Infrastructure funds have done their bit to keep traffic levels up at the world's airports, sending their fundraising groups out to coax equity out of ever-more obscure sources. But potential limited partners are wary of infrastructure funds as an asset class.

Preqin, a London-based research provider, says that 108 infrastructure funds are currently trying to raise capital. Cumulatively they are looking to raise over $100 billion. But so far this year, only two funds have actually closed: H21 Infrastructure I – a $200 million global fund of funds that will invest in both developed and emerging markets – and Fondi Italiani Per Le Infrastrutture – a Eu1.9 billion ($2.6 billion) fund focused on Italian assets.

What is so striking about these numbers is not only the scarcity of successful closings, but also the huge slowdown in comparison to 2008. With first quarter closings of around $2.3 billion, it represents on an annualized basis a plunge of around 60% in fund raising for the asset class. And the numbers have not improved in any measurable way in the second quarter.

Infrastructure Funds Raised
(2005–Q1 2009), US$ billion
Year                   Emerging Markets Funds             Developed Markets Funds
2005                      2.3                                              4.8
2006                      3.2                                             16
2007                      3.4                                             27.9
2008                      8.3                                             20.5
Q1 2009                0.7                                               2.3
Source: Emerging Markets Private Equity Association,
Private Equity Intelligence, Probitas Partners

The reasons for this collapse are both specific to infrastructure as an asset class and more generally linked to the wider financial market collapse. Limited partners have not had a pleasant experience with the investments that they have already made in infrastructure funds. The assumption that these investors bought into in the 2005-2008 vintage of funds was that the best returns were made through high leverage. Fund managers earned their keep through M&A fees and the use of financial products such as accreting swaps. High leverage worked in a rising market, but when the recession hit a single-digit decrease in usage of a fund's asset translated into high double-digit losses for the investors in the fund.

"A lot of funds have run into trouble as they bought assets at very high valuations," says Ravi Bugga, a senior manager for transport at the International Finance Corporation (IFC). "So the funds are licking their wounds and LPs are troubled."

Falls mean fee examinations

To date, losses for limited partners in infrastructure funds have been less visible than in other asset classes such as private equity or hedge funds, primarily because these assets are much harder to value. But now that infrastructure investors such as Babcock & Brown have collapsed and both they and their lenders have become forced sellers of assets, other funds will have an obligation to mark down the value of their portfolios.

"There is a certain amount of misery out there among the LPs," says John Campbell, a senior partner at fund adviser and placement agent Campbell Lutyens in London. "This was meant to be a more diversified, less correlated type of investment playing to the fundamental differences infrastructure investment can offer – access to long-term, relatively predictable, often inflation risk-mitigated flows of income. How can a head of infrastructure investment at a pension plan or other investment institution go into their investment committee meeting, saying that they had invested in infrastructure funds for the bond-like returns and then lose 30% or 40% in a single year?"

Furthermore, infrastructure assets have proved to be spectacularly unsuited to supporting the fee structures that fund managers imposed. Applying traditional private equity type fees of 2% of assets and 20% of profits to infrastructure assets that generate returns of between 8% and 13% a year, leaves limited partners with a miniscule return for an investment that turned out to be much more risky than they had previously imagined.

"The basic construction of the infrastructure funds model was poorly done," says Campbell. "One fundamental change we are now seeing is that funds are starting to be structured with a proper alignment of interests between limited partners and general partners. This is reflected in many structural aspects – the life of the funds, the levels and method of calculating management fees and carry and the disclosure and division of transaction, financing and other fees"

Another important reason why fundraising has fallen so sharply for infrastructure funds is that appetite for exposure is correlated with appetite for other asset classes. Investors allocate fixed proportions of their assets to public equity, fixed income, private equity and infrastructure. When the value of their public equity investments decline by 30% or 40%, they have to make equal reductions in the holdings of other asset classes to maintain their asset allocation ratios. As a result infrastructure allocations have suffered.

A good illustration of this process at work is Alaska's Permanent Fund, the state's $38 billion oil revenue fund. In 2007 it had decided to make an initial 2% allocation of its fund to infrastructure and put a combined $850 million into Citi Infrastructure Investments and into Global Infrastructure Partners, the infrastructure fund joint venture between Credit Suisse and GE. In July 2008, the Alaska fund decided to increase its allocation to 3% and so looked to make two additional investments, a $500 million investment Goldman Sachs' second infrastructure fund and $250 million into a second infrastructure fund being raised by Alinda.

