Finding the sweet spot: Middle-market funds tap deep pool of investment opportunities
Beth Mattson-Teig, Institutional Investing in Infrastructure, 7.1.23 – Megafunds have plenty of muscle when it comes to raising capital. But middle-market players have emerged as a leader when it comes to dealmaking.
The vast majority of transactions in the infrastructure arena are taking place in the middle and lower end of the market, and that opportunity set is attracting attention from both investors and large funds that are introducing their own middle-market strategies. According to Hamilton Lane, 96 percent of transactions completed in 2022 involved assets with enterprise values below $2.5 billion, and 78 percent of transactions featured assets with enterprise values under $500 million.
“We’re seeing a pipeline of opportunities in the middle market that is as good as we’ve seen in 20 years,” says Stephen Simpson, a partner at Instar Asset Management. “We believe there is a real need for infrastructure investment in the middle market to help small and medium-sized businesses delivering essential solutions and services to grow and drive long-term value in the communities they serve,” adds Simpson.
As a middle-market manager, Instar is set up to do between one and three platform deals each year where it can spend a lot of time with the management team to focus on driving value and pursuing growth opportunities. “We’re looking for businesses that are poised to benefit from macro trends such as demographic shifts, urbanization, technological change and some of the sustainability imperatives coming from government entities and businesses,” says Simpson.
In the mega-cap sector, there might be a dozen deals a year that are being chased by the top 10 largest global players. “What you see in the mid-markets is that there are hundreds of opportunities every year, which gives us the opportunity to pick and choose financially, and to work with the best entrepreneurs, owners, founders and developers in a more creative way,” says Willem Jansonius, partner and head of CIF at DIF Capital Partners. One advantage of that large pool of prospective deals is that it allows middle-market GPs to come in at a lower entry point than what one would see in the mega-cap areas of the market. Secondly, there’s much more value creation to be done and significantly more upside to be realized when working with management teams, partnering with them and bringing these companies to a scale, he adds. That pipeline of opportunities is just one of the reasons the middle market is attracting more attention from investors. Investors also like diversification, the ability to tap niche markets, value creation and, of course, total returns. “In today’s inflationary environment, we’re observing increasing demand for higher-returning, value-add strategies as a driver of capital allocation,” says Emil Henry, founder and CEO of Tiger Infrastructure Partners.
GPs target energy transition, digital strategies
Middle-market strategies are taking advantage of a number of key trends within the infrastructure market. “We do see a very significant decrease in the more plain-vanilla operational trophy infrastructure assets,” says Jansonius. For example, airports, ports, midstream and conventional energy companies used to be a very significant piece of the market a couple of years ago. In the current market, a majority of the transaction flow is related to energy transition and digitalization, and it is very much focused on the smaller and younger side of the infra business, he says. That shift is really driven by the net-zero initiatives coming from governments, municipalities and companies. There also is a focus on fiber build-out, especially in rural and small-town America, and there are similar trends in Europe. “Those two sectors were relatively niche markets five years ago, and today that’s probably 80 percent of the transaction volume in infrastructure,” says Jansonius. Tiger Infrastructure is focused on energy transition, digital and transportation because of powerful trends and tailwinds driving the need for newer infrastructure in those sectors. In the case of the energy transition market, for example, the industrialized world has coalesced around the Paris Accord, and most countries now have renewable targets, notes Henry. “Trillions of dollars of investment will be required to hit those targets. So, it’s a clear tailwind in front of which we’ve positioned ourselves for years,” he says.
In recent years, competition has driven prices higher for mature assets. Some digital assets now are trading in the market for 20 to 30 times EBITDA, which are historically high, notes Henry. That dynamic is favorable for firms that are creating new assets at the cost of construction, or expanding existing assets, and therefore are looking to sell into these high multiples, he adds. One example where that has paid off for Tiger Infrastructure is its investment in Zenobe, now a leading energy-storage company. Tiger provided the early capital to transform Zenobe’s small portfolio of U.K.-based assets into gigawatts of pipeline and operational transmission-connected battery-storage projects and global leadership in vehicle fleet electrification. Tiger Infrastructure believes it was the first infrastructure fund to invest in gridside battery storage.
