Speaker 12024 looks to have been another underwhelming fundraising year for the infrastructure asset class overall, according to Infrastructure Investor's third quarter fundraising report. LPs seem content to sit on their capital for now, until they get clarity on how significant macro challenges and political changes play out as we enter a new year. So, we continue to wait and see where they direct their spending once confidence returns. When that happens, a part of the market that may well be on the radar of more LPs is the middle market, where opportunity to scale up and achieve outsized returns could draw attention away from the larger cap space. And so, it's the mid-market that we turn our focus to in this episode, reported by Helen Luhr and sponsored by Ridgewood Infrastructure and I Squared Capital. Joining us is Ross Posner, managing partner of Ridgewood Infrastructure, a US-focused lower middle market specialist firm investing in the water, transport, and energy sectors. And also joining us is Gautam Bhandari, managing partner of Ridgewood Infrastructure and also joining us is Gautam Bhandari, managing partner of Ridgewood Infrastructure and also joining us is Gautam Bhandari, co-founder and managing partner of I Squared Capital, a global mid-market player with $40 billion of assets under management. Welcome to the Infrastructure Investor Podcast. For many, defining the mid-market has become more complicated over the years, as some managers operating in this space raise ever larger funds that are closer to large cap. So, to kick off, our guests gave their take on this and their thoughts on how this broad part of the infrastructure sector has evolved.
Speaker 2So, look, I think, luckily, this industry has now started thinking along the terms of capitalization.
Speaker 1That's I Squared's Gautam Bhandari.
Speaker 2I would say 10 years ago, people didn't think about it in those terms. They thought along certain risk axes, right? So, core, core plus, value add, super core, words like that, right, which are all sort of borrowed from real estate, but effectively defined risk. I think, in the last three, four years, people have, have started thinking very helpfully along another axis, which is size. It's the most logical thing to think around. And within infrastructure, you know, there are the small cap, there's the mid cap, and there's large. And if you look at, you know, I don't know, research reports from the consultants, and there's a helpful one from Goldman Sachs, generally, the industry has settled into a definition of sort of deals below 300 as being on the smaller end of the spectrum, and then 300 to one and a half billion. I think in the Goldman's study, it's two billion. The Hamilton Lane has a study of two and a half. So, so some number, let's say between 300 and one and a half as being mid cap, and then above one and a half as being large cap. You have to also recognize that this is a very capital intensive asset class, right? So, what is normal in private equity would be considered, you know, somewhat small here, you know, equipment and the capex that is required in this asset class is large. I often joke that for a good LNG facility, or maybe a power plant, 50 million only buys your feed study. So, you have to recognize that. And the second thing I would say, and I think, frankly, I didn't completely comprehend it till I did my own math, is that, you know, over time, inflation, especially construction inflation, is very real. So, what was, you know, a two, $300 million project 10 years ago is no longer $200 million project today. And I think people, you know, sometimes don't recognize it because our timeframes are set. But in reality, over the 10 odd year period, construction inflation has ranged between five and a half to 6%. So, it's a very significant number. And these sizes do drift.
Speaker 1Like all private markets, the infrastructure asset class has experienced its share of challenges in the face of a turbulent macroeconomic and geopolitical climate. So, our guests gave their assessments of how well the mid market segments has fared in terms of both fundraising and investment opportunities. Here's Ridgewood's Ross Posner.
