Reassessing Australian infrastructure investment

Highly geared assets are just one liability in the infrastructure space. Plagued by failed public private partnerships (PPPs), governance issues and the pressures of being overladen with debt, the infrastructure sector is in need of serious reappraisal as an investment. Quite simply, investors are often left wondering if it is a good long-term venture.

Australia itself proved to be a highly leveraged environment, with the infrastructure space marred by management troubles and overly complex vehicles. There may be a volume recovery story in the works for toll roads and railways (airports are virtual monopolies), but ports, for example, felt the effects of the global downturn particularly keenly.

“Probably the major sector affected last year was ports, where we did see quite a big drop-off in volumes,” said Jon Fitch, executive director, infrastructure securities, Macquarie Funds Group. “But other than that, volumes were fairly robust. The underlying operations were certainly a lot stronger than have been implied by the share prices of many infrastructure companies.”

He believes that despite recent market dislocations, the fundamentals of infrastructure investing have pretty much remained in place. “And potentially, if we look ahead, they were enhanced by that,” he added.

Similarly, Peter Meany, head of global listed infrastructure at Colonial First State Global Asset Management (CFSGAM), said although there were some short-term shocks on the volume side, over the long term the sector would deliver sustainable growth.

But along the way things seemed to have become too complicated in the sector — possibly fuelled by the success of privatisation. Despite some wins over the last decade — particularly overseas and in utilities — many organisations that bought assets at expensive prices were only able to justify them through heavy gearing and the belief that interest rates would stay cheap. They paid a heavy price.

Babcock and Brown is on its last breath, while another major player, Allco, has already met its demise. Arguably, while underlying structures were sound in the sector, easy credit markets led to capital structures being too highly geared — a problem that could be addressed if companies internalised their management. Macquarie Infrastructure Group’s recent reshuffling may be interpreted by some as an effort to address such risk issues.

But like many sectors, infrastructure simply slowed down in response to the economic downturn. What this means, as Chris Trevillyan, senior consultant and head of infrastructure research at Frontier Investment Consulting remarked, is that the need for infrastructure investment in the long term is huge.

“The maintenance capital required for existing infrastructure alone is enormous, let alone new infrastructure and the requirement from growth in emerging markets.”

The Minister for Infrastructure, Anthony Albanese, acknowledged that the sector is in a state of flux and under some pressure, a challenge for a government looking for greater involvement from the private sector.

“There is no doubt that there has been a retreat of private capital as a result of the global financial crisis, and there’s been a reduction in the availability of credit. This has placed pressure on the capacity of the private sector to invest in infrastructure,” Albanese said.

He added that the Government consciously increased its infrastructure spend to fill the void that’s been created as a result of the global financial crisis — $22 billion was allocated in this year’s Federal Budget. The national broadband network and renewable energy are both high on the agenda.

So how are we doing?

Many spruik Australians’ talent in privatisation processes along with our strong utilities, but Meany was quick to point out that Australia was the worst performing infrastructure market in the world. He added that this was a difficult message to convey to investors, since poor overseas share price performance was grabbing headline space.

“The rest of the world’s infrastructure has really behaved as you would expect in an economic downturn, so they have been more defensive in performance over the last two years. The problem for Australia is the amount of leverage that’s been put into these vehicles, the complexity of these vehicles, and the governance issues that are starting to be sorted out.”

Elsewhere, infrastructure stocks are more traditional in nature, he said.

“They’re very simple company structures, there’s a good alignment of interest with the investors, and the leverage is appropriate.”

Dennis Eager, portfolio manager at Magellan, said assets that are truly infrastructural would be quite defensive investments, generally robust throughout an economic cycle with inherent protection from inflationary spirals.

He said if too much debt is put into a low-risk asset (eg, a toll road or an airport) the risk increases and the defensive characteristics are lost.

“They become just like a normal equity play. What we’ve seen over the past decade is more and more gearing, and more and more debt going into these assets. So they don’t behave the way investors expect.”

However, the financial crisis prompted a progressive de-gearing of these assets, he said, with companies raising additional equity to pay off debt — such as Connect East Melbourne with its toll road.

As for overall performance, Meany said in the period from September 2007 to September 2009, their fund (which had 95 per cent of its investments outside Australia) was down about 15 per cent. As a comparison, the MSCI World Index was down about 32 per cent.

“The sector outside of Australia has delivered exactly what it needed to do. The earnings of utilities, regulated utilities and pipelines — the sort of boring assets that were defensive in the downturn — have held up well. These stocks have, despite a very ugly environment, been more defensive,” Meany argued.

“As the markets turn and confidence has come back, it’s been the transport infrastructure stocks — roads, airports and ports — that have rebounded strongly with the market. There’s been strong evidence of recovering traffic and passenger volumes around the world.”

