Private Infrastructure Equity: The Overlooked Middle Market

Greg Campion: Infrastructure investing has seen a surge in recent years, both on the equity and debt sides as investors have come to appreciate the many benefits of the asset class, which include attractive yields and inflation protection among many others. Despite this growing popularity, misconceptions still exist and investors may actually be ignoring some of the most attractive parts of this market.

Mina Pacheco Nazemi: We're seeing the biggest opportunity in that small lower end of the market. If you look at the statistics, 80% of the capital being raised is in funds that are above a billion, 70% of the capital being raised is just with five different platforms, so we like investing in opportunities that are too small for those bigger platforms to invest in, so think about distributed assets like battery storage, think about small scale data centers and therefore those projects are way too small for those larger platforms to invest in. And this is the opportunity that we think is overlooked, underappreciated, and where we see the best opportunity for our investors today.

Greg Campion: That was Mina Pacheco Nazemi, and this is Streaming Income- A Podcast from Barings. I'm your host, Greg Campion. Coming up on the show, Private Infrastructure Equity- The Overlooked Middle Market. Before we get into the conversation, if you're not already following us and you're interested in hearing our latest thoughts on asset classes like high yield, private credit, real estate, and more, just search Streaming Income on Apple Podcasts, Spotify, YouTube, or wherever you get your podcasts. With that, here's my conversation with Mina Pacheco Nazemi. All right, Mina, welcome to the podcast.

Mina Pacheco Nazemi: Thank you, thank you for having me.

Greg Campion: Excited to have you. It's been a little while since we've had you on the show.

Mina Pacheco Nazemi: Yeah, we've been working on good stuff, so we're excited to be here.

Greg Campion: Awesome, cool. Well, for our listeners who may not be familiar with you or have heard prior episodes, can you talk a little bit about your role at Barings and the group you head up maybe to start out?

Mina Pacheco Nazemi: Yeah, so I run the Diversified Alternative Equity Team, we invest in both private equity and infrastructure equity. We tend to focus on the small lower end of the market to help our clients get access to kind of niche strategies in both private equity and infrastructure, and I know we're here to talk more on the infrastructure side today.

Greg Campion: Mm- hmm, mm- hmm, awesome, awesome. Yeah, and your team puts out a lot of great work too, so anything we talk about today, chances are there's something on Barings. com that people can go check out. So yeah, let's dive in, so we're going to talk about private infrastructure equity today. I mentioned in the intro that we're seeing just a real growing popularity investing in infrastructure I think broadly speaking, both on the equity side and on the debt side. I think there's a number of reasons behind that, and of course, you have all these kind of big structural trends like the boom in AI, the growing focus on climate and sustainability, et cetera. Now your team is very much involved in investing across several different verticals, I would say, so digital infrastructure, energy transition, transportation mobility, and circular economy, to name a few of them. So I'd like to talk about some of the investments and some of the opportunities that you all see in those areas, but maybe just to start, as you look across all of these different areas, it'd be interesting to hear you talk about what are the common elements that you see that are appealing from an investment standpoint?

Mina Pacheco Nazemi: Yeah, so it's a great question, especially for investors who are new to the asset class and are starting to build that allocation, infrastructure equity, into their portfolio. From a top level down, from a CIO level down view, the way we think about it and how we think this is a good allocation into your portfolio is candidly we're starting with it's a great diversifier. It's a great diversifier given you're most likely to have much corporate exposure, corporate credit, corporate equity type exposure across your portfolio. And as you mentioned, we're investing in a real asset, so you have a hard asset, it could be digital fiber, it could be edge computing data centers, it could be battery storage. So the fact that you are diversifying with a hard asset in a differentiated asset is I would say number one. Two is the fact that we're investing in these assets where there's contracted revenues, so most of these businesses have contracted revenues, you have the fact that you can foresee your cash flows, you have inflation escalators, so it's really great as a kind of a downside protection for your portfolio where you're investing in these assets with predictable cash flows in assets that are frankly necessary, you need to have your internet, your infrastructure there for your businesses, for your home. And then the fact that you are also getting some potential upside, and we can talk more about how our investments all have this kind of downside scenario where you're going to get a steady cash flow but there's upside potential in those business models. So one is, like I mentioned in the beginning, so you have that as a diversifier, you have great assets, contracted revenues, inflation protection, and the fact that it has the tailwinds, as you referenced in your introduction. We have a growing need for assets to help us in the energy transition, we have a growing need given everything going on with AI, or even without AI, just more and more demands for data and not having a lot of latency in terms of having in your service, so information is easily accessible and do what you need to do from a business perspective and you can sit at home and watch all those shows on Netflix.