Speaker 3Ross Posner: On the fundraising side, what you've seen over the last number of years is a cycle. So, we're not surprised by it as it relates to LPs, as they call it, the denominator effect, and how it's impacted them, as well as liquidity, you know, kind of a slowdown in the M&A market slows down return of capital to limited partners. And we've seen that in other cycles. I think the key is, for all of us investing, that you have an enduring investment strategy that carries you through all of those cycles. On the investing side, he says it's been a time of opportunity for his firm. Ross Posner: From an investing standpoint, we've seen great opportunity. You know, as you think about rates increasing, inflation, supply chain, you know, other macro factors where we focus at the smaller end of the market, we are investing in good businesses, and then we're growing them. And so, our partners or the counterparty with whom we're working can utilize greater capabilities and expertise in a more dynamic macro environment, like the one we've had over the last three or four years. So, for us, we've actually seen ample investment opportunity. We're obviously selective, and we utilize an enduring investment strategy so we can invest through the cycles. And then the limited partners recognize that, and as they have greater liquidity and their ratios of asset allocation come into greater balance for themselves, you know, then it creates the opportunity for them to deploy more capital into funds like ours or like Gautam's.
Speaker 1Bondari is similarly upbeat in his assessment. He sees a mid-market that's proven resilient through COVID, an energy crisis, and an inflationary period. In fact, he says, it's been a time of reinvention. And with that comes new opportunities.
Speaker 2I would say, actually, it's a fantastic time to invest, right? I mean, if you think about inflation for the past, I don't know, 15 plus years, it's been very benign, right? So, if you asked, you know, entering finance analyst, you know, to model, he would just generally plug in inflation at 2% or 1% and go on with it. So, we have lived in an era, frankly, of very low interest rates and low inflation. And so, during those times, it was always hard to convince an LP to think about inflation linked assets, which is what real assets are, right? So, real assets are inflation linked. In order to get yourself linked to inflation, you do give up some upside. But I think the past decade was one where, you know, frankly, people thought rates are forever low. And so, in some sense, when you look at times today, which is, you know, just step back and think about it, we live in a time where rates are higher, inflation is real. And in fact, it's not sort of fully tamed. It is down, but it's not fully down to the level that Fed and all other regulators would like to see. And then we also live in, frankly, a very de-globalized world, a world and a society that has been polarized. So, I think in such time, people are reinventing the supply chains. There's a massive rush in AI and everything else to make your societies green, to build the latest, greatest infrastructure, because it is really a hunt about jobs. So, infrastructure is intricately linked to that. And so, I think when it comes to investment timing, I think there couldn't be a better time. And finally, people have recognized that infrastructure assets do produce and have actually outperformed many other assets in this time.
Speaker 1While we're on the theme of outperformance, various commentators throughout Infrastructure Investors 2024 coverage have lauded the mid-market for achieving just that in comparison to the large cap segment. And Bandari agrees.
Speaker 2Look, I mean, there are various consulting reports that basically point out to the same fact that some very large assets or the large end of the capitalization has not gotten the same alpha as mid-market assets have. And so, I think that's a fact. I think when you think about the causes for it, I think there are several. One of the causes, of course, is as you think about a middle market company, often these are family-owned businesses or smaller businesses that run very lean. And once they come into professional ownership, you're able to pull a lot more levers than you would from a very large company. There is, of course, direct governance, right? So, generally, mid-cap deals are 100% controlled or majority control. Sometimes in that data set for a very large cap, there are minority positions because these are massive companies and you can only have that much influence at board level. We, at iSquared, focus on majority control or 100% control transactions. And remember, we build companies often from scratch and up. So, the second element, of course, is you're coming in at cost, right? So, when you're building or you're doing CapEx, and if you do a disciplined job, you're coming in at cost. You can't come lower. So, you have that margin of safety, right? Effectively, it's about where you're coming in from in a very fragmented industry or very fragmented sector. You're buying family owned businesses or sort of businesses that are yet to be professionalized and yet to have the advantages of operating leverage and financial leverage. And then finally, there is a fair amount of growth in this. And when we build these platforms from scratch or from smaller companies and add on, sometimes it's M&A, so very small M&A at very reasonable multiples. Other times it's CapEx and those are at cost. If you combine all those three, four things together, you can end up with significant alpha. And I think that's what mid-market is known for.
