Developed economies attract the vast majority of institutional capital. But investors should see global infrastructure markets as existing on a spectrum, writes Christine Senior
The need for infrastructure is universal. Whether in developed or developing markets, people need water and electricity, roads, and ports and airports, and telecommunications. Demand is there, but the necessary conditions for financing and building can be found lacking.
The large majority of infrastructure investment goes into developed markets. The UK, western European countries, the US, Canada, and Australia are attractive as stable democracies with reliable regulatory and legal systems that reassure investors. Their advantages over emerging economies in the competition to attract capital are obvious.
The maturity of a market and the length of time its regulatory system has been in place are two factors that weigh heavily with investors. But even within the developed world not all jurisdictions are equal. According to Daniel Wong, head of infrastructure advisory, at Macquarie Capital. He says: “UK water assets have been regulated for over 20 years. The relationship between company and the regulator is well established. There is a perception of increased predictability of the future investment environment. But, for example, in Germany the electricity network had a new form of regulation only in the last five years and, at first, many investors found the experience of investing a bit uncertain and struggled to deploy capital. Five years down the track, the perception of that regulation has stabilised and there is plenty of capital flowing.”
It is not only regulation that needs to be well established. In the developed world the assets themselves are more likely to have a track record of performance behind them. A detailed history of past operations and financial performance make future predictions of usage and therefore future revenue a more exact science.
Wong says: “A road that has been operational for 10 years that has been tracking traffic and collecting tolls is a much more predictable investment than a new road. That factors into how investors look at each asset. In developed countries there is a larger volume of investment opportunities that fit that description.”
Developed markets also score well as far as availability of finance is concerned. “In many cases markets for bank debt and capital markets for bonds are more developed,” Wong says. “Therefore, the cost of capital is lower in developed markets, which makes financing of these projects more efficient. That then makes it a more feasible project or a higher valuation which encourages the existing owner, whether a government or company, to sell it.”
As investors, such as pension funds and sovereign wealth funds, seek to boost portfolio returns in a low interest rate environment, infrastructure looks appealing and is gaining ground as a more mainstream asset class for investors. Some examples are Canadian pension funds Borealis (the infrastructure arm of Ontario Municipal Employers Retirement System) and Ontario Teachers Pension Plan (OTPP), which jointly bought the HS1 high-speed rail link between London and the Channel Tunnel in 2010. OTPP also has stakes in Birmingham and Bristol airports in the UK, and Copenhagen and Brussels airports. The Kuwait sovereign wealth fund KIA has recently announced plans to invest $5bn (€3.7bn) in core infrastructure, mostly in the UK, over the next few years.
In Europe this means the opportunities are not what they once were. Large inflows of capital have raised valuations and squeezed potential returns for investors.
Andrea Echberg, partner and head of European infrastructure investments at Pantheon, says: “The problem is that we have large amounts of capital chasing what is, compared to past years, a relatively light deal flow. There is $75bn dry powder in infrastructure funds, and there is sovereign wealth fund interest. Then you have direct investors who want to invest in infrastructure and have a lower cost of capital. All these pressures in a low interest environment are driving valuations up to quite high levels. We are also seeing leverage limited by banks. It means investor returns for core infrastructure assets are being squeezed to 8-9% IRR from 11 or 12% just a few years ago.”
This is one factor that is driving investors to look beyond the developed world. Emerging markets have one important advantage: it is where population and GDP growth are strongest. This has implications for user demand for new infrastructure, and so for the future growth of revenues. The growing middle classes buy new cars, and all the other power hungry trappings of a comfortable lifestyle. This in turn increases demand for new roads and power generation and distribution.
Echberg says the contrast between economic growth prospects in the developed and developing markets is what makes the latter attractive to investors.
“European markets remain extremely challenged in terms of GDP growth, and the US shows signs of recovery but remains sluggish. In emerging markets you see quite fast growing populations, a growing urbanisation and in particular in Asia you see an increase in disposable income which is leading to the emerging middle class purchasing appliances and maybe cars which is driving demand for energy and also for transportation infrastructure to support that. The fundamentals of various emerging markets are ultimately giving rise to a need to invest into infrastructure, whether that’s upgrading roads or building new power supply generation and distribution systems.”
Emerging markets play an important role alongside developed markets in the Partners Group’s infrastructure portfolio. Dmitriy Antropov, vice-president in the infrastructure department, says: “The key aspect of emerging markets infrastructure is that it often creates intrinsic value for the users or broader economy. The efficiency gains, which can be obtained from the infrastructure build-out, positively impact both the ability to pay for infrastructure and the propensity of users to pay. As a result, returns, which can be obtained in the emerging markets, tend to be more sustainable and offer higher upside potential.”
Many investors are still cautious. Lack of a strong legal system and potential difficulties in the enforcement of contracts form a major stumbling block to investor involvement.
