Infrastructure debate: The business of building
Infrastructure investment is not without risk. Even the US has found this; the collapse of a bridge in Minneapolis in August led to the realization that much of the country’s ageing infrastructure needs refurbishment. But flows of new money bring their own problems. Investment skills and experience remain the pre-eminent qualities required to succeed.
• The UK and Europe remain the lead markets for infrastructure investment.
MW, JPMorgan Where are the greatest opportunities in infrastructure – equity investment and debt finance?
The same can be said for Brazil, which has huge potential. Brazil is working on a road programme that is very attractive, but again not all international banks are happy to take the risk. Chile is a very mature market. Other countries in Latin America are less attractive. There are a couple of deals in eastern Europe that are interesting because of their size – transactions of €500 million or even €1 billion. We are looking seriously at Hungary, Poland, the Czech Republic and Slovakia. In western Europe, the UK continues to be the number one spot for project finance business. Spain and Portugal are also powerful markets. If you add the infrastructure financing volume of the UK and Spain, it’s about the same size as the US. But there will be a big push in US infrastructure in 2008/09. Up to now there have been only a few infrastructure transactions in the US, such as the Indiana toll road, Chicago Skyway and the Pocahontas Parkway. There will be a couple of concession tenders next year, probably in Florida and Pennsylvania. Finally, in the Middle East region, it’s rather more an energy/utilities market than an infrastructure one. There are only a limited number of transport projects in the region, but with large financing volumes. The margins are tight, but there are and will be lots of opportunities.
LN, Watson Wyatt Our investors hire managers to help them make those decisions. If there is an allocation to the higher-risk, higher-return markets that is still safe enough from the regulatory perspective, it may be attractive. But so far most of the allocations have been to Europe and the US.
MW, JPMorgan We’ve acknowledged that some investors want infrastructure for portfolio diversification and predictable cash yields, while others are looking for enhanced returns and growth. There appears to be an increase in risk appetite, but you need enough equity and enough debt. Is SocGen providing debt in Asia for example?
MV, Société Générale China, on the infrastructure side, is mostly asset-based. We wrote about $500 million with Chinese Airlines this year, and we expect similar growth next year. A lot of those are tax-driven and the Chinese banks’ liquidity is incredible. The demand is huge, and there is a similar story on the shipping side. In India, the regulatory environment is almost set against international banks coming in, either in terms of setting your local regulatory capital base or your ability to lend in local currency. That is a big issue for India, and people are lobbying hard.
MW, JPMorgan Our clients are looking for low volatility and steady predictable returns. They may have a place in their portfolio, which is more like private equity, that’s prepared to take on the growth profile, the variability of margins and so on. As investors gain more experience with infrastructure, over time they find room for additional risk. There’s a great appetite for China, India and those countries in between.
The investors interested in Asia seem to be different from those interested in the OECD countries. The economies and stock markets have done well in China and India, so there’s a lot of local wealth, some of which is looking to invest in infrastructure there. Petrodollar investors also seem to have a greater interest in the growth profile and risk profile than India, China and others seem to offer.
DG, ABP A huge amount of dollars needs to be spent but there’s a challenge. Texas roads were going forward and then they were stopped for two years. The New Jersey Turnpike? The governor says it’ll never be sold. Will New York City ever privatize their bridges? They may, but when? That’s the challenge. However many billions have been raised for infrastructure, if the credit crunch is a bit slow, if governments are slow in adopting these rules, if 2008/09 becomes 2010/11, as we get closer to these funds’ maturity deadlines, there may be style drift. As funds take on more risk that definition of infrastructure becomes even broader.
CB, Alinda There are 50 states in the US, which for an infrastructure investor is like dealing with 50 countries. Within each state there’s more than one level of government, and some assets are available at the local level, which further complicates the process for the investor. There is also a lot of infrastructure not owned by government but already in private sector hands, and a lot of privately owned infrastructure is changing hands. Electricity utilities, gas distribution and electricity transmission are nearly all in private sector hands. If you focus on the headlining marquee transactions, you may think there’s been a lot of promise and it hasn’t been delivered. However, if you include private sellers as well as public sellers, we’ve found no shortage of infrastructure transactions in the US.
