Governments around the world are facing up to an unpalatable truth: that infrastructure is absolutely critical but extremely expensive. Organisation for Economic Co-operation and Development (OECD) countries are saddled with ageing and out-of-date infrastructure at the very time that public finances are becoming increasingly tight; and developing nations are discovering that infrastructure bottlenecks are the single biggest constraint on economic growth.
The amount of investment needed is mind boggling. In the US, the American Society of Civil Engineers forecasts that $1600bn needs to be invested in US infrastructure during the next five years. A report from investment bank and brokerage CLSA forecasts that China needs to spend $1200bn on infrastructure in the next five years. And the Indian government estimates that almost $500bn investment is needed by the end of 2012.
The demand for infrastructure is only going to expand in the decades ahead, driven by global economic growth, climate change, urbanisation, ageing populations and growing congestion. Worse still, most governments are facing a serious funding gap. A joint study by the Urban Land Institute and Ernst & Young estimated that the US will experience at least a $170bn shortfall in infrastructure spending; and CLSA estimates that government spending in China will only account for 62% of the country’s needs, leaving a hole of about $450bn.
Private sector role
To close this looming infrastructure gap, the private sector will have to play an increasingly important role. This fact is not lost on investment banks and private equity houses, and funds are sprouting up in growing numbers and in bigger sizes.
In May, Morgan Stanley closed its Morgan Stanley Infrastructure Partners Vehicle at $4bn, far exceeding its initial target of $2.5bn. Global Infrastructure Partners, an independent joint venture between Credit Suisse and General Electric, recently closed its worldwide infrastructure fund at $5.6bn, after an initial investment of $500 from each of the partners. Also in May, Citi announced that it had partnered with Vancouver Airport Authority, acquiring a 50% stake in YVR Airport Services, which operates 18 airports in seven countries. Separately, the banking group is also raising another $3bn infrastructure fund.
Standard Chartered is currently raising a pan-Asian fund in partnership with IL&FS, an Indian infrastructure player. Both partners are putting in $150m, and the first close is expected in mid-July at $500m. About $1bn is targeted by the year-end. Goldman Sachs Infrastructure Partners is raising a second fund, expected to close at $7.5bn, having fully committed its first $6.5bn fund, which was raised in 2006.
The giant private equity houses are also diversifying into this space. In May, KKR unveiled plans and said that it had hired George Bilicic, previously responsible for power, energy and infrastructure at Lazard, to lead an expected $10bn fundraising.
Investors clearly cannot wait to put their money to work in this space – infrastructure companies with defensive, cash-generative assets offering long-term value have remained attractive to investors in recent months, despite the credit crunch. Add this to the growing pressure on many government budgets, and the development of new projects by infrastructure specialists or the sale/ leasing of existing assets to funds is an obvious move.
Who is investing in what?
As a reflection of worldwide demand, many new funds are global or pan-regional in nature and – although there is some difference in focus – power, energy and transport rank high on the list of desirable assets.
The funds have different criteria for what makes an ideal investment. Matt Harris, a partner at Global Infrastructure Partners (GIP), which is targeting energy, transport, and waste and water management, says GIP prefers assets with “operational complexity” because they offer the greatest scope for adding value through operational enhancement.
In February, acquisition vehicle WasteAcquisitionco, comprising GIP, Montagu Private Equity and UCIL (a holding company of UK bank HBOS, which has a 14% stake in the bid company), acquired UK waste management company Biffa in a deal that values Biffa at about £1.2bn ($2.35bn).
“At one end of the scale, toll roads have little operational complexity; they are often drive-through, with an automated payment mechanism,” says Mr Harris. “At the other end of the scale, integrated waste management has quite a lot: the logistics associated with collection routes; pricing associated with landfills and collection; recycling; and a lot of industry dynamics around technology and the environment. This provides a lot of potential to add value through improving operational efficiency.”
Risk and return
At the SCI Asia Infrastructure Growth Fund that is currently being raised by Standard Chartered and India-based partner IL&FS Investment Managers, principal Andrew Yee says that the fund will concentrate on power, energy and transportation. He says that the greater risk inherent in Asian infrastructure, particularly new-build projects, than in developed country infrastructure is more than adequately compensated for by the fund’s attractive returns. “We are targeting 25% gross equity IRR [internal rate of return] rather than the 10% to 15% that you might expect from global or developed country infrastructure funds,” he says.
Although SCI’s fund has yet to reach final closing, it already has three seed assets, with a value of $200m, that the partners are warehousing until the fund’s first close: ITNL, the largest toll road operator in India; the Meiya Power Company (MPC), producing 4000 net megawatts in China, Korea and Taiwan; and a small stake in Malakoff, the largest power generator in Malaysia, producing 5000 net megawatts.