Greg Campion: That's what it's all about.

Mina Pacheco Nazemi: Yeah, it's all about-

Greg Campion: The backbone to support our consumption habits.

Mina Pacheco Nazemi: Absolutely, absolutely.

Greg Campion: Now, you mentioned this idea that there's this kind of inherent downside protection I guess, with regards to investing in these asset classes that are backed by hard assets, but also with upside potential for capital appreciation. Tell me a little bit more about that capital appreciation side of things, because I think that maybe is a little bit different than what you or some would historically think about from infrastructure, right? It's seen as this steady quasi- boring asset class, is that changing I guess is the question?

Mina Pacheco Nazemi: Maybe the best way to think about it is within the spectrum of infrastructure, we are tending to be in that value- add and opportunistic side. So very similar to real estate, you can have an Infrastructure Core, Core Plus, value- add, and opportunistic. So you're right, infrastructure, the boring, what we call Infrastructure 1.0 so your toll roads, your airports, your standard fare, your large- scale utility is really in that what we call the Core Plus, so infrastructure 1.0, Where we see the biggest opportunity is in that value- add and that opportunistic. So to your point, you have elements of that baseline cash flow, but you have the ability to have the capital appreciation because there may be additional projects that we can bring online. So I'll just give you a quick example. We invested in a battery storage project about 30 megawatt in Texas. Three, I would say, small cell battery storage projects, but when we made the investment, we could see the contracted revenues, we saw the opportunity with those three assets, but we also had a pipeline for 12 additional assets, and therefore we were investing in the potential to develop those additional 12 assets. So that is added alpha in terms of as you have your baseline returns from those three initial projects, and then you get that added alpha as we bring those 12 projects online. As we underwrite that, there is that ability to foresee a baseline return, and then we are taking execution risk on generating another 300, 400, 500, 600 basis points more as we bring additional projects online. And what we're seeing in the market is given all the capital that's been raised with the larger platforms, there's a thirst and the demand for great platforms and they're really interested in buying up these different projects and platforms that we've been building from the ground up.

Greg Campion: Okay, okay. So now in terms of returns, and obviously for compliance reasons and other reasons, we don't really want to get super specific on return expectations, et cetera, but it would be interesting just to hear. So you made this distinction between Infrastructure 1.0 and Infrastructure 2. 0, is there a way to wrap your arms around how that targeted return potential between those two might differ or are the asset classes or sub- asset classes too disparate to generalize that?

Mina Pacheco Nazemi: No, the data's there in terms of where Core and Core plus has been. Core, Core plus has been in that 4- 6%, maybe 7% range.

Greg Campion: So that's like investment grade equivalent.

Mina Pacheco Nazemi: It's basically investment grade mean, and our view candidly on that is if you're going to be generating, let's be generous, a 6% or 7% return on the Core, Core plus, and for equity, you might as well just do the inaudible, and you're at the top of the stack. As we think about infrastructure equity in that Core Plus value add and what we call our Infrastructure 2. 0, you can basically be getting private equity like returns. So you can be getting 14% to and 18%, 19% depending on the project, depending on the jurisdiction, and also depending on timing. We've had great demand on having kind of dark fiber and just general data centers and availability, and so there's just been a lot of demand, AWS has been buying a lot of those types of assets. So then you can see that you can get on the higher end of that spectrum. So we like it, we like it, especially as for insurance investors who know that they have to get an RBC charge, so you can basically be getting private equity like returns with the infrastructure profile and with having some of that downside that I talked about earlier.