Following key trends
Middle-market managers are pursuing a variety of strategies. For example, NOVA Infrastructure sees more investment opportunities ahead in water infrastructure in the United States. “One of the trends in the U.S. that a number of people have been focused on but is hard to capitalize on is the very poor state of our water infrastructure,” says Chris Beall, co-founder and managing partner of NOVA Infrastructure. The combination of mismatched regulatory structures and growing industrial businesses in places that are experiencing more drought has contributed to a very poor water system. “The upgrading of that system is becoming more and more important, and you’re seeing a number of strategies to capitalize on that. And we think that will be an important trend going forward,” he says.
NOVA also is focusing on “alpha” markets — those with better demographics, higher levels of population growth and higher levels of GDP growth — and the firm has assets in areas such as Florida; Toronto; and Charleston, S.C. For example, the firm owns a stake in Harbor Logistics in Charleston, which is one of the fastest-growing ports in the U.S. “We’re taking advantage of Charleston’s growth, and even within that market we’re in a higher growth segment of the port logistics space,” says Allison Kingsley, co-founder and partner at NOVA Infrastructure. NOVA also has invested in telMAX, a fiber business in Greater Toronto, which was recognized as the fastest-growing city in North America in 2020. “So, all of those are examples across sectors where we’re trying to locate in alpha markets,” says Kingsley.
Instar takes a broad origination approach that allows it to pivot to areas where it sees relative value. For example, the firm has made two investments in controlled environment agriculture over the past two years. “They’ve got a great critical infrastructure profile along with great tailwinds, great sustainability elements, excellent growth potential, and we were able to acquire them at better relative value than some of the other infrastructure sectors commanding a lot of attention,” says Simpson. Instar is leveraging the deep relationships its team has developed in the marketplace over the past 20-plus years to source interesting opportunities. “Our goal is to be aware of every opportunity in the marketplace, so that we’re in a position to be highly selective of which investments we pursue and can pivot to subsectors offering better relative value,” he says.
Navigating challenges and opportunities ahead
Despite more entrants into the middle-market space, competition is not as intense as one might expect. “We have seen, especially in North America, a lot of players move up to the mega-cap range. So the mid-markets in North America are less crowded than in other parts of the world. For us, that’s a massive opportunity,” says Jansonius. Many of the large players today actually started in the mid-market and moved out, and many of the LPs have followed them. At the same time, the mega-cap area of infra has become crowded. “So, I think many North American LPs especially recognize that there’s a real window to rebuild a presence in the mid-market, simply because today there’s just much more value, more deal flow and more opportunities,” says Jansonius.
DIF Capital also tends to focus on “whitespaces,” or areas where the degree of infrastructure competition is relatively low, such as firms that are providing fiber in the Canadian prairies. In January, DIF Capital Partners closed on an investment in RFNOW to fund the further growth of its telecommunications network. RFNOW currently provides enterprise fiber, residential fiber, fixed wireless internet and phone services over its 932-mile fiber optic network and tower portfolio in Manitoba and Saskatchewan. DIF Capital has been one of the few groups building out fiber to these smaller communities, which is great for the local economy, and at the same time brings a lot of value, adds Jansonius.
Yet, investors do need to navigate cautiously in the middle market. An obvious disadvantage from the investors’ perspective is the size. For LPs that need to put big checks out the door, it is tough to do that in the middle-market space. It’s difficult to make a $1 billion commitment into one middle-market fund. In addition, creating value and growing companies inherently require different skill sets, especially when it comes to ensuring the right teams are in place with clear strategies for success. “When your strategy entails building infrastructure businesses to scale, quite often your C-suite, your most important team of leaders, is not fully built out at the time of an initial investment,” says Henry. “Part of the art of transformative growth is to help portfolio companies identify and recruit key players, while providing hands-on expertise in helping implement their strategies.” Tiger Infrastructure’s specialized operating partners bring the expertise, skills and experience to help instill best practices not only in operations but also in areas such as ESG and risk management, he adds.
GPs also are navigating in a market where interest rates are higher and lending has tightened, which is creating both challenges and opportunities. Companies that use debt to grow their business will have to finance or refinance existing debt in a market where capital is more costly and less available. In particular, entrepreneurial companies that have used bank debt will have to look for alternative sources of capital. “We do think there will be more equity required or more founders looking for strategic partners to help grow the business as debt capital markets are more constrained,” adds Kingsley.