Talk Your Book: Investing in Infrastructure

0:00Today's Animal Spirits Talk Your Book is brought to you by Stepstone Private Wealth. Go to stepstonegroup.com to learn more about how you can invest in hard assets in their infrastructure fund. That's stepstonegroup.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:44Welcome to Animal Spirits with Michael and Ben. On today's show, we spoke about something incredibly important, under-discussed, under-represented, at least on this show. We've never spoke, I don't think, about infrastructure. things like toll roads, bridges. How do they get funded? Who invests in them? Airports. It's a huge asset class in Australia. Okay. But not so much in the US. We actually had an Australian fund manager back in my endowment days that invested in infrastructure asset and they owned the Chicago toll road. And you could see it become because it used to be you drive there and they had this basket and you'd throw the change in there back but when you could just pay with change and now it's dollar bills and credit cards and stuff and when they came in as a buyer of the toll road you could see that the technology get better right the swiping of the card or put the touching the card to it and that sort of thing you know what railroad i used to own pennsylvania love that game you know what i mean hot take monopoly's overrated nope how many how many games have you ever finished in your life dozens i feel like it's a game you play and literally never finish.

1:57Nope. Because someone always gets too much money and then everyone throws up and I'm done. Infrastructure was the play. Overrated. Actually, real talk, nobody won Monopoly getting the railroads or the utilities. But be that as it may, you and I actually did, we had an infrastructure experience when you were in New York last week, going through the turnstiles, boom, tap the phone. That is kind of cool. That makes it so much easier having to go to the machine and enter all this information in. And it is the kind of thing where you can't say anything is specifically recession-proof, but people are going to continue to use stuff and cash flows are coming in.

2:29So in that way, it's unlike a lot of different asset classes. Well, you would have said Subway's are recession-proof until pandemic. True. So anyway, interesting conversation about an asset class that is not very familiar to a lot of investors. It has equity-like characteristics, fixed income-like characteristics. So here's our talk with Bob Long from StepStone Private Wealth. We are rejoined on the show today by Bob Long. Bob is the partner and CEO at StepStone Private Wealth. Bob, welcome back to the show. Thank you. We've talked to you in the past about investing in different private assets and private funds.

3:06Today, we're talking about a new one that we've actually never had on Talk Your Book before, infrastructure funds. I've had a little experience in this space, and I guess it can mean different things to different people depend on what you're investing in. How do you think about the infrastructure space? Yeah, that's a really good question. And it is an asset class on the private side in particular that's emerged since the financial crisis. So, you know, around 2010, about 170 billion a year was raised, and now we're over a trillion a year raised for private infrastructure. And it spans the gamut, but there are certain essential characteristics.

3:37First of all, primarily infrastructure investments are essential services that are resilient to an economic cycle, at least designed to be, produce relatively predictable cash flows, typically from contracted, often regulated revenue streams. That revenue often has a built-in inflation protection. And then from a legal or practical perspective, there's really limited competition. There are high barriers to entry. Think toll road or airport. Toll road is the one that I've heard before. Yeah. I thought maybe you could give some other examples for people who haven't invested in this space before.

4:09As you said, infrastructure term can span a very wide range. What we think about, particularly for individual investors, is staying with three food groups. So power, data, transportation. So within that power would be energy, transmission and distribution, energy storage, which is pretty interesting. The infrastructure for electric vehicles, data, fiber, cell towers, data centers, transportation, what you'd expect, airports, toll roads, mass transit, et cetera. So info can be really broad. What we think about for individual investors is those three food groups. Could you talk, this is so foreign to me, I'm curious, the investing, what are you actually investing in?

4:52Is it the projects? Is it the companies? Is it the contracts? Is it secondary markets? How does all of this work? Really good question. And part of the reason this asset class as a private asset class and for individual investors is emerging and new. So we're investing in both projects and companies, but the companies are very close to the project. So you might think about it as an investor, think about it as project risk more than operating company risk. So it's particularly foreign to U.S. investors. If we were in Canada or Australia, this would be more common to you. Again, very good question.

5:29How did it get such a big deal in Australia? Because that's what I've always heard too, is that a lot of the individual retail investors invest in infrastructure there too. They do. So not to digress too much, but Australia has a more developed, in my opinion, thoughtful approach to define contribution benefit to your retirement. So they have superannuation plans that are portable as you and I go from job to job. They were early to the private markets. I won't get the figure exactly right, but I think the average individual there is 15 or 20 percent in his retirement plan in private assets. So for a lot of reasons, Australia is ahead.

6:07I think the way to understand this is we're all familiar with the crumbling infrastructure of the United States. We don't need to go down that path, right? But there's globally, we believe, about a$3.9 to$4 billion per year gap between what's needed and what governments are going to fund. So a smart government official, I saw a quote this week, he said, U.S. Undersecretary for These transitions need to be private sector led and government enabled. So private capital within a regulated construct, we don't want numerous airports being built, for example, but private capital to facilitate the growth and development of infrastructure of the types we talked about, earning a fair return.

