BY RENÉ LAVANCHY | JULY / AUGUST 2021 – IPE REAL ASSETS MAGAZINE
As fixed hurdle rates pushing infrastructure fund managers to take undue levels of risks to hit an 8% target? René Lavanchy reports.
There are some received wisdoms of infrastructure investing that are rarely questioned: well- structured projects will always find finance; risks should be allocated to the parties best placed to manage them; and closed-ended infrastructure funds should have a hurdle rate for carried interest of 8%.
The hurdle rate, said to have been inherited from private-equity funds, has survived the ups and downs of the infrastructure equity market for over a decade. Despite the emergence of longer-term and perpetual fund vehicles, the 10 to 12-year closed-ended fund remains the norm in infrastructure asset management, and within that, the 8% hurdle rate dominates. But there are voices who describe the 8% rate as not only anomalous in the current market climate, but potentially even dangerous.
“This is a completely ad hoc number,” says Frédéric Blanc-Brude of the EDHEC Infrastructure Institute. “It has become more and more difficult to beat this hurdle… but most of the time the [limited partners] still insist on it being there.”
Blanc-Brude points to a steady decline in expected returns from infrastructure assets over the past decade – albeit the decline bottomed out in 2016-17, when valuations peaked, according to EDHECinfra data. Expected returns from assets in the institute’s Infra300 index averaged 7.75% in Q4 2020, compared with 13% 10 years ago, and for some sub-sectors, the returns are lower.
“If you’re investing in wind farms or solar farms, expected returns are nowhere near 8% – more like 5% or 6% before fees… and then, if you invest in other sectors, often it’s also less; 7% on average would be more accurate,” he argues. Nonetheless, limited partners (LPs) continue to demand – and get – their 8%. Both Brookfield and Global Infrastructure Partners’ latest flagship infrastructure funds, which closed in 2020 and 2019, respectively, feature an 8% hurdle rate.
Where managers have managed to negotiate a lower hurdle rate, it appears to be in exchange for structuring a different type of fund vehicle telling a different story. An example is the emergence of the so-called super-core fund. Macquarie’s 2019-vintage Super Core Infrastructure Fund, for instance, focuses on regulated assets and has a 20-year life. The hurdle rate is 4%. Brookfield Super Core Infrastructure Partners has no hurdle rate at all, with incentive fees instead linked to quarterly cash distributions to LPs.
One way of looking at this is that the hurdle rate is the tail wagging the asset management dog. Instead of hurdle rates moving up or down in line with actual perceived asset returns – as Blanc-Brude argues they should – asset managers have reshaped their products around the rigid hurdle rate, creating a core or super-core product for some assets and moving into ever more fringe assets for their traditional closed-ended funds. Asked if the hurdle rate has been a driver of this style drift, Anish Butani, a senior director at asset manager selection firm Bfinance, says: “You could say it has, but at the same time, it instils a certain level of discipline.”
The gap between the hurdle rate and the actual returns observed from infrastructure assets, Blanc-Brude argues, can lead to two outcomes. One is to invest in riskier assets. Indeed, he takes the view that the problem of the hurdle rate is one of the reasons for the widespread trend among infrastructure funds to invest in so-called core-plus or value-add assets over the past few years. Another, is that general partners (GPs) may add debt to their fund vehicles – either at holding company or fund level – to boost returns. “Their clients, the LPs who initially wanted to invest in real assets, could instead find themselves invested in a lot of financial risk,” he argues.
At least one asset manager agrees. “The hurdle rate is very well adapted to private-equity or venture-capital investment activity, where the name of the game is to create value by achieving high exit multiples. The infrastructure investment philosophy is entirely different,” argues Pierre- Loïc Caïjo, CIO at Geneva-based Adiant Capital, which seeks to invest in sustainable infrastructure and private-equity opportunities, and does not use a hurdle rate. “The primary value driver for LPs… should be predictable returns year after year, in the long term, not high exit values.”
