Matthew Bright Infrastructure Funds Research Paper Jan 08


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A paper written way back in 2007 when listed infrastructure funds were still all the rage.

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Matthew Bright Infrastructure Funds Research Paper Jan 08

  1. 1. IBUS6015: INNOVATION AND ENTERPRISE SPECIAL PROJECT WORKING RESEARCH PAPER Infrastructure funds and the macroeconomic drivers of entrepreneurial asset packaging: the Australian experience Matthew Bright SID: 200006022 January 2008The inception of the first listed infrastructure fund on the Australian Stock Exchange in December 1996,Macquarie Infrastructure Group, was a structural innovation which pooled illiquid infrastructure assetsinto a liquid investment vehicle. This new product was developed in response to a facilitativemacroeconomic climate in Australia at this time of equity market momentum, lower bond yields and lowinflation, which occurred after a period of recession, Government asset privatisation and foreign bankingderegulation. This paper studies how Australia’s macroeconomic climate at that time and in the ensuingten year period from December 1996 to December 2006 facilitated entrepreneurs’ perception of profitableopportunities and decision-making in new product development and decision-making by corporateentrepreneurs. It highlights significant correlations between corporate activities and macroeconomiccycles.
  2. 2. IntroductionInfrastructure funds are today a prominent part of an emerging asset class in global financialmarkets in both established and emerging economies. In the fifteen months to July 2007, seventytwo new infrastructure funds raised US$120 billion of capital commitments globally (Orr, 2007).These funds operate on sector-specific or diversified investment mandates and are managed byasset managers, private equity fund managers or large investment banks undertaking proprietaryinvestments through dedicated business units.Such fund raisings are indicative of financiers’ desire to invest in the infrastructure space, wherethere was earlier estimated to be an $8.5 trillion backlog of infrastructure worldwide to bedelivered by 2010 (Faye and Tito, 2003) and a $1.6 trillion backlog in the United States alone(Orr, 2006 and RREEF, 2006), with extensive opportunities for private sector participation.World Bank estimates have previously valued the world’s infrastructure stock at US$17 trillion(UBS, 2006), including listed, unlisted, private and state-owned assets.In order to understand the fund raisings and transactional activities of infrastructure funds in thecurrent investment climate, it is pertinent to examine the origin of the infrastructure fund model,the macroeconomic and supply/demand factors which spawned its inception in Australia in the1990s where the first infrastructure fund was conceived, developed and exploited. Australia isone of the most mature markets for infrastructure in the world, with the asset privatisationswhich took place in the 1990s having spawned an enduring investment phenomenon.This paper analyses the macroeconomic factors which enabled the entrepreneurial proprietaryinnovation by listed infrastructure funds (and their parent companies) between December 1996and December 2006 by the managers of two of the seven pioneering funds identified by the 2    
  3. 3. Collaboratory for Research on Global Projects, Stanford University (Orr, 2007), includingMacquarie Bank Limited’s Infrastructure and Specialist Funds (ISF) business unit (a firstmover); and Babcock and Brown Limited, an asset manager (a fast follower). These investmentfirms are the two dominant, domestically-headquartered, globally-active players in theinfrastructure funds business which undertake proprietary investments in infrastructure assetsand securitise these assets through their infrastructure fund vehicles.Existing academic literature on infrastructure funds centres on issues such as the significance ofinfrastructure in investment portfolios (Peng and Newell, 2007); and the political economyconsiderations associated with privatisation, public private partnerships (PPPs) and securitisation(Jeferris and Stillwell, 2007); whilst extended media coverage has dwelled on controversialmicroeconomic considerations associated with infrastructure funds such as fair value accountingmethodology, fee structures, capital structure, sustainability (Chancellor 2007, Haigh, 2007 andMaclean, 2007). Analysis has thus far neglected to examine the macroeconomic climate whichfacilitated the entrepreneurial opportunity to capitalise on the transition from public assets toprivate ownership and transferral to shareholder ownership.In 1996, a triad of macroeconomic trends including low inflation, constant bond yields andupward domestic equity markets momentum, coupled with the Australian Government’s policyrevision towards infrastructure ownership and development facilitated Schumpeterian creativedestruction by Australian investment banks and spawned the birth of infrastructure as a discrete,alternative asset class.Analysis in this paper is directed towards how macroeconomic phenomena impacted the originalinception and subsequent performance of infrastructure funds from December 1996 to December2006 in Australia, one of the most mature infrastructure markets in the world. A typical 3    