DG, ABP I’m surprised that, in transactions since the credit crunch, there are lenders offering full underwriting, and banks with aggressive pricing stepping up for these transactions. The headlines imply that it’s all closed. The project financing market for asset-based deals still appears to be wide open, with a number of lenders, particularly foreign banks, that are aggressively pursuing financing opportunities.
MW, JPMorgan Exit strategy is relevant for even OECD countries, because most strategies involve closed-end funds. But it’s particularly germane to the non-OECD world.
CH, 3i Having had a large private equity business in Asia for some time we’ve become comfortable with how to develop deal structures that allow you to invest in the right structure and then repatriate your capital. It’s not usually simple, but it is possible. Also governments in some countries are being very constructive about helping external investors: for example, the Indian government. They want to attract private sector capital to fund infrastructure.
MW, JPMorgan Do equity returns available in developing markets match the expected return profile, given the additional risk? You have to take a view on the currency, on political risk, and you have to be more creative on exits.
PL, Depfa Are those returns available only to those who have the early-mover advantage? Before a market has developed and the government decides how it wants to engage in privatization, it is a higher risk, so perhaps deserving of those returns. Do you see the maturing of the market and more competition driving down yields?
MV, Société Générale In the UK or western Europe and increasingly in EU accession countries, you’re seeing return erosion as pathfinder deals are put together, placed and seem to be successful, and then become commoditized. The US needs to develop a regulatory and contractual framework that will make the rules easier. In Asia we’re always looking for the economic and transportation flows. You’re trying to lock into that. In Brazil, the more attractive opportunities may be with corporations such as CVRD and Petrobras, that have pierced the sovereign ceiling in terms of rating. Their flows are more interesting than trying to finance a public sector development project where you’re not sure that the underlying infrastructure is going to be filled in behind it.
PL, Depfa But they are different types of deals: airports play on economic cycles, as opposed to public, social infrastructure projects. There’s obviously an opportunity, but with higher risk because it is more cyclical.
MW, JPMorgan Whether it’s regulated or not is one factor, but who’s regulating it – which state, province, country? How about on the credit side? Which countries and which states or provinces would you be prepared to finance, given that there are different regulatory regimes, levels of transparency, of predictability?
DMH, Caja Madrid The margins we apply to a classic UK PFI structure are much lower than if we take traffic risk. What’s more, the US has a premium on margins compared with the same asset class in Europe. When it comes to syndication of large amounts, not many banks are prepared to take these risks in the US, because they are not familiar with these kind of assets. Among the latest transactions, there’s not one American bank financing this infrastructure type of business. So of course there’s a premium when it comes to underwriting large amounts. The Spanish central bank, for example, has classified country risks by categories. This determines if a Spanish bank has to provision its lending activities in specific countries. So whether or not you have to provision in a country is beyond our control. It depends on the asset class and on the country.
MV, Société Générale But the returns are lower than in the US. Apart from Macquarie, it’s mostly European sponsors. On Sea-to-Sky, on Richmond-Vancouver Airport and the A25 toll road in Montreal, the returns are at similar levels to Europe. Over time, as in Europe, people get their minds around the better management of risk in the private sector. If there’s equity at risk, there will be a focus on performance and delivery on time and on budget. Canada has got its act together with the equivalent of Partnerships UK.
DG, ABP So Europe has the lowest returns, Canada’s next and then the US is higher and the emerging market will be the highest?
DMH, Caja Madrid The return on equity for roads is below two digits in Spain. Spain’s concession law comes from 1972, compared with the US, which has only been discussing public-private partnership structures for three or four years. In Spain there’s an implicit guarantee from the public authority, if the concession goes bankrupt. So that is attractive and is the reason why pricings in Spain are probably among the most aggressive in Europe.
MW, JPMorgan That’s Spanish government bonds plus a spread?
The US has probably 50 different legal frameworks; some of them are doing well, like Florida or Texas, but there are a couple of PPP mechanisms that are successful in Portugal and Spain, and we don’t understand why they have not been transferred to the US. Raising real tolls that affect the end consumer is a political issue. The US has a unique opportunity of transferring successful European PPP structures. We have been looking at brownfield projects in the US, but there will be some greenfields with construction risk and environmental issues. In the US the expropriation risk is allocated to the concessionaire, which makes it difficult to finance. Even in eastern Europe the public authority takes the expropriation risk.
