Healthy outlook for infrastructure investment despite failed public/private partnerships

Despite failed public/private partnerships and the complexity surrounding Australian infrastructure, Benjamin Levy discovers all is not lost in the sector.

Infrastructure is a complex problem for the financial services industry. The sector is repeatedly called on to invest in more local infrastructure, but concerns about transparency and a lack of understanding of the risks and returns — along with expensive and bureaucratic bidding processes — is stymieing more investment.

The sector is also plagued by failed public/private partnerships (PPPs), with both the Government and the investment industry unwilling to take on the investment risk involved in a project.

The result is a shortage of infrastructure projects being built, with investors looking overseas for infrastructure projects and calling on the Government to think flexibly about how to solve risk problems.

The fallout from the global financial crisis (GFC) has created yet more problems for the sector, including the ballooning cost of debt financing, which is making it difficult for new infrastructure assets to be successful.

However, it is not all a lost cause, with mature assets and global renewable energy providing plenty of opportunities for investors.

Transparency and complexity

Industry super funds have been called on again and again to invest more in local infrastructure, but the problems with the nature of infrastructure projects are standing in the way of new investment, according to Association of Super Funds of Australia (ASFA) chief executive Pauline Vamos.

“The superannuation industry is called on time and time again to invest more of members’ money into infrastructure.

"And we say that we already invest in infrastructure, and there are a number of infrastructure projects that we have difficulty investing in because they have no transparency, and there’s no ability to really understand the risks and the potential return,” she says.

Throughout 2010, the financial services industry has also been calling for problems marring the infrastructure sector to be fixed.

A Financial Services Council (FSC) PricewaterhouseCoopers survey of financial services chief executives in August found that the key barriers to infrastructure investment were the scale and complexity of infrastructure transactions, the lack of confidence, the costs for retail investors, and the political system.

PricewaterhouseCoopers wealth management leader Andrew Wilson said that securing funding from super funds was about providing the industry with confidence that infrastructure would deliver a reasonable return commensurate with an acceptable level of risk.

The ability to assess the returns from an infrastructure project is affected without an understanding of the potential risks and returns, Vamos says.

“Take the case of the Cross City Tunnel in Sydney, which is a great bit of infrastructure, but the estimates on the number of people going through were underdone and there were a lot of provisos around it. So we know there is a real risk,” Vamos said.

“But you have to be able to have certain assumptions about the returns — that is part of your fiduciary duty. So if you don’t have enough money to make reasonable assumptions about the returns, then we can’t really invest.”

Super funds are always called on to invest more in infrastructure because they drive the economy, and a stronger economy drives strong superannuation — but individual funds have to take investment on a case-by-case basis, Vamos says.

“We support infrastructure investment because super invests in the whole economy. If we drive the economy, then we will drive better returns for our members. But again, that’s on an industry-wide level.

“Individual funds must ensure that they are able to take on that risk, and that from a cash flow basis, they will be able to get some cash returns. Also, from a liquidity basis, they want to make sure that having so much in an asset that can’t be sold quickly won’t leave them short,” she says.

Vamos warns that the industry also needs to work on increasing its level of experience in overseeing infrastructure investments, calling it a fiduciary duty.

“We are working on our agenda for next year on a best practice paper about this subject,” Vamos said.

However, Morningstar co-head of fund research Tim Murphy says the complexity and non-transparent nature of infrastructure depends on the asset — and some are less complicated than others.

“It comes down to asset by asset, different projects or infrastructure projects are geared differently or have different payment structures. It’s hard to make a generalisation about it across the board — it varies on a case-by-case basis,” he says.

AMP Capital head of infrastructure and portfolio management Paul Foster says people looking to invest in infrastructure as an asset class need to understand asset-specific risk before investing in certain projects.

“You need to do very bottom-up, very comprehensive asset-specific due diligence before you make an investment decision. By their very nature, these are relatively long-term, relatively complex financing structures and any investor needs to understand those risks properly before committing capital,” he said.

Government help

It is clear the investment industry wants the Government to step in and fix some of the problems in the infrastructure space.

“In order to bid for an infrastructure project and fund it, you have to go through a big process. This is state-based but it costs [a minimum of] $250,000 just to bid. For the very large funds that have a great deal more experience, this is possible, but for the medium to small sized funds there’s no way they’re going to do that,” Vamos says.

“So what we’ve been calling on for quite some time is a national-based bidding system that is much cheaper and has less bureaucracy around it, along with the development of much easier methods to value investment and to value the returns and risk,” she says.

At an Australian Institute of Superannuation Trustees lunch late this year, Australian Council of Trade Unions assistant secretary Jeremy Lyons called on super funds to find better ways to invest in local infrastructure projects without compromising investment returns.

“It’s unacceptable that super funds in Australia can routinely find it easier to invest in projects overseas than in Australia,” Lyons said.