  4. 4. invention/innovation/diffusion process occurs in this period, where the innovating operator ofinfrastructure funds, Macquarie Bank, conceives and exploits the infrastructure fund model,commencing with Macquarie Infrastructure Group in 1996, and achieves temporary marketpower until Babcock and Brown copies and enters the market for listed infrastructure funds in2004.The paper begins with a description of the methodology used in research. The early sections ofthe paper consider infrastructure as an asset class, the investment opportunity and the Australianexperience. The body of the paper considers the macroeconomics of infrastructure in Australiaand corporate entrepreneurs’ decisions in this climate. An appendix offers a broad businessoverview of the asset packaging business.MethodologyAnalysis is conducted in two parts. Firstly, qualitative analysis examines the characteristics ofthe infrastructure asset class (with a brief explanation of the asset business also included atAppendix A). Second, quantitative analysis surveys the macroeconomic climate and howindividual variables collectively influence the inception of infrastructure funds and corporateactivity and affect their performance over a ten-year period. Primary analysis centres on theperiod of December 1996 to December 2006, with secondary analysis examiningmacroeconomic trends for the immediate earlier corresponding period prior to the inception ofthe first infrastructure fund.Quantitative research is orientated towards the analysis of the interaction betweenmacroeconomic variables including Australian Government 10 year bond yields, inflation,interest rates, equity market movements, with company decisions including listed infrastructure 4    
  5. 5. fund capital raisings and stock market listings and corporate activity by these funds and theirparent companies.Observing the interaction of macroeconomic variables with corporate decisions in the period ofinfrastructure fund innovation (and relative to the prior corresponding period) gives an insightinto the decision-making of entrepreneurs in a sequential multi-period setting. It is important toexamine the initial macroeconomic setting which facilitated the entrepreneurial opportunity, itsgrowth prospects and subsequent innovations.Australia is selected as the case study as it is the market where the innovation occurred, now oneof the most mature markets for infrastructure investment in the world (alongside Canada and theUnited Kingdom) and the global headquarters for the two most prominent investment firmsactive in global infrastructure investment, Macquarie Bank and Babcock and Brown Limited.The business environment has undergone significant changes since infrastructure privatisation inthe 1990s with the inception and operation of multiple infrastructure funds. 1. Infrastructure The infrastructure fundThe infrastructure fund was a new-to-the-world product, an invention that created an entirelynew market of primary demand, leveraging firm strengths into a new activity centre in agreenfields market. Typically, in greenfields market identification, firms look for emergingtrends and develop a fringe market through product and process innovation to orientate theproduct to markets with the goal of market dominance and the objective of market leadership atproduct inception. The innovator undertakes a first-to-market strategy of ‘leveraged creativity’ -using the firm’s existing strengths and brainstorming creative applications to arrive at newproducts. Future products which are developed are adaptive products – the firm takes its own 5    
  6. 6. product and improves it in some way, with declining cumulative expenditures curve in productdevelopment.The asset classInfrastructure is the fixed wealth of nations (Orr 2005). Infrastructure assets are the physicalstructures and networks which provide the essential services required by societies and economiesto function. Infrastructure is divisible into two categories: economic and social infrastructure.The unique attributes of various industry segments vary by their asset cash flow structures andlife cycles. Economic infrastructure includes user-pays services in sectors such as transport (tollroads, bridges, tunnels, sea ports, airports, rail and ferries), energy and utilities (gas distributionand storage, electricity distribution and generation, waste collection and processing, watertreatment and distribution, renewable energy), communications (satellite