Author: Gordon Feller
ANALYSIS / INFRASTRUCTURE FUNDING

Many Asian countries desperately need to upgrade their infrastructure while cash-rich private equity funds are scouring the region for long-term investments. Is this a match made in heaven?


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Nag: We can only meet a small fraction of the needs.

Over the past few years private equity (PE) funds have raised billions to invest in emerging markets, especially in Asia, and a rising amount is finding its way into infrastructure projects. With global infrastructure investment requirements likely to rank in the trillions of dollars over the next 10 to 15 years, assuming even moderate growth projections come to pass, any additional cash is welcome.

India alone estimates that it will need to raise infrastructure investment from today’s 3.5% of GDP to 8% of GDP by 2012. According to the country’s finance minister, P. Chidambaram, India will have to invest almost $500 billion at current prices over the next five years in order to meet its infrastructure development needs.

India is one part of a much bigger story. Rajat Nag, managing director general of Manila-based Asian Development Bank (ADB), says Asia will require at least $3 trillion in infrastructure investments in the next 10 years, and the fast-growing region will need to look beyond traditional sources of funding for these projects. Asia has 700 million people without clean water and 1.6 billion people without proper sanitation, he says.

The infrastructure needs are tremendous, but meeting them is a prerequisite for growth, Nag explains. “It is important to make sure that there is adequate emphasis on rural infrastructure and quality of life,” he says. “We must provide better rural roads, irrigation systems and educational facilities.” Urbanization will remain a trend in the region as people seek better opportunities in the cities, he predicts, adding that “we need to accept this migration and prepare for it.”

The need for infrastructure investment is unarguable, particularly as inadequate investment in water, transportation, communications and electricity can constrain an emerging economy’s prospects. Fortunately, many of Asia’s economies enjoying sustained growth are better positioned to pay for infrastructure investments than ever before and, until the middle of this year, were surfing a wave of private investment that was augmenting their own funds. Unfortunately, the jitters caused by the recent global market turmoil changed risk perceptions among both infrastructure developers and infrastructure financiers. While they are not exactly turning tail and fleeing for the nearest investment-grade bond offering, they are certainly taking a longer, harder look at investments they are considering making in emerging markets.

A Mass of Contradictions
Funding infrastructure development in an emerging market is a highly complex process. The cost of building infrastructure in developing countries is generally borne mainly through tariffs and taxes. But many of those countries are offering tax holidays and other financial incentives to attract manufacturing and other companies. This transfers the tax burden onto the general population while adding to the demands on transport, power, water, sanitation and other services.

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More cars on the road may be a sign of economic prosperity, but that in turn means investing in motorways.

That is where the private sector comes in. With the local governments tending to lack the capital to build the infrastructure they need, private sector involvement can make the difference between a project being built or staying on the drawing board. In many ways the market is perfect for private funds, too. After all, private equity funds are willing to sink cash into projects for years at a time, and they like predictable and sustainable cash flows. That is something the infrastructure can offer, given the predictability of water and electricity and toll road demand. Such predictability is a particularly attractive feature for pension and insurance funds, which are increasingly investing in PE funds. Additionally, the barriers to entry in infrastructure tend to be high, so the threat of competition to the finished project is limited.

The risks are high, too, however. Simply building or running infrastructure in emerging countries is inherently risky. The projects tend to be very much exposed to the host country’s economy. For example, many build-own-operate-transfer projects operated by private companies fell into default after the Asia financial crisis when the customers they relied on to pay their utility bills could no longer do so. In addition, governments sometimes change the regulations surrounding the projects they want to be built, or withdraw promised subsidies in mid-investment. In a 2004 study on project finance performance, sovereign-related issues were found to be the principal reasons behind 27% of all project finance rating downgrades and 37% of all defaults.

“Private investment has great potential in the Asian infrastructure market, [but the] risks of default can be significant,” states Joseph Anderson, a Singapore-based partner with the law firm of Morrison & Foerster. The focus of private equity funds—maximizing returns—can also potentially add risk to infrastructure investment. Private equity funds rely on high leverage to gain good internal rates of return—typically 10% to 20%—but infrastructure projects already tend to be very highly leveraged. Competition for the good projects tends to force up prices, which could mean even higher leverage is needed to achieve target returns.

