The Growing Complexity of the GP/LP Relationship

By Peter Allison

One of the more intriguing points to emerge from the InfraAmericas and InfraNews organized Infrastructure Investors Forums (IIFs) in New York and London last month was that GP managed infrastructure funds are increasingly looking for an angle to differentiate their offering from that of their competitors and, most important, from other forms of capital.

A number of those GP managed funds said they were now sourcing deals with a greater degree of complexity in order to create value for their LPs.

That might involve investing in points of the energy supply chain that involve a deeper understanding than a simple pipeline. It might involve a detailed analysis of US shale gas reserves in order to assess their impact on existing midstream capacity before making an investment decision. Or it might involve investing in a portfolio of renewable energy assets.

By focusing on those more complex assets, and on making sure they are well run, GPs think their funds can deliver higher returns to investors.

Sadek Wahba, a managing director, chief investment officer and global head of Morgan Stanley's infrastructure fund said operational improvements at the asset level could easily generate an extra couple of hundred basis points over the fund's base case.

Joseph Adams, a managing director within the private equity business at Fortress Investment Group said his firm could increase the EBITDA of Florida East Coast Railway, a Fortress portfolio company, by four times over the next four years through operational improvements. Other GP managed funds can no doubt point to similar examples.

Keeping the LPs Happy
There's a reason why those GPs are placing an emphasis on their operational skills and not just their skills as financial engineers.

In short, they need to demonstrate to an increasingly sophisticated and a sometimes skeptical end investor base that they know what they're doing.

That sophisticated end investor base wants to see more sophisticated investment decisions. It wants to avoid the mistakes that some GP managed infrastructure funds made by over-leveraging otherwise stable and predictable infrastructure assets in the credit bubble of 2006. Mike Powell, head of alternative assets at the UK's Universities Superannuation Scheme (USS), an end investor in infrastructure, made the very relevant point that those mistakes had been made with LP's capital.

The Cost of Capital
The growing scrutiny the GPs are being put under by their LPs is only a part of the story, however.

The other part is the threat that some of those LPs present to their business should they decide to invest directly in infrastructure assets. LPs such as pension funds, endowments and sovereign wealth funds (SWFs) have a much lower cost of capital than GPs. Typically that cost of capital, on a levered basis, might be 9% or 10%. GP managed infrastructure funds can't compete with that.

It is one of the reasons why pension funds have been able to outbid infrastructure funds on recent transactions like the UK's High Speed One rail concession.

While this is an obvious concern, the saving grace for GPs is that there are only a handful of LPs that can actively pursue infrastructure deals as direct investors. Those direct investors probably number about 20. They're mostly Canadian, but there are Australian, European, Asian and Middle Eastern ones too. The other saving grace for GPs is that most LPs are not set up to do direct investing, which means very few are likely to follow the example of those Canadian and Australian pension funds.

But it is not a reason for GPs to get complacent.

Their strength should be in sourcing deals where their project managers, engineers and asset managers can add value. It is not in competing in a public auction they can never hope to win by bidding a lower cost of capital than a direct investor.

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