systems and cablenetworks) and specialty sectors (car parks and storage facilities) (CFS 2006, RREEF 2005,RREEF2006). It is estimated that 70% of Australia’s infrastructure is economic infrastructureand 30% is social infrastructure (Senate). Social infrastructure includes state-pays services insectors such as healthcare (hospitals, aged care), education (schools), housing (affordablehousing) and judicial and correctional facilities (courts and prisons). Transactional activity ineconomic infrastructure may occur by way of acquisition, trade sale, privatisation, developmentand construction or joint venture. Transactional activity in social infrastructure generally occursthrough public private partnerships as Governments opt to retain control of core clinical andsocial services in line with public policy (CFS 2006, RREEF 2005, RREEF2006).The investment opportunityIn broad economic terms, infrastructure assets exhibit low volatility; possess cyclical immunity;and hold monopoly, duopoly or oligopoly positions with sufficiently prohibitive barriers to entry, 6    
  7. 7. inelastic demand and non-rivalrous characteristics (Orr 2005, Peng 2007, RREEF 2007, CFS2006). Attractive considerations include counter-cyclical demand strength and populationgrowth; captive customer bases; stable, predictable inflation-linked revenue streams with growth;low operating risk and require low capital expenditure; low correlation of returns with other assetclasses; and investment lifecycles compatible with pension funds seeking long-term investmentsto match their long duration liabilities. (Orr 2005, Peng 2007, RREEF 2007, CFS 2006).Infrastructure investors seek stable earnings from essential goods and services, portfoliodiversification, investment in an asset class with low correlation to price fluctuations in otherasset classes and a tax effective income stream with tax deferred components (ASX 2006). Thesecharacteristics are strongly appealing to institutional investors seeking conservative growth withlow investment risk. Pension funds in particular see the infrastructure asset class as a substitutefor long-duration fixed income (Orr, 2005). In 2006, $8 billion of infrastructure investment inAustralia accounted for approximately 2% of the country’s $900 billion in superannuation (Peng2007). By 2012, infrastructure investment is expected to increase to $65 billion – 5% of totalsuperannuation fund assets (Peng, 2007 and Nielson, 2005).The infrastructure asset class is susceptible to systematic risks, such as in (i) credit marketcontractions which may cause reduced access to debt for infrastructure financiers/operators; and(ii) increases in bond yields, where investors exit infrastructure assets for bond investments asthe risk premium increases under such scenarios. Non-systematic risk includes (i) interest raterisk for asset/operational financing and refinancing; (ii) operational risk in adjacent businessessubject to cyclicality (such as airline risk on airport revenues); and (iii) changes in regulatorypolicy on regulated utilities (RREEF 2006, ASX 2006). 7    
  8. 8. 2. The Australian Infrastructure Market: a Case StudyEnvironmental OverviewIn the 1990s in Australia changes occurred in the role of Governments in the provision ofinfrastructure with trends shifting towards Government facilitating the private sector provision ofinfrastructure by way of partnership (House of Representatives, 2003). The infrastructureinvestment opportunity for private sector operators in Australia originated in (1) the privatisationof Government trading entities in the 1990s, owing to microeconomic reform policy to use theproceeds of asset sales to retire outstanding Government debt and to incentivise privatecompanies to operate these entities with higher service standards and competitive pricing forend-users (CFS 2006); and (2) the entry into public private partnerships with private sectorconsortia to engage private business efficiencies for the delivery of public infrastructure. Thescale of privatisation in Australia undertaken between 1990 and 1997 was second only in dollarvalue to the United Kingdom (the most advanced market for privatization) in that period (RBA,1997).Profitable investment opportunities in the mature Australian infrastructure market have existedsince the privatisation period. The UBS Australia Infrastructure Index (a sub-index of theS&P/UBS Infrastructure and Utilities Index, the benchmark industry index) reports returns of20.2% (annualised returns) over ten years, 30.2% over five years, 28.4% over three years and32.2% over one year for Australian infrastructure versus returns for UBS Global Infrastructure of13.8% over ten years, 29.5% over five years, 29.5% over three years and 26.7% over one year.The transition to investable assetsInfrastructure’s supply-side problem emanated from the fiscal constraints on Government whichhad led to underinvestment in infrastructure maintenance, renewal and development, persisting 8    
