Infrastructure secondaries?
Hello, it seems like infra secondaries continue to account for the larger share of the total secondaries transactions volume lately. I understand that investors like the infrastructure as an asset class given that it is typically inflation-hedged and backed by long-term contracts in light of the recession. But in the long term, what’s the appeal of this asset class? Infra funds generally deliver lower net returns (1.5+/-) than buyout, growth and VC. So, what’s the point of entering into the asset class via secondaries while the primary return is already pretty limited?
For growth/VC, expected returns are higher, but generally, risks are higher and realizations take longer. So, secondaries have their appeal as an alternative by providing stability and faster distribution at the expense of lower returns. Also, the deltas between top quartile funds vs. low quartile funds are very large. Therefore, the secondaries strategy makes sense in this case.
But what about infrastructure secondaries? Returns are generally sub-optimal. Infrastructure investments are already downside-limited in many cases. Deltas between funds are generally lower. Am I missing something here?
Well, you've certainly done your homework! You're right that infrastructure investments, including secondaries, often have lower returns compared to other asset classes like growth or VC. But let's not forget, it's not all about the high returns. Here are a few reasons why infrastructure secondaries can still be appealing:
Stability: Infrastructure investments are known for their stable cash flow profile. This is because they're often linked to essential services or assets that generate consistent revenue, regardless of economic conditions. This stability can be particularly attractive in uncertain times or for investors with a lower risk tolerance.
Inflation Hedge: Infrastructure investments are often linked to macro indicators like inflation and GDP. This means they can act as a hedge against inflation, which can be a valuable feature in an inflationary environment.
Diversification: Infrastructure investments can provide diversification benefits. They tend to have a low correlation with other asset classes, which can help to reduce portfolio risk.
Yield: While the overall returns might be lower, infrastructure investments often provide a strong cash yield. This can be attractive for investors looking for regular income.
Downside Protection: As you mentioned, infrastructure investments often have a protected downside. This can make them a safer bet compared to other types of investments.
So, while the returns might be lower, the combination of stability, inflation hedging, diversification, yield, and downside protection can make infrastructure secondaries an attractive proposition for certain investors. It's all about balancing risk and reward, and for some, the lower risk profile of infrastructure secondaries is worth the trade-off in terms of lower returns.
Sources: Overview of Infrastructure Private Equity, Pitchbook: PE Secondaries to Boom in 2023
While you're right that infra funds typically target lower returns, the way that their underlying assets are valued make them interesting to secondary buyers. Even if a company returns 10-12% net over the GP's hold, it doesn't necessarily mean the business is compounding at that rate annually - often in infra, big write ups are chunky and only happen a few times throughout an asset's life. For instance, if a developer is building a solar farm, they'll use a much different discount rate while it's under construction to once it's built. Say you were to buy an LP stake in a fund at 80 cents where this asset makes up 20-30% of NAV and it's written up by another 25% only a few months after you close, returns start to look incredibly attractive. If you are able to form differentiated views surrounding certain portcos reaching mechanical completion, winning big contracts, benefiting from new subsidy regimes... etc. you can do very well. I guess in short there's just a lot of alpha in infra secondaries if you actually know what's going on with the underlying businesses you're underwriting and aren't just relying on the bare bones reporting GPs have given you. Secondary returns can be less correlated with underlying fund performance than you may think.
Thank you for your comment. I have not come across infrastructure LP-led positions trading at 80% to NAV. Typically, infrastructure assets in the secondaries market trade at NAV or at very slight discounts if any. Also, your comments seem to apply more to greenfield portfolios, which secondaries investors generally avoid. Overall, do you believe that infrastructure secondaries is a good space for building careers?
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