Mid-Market Infrastructure: Taking Advantage of the Upswing
One of the most significant breakthroughs in the relatively short history of private markets has been the emergence of infrastructure as an investable asset class on its own. In roughly two decades, the capital raised to fund infrastructure private markets has increased considerably.
The features of providing protection against inflation, generating a consistent cash income, exhibiting defensive growth, and having a low correlation with other asset classes offer substantial advantages to weather all economic conditions, particularly during periods of elevated inflation.
Historically, infrastructure has been linked to large assets that draw substantial amounts of funding from major funds. Nevertheless, there are opportunities for investing that extend beyond the “mega” assets. Transactions in the middle market might provide a competitive edge over larger competitors.
“The lower and middle market represents a large opportunity set, accounting for 95% of transactions in 2023,” noted Taylor McManus, principal, real assets investments, at Hamilton Lane. The firm’s infrastructure investment platform is a staunch advocate for the lower and middle market due to the numerous investing advantages it offers, including appealing entry valuations, more potential for value creation, and historically stronger realized returns.
The definition of infrastructure middle-market is subject to interpretation. It is commonly understood as investments with an enterprise value of less than $1 billion or equity commitments of less than $500 million. However, different investors may have different classifications, and the definition may change over time as average transaction sizes increase due to larger pools of investible capital, inflation, and multiple expansion.
Investors are now contemplating infrastructure funds with a value of up to $8 billion as being suitable for the middle market, according to StepStone Group LP, a global private markets firm. Within private equity, the firm has traditionally categorized the upper limit of the middle market as funds with a size of up to $3 billion. Consequently, the private equity team now categorizes funds with a size of up to $7 billion as middle market.
“Whereas large-cap managers tend to deploy billions into marquee assets and take-private transactions, mid-market GPs tend to be more specialized in standing up new platforms or “buying and building,” adding potential exit multiple expansion for a scale premium as modest-size platforms grow, noted Stepstone. “On exit, a smaller fund can sell to a larger fund or a strategic buyer, whereas large asset positions in larger funds may have more limited liquidity options.”
“At face value, the ‘one-stop-shop’ approach offered by large asset managers can be advantageous for investors seeking to consolidate manager relationships, benefit from additional fee-breaks, and underwrite existing track records,” wrote Hodes Weill & Associates, a global capital advisory firm focused on real estate, infrastructure and other real assets, in recent market commentary. “However, many investors remain skeptical about whether they will capture the alpha they seek from middle-market opportunities through these large-cap relationships.”
Although the advantages of investing in the middle market are frequently discussed, there is less discourse on the methods via which institutional investors can gain access to middle-market strategies, observed Hodes Weill & Associates. “With continued growth and maturity of the infrastructure asset class, additional ways to capture middle-market infrastructure opportunities should emerge from team spinouts, secondaries funds, and alternative asset managers (e.g., real estate and private equity) entering the space.”
“The larger concentration of capital being allocated to fewer large-cap funds has led to higher competition for deals with enterprise values over $2.5 billion. As a result, we believe that lower and middle-market opportunities continue to be an attractive segment due to less competition from an increasing number of large and mega-cap funds which all compete for the same deals,” added Hamilton Lane’s McManus. The alternative investment management and advisory firm noted that it allocates 69% of its infrastructure portfolios to lower and middle-market funds.
While investing in the middle market infrastructure offers numerous advantages, it also presents certain challenges, noted Stepstone. The range of opportunities is far bigger, with a greater number of general partners to consider compared to the large-cap world.
“Active participation in the less trafficked middle-market, however, brings the potential for outsize returns from top-tier managers, along with a portfolio ‘edge’ created by sector and strategy diversification and potential for greater alignment and access to smaller GPs.”