Private equity sees gold mine in potholes

NEW YORK (Reuters) - Private equity firms suddenly short on big buyout targets are revisiting an elusive goal -- the privatization of infrastructure.

The crumbling network of roads, ports and bridges have previously intrigued private equity, but a political backlash derailed a wave of anticipated deals sparked by the Chicago Skyway lease for $2 billion in 2005.

Cash-strapped states might now reconsider their aversion, especially if private equity firms are willing to spend as enthusiastically for infrastructure assets as they were before a credit crunch made public markets unreceptive to them.

"The U.S. is falling apart and needs rebuilding," said Craig Fuehrer, a managing director in the industrials group at Deutsche Bank. "State budgets alone can't handle this."

Infrastructure spending accounted for 3 percent of U.S. gross domestic product from 1950 to 1970, according to a New America Foundation report. Since 1980, that figure has dropped below 2 percent. Citing deficient bridges, overwhelmed airports and shoddy roads, the report finds "a huge accumulated shortfall of needed investment."

The deadly collapse of a Minneapolis bridge this month brought the integrity of U.S. infrastructure to the nation's attention -- and some say the tragedy may ultimately prompt public referendum on the need for privatization.

Governments have struggled to maintain infrastructure while balancing tight budgets and facing potentially onerous obligations as America grays.

"States are motivated to monetize assets," said Evan Ladouceur, Citi's head of gaming investment banking. "There are budget gaps, but also looming are unfunded, vested pension liabilities. These amounts can make annual operating budget shortfalls look insignificant."

Illinois, which last month rejected a plan to sell its state lottery, has a pension system that is nearly 40 percent underfunded, said state Sen. Bill Brady -- resulting in a shortfall of about $45 billion and causing the state to sell assets to meet required contributions.

"Fiscally it's a devastating position to be in," Brady, a vocal critic of overspending, told Reuters. "We have to meet our cash flow needs. As long as there are assets that can be liquidated and there is no other means, we will have to liquidate those assets."

NEW ASSET CLASS

About a dozen major infrastructure funds, which bankers say are currently raising at least $50 billion of new capital, are eyeing the state-owned assets.

With lenders spooked by credit markets and unwilling to fund the leveraged buyouts that had preoccupied private equity firms for years, lotteries, bridges and toll roads have gained new allure.

Grant Kelley, chief executive of Colony Capital Asia, says the blend of stable and predictable cash flows with potentially above-market returns from financial engineering make infrastructure unique.

But critics have said taxpayers risk getting short-changed under public asset deals and that profit-minded investors are more likely to raise prices for services that are often monopolies.

Kelley, however, said private owners could add value.

"Infrastructure consumers (such as rail commuters or airport travelers) will absorb 'fair' pricing where there has been some demonstrable improvement in service following a transfer of ownership," he said. "Yet because of barriers to entry, the business itself has relatively low volatility."

With private equity increasingly keen on infrastructure and states under growing duress, the United States may be primed to join Europe and Australia with its own privatization wave.

"A new asset class would emerge in the US that could be very lucrative," said Citi's Ladouceur. "One lottery privatization could cascade into several others."

'FILLING THE ROLE NICELY'

Funding the privatization push are institutional investors, who say relatively entrenched infrastructure assets are compelling as they navigate tumultuous debt and equity markets that increasingly seem to move in lock-step.

"Infrastructure fills a role nicely," said William Atwood, executive director of the Illinois State Board of Investment. "It gives a relatively good yield and provides the low correlation that historically had come from fixed income."

The state pension fund has about 5 percent of its $12.5 billion portfolio allocated to infrastructure investments.

The development of infrastructure in the United States may ultimately parallel another asset class, which eventually matured into a mainstream strategy for institutional investors.

"To some institutional investors, infrastructure today probably looks like real estate 15 years ago -- lumpy, hard to categorize and completely illiquid," said Scott Landress, chief executive of investment firm Liquid Realty Partners and former Bank of America real estate investment banking head.

"But massive amounts of equity are being deployed into infrastructure funds," he said. "Its emergence as a bona fide alternative asset class appears today to be a self-fulfilling prophecy."