Harvesting the middle: The alpha in mid-market infrastructure
19 / 04 / 23 - 0 minute read
Infrastructure has traditionally been associated with large-scale assets essential for any well-functioning society including airports, roads, ports, and utilities. These crown jewel assets attract significant sums of capital from large infrastructure funds, however, there exists opportunities for investment beyond the mega assets. Deals within the mid-market can offer a comparative advantage over their larger peers.
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The mid-market
The definition of the infrastructure mid-market is a subjective one, with classifications varying between investors, and ever-evolving as average transaction sizes increase due to larger pools of investible capital, inflation and multiple expansion.
PATRIZIA considers the mid-market of infrastructure as deals of less than €1 billion in enterprise value at entry, or funds of less than €3 billion in equity.
“PATRIZIA has been investing in the mid-market for over two decades,” says Justin Webb, PATRIZIA Managing Director of Investment Solutions. “Despite its changing landscape, we see the mid-market as a space where we have expertise, and one where we can continue to deliver attractive returns for our investors.”
A strong performer
Performance data on infrastructure funds shows mid-market core and core-plus funds have outperformed their large-cap peers over a protracted timeframe. The median internal rate of return for mid-market funds since 1996 was 250 basis points higher for core funds, and 150 basis points higher for core-plus funds, according to PATRIZIA’s recent research report, The Path To Promotion For Mid-Market Infrastructure. When considering a median net multiple, mid-market infrastructure also outperforms its large-cap peers in value-add strategies.
Justin Webb, PATRIZIA Managing Director of Investment Solutions
Catalysts for alpha
There are four main drivers of the observed outperformance: relative market efficiency, active ownership, opportunity sets, and entry multiples, with PATRIZIA expecting these drivers to continue to fuel mid-market alpha.
Relative market efficiency
Through 2022, the mid-market made up over 80% of the number of executed deals, paving the way for mid-market managers to discover attractive investment opportunities.
Furthermore, a greater proportion of mid-market deals are sourced from independent companies (companies without previous private ownership or investors) compared to within the large-cap market. This may offer a competitive edge to the mid-market given that fewer deals in the mid-market space are being negotiated or sourced from sophisticated financial companies or investors.
PATRIZIA’s regional focus further enhances its ability to originate deals in the mid-market space, where local relationships drive deal flows.
Active ownership
Unlike large-cap assets, which have often been thoroughly combed for improvements, the mid-market typically offers more opportunity for value creation through active management, which can drive comparatively higher returns. Active management refinements can range from appointing management to negotiating key contracts.
An example of value creation through active ownership is PATRIZIA’s investment in Kvitebjørn Varme AS (KVAS). In 2018, PATRIZIA acquired KVAS – a district heating operator in Tromsø, Norway. KVAS produced 90 gigawatt hours (GWh) of thermal energy per year, largely from low-carbon generational technologies, such as a waste-to-energy plant.
Following the acquisition, PATRIZIA increased the asset’s profitability by retrofitting a boiler to transition the fuel source from electricity and oil to waste wood. A year after acquisition, the asset recorded a material uplift in valuation driven by accelerated customer connections, an increase in the district heating production cap, and an increase in the maximum load factor.
On the back of this success, PATRIZIA extended the capacity of the existing incinerators and added a new incinerator in order to increase capacity by 67% to 256GWh from a previous level of 153GWh. In 2022, PATRIZIA successfully merged KVAS with SAREN Energy AS, another district heating operator in Tromsø. The valuation of KVAS almost doubled in 2022, as a result of the merger and the expansion project.
Kvitebjørn Varme AS (KVAS)
Opportunity sets
Allocating to mid-market funds can unlock a diverse set of investment sectors. Mid-market and large-cap infrastructure investors cannot practically access the same opportunity set, which is likely to be contributing to mid-market alpha.
Over the last 12 months, most deals within the infrastructure mid-market were in the renewable energy space, particularly solar and wind, whereas large-cap infrastructure focused largely on the telecommunications, gas and oil industries.
PATRIZIA has identified four key macro trends for infrastructure in the long term: decarbonisation and the energy transition, digitisation, demographic change and urbanisation, and climate change. The alignment of these trends with the opportunity set available to mid-market investors paints a favourable outlook for mid-market strategies.
Lower entry multiples
Mid-market transactions are cheaper, with lower entry multiples than their large-cap peers. As part of its strategy, PATRIZIA works to transition assets from mid-market to large-cap assets.
“If a manager can acquire a mid-market asset and grow it into a large-cap asset through strategic growth bolt-on acquisitions and active management, all else equal at the point of sale, it is likely to experience a valuation uplift,” says Justin.
PATRIZIA is playing out this thesis through a growth bolt-on strategy with its investment in Kinland AS. In October 2019, PATRIZIA acquired Kinland – a Nordic social infrastructure business. The acquisition started as a competitive auction process, however, PATRIZIA’s relationship with the vendors allowed it to secure a preferred position to complete due diligence for the asset under an exclusivity and cost-coverage arrangement.
After the purchase, a PATRIZIA employee was appointed as an interim CEO until a new management team was in place. In further active management decisions to move the mid-market company towards large-cap, both in terms of asset size and operational characteristics, PATRIZIA grew the asset from 172 properties to more than 317 units, creating substantial value.
Kinland AS
Piecing together the portfolio puzzle
Mid-market infrastructure is the quiet achiever of the infrastructure family – funds in the mid-market have outperformed their large-cap peers across most strategy types while commanding far less attention.
Nevertheless, given broad variance in performance results, it is vital to select the right manager, particularly one with a proven track record in the mid-market space. Attention should also be paid to the strategy the manager is pursuing, with core or core-plus strategies having the ability to moderate the downside risk of the investment.
As for whether investors should pursue large-cap or mid-market infrastructure strategies, Justin states: “Mid-market funds deserve a seat at the table. The inclusion of a proven mid-market manager alongside a large-cap manager can provide greater diversification benefits and improved risk-adjusted returns.”
Mid-market infrastructure is the quiet achiever of the infrastructure family – funds in the mid-market have outperformed their large-cap peers across most strategy types while commanding far less attention.
