Infrastructure M&A presents its own set of unique challenges and opportunities that must be skillfully navigated to create successful outcomes. In this article, Kirkland partner Michael Brueck will look at this area and share trends that he is spotting.
While some pockets of the M&A market have shown inconsistency in the wake of COVID, interest in the infrastructure sector remains strong. The factors that incubate a healthy dealmaking environment in this asset class remain favorable, and continued interest in the sector should be expected. But infrastructure M&A presents its own set of unique dynamics that must be skillfully navigated to create successful outcomes.
Investor Demand Remains Strong
There continues to be significant “dry powder” in the infrastructure space. Funds continue to raise capital in both the United States and other geographies, with more than 100 funds having raised more than $80 billion globally targeting the asset class in just the last two years. This robust fundraising environment owes some of its success to the types of investors who allocate to infrastructure. For example, pension funds find the stable, long-term returns backed by hard assets to be attractive for their investment horizons. This stability allows infrastructure funds to target lower returns than many private equity funds and to have longer holding periods, positioning infrastructure funds well to offer compelling value to sellers of infrastructure assets.
But Where to Deploy Capital?
Despite the strong demand for infrastructure assets, there is a significant shortage of traditional infrastructure in United States for investors to acquire. While the U.S. is in the midst of a widely acknowledged funding gap for infrastructure (with U.S. public infrastructure receiving a D+ grade in the American Society of Civil Engineers’ most recent “Report Card for America’s Infrastructure,” the U.S. has not broadly adopted a public-private partnership (P3) model that could provide needed funds for public infrastructure projects.
Instead, the P3 model—in which a private investor typically provides its own capital and expertise to design and develop a project in exchange for the right to operate it for an agreed income stream—remains more prevalent in other geographies such as Europe. However, where the traditional P3 model has been adopted in the U.S. and subsequent “brownfield” sales of existing privatized infrastructure assets have occurred, there has been tremendous interest from buyers and high valuations, with reports of some assets selling at Ebitda multiples of more than 30x.
The combination of strong investor demand for traditional infrastructure and a lack of supply in the United States means that investors must often look outside the U.S. for more traditional P3 opportunities, or must expand their definition of the types of opportunities that will meet their investment criteria. But as luck would have it, market participants define infrastructure very broadly, and while there is no one single definition, a broad range of asset classes that are expected to provide stable, long term returns can fit the bill.
What’s more, infrastructure fund documents often provide wide flexibility in what can be acquired, and for how long, with “open ended” funds being more common in the space than in other corners of the private equity world. As a result, in addition to seeking out roads, rail, bridges, tunnels and ports, infrastructure investors have actively pursued digital assets such as data centers, towers and fiber, as well as student housing, parking garages and “social” infrastructure such as for-profit education, among other assets classes.
Funds with “supercore” strategies have even greater flexibility to pursue adjacent industries. And while the full impact of the pandemic remains to be seen, the overarching trend toward transportation and logistics, as well as digital infrastructure, being a central part of the economy is not likely to go away, but could further increase interest in these market segments.
As infrastructure funds look to deploy outside of mainstream “infra” and veer into the domain of the more traditional private equity world, deals will continue to reflect traditional M&A terms and processes more than the project finance type constructs that some infrastructure buyers might be used to. These include competitive auctions with no long-term exclusivity, and M&A terms and tactics that resemble a public company acquisition more than a privatization, project financing or proprietary acquisition. Infra buyers who plan to participate in this ecosystem will need to gear up for the traditional M&A experience.
Current Deal Trends
So, with all this said, what are some current trends emerging in the infrastructure M&A space
1. Continuing the push toward public company style deal terms
In recent years, while the M&A markets were robust, sales of private companies and businesses have gravitated toward “public company” style deal terms and practices. These terms include limited closing conditionality (generally limited to the absence of a “material adverse effect” at closing, material compliance by the seller with its covenants and obtaining necessary regulatory approvals), while other conditions often desired by buyers, such as receipt of third party contractual consents or other guarantees of performance between signing and closing, generally have not been accepted by sellers.
