The picture of new financiers feeding off cheap global credit to close Asia’s infrastructure gap looks increasingly shaky. Global financial turmoil is already taking its toll
While western economies grind to a halt, Asia is booming.
But every boom comes at a cost: across the region, ramshackle transport, decrepit communication links and poor energy supplies are being stretched to breaking point. The ADB estimates Asia’s infrastructure financing shortfall stands at around $300 billion a year – more than Vietnam’s GDP.
In recent years governments across the region have cranked up spending while regional banks and a host of dedicated infrastructure funds have moved determinedly into the sector. Banks and portfolio managers have raised a flurry of listed and unlisted funds at speeds rivalling China and India’s booming industrial output.
Last November, Babcock & Brown reached first close on its $400 million wholesale Asian Infrastructure Fund in conjunction with the Bank of Tokyo-Mitsubishi. AMP Capital launched a $500 million Asia fund in the same month.
A growing number of funds have taken equity positions in construction companies. In March, CIMB-Principal Asset Management opened its Asian Equity Infrastructure Fund for investment, aiming to achieve a 10% return over the next three years.
Meanwhile, some portfolio managers have taken ownership of physical assets themselves. For example, VinaCapital Investment Management broke new ground by listing its $402 million closed-end Vietnam Infrastructure Fund on the alternative investment market (AIM) of the London Stock Exchange last July.
Storm clouds
But the picture of new financiers feeding off cheap global credit to help close Asia’s infrastructure gap looks increasingly shaky. US financial turmoil has spread – and the rout is already derailing government spending plans across the region.
The Philippines, hit by falling exports to the US as well as a rapidly appreciating currency, has been forced to slash its infrastructure investment to 2% of GDP this year compared with an already meagre 3% in 2007; $390 million in funding for various public work projects is reportedly on hold, while around $96 million-worth of port and airport projects have been scrapped.
The credit squeeze has brought home the risks of investing in small south-east Asian economies and has caused risk aversion among foreign investors, say some financiers. “Philippines – along with Malaysia and Indonesia – will find it difficult to see foreign participation under this environment because project size is a lot smaller, and getting out of a deal is so much more difficult than in India and China,” says Bharat Parashar, chief investment officer of Emerging Markets Partnership’s (EMP) joint venture with Daiwa Capital Asia Ltd Fund.
The fear is that the credit crunch will expose the financing rush of the past two years, which has to a great extent hidden the numerous regulatory, political and liquidity risks of infrastructure finance.
Bank loans for infrastructure projects have been dished out at record speeds, thanks to a growing trend across the region towards government revenue guarantees. This has not only led to highly leveraged deals hinging on such guarantees; it has also undermined traditional risk analysis for working out appropriate levels of senior, subordinate and mezzanine debt, as well as reasonable rates of return.
“All commercial banks with their tons of cash have been chasing these projects, and sometimes appraisal mechanisms and due diligence have been diluted,” says S Nanda Kumar, global infrastructure and project finance analyst at Fitch Ratings in Chennai.
Moreover, projects have been financed over the last two years in an economic up-cycle where financing assumptions have been generally bullish. But given the infancy of toll road projects, for example, that run for 15–20 year business cycles, there is no real precedent for their financial performance or the sustainability of such leverage.
Integrity test
Facing the pressures of a slackening global economy and a deepening global credit crisis, the financial integrity of these projects is likely to be tested severely. Conor McCoole, head of Asian project finance at Standard Chartered, observes that the credit crunch has hiked the cost of debt and refinancing operations. “Loan pricing did bottom out in the middle of 2007. We have seen evidence on a term basis of pricing widening by at least 30bp per annum among international banks,” he says.
What’s more, appetite for leverage in cross-border transactions has dropped off, derailing new deals, explains Stephen Paine, global head of infrastructure at UBS. “In May last year, we would have approached $15 billion deals without even blinking, but now getting debt for $1 billion deals is difficult,” he says.
McCoole also points out that governments and private financiers in the region, fearful of a volatile US dollar have now “reduced appetite for long-term USD loans”. This has forced investors to opt for local debt despite higher domestic interest rates, more expensive hedges and variable debt-to-equity composition in the short run.
Before the crisis hit last summer, infrastructure funds were embracing aggressive capital structures in the wake of large-scale returns that recent funds have generated. “We have had extremely competitive returns over the last two years by investing with the IDFC Project Equity Fund [run by Indian private equity firm Infrastructure Development Finance Corporation], which has generated around 25% annual profit,” says Anubha Shrivastava, south and south-east Asia portfolio director at UK government-owned fund Capital for Development (CDC).
“But it is now becoming harder and harder to do deals that yield private equity profits. As more assets become more operational it will become a lower risk, lower return game in the region,” she explains.
And yet some funds may still be treating infrastructure investments like private equity, says Nanda Kumar. “Accelerating equity returns have resulted in aggressive leveraging of projects. In the emerging markets of Asia, project risks may be too high and too unexpected to allow for this kind of regearing.”
But the tide of private capital-targeting developing economies needs a home, and intense competition for some projects suggests a larger problem than the liquidity strain emanating from western markets: the sheer shortage of good deals.
This has forced financiers to chase – and overprice – a small number of large utilities, airports and public toll roads. “If you ask financial sponsors active in the infrastructure sector, they will say they believe there is no shortage of equity for infrastructure transactions, but there is a shortage of quality deals in Asia,” says McCoole.
Investors agree. “Asset inflation is going through the roof, and the guy that loses out is the investor. I was told that you buy low and sell high; nowadays people are buying high and trying to sell higher. It does not make sense,” Parashar says.
Across Asia, infrastructure funds are acquiring utility companies, which are effectively financially – and managerially – connected infrastructure projects, rather than individual transactions.
“This interest in utility companies may be opportunistic, a sign that there are insufficient finance-friendly projects, or a manifestation of frustration at the pace of infrastructure-related legal and regulatory reforms,” Bill Streeter, head of international public finance for Japan and Asia Pacific at Fitch Ratings, says.
In fact, the intense competition for government-backed mega concessions has forced EMP’s Parashar into traditional research-intensive proprietary deals.“The only place you are going to find value in Asia these days is if you get in early, and are willing to put in a big resource commitment and time to develop a project yourself,” he says.
There is enough liquidity around to finance many new projects, but the lack of foreign investor-friendly transactions highlights the age-old problem of poor project management and a weak regulatory climate in Asia’s developing economies.
Domestic bid
But this has not dashed the confidence of domestic participants, who are further emboldened by what they see as the sector’s relative immunity from the global credit crunch.
They point out the majority of capital is home grown, provided by medium- and long-term loans from domestic banks. This will reduce the impact of any mass exodus of foreign investors while the uptake in local currency financing has removed previously unbearable exchange rate risks. Furthermore, although the global liquidity strain has dampened investor interest, it has not undermined the credit quality of the vast majority of existing projects.
Streeter argues that most deals have sufficient financial flexibility: a long concession life, surplus cash flow after debt service, and funded reserves. This means projects in most cases will be able to weather the “usage and revenue effects of economic cycles, as well as the financial market uncertainties of debt refinancing”, he says.
After a two-year feast on complicated and aggressive layers of debt, the credit crunch may then serve as a healthy correction. Rising interest rates and credit spreads will force projects that have weaker financial profiles to enact more conservative debt repayment terms, while lucrative future revenue flows should more than compensate for the higher cost of debt.
But to ensure Asia’s ambitious financing vision becomes a reality, governments must consummate their recent marriage with foreign investors by reforming their regulatory regimes and boosting lucrative deal flow.