Greg Campion: Okay. And I will just make a disclaimer here to say that these are targeted returns that we're talking about, not guaranteeing returns. Past performance is no guarantee of future, et cetera, et cetera. Okay, so one of the things that you kind of alluded to there was what's going on in terms of the fundraising environment here. So I mentioned upfront, we are seeing increased interest and a lot of demand obviously for infrastructure assets. So you're seeing all kinds of infrastructure deals, all kinds of mechanisms for financing them, but what are you broadly seeing as you look out there? And you're out there talking to investors, what are you broadly seeing in terms of the fundraising landscape today?

Mina Pacheco Nazemi: It's highly concentrated. So if you look at fundraising in the last, call it five years, 80% of the capital going into infrastructure has been going to billion dollar plus business or funds. And actually, if you look at the last couple of years, about 70% of the capital raised has gone to five firms. So as a person who's been investing for over 20 years, I've learned that following the herd is not a way to generate returns, and so where we tend to be is in that smaller segment of the market. And what we love is we're buying building assets, and we're basically selling it upstream to some of these platforms where they have a lower cost of capital, they've raised$ 20 billion, $30 billion. They need to put their capital to work, and they need to put their capital to work in these strategies around the energy transition, they need to put their capital to work, recognizing all the demands for power and energy, so that's how we see the market. We've always focused on that small lower end of the market, as I referenced in our introduction, on the private equity side and very similarly on the infrastructure side, and that's where you can be niche and you can be nimble and candidly just take advantage of just the flows of capital and take advantage of just all that capital that's sitting out there with these bigger platforms, and basically provide them and give them access to an investment where they can deploy capital on their end. So we love that, we love that, and seeing that imbalance. The other thing that we do is not only are we directly investing in assets, but we also do invest in managers, so teams that have spun out. So that imbalance also enables us to really be meaningful with these smaller, newer, emerging managers, provide them with that capital to start out their firms, and get some preferred economics, anchor economics, which really accretes to the bottom line and accretes to our investors.

Greg Campion: Let me just follow up on that because some of those statutes throughout there are pretty astounding in some ways, I would say. So basically my understanding of what you're saying is heavily concentrated, you're seeing these kind of large or mega funds raising almost all of the capital. Did you say in the last, is it in the last few years, the top...

Mina Pacheco Nazemi: Five managers have been like 70%.

Greg Campion: Okay, wow, so that's super concentrated,

Mina Pacheco Nazemi: Super concentrated. And of course these names have multiple products, but the fact that you have that manager concentration of five different managers being 70% of the allocations, it's really astounding. And look, we saw that dynamic 20, 25 years ago in the private equity side, and in my career, we've taken advantage of those opportunity sets. And there are teams that are spinning out of these platforms, so there are these teams who have the experience who are spinning out of these platforms, and we are backing them, and we are backing them, and we're helping them providing them with that capital so that they can continue to do what they've done and what they've done for many years in their career. And as I described, help them get back to basics. So these platforms that I referenced started out not raising$ 20 billion dollars funds, they started out by raising smaller funds and they had a lot of successes, and through the successes they've gotten much bigger. So when we're identifying individuals and teams to spin out, those are teams who are saying, " Look, I don't want to deploy multiple billion dollars in a specific project, I want to go back to basics in what I was doing 10 years ago and doing smaller scale projects, it doesn't require all that capital." And they're betting on their careers, and that's what we do, we like to bet on people and having that alignment with them where their success is critical for their careers, there's no fallback for them, and that's the type of partnership that we look for with our managers.

Greg Campion: Yeah, yeah, that's really interesting how the two parts of your business are kind of complementing each other there, where you have the direct investments in some of these assets and then the dynamic you just described. You and I have talked about emerging managers on this Podcast before and I think you and your team have all sorts of data that shows that historically what you've seen is the performance of fund 1, 2, 3 tends to be on average much stronger than later funds, as funds get bigger, et cetera, et cetera.

