Infrastructure projects pull in new investors

Once Ernst & Young’s head of project finance, James Neal is now the firm’s head of infrastructure advisory, yet his job has not really changed. What has been changing rapidly are the structures and the players with which he deals. If ‘project finance’ was once a specialised and rather unfashionable activity, ‘investing in infrastructure’ is all the rage. And although in the past new investors concentrated on mature assets, their sights are now turning to greenfield projects.

Long-term bet

Investor interest in infrastructure has intensified dramatically as the taste for alternative assets catches on. For investors – and long-term investors in particular – infrastructure assets offer sustained, stable returns over long periods with relatively low risk. Banks and money managers have clambered aboard with new investment vehicles, and the prices of assets are being bid up to bubble proportions.

Though the definition of what constitutes ‘infrastructure’ assets continues to expand, at their core they remain the same as those that attract traditional project finance: transport and utility developments, with elements of telecoms and energy. Historically funded largely by the public sector, their financing has been transformed internationally by privatisation and public-private partnerships (PPP), and in the UK, by the private finance initiative (PFI).

PPP structures have been applied to toll bridges and roads, railways, schools, hospitals, water and waste, government offices and even defence. And they have been the gateway to infrastructure for an ever-widening pool of new investors.

“The banks have been there for years, with a recurring appetite to fund infrastructure, energy and telecoms projects,” observes Emmanuel Rogy, head of project finance Europe, Middle East and Africa (EMEA) at BNP Paribas. “The new animals are equity-type investors. They have increased liquidity and are looking for returns so there is a demand for assets. At the same time, while there is a demand for public sector investment, governments can’t cope with the size of the investments required.”

Beyond a specialist circle of sponsors and contractors, a handful of sharp-eyed money managers spotted the possibilities in the 1990s. They included, famously, Macquarie Bank, the one-time Australian arm of merchant bankers Hill Samuel, whose 18 infrastructure funds own airports, toll roads, water utilities, ports and similar assets in more than 20 countries. Innisfree, an early equity investor in PFI contracts and now the largest stakeholder in UK hospitals outside the National Health Service, was another pioneer. So was Babcock & Brown, founded in San Francisco but today listed in Sydney because Australia has been so rich in PPP deals.

These were what Ernst & Young’s Mr Neal calls the “first wave” of new infrastructure investors. While not everything they touched turned to gold, some of the first funds logged returns of up to 20% – rich rewards for a supposedly low-risk, low-return punt on a ‘dull’ sector. They have now caught the attention of a key segment of the investing community, one that has begun to appreciate the benefits of dullness as long as it promises dependable returns.

The bursting of the 1990s equity bubble has obliged pension funds to rethink their asset allocation strategies in the light of their long-term liabilities. For them, and for other institutional investors, the idea of ‘alternative investments’ has become increasingly orthodox.

Alternative asset mix

These supposedly non-correlating asset class alternatives to mainstream equities and bonds originally included hedge funds, property, commodities and, latterly, private equity. Today, for investors with an eye on the long term, infrastructure is an increasingly important element in that alternative mix.

The assets themselves have undeniable attractions for pension funds. They offer stable, predictable, inflation-linked long-term cashflows extending for 10, 20 or perhaps more years into the future. That predictability may be the result of monopoly status or high barriers to entry, a regulatory framework, concessions or offtake contracts. For anyone with long-term liabilities, these are comforting attributes. They are also attractive to lenders, allowing cheap leverage to enhance returns.

These days, however, it’s not only toll roads and power stations that qualify as infrastructure. Fund managers and dealmakers apply the label to any business that exhibits the aforementioned stability of cashflow. Recent ‘infrastructure’ transactions have embraced a concessionary Isle of Wight ferry service in England and a string of German motorway service stations.

Exchanges as utility

An unsuccessful Macquarie bid for the London Stock Exchange recast exchanges as a kind of utility. And in the US, where private infrastructure finance is making an unusually late but typically enthusiastic showing, states like Indiana and Texas propose to privatise their official lotteries on a concessionary basis, much like toll roads.

Today, a 1% or 2% allocation to infrastructure investment is not untypical for pension funds, although some have been more enthusiastic. “Some Canadian funds have been more extreme,” says John Burnham, head of infrastructure at Citigroup Global Markets. “One said it would put 10% into property, 10% into forestry and 10% into infrastructure – that’s a huge shift. The highest [infrastructure allocation] I have seen is 15%.”

There are plenty of new parties willing to invest that money on their behalf. In the second wave of infrastructure fever, copycat funds have been launched by almost every investment bank, alone or in partnership. For example, Goldman Sachs, Morgan Stanley and Citigroup have set up their own vehicles, while Credit Suisse has partnered General Electric.

