Neither the conventional private equity model nor the real estate model provides a complete solution to all the challenges faced when managing infrastructure investments, according to Zeeshan Ahmed and Jose Auborg
Today, for the first time in history, half of the world's population lives in cities. This means that the role of infrastructure in sustaining economic growth and quality of life has never been more important. In this context, infrastructure has become a major focus and a real challenge for most governments, with a greater need for substantial investment into these strategic assets.
In the US and many western European countries, much of the infrastructure has deteriorated and, as a consequence, there is greater demand across all sectors (for example, transportation, energy and schools) to replace ageing infrastructure while also helping to sustain population growth and rapidly expanding urbanisation.
At the same time, emerging economic giants, such as Brazil, China and India, are also facing the major challenge of implementing an efficient infrastructure strategy, fundamental in supporting their pace of development in the short term.
In the context of the economic and debt crisis, governments are looking at the opportunity of attracting private investors to co-finance infrastructure projects with growing interest. The state therefore changes its role from owner and provider of public services to purchaser and regulator of such services.
Private investments and private public partnerships (PPP) in infrastructure provide many benefits for nations to solve their infrastructure deficits and enhance public service delivery:
• Financing responsibility and shifting risk to the private sector;
• Cost savings;
• Stronger customer service orientation;
• Focus on outcome-based public value rather than on the physical assets.
For some years now, the number of infrastructure funds has been growing exponentially; investors now perceive infrastructure as an attractive asset class that offers long-term and stable income perspectives with a risk profile lower than a traditional equity fund. Pension funds and insurance companies in particular are natural investors in this emerging asset class, and have become the most active in this sector by including infrastructures in their portfolios to match their long-term liabilities.
Broadly speaking, infrastructure investments are of two types - greenfield projects and brownfield projects. The former are where investors fund the building of the asset, as well as the maintenance when it is operational. Brownfield projects involve an existing asset or structure that requires improvement.
Although brownfield projects are generally characterised by a lower level of risk, it would be a mistake to conclude that every brownfield investment necessarily has a low-risk or bond-like return due to the condition of existing assets and potential for value creation.
In addition to the typical risks inherent in most alternative investments, infrastructure investments are more exposed to:
• Force majeure - strikes, terrorism, earthquakes and other natural disasters, etc.
• Political/country - political instability, general security, nationalisation, breach of contracts/concession, continuity of fiscal policies, public acceptance, etc.
• Legal and contractual - approval, licenses and concession from local authorities, enforceability of contracts and agreements, judicial systems, governance system, etc.
Thus, the risk and return of each infrastructure project is a function of the structure of the investment and how that structure addresses a number of specific important risks.
Traditionally, infrastructure investments are structured either as a typical private equity, or as a typical real estate model although, more often than not, infrastructure assets are likely to originate from private equity transactions in the initial structuring phase (that is, development or rehabilitation stage).
By contrast, infrastructure assets behave more like long-duration alternative fixed-income assets in the operations and maintenance phase, or the post-completion phase. However, due to specialised assets, neither the conventional private equity model nor the real estate model provides a complete solution to all the challenges faced when managing infrastructure investments. These investments therefore demand the use of a distinctive model, with distinctive experiences and competencies.
As these investments are generally on a long-term basis, the risk profile and challenges vary from one stage to another during the life of the investment. Although infrastructure investments have, in recent years, experienced unparalleled growth, they are still considered a niche sector dominated by a few specialised players, mainly investment banks. We therefore view infrastructure investments as a separate asset class for alternative investments:
• Assets are niche in their nature and complexities, with rare comparable transactions - lack of reliable benchmarks and key performance indicators.
• Wider risk horizon - particularly the political environment and fiscal policies of the target jurisdiction.
• Different operational challenges compared with other classes of alternative investments, such as political stability, war, terrorism, natural disasters, continuity of government policies, etc.
Given these dynamics, institutional investors are increasingly allocating funds separately for infrastructure investments, either to manage long-term liquidity requirements, or simply to diversify their investment portfolio.
The Luxembourg marketplace has clearly demonstrated its willingness to position itself as a major financial centre offering solution services to infrastructure funds. The Association of the Luxembourg Fund Industry (ALFI) has set up a sub-committee dedicated to developing and promoting solutions to attract infrastructure funds.
Zeeshan Ahmed and Jose Auborg are senior managers at Ernst & Young, Luxembourg