  9. 9. against unsatiated end-user demand for essential services. The origin of infrastructure as adistinct asset class transpired from opportunistic private sector financiers and infrastructureoperators exploiting this supply/demand imbalance through structural innovations of theinfrastructure fund and through the placement of cash inflows from superannuation fundsseeking stable, long-yielding investment opportunities.Supply of investment opportunities for financiers and their co-investors is dependent onGovernments’ willingness to privatise assets and to enter into Public Private Partnerships (Orr2007, RREEF 2006, ASX 2006). Presently, the domestic market for infrastructure investmentshas reached a level of maturity where demand now outstrips supply for infrastructure assets.Infrastructure fundsThe infrastructure funds analysed in this paper are indicative of infrastructure funds commonlyoperating in Australia with global investment mandates. Macquarie Infrastructure Group (MIG)develops and manages toll roads around the world. Macquarie Airports (MAp) is one of theworld’s largest private airport owner-operators. Babcock and Brown Infrastructure (BBI)acquires and manages diversified infrastructure assets globally, across three asset sub classes:energy distribution and transmission, transport infrastructure and power generation. Babcock andBrown Wind Partners (BBW) is a globally diversified listed stapled entity investing in windenergy generation assets. Macquarie Bank Limited is a diversified full-service investment bank,whilst Babcock and Brown Limited is a specialised infrastructure and real estate asset manager. 3. The macroeconomic drivers of infrastructure funds in AustraliaOverviewThe interaction of macroeconomic variables has a significant influence on the formation ofentrepreneurship opportunities. Fundamental macroeconomic trends have influenced 9    
  10. 10. infrastructure’s emergence as an asset class, its exploitation through asset packaging andfinancial product development and investors’ financial commitments to the asset class. It is theauthor’s hypothesis that the domestic Australian macroeconomic environment was a catalyst inthe inception of the first infrastructure fund and continued to be of considerable importance tothese domestically-headquartered and globally-active funds in corporate activity undertakenthroughout the sample period.At the inception of the first infrastructure fund in Australia, declines in interest rates to ahistorically low cost of debt and corresponding decline in bond yields, coupled with low inflationand rising equity market movements enabled opportunities in listed infrastructure fund creationand corporate activity for the ensuing ten year period. As interest rates and long-yield bonds heldsteady over this period, Australian investors’ (particularly superannuation funds) appetite for anasset class offering similar stability to bonds (for a risk premium) shifted interest to the equitymarkets, with infrastructure fund investment opportunities providing greater upside for relativelysimilar risk.As the infrastructure asset class has matured and become accepted in Australia, its sensitivity tomacroeconomic factors has also held. Investment in listed infrastructure funds is heavilyinfluenced by inflation rises and bond yields (UBS, 2006) and equity market momentum whichallows for heightened deal activity, a strong market for primary and secondary capital raisings,listed vehicle market capitalisation growth and lower fee structure scrutiny (Merrill Lynch,2006).Data Sources and AnalysisAnalysis is conducted using Australian macroeconomic data for December 1996 to December2006 (the sample period). The chronological logic for this sample period is that Macquarie Bank 10    
  11. 11. lists its first infrastructure fund, Macquarie Infrastructure Group, on the Australian StockExchange in December 1996, with ten years providing a logical sample period for organic andbolt-on growth and the entry of and Babcock and Brown as a competitor in the infrastructurefund market in October 2005.Data sources include inflation and interest rates from The Reserve Bank of Australia (RBA);superannuation statistics from the Australian Bureau of Statistics (ABS) and AustralianPrudential Regulatory Authority (APRA); share prices and associated information from theAustralian Stock Exchange (ASX); and indices from UBS Australia.Pre-Macquarie Infrastructure Group listing - the immediate prior corresponding period fromJanuary 1990 to December 2006Based on what would be in future treated as the macroeconomic drivers of the infrastructureasset class, December 1996 was an opportune time for a macroeconomic-interpretiveentrepreneur to list the first infrastructure fund on the ASX. As Australia came out of recessionin the 1990s, RBA monetary policy decisions to cut interest rates led to a decline of interest ratesfrom 17.5% in January 1990 to 6.5% in December 1994, the point at which MacquarieInfrastructure Group listed on the ASX (Figure 1.1). During this same period, 10-year AustralianGovernment bond yields decreased from 12.8% in January of 1990 to 7.7% in December 1996(Figure 1.1) as a result of asset privatisations (all classes) being used to retire debt (RBA). TheRBA consumer price inflation rate (all groups) decreased from 8.6 points in March 1990 to 1.5points in December 1996 (Figure 1.2). Against this economic picture of low interest rates, lowerbond yields and low inflation, the S&P/ASX200 Total Return Index increased from 6,304 pointsin January 1990 to 9,858.9 points in December 1996. 11    