The Government could facilitate easier super fund investment in infrastructure if it designed a new tax framework for the sector, Lyons said.

“The Government needs to take better account of funds management decisions and design a tax and procurement framework that facilitates investment by funds in an Australian context.

"Too many Australian infrastructure projects involve high fees and suit investment banks and construction consortiums but not super funds,” he said.

PPPs and passing the ball

However, the problems with infrastructure investment are more complicated than that, and it encompasses the failure of the PPP system, according to Australian Super head of infrastructure Suzanne Findlay.

“Generally speaking, where the industry funds have made comments about the structure for investing in PPPs, it’s been about the sharing of risk between the different participants: where there’ll be a construction company, a financial arranger and equity investors as part of a consortium.

“The construction company, even if they invest in the equity, tend to make most of their profits from doing the construction, so they get paid for that before the asset is operating.

"And similarly, the financiers tend to get paid early in the process, whereas the equity investors are paid over the life of the asset, which might be 30 years. The experience has been that there hasn’t been enough of a buffer left for the possibility of something going wrong during the life of the asset,” Findlay says.

“Equity investors are the only ones left to earn their earnings, and they’re the ones that might suffer from that, because the other participants in the consortium have already taken their earnings,” she says.

That risk was so high that, particularly before the GFC, the bids that were put in for infrastructure projects were such that the return for equity wasn’t high enough to cover the risk, Findlay says.

“It means we were less inclined to invest in those projects in Australia,” she says.

Infrastructure is a global asset class, and if there are any investment risk problems with local infrastructure investors will simply look elsewhere, Foster says.

“We think about it from a very bottom-up, asset-specific basis, and our view is that superannuation funds are likely to maintain an approach that is absolutely focused on their objective, which is generating the best risk-adjusted returns for investors.

"If those opportunities are available locally, fantastic; if not, they’ll happily go and find them elsewhere,” Foster says.

Gearing and bad forecasting played a part in contributing to high-risk infrastructure projects in the last decade, according to Murphy.

“In the last 10 to 20 years, there has been a bit of a push in infrastructure for PPP projects, most of which have gone kaput. For example, the Cross City tunnel, the Lane Cove tunnel and others; gearing was an issue with most of those, as well as dumb forecasts,” Murphy says.

Both sides appear to be passing the ball on infrastructure, with neither the investment industry nor the Government wanting to take on the risk involved.

“With the discussions that have been going on for a couple of years about super funds investing more in local infrastructure, it has been raised with governments that they could build the infrastructure and then sell it to equity investors once the construction risk was gone, but they haven’t wanted to do that because they prefer to have that risk borne by the consortium,” Findlay says.

The result is that there is not enough infrastructure being built in Australia, and that is in turn stymieing more investment in the sector.

“Each state will probably only bring one or two PPPs to market each year, and they tend not to do that in a year when there’s an election. So there’s not actually that many PPP’s coming to market each year,” she says.

While KPMG came out with a study for Infrastructure Australia showing that there was the right amount of participants in the market given the number of projects available, Infrastructure Australia would certainly like to see more projects available for funding, Findlay says.

“But it’s something that the state governments are going to have to change so that there are more projects and participants,” she says.

Government has a responsibility to fix the issues that are making the private sector hesitate before investing in infrastructure, according to Foster.

“There is a need for governments to really understand on a project specific basis what issues might be causing the private sector to back away, and then think flexibly about the way they address that,” he says.

“For governments to think about procuring new infrastructure via a PPP framework, I think they have to be willing to think flexibly about the pinch-points within those various PPP projects, and acknowledge that it won’t be a one-size-fits-all solution — they’ll need to be responsive to the specific risk issues that may need mitigation,” he says.

Debt finance

Another issue that is dragging down infrastructure is debt finance — a legacy of the GFC.

“The one thing that has changed immensely since the GFC is really with respect to the debt markets. Debt is an important component of financing in infrastructure project, and the debt markets have changed significantly,” Foster says.

“There is just not as much leverage out there to finance assets, and the pricing of that debt has also gone up. A mature

"A minus toll road that we’re involved in was able to borrow money at a debt margin below 50 basis points prior to the GFC, and when we came to refinance the debt around that asset late last year we saw a quadrupling of debt margins.

“And thirdly, debt length has changed, so we have these extremely long-duration assets with very predictable long-duration earning streams and cash flows but it’s very difficult to access debt within the Australian market beyond five years,” he says.

“So we’re getting a mismatch between asset duration and the capital structure that you can place around it,” he says.

The ballooning price and shrinking availability of debt is making it difficult for new infrastructure projects to be successfully ‘closed’, Foster says.

There is plenty of equity capital from super funds and managers acting on their behalf, but the biggest challenge and barrier to those projects coming to fruition is the availability of attractively priced debt finance, he says.

Some gearing levels can grow to 80 per cent debt, according to Findlay.

