London - Power distribution systems may not sound like trophy assets, but for investors seeking higher returns in a low interest rate world, such European infrastructure is gold dust.
Established infrastructure assets - defined as “core”, from wind parks in France to gas pipelines in Norway - generally offer less risk than “greenfield” projects and higher returns than those available from schools or hospitals.
And while government stakes in companies such as Nordic utilities Vattenfall and Fortum could come on the market in 2014, these alone won't satisfy demand.
“Assets are not coming to market as freely as they have done in the past or as they had been expected to come in relation to government privatisation,” said Hamish de Run, Infrastructure Partner at Hermes GPE.
A lack of political appetite for state sales, a decline in the number of forced corporate sellers thanks to a buoyant debt market and a shortage of reinvestment opportunities for funds that already hold some of the assets are all playing a part.
Reasons vary from country to country, and while some of the debt-hit southern euro zone countries have been more active sellers, higher-quality assets in the more politically secure and economically stable countries of northern Europe are scarce.
In October, the Dutch finance ministry scrapped plans for an IPO of grid operator TenneT, while talk about a sale of part of the French state's stake in electric power utility EDF has gone quiet.
There is little political inclination in Germany to endanger a government coalition with an unpopular sale of 'Crown Jewel' assets, while the UK, which pioneered the sale of state infrastructure, has little left to sell.
British and German plans this spring to sell a stake in government-controlled uranium enrichment firm Urenco, estimated to be worth up to 10 billion euros ($14 billion), hit resistance from the Dutch government, which owns a third.
Sources say a sale or IPO may be revisited in early 2014.
“We see an overhang in demand for core infrastructure assets - operational, very well-regulated or long-term contracted assets, with inflation protection and very predictable cash flows,” said Markus Hottenrott, chief investment officer of Morgan Stanley Infrastructure, which manages $4 billion.
Pinning down the size of the infrastructure market as a whole is difficult, given the varying definitions.
Taken as assets with government involvement at some level, such as price setting or regulation, JPMorgan Asset Management said the UK alone, Europe's most mature market, has $1-$1.5 trillion of investible assets.
The slice of that figure considered “core” is much smaller, however.
An asset is generally defined as such when it has been running well for a number of years and the income is steady and reliable - qualities that make them more expensive and reduce the payout attraction to equity funds.
PENSION FUND POACH
The entry of investors such as pension funds, insurers and sovereign wealth funds to the market has challenged the dominance of traditional infrastructure funds, which are having to take on more risk to bag the returns they seek.
“They are being forced to take more operational risk, financial leverage, looking at opportunities in an earlier stage of that life cycle such as greenfield, etcetera, because the core assets are being bought by long-term, direct investors,” said de Run of Hermes GPE, which at the end of September was managing 2.6 billion pounds ($4.25 billion) in the sector on behalf of clients including pension funds.
In October, for example, two funds managed by Goldman Sachs and two Danish pension funds said that between them they would buy 26 percent in Danish state-owned oil and gas group DONG Energy, a European market leader in offshore wind, for 11 billion Danish crowns ($2 billion).
For funds looking to invest in core assets, the internal rate of return - a preferred measure of value by many infrastructure investors - has slid.
“Investors used to expect 10-12 percent returns on core assets, but in today's environment, when interest rates are so low and there is ever-increasing demand for these assets, getting that is almost impossible,” said Serkan Bahceci, Infrastructure Strategy at JPMorgan Asset Management, which manages $3.5 billion in its various infrastructure funds.
Serkan said he expected the Fortum and Vattenfall assets to return “single digits”, but still more than the returns on offer from safer government bonds, with benchmark German Bunds, for example, yielding 1.75 percent.
Falling returns has not stopped the number of equity funds in the market from growing, industry data tracker Preqin said in a November report, flagging a record 58 Europe-focused funds looking to spend a combined 24 billion euros.
“While there is a significant amount of capital being raised to invest in European infrastructure, the fundraising market is very competitive, with a record number of Europe-focused funds on the road,” the report said.
That pales into insignificance, however, when compared with the many billions more gearing up to be deployed by pension funds and insurers, which have a cheaper cost of capital and more flexibility in financing than equity funds.
While no firm Europe-wide data exists, de Run said European and US pension funds allocated around 2-3 percent of managed assets to infrastructure. While that is increasing, it is still some way behind the figure for pension funds in market leaders Canada and Australia, which can be as high as 10 percent.
Reduced supply and increased competition have meant that the bulk, 58 percent, of deals done by equity fund managers between 2011 and the year to date in 2013 were valued at less than 100 million euros, with just 10 percent above 500 million euros, Preqin said.
For Jason Clatworthy, a member of the infrastructure team at consultants Deloitte, which recently undertook a survey of infrastructure investors, the scarcity of deals built up a head of steam for pricing battles when sales do appear.
“Core deal values will remain strong as there is still, ultimately, a shortage of high quality assets with established yielding profiles in the market. Therefore when they do come, they get quite aggressively bid and prices remain high.” - Reuters