MW, JPMorgan The US only started looking at the toll road and airport sectors three or four years ago, so it’s not surprising that they might be a few years behind. The US has 50 states but the European Union has 25, so we could ask why Spain’s concession experience hasn’t moved to other EU countries. The politics takes time, but it is happening. They are talking about availability-based tolling in certain states in the US and it will vary from state to state. Do equity investors differentiate between Europe and North America? Do they differentiate across countries or regions?
LN, Watson Wyatt It lowers risk to diversify across countries and is a natural thing to do. For non-US investors in US infrastructure, there are tax implications that may make it slightly less attractive. Australia and the UK are the most mature markets, whereas continental Europe and the US look more fragmented and theoretically offer better opportunities. Clients look to construct portfolios that provide them with balanced exposure to different geographies. What worries us, however, is the amount of money that has been recently raised in all of these geographies. We believe in the long-term case for infrastructure. All the necessary prerequisites for further development of this asset class are in place while the number of funds in our database has increased dramatically over a very short period of time. So much money has been raised recently and such a big share of this capital is in first-time funds that we wonder if there is enough high-quality managers to transfer clients’ money into investment opportunities.
PL, Depfa Another example: the Middle East and Saudi Arabia have so many petrodollars. So the funding for new infrastructure is not a problem, yet they have interrupted power and water supplies in Jeddah and Riyadh. Why? Because the public sector doesn’t have sufficient capacity to build and implement new structures quickly. That’s why there’s a big opportunity for the international practitioners, together with project sponsors and operators, to make a difference, get involved and help government in these countries to develop new infrastructure.
MW, JPMorgan What about volatility in the credit markets and equity markets and the impact on infrastructure investing?
MW, JPMorgan What are you seeing in terms of spreads, rates, tightening of covenants?
DMH, Caja Madrid Even if not involved directly in the sub-prime crisis, every bank is suffering from the inter-banking market not working properly. It’s difficult or very expensive to get money on more than a three-month or six-month basis.
CH, 3i Spreads are widening, but treasury bills and Libor, eventually hopefully, are coming down to compensate. The interesting part from an equity perspective is the crossover between what was debt now being priced as equity. There is a part of the risk spectrum where banks find lending extremely unattractive, the quasi-mezz pieces, and they are being priced in a lot of the banking offers ahead of the pricing the equity fund’s prepared to put on it. That funding gap is playing through on how people price assets. Funds are divided as to whether they take that sub-debt on their own books.
CB, Alinda There are several lessons to be learned from the Minneapolis bridge collapse. The first is that infrastructure investing is not without risk. Things can go horribly wrong. There’s a need for due diligence, particularly engineering due diligence, in the acquisition stage, and a need for attention to maintenance as the owner-operator. But on the positive side the Minneapolis bridge collapse emphasized to the US public that there is a lot of US infrastructure in need of refurbishment. It is now known that there are 73,000 bridges that have been declared structurally deficient – there is great deal of money needed to fix them. There’s an issue as to where the money is going to come from. With continuing pressures on government budgets, the money is not going to come entirely from governments. Private sector capital will also be needed. As a result of Minneapolis, politically the pendulum is swinging in favour of private capital.
MW, JPMorgan How do lenders look at the opportunity as well as the risks involved in America’s ageing infrastructure?
PL, Depfa Banks will always want independent due diligence, but whatever comfort the reports give us, we know that the outcome will always be different. We’re looking to reserve enough cashflow in the project to cover the likely unforeseen maintenance. Flexibility in structuring is important to enable the project to be self-financing and to deal with those problems, and perhaps accelerated capex if something unexpected turns out. From an equity perspective, it’s inefficient to tie up additional cash, but that can be dealt with through LCs and contingent support. I’d like to see more of a true partnership approach between the public and private sectors develop as a mechanism for sharing future risks. For example, in return for limiting the risk for the private sector partner, eg, by putting a floor on the IRR, perhaps there should be a graduated sharing of revenues above a certain base level with the public sector grantor. To encourage the private sector to take on assets with latent defects there has to be a flexible way of getting a sustainable long-term partnership in this type of structure. I question whether spending a huge amount of money on due diligence is money well spent if the public sector can mitigate those uncertainties. The collapse will force people to be more creative.
