By Hamlin Lovell, NordicInvestor
Nykredit has been an investor in illiquid assets since the early 2000s, but significantly stepped up the exposure in 2014 with allocations to infrastructure equity funds, where there is now around EUR 800 million invested. NordicInvestor interviewed Ulla Agesen, Head of Alternative Investments and Manager Selection, to identify what Nykredit is seeking from its external infrastructure managers.
The genesis of the infrastructure allocation was partly a switch from fixed income. “We know infrastructure does not have the same risk profile, but at least we have some of the income characteristics”, says Agesen, who builds alternative investment portfolios and advises clients such as endowments, foundations, high net worth individuals and private pensions. (Nykredit’s Treasury invest in many of the same funds).
She views infrastructure equity as less risky than private equity, partly because its yield and essential function in society provide downside protection. Performance has been strong and structures have remained fairly resilient during 2020: “the return target of 10-12% from the dedicated private infrastructure equity program has been met over the past six years and is mainly driven by GPs buying well, carrying out operational improvement and asset management as well as looking for growth opportunities and synergies. There can also be some added value from leverage, which on average is 40-50% at the underlying asset level. Leverage costs have not risen post-Covid and some funds have even been able to refinance on better terms. Some have also renegotiated or obtained waivers of covenants. Overall, our impression is that lenders have been quite accommodating”, she says.
Some of the stability in returns may come from assets being regulated. “It is not straightforward to determine the split between regulated, contracted and market-oriented revenues, because some assets might be partly regulated. But even where assets are not regulated, there are usually long term contracts or PPAs (Power Purchase Agreements) in place”, she says.
Indeed, infrastructure investors can take a 10, 20 or 30 year view. Some assets such as airports have seen some write downs in the wake of Covid-19 and will need time to get back on their feet. Additionally, “some transport assets are proving to be relatively resilient, partly because they are availability-based. Social infrastructure such as elderly care, nursing homes and private hospitals is a country specific story but can be buoyant”. Agesen does not expect a lot of exits near term as valuations are volatile in the current market due to uncertainty about the effect of Covid-19.
Three ‘D’ Megatrends
Geographically, the focus is mainly OECD countries though there can be some assets in countries such as India where GPs have relevant experience. The big trends guiding the infrastructure allocation are the 3 ‘D’s: Data, decarbonization, and demographics. “Data leads to more connectivity, and are in areas such as date centres, fibre networks and telecom towers. Decarbonisation is a major theme behind renewable energy. Demographic trends increase the need for health infrastructure and urbanization”, says Agesen.
These growth stories are undeniable, but in some cases they may already be factored into valuations. Agesen finds that, “some telecom related assets are starting to look expensive as are some onshore renewables such as wind farms. Therefore, GPs need to work harder and seek more complex deals or in some cases at the pre-permit greenfield stage to earn additional risk premiums. Greenfield funds can also be a longer duration than the typical 12 year closed end fund structure Nykredit invests in”.
Vehicles and investors
The program is entirely invested in external funds, including some co-investments, and is indirectly exposed to over 100 assets. There is a mix of mega, mid-market and smaller deals. There is exposure to some of the biggest general partners, such as Brookfield, and also smaller deals. Nykredit’s fund and co-investments usually sit alongside other pension funds, which could come from the US, Canada, Australia, UK or Spain, as well as other Nordic countries. In any case, Agesen likes to keep in close contact with other LP investors.
ESG, excusal rights and Impact Investing
“Overarching the three D megatrends is sustainability”, says Agesen. UNPRI membership is not a hard requirement for external managers, but all bar one of Nykredit’s infrastructure managers are in fact UNPRI signatories. “Nykredit does not have a box-ticking checklist for managers’ ESG policies, but does take a close look at their culture, including how ESG improvements are prioritized at the asset level. If managers are investing in energy, they will need to show some awareness of decarbonization. Nykredit will also often be present on Limited Partner committees, which can be a way to influence policies”, she explains.
Of course, being locked into managers for a typical period of 12 years means that sometimes Nykredit’s ESG policies may evolve faster – or move in different directions – to those of its managers. One way to address differences between ESG policies is excusal rights, which are negotiated in side letters. Rather than trying to redeem from an entire fund (or sell interests on the secondary market), Nykredit could use excusal rights to simply avoid exposure to certain underlying investments. Nykredit has not actually made use of excusal rights yet, but they provide a useful workaround solution in cases where differences of opinion cannot be resolved.
Impact investing projects need to meet the investment objectives and not all of them do. “Some impact investments such as energy transition can match the return target, but some other impact projects – such as clean water in frontier markets – do not aim to offer the same level of financial returns”, says Agesen. “Nykredit could contemplate other strategies where impact trumps financial return, but this will be in a separate vehicle”, she adds.
Political risk has been seen recently in threatened nationalization in the UK, if Jeremy Corbyn’s Labour Party had won the election, and Spain’s changes of policy for the solar industry. In 2014, Spain retrospectively and unilaterally changed feed-in tariffs for solar electricity, which has led to more than 50 disputes conducted through court tribunals and arbitration. Even where investors have been given arbitration awards, it is not clear whether the Government will pay them.
This type of political risk goes with the territory of infrastructure investing, but Agesen is constructive on the long term outlook. “Infrastructure is central to society and is needed in a number of sectors, and government debt related to Covid-19 may increase the need for private capital. There is also a great need for spending to maintain current infrastructure, and to allow for green transition to a lower carbon economy”, she points out.
For much of 2020, due diligence has only been virtual, and Agesen is very much looking forward to resuming site visits in her search for compelling infrastructure equity investments.