In fact, Meany flagged “probably the best opportunity” today as the “volume recovery story”. With the downturn, volume-sensitive infrastructure has become relatively cheap.

“We probably moved from being 60 per cent defensive to 60 per cent growth, if that makes sense. So over the last six months we’ve owned more toll roads and airports and rail stocks, in the belief that volumes will recover and get back to normal levels — just as they have over the last 10, 20 and 30 years.”

But it’s the defensive side that may prove attractive to investors looking for somewhat safe investment options.

Eager said it’s the boring, reliable companies overseas that tend to deliver decent returns to investors. Companies with more exotic models are unique to Australia, he noted. “What you find overseas are just normal companies that have been around for a long period of time and own the infrastructure there.”

So despite some appealing opportunities on home soil, it seems that the industry is still looking offshore for investment opportunities.

Macquarie’s fund, like CFSGAM’s, has little exposure to Australian stocks.

“It’s still a sector that’s developing,” Meany pointed out. “Privatisation has been done well here, but outside of Australia there are still a lot of opportunities for infrastructure assets to come into the private sector. That will grow our universe and give us more opportunities to invest around the world.”

Fitch echoed the sentiment: “Australia is a fairly mature market, so I’m not saying that there aren’t going to be good investments in Australia. But as other countries embrace the privatisation of infrastructure assets, that may provide a broader set of opportunities than what an investment may be able to offer in Australia.”

In addition, exposure to overseas assets allows greater diversity for investors and offers much more liquidity into the investments.

Coming from the institutional side, Garry Weaven, chair of Industry Funds Management, said there will be a growing case for Australia. But in the meantime, with more struggling markets overseas (notably the US and Europe), he suggested that some of the best buying opportunities may well be found offshore.

“For our point of view, we would maintain a keen interest in looking at the Australian market. After all, it is our home and the home of our ultimate beneficiaries. We would continue to try and give it priority, but at the end of the day our job is to maximise the longer-run returns for the members.”

The other side of the fence

As for the institutional side in general, industry funds — arguably the pioneers of infrastructure investment in Australia — remain confident in the sector despite the slowdown in investment, noting potential ‘brown field’ opportunities.

“Most of our client super funds have strong cash flows, so over the next couple of years they will increasingly be in a position to resume investment in the infrastructure space,” Weaven said.

“The more important problem may be that the pricing of some existing assets, both in Australia and around the world, is now more attractive. So new projects have to compete with that in terms of rate of return.”

Weaven said on the retail side, however, most of the funds had “very little liquidity tolerance” and, unable to meet demand for redemptions and payouts, some funds have been frozen.

Ross Israel, head of global infrastructure at QIC, said there was a range of opportunities for investors looking for interests in high-quality infrastructure assets which, until recently, had been “very tightly held”.

“Listed infrastructure entities with high debt levels and/or complex structures are being questioned by the market,” he said. “Many of these listed funds are raising capital to deleverage their balance sheets or fund expansion capital expenditure. They are also undertaking strategic reviews to determine the best way to deliver value to their investors.”

Trevillyan argued there had been a push back from investors globally towards manager products “that are poorly structured, with significant conflicts of interest, poor alignment of interest and high fee levels”, which had led investors to consider alternatives to a blind commitment to a manager’s fund.

“There has also been an explosion in the number of new managers and new products entering the infrastructure sector globally over the last few years. It is expected that a number of these managers/products will no longer exist and we are already starting to see signs of that (eg, ING, RREEF in the US, Santander) or will have very different product offerings.”

It may well be a matter of investors cooling their heels. “Our clients are typically in the position of already having material exposure to infrastructure investments and therefore the ability to be patient and have no pressure to rush into new investments in infrastructure,” Trevillyan said.

Despite the quiet confidence, the institutional side acknowledged the issues investors have had to work through, including the debt levels their assets can support.

“Refinancing existing debt has seen significant increases in cost, and this has forced owners to critically review their business plans — especially expansion projects,” Israel noted.

“More positive, however, is the Government’s responses to the global financial crisis, which has seen significant stimulus packages focus on infrastructure initiatives. For this reason and the recent improvements in debt markets, the future for infrastructure investors looks positive.”

Politics and policy

The Federal Government’s sizeable budget allocation towards “larger and longer-term nation building projects” earlier this year showed Labor is serious about addressing infrastructure problems. The Government inherited, according to Albanese, an economy with “a significant deficit in infrastructure and skills due to underinvestment [of capital from the mining boom]”.