However the investment in Alinda soon became a victim of the financial crisis. "We ended up not making that commitment before the contract was signed – it had nothing to do with Alinda and everything to do with the denominator effect," says a spokesperson for the Alaska Permanent Fund. "As our stock portfolio dropped in value, we had to rebalance elsewhere, and not making the commitment to Alinda was one of our strategies."

Survival mechanisms

Some infrastructure fund managers have sharply curtailed their fund raising activities, while others are adopting strategies that are designed to get limited partners to open up their wallets. One of their favourite tactics is to use interim closes, announcing a first but not final close of a fund once 2-3 major, cornerstone investors come in. This gives other smaller investors comfort that the fund has sufficient resources and that it will survive. It also allows the fund managers to go out and compete for deals and assets. According to Preqin, of the 108 funds on the road looking to raise capital, 40% have already achieved an interim closing.

Managers have shifted their focus to developing specialised funds. Rather than the large multi-sector funds that invest in existing, regulated assets in OECD countries that dominated the 2005-2008 period, the majority of funds on the road at the moment have a niche specialization. Preqin says that 70% of the 108 funds on the road have a specific country or regional specialization, while 30% are globally focused. In April, HSBC Specialist Fund Management completed an interim closing of Eu117 million on a specialised environmental fund. First Vanguard is aiming to launch a $500 million fund that is both region- and sector-focused with an Asia water and wastewater concentration.

Private sector managers have become much more eager to form joint ventures with public sector or multilateral agencies. Once content to be limited partners in funds, and lenders of last resort, these entities now form the backbone of both debt and equity markets in project finance. Development finance institutions can point to how such management roles allow them to achieve their mission of mobilizing capital, although they also give them potentially much greater returns.

UBS has formed a joint venture with Abu Dhabi's sovereign investment vehicle ADIC and had raised $250 million for an initial close of a maiden infrastructure fund investing in Middle East and North African assets. In 2008 Macquarie teamed up with IFC for two single country funds, one in Russia and one in India, the second of which also featured the State Bank of India, adding local government support to the venture. Macquarie is not new to single-country funds, as one of the largest outside infrastructure developers in Korea, and multilaterals have long wanted to stimulate more infrastructure equity investment. But the balance of power between the DFIs and fund managers has shifted sharply in the last 12 months.

The IFC, both as a lender and equity provider, has been funding infrastructure since 1992, and making commitments to infrastructure funds since 2007. This year it is in the process of becoming a fund manager in its own right and is trying to raise money for the IFC Infrastructure Crisis Facility. The facility will mobilize $5 billion in debt and $1.5 billion in equity from various governments, sovereign wealth funds and public pension funds and invest it in greenfield infrastructure projects in emerging markets that have stalled due to lack of commercial debt and equity interest. China's sovereign wealth fund CIC is reported to be very interested in investing in the facility.

The facility is not designed to be a permanent replacement for long-term infrastructure equity, and will not operate in the same way as the infrastructure funds that have sprouted in the last four years. It will provide interim funding to government-inspired projects that are not fully-cooked, replacing capacity that has disappeared from the market.

Private sector players are also looking to fill voids left by departing market participants. At one point bankers hoped that infrastructure funds might step in to replace traditional senior debt providers both in fixed-rate and commercial bank markets. Beyond a small number of mezzanine deals and secondary market purchases, usually for equity-related reasons, this has not been the case. Instead, specialist debt funds are beginning to emerge: For example, the Gravis Capital Partners Infrastructure Fund, the first debt-based infrastructure fund, will provide subordinated debt to UK PFI projects.

UBS and Macquarie have both launched funds of infrastructure funds, while Macquarie is also launching funds of listed infrastructure securities, saying they will allow investors to benefit from the huge rises in infrastructure spending by countries around the world, but also provide daily liquidity. But the best chance of rebuilding infrastructure equity market capacity lies in the US, easily the largest untapped market for infrastructure funds looking for money.

A small minority of the large public pension plans has committed allocations to the asset class. But many more are poised to do so. "I am absolutely convinced that the bigger US pension funds are all looking to find a way to get into this asset class," says Ben Heap, head of North American infrastructure asset management at UBS Global Asset Management. "There has been a lot of investor education in the last few years. I expect this to rapidly become a multi-billion dollar market and not just a single billion dollar market."

State pension systems in North Dakota, California, Maine, Illinois, Alaska, Washington, Texas, New York and New Jersey have made infrastructure allocations. Fund managers hope that these commitments will not only replace the last wave of wounded limited partners, but also provide a measure of political cover for states' proposed, and often contentious, asset monetisations.