Real infrastructure’s revival

A change in interest rates is bringing a renewed appetite for core and core-plus strategies, says Arjun Infrastructure Partners’ founder Surinder Toor, and the mid-market is also on LP radars

Many LPs had moved away from core and core-plus strategies in the decade prior to interest rates returning closer to long-term averages over the past two to three years, focusing instead on value-add managers, particularly in the energy transition and digital infrastructure industries.

However, a recent spate of activity in the transport sector is indicative of a return to more traditional forms of infrastructure, says Surinder Toor, managing partner and founder of Arjun Infrastructure Partners.

The mid-market is also experiencing a rise in prominence, given its superior risk-adjusted returns, and despite tales of arduous fundraising in recent months and years, Toor believes conditions have never been better.

Q Where are LPs focusing their attention, in terms of investment theme and sector?

You won’t be surprised to hear that the energy transition and digitalisation feature in just about every LP meeting. In terms of the energy transition, the focus includes plain vanilla renewables, perhaps through large platforms, but there is also increasing attention on newer technologies such as battery storage, green hydrogen and power-to-x. And, of course, data centres and fibre are in vogue as well.

A low interest rate and equity return level over much of the decade between2010 and 2020 caused many LPs to move away from traditional infrastructure –or what Canadians and Australians defined traditional infrastructure in the late nineties and early 2000s. Unable to secure the returns they were looking for in those core infrastructure strategies, those investors instead moved up the risk curve to focus on value-add and private equity-style infrastructure managers.

However, as the macro environment has moderated, traditional infrastructure assets, regulated, contracted or those with long demand histories in the transport space, for example, are starting to become interesting once again with respect to the risk-adjusted returns they can now provide.

We have recently seen Ardian and Saudi Arabia’s sovereign wealth fund PIF acquire a stake in Heathrow. Newcastle Airport is also up for sale and Ontario Teachers’ Pension Plan has put all its European airports on the market. That activity reflects a return of appetite for transport infrastructure. There is less concern today around assets that carry some kind of demand risk.

Q The macroeconomic backdrop is helping to drive the opportunity set. What challenges is it creating elsewhere?

The primary challenges exist around financing and refinancing assumptions. The cost of financing, when it becomes due, has an impact on the valuation of existing assets. However, it impacts different assets in different ways. Assets that have very long-dated, fixed-rate financing in place have been relatively protected from changes in rates compared to new build assets where the shift in rate environment has been significantly more problematic.

Fibre-to-the-home strategies in Germany and the UK have experienced particular difficulties, for example, along with some EV charging networks. Prior to the rate changes, it was possible to obtain financing for businesses that, in my opinion, do not fall within the true definition of infrastructure. It was possible to borrow capex facilities at one to two percent all-in cost to build out what were essentially private equity assets. But that market has now gone completely. However, for managers, like ourselves, focused on more traditional assets, the approach has always been to use long-dated financing, so the change in environment has been less of an issue.

The other prominent feature of the recent macroeconomic environment has, of course, been inflation. But again, that has generally been a positive for the type of infrastructure assets that we own, which typically have contracted protections built in. When you have inflation hitting 20 to 21 percent as we did in the three years to Q1 of this year, that then feeds directly into revenues for real infrastructure.

Q Has the emphasis of LP due diligence changed considering both the macroeconomic and geopolitical backdrop?

All GPs are facing an ever-increasing regulatory compliance burden and so there is definitely a greater focus on that element during LP due diligence. I would also point to cybersecurity, which has become a key priority for LPs, not just at the manager level but also within each individual portfolio company. It’s easy to see why.

I don’t think I have spoken to a utility CEO that hasn’t been subject to some form of foreign interference of its IT systems, or faced some form of denial-of-service attack or other ransomware over the past few years. These things are seldom well publicised but they are certainly pretty commonplace today, and so it is inevitably something that LPs are delving into.

At the same time, we are also seeing more consolidation among GPs. That has led to increased questions around succession planning and the resilience of the team, as well as how teams are aligned with the interests of the underlying investors.

Q Where have LPs been focusing their attention in terms of the size of assets being targeted?

The mega-managers have cleared up most of the capital raised over the past five to ten years. There have been some highly successful strategies among those big names. But, of course, many of those firms were mid-market players themselves a decade ago.

What we are increasingly hearing is that while they have had a good run with these GPs that now have $40 billion or $50 billion under management, they recognise that those firms have become so large and diversified that each of them represents the market by virtue of their size. They all have a very similar risk/return profile and investors simply don’t need exposure to more than one or two, and alignment is also in a different place.

That, of course, then frees up some allocation to back the new generation of mid-market managers that are now coming through, and that makes sense from a risk-adjusted return perspective as well. Deploying capital with a mid-market firm can probably get an LP an extra 100-150 basis points for the same risk profile.

In addition, there are some softer factors at play in this decision making. LPs like the fact that they believe they will be more important to a mid-market GP than to a mega-manager with hundreds and hundreds of investors in a fund. They understand that it should translate into more attention and greater transparency.

Finally, in addition to superior returns, bilateral transactions are more prevalent in the mid-market, while once you get to $2 billion or $3 billion in size, deals are most likely to be completed via auction processes. That reduces the asymmetry of information during the due diligence phase, potentially lowering the risk for managers and therefore for their LPs as well. Also, many LPs are raising the question of exit strategies for this size of asset and the ability to meaningfully drive returns.

Q What elements of ESG are investors particularly focused on? Is it still the case that the E dominates in Europe while the S dominates in the US?

That is broadly still the case. Of course, there are parts of the US where you have to be a bit wary about mentioning ESG at all. Within Europe, however, the focus is still very much on environmental concerns. We carry out climate scenarios on every asset we look at in terms of heat and water levels. Compared to three to four years ago, ESG screening now takes place very early in the investment process. Further, we recently adopted an initiative whereby every one of our investee companies has adopted a net-zero strategy, which I think is a first in our part of the market.

In terms of LP due diligence, meanwhile, I would say that ESG is a gating item for European, Australian and Canadian investors, in particular. You won’t get a second meeting unless you satisfy some pretty high standards when it comes to the integration of ESG into your investment processes. There are some isolated pockets, primarily within the US, where that is not the case, but even those are relatively few and far between as people draw the link between ESG and stranded asset risks.

Q Following a challenging fundraising environment in 2023 and much of 2024, how do you see this situation evolving? What do you believe 2025 will bring in terms of LP appetite and infrastructure’s fundraising fortunes?

The fundraising environment feels more positive than it has not only for the past two to three years but for the almost 10 years that Arjun has now been operating. I realise that is at odds with what we’ve been hearing from the very large GPs, in particular.

Different parts of the market have been affected differently. With those mega-funds, investors have often been waiting to receive distributions from the prior fund before they have been willing to commit to its successor. But we are a long way down the size spectrum when compared to some of these $20 billion or $30 billion funds. We are a rounding error by comparison.

The fact we are now raising our third vintage, that we have been around for close to a decade, and that there is renewed interest in core and core-plus strategies, as well as for the mid-market with its attractive risk-adjusted returns, means that, to me, appetite feels stronger than it has ever been.

Q What would you say is the defining trend that will impact infrastructure fundraising over the course of the next year?

The key trend is the return in appetite for traditional infrastructure. Prior to the change in rates, you would seldom see North American LPs considering European core strategies, for example, but that has now changed. Rates have had the biggest impact in terms of how infrastructure is positioned.