“For social infrastructure assets, like hospitals, the gearing tends to be about 80 per cent debt and 20 per cent equity, so there’s actually more requirement for debt than equity.

"When IFM talked to representatives from each of the state governments, they were as concerned about debt investors as equity investors. This has come out of the GFC, since while the banks are still lending to infrastructure, it’s lower amounts.”

Australian Super has made investments in infrastructure debt rather than infrastructure equity in PPPs as a result, Findlay says.

Opportunities

Despite the problems the industry is having with non-transparent products, PPPs and debt financing, there are still plenty of opportunities in the infrastructure sector — particularly when it comes to renewable energy projects.

“Renewable green energy is one of the sectors where you have seen new projects successfully closed in the period after the GFC. There have been some interesting approaches towards those sorts of things happening with the debt markets,” Foster says.

“A very large wind farm project was closed in Western Australia towards the end of last year, and the Danish credit bank stepped in and effectively provided debt financing for 15 years for that project. They had an interest in doing that because it was a Danish company providing the wind turbines that were going to power that project,” he says.

Super funds are one of the bigger players in the renewable energy space. Retail industry super fund REST joined with UBS International Infrastructure Fund in April this year to buy Investec’s Western Australian Collgar wind farm, which is expected to be completed in 2012.

The largest asset for Australin Super in the renewable energy space is Pacific Hydro, which specialises in hydroelectric and wind farm projects across Australia and in Chile.

“At the moment, Pacific Hydro has more under construction in Chile than in Australia, which has to do with the regulatory environment for renewables and the uncertainty about carbon pricing in Australia,” Findlay says.

Australian Super would prefer more certainty about possible carbon pricing in order to price future investments in the space, Findlay says.

Murphy warns that the renewable energy sector is getting more speculative in nature, but it’s not accessible for most investors.

“Often these sorts of things that are supposedly environmentally friendly are reliant on Government subsidies which typically you can’t count on forever, so you open yourself up to greater Government regulatory risk, but that’s the sort of stuff that’s not typically accessible for must most advisers or individual investors,” he says.

“The main opportunities for people in infrastructure are in listed securities such as infrastructure projects and airports. If you look at the global listed infrastructure funds that are available in the adviser space, this is the sort of thing that people are investing in,” Murphy says.

When it comes to mature infrastructure assets like airports, looking locally will be more successful than a search overseas. “We quite like the regulatory environment in Australia and there’s good growth to the airports here,” Findlay says.

Airports in Europe don’t get to keep the upside of their retail revenue, because it’s effectively capped, unlike Australia, Findlay says.

“We’re seeing very good opportunities across all sectors, we’re seeing a lot of good opportunities in the secondary market place, we talk about existing sectors like airports, globally, are being turned over and are changing hands, and certainly, across the spectrum geographically there are opportunities,” he says.

The opportunities in existing infrastructure assets is so strong that investors are willing to look to existing assets rather than bidding for new projects, Foster says.

“Quite frankly, one of the challenges for new project procurement, new PPPs, is the fact that there is still quite a healthy pipeline of secondary market opportunities,” Foster says.

Portfolio uses

Advisers cannot hope to make direct investments in infrastructure assets, according to Murphy.

“Large super funds don’t require liquidity, so they can make large direct investments in assets like local infrastructure,” he says.

Low or no-liquidity high investment amounts are barriers to investing directly in infrastructure, Murphy says.

“If you’re a big super fund with billions of dollars at work and you put in a couple of hundred million dollars in an infrastructure project, it’s not a huge part of your portfolio; but if you’re a small fund or a rich individual with a couple of million dollars, infrastructure projects need hundreds of millions to fund them,” he says.

The FSC PricewaterhouseCoopers survey also found that a focus on short-term performance and daily unit pricing was a barrier to infrastructure investment.

However, investing directly in infrastructure doesn’t suit the needs of retail investors for the same reasons, Murphy says.

“If you’re talking about direct projects, they’re clearly not liquid, they’re long duration, and the way that most retail investors invest, it’s not suitable for them,” he says.

“The only investor that it’s suitable for is investors that don’t need liquidity and have large duration investments to make — which would be super funds.”

“Trying to put that into a fund that’s priced regularly and for investors to go in and out of is frankly a dumb idea. You just have to see what happened with direct property funds through the GFC — many of which are still frozen. You can see the implications that could have,” he says.

Foster also warns that listed infrastructure assets can be a drawback for retail investors.

“One of the interesting lessons that came out of the GFC around infrastructure was the way that the assets were packaged. A lot of investors held exposure to the asset class via listed securities, or portfolios of listed securities, where despite the fact that the assets perform largely as they had been anticipated to perform, the fact you own something listed on the stock market reminds people that they own equity market beta,” he says.

A blend of listed and unlisted infrastructure is best in a portfolio to mitigate market beta, Foster says.