Chris Lawton at Ernst & Young’s global real estate center in New York says this “has introduced more risk into infrastructure as an asset class.” This summer Lawton and his colleagues have seen a tightening of credit in infrastructure financing as a result of the liquidity squeeze in credit markets generally. “This credit tightening makes it more difficult to put infrastructure deals together,” he notes.

There is, however, a positive side to the credit tightening, as Lawton points out: “It is likely to take some heat out of prices for infrastructure assets, which will lead to more financially sustainable investments. This is perhaps less of an issue in Asia, where the level of competition for infrastructure deals has not been as intense as other parts of the world.”

Infrastructure deals in emerging markets face additional risk factors in that they are primarily greenfield developments—therefore they have no cash-flow history to assess—overlaid with the inherent disadvantage they face relative to mature economies in political stability, legal framework and transparency.

There are some risks that are less visible than others. Lew Watts, CEO of PFC Energy in Washington, DC, worries that “irrespective of the appetite of investors, the capacity of the contractor community” is a problem. His firm calculates that “a significant number of the largest projects of energy companies are being delayed. There are many reasons for this, not least the complexity and the increasing environmental and social requirements of governments and lenders, but the largest…contractors are clearly stretched in not only responding to these demands, but carrying out the work itself.”

Despite the hurdles, money can be made. EMP Global is one private equity investor that has proved that private equity infrastructure investment can be successful. It made a strong move with a Senai Desaru Malaysian toll road investment. “In general terms, infrastructure can be an interesting area for PE,” says CEO Collins Roth. “However, its long gestation period can make it difficult to fit into the normal lifecycle of a PE fund. Given that it takes several years to develop and build a project and then prove its returns, it requires a patient investor. As a result, many people view it as a distinct asset class.”

The returns on infrastructure projects are often in the low to high teens on a cash-on-cash basis, but with more potential upside based on a future sale once the project has been completed. As a result, many of EMP’s infrastructure-related investments “have been structured not as investments in single projects but more as investments in growth companies, with a focus on investments into multi-asset companies that are looking for capital to build add-on capacity or consolidate a market,” says Roth. “In this fashion, more traditional PE returns are achievable.”

Joining Forces
Both local governments and transnational organizations in the region have welcomed the rise in private investors’ involvement in infrastructure funding in Asia. “We can only meet a small fraction of the needs, so the private sector must invest more,” Nag of the ADB says. The ADB’s annual project lending amounts to about $7.4 billion, of which 54% goes to infrastructure lending, with the average project costing about $100 million. “The private sector will be looking for the right climate, which means good governance and fairness,” Nag says. “The enabling environment has to be right.”

Nag sees the current involvement of private equity as something of a stepping-stone, though, and believes Asia needs to develop a regional bond market to help finance projects, which over time should prompt greater investment in infrastructure. “Once you start the process going and attract greater public-private initiative investments, and they work, this will attract others,” he says.

Nag is also hoping the region’s central banks will deploy some of their vast foreign exchange reserves to help jump-start infrastructure investment projects. While the central banks are looking to diversify their holdings away from US treasury bonds, the safety of these reserves is of paramount importance, “but beyond a certain level necessary to protect your currency, the reserves should be used in the best way possible to meet needs,” Nag says. This could include some investments in physical infrastructure, including highways, power projects, drinking water projects and airports.

Even the central banks might be more cautious, though, as a result of the recent global financial turmoil. Everyone in the infrastructure industry—especially in water, power and transport—recognizes that they face special challenges, including a few that arise from the inherently longer-term nature of their transactions. Financiers and operators managing infrastructure systems are watching the global markets closely, although those most active in emerging markets recognize that their time horizons make it harder to measure the impact of potentially short-term blips on their project risk factors. The hard call is whether or not this is really a short-term blip.

Investors Hang Tough
For those investors who see the connection between growth in GDP and growth in infrastructure, the current short-term volatility is not scaring them off. Jack Hennessy, managing director and partner at Baring Private Equity Asia, says that “growth in GDP is the main driver for investments in infrastructure.” Given that GDP growth in the Asian emerging markets is not expected to decline significantly, the argument for continued investment in infrastructure is as strong as ever. And despite the general queasiness in the market, infrastructure investors seem to be staying the course.