For Kyle Mangini, global head of infrastructure at Industry Funds Management, this is the absolute key issue that decides whether IFM invests. “In infrastructure once you put $1bn on the ground you can’t pick it up and move it,” he says. “You are very much tied to a particular geography. If you put that investment in you have to be absolutely certain the deal will be the deal, and there’s clarity around enforceability of the contract.”
Alongside legal considerations, potential investors are nervous of involvement in a nation that may not have a regulatory system that has proved itself robust over time. Emerging nations often lack the necessary framework for privatisation of assets, says Mangini.
“In many developing countries they don’t have a regulatory base to allow for privatisation in distribution or water for example. In European markets where regulatory systems are well established, it’s straightforward to privatise an asset; with a less developed regulatory system, it’s almost not possible.”
Another issue is development risk. The fact that these economies and their infrastructure are most likely to be relatively immature means that greenfield developments rather than established working assets with a revenue record are more likely to be the way into the market. This could be a risk too far for overseas investors.
But another view comes from Wong. He sees these early stage developments of infrastructure in developing markets as exciting. “The nature of developing countries is they are undergoing a higher growth phase as opposed to developed countries, which is linked to new-build infrastructure activity. As a result there are lots of opportunities to participate in new build there. That is the exciting part of the infrastructure sector. It often involves working with local companies or working with construction companies or strategic companies who have experience in taking their expertise from one country and using that in a developing country or environment.”
Though a more rigorous process for evaluating projects is demanded for untested markets, in a few cases new ventures can sometimes turn their inexperience into an advantage. Faisal Rafi, head of research at consultancy RisCura, cites South Africa as an example, which has recently rolled out a renewable regime. “They have had the benefit of studying what happened in the UK, US, Germany and Spain, and they have tried to bring out legislation which has learnt lessons from the pioneers,” he says. “That’s a rare exception. Most of the time you are sceptical and looking for reasons why this might not work out and you may end up not making money because of regulatory risk.”
Because of the risks involved investors will naturally seek higher returns. For that reason, says Rafi, emerging market infrastructure can be directly compared to private equity where the risks are similar.
“It’s not like buying a toll road in the UK or US where you are looking at government bond yield plus some kind of illiquidity premium, plus some premium for operational risk. For an emerging market project, especially when it’s skewed towards development, you need to get a high private-equity level of return and you need to be convinced the manager has the ability to do those projects and make money. It’s very much how you assess a private equity fund.”
But generalisations about a lack of legal and political certainty in emerging markets can be misleading. The immutability of contracted arrangements is not always guaranteed in the developed world either. Two recent events have shown that governments do not always honour commitments, even in western Europe.
Spain recently announced a change in the feed in tariffs (FIT) paid for renewable energy which will have a devastating impact on investor returns. Recession-hit Spain found itself with a €26bn energy tariff deficit because of generous industry subsidies, and, after several cuts in the subsidy rate, in July the Spanish government abolished FITs completely.
Norway was also the focus of investor rage when it cut tariffs charged for use of its gas pipeline Gassled in order to increase profits to finance further gas exploration. CPPIB, the asset manager of Canada Pension Plan and ADIA, Abu Dhabi’s sovereign wealth fund, are among institutional investors involved in the project. Some investors are planning legal action against the Norwegian Ministry of Petroleum and Energy.
While it is common to talk broadly about developed-versus-developing economies, in practice there is a spectrum. Some emerging nations can boast conditions close to those in the developed world. And some developed countries, especially those still labouring under onerous debt burdens, are not the first choice for investors looking for stable revenue streams.
Wong says countries on the cusp of moving from developing to developed, as far as infrastructure investment is concerned, include Chile, Mexico, Brazil and India.
“Those just outside the perimeter of developed countries are being reviewed very closely by investors, and there is a significant amount of deal flow. Canadian pension funds are, for example, very large investors already in Chilean infrastructure. Chile is not really a developing country on the ground. In Mexico, a significant amount of infrastructure – roads, airports, power – are all regularly changing hands and of interest to infrastructure investors.”
Some crossover economies are actually benefiting from economic problems in more traditional infrastructure markets, according to Antropov. “Some more advanced emerging economies – for example, Chile – have experienced a substantial pick up of investor appetite on the back of potentially reduced allocations to some of the traditional European markets, which continue to suffer from the financial crisis. At the same time, the overall share of emerging markets infrastructure in the portfolios remains low.”
For pension funds, developing-nation infrastructure remains something of a minority
interest, even where infrastructure investments generally are recognised as having a valuable role in their portfolios.
Toby Buscombe, EMEA infrastructure leader at Mercer, says his clients, who are UK pension funds, regard infrastructure as a lower risk diversifier with some inflation linking potential within the return seeking, as opposed to the liability matching, portion of their portfolios.
Developing-market infrastructure is only of interest to the few, he says: “Typically it’s the larger, more sophisticated and better resourced schemes that are potentially considering it. They have effectively got the bandwidth and size and already have an infrastructure investment programme with developed market exposure, so they are looking to layer on opportunistically some developing market exposure to potentially target some specific market themes and return opportunities.”