“We like ‘platform’ assets – existing companies with strong, multiple operating assets, long track records of investing in their sector and good management teams already in place,” says Mr Yee. “ITNL, for example, already runs thousands of kilometres of toll roads and is adding thousands more. MPC already has 17 operating power plants [15 in China, one in Korea and one in Taiwan] offering good diversification in terms of fuel types. Less than half our portfolio is coal fired; approximately one-third is hydro and one-quarter is gas.”
Brownfield versus greenfield
| Sadek Wahba, chief investment officer and global head of Morgan Stanley Infrastructure, says that in general, funds are more interested in existing assets rather than new build (greenfield) assets. “Greenfield projects have more inherent risk than existing assets, including construction risk and the difficulty of predicting future revenue growth,” he says.“For example, an existing toll road has a track record; you know the historic traffic flow. On a greenfield road, you have to forecast use and make assumptions about population growth and urban development, which is much more difficult to do,” says Mr Wahba. |
That said, Mr Wahba says that Morgan Stanley “has the ability to invest” in greenfield assets. “We have allocated a part of our fund to emerging market assets, and in emerging markets there is a need for basic infrastructure that does not exist already, such as roads, ports and rail networks.”
Mr Wahba declines to outline how much the fund would invest in greenfield or non-OECD assets, saying that there is no particular target.
Others like brownfield assets. “We’re comfortable with [the risks associated with] what we call brownfield assets. In other words, if we buy an operating asset, we might tack something onto it that represents a new development,” says Mr Harris of GIP.
Mr Yee says SCI aims to manage the risk-return profile of the overall portfolio: SCI will take on limited greenfield risk, but only with a local partner that has significant experience in the specific business area. “Our [portfolio companies] may be expanding existing plant or developing greenfield projects but they will always follow our business model: companies with strong existing cash flows that are run by experienced management teams. This approach ‘de-risks’ the portfolio. No more than 20% to 30% of our portfolio will be wholly greenfield,” he says.
Intense competition
| One thing that the recent inflow of money into the infrastructure space guarantees, however, is competition. John Schmidt, an attorney at US law firm Mayer-Brown, says that the US market is increasingly competitive and that many projects are being forced into a second round of bidding.That can be expensive. When the lease for the Pennsylvania Turnpike in the US went into the second round, for example, Citi and its partner Abertis had to bump up their offer by a substantial 21% to beat rivals. “There are only so many toll roads of this quality to go around,” says Mr Schmidt. |
A similar dynamic was evident in the Biffa acquisition. The final deal valued Biffa at 350 pence a share, equating to 23.5 times an average forecast for the company’s 2008 earnings per share. Although this may seem expensive, some analysts were suggesting that something closer to 400 pence a share was more realistic. A price hike looked possible at one point amid rumours that French water giant, Suez, and Guy Hands’ firm, Terra Firma, were carrying out last minute due diligence.
So, with competition fierce and many funds focused on the same sorts of targets in the same markets, are there enough existing infrastructure assets to go around? The problem is quite the opposite, says Mr Wahba: there is not enough money.
Not a bubble
“Is there some overheating and price increases because there’s too much money chasing a few opportunities? In some areas and some sectors, absolutely,” says Mr Wahba. “US toll roads are a case in point because there have been so few opportunities; it is a similar story in UK water assets because such good, fundamental assets are very popular. But overall, there isn’t enough money to meet the huge needs of global infrastructure.”
If nobody will call it an infrastructure bubble, some asset prices have certainly been over-exuberant. Shares of Reliance Power, which raised $3bn in India’s largest initial public offering (IPO) to date, dropped on their debut in February. Analysts attributed the stock’s performance to a too-high valuation before the company had commissioned a single power-generation project.
“Reliance is a good company but there was a lot of hype around the issue and the IPO was overvalued. And that is bad news for similar infrastructure deals,” says a local fund manager.
Mr Yee acknowledges that some assets have been overvalued but he argues that there are still good assets to be had if you stick to realistic assumptions. “We don’t look at stock markets as the basis for our calculations. We look at very long-term discounted cash flows based on conservative assumptions and value the asset on that basis. We are not prepared to run with the pack that is chasing assets for the sake of owning assets.”
Credit crunch effect
In any event, many asset prices have fallen to more realistic levels – the credit crunch and the fear of economic downturn have seen to that. But it is both good and bad news for infrastructure players. “Debt is more expensive and leverage levels are lower but valuations have come down a bit,” says Mr Harris.