Speaker 1Posner shares a similar narrative for
Speaker 3the lower mid-market in the United States. At the smaller end of the market too, I think a couple of additional points. The fragmentation. So in the US, as an example, 40% of the market requires less than $150 million of equity need, 40% of the transaction volume, yet less than 10% of the capital raised is focused on that part of the market. So there's a structural inefficiency there, which is attractive as it relates to origination, bilateral sourcing. And then I think in the middle, once one owns it, whether it be I-squared, whether it be Ridgewood Infrastructure, we're doing many of the same things as it relates to growth, as it relates to average costing down via accretive acquisitions, whether it be deploying capital capex at cost rather than some enterprise value. But then also at exit, we like to call it having multiple ways to win. So everything we're doing, we're thinking about exit at entry, and we're building our businesses eventually to be owned by that long horizon owner, whether it be a strategic or financial. And years ago, five years ago, we used to, and still do, talk about surety of closure. Having that competition at exit helps to drive surety of closure. And I think that's a great way to do that.
Speaker 1Value creation and delivering growth are, of course, key missions for both Ridgewood and I-squared. So what's the best route to achieve those goals?
Speaker 2Here's Bhandari. I think for us to deliver the maximum amount of value creation, you need to focus on segments that have a lot to do with new asset creation, right? And new asset creation fragmented with developers. So we are a big believer in that asset class. That's a global phenomenon, by the way. It's a global phenomenon. I think that's a great way to do that.
Speaker 3be a lot of growth as we can see it, and then some unforeseen things as well, which probably require thoughtful execution and provide for more opportunity as an investor.
Speaker 1Bandari believes all the signs are flashing green for new infrastructure development. And critically, the urgency is also there at the political level.
Speaker 2So I did spend some time actually researching agendas of the various governments, whether it be Mexico, Brazil, or UK, or Indonesia, or India. And infrastructure featured prominently in every election plank. Infrastructure, jobs. Infrastructure, jobs, right? And so I think that is quite unique. It's to a point where even the politicians are very sophisticated and educated about having private involvement in infrastructure, which used to be technically 10 years ago, the government will build and shall provide. The governments with record deficits are actually now seeking that private involvement. And you see that private capital going up over time. I think I point out even in Russia, which I thought would be interesting. So I Googled Mr. Putin's election plan and infrastructure was number two. So here you go. Regardless of whether you're assured victory or not, you still actually want good infrastructure for your citizens. And I think that's phenomenal. How we go about achieving it will be very interesting. I do happen to believe that private capital is super important just to get projects delivered in time. Also, one big part of infrastructure is delivery here and now, right? So I think a couple of weeks ago, Sam Altman had gone to the White House with a proposal on AI. And guess what the title of his presentation was? It was infrastructure is not the only thing that is important. It's also the destiny. That's very bold, right? I mean, I think many of us would not, would have shied away from a title like that, but it's coming from a technologist. And he's recognized that in order for advancements, specifically in AI, it cannot happen without, you know, five plus gigawatts of power. And I think he wants seven of these clusters done. So you can't do it with your existing infrastructure, with the aged infrastructure, with the government trying to provide this over a decade. So effectively, it is what will distinguish sort of the next race of job creation and economic development. And let's face it, a lot of the infrastructure in the U.S. is very old. The U.S. as a country has spent only about one to one and a half percent of its GDP on infra. China has spent nine, right? And there are many other nations globally, including Europe and Asia and Latin America, that are woefully inadequate. So I think it's important to think about that. I happen to believe that's an infrastructure supercycle. I think eventually when you produce good returns and alpha, capital does flow. So it will take time, maybe a lot longer than Ross and I would like, but I think it will happen. And I do believe we are on the cusp of
Speaker 1infrastructure supercycle. So a nice combination of big trends like artificial intelligence and the energy transition are creating an unprecedented need for new infrastructure assets to meet the needs of the world. And I think it's important to think about the need for new infrastructure assets to meet the needs of the world. If you want to hear more episodes, you can check us out wherever you listen to podcasts or at infrastructureinvestor.com. Thanks for listening.
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