MV, Société Générale From a lending point of view you look at the quality of the sponsor and the underlying contractor. You look at superstructures, bridges and tunnels far more conservatively in terms of pricing and maintenance reserving than if you were laying blacktop, widening, or upgrading. Equally, you’ll be more conservative with bore tunnels than with a submerged tunnel because of the underlying geology. Even though you do the geological surveys, when you start working you have cost creep.
DMH, Caja Madrid Over the last year, since the PF market has become more aggressive, it’s the sponsors that have done due-diligence reports and the banks have not been involved. This will change and when it comes to transactions such as tunnel links or bridges, we will also ask for tighter turnkey contracts with acceptable liquidated damages and higher liability caps. The contractual side is important in those transactions, as is the name of the sponsor.
CH, 3i It throws up issues around reputational risk. You’re taking on risks in an infrastructure investment that you’re not taking on in a lot of private-equity investment. You’re dealing with assets that are capital-intensive, where, if there’s a failure, lives are at stake or there’s material disruption with political fallout. Everybody can think of an example of infrastructure failure that has reflected badly on equity sponsors. As an equity investor it’s about making sure that you’re working with the right partners in the construction phase, that you understand and manage the risks and that you’re seen to be a responsible investor.
MW, JPMorgan Is there too much money chasing too few deals?
LN, Watson Wyatt We believe that there is a significant growth potential for private investments in infrastructure assets. We also see a lot of interest from institutional capital to invest in this asset class. What we have serious concerns about is the lack of experience and skill of the numerous players that are entering this market in an attempt to leverage this recent spike in investor interest.
There are a few other concerns with this asset class that make it look even more risky in investors’ eyes. As in every emerging asset class, the fund structures are evolving. Our clients want to hold these assets for a long time, hence open-ended vehicles are interesting. But the majority of funds are closed-ended as this allows managers to participate in profits after exit. Managers are becoming more innovative in developing investor-friendly fund structures. We see a lot of different types of offerings. However, it is an emerging asset class and only time will tell what is most attractive for investors.
Another big problem with infrastructure funds is that they have taken their fee structure from the private-equity market, where fees are higher; if you are prepared to pay these fees then you are assuming you are paying for shareholder activism and for high alpha generated by managers. But is this applicable in infrastructure, where many managers buy mature assets with stable cashflows that generate current yield but do not lend themselves easily to significant growth and operational improvements? Will infrastructure managers be able to deliver the returns they promised their investors after fees? It makes us more nervous the more we think about it.
In summary, we believe that there is long-term growth potential in infrastructure as an asset class, but there are some signs that the current market is getting overheated by newcomers and first-time funds. It is crucially important for investors to ensure that they partner with managers that have both skill and experience to ensure that they achieve the expected results.
DG, ABP The number of managers in infrastructure has exploded in the last two years. You have got to get the management team right. If you picked a poor manager and he picked a good asset, you’d get an average return. If you picked a good manager and an average asset, you would get an above-average return. However, in the past two-year period, every fund has increased, typically by double. You have more managers with twice as much money. So you look at their track records. How long did it take the previous fund to invest its assets? Maybe three years. You typically have an investment period of five years in these funds. Let’s say we’re 18 months into it. You have the credit crunch. Things slow down. There are still a lot of assets out there, and the managers are not getting the funds invested. You get further into the investment period. Returns go down because there is more and higher bidding for assets, by more managers with more money, which results in the returns being lowered. How low do the returns go? That’s the risk and challenge that concerns us.
MW, JPMorgan Do lenders have similar concerns about the quality of the teams and their deals?
PL, Depfa It depends on the asset you’re purchasing. An operational company with embedded management and a good operating track record is one thing. If it’s a greenfield project or where there’s a requirement upon the fund manager to manage the asset himself, then we would have a different view. Many people have been attracted to raise funds who don’t have great track records, and we are therefore selective in who we support.
DMH, Caja Madrid There are too many players now. For example, with the Pennsylvania deal there are 14 or 15 groups teaming up. Almost every banker is building up their own infrastructure fund, you have to deal with a lot of sponsors, and the chances of winning a competitive tender are getting lower. We don’t like it and we are careful in choosing our partners.