Vying for attention alongside such marquee issues as climate change are highways up and down the east coast, metro rail in several Australian cities (although just last week the Government’s $309 million Southern Sydney Freight Line was being “re-evaluated”), ports (‘international gateways’ for exports) and, of course, a national broadband network. And all have been promised by the Government: “Nation building for every corner of Australia,” Federal Treasurer Wayne Swan pledged.

Albanese, whose portfolio also consists of transport, said the Government’s approach is two-pronged: investment and policy reform, “in terms of promoting efficiency and productivity in the economy”.

But, despite a mention in the Review into the Governance, Efficiency, Structure and Operation of Australia’s Superannuation System (the Cooper Review), the idea of mandating investment from superannuation funds is not on the cards, Albanese insisted. “I think quite clearly with superannuation funds, they have fiduciary obligations that would prohibit the direction of where those funds could invest.”

He did say, however, that there could be policy mechanisms that encourage investment into infrastructure with super funds.

“Infrastructure does provide a secure, steady rate of return that has been shown to have major benefits for investors — as well as the macroeconomic benefits,” Albanese noted.

“And I think … Australian superannuants would benefit both directly and indirectly … were there to be investment or a greater level of investment in Australian infrastructure by superannuation funds.”

Nonetheless, at a time when the Cooper Review has clearly thrown the possibility onto the agenda, the question of how to engage the private sector more strongly is ever prevalent. It’s a move the industry universally panned, with most having said it would never eventuate.

“This government seems fairly committed to the idea that … trustees have a fiduciary responsibility to do the best they can in their investments on behalf of their members, and I think there’s no apparent desire to interfere with that,” Weaven said.

“Whether or not any sort of particular incentives are being considered seriously, I don’t know.”

It’s a sentiment shared industry-wide. “I don’t think any government is going to dictate to super funds how their monies should be invested,” agreed Magellan’s Eager. “I think that just creates a massive conflict for the trustees, who are there with the sole responsibility of maximising the wealth of the unitholders in that superannuation fund.”

Nevertheless, the issue was canvassed in the Cooper Review as follows:

“Because super is concessionally taxed, compulsory and otherwise facilitated by government, should government … be able to influence whether super funds make particular investments (eg, infrastructure) either by directly mandating some level of participation (eg, like a ‘20/30 rule’) or providing strong incentives to do so; and … remove barriers (if any) preventing trustees investing in long-term investments, such as infrastructure? To what extent do these barriers exist?”

Of the numerous submissions received, there appeared to be minimal, if any, support for the notion. The Association of Superannuation Funds of Australia (ASFA) said it was against restrictions being imposed to “enforce more diversification to other asset classes or any directed investments”. In other words, like just about every other industry body or company, ASFA would oppose any government direction to invest in infrastructure.

And as Trevillyan pointed out, another issue to consider is that forcing super funds to invest in specific areas would remove the pricing tension of the free market and create artificial pricing environments.

“Further, a mandated system risks stifling innovation,” he said. “Although commonplace today, investments in areas like infrastructure were not common 10 years ago. It is possible that an environment that mandated specific investments (which tends to be more conservative) would lead to lower innovation and reduced acceptance of new ideas in the future.”

Despite these concerns, there’s no doubt funds are needed to bolster the flailing infrastructure sector in Australia.

“It’s clear that from the extent of the investment that will be required in infrastructure over coming decades, the public sector can’t do it alone. We need to mobilise private sector capital and put in place policy mechanisms to do that,” Albanese said.

Investor trust in government may be waning following such PPP debacles as the Cross City Tunnel (the model was, arguably, quite good but motorists have antipathy towards it), but infrastructure investment can prove itself to be a solid long-term investment. And the idea of dipping into super funds may well have some merit.

“The long-term nature of infrastructure assets and their diversification benefits already make them an attractive investment for superannuation funds,” QIC’s Israel said.

“Governments have long been a key stakeholder in infrastructure projects, but they are becoming aware of the benefits generated through collaboration with the private sector,” he noted. “As the infrastructure sector continues to mature, investors and governments are working together to reconcile public interest benefits and commercial returns for investors.”

For Israel, collaborative arrangements that promote “the efficient development and operation of infrastructure assets” were more likely to achieve both the Government’s and investors’ objectives.

Another consideration the Government would have to take into account is the advent of renewable energy as an infrastructure subsector.

Weaven said the Government needed to look at tweaking its renewable energy target legislation. In all the chopping and changing, it has produced a regime that was highly favourable to solar hot water manufacturers but, in the short term, less attractive to new clean energy generation developers. It’s an area that would require approximately $20 billion over the next five to 10 years to reach the Government’s targets.

Despite this and the many other challenges the Government — and the sector — would face, Albanese remained optimistic.

“We must bear in mind that Australia is, of the advanced economies, the fastest growing. And we have the second lowest unemployment rate, the lowest debt and the lowest deficit.”