Much has changed since the G20 and multilateral development banks (MDBs) decided to bring institutional investors, such as pension funds and insurance firms, into the financing of emerging market infrastructure a few years ago, with the long-term goal of establishing an emerging market asset class.
MDBs, which provide only a small part (less than 10%) of total emerging market infrastructure spend today, are radically changing themselves. At April’s Global Infrastructure Forum 2017 in Washington, DC, MDBs formally agreed that expanding private investment – which they have sought for some time – is more important than just extending loans to governments.
New incentives
Leading the initiative, the World Bank Group, the world’s largest MDB, is adopting a new internal incentive structure. Called the ‘Cascade’ approach, this rewards managers for how much private investment they catalyse, not how much money they move.
It also requires managers to prove they have exhausted all options of engaging the private sector before turning to the very last resort of public funding/public works. World Bank Group officials say the approach is currently focused on infrastructure but it will be expanded to the whole of the institution’s businesses in finance, education, health and agriculture.
The commitment to crowd-in institutional investment in emerging market infrastructure has also resulted in an unprecedented consensus among MDBs that they need to work on all aspects of infrastructure development, upstream and downstream, and in several countries simultaneously, so that over time, and cumulatively, the endeavour will succeed.
Additionally, MDBs now agree that besides being consistent in, for instance, the policy advice and institutional reforms they recommend to governments to create investment-friendly frameworks and enabling environments, they must also be coherent and systematic in how they evaluate and address the risks for private investors in developing countries and in public-private partnership (PPP) projects. They agree they must be consistent in the way they interact with the private sector.
It is a far cry from a few years ago, when traditional MDBs were rivals, competing over the most promising emerging market infrastructure deals. “G20 finance ministers and central bank governors want us to work more as an MDB system, than as separate, individual organisations,” World Bank Group president Jim Yong Kim said at the Washington, DC forum.
Greater standardisation urged
Another important takeaway from the forum, advocated by Jordan Schwartz, director of the World Bank Group’s overall infrastructure policy, is that there needs to be much more standardisation of legal and regulatory frameworks, contractual terms, structures and PPP processes.
This extends to the instruments used to finance projects, including the plethora of risk mitigation products and guarantees MDBs deploy to bring institutional investors into emerging market infrastructure. More standardisation is needed for there to be any chance of establishing the kind of information symmetry required for a tradeable and well-defined asset class.
Forum participants also emphasised the urgency of the task. Amar Bhattacharya, a senior fellow at the Brookings Institution and a forum adviser, said: “We are probably at an inflexion point where both the public and private sectors are now taking the matter seriously.”
One reason for the urgency is the opportunity factor of attracting institutional investors which, according to the Organisation for Economic Co-operation and Development, have roughly $75,000bn under management. Analysis suggests many pension funds need new sources of investment returns for their long-term liabilities in the continuing low-interest rate environment in G7 countries, and are searching for yield.
Rashad Kaldany, executive vice-president at Caisse de dépôt et placement du Québec (CDPQ), one of Canada’s biggest pension funds, says that, although US interest rates are now slowly rising, it is going to take a long time before sovereign bonds in G7 countries reach the 4% to 5% rate that is near the returns that pension funds seek for their members. “There will be a continuing need for other types of instruments for these institutional investors,” he says.
Mr Kaldany adds: “We are now considering projects both in emerging markets and with a little bit of what we call 'economic risk', possibly even some greenfield risks [during the initial, construction phase of a project].” CDPQ, however, is exceptional among pension funds in having its own in-house infrastructure due diligence capabilities, a dedicated infrastructure portfolio and experience investing directly in major projects for more than 15 years, including the UK's Heathrow Airport and the Eurostar railway service.
Viktor Kats, co-head of an infrastructure fund that is part of the International Finance Corporation’s (IFC) Asset Management Company (AMC), says a first step when persuading institutional investors generally to put their money into emerging markets and in infrastructure “is bridging the gap in their understanding” between the real risks of such an investment and the higher risks often perceived by investors.
Mr Kats says this is the aim of the IFC’s first initiative in the area, AMC, which manages third-party institutional capital across several funds. It allows institutional investors to learn about the risks of various projects and do transactions jointly with the IFC in markets where they have no prior experience. Since AMC’s inception in 2009, $9.8bn has been raised from 53 international institutional investors.
The climate change effect
The other reason for the urgency of bringing in institutional investors in emerging market infrastructure development is that the gap in financing basic services – such as water, sanitation, energy and public transport in developing countries – is already about $3500bn annually (according to World Bank estimates) and is increasing due to rapid urbanisation and the challenges of climate change.
Indeed, according to the World Bank, developing countries require $2500bn more a year for infrastructure investment if they are to meet the 2030 UN Sustainable Development Goals and develop the infrastructure needed to mitigate and adapt to climate change under the COP21 Paris Agreement. They currently receive roughly $1500bn in infrastructure investment, about 70% of which is provided by developing countries themselves with around only 20% by the private sector.
Filling such a huge financing gap has recently become even more uncertain following US president Donald Trump’s decision to pull out of the Paris climate accord. The US government had already halted a yearly $3bn commitment in aid to the UN Green Climate Fund, which was part of an annual $100bn pledged by wealthy countries to their poorer counterparts under the agreement.
The goal is to help these countries to shift their economic development to renewable energy before they become dependent on fossil fuels, and to build infrastructure that can resist the conditions associated with climate change, such as increased flooding and more powerful storms.