A growing number of private equity funds are forming, many focused tightly on the Asian market. Australia’s Macquarie Bank’s infrastructure funds, Credit Suisse’s infrastructure joint venture with GE Infrastructure, the Carlyle Group’s new fund and infrastructure funds at Goldman Sachs and JPMorgan have all raised billions that they hope to deploy into infrastructure investments. India’s ICICI Bank has just launched a $2 billion fund aimed at grabbing a slice of the massive infrastructure spending promised in India. The fund will invest in ports, aviation and power projects.

In August of this year, just as the credit crunch was kicking into high gear, 3i’s new and unlisted India Infrastructure Fund—jointly run with the India Infrastructure Finance Company—announced a target size of $1 billion. With a primary focus on power, ports, airports and road projects in both early-stage and mature infrastructure operations, 3i says that it intends to invest a minimum of $250 million into the fund. 3i, which has a 20-strong global infrastructure team scattered in Mumbai, Singapore, London, Frankfurt and New York, is banking on its “established presence in India.” That presence is not inconsiderable: Since 2005, 3i’s India team has invested $325 million in a broad range of sectors including real estate, media, automotives, infrastructure, power and ports.

Vijay Vancheswar, group head and vice president at Bangalore-based infrastructure funding specialists GMR Group, says his investment-focused company is betting on one key fact: “Over $425 billion has been earmarked by India’s policy planners, and the government has a needed spend in these areas over the medium term of five to six years,” he says. Global volatility will, he thinks, only “have a temporary implication on developing economies,” and GMR is quite confident about the temporary cyclical impacts. “The underlying fundamental strength of these economies will govern,” he says.

In December 2006 Goldman Sachs announced its first dedicated global infrastructure fund had raised an astounding $6.5 billion. With such large pools of capital available, such funds now have the capacity to make huge investments—and possibly to buy entire ports, rail systems or power and water facilities.

Certainly the capital from such private funds would be welcomed in Asia’s developing markets. The International Energy Agency estimated, back in 2002, that more than a billion people in South and East Asia, excluding China, lacked electricity. But of the $400 billion in capital raised to invest in developing country infrastructure, only $58 billion derived from the private sector, down from a peak of $128 billion in 1997. As private funds seek ever more tempting opportunities and deploy ever larger tranches of funding, the chances are high that the private component of Asia’s infrastructure funding will grow sharply.

According to Victor Ma, CEO of Yuanta Financial Holdings, Taiwan’s biggest brokerage firm, investors have become more risk-averse. The turmoil of the subprime market in the United States has had a negative impact, he believes, adding that his own firm trimmed its exposure. “We set hedges on our positions and significantly downsized our exposure in the markets,” he says.

But most observers believe this is evidence of short-term nerves, not a long-term loss of confidence. They argue that if projects are well structured and thoroughly scrutinized and provide a genuinely needed service at reasonable prices, then private equity managers can make them succeed. It is the challenges of hedging what is frequently internationally held debt against local revenues, and the challenge of pricing infrastructure services at an acceptable level to consumers who are not used to paying full-cost pricing, that will continue to give potential private equity investors some major pause for thought.

The opportunities for private equity in Asia’s infrastructure sector certainly exist, but it will still take a lot of due diligence—not to mention a fair amount of nerve—to pursue them.

FUNDING FRUSTRATIONS
A fundamental problem for the sort of major infrastructure projects that private equity funds target is that they typically have to be financed internationally in US dollars, euros or Japanese yen because the local markets are too small to raise large levels of debt in long tenors. In addition, some big-ticket items, such as power islands and specialized machinery and equipment, must be imported, and projects must pay for them with a hard currency.

Only locally sourced project inputs, such as labor and perhaps some raw materials, can be paid with local currency, which is typically a fraction of total project costs. And if being built from scratch, an infrastructure project will not generate any money for many years. It is taking a lot on faith that the project will work and will make enough money to pay back all the debt raised beforehand.

This problem is only exacerbated by the fact that consumers in many emerging countries pay a fraction of the actual cost for water or electricity because of government subsidies. If they were subjected to the true costs, they would probably resist paying them. This means that potential infrastructure investors have to either accept revenue streams lower than they would like to charge or, more likely, accept subsidy streams from governments that can be notoriously fickle in maintaining agreed payment levels over a 20-or 30-year lifespan. It’s not easy making money in infrastructure.


Gordon Feller