In addition, post-closing indemnification—which has historically been a staple of private company deals—has frequently been cast aside in recent private M&A transactions in favor of a deal structure that does not provide any indemnity by the seller following the closing. The rise in representations and warranty insurance has facilitated this trend, with R&W insurance providing a ready-made solution for buyers to replicate their own indemnity package with an insurer, and the cost of such insurance becoming a negotiated point between buyer and seller to be factored into the overall deal price.
While in some other corners of the M&A universe, the balance of leverage between buyers and sellers remains to be seen in light of the Covid pandemic, given the imbalance of supply and demand for high quality assets in the infrastructure space, it would not be surprising to see these seller favorable trends continue. This is especially true for sales of coveted businesses where a competitive dynamic is at work (e.g., through a broadly marketed sale process) and where buyers have sufficient visibility into the future of the business to have full conviction for the opportunity. But of course, in M&A everything is negotiable, and terms must be viewed in the context of price, ability to execute and other factors that may be important to sellers.
2. Sales of infrastructure assets by strategics
For years, the M&A market has seen the substantial impact of shareholder activism in generating M&A opportunities. Activists have routinely advocated for both the sale of entire companies as well as businesses or assets that they consider to be non-core. In response (and in anticipation), well-advised companies have sought to “be their own activist” and take proactive measures to ensure an optimal asset and capital allocation mix so that they are well positioned should an activist arrive at their doorstep.
This trend has instilled a best owner mindset among some strategics who have historically maintained a vertically integrated supply chain, and there are a number of examples in the market of these companies selling rail, terminal and other assets to well-qualified long-term strategic partners who can provide both an upfront payment for these assets as well as long-term stability in operating them for the benefit of the seller.
While activism during the 2020 proxy season has been slightly subdued—likely given the impact of the pandemic on the ability of activists to come to the table with a well-articulated thesis to drive improvement in an uncertain environment—expect the trend toward companies rationalizing corporate assets to continue and even accelerate as financial strains may cause strategics to explore the divestiture of additional non-core assets.
Private equity firms may want to have companies on “speed dial” that are sitting on non-core assets that could find their way into the hands of a new owner. However, the ability to successfully execute these deals requires the buyer to have the operational capabilities to effectively operate those assets. Therefore, unless the investor has existing experience in the space and an operational platform, it may need to partner with an operator (which could be a strategic), with such a partnership presenting unique and interesting challenges and opportunities
To that end, successful infrastructure investors may wish to cultivate a network of operators with whom they can partner on deals, or even establish an investment platform through an operator that it can partner with on future opportunities.
3. Increasing buyers’ skin in the game
The disputed deals of the Covid era have highlighted distinctions in the remedies available for sellers based on whether the acquiror is a strategic or financial buyer. While strategic buyers are generally subject to a full specific performance remedy, financial buyers are typically subject to a reverse termination fee structure where, if the buyer’s debt financing fails to be funded at closing, the seller can receive the termination fee but cannot force the buyer to close the deal with equity.
And while best practice is for buyers to obtain binding debt commitment letters at signing with an expiration date that matches the “outside date” in the purchase agreement, should a buyer seek to terminate a signed deal due to the alleged failure of a closing condition to be satisfied, resolution of the resulting litigation could cause the debt commitment letters to “time out,” even if the outside date in the purchase agreement is extended by a court. If that occurs, the seller’s remedy will be limited to the amount of the termination fee.
To address this issue, expect more sellers to push financial buyers to commit to an “all equity” deal or to seek higher reverse termination fees from buyers. Given concentration limits that often exist in fund documents preventing a single investment to constitute more than a specified percentage of the fund’s capital, an all equity financing structure won’t be available for all deals, but it could be achievable for deals of the right size (especially by larger funds). But for sellers who seek to pursue this route, casting aside the traditional private equity remedy structure may be easier said than done.