6:55Now, a fair return is different when you've got the benefit of what's effectively a monopoly, like an airport. Right. And that's what I think is really interesting about the asset class. So to quote broad public numbers, not our portfolio. And of course, past is not prologue. Private infrastructure index. You know, these figures are sort of through mid last year. Ten, 10 percent plus over a 10 year period return with a vol of sort of four percent per quarter. So this is an eat your vegetables asset class to an extent. This is a get at it, what I would determine an attractive return in exchange for the risk.

7:36And it's emerging. It's not well understood, but we think it's very interesting for individual investors to have access to this. You know, it's not as sexy as high returning as real estate, which tends to be, well, a lot of which tends to be quite levered, right? But it's a diversifier. It's an alternative. And the reason you're seeing so much interest in Infra right now, and it's not just us, it's a number of providers, is because people are recognizing Infra can diversify that real assets exposure. It's an adjacency to it and provides you different risk reward characteristics. We'll get into the risk aspect of it.

8:13But before we do, I'm curious about how this works, how these projects get funded. So StepStone is either in the market for these deals or they get approached by a deal. and then they say, okay, you have a$10 million allocation, go raise the funds and come back to us in three months. Like, how does all of that part of it work? Really good question. So we have a stepstone on Allocator. We're one of the largest allocators of the private markets globally, putting out about$80 billion a year, working primarily with and through general partners who we believe to be the best at what they do globally.

8:48So we are committing to funds managed by these partners. In our infrastructure business, we do a tremendous amount of co-underwriting, co-investment into the project. So as you described, they bring us a project, we underwrite it, we invest in it. But for an evergreen fund like Structure, our evergreen infrastructure fund for individual investors, like all evergreen funds, like we talked about in our prior two conversations, secondaries, buying existing assets on the secondary market is critical. And in fact, we talked maybe two years ago, we touched on infra and perhaps in our off the record pre or post, we talked about how infra was not yet ready for an evergreen fund because there wasn't enough secondary flow.

9:35So now we'll get into this. Structure is an interval fund. It's an evergreen fund continuously investing. Two years ago, we didn't believe there was enough secondary flow to get an evergreen fund to start and stay on the upswing in the J-curve. But that's changed. Like we talked about earlier, the amount of capital raised in infrastructure is up like 8x over a 12 or 15 year period of time. And so just like private equity didn't initially have a mature secondary market, now there's a mature secondary market. Therefore, we now, and it's fairly recently, felt comfortable bringing an infrastructure evergreen fund, which requires us to invest that capital to be effective, largely in secondaries.

10:20Why is there so much more liquidity in the secondary markets now? Is it just because there's more capital in the space? Yes. And there's just more trading and more liquidity going on? The industrial logic of much more capital there. Like if you look at the private equity market, which will be a good barometer, right? It's at a market that's ahead of private infrastructure. 3 % or so of what's outstanding will trade in the secondary market in an average year, give or take. So now that the infra, you could call it the basic market or the primary market. Now that we're 10, 12 years into a mature market of size, there is enough secondary flow.

11:01And that's what allows the secondary market. I would imagine that these things don't trade on an exchange. How does, where does the liquidity come from? Is this just boots on the ground? Like where do these deals come from? Really important question. So they definitively don't trade in a USO market. And in fact, they are highly, highly negotiated transactions. Moreover, the sale of private fund interest is distinct in comparison to anything else I know in the capital markets. If I own an investment in global infrastructure partners, which was in the news recently, right? BlackRock bought them.

11:39Exactly. If I'm a limited partner in that fund, I can't sell it without getting that general partner to approve it. Moreover, there's no requirement that the various bidders for that asset, my limited partnership interest in that fund that I seek to sell because I need liquidity, get equal information. As if you will, there's no prohibition on insider trading and I'm generalizing here. So it's a highly negotiated market. And we believe we bring a competitive edge to it because we're deploying about$14 billion a year. We're one of the largest allocators to the inframarket globally, two leading general partners.

12:21So with one of their existing LPs wants out, we believe we are a favored buyer, both because we know them really well, because we commit so much capital to their funds. And then third, we've made tremendous investment in data and analytics that allow us to analyze quickly that interest in a world where there's limited information, uneven information, non-standard information, and determine whether it makes sense to buy it on the secondary market. By the way, those secondary market sales are typically at discounts to net asset value. Now, the discounts you'd see in infra are going to be less than what you'd see in private equity and even less than venture.

