Infrastructure investment has been around for a decade or more, but in the heady days of the dot.com boom, would not have been classed as a sexy sector and was also poorly understood. Now, in view of the consensus that we are in an era of relatively low returns, investors both institutional and retail have been discovering the attractions of this new asset class.

Infrastructure investments vary considerably in size and form. The building and operation of the toll road motorway M2 in Sydney by Macquarie Bank, a world leader in this genre, was an early example of the private sector takeover of a traditional state function. Roads, bridges, airports and ports are aspects of essential infrastructure that have been built and operated by the private sector all over the world.

Infrastructure embraces both fully privatised entities such as airports and joint projects between the state and private sectors. Examples of the latter are hospitals, schools and prisons and other government buildings where the state remains responsible to the populace but farms out either the construction, the ongoing operation or both to the private sector. Often, the justification is that the private sector will deliver on cost savings and improvements to efficiency

Infrastructure investment, by its very nature, involves the establishment of a large capital asset initially, which then needs a programme of ongoing maintenance and operation.

Environmental services is likely to be a growth sector as governments alone cannot handle the increased pressure to clean up and protect the environment. A case in point concerns waste disposal, the target of tightening environmental legislation in European cities.

Utilities such as water, power, energy and related activities at all stages of the value chain, including pipeline networks and plants, are also candidates for infrastructure investment. For instance, Deutsche Bank, through its giant New York property arm RREFF, bought UK water assets from the buyout equity firm Terra Firma. The global insurance giant Allianz linked up with the UK construction company Laing on the UK government's Private Finance Initiative.

What is infrastructure?

There is not one definition of infrastructure used by all investors. In general it refers to the large-scale capital assets of a country, which provide facilities and services regarded as essential to the functioning and development of the economy and society.

Two broad classes can be identified:

• Economic infrastructure - Roads, railways, ferries, bus and light rail facilities, bridges, tunnels, airports and ports, telecommunications infrastructure, and utilities such as water, gas, electricity (all aspects including transmission, production and distribution) and waste processing.
• Social assets – hospitals and other healthcare facilities, schools, universities and other education facilities, judicial and correctional facilities, public housing and defence support services.

The large element of initial capital needed for development constitutes a high barrier to entry. Their long life is another feature.

Traditionally the state has been wholly responsible for infrastructure but now, depending on the political ideology of the country concerned, there is increasing recognition of the private sector’s potential for doing a superior job in reducing cost and increasing efficiency.

The private operator’s role includes designing, building and financing the construction of the assets and then maintaining and operating them. In return, they receive either contracted payments from the state or revenues generated by these assets.

Often the assets are for a single purpose, such as a particular road, airport, pipeline or school. Sometimes, they are held for a finite period contracted with the government, after which they revert to the latter. Others are fully privatised and the ownership rests with the private sector operator but remains regulated by the government.

Infrastructure businesses are in general natural monopolies requiring very large economies of scale in their initial construction. Typically, the marginal cost of the actual service or product would be very low, for example, the passage of a single car over a bridge or the cost of a single telephone call. For the service or facility to be commercially viable the initial capital expenditure needs to be paid for. Where formerly this was met out of taxes, under privatisation, when an economic asset is involved, the capital cost is recovered by the private operator directly from the user, by including it in a levy on the latter.

The monopoly situation introduces the need for regulation or state supervision so that the operator is constrained from earning abnormal profits. Such regulations, however, also have their advantages to the operator in as much as they promise a stable environment which enhances the reliability of the cash flow stream.

Three phases

An infrastructure project typically has three phases from start to finish. The first phase involves the bidding by and the subsequent selection of the contractor. The second phase comprises the actual construction. The third and final phase consists of the ongoing operation of the facility or service, for which the project created the necessary infrastructure.

The bidders for a PFI hospital project, for example, would typically be a consortium of a builder, a financial institution and a facilities manager