This article is sponsored by Ridgewood Infrastructure
Now more than ever, the lower mid-market is catching the attention of investors. While the mega-funds chase the top end of the market, LPs are increasingly seeing the potential of managers that can snap up smaller essential infrastructure assets at more reasonable valuations and then employ a repeatable value creation strategy.
Specialist US investor Ridgewood Infrastructure is a case in point, targeting growth opportunities across a range of subsectors. Managing partner Ross Posner discusses what makes the lower mid-market particularly stand out and where the sector is headed.
How does value creation in the lower mid-market differ to the larger deal space?
There is a disproportionate opportunity to create value in the lower mid-market. As the saying goes, it is a lot easier to steer a small boat than it is to turn a large ocean liner. The enhancements we make as we take a small business and scale it, broadening its reach geographically or in terms of the products and services that it offers, can have a transformational impact on the business and its value. We accomplish these objectives through a focus on repeatable and controllable initiatives which ultimately enhance the strategic position of the assets in which we invest.
We have a value-creation playbook and team that are purpose-built for the lower mid-market space. Our people know how to accomplish our objectives and to do so in collaboration with founders, families and other stakeholders, such as municipalities. In the lower mid-market, it isn’t simply what you’re doing, it is who you are doing it with; ensuring you have the right temperament and expertise to bring everything together is key.
How would you say that the lower mid-market has fared in this new higher cost of capital environment?
The lower mid-market has performed relatively well in the recent environment. However, it’s really hard to generalise by size. It’s asset selection that matters. Our focus is always on the essentiality of the services being provided, the inelasticity of demand for those services and the characteristics of the cashflows. For us, it’s a thoughtful balance of downside protection and growth.
Specifically relating to size and this market environment, the lower mid-market does have some unique characteristics. These businesses are oftentimes previously owned by founders or families that may have historically financed their business with personal capital and local banks.
That means, it isn’t only the cost of borrowing that is an issue but also the availability of debt capital. And with higher cost capital, they’ve also heightened their expectation for that capital, meaning they want more than just money – they want a partner who can really help them grow. While we provide capital for growth, we actually provide much more and people are valuing that even more in this market.
How would you describe LP appetite for lower-mid-market infrastructure today, and what role is this segment playing in investors’ portfolios?
As the infrastructure market matures, LPs have become increasingly sophisticated in their approach to portfolio construction. Investors understand more than ever that having some of their allocation directed towards lower-mid-market opportunities can really help them accomplish their objectives. That involves everything from absolute returns, risk-adjusted returns, portfolio diversification and having the underlying portfolio level exposure that they simply can’t access from other parts of the market.
The regulated water industry is a great example. There are around 65,000 regulated water and wastewater utilities in the US. Somewhere in the region of 90 percent of those serve less than 10,000 people, so if you want to invest in this space you need to do so at the smaller end of the market. We’ve done just that through a focused strategy leading to 20 completed acquisitions, completed at material discounts to the public comp set. We’ve now built a compelling mid-sized water utility that is attractive to both strategics and financials. Given what we’ve created, we’ll eventually harvest the investment with strong returns to our LPs.
This is just one great example of being able to bring together a compelling investment thesis in a very attractive market segment that would almost certainly not be possible to access via investment in larger infrastructure funds. The LP universe now understands these advantages and is investing capital in support of the lower-mid-market investment strategy.
What other investment themes are exciting and well suited to the lower mid-market, in addition to regulated water utilities?
What’s interesting to note is that the lower mid-market is the segment in the US that has the largest number of transactions and, relatively speaking, attracts the least amount of capital. That structural inefficiency is attractive to us, and it cuts across all sectors.
The water thematic, for example, remains an area of ongoing focus for us. Around six months ago, we made an investment in a company called WRM, which is a non-hazardous water treatment business. That company plays a really important role in the value chain, treating the effluent of commercial and industrial companies – the liquid by-product of whatever it is that they are doing – and municipal treatment facilities.
Separately, we also own an asset called the Prospect Lake Clean Water Center, where we are building a new water treatment facility for the City of Fort Lauderdale in Florida. We have already broken ground, and the asset will eventually supply the city with over 70 percent of its freshwater needs.
Meanwhile, traditional renewables – solar plus storage, and wind – are areas we are interested in but have viewed the risk adjusted returns to be challenging when one considers the enormity of the capital inflows into that space. However, that has started to change because many of those investments run into difficulties. We anticipated these difficulties and have been working with companies to create mutually acceptable solutions involving deploying fresh capital.
We believe that the fundamental secular growth trends around renewables are extremely strong and that we are now in the midst of one of the most interesting valuation periods of the past five years. In fact, we recently made an investment in a company called MN8 Energy, which is among the largest privately owned independent renewable power producers in the US.
Another macro trend that’s been gaining momentum over the past several years is the onshoring or reshoring of manufacturing into the US. That is creating a lot of opportunities around transport and logistics; a thematic that we have already invested into.
Finally, more generally from a structural standpoint, we are seeing large corporates managing their balance sheets more mindfully. They may be keen to avoid issuing what they perceive as dilutive equity to fund growth, for example, or may have capital constraints around their debt.
That means that they are open-minded about creating joint ventures with firms like ours. In short, there are multiple different strategies and thematics that we are currently pursuing, and we view this as a really exciting time to be investing in the lower mid-market.
How do exit dynamics compare at opposing ends of the size spectrum?
There are multiple ways to win in the lower mid-market. The breadth and depth of the market is creating competitive tension to further enhance value as well as provide surety of closure, something that wasn’t really talked about much a few years ago but is critical in this part of the market cycle.
I would add that as specialists in the lower mid-market, we often start where others simply can’t. The deals that we invest in are too small for them. If you have a $10 billion or $20 billion fund, you can’t make $100 million investments. We, however, can start with something of that size and then scale it to a point where it becomes interesting to larger financial buyers, either as a start of a new platform or as an add-on for one of their existing investments. The same applies for strategic buyers for whom our larger business is now at a meaningful size for them.
A good example of this strategy in action would be the mid-sized regulated water utility that we created through the acquisition of a number of smaller utilities. We’ve created significant scale in a highly attractive geography and have standardised operations so that when it comes to exit, it will be easy to integrate the business into a strategic or for it to be adopted by a core financial buyer. We’ve made a series of 20 acquisitions to-date, creating a business of scale that now makes sense for these larger players. The heavy lifting has been done.
I would say that it is important to ensure that what you are creating is unique. Our water utility is among the largest, single state, independently owned regulated water and wastewater utilities in Texas, which is one of the most attractive markets in the US. That means that when we come to exit our investment it will be compelling to both strategics and financials. If they miss this trade, there is no other comparable company in Texas that they can buy.