Mina Pacheco Nazemi: Yeah, no, and I think it's even, we have one of our white papers that also shows that data as well, and we've done that for infrastructure as well, and it's even more astounding in that kind of Fund IV Plus. To your point, you see most of the performance really in the middle, and just hovering in that median return, versus if you look at earlier in the cycle for the Fund I, Fund IIs, Fund IIIs, you tend to see more first and second quartile. Maybe I should also add, as part of our toolkit, we're directly investing in assets, we're investing in managers, but we also have more of a JV- type structure approach with some of our operating partners in the strategy, which is very akin to, and I would describe it to real estate, where we may find great operating partners who have experience, who've been, let's say in the power space for 15, 20 years, may have been successful with getting backed by a private equity infrastructure fund, and we're very comfortable working directly with those operating partners in a JV- type structure model and backing them as they've identified a platform or project that they want to pursue within their sector expertise.

Greg Campion: Okay, cool. So let's talk about a couple of specific examples because I want to understand this dynamic a little more. Just so my understanding based on at least part of what you're saying around the fundraising environment is that you've got these mega funds out there who have raised the vast majority of capital in this asset class, therefore, have a massive amount of capital to deploy in the asset class. Therefore, and we've seen this in some other asset classes as well, like direct lending, they are obviously much more incentivized to go after the much bigger projects, much bigger deals, they need to just put dollars to work, and it just...

Mina Pacheco Nazemi: It's inefficient for them to do smaller investments because they can't have a portfolio of a hundred investments if they have a$ 20 billion fund.

Greg Campion: And you would just need a massive team to do the proper due diligence on all of those deals. So therefore, and this is me kind of jumping to the conclusion, but I think this is what the conclusion is, therefore the lower and middle end of the market is a more kind of inefficient market, and maybe there's more value there. So talk a little bit more about that concept and then maybe if there's an example or two you can provide that kind of helps illustrate this, that would be interesting?

Mina Pacheco Nazemi: What we do at the end of the day, as I kind of even described with this kind of battery storage project, is I describe it as we're building to Core. So we building assets, we're pursuing these projects such that we're creating a combined cashflow that can be sold upstream to these bigger platforms as a core infrastructure because you have these contracted revenues. So-

Greg Campion: This is the one in Texas that you're talking about?

Mina Pacheco Nazemi: Yeah, the one in Texas that we're talking about.

Greg Campion: Does this support the overall kind of power grid or?

Mina Pacheco Nazemi: Yeah, it's exactly supporting the power grid, but the theme is the same across everything that we do. We've done investments within the geothermal space, we've done investments in digital fiber, we have district heating in the UK, but the theme is still the same. Where we're building to core, we're basically building assets that are small and modularized, not as complex. It's not like we're building large scale utility, the fact that we're doing small modularized where you're not taking technology risk, you're really just taking construction risk but it's not as complex. The permitting is not as complex as a large scale toll road, it's not as demanding, there's a lot of conversations about permitting and the politics around getting these projects getting done. So we absolutely love that dynamic because what you see on the larger scale projects is you are taking a lot of more regulatory risk, you're taking on the impacts of weather really can be, if you have a hurricane that hits and your large scale utility, that impacts it, but if you have your power being stored in smaller modularized, distributed in an MSA, if a hurricane hits, it's not going to hit all of your assets at the same time. So it de- risks the investment just by the nature of how it's distributed. So we absolutely love that dynamic there. So maybe other kind of examples-

Greg Campion: Can I just ask you, what is MSA?

Mina Pacheco Nazemi: Oh, just a metropolitan, the metro area. So within an MSA, so the Charlotte, Los Angeles, or Chicago.

Greg Campion: I see, see. I like how you were describing some of these assets as being smaller, modular, distributed, and therefore they're almost like less exposed to some of these big risks, whether it be climate or even flying under the radar to some degree with regards to regulatory risks and even some of the red tape around permitting and stuff like that, that's super interesting, so that's the case I think that you described on the battery storage side. Is that kind of broad based trend, and I know I'm curious, I think your team did a data center deal in Pennsylvania, it'd be interesting to hear about that one as well?