Mr Yee agrees but believes that the good largely outweighs the bad. “Equity markets have fallen so there are less avenues for infrastructure funds to divest assets and realise profit,” he says. “On the flip side, it also means that local developers [builders or promoters that have the concession to develop a project] have to be more realistic. And if asset prices, particularly in India and China, have come off by 25% to 30% this year, then it means our returns over the longer term will be even higher.”
There is a positive correlation between economic growth and infrastructure asset performance. And the world’s economies are definitely not de-linked: if Walmart stopped buying Chinese products, factory production would slow down, less power would be needed, fewer logistics services would be used and fewer goods would be shipped through ports and airports.
But Mr Wahba says that infrastructure assets can still perform well through the cycle. “You have to maintain a disciplined approach to investment,” he says.
“For example, our investment in the Port of Montreal has performed above expectations. It has a good mix of imports and exports. So if imports are down because they are more expensive because of the dollar devaluation, then exports have risen. Net-net, our volumes are up.”
Politically sensitive
Good cash flows and strong, reliable returns are clearly an attraction to new, as well as existing, infrastructure investors but this asset is not without risk. If the risks of emerging markets are often highlighted – BP’s current plight in Russia is a case in point – the privatisation or private development of public assets and services is often a very touchy subject in developed economies, too, particularly where local and national politics can rub up against each other. The protection of territory can sometimes outweigh the economic logic behind private infrastructure investment.
“The flood of new investors may see infrastructure as an ‘easy’ asset class, but this is a naïve view,” says the manager of one US infrastructure fund. “Infrastructure assets can be very politically sensitive – whether this concerns the tolls levied and profits made by private operators, service provision in schools or nursing homes, or the operation of public airports and ports in a terrorism-sensitive environment. [Such assets] have to be managed in the public eye and under close scrutiny by governments and regulators. They are acutely sensitive to public feeling. This is not always a straightforward asset class.”
In the US, the leasing of Chicago Skyway to Australia’s Macquarie Infrastructure Group and Spain’s Cintra for $1.83bn in 2005 was seen as a landmark transaction that would set the precedent for subsequent transactions. When the same duo secured the neighbouring Indiana toll road concession for $3.8bn the following year, the case seemed to have been made.
Private versus public
But the fight for private over public is not yet over. In mid-2007, Texas governor Rick Perry was forced into a public climbdown when he signed a new transportation law giving local authorities more control over local road projects in response to public fears about runaway toll roads.
A similar high-level tussle is now occurring over the Pennsylvania Turnpike concession. On May 19, the $12.8bn bid by partners Citi and international toll operator Abertis won the concession (subject to approval by the legislature) on a 75-year lease of the Pennsylvania Turnpike. Yet, despite crippling debt levels and crumbling roads, the current operator, state-backed Pennsylvania Turnpike Commission (PTC), is resisting the state governor’s privatisation plans.
On the day that the winning bid was announced, PTC CEO Joe Brimmeier issued a press release arguing that Act 44 – which was passed last year and authorised a 50-year partnership between the PTC and the Pennsylvania Department of Transportation (PennDOT) – had already begun to address the state’s transportation-funding crisis. In his statement, Mr Brimmeier played on familiar public fears, saying: “Under Act 44, the turnpike will supply PennDOT almost $84bn over 50 years without raising taxes or outsourcing a critical asset.”
However, Mayer Brown’s Mr Schmidt, who served as legal counsel to the State of Pennsylvania in the toll road deal, believes that such actions are little more than delaying tactics. “The economic logic to privatise some assets and use that capital for other purposes, particularly at a time of economic downturn, is too strong for government to resist,” he says.
His instincts may be right. On May 28, US secretary of transportation Mary Peters expressed strong support for the transaction. Not least, she said, because just that one toll road deal represented more than one-quarter of the federal government’s annual budget for highway construction.
“Such numbers make this [privatisation] process unstoppable,” Mr Schmidt adds.
When asked for an interview about its infrastructure fund, Citi said it was unavailable for comment.
No market is entirely immune from the forces prevailing in others, and the infrastructure sector is no exception. But its unique characteristics make it a little more resilient than others. For one thing, economic slowdown robs government coffers of much-needed tax revenue and helps to put more assets into play. Equally, many infrastructure assets are beloved by investors precisely because of their long-term predictability – whatever the weather.
“Infrastructure assets are not immune to economic ups and downs; but because they tend to be providing basic goods and services that even in a downturn or recession are used by a consumer, they are generally more recession resistant,” says Mr Harris.
And until that rule is rewritten, big money will continue to flow towards infrastructure funds.
