Yield-hungry investors, and pension funds looking to match their long-dated liabilities, now classify infrastructure finance as a safe and distinct asset class. According to a research project at Stanford University, an avalanche of cash has poured into project finance over the last two years, with over 70 newly-created global funds totalling an estimated $120 billion of capital. This has led to fears that there are now too many players hankering for their first deal, racking up prices, driving down yields, weakening covenants and swallowing huge chunks of debt in a market with a limited supply of viable projects.
“It is absolutely clear there are more funds than opportunities to invest. Many global funds have been keen to establish themselves and have been very aggressively pursuing some assets,” Stephen Paine, global head of infrastructure finance at UBS tells Emerging Markets. But exuberant leverage in a benign credit environment is over. Tightening liquidity and rising borrowing costs will crush cash flows, debt coverage ratios and returns. “Until the recent credit crunch, in terms of the quantum of debt, pricing and covenants, it was the most benign environment I can remember. It will now clearly be a lot more difficult to do business,” warns Paine. The prospect of the contagion spreading to emerging market projects is a real threat to their economic growth, which depends so heavily on overcoming capacity constraints and infrastructure bottlenecks. It will also undermine renewed efforts by policy-makers in the region to court international capital after decades of failing to provide vital public services.
Macquarie leads the way
AMP Capital launched a $500 million Asia fund last November, and a $5 billion India fund was set up in December between IDFC, Citigroup and Blackstone. Many of these new players are following the trail established by Australian pioneer Macquarie. The group’s unique strategy of scouring the globe for assets, creating specialist listed and unlisted funds – with the parent company then charging large management fees – showed infrastructure could be a liquid asset class with a comforting exit strategy while generating huge returns. In fact, the bank’s flexible accounting rules allow asset inflation to be marked down as revenue, releasing profits now on the back of expected asset prices in the future and refinancing at discounted rates.
But with 25 listed funds and $160 billion under management, the group could be badly hit by the demise of cheap credit. According to a Macquarie Infrastructure Group report, a 0.5% rise in interest rates would wipe $800 million off its assets. “Macquarie has put a model together that is based upon putting massive leverage in their portfolios and concentrating on the velocity of capital, but their returns are going to be hurt very badly now in this environment,” Sean Wallace, senior managing director for Asia Pacific at Darby Overseas Investments tells Emerging Markets.
Indeed, during the market unrest over the summer, share prices in the Macquarie Korea Infrastructure Fund performed particularly badly, dropping 15% April to July, triggered by the global liquidity strain and the deteriorating credit profile of its concession companies. This volatility may destabilize foreign investor sentiment in the region, since it is the largest Asia-specific fund, worth around $2 billion compared with the $2.8 billion of new foreign capital that invested in Asian projects in 2006.
Wallace argues that Macquarie’s most powerful effect in the region has been to galvanize competition to unprecedented levels, forcing investors to take on more risks. “Prices have gone up, and competition in Korea and the whole region has increased dramatically over the last two years. This competition for deals has made us alter our strategy and change our risk profile – we are now taking on more operating risk and looking to increase our returns,” he explains.
Aggressive financial engineering
But fortunately, the highly leveraged Macquarie model is unique, and global unlisted vehicles dominated by pension funds seeking long-term stability at fixed rates dominate the market. Nevertheless, what is worrying is their opportunistic investment structures, which are increasingly aimed at financial engineering and pro-cyclical investment gambles.
“There are some funds out there that as part of their strategy may rely more heavily on financial re-engineering upside and offer this risk/return perspective to their investors. But you need to make sure first the fundamentals of infrastructure as an asset class are there – namely, sustainable and predictable cash-flows – otherwise you may be exposing investors to a different kind of risk,” Hafeez Ahmed, CFO at ABN AMRO Infrastructure Capital Management tells Emerging Markets.
Of course, changing one’s risk assessment through optimizing risk-adjusted returns and refinancing is at the very heart of the capital markets. But the fear remains that this engineering model has created complacency, and undermined investment manager efforts towards maximizing the underlying assets of a project, and developing strategies to optimize income from its operations. Given the heightened operating risks in emerging markets, this is dangerous, since investors need to manage their projects strategically to reduce technical risks and engage with stakeholders, mindful of the changing political and social dynamics during the long life cycle of a project.
The end of the road
The next six months will be critical. What’s clear is that the market for highly geared deals with slack covenants for leveraged buyout debt has dried up. Triggered by the fallout from the sub-prime mortgage crisis, investors now have less appetite for deals based on capital structures featuring overlapping layers of debt (often short-term), high leverage and huge complexity.
In fact, according to Michael Wilkins, head of Standard & Poor’s European infrastructure finance ratings group, $34 billion of leveraged infrastructure acquisition loans may be left on the banks’ own balance sheets, as they will not be able to sell on the loans because of current market distress. But crucially, he believes that credit risks have been mitigated in the vast majority of EM project finance deals. “These regions should not be affected. Deals have been tightly structured with the appropriate allocations attentive to the overall credit risk profile,” he says.
So a significant slowdown in the EM project finance market is not expected, but credit risks will now be approached with more caution. In the short run, this may result in less competition for assets and lower prices, which could compensate for more expensive debt.
“Some people may not get the top prices for their deals, and equity/debt ratios will become more conservative. So prices are going to normalize, markets will adjust and reach natural equilibrium,” says Wallace at Darby. In fact, the bull market over the last two years may have increased market supply, since “public-sector authorities globally have greater confidence in the value of selling such assets, so such aggressive competition has overall been a benefit,” argues Paine.
So prudent credit risks have generally been adopted, and more realistic valuations of projects are coming, but will tighter liquidity affect existing exposures to EM projects? Perhaps not. According to the Collaboratory for Research on Global Projects at Stanford University, the average size of an investment taken by newly created infrastructure funds in a developed country is 64 times larger than in a developing nation. This suggests that those funds that have already been partially or fully invested are significantly less leveraged in emerging economies, so they will be less hit by a tighter lending climate.
Furthermore, the increasing resilience of the emerging world to macroeconomic shocks and financial market distress emanating from the West means infrastructure is likely to maintain its feature as an asset class with strong and stable returns. “The catastrophic crash of private infrastructure investments in Asia during the late 1990s hurt many investors, but now we are living in a new paradigm of strong economic fundamentals propping up risk appetite,” says Collins Roth, director with US-based private equity firm Emerging Markets Partnership.
He argues that most investments dedicated to the region are banking on strong, organic growth, rather than exploiting the financial structure of their projects to boost returns as happens in US and European markets. In fact, even if a project is significantly geared towards the broader market conditions that facilitate the refinancing of debt, risk-adjusted returns will still be promising, given the abundance of domestic liquidity, sharply contrasting with the crisis in the short-term western money markets.
“When talking to investors in developed economies, a lot of yield has been squeezed, and so some EM assets are now looking more attractive, especially as they are buoyed by the abundant liquidity in these regions,” Maurice Hochschild, global head of infrastructure finance at Investec, tells Emerging Markets. Indeed, the launch of the $272 million Zones Corp Fund in 2005, a 75:25 equity joint venture between Abu Dhabi Commercial Bank and Macquarie, indicates a growing trend towards an ideal combination: plentiful emerging market capital complemented by the management expertise of established players in developed markets.
For analysis on how India's capital controls are affecting infrastructure investment, please see "A crack in the plan".