13:04I was going to ask you that softball question. Because you're bringing liquidity, surely you must be getting the better end of that transaction. We believe the purchases we're making are attractive. Discounts in infrastructure have historically been sort of high single digits. Wow. And last year, we were able to execute a number of transactions in the low, sometimes mid, but let's say low-mid double digits. And those are discounts to net asset value and what we believe to be fair value. Bob, I had a little bit of experience investing in infrastructure funds when I was in the endowment space. And see if this still jives with you with the description of it.

13:46So you mentioned there's a private and a public relationship there, right? The government either doesn't want to take care of the roads for the tolls or whatever, or they just want to get it off their hands because they're in trouble. So the example I always heard was, okay, we're going to give a 50 - or 100-year lease to this private company. They can come in. They have to take care of the road for the toll, but they can also jack up the tolls if they want every year for inflation or upkeep or whatever it is, and they're the ones that have to do it. So it's sort of this private-public relationship there where the municipality still owns the asset, but it's leased out to it.

14:23Is that kind of how this works still or not really? That's a very common example. And let me refine it a bit. First, those revenue streams typically have, or I should say often have, an inflation escalator built into the revenue stream. Now, you wouldn't typically get an inflation escalator to then have an unfettered right to raise prices too, right? There'd typically be some regulatory authority, public utility authority, at least in the United States, which I know best. You can't have it both ways, but what you described is exactly it. It is a transfer of a substantial amount of the risk to private capital.

15:04And for that, private capital gets some protections, some concession is often the word used, in order to generate what the infrastructure manager believes is an attractive return. But as you might imagine, what's really interesting about it, these things are not very correlated to other assets. I would argue, actually, I believe, we believe strongly and the research backs it up. Infrastructure is the asset that is, and I'll limit myself to institutional asset classes. I have no opinion on Bitcoin, etc. It is the institutional asset that when you add it to your portfolio, it has the least correlation with what you already have.

15:50So then what does drive the return stream for these asset classes? Quality underwriting, ensuring that the general partners you've invested alongside can add value, because there are certainly competition in most cases for these projects, that they can add value. They have the specialized expertise in the markets. And as you might imagine, I compare contrast with private equity. So it's a lot of the same skills, you know, building a company culture, increasing revenue, decreasing cost. But with infra, you also have to have a deep expertise in government regulation. For example, you have to understand how these work.

16:33And so it's the typical private markets playbook. And I would add that element to it. that's what allows you to succeed uh of course with the return profile it's also critical to avoid losses right very important to avoid losses and this is on the on the continuum of growth versus income i think it's one of the things you guys want to talk about you know infra sort of sits between and in our fund we're going to do core plus you can think of infra like you might think of real estate. Core, core plus, value add, opportunistic on the risk reward spectrum. Our fund is core plus, we're income oriented and value add, which is somewhat more growth oriented.

17:19So we sit in that, you know, core would be lower risk, low return, opportunistic, high risk, high return. We're in the middle. So are these income plays? And if so, where does the income come from? I guess in the case of a toll road or an airport, are these uh like local revenues i mean how does all that work yeah good question they do they organically produce revenue it's not like a private company or most of them do it's not like a private company where you know you're investing particularly high growth company you're investing the profits back in you know when when that toll road has met its debt covenants it generates a regular stream of income.

17:58Same with the airport. So in a core plus asset, there's generally income from the beginning or close to the beginning. In a value add asset, there might be a buildup period to get to income. But nonetheless, they are designed as mature assets to generate a regular cashflow. So I guess just to follow up on that. So like for something, when something like this is getting built, the municipalities issue bonds. You're not investing in the bonds. You're not investing in the equity. You're investing in the funds that are buying these mature assets. Yes. And let's break that down a little bit. So I'm here in Charlotte and there's a toll road inside of my office, right behind me.

18:43The private company invested most of that capital and it took six or seven years, it seems like, of traffic jams and whatnot to expand, to increase the lanes, to put in toll lanes. Some of that capital was public, some of it was private. But then once it was built, they're reaping that revenue and pretty quickly reaping revenue in excess of their cost. And then that flows up through the fund to us, or if we own as a direct investment, it flows directly to us. So they are assets that are designed to generate cash flow when they're mature and working. So since the asset itself is more liquid, does that cash flow then translate into distributions for your investors?

19:33How does that work? What's the experience like as an investor in a fund like this? So for structure, our interval fund, we do distribute all of our net income and capital gains every year. We expect that in the first year or so, there will be limited distributions. And of course, I can't commit to any particular number here. But over time, yes, the return of this fund will come from about half regular income and about half from capital gains. I'm trying to think about where the appreciation comes from. So like, I keep coming back to this as a toll road. It feels like, I don't know if roads are a depreciating asset because the cash flows are constant, but then there's a lot of like maintenance involved.

