How PE infrastructure funds are getting new options

REIT private letter rulings provide PE infrastructure funds with an alternative vehicle to invest in pipelines and fiber optics.

Infrastructure funds have been one of the most popular PE fundraising classes in recent years. In aggregate, PE firms have raised more than US$388b over the last five years for investments in the infrastructure, according to an EY analysis of Preqin data. Currently, PE firms have more than US$217b in dry powder available to fund new deals. Infra funds have raised US$100b over the last 12 months, up 24% to the US$81b that was raised over the prior 12 months.

However, structural barriers such as inconsistent legal frameworks across jurisdictions, the amount of time it takes to complete public-private partnerships and high competition for a limited number of attractive assets is making it difficult for the industry to effectively deploy capital. In the first half of 2019, PE firms announced infrastructure deals valued at US$212b, down 7% from the same period a year ago, and on pace for the lowest total since 2015.

Continued strength in fundraising amid a challenging environment for deployment

Two new IRS private letter rulings (PLRs) obtained by EY teams for separate clients may make it easier for PE funds to invest in certain types of energy and telecommunications infrastructure – two of the hottest areas of interest for PE investors. The rulings pave the way for real estate investment trusts (REITs) to own and operate energy pipelines, storage tanks and fiber optic lines in certain cases.

Energy and telecommunications infrastructure have been some of the most sought-after investments by PE funds, which are looking to capitalize on the increase of US oil and natural gas production and the surging demand for bandwidth and the move toward 5G wireless, the backbone for the internet of things (IoT), autonomous vehicles and similar technologies.

Since 2015, there have been 777 PE deals for energy storage and pipeline assets, with pipelines and storage totaling close to US$150b. At the same time, there have been 306 deals for various types of telecommunications and wireless infrastructure totaling more than US$110b.

The PLRs provide PE investors a tax-advantaged option for investing in these assets, as REITs generally do not pay US corporate income tax. The REIT structure provides potential incremental value for PE investors who are looking to acquire these popular assets, either as a single target or as part of a roll-up strategy.

What are rents from real property?

The PLRs revolve around the question of what constitutes “rents from real property.” An entity may qualify as a REIT if substantially all its revenue is rents from real property.

That test is simple in real estate such as an apartment or office building. In those cases, rent is paid for the exclusive right to use a certain fixed space over a certain amount of time for a fixed amount.

For a storage tank or pipeline, it can be more challenging, said David Miller, Co-Director, EY Americas Passthrough Transactions Group and an author of the private letter ruling requests. In those cases, a user is paying for capacity and may not know in which tank their commodity is being stored. In addition, their commodity may be commingled with another user’s commodity. Furthermore, the payments may be fixed, may be based on “throughput” or a combination of both.

For PE investors, these PLRs present a welcome development. REITs are a well-known vehicle in capital markets and often receive a premium valuation in the market. Many global investors in PE funds, including global pension funds and sovereign wealth funds, can receive a favorable tax treatment for distributions received from a REIT and on gain when they sell REIT shares, says Michael Doolan, EY Americas Infrastructure Tax Leader.

Whether a REIT is an appropriate vehicle for a particular asset is a function of the nature of the asset, the nature of the payments received for the use of the asset and, in some cases, regulatory issues. In the appropriate circumstances, however, a REIT is a compelling alternative as an investment vehicle for a PE fund compared with a C corporation blocker.

Given this backdrop, EY teams expect that REITs will emerge as the owners of midstream and telecommunications infrastructure assets, both in the private and listed markets.