Mina Pacheco Nazemi: Yeah, it was a hyperscaler, and look, we made this investment years before the AI. A conversation was happening in terms of the demand for energy, so we had a hyperscaler and then our source of energy was a low cost energy clean provider, and we saw that opportunity. So we saw the opportunity with the fact that you had the hyperscaler, and then you had your energy source, and we thought there was value. So going back to the comment I made earlier, there is value in those two hard assets. We understood the contracts related to those hyperscalers, but we saw the upside with them because, I'm not going to say we foresaw this euphoria around AI, but we knew that there was just going to continue to be more and more demand for energy. And if you think about what happened with Bitcoin over these years, you need to have the energy, the power to run all the computers and do what you do as a miner. So that is an example of where we sold that upstream, we sold that to pick one of your five FAANGs, and they really liked the asset and they were able to pay more, and because they needed that and they wanted to secure their power. And we're seeing that thematically, we're seeing that thematically, we have a dark fiber deal in another large metropolitan area, and I was just there earlier this week. And in that platform, again, I'll just describe it, one of the FAANGs just said outright, " I'm going to buy 10% of your capacity of your fiber in this metropolitan." Because they are just trying to lock in. Think about it, locking in their capacity, locking in so that they can have their ability to do what they need to do as their business continues to grow, as they continue to double down, and they also foresee the just continued need for power to fuel all that data that's flowing through their system.

Greg Campion: It almost comes back to this idea of the lower and middle part of the market being this inefficient part of the market that may not make sense for either the big mega infrastructure funds to go down into and spend a lot of time on, or like I think you're referencing here with some of the FAANGs and others like these more strategic buyers, they may not have the time or resources to be going asset by asset and creating these types of things. So I think one-

Mina Pacheco Nazemi: And it's necessary for their business. What happens if Amazon doesn't have access to power? What happens if Amazon doesn't or Meta, right? So it's becoming so important and powerful, and we've had this thesis for over the last five, seven years here on that's just where the trajectory is. And so as you think about infrastructure being a critical, critical item, historically it's been okay, do you have water? Do you have an electricity? But electricity and power is just even becoming more important and digital is just an important component of that.

Greg Campion: Now, thinking about the economics of some of these deals, I know I've heard you and the team talk in the past about kind of valuation, multiple arbitrage, so tell me a little bit more about that idea and what's going on there?

Mina Pacheco Nazemi: So the buy versus build multiple is how we think about it. Do you buy it, and we could see the multiples, what these assets are trading at. Okay, I'm going to just pick a data center of picking data centers where you're buying, you could buy it at 20 times multiple, or do you build it at the smaller scale at significantly lower than that and aggregate multiple projects, multiple entities to basically, as you aggregate it, you could get that multiple arbitrage as you sell it up market?

Greg Campion: Okay? So it's cheaper to build the assets at a small scale so that build multiple is lower, but then as you build more of these assets and you end up with something that is of scale and something that these bigger players are willing to pay up for, that's where you see that arbitrage?

Mina Pacheco Nazemi: Absolutely, and we don't underwrite for that arbitrage, to be clear in terms of how conservative we are, but that goes back to one of the components of the accretion that you can have investing in this segment of the market. So it's not underwritten but we'll take it when someone wants to pay 2X the multiple that we built a specific platform at.

Greg Campion: Yeah, sure, sure. Okay. I just want to ask you just in terms of sourcing deals, you mentioned relationships with various operating partners and other partnerships, so let's talk a little bit about that because I'd be interested. Everything from Texas battery storage to this hyper scale or data center, it'd be interesting to hear where some of these deals come from.