MV, Société Générale There are some new guys who have not built up their teams and don’t have enough experience, track record or knowledge. One of the attractions of infrastructure is that the operational gearing and cost base is relatively low. My concern is that a lot of the value enhancements that come from management and have been achieved to date have come through financial engineering. That’s been in soft credit markets and we’ve all benefited from that, both on the equity and the debt sides. To truly get value and management return for paying fees, it’s a bump-and-grind business in terms of managing the underlying cost base and improving overall financial returns, and that will stretch out. When you build up your asset base, you quickly need asset managers in addition to your bid teams and decision-makers to put the assets on at the front end. There is a shortage of those asset managers in the infrastructure sector.
PL, Depfa The typical private equity model is not really appropriate for infrastructure assets. There’s a big turn-off for the public sector when looking at whether they can monetize or partially privatize the capital tied up in public infrastructure assets. They fear the political ramifications of disgruntled consumers and voters having to suddenly pay higher water charges or tolls because a very active and aggressive asset manager is trying to boost his equity return. That is holding up market development in some jurisdictions, where perhaps a more sympathetic longer-term, less aggressive approach is needed from the private sector.
CH, 3i The infrastructure market has developed more rapidly than private equity, so people have cottoned on to the new asset class and have been determined to put money to work. As a result you have a benign fund-raising environment from an equity perspective. A lot of funds that would have had no chance of raising a fund in the more competitive private equity market have suddenly found themselves fully funded almost against expectations. How does that change our business as an equity investor? In the short term there are a lot of people with money to spend who aren’t wise enough to spend it at the right cost of capital. We’re trying to use the skills that will make us strong long-term investors, around asset management, around deal assessment, around manufacturing deals too, and trying to get to deals that aren’t part of an auction process. It’s not just a charge to the line on a cost-of-capital basis. We have a long-term horizon and will spend our money when we think we can get the returns we want. So much money has been committed to funds with a structure unsuitable for the long-term nature of the infrastructure asset classes. The next evolution will be more sensible structures with more sensible fee structures. You can’t charge two and 20 when you’re making people 12% or 15%. We need more long-term structures, so that investors, if they choose, can hold on to asset pools that provide them with what they want. There should be more incentives to deliver on yield as well as on capital growth. Funds are not incentivized to deliver yields in the same way that they are to deliver total IRR. In five or 10 years there will be a smaller population of successful funds, as in private equity. The shake-out will be radical; success will be based around the quality of origination, how deals were transacted, how risk was assessed and priced, the breadth of the portfolios put together and the strength of the asset management capability that was built. Investors will realize that buying complex infrastructure assets is not as risk-free as they had believed.
DG, ABP Investors would be open to a structure that paid lower fees upfront and paid more to the manager based upon the return, but I haven’t found managers willing to accept that structure. If managers hold to their standards, evaluate the risk and when they’re not getting the return they do not purchase the asset, then they will be rewarded in the future for not spending all the money in the fund. If they return some of that money to the investors, the second fund they go out with, they’re going to get that money back from the same investors. They would win a gold star for having invested only in assets that had a good return, rather than going into auctions or over-bidding. Managers tell us that they will invest the money in five years. The fear is that if they get towards the end of the investment period and they haven’t managed it, returns will start to slip. I rarely hear about negotiated transactions where there are not several people who show up for a sizeable acquisition. I do not know how you spend $30 billion or $40 billion on small, negotiated transactions.
CH, 3i I don’t think $30 or $40 billion will get spent, but certain funds will prove they have the quality of management team to spend money off market in less competitive environments. That’s how private equity has gone. The firms that built successful franchises are those skilled in sourcing deals.
DG, ABP There are many infrastructure funds with qualified, experienced managers. Their average age is probably higher than in many private equity funds. But I have concerns about the rush to invest in renewables. They’re green, they’re socially responsible, but where are the experienced people who have developed and operated renewable projects long-term? Most of the investments are small, but there seems to be a lot more money going into these assets than there is seasoned expertise available. A lot of people with considerable experience in financing large-scale infrastructure projects are chasing these investments, but I doubt if those management teams have been operating facilities in renewables.
MW, JPMorgan Well thank you all very much for sharing your views on a wide variety of important topics as they relate to infrastructure investment and finance. I look forward to meeting up in 12 to 18 months to see how things unfold in 2008 relative to our prognostications.