutional asset class. The U.S. has been catching up, but there remain complex political and regulatory hurdles to successfully transacting on many of these assets. Multiple agencies and regulatory bodies at the local, state, and federal levels are often involved, and it can be a challenge politically as these can be critically important assets that affect residents on a daily basis,” he said.
The Chicago Teachers Pension Fund invests in infrastructure through both closed-ended and open-ended commingled funds. “We see value and opportunity in both of those structures, although we only utilize commingled funds, since it would take too much capital to efficiently invest through a separate account,” Freihammer said. For real estate investments, Chicago Teachers expects 7% to 9% gross return for core/core-plus real estate over the long term. For core infrastructure, it expects 6 to 8% gross returns over the long term.
The Chicago fund currently has an 11% target allocation to real assets, of which roughly 25%, or about $225 million, is invested in infrastructure. The remaining 75% is allocated to real estate, representing approximately $760 million. The fund’s target allocation to real estate is 9% and its target allocation to infrastructure is 2%. The fund just issued an infrastructure-investment request for proposals (RFP) to maintain its current infrastructure allocation because, “Some of our older vintage year closed-end funds are liquidating, so we were slightly below our target. We wanted to bring it back up to two percent,” Freihammer said.
Another fund targets North America
The Pennsylvania Public School Employees’ Retirement System, (PSERS), with $54.1 billion in assets, is another pension fund with its sights set on North American infrastructure. In January, the fund announced it would invest up to $500 million in the open-ended Blackstone Infrastructure Partners (BIP) fund, which will invest in infrastructure assets across the energy infrastructure, transportation, water and waste, and communications sectors, with a primary focus in North America.
A commitment to the fund will be allocated from the infrastructure portion of PSERS’ real assets portfolio. The infrastructure portfolio is slated to be 66% private funds and 44% listed securities. Investment in this fund will increase PSERS’ infrastructure exposure, which is currently below a long-term target of 2% of total assets.
Types of investments
Secondary stage deals continue to represent the largest proportion (64%) of deals investors are buying up, while greenfield assets made up 33% of deals and brownfield projects comprised just 3% of deals, according to the Preqin report. The most activity has been in mature assets, which have less risk, so investment has been focused on those assets, resulting in competitive pressure, Adefuye said. The Chicago Teachers’ fund’s infrastructure investments are predominately in brownfield and core projects, Freihammer noted.