Resilient Infrastructure: Structural Problems

Upgrading our energy, water, transport, agricultural and community infrastructure requires agreement between four sets of players:

  • City, town or community officials with infrastructure needing upgrade;

  • Utility providing relevant service to community residents;

  • Source of the capital funding construction of the project;

  • The deal-makers who represent the money and negotiate the deals;

Historically the best financial returns are produced at the dealmaker level -- typically private players earning private market levels of pay.  Whether bankers, lawyers or private equity players, these players generally do a better job of taking care of themselves than they do of caring for others around the table.   They win because they can recruit and retain the highest level of talent, in part because they can afford to pay more and in part because they are independent of the regulatory structure that limits public employees and their fiduciary duty is to their profit not to the city or community.

 

The next most sophisticated teams reside at the utility/corporate service provider level, which may not be able to pay "private equity" premiums, but typically can out-compensate state or local government officials and employees and again is focused on maximizing corporate profit.  

 

When state, city and local systems often try to take on these infrastructure building and service providing tasks themselves, the results are typically disappointing.   That disappointment then leads the next set of elected officials to choose the opposite path - delegating everything to an outside private firm.  The operational results are typically better, but the costs increase substantially, in order to feed the earnings appetites of the private players.  

The other player of relevance, but one who is often not directly at the table, is the ultimate provider of the underlying capital. These are the large institutional capital holders, the sovereign wealth funds and the large state and city pension funds.  Without their capital, the deal-makers would have little to work with.  However, here too, history suggests that in the negotiation between the deal-maker and the pension fund, the much higher paid private executive often gets the upper hand over the theoretically better positioned pension or fund investment staff.   The deal terms between the big funds and the big private equity houses on their face suggest the imbalance:

  • They typically imply a long-term, i.e. 10-year, commitment of capital and thus essentially hand out ten-year employment contracts to the senior executives at these firms;

  • They guarantee a fixed level of management compensation, often from 1-2% per year of the money committed to, from which the private firms pay salaries and equity compensation far, far higher than their state fund counterparts;

  • They give 10-30% of the upside to the private fund, but almost fully absorb the downside -- if the private fund disappoints, the remedy is to not give them another 10-year contract. Options theory suggests this is a very favorable trade for the private equity player.

  • The private equity firms themselves compensate their owners far more highly than the senior-most executives at other private organizations, such as banks or publicly-traded public companies.  The net result is that doing business this way is an expensive way of putting capital to work, but one that has been around so long few public fund managers or boards are willing to challenge or change it.

  • When things aren't working, the underlying capital providers have very limited ability to fire the team, nor can they stop the funding; they can only make changes at the end of the Fund life.

Compare these structures to how those same private equity firms deal with the companies they invest in:

  • Employment is typically at will; with fairly short severance terms and compensation strictly monitored to make sure it is in line with market comparables;

  • Equity is provided, but in the form of Common Stock; with four-year or longer vesting, such that unless the investors make money, the employees (who often founded and made the initial investments in these firms) themselves make no gains;

  • The Boards of Directors of these entities are controlled by the investors, who aprove the annual budgets, extraordinary spending, compensation plans and the hiring and firing of key executives.

  • When things aren't working, the board either fires the team or stops funding their bad behavior.

This latter structure has been extraordinarily successful in building Silicon Valley and otter global entrepreneurial companies.  There is absolutely no reason it cannot work for a set of public institutional funds who themselves behave the way the private equity firms they give money to behave with that money.  So why don't they do it?

Because the compensation structure in use at virtually every major public fund is based on what is referred to as a "benchmarking" system.  The benchmark is typically the average return earned over a given period by a selected group of peers.  If you perform poorly, but so do the teams you are benchmarked against, there is no downside.  On the upside, bonuses are small compared to the private market.

 

As a result, very few managers deem it worthwhile to take on meaningful risk given the disproportionate outcomes of a) getting fired if you are wrong or b) getting a small bonus if you are right.  This is even more true when you are trying to go up against the advice of much more highly compensated and often smarter/more experienced private teams.  The net result is a trend toward mediocrity while at the same time having all those benchmarked managers competing with each other to get access to the "best" of the private money managers.  In that system it isn't a surprise to see who wins.

The better solution would be to have the institutional investor directly own the fund.  This is not a "direct-investment model" inasmuch as it doesn't ask the pension manager or team to make individual investment decisions.  Instead, the "own" the decision-making firm, acting as its Board of Directors, setting annual budgets and with full authority to hire and fire the actual investment team.  This structure allows the fund to hire highly competent investors, pay them at market rates, not have to pay a premium for the senior partners otherwise acting as "owners" of the fund, allows the institutional investor to shut down a poorly performing fund at any time, not just after 10 years; it also creates complete alignment between owners and principals in the outcome, is the best possible way to ensure that our cities, town and communities have access to the energy, water and other infrastructure systems they need.  However, such "hybrid" structures are challenging to adopt because:

  • They challenge the status quo;

  • They under-price existing private equity players and thus highly likely to be challenged by the incumbents;

  • They have the ability to better recruit and compensate their staff's in ways that doesn't engender support from their lesser-compensated owners;

 

But, such hybrid structures would almost certainly lead to better results.  In addition, where several larger institutional investors team up to create a hybrid corporate structure, they gain advantages of scale in getting better terms from third party contractors, hiring better teams and having greater negotiating leverage.