The freight rail industry, and short line railroads in particular, will likely continue to be the target of mergers and acquisitions (M&As) in 2020 and beyond because private equity firms are recognizing the long-term value of infrastructure assets, according to industry observers.
This year alone, the examples have been numerous, from the acquisition of short line Genesee & Wyoming by infrastructure investment firms Brookfield Infrastructure (NYSE: BIP) and GIC, to OmniTRAX’s acquisition of short line assets in Ohio and the acquisition of short line Winchester & Western, among OmniTRAX’s many other activities in 2019.
Also this year, infrastructure investment firm First State acquired Patriot Rail’s rail and port operations in the Southeastern U.S. from SteelRiver Infrastructure Partners and RailUSA purchased a short line in the Florida Panhandle from CSX (NASDAQ: CSX).
Other M&A activity includes the April 2019 acquisition of Regional Rail, an owner-operator of short lines and rail assets in New York, Pennsylvania and Delaware, by 3i, an infrastructure investment fund based in the United Kingdom. And then Regional Rail acquired Pinslys Railroad’s Florida operations in October.
What many of these transactions have in common is that they are the result of an “explosion of interest” among financial buyers, who are effectively private equity firms, said Bill Kucera, a partner at law firm Mayer Brown in Chicago. Kucera helped represent 3i and Regional Rail in their transactions this fall.
“Infrastructure is hot, firms have resources to chase these deals, and these are assets that they think fit well into their investment profile,” Kucera said.
Why do financial buyers want to invest in infrastructure?
Buying infrastructure assets is a relatively new phenomenon because financial acquirers historically have focused on investments that have a short investment horizon of three to five years.
“They buy a company with the complete intention of flipping it quite quickly,” Kucera said.
But now, more firms are focusing on longer-lived assets. These assets were traditionally infrastructure assets such as toll roads and airports, but interest has grown into utilities, pipelines, cell phone towers, ports and terminals — and even railroads.
“Infrastructure funds really started 10 or 20 years ago, and the idea was more around supporting private-public partnerships. You think about investing in a hundred-year toll road concession or airport operating concession,” said Ben Marks, an M&A advisor for an investment bank. “But the reality is that there are very few of those [opportunities], and so these infrastructure funds have basically been forced to become more creative with respect to an infrastructure asset.”
Marks recalled one such example of creativity — when an investment fund in Canada acquired a school bus transportation business.
“I don’t think school bus operators would’ve been considered infrastructure-like, but they’ve got long-term contracts, for example. They’ve got a lot of hard assets,” Marks said. “And, by the way, in a downturn, kids are still going to school. I would say the recession susceptibility is pretty low.”
The value of short line railroads
Short line railroads are attractive assets for several reasons. For starters, they’re cost-competitive.
Short lines have “become very competitive, mainly because they’ve got very low cost of capital, especially relative to traditional private equity but even relative to some of the strategic consolidators,” Marks said.
Another reason the railroads might be an attractive investment is demand trends for rail service. There will always be customers whose needs the railroad meets, even if the railroad faces competition from trucks. Meanwhile, some railroads might be in locations where it’s harder for trucks to access or where labor markets are tight.
“I guess I would call it the monopolistic tendencies of [rail]. You’re dealing with a lot of customers who are captive to rail. This is the only railroad that’s serving their facility, and they’ve integrated them in a way [with their operations[,” Marks said.
While infrastructure investment firms have dominated much of the M&A news in 2019, there are other players out there, too. They include short line industry executives seeking to build their own platform and consolidators who engage in strategic buying with the idea of professionalizing a lot of these short line properties, which are family-owned.
Another reason why M&A activity for short lines is poised to continue is the opportunity it presents for sellers.
“It’s a good time to sell,” Kucera said. “In my experience, these assets are in high demand, with a lot of sophisticated, big, credit-worthy companies chasing [them]. And when you’re able to create a competitive dynamic, you’re able to realize nice returns or nice exit values for sellers.”
These sellers are usually short lines run by families or entrepreneurs, Marks said.
“There are several hundred of these shortline railroads. … Most of them won’t sell, but there are a few where they don’t have succession plans or the son or daughter wants to do something totally different than being a railroader,” Marks said.
Some sellers are industrial-related companies, such as a sand mining company, seeking to sell their transportation-related businesses. And then there are the Class I railroads seeking to divest of portions of their networks.
“There’s a tremendous amount of demand, and I think we’re going to see some decent supply as well from some properties,” Marks said.