  12. 12. The activities and performance of the selected infrastructure funds and their parent companiesfrom the sample period based on the corresponding macroeconomic climateIf the infrastructure funds business is as reliant on macroeconomic factors as suggested andcorporate directors are interpretative of domestic macroeconomic indicators in decision-making,there should be some logical correlation between company decisions and macroeconomicmovements. Decisions made by Macquarie Bank Limited and two of its infrastructure funds,Macquarie Infrastructure Group and Macquarie Airports were examined for the period ofDecember 1996 to December 2006; and by Babcock and Brown Limited and two of itsinfrastructure funds, Babcock and Brown Infrastructure and Babcock for the period of July 2005to December 1996 and Brown Wind Partners for the period of September 2004 to December2006.The most significant macroeconomic movements over the sample period include 10-yearGovernment bond yield dropping from a high for the period of 7.37% in December 1996 to a lowfor the period of 5.1% in December 1998; interest rates declining from 6% in December 1996 tothen reach a high for the period of 6.25% in August 2000, with a decline to 4.25% by December2001, to close out the period again on a high of 6.25%; inflation remaining relatively constantsave for a high of approximately 6% from September 2000 to June 2001; and the S&P/ASX200Total Return Index showing sustained equity market momentum, ascending from 10,000 pointsat December 1996 to reach 35,000 points at December 2006.Corporate announcements show that the parent companies for infrastructure funds, MacquarieBank Limited and Babcock and Brown Limited elect to undertake capital structure changes,capital raisings and infrastructure fund raisings between mid-to-late-2000 to late-2001, where inthe macroeconomic climate there is a marked decrease in interest rates from 6.25% in August 12    
  13. 13. 2000 to 4.25% in December 2001, a marked decrease in inflation from 6.1% in September 2000to 2.5% in September 2001 and a decrease in bond yields from 6.28% in August 2000 to 5.21%in October 2001 (with some volatility in yields in between). During this period MBL completesthe fund raising for Macquarie Airports Group (the unlisted predecessor to MAp) and undertakesa parent company capital raising; whilst MIG undertakes a change in capital structure (adding aBermuda-based third arm to its staple security), makes two significant acquisitions andcompletes a large placement.The most significant period for corporate activity within the sample space occurs betweenNovember 2003 and May 2006, where in a period of constant low inflation, interest rates and 10-year bond yields both hover between 5% and 6%. Corresponding to this, the S&P/ASX200 TotalReturn Index rises from 17,126 points in November 2003 to 29,776 points in May 2006, thefastest growing period for the sample. In this period, there is substantial domestic infrastructurefund activity from MBL (one new infrastructure fund raising); MIG (two major assetrefinancings, a large placement and asset demerger); and MAp (two placements and theacquisition of Sydney airport). At this time BNB enters the market (raising capital for 4 newinfrastructure funds); with the backdoor listing of BBI (formerly Prime Infrastructure,conducting two domestic acquisitions and a capital raising); and the listing of BBW (acquiringthree domestic wind farms and conducting a capital raising). There is also extensive internationalactivity, from all parties, however, this is not analysed given that international macroeconomicfactors also impact corporate decision-making in this capacity.The most constant period for all key macroeconomic indicators for the period is from October2002 to August 2003, where a significant number of world events occur, including the Balibombing in October 2002, the SARS outbreak in February 2003, the Iraq war Feb 2003 and the 13    
