Investing on shifting sands – infrastructure investment into non-core assets

April 2020  |  SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2020 Issue

Investment in infrastructure assets has somewhat bifurcated over recent years. A pool of investors have focused on traditional or core infrastructure assets, pursuing relatively low, but predictable returns, such as greenfield projects, utilities and other heavily regulated sectors, while others have challenged historic assumptions and pushed the boundaries of the asset class, seeking higher returns but still focusing on assets demonstrating infrastructure DNA, such as essential services, pre-existing predictable cash flows and high barriers to entry. This shift has blurred the lines between investment mandates, bringing the likes of infrastructure investment funds, new direct investors, including pension funds and sovereign wealth funds, and private equity (PE) buyout funds closer together. A key feature of this ‘non-core’ or ‘core-plus’ infrastructure investment is the evolution into new sectors, many of which were previously the exclusive targets of PE buyout funds or corporates. Social infrastructure, especially healthcare, fibre optics, digital storage, aquaculture and crematoria, are a few recent examples.

The significant opportunities associated with investment in non-core infrastructure also come with challenges which need to be managed in order to adapt to the commercial and practical realities of investments in these assets. In this article we look at some key considerations which are a focus for PE infrastructure investors operating in this space.

Equity investment

In-depth diligence. Regulated infrastructure assets are often self-contained investment propositions with publicly available information, clear revenue streams, long-term contracts, high barriers to entry, and digestible risks and markets. Conversely, the inherent nature of investing in non-core infrastructure assets requires investors to address less clearly defined parameters. The nature of investment in non-core infrastructure requires a greater understanding of the business model, competitive landscape and inherent risks involved. It is critical that PE infrastructure investors undertake detailed commercial and legal diligence to understand the robustness of the revenue streams and contracts, understand the nature of the barriers to entry, test markets and understand the often piecemeal regulatory environment, particularly in new and developing non-core sectors.

Upskilling expertise. The constantly shifting nature of the non-core infrastructure asset class can require PE infrastructure investors to rapidly upskill their expertise, knowledge and capabilities. This feature is particularly unique to non-core infrastructure investment as, while traditional buyout funds have adapted their mandates across the value chain, for example into venture and growth together with some ‘strategic opportunities’ mandates, the sectors into which buyout funds invest have remained relatively stable, with the obvious exception of the disruptive impact of technology. The ability to be dynamic with resource has therefore been of critical importance to PE infrastructure investors, who often have relatively lean investment teams. The investors which have been flexible in developing sector specialist knowledge are often able to gain an advantage over competitors by being able to identify opportunities that exhibit infrastructure characteristics, pursue bilateral opportunities and also obtain the comfort internally that is required to approve such an investment.

Reputational risk. Reputational risk has been a significant issue for many PE infrastructure investors. One sector which has challenged these investors has been social healthcare. In the current climate, both politically and with some recent high-profile failures in the broader sector, it is imperative that any investor recognises the challenges such an investment presents. Many PE infrastructure investors have been able to successfully carry out the diligence to identify the key concerns, and together with expert advice, put in place structures and management teams to address these issues as part of the business plan. However, the reputational risk associated with the healthcare sector has proved a step too far for some investors. Similarly, many sponsors are facing increased pressures or have made conscious decisions to move away from non-sustainable investments, such as the older carbon-producing energy investments.

Debt finance. When financing the acquisition of non-core assets, PE infrastructure investors must think about more than simply arranging a traditional ‘infrastructure style’ financing package. A balance needs to be struck between ensuring that debt funders maintain their key protections, including a sufficiently fulsome security package with both a single point of enforcement and defensive asset level security, but at the same time, ensuring that the financing arrangements provide investors with the operational flexibility to grow their investment and pursue bolt-on acquisitions. While historically, infrastructure assets have been financed by the bank markets, PE infrastructure investors have been willing to optimise the financial structure of deals. This has meant looking to the private placement, leverage or high-yield markets, or, through ‘holdco’ or ‘midco’ debt packages, to enhance returns and help maximise value. One challenge that PE infrastructure investors face in meeting the expectations of their debt funders is that non-core assets may have traditionally been financed by other divisions of a financial institution, such as the real estate desk of a bank. If a lender has an ongoing relationship with a target business and its management, when rolling into a new deal, that lender may seek to retain terms and deliverables which are not typically common in the PE infrastructure space, such as regular delivery of valuations for real estate or shipping finance style covenants for ferries or other vessel-based businesses. The key for PE infrastructure investors is therefore to strike a fair balance in respect of credit risk for the lender and the flexibility it requires to develop its portfolio business to extract sufficient returns on an ongoing basis.