The general idea, following in Macquarie’s footsteps, is to attract third-party funds for investment in infrastructure deals, and to earn fees for as many other elements of the transaction as possible, while committing relatively little of their own capital. Fee-generating activity might include limited recourse debt, capital markets fundraising (both debt and equity), initial public offering (IPOs) and mergers and acquisitions (M&A).

The infrastructure craze is generating a convergence of different shades of financial markets activity that is challenging banks’ existing organisational structures by sector and by discipline. It has also made the recruitment market for infrastructure finance experience – previously rather unloved – very hot indeed.

Rebranding

The lower returns and long-term nature of these investments kept them off the radar screens of private equity firms until recently. But even they are now starting to show an interest. Carlyle Group has set up an infrastructure team, and the likes of Kohlberg Kravis Roberts are taking a closer look at infrastructure assets with which they think they can get leverage. As certain private equity firms rebrand themselves as asset managers, infrastructure is a space they feel they ought to fill.

All this adds up to a lot of money. Deloitte estimates that $100bn-$150bn of equity was raised by funds for infrastructure investment in 2006, and much of that has yet to find a home. The resulting competition for assets has forced prices up and returns down. Irish financier Dermot Desmond caused some sharp intakes of breath last year when he sold his London City Airport to a US consortium that included AIG for about £750m, having paid £23.5m for it in 1995.

The third wave of this phenomenon, now under way, is a form of disintermediation. Several pension funds have cut out fund management middlemen – and their fees – to become direct investors. Perhaps the best known is the Ontario Teachers’ Pension Plan, once the largest investor in Macquarie funds, but now running its own $8bn infrastructure portfolio. Its assets – which it describes as “inflation-sensitive investments” – include power generation, toll roads, airports and pipelines, and it was recently the sole investor in a $2.4bn acquisition of four North American marine container terminals.

Another direct investor is the manager of Quebec’s pension fund (and Canada’s largest fund manager) Caisse de dépôt et placement du Québec, part of the Ferrovial-led consortium that bought UK airport owner BAA in 2006.

There is both a primary and a secondary market in infrastructure assets and most of the new investor interest has centred on the secondary tier. As primary funds investing in the equity layer of greenfield construction projects, the likes of Innisfree have been the exception rather than the rule. And although at 15% to 18%, primary returns compare favourably to secondary market returns of, say, 8% to 10%, the risks are considerably higher.

“There’s a lot of upfront risk – bidding risk, construction risk, government risk – and many investors don’t want to take that on,” says Mr Neal. “Once the project is complete, it’s a more attractive asset to sell on.”

In addition to the risk and effort, after bidding and building, it may be five or six years before a greenfield venture starts generating dividends. The escalating prices of brownfield assets, however, have prompted some investors to think more intently about putting money into primary projects. To manage the attendant risks, it makes sense to form partnerships with those who know how to deliver such projects, and this is beginning to generate disintermediation of a slightly different sort.

Last year, the private equity arm of UK fund manager Henderson Group acquired PPP specialist contractor John Laing for £887m. “Now Henderson won’t have to bid for completed assets in competitive auctions, because it will be building them itself,” says Tony Rocker, who heads the alternative investment group at KPMG UK. “We will see more joint-venturing in advance of deal flow by primary investors with partners who understand construction risk.”

In a mirror image deal, Britain’s Land Securities recently paid just under £1bn for Secondary Market Infrastructure Fund, a leading PPP investor. Property developer Land Securities has recently established a position in the primary PPP market and believes that the two businesses will combine to create a “formidable” offering.

“The two sectors [primary and secondary] are showing increasing convergence,” notes Ian Ellis, chief executive of Land Securities Trillium, the firm’s property outsourcing arm.

Primary investment

PPP projects are likely to be the most common platform for further primary investment in infrastructure.

“Such is the appetite of investors that they are getting closer to the procurement face of the deal,” says Mark Berry, partner and PPP specialist at lawyers Norton Rose. “In the UK, the PFI market is quite mature, and investors realise it provides quite a nice, steady stream of income – government-backed, with most of the risk passed on to others.”

As players and their bankers feel more familiar with the risks and how to price them, people are beginning to create their own projects, Mr Berry says. “Waste, for example, is a huge business waiting to be done,” he maintains. “It’s difficult to get off the ground, but PFI investors are coming in, acquiring land and selling capacity to the public and private sector – testing belief in the PFI principle.”

Things are moving fast. In raising funds for infrastructure investment, Carlyle has indicated it would channel about 20% into primary projects. CalPERS, the Californian public pension fund, is evaluating a private equity investment to build ethanol plants. And managers are looking further afield by geography as well as by asset type.

In July, AIM listed a new infrastructure fund that should sort the tough players from the wimps. Launched by South African investor Brian Myerson and hoping to raise $180m, it is called PME African Infrastructure Opportunities. Its focus will be “very early stage” projects, and it has targeted returns of more than 30%.