20:18So maybe you could, it doesn't have to be the toll roads. Sure. Where does appreciation come from? And then like, why would there be an exit? First of all, the assets are very long-term hold in general. but when an asset goes from say core plus to core because the risk is declined, then you're able to sell it. Think about it like a cap rate in real estate. You're able to sell it at a lower cap rate and therefore for a higher value than what you have in it. So it's like a bond. It's like a bond. When these assets are mature and cash flowing, the revenue streams are very reliable. So they've been de-risked.

20:56they've been de-risked. Moreover, you can often refinance them a couple of times as you own them, as you've paid down debt, you decrease cost. And so you can get appreciation or a pot. I'm not sure try to adjust whether that's a capital gain from tax or not. I don't think it's important, but you can get a, an event if you will, as opposed to just a regular stream from a refinancing event and then a sale of that. Or you might sell a piece or a part. You might, it's an airport. You might offer, you might enter into a long-term lease with a new airline for some gates and get a substantial payment up front.

21:39So there are a number of ways to monetize those cash flows, but your question is on point. And it's not like a company where you're going to buy it, you're going to own it for five years, probably not going to take any meaningful capital out until you sell it. These are different. So these are illiquid investments, obviously. The structure of the interval fund, I'll let you explain in a second, but actually, you know what? No, let's just do that. Why don't you explain the structure of how an interval fund for those that are not familiar with how it works? Happy to. So an interval fund is an evergreen fund.

22:10It takes in money, ours does, on a daily basis and offers quarterly liquidity, in our case for up to 5 % of the fund, not of your investment. So daily in's, quarterly out, it's evergreen. So you come into an existing portfolio of mature assets that's designed to start and stay on the upswing of the J curve and avoid the challenges you experience in the typical private fund. Moreover, you put all your capital in up front. You don't have the unpredictable back and forth. Typically, minimums are low. You're saying no capital calls and that sort of thing. No capital calls, and the distributions are semiannual or quarterly and predictable.

22:47So these are 1099 vehicles, not K1 vehicles. so they're more convenient for individual investors. Low minimums, our minimum for structure is$25 ,000. So they are designed, they walk and talk very much like mutual funds, but with the 5 % per quarter liquidity, and I want to stress, that's of the fund, not of your investment. So most of the time, most investors can get out at 100 % of net asset value on a quarterly basis with short notice. Unless everyone wants out at the same time, of course. Absolutely. And so the key to that is to manage both the diversity in your investments, but the diversity in your investors.

23:30And I should point out that if you invest in an infrastructure fund through your local private bank, some sort of feeder fund, you have essentially no liquidity in that fund. and while the liquidity in this fund is 5 % a quarter, and you're absolutely right, there are situations, we've not experienced it, but it does happen and it can happen, where investors are prorated. You do get out your prorate apart. So imagine 10 % one out in a given quarter, you get half out. And so these are hybrids. I like to be really upfront about this. An interval fund sits between your daily traded exposure to something like a REIT or a BDC, which invests in private credit, a public BDC, between your daily traded exposure and your 15 year lockup to a private fund, it sits between.

24:21In the case of an interval fund, you can't sell it every day, but when you do, you will like the price. You'll get out at 100 % of net asset value. So that's the way we think about it. Can you explain to us, how does net asset value get set every day in something that doesn't trade every day? Where does that price come from? In general, we use our proprietary analytics to predict the values or estimate the values of these assets on a daily basis. And we're able to do that based on the massive amount of data we've gathered and the investment we've made in these analytics. And as you might imagine, we backtest that on a regular basis.

25:00There are, of course, estimates, but they are our best estimate of the value of those assets on a daily basis. How about the fee structure? How does the fee structure work for a fund like this? So in structure, our interval fund, we charge 1.6 % management fee and there's no carried interest or promote. That is our full fee. And I should point out, while that is slightly more than we would charge institutional investors for the same assets, the same investment strategy, it's really just modestly more. And that's a really important point, I think. But Stepstone, of which Stepstone Private Wealth is merely a small part, we are primarily an institutional asset manager.

25:42We're investing in infrastructure, private equity, private credit, and real estate for the world's largest institutions. What you get in structure, the Interval Fund, is the very same assets. We're just another client of Stepstone getting our pro-route apart of the same investment Stepstone's doing for those large institutions. All right. So, Bob, your management fee is exclusive of any of the underlying fees and carry that might be charged at the fund level? It is. So, we charge a 1.6 % management fee, no carried interest or performance fee, no acquisition distribution fees. It's a 1.6 % fee.

26:20Yes, we do have fees that are charged when we invest in another fund. Now, we offset much of that by buying funds at a discount. And those underlying fund fees, we estimate at about 75 basis points per year in terms of management fees. Underlying carried interest when they occur, those are harder to estimate. And typically the co-investments, when we go directly into a company as opposed to a fund, we get those with low or reduced management fees or carried interest in comparison to a typical fund. Bob, remind us how the partnership with Stepstone works. Are you getting retail investors coming directly to you or you're going straight through the RIA channel?