Investing with management

As the non-core infrastructure asset class has developed with M&A activity of existing assets being commonplace, PE infrastructure investors have had to become familiar with incentivising management teams through equity participation. The key tension is that the usually longer-term investment horizons (often more than five years) requires a differentiation in the management incentive plan (MIP) terms to those typically offered by PE buyout funds. Giving management enough certainty that their MIP will crystallise within an acceptable period can be difficult where PE infrastructure investors have little pressure to realise their investment and deliver those returns to investors in the short term. Below, we look at some key points PE infrastructure investors need to consider.

Synthetic exit. Synthetic exit arrangements, typically structured as put/call options over management’s equity, provide a mechanism to deliver liquidity to management prior to a PE infrastructure investor’s exit. Infrastructure investors should consider the timing, trigger and funding of the option. Timing of the synthetic exit is typically aligned with an investment horizon of five to seven years with management holding the right to trigger a put option. However, investor triggered or automatic synthetic exits are also not uncommon. PE infrastructure investors need to ensure they have long-term visibility to provide adequate time to structure and fund the MIP payout. This can be achieved by undertaking periodic or annual calculations of the MIP value and implementing a significant time period, such as 12-18 months, between the synthetic exit being triggered and the MIP being paid out to management. Philosophically, PE infrastructure investors should resist any absolute requirement on them to fund the payout, with the underlying business funding such payout from available cash resources. If the business is unable to fund the MIP, there should be an ability to delay payment until there is available resource in the ordinary course. Dividend blocks, interest accrual on the MIP payout amount and other restrictions can potentially be offered as protection until payment is made.

Leavers and vesting. As an alternative, or in addition, to synthetic exits, PE infrastructure investors can offer bespoke terms on management’s vesting schedules and leaver arrangements. Typically, buyout funds offer terms for three types of leaver – good, bad and intermediate – with the default bucket being intermediate leaver and vesting applying over the life of their investment on the sweet equity or growth shares. PE infrastructure investors, however, face challenges with this approach as leavers after five or six years, for example, may not be aligned with the investment timeline but may have been instrumental in driving growth in that period. Shorter vesting schedules, aligned with typical buyout fund timelines, but with a meaningful proportion deferred to exit, together with bespoke application of leaver definitions, can be a means to strike the right balance for PE infrastructure investors.

Thresholds and valuation. PE infrastructure investor MIPs often feature a greater variety of structures and targets under which management participate after achieving the preferred return hurdle. Business plan and earnings before interest, tax, depreciation and amortisation (EBITDA) targets, applying to a proportion of the MIP entitlement, can be utilised alongside the traditional internal rate of return (IRR) targets and money on money (MoM) multiples in order to reflect the nature of the investment, distribution profile and investment timeline. On a synthetic exit, valuation methodology is key where IRR and MoM multiples are adopted. PE infrastructure investors should agree up-front a clear valuation basis and mechanism to avoid any dispute with management. For example, will the valuation be based on a deemed full sale or will a minority discount be applied? Should the same multiple from the acquisition be applied, or reference be made to comparable multiples in the market at the time? Often, PE infrastructure investors prefer to use their own internal valuation as a base, which may be disputed by management. Alternatively, determination by a third party, independent expert may be time consuming and costly. Any dispute process needs to be well considered and defined, as well as any allocation of costs among the investor and management.

As demonstrated in this article, investment into non-core infrastructure assets is constantly evolving. In an ever-more competitive space, PE infrastructure investors continue to explore the boundaries of what is considered infrastructure and we can expect that trend to continue in the coming years.

James MacArthur is a partner, Ed Freeman is counsel and Tom Fisher is an associate at Weil, Gotshal & Manges (London) LLP. Mr MacArthur can be contacted on +44 (0)20 7903 1225 or by email: james.macarthur@weil.com. Mr Freeman can be contacted on +44 (0)20 7903 1554 or by email: edward.freeman@weil.com. Mr Fisher can be contacted on +44 (0)20 7903 1517 or by email: thomas.fisher@weil.com.

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James MacArthur, Ed Freeman and Tom Fisher

Weil, Gotshal & Manges (London) LLP

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