Pension funds are fuelling an investment push into global infrastructure – and fund managers are looking increasingly to emerging markets in the search for high returns. Regional equity funds, though largely focused on developed markets, or at worst, undervalued assets in emerging markets, are also developing in a number of emerging infrastructure markets.
As private infrastructure financing gathers pace in developing markets, the standard model of debt and equity financing could be on the verge of changing, as it has already in developed markets.
As John McCarthy, managing director, head of Europe, Rreef Infrastructure, says: “Previously, it was largely the banks guiding pension funds into infrastructure. Now we are reacting to demand, and more pension fund investment in global infrastructure is almost a self-fulfilling prophecy.”
This year, new bank-managed infrastructure funds include ABN Amro with a E500 million fund, Deutsche Asset Management with its E1 billion Rreef fund, Credit Suisse First Boston/GE Infrastructure with a $1 billion fund and Goldman Sachs with a $3 billion fund. Morgan Stanley and JP Morgan are also moving into infrastructure, as are the major private equity houses – Kohlberg Kravis Roberts and Blackstone, for example.
The number of pension funds keen on infrastructure investments is also increasing. These include France’s E29 billion state fund, the Fonds de Reserve pour les Retraites, and the £21.7 billion UK universities superannuation scheme. Although the majority of these high-profile vehicles are destined for investments in developed markets – notably public-private partnerships (PPP) and private funding initiatives (PFI) [see box] – the scope for high returns in emerging markets is substantial.
Institutional investors are looking closely at the potential for strong returns from infrastructure projects, which provide longer-term, relatively stable returns that are less sensitive to business cycle fluctuations or stock market volatility. Returns are often positively correlated with inflation, another important hedge for the portfolio.
As Philippe Valahu, acting director of operations at MIGA, says: “This presents a financing opportunity for infrastructure projects in the region, as pension funds, in particular, are looking for medium- and long-term issues to balance and diversify their portfolios, which may be excessively liquid or overly weighted toward short-term return.”
Latin push
In Latin America, for example, the growth of PPP, and pensions fund and capital markets reform are creating new sources of home-grown infrastructure funding.
Following a rush to privatize infrastructure in the 1990s, private participation in infrastructure projects in the region slowed. Total investment in infrastructure in the region is pegged at less than 2% of GDP.
But the combination of a strong growth outlook, reduced country risk and rising demand could entice private investors back into Latin American infrastructure projects. Despite some political resistance to privatization, many Latin states are doing what they can to encourage new private investment – through policy improvements that clarify roles and responsibilities for concessions, and through fiscal strategies that are reducing country risk premiums.
Fund managers of pension and health funds – privatized since the 1990s – are also searching for private issues in local currency. In Chile, for instance, the combination of well-developed capital markets and a pool of large institutional investors has yielded private financing for most of the nation’s recent $8 billion investment in new transportation networks and water treatment plants.
Banks project lending to the region have yet to see a competitive threat from capital markets: bank project lending hit $140 billion in 2005, compared to bond issues of $12.5 billion. But the potential for more attractive terms, and lower cost of project capital provided by capital markets issuance sold to local pension funds and other institutional investors, particularly when covered by monoline or multilateral-backed risk mitigation instruments, will become a serious rival in the coming years – not only in Latin America but anywhere with a developing capital market.
Fund managers are eyeing the Arab markets too. Most recently, Dubai-based Abraaj Capital has entered into a joint venture with Deutsche Bank and Ithmaar Bank to raise a $2 billion Islamic private-equity fund to invest in infrastructure in the Middle East, North Africa and South Asia. And CIMB and Standard Bank have launched the South East Asian Strategic Assets Fund, a private-equity fund investing in infrastructure, energy and natural resources deals in south-east Asia. The fund’s co-sponsor is the Employees Provident Fund of Malaysia.
The Macquarie template
Global toll road operator Macquarie Infrastructure Group (MIG) is one of the headline funds of Macquarie Bank, the acknowledged pioneer and world leader in infrastructure fund management. It is also widely seen as the model for funds looking to set up shop in the booming global infrastructure. But MIG has released disappointing results.
MIG net profits before finance costs are down year-on-year to $424.7 million from $772.6 million – according to MIG, caused by lower revaluation income (borrowings made against the rising value of assets, and paid out as dividends on the expectation of cash to come). The same happened in 2004 when MIG reported a loss of $251 million.
The problem for MIG – and potentially for those new infrastructure funds that have set up shop over the past year and plan to copy the Macquarie template – is that it has made very solid long-term assets attractive to investors by borrowing or refinancing with cheaper debt to make short-term dividend payments. That is only possible when asset prices are increasing and cheap debt is available. The template is made difficult by rising interest rates, which spawn a host of other variables that do not fit into the equation – and interest rates are rising.
Theoretically, MIG’s assets (toll roads) are inflation- and interest-rate proof. If interest rates rise to combat inflation, MIG can increase its toll prices by inflation or more. But for MIG to continue to grow and pay short-term dividends, it needs access to cheap debt and equity financing to fund acquisitions – a potential credit crunch acknowledged by MIG itself. And interest rate rises both increase cost of debt and make traditional fund markets more attractive to the pension funds and retail investors that MIG has tapped to date.
Macquarie’s growing pains are neither fatal nor symptomatic of a problem with infrastructure investment – merely the result of aggressive financial engineering. And MIG has a very strong long-term asset portfolio. Furthermore, analyst reservations about the sustainability of the MIG structure have been confounded again very recently, with MIG successfully refinancing its M6 toll road in the UK in a £1 billion deal where £392 million is released back to MIG as a dividend through the use of an accreting swap mechanism – the first time such a mechanism has been used in the UK PPP market.
Nevertheless, the type of highly-leveraged deal synonymous with MIG to date may prove harder for investors to swallow in a changing lending climate (as might the fees Macquarie Bank generates internally from selling assets from one of its own funds to another). It seems certain that, if interest rates continue to rise, MIG will start tapping the unlisted market to fuel growth, a sector that is dominated by pension funds looking for long-term stability at fixed rates, and with little appetite for the kind of high-leverage structure MIG favours.
Fund managers concede that, while Macquarie has been very successful, they will not be following the same template. As Bob Parker, vice-chairman of Credit Suisse Asset Management, says: “We are going to focus on projects where returns are less sensitive to leverage and more cash-flow based.”
Convergence
Deals like the MIG/Cintra-sponsored Chicago Skyway project have astonished US banks into action – despite bidding more than double that of the nearest other bidder for the 99-year toll bridge concession, the pair are looking at a return on investment (ROI) of between 12% and 15% after some clever financial engineering.
Similarly, the growing acquisitions and privatization of infrastructure operators – for example, France recently sold off its state-owned toll road companies – are creating convergence between private equity, infrastructure funds, pension funds and even bank debt.
The size of these acquisitions and the nature of the assets (infrastructure requires specific market expertise) have meant more consortium deals, and the birth of large consortia combining private equity and hedge funds with infrastructure funds and pension money. For example, in the bid for BAA earlier in the year, the winning bidder Ferrovial was joined by long-term pension fund manager Caisse de depot et placement du Quebec and GIC Special Investments, the private-equity arm of the Government of Singapore Investment Corporation.