Mina Pacheco Nazemi: So as we've talked about in different podcasts before, we've exclusively been focused on always investing on the small lower end of the market. We have a reputation as a firm, as a team, to really know how to invest with smaller managers in the smaller segment of the market. Because we've backed some of these platforms that are now Megas, we know a lot of the individuals, the teams from over the years so there's that natural connectivity there, but there's just so much talent, there's so much talent that's come out of even your traditional. They could have been someone who came out of the energy space where I had worked at an energy company, they know what they're doing. One of our operating partners was a three- time CEO in the telecom space, and so we're exploring opportunities with him because he sees the market and obviously has a proven track record of running businesses in the telecom space. So it's all of the above. Look, I always say my job is to look under every rock and look at every opportunity and ensure that we have the broadest funnel to see that we're making the best investments within a given vintage year or a given couple of vintage years, and so having that openness to look at everything really informs us. The other thing I'll just talk about, I think, is a big differentiator in what we do, especially for investors who are newer to the asset class, they really are drawn to the fact that we have our own set of what I call our library of our KPIs. So what does that mean? So for all the different sectors, we have our own data points and statistics on what are the specific milestones or what are some of the KPIs of a business in the digital space or what it should be and whatever, in district heating. So it's that data point that helps us not only determine as new opportunities come in, is this a good business model? Is this a business that's going to be successful? Are they doing something different that's going to set them up for success? And so we aggregate all of that, we leverage our operating partners, we leverage our just managers that we've given capital to, to really kind of help us determine as we're making those direct investments, if we're making those direct investments in assets. We've seen a ton of deals like Fiber to the home. We've seen of a lot of transactions in the school busing, which is a quasi infrastructure type deal, so we even have statistics on what's been the driver turnover, how much is the CapEx, and how often do you have to change out your bus fleet? So it's having those data points that when we see new deals come in, we can evaluate and say, " Well, the last five deals had this range of data points in terms of those KPIs, where does this fit in?" And it just makes us better investors. And then for our partners, we provide them that feedback. It's like, " Well, we like you, we like your deal, but the KPIs for your business or your expectations or your margins," We will give them that feedback, " are not up to our standard, and therefore that's why we're passing." And it just makes us a better business partner with our managers as well.

Greg Campion: Awesome, that's cool. All right. So just to finish it up here, I wanted to zoom out a little bit and take it back to the investor or LP seat and just think about two things really that I'm curious about. One is, you had mentioned insurance companies as investors in this asset class upfront, so it'd be interesting to hear about just broadly where you're seeing interest from a client perspective, and then secondly, if you think there's any misconceptions that remain out there around this asset class, it'd be interesting to hear about those?

Mina Pacheco Nazemi: We're seeing interest from all types of investors. So it could be say, pension plans, it could be corporate pension plans, insurance companies. I think there are a lot of these investors are seeing the value, they're concerned about inflation, and they like the fact that you have a hard asset, you have the inflation protection as a contracted revenues, so they really like that profile. There's really two big misconceptions. One is that investors think infrastructure, they think this lower return and yielding lower returns, so think generally from a return perspective in that 6% to 8% on a best case scenario, which really correlates to Core, Core Plus, and what we described as an Infrastructure 1. O. But as we've talked about throughout this whole podcast, there are opportunities to generate more private equity returns, and you think about investing in that value add and that opportunistic. The second I would say, big myth out there is that infrastructure requires billions and billions of dollars, and therefore, that's why you need to have these mega funds to go after these opportunities. And hopefully throughout this whole conversation, we've been able to help you understand that the opportunity is not on the larger end of the market, it's in that smaller end. So therefore, being a smaller manager with less than a billion dollars still is the place to be because you are able to take advantage of these smaller scale projects. Again, aggregating them to potentially being larger that can be bought by the bigger platforms. And so you don't need to be large to invest in the asset class, which is really also great for those smaller institutional investors. They may have a$10 billion, $ 15 billion total portfolio, so you don't need to have a lot of capital to be a player in the infrastructure space. So those, I would say, are the biggest myths or misconceptions that I see in the market, and hopefully we'll have an opportunity to connect with you all who are listening to see that there is this opportunity to generate these great, great returns and invest in areas of the market that are growing and frankly inaccessible in the public markets, and probably inaccessible with your exposure to the larger end of the market.

Greg Campion: Awesome. Well, thank you. I think we have hopefully done a good job shedding some new light on this asset class today, I certainly feel smarter about it, hopefully our listeners do too, and hopefully we cleared up some of these misconceptions about the private infrastructure equity space, especially in that smaller to mid part of the market. So Mina, thank you very much, I really appreciate this.

Mina Pacheco Nazemi: Thank you for your time.

Greg Campion: Thanks for listening to or watching this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at Podcast @ Barings. com. That's podcast @ B- A- R- I- N- G- S. com. Thanks again for listening, and see you next time.