  14. 14. Jakarta bombing in August 2003. During this period, Macquarie Bank undertakes several largedomestic transactions, including the sell down of significant interests in both MIG and MAp andthe completion of an infrastructure fund IPO.The broad performance of listed infrastructure in the sample periodExpanding the start of the sample space to the commencement of the 1997 financial year in July2006 to the end of the 2006 financial year in July 2006 (Australian financial years are dissimilarto calendar years), it is notable that the number of listed infrastructure entities grew from four inJuly 1996 to 20 in June 2006 with market capitalisation growing from below $1 billion in July1996 to in excess of $20 billion in June 2006 (Colonial, 2006). Over this period, listedinfrastructure funds show a higher correlation with 10-year Australian Government bond yieldsthan unlisted infrastructure funds, with the former exhibiting an R2 measure of 0.46 and a highercorrelation of -0.68 and the latter an R2of 0.08 and a lower correlation of -0.28 (Colonial, 2006).Colonial explains the negative correlation as being a result of the long-term bond rate beingtypically imbedded in the discount rate used to value infrastructure businesses, where holding allelse constant, if the bond rate rises, the discount rate applied to valuing the businesses will falland the resulting net present value (NPV) of the businesses will fall as a consequence.Using a correlation matrix for Australian asset classes for the sample period (rolling annualnominal total returns on monthly resets) show that listed infrastructure (using the UBSInfrastructure and Utilities index as a proxy) has a strong positive correlation of 0.23 to equities,0.33 to REITs and 0.50 to bonds (Colonial, 2006).At a risk-free rate of 5.9%, listed infrastructure for the sample period exhibits a Sharpe Ratio of1.5 (a measure of a reward-variability ratio), on par with other major asset classes includingequities, REITs and direct property. At a 0% risk-free rate, listed infrastructure for the sample 14    
  15. 15. period exhibits a lower Sharpe Ratio of 1.1, substantially higher than equities, but only slightlyhigher than REITs and direct property (Colonial).SuperannuationCorresponding to the trend toward infrastructure investment over this period, superannuationfund managers’ allocation to the asset class played an important part as superannuation earningsduring this period became and increasing important part of Australia’s income mix, withsuperannuation assets as a proportion of GDP growing from 37.9% in June 1996 to 98.8% inJune 2006, based broadly on public policy outcomes from a Government-mandated compulsorysuperannuation contribution of 9% of employees’ salaries. In the ten years from June 1996 toJune 2006, Australian superannuation assets nearly quadrupled from $245 billion to $912 billion(APRA, 2007) with an industry average rate of asset growth of 14 per cent (based on improvedcontributions and increased investment earnings), representing strong real growth in a period oflow inflation.It is difficult to estimate the amount of superannuation contributions to the infrastructure assetclass and infrastructure funds in particular over this period. Estimates of infrastructureinvestment by superannuation funds were estimated at 2 per cent of total fund assets in 2002 at$8 billion, with projections that by 2012, $65 billion or about 5 per cent of projectedsuperannuation assets would be invested in infrastructure (Nielson, 2003). Nielson notesconjecture regarding other lower estimates of $5 to $6 billion investment for that period anddoubts surrounding accuracy given uncertainty surrounding fund reporting methods, investmentclassifications and fund structures. The industry fund sector provides the best overall informationon levels of investment in infrastructure. During 2003 the average proportion of an industryfund’s portfolio invested in infrastructure equity was about 4.3 per cent. 15    
  16. 16. Discussion and ConclusionIt is evident that there is a significant correlation between the interaction of corporate-decisionmaking and domestic macroeconomic variables in the infrastructure fund space in Australiawithin this period. The inception of the first infrastructure fund was a new product developmentin response to demand facilitated by changes in market structure and a facilitativemacroeconomic climate. Corporate decisions made in the ten ensuing years appear to be relatedto when bond yields, interest rates and inflation.Beyond the scope of preliminary analysis undertaken in this paper, stronger empirical evidence isrequired to determine the extent of correlations, including triangulation and regression analysis.Further studies may also elect to undertake more extensive financial analysis, to study feestructures and why infrastructure funds appear to underperform relative to their sponsors. Otherstudies may possibly choose to examine the valuation of infrastructure funds by their assets andfee structures using the proprietary-developed Morgan Stanley Dividend Discount Model (alsoadopted by UBS) which separates asset values (aligned with domestic 10-year Government bondyields and sovereign risk premiums in assets’ countries of origin) from management fees. Otherstudies may choose to use a Bass model to consider the invention/innovation/diffusion processpresent in this industry, market and period.   16    