Unsurprisingly, asset managers who do use a fixed hurdle rate reject the suggestion that there is anything anomalous about the 8% rate. “I do not think it’s strange. The whole point of that hurdle is that it’s an absolute benchmark, irrespective of what the market is,” says Adam Ringer, a partner in AMP Capital’s infrastructure equity team.
Spence Clunie, managing partner at Ancala Partners, says: “If you reduced the hurdle [rate], there would be an incentive for funds to pay more for the same asset, so it would just push prices up even higher. We have already seen this in the so-called ‘super core’ part of the market.”
Ancala, a fund manager that specialises in mid-market infrastructure, invests both in core-plus and core assets, including regulated utilities, and offers a 9% hurdle rate. Clunie also points out that, if hurdle rates changed in line with interest rates, they could move several times over the lifetime of a 10-12-year fund.
But Blanc-Brude says LPs should not be put off by this. They are used to using market benchmarks in equity and bond investments, he points out.
However, this would extinguish the principle – which Blanc-Brude regards as a fallacy – that infrastructure is an absolute-return investment.
Alastair Yates, managing director at Macquarie Asset Management, says: “Overwhelmingly, the feedback we receive is that investors continue to prefer a fixed hurdle rate.”
Beyond the fringe
Whether asset managers are taking inappropriate levels of risk to clear an 8% hurdle rate comes down in large part to the highly subjective question of where one draws the line between infrastructure and private equity. “In the sustainable infrastructure sector, it is common to see infrastructure players investing in platform build-ups move up the value chain and invest in the significantly riskier development phase,” Pierre-Loïc Caïjo says. “All of that does not conform to the initial idea of infrastructure as a lower-risk, lower-return asset class.”
Adam Ringer, who declines to confirm the hurdle rate AMP Capital uses for its unlisted infrastructure funds, argues that the perception that certain core-plus assets it targets (such as unregulated fibre networks, and care homes, in which AMP Capital has invested for more than a decade) are inherently riskier than more traditional infrastructure assets is wrong; the risks are simply different.
A more pressing question amid the increasing variety of assets labelled as ‘infrastructure’ is how well LPs really understand the risk profiles of the portfolios they are invested in. Asset managers are predictably reluctant to go on the record to question the judgment of their LPs, but a source at one of the larger managers comments: “We have observed some managers taking more private equity-like risk for infrastructure returns, in the form of higher leverage, shorter hold periods, more merchant or volume risk and higher commodity price exposure.”
Bhutani says: “Investors we advise, when they’re looking at high-returning infrastructure – 10%- plus – understand these aren’t coupon-clipping assets. Investors know if they want to clip a coupon, [they can] go into an open-ended fund, accept a lower rate of return and a lower hurdle rate that comes with that.”
But it is not only core-plus assets that critics of the fixed hurdle rate are concerned about. Both Blanc-Brude and Pierre-Loïc Caïjo point to particularly sharp declines in returns on renewable energy assets in recent years, opening up a gap with target returns. “We see for instance returns for south European solar merchant assets converging to below 8% levered equity return,” Caïjo comments. “If the buy-in price is too high, there is potentially an increased risk of default on the loan facility…. I believe we will see more distressed situations in the near future.”
Another market watcher says renewables funds promising returns above 8% may fall short as they mature in the next few years: “I think renewables are in for a point of reckoning – everyone is throwing money at them because of ESG. Can you tell me someone who has made good money out of renewables… Right now, we haven’t seen that, and I think we’re going to start finding out [with] all the money that’s gone in.”
For the time being, there does not appear to be much appetite for the industry as a whole to debate the wisdom of the 8% hurdle rate – at least not until a high-profile failure takes place.
Nevertheless, Blanc-Brude expects to see it challenged in the coming years, as multi-asset investors grow their exposure to infrastructure and seek to understand how it performs relative to other asset classes – and as individual members of pension funds start to become closer and have greater choice over where their retirement capital is invested. “The interest of the regulator in such assets has increased considerably for the same reason. This is not a rounding error in the portfolio anymore,” he adds.