Launch of a new fund
Mr Trump's announcement came too late for the IFC’s recent launch of a $2bn Green Cornerstone Bond fund, the largest of its kind dedicated to emerging markets. The IFC is investing $325m in the fund while Amundi, its partner and Europe’s largest listed asset manager, is expected to raise the rest from institutional investors over seven years.
Jean-Marie Masse, a senior IFC investment officer and one of the fund’s general managers, says the initiative will have several positive effects. For instance, institutional investors will be able to obtain higher yields than if they bought green bonds in their own advanced economies. To provide further comfort, the IFC has agreed to provide first-loss protection that will automatically raise the credit rating of the bonds’ senior tranche to the AA or AAA level that institutional investors typically require in green bond markets.
Making the bonds green will also help emerging markets face the challenge of adapting to, and mitigating, climate change by developing infrastructure in three areas: renewable energy, energy efficiency and public transport.
But most importantly, Mr Masse says, the IFC’s role will be in “disseminating, maintaining and training banks in emerging markets about the standards of green bond issuance”. This will be possible, he says, because as the fund is the buyer of the bonds from local emerging market banks, it has the leverage to insist that the banks establish the same conditions as when the IFC issues its own green bonds.
This means they must be subject to an external review to certify that the underlying infrastructure assets are indeed environmentally friendly, and the issuer must provide an annual impact report on the project’s progress. “We feel there is potential to develop the market in 21 developing countries,” says Mr Masse.
Turkey’s precedent
For large-scale and complex infrastructure in emerging markets, a different risk mitigation scheme, implemented for the first time in Turkey in December, also has potential. The novelty of this scheme is that it combines political risk insurance from MIGA (the World Bank’s insurance arm) – which covers expropriation, breach of contract, transfer restriction and inconvertibility – with two European Bank for Reconstruction and Development liquidity-support facilities.
The first can be called when there are cost overruns or delays during the initial construction or greenfield stage of the project. The second comes into play on the first day of a delay, or halt, in the revenue payments of the project when it is operational, or at a brownfield stage, to ensure that bondholders' investments continue to be serviced even if the underlying project is terminated and/or the Turkish authorities have stopped making payments.
This comprehensive derisking helped overcome investor concerns about buying long-term bonds to finance a project to build and manage a hospital in Elazig, in eastern Anatolia, a region with limited access to quality healthcare. The project is part of the Turkish Ministry of Health’s ambitious €15bn PPP programme to build 30 hospitals around the country.
As a result, a sub-investment grade project bond issued by the project developers – a consortium led by global asset manager Meridiam – obtained a coveted ratings bump to Baa2 (investment grade level), which is two notches above Moody’s current sovereign rating for Turkey. This satisfied risk-averse institutional investors that are restricted to investing only in highly rated bonds.
Further comfort is provided to the international investors by having the €288m in bonds issued by an offshore special purpose vehicle and Turkish authorities’ agreement to assume the risks of converting the project’s Turkish lira-denominated operational payments into euros.
On demo mode
The Elazig hospital is considered a demonstration project. “The intention is to try and replicate this type of scheme so that institutional investors have sufficient risk mitigation to consider long-term investments outside their typical markets,” says Nkemjika Onwuamaegbu, MIGA’s lead underwriter on the project.
MIGA communications director Vamsee Krishna Kanchi says the idea is for the scheme to apply across multiple sectors and multiple regions. But some observers are asking if the scheme is too complex for emerging market financial institutions to structure it on their own. A prime consideration of the Asian Development Bank’s (ADB’s) new Credit Enhancement of Project Bonds Facility, by contrast, is that there is local participation in the due diligence and that local financial institutions can reproduce risk mitigation products.
For instance, the ADB has partnered with government-owned financial institution India Infrastructure Finance Company (IIFC), which, besides providing loans, also wanted to develop a local guarantee product to improve the new facility's bonds credit rating, and establish an alternative source of funding for infrastructure development.
The upshot is that the ADB, together with IIFC and local credit rating companies, crafted a novel, first-loss partial credit guarantee for two Indian energy projects, one a wind power project and the other a solar power plant, both at a brownfield stage that needed refinancing.
The credit enhancement raised the project bonds’ local credit rating from BBB to AA, which is the minimum required by Indian pension funds and insurance companies. The bonds were also issued in Indian rupees. “From a developmental perspective, our intention was to do a couple of deals with IIFC so that IIFC will be able to continue doing this on its own, as the market gets used to the product. We wanted this to be a sustainable event,” says Bart Raemaekers, head of guarantees and syndications in the ADB’s private sector operations.
Notwithstanding this, Mr Raemaekers thinks the market-based pricing (or fees) for risk mitigation guarantees that MDBs are obliged to charge, combined with the market-based reward (or yield) investors expect for buying the bonds, can sometimes be higher for a project developer than the bank loan alternative, which in India at least is readily available. “It’s a fundamental point,” he says.
Hung Tran, executive director at the Institute of International Finance, also says the costs and complexities of some of these credit enhancement schemes can be challenging.
What’s the solution?
Mr Kaldany believes the financial industry and other private sector players need to develop these instruments; it should not just be left to the public sector to play that role, he says. It is also widely expected that once emerging market infrastructure bond financing becomes mainstream, the costs of the guarantees and the yields on the bonds themselves will most likely fall.
Summing up the progress establishing an emerging market asset class so far, Mr Schwartz says: “The efforts we are making now will pay off over the next several years. But there is not going to be a hockey stick that turns around the levels of investment overnight. It’s a long, hard slog, upstream to downstream.”