  17. 17. Appendix A: Infrastructure funds – a business overviewFinancial SponsorsAt the company level, infrastructure funds are operated by two types of firms: financial sponsorsand industry players, the latter of which whose infrastructure funds generally house theircompany assets for transparent valuations, with funds being managed by a parent entity.Infrastructure funds may be listed or unlisted vehicles. Listed infrastructure funds can providethe upside of greater liquidity and performance benchmarking and the downside of a lower risk-adjusted return, given significantly higher volatility, and a higher correlation with publicequities. Unlisted infrastructure can offer a higher, risk-adjusted return due to lower volatilityand low correlation with equity and bond markets, with the downside of illiquidity andpotentially longer-term cash flow realization. Comparable to industry funds, the 72 financialsponsor-managed funds raised in the fifteen months to July 2007 have raised US$120 billion andhave significantly greater buying power than listed infrastructure funds operated by industryplayers estimated to have only $40 billion to invest in infrastructure (Orr, 2005).Fund platformsTypically, a financial sponsor operating an infrastructure fund will manage a portfolio ofinfrastructure funds. Sponsors managing an infrastructure fund platform draw on parent companyhuman and capital resources and relationships to source and acquire attractive infrastructureassets from willing vendors at or below implied fair values; to structure these transactionseffectively from financial, legal and tax perspectives; and the operational capabilities to managethese infrastructure assets so as to deliver value for investors. The business model is based on anasset manager (or an investment bank with asset management capabilities) raising public capitalthrough discrete listed or unlisted infrastructure fund vehicles to finance the acquisition of 17    
  18. 18. infrastructure assets by way of private equity-style investment with public finances. The sponsorthen uses its resources and capabilities (or those of one of its divisional business units) to managethe ongoing operation of its infrastructure funds in exchange for trailing management andperformance fees.Corporate EntrepreneurshipAs a study in corporate entrepreneurship, the business model’s innovation lies in securitisingassets in an illiquid sector which are inimitable, scarce and non-substitutable and selling units toconservative, growth-seeking institutional and retail investors seeking to make liquidinvestments in an illiquid asset class (separating ownership and control).The entrepreneur’s innovation in process is achieved by deploying the firm’s human and capitalresources and its capabilities in financial engineering and asset management as a competitiveadvantage in asset packaging. Sponsors earn Schumpterian (entrepreneurial) rents on theirstructural innovations in packaging infrastructure assets which generate Ricardian (scarcity)rents. Investors earn capital growth and income from their investment in funds. The businessmodel is based on intangibles including ideas, product creation, technologies, services andadvanced market understanding. Competitive advantage lies in complex intellectual propertyvested in people and management processes, which is both difficult to imitate and easy forsuccessful sponsors to replicate geographically into new markets.The model relies on securitising the principal’s operating assets, separating management fromownership and retaining control, raising external capital to fuel growth and maximisingtransactional participation opportunities. The model operates under the concept that a sponsordoes not need to own its operating assets (only the management rights to them) as they are animpediment on the parent company’s balance sheet to fast growth, being better dispersed across 18    
  19. 19. a large institutional and retail shareholder base who can earn cumulative growth on these assets’appreciation in value and the dividends payable from their growing cash flows. A sponsor needsonly to own the management interests to these assets for which in exchange for ongoingmanagement and outperformance fees it provides its company’s management expertise in theirfinance, operation, management and maintenance. The sponsor, using its proprietary resources,can maximize profit for itself through appreciations in asset ownership, transaction advisory feesand ongoing management/advisory fees from managed funds and for investors through theirparticipation as asset owners in managed funds, receiving dividends and capital gains.At a transactional level, sponsors typically earn upfront underwriting fees from launching theinfrastructure fund from their own balance sheet onto the equity markets; and advisory fees forutilising their financial advisory resources (providing mergers and acquisitions advice, dealstructuring and financial arrangements). In return for delivering value for investors under thismodel, sponsors earn base management fees, linked to equity under management (EUM) orassets under management (AUM) (generally uncapped, offering unlimited upside) andperformance fees when the fund outperforms its prescribed benchmark, which are assessed on aparticular date (again, uncapped).Transaction StructuresA typical transaction may occur by way of the following process. Firstly, the principal uses itsdeal-making capability to source appropriate infrastructure asset/s to acquire (typically withstable cash flows and generally with monopoly positions or favourable long-term contracts). Theprincipal then acts as its own investment banker, employing its corporate advisory and financialengineering skills to structure and execute the transaction. Financial completion is achieved bydrawing down on finances typically from the principal’s balance sheet (and sometimes that of its 19    
  20. 20. co-investors) and raising a large debt component. The principal then, acting as sponsor, transfersthe asset/s on to its most appropriate infrastructure fund by way of a related-party transaction,booking transactional advisory and underwriting fees. The principal integrates the asset/s into itsportfolio and manages the asset/s on behalf of the fund, receiving base management fees (annuityincome streams) and performance-based management fees thereafter. If an appropriate vehicledoes not exist, a separate transaction may take place whereby the principal lists a fund (oftenwith a sector-specific mandate) with a collection of seed assets from its parent balance sheet.Across the spectrum, the principal acts as a financial adviser, underwriter, broker, fund and assetmanager and principal. As the prominent example, Macquarie Bank leverages opportunitiesacross IBG for maximum value. For governance purposes, ISF separates its Infrastructure Fundsbusiness from Macquarie Advisory. The Infrastructure Funds business focuses on active assetmanagement, investment evaluation, capital management, legal and compliance, tax andaccounting, investor and media relations. Macquarie Advisory focuses on sourcing investmentsand deal execution.Vehicles and fund structures are similar in principal to private equity investment in that they arestructured to generally make diverse investments in the sectors within their asset class and tomobile capital quickly to take advantage of potential deals. The comparative distinctionsbetween private equity funds and infrastructure funds are that: (i) infrastructure sponsors possessmore diversified infrastructure asset portfolios, whereas private equity sponsors typically possessmode diversified sector portfolios overall; (ii) infrastructure funds (and their investors) havelong-term investment approaches and more conservative equity hurdle rates, whereas privateequity funds operate under a shorter-term acquire/restructure/exit approach; (iii) sponsor partyprofits in infrastructure funds lie in a fee-generating holding strategy based on asset 20    
  21. 21. appreciation, management and outperformance fees, whereas private equity firm profits lie areachieved by profits at terminal divestment; and (iv) infrastructure asset vendors are typicallyGovernment parties divesting assets which provide essential services to society and if such assetsare regulated, prefer to transfer assets to long-term orientated counterparties. 21    
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  23. 23. Orr, Ryan J. "The rise of infra funds." Project Finance International - Global Infrastructure Report 2007,Supplement, June, 2007, pp 2-12.Peng, H. P. and Newell, G., 2007, The Significance of Infrastructure in Investment Portfolios, PacificRim Real Estate Society Conference 21-24 January 2007, FremantleReserve Bank of Australia Bulletin, 1997, Privatisation in Australia,RREEF Research, 2005, Understanding Infrastructure. RREEF Real Estate and InfrastructureResearch: London.RREEF Research, 2006, Opportunities in Private Infrastructure Investment in the US. RREEF Real EstateResearch: San Francisco.RREEF Research, 2007, Performance Characteristics of Infrastructure Investments. RREEF Real EstateResearch: San Francisco.Senate Select Committee on Superannuation, Investment of Australia’s Superannuation Savings,December 1996, Chapter 3.UBS Investment Research Australia, 2006, UBS Infrastructure and Utilities Index Global Index ReportUBS Investment Research Australia, 2006, Q-Series: Infrastructure and UtilitiesUBS Investment Research Australia, 2007, Global Analyser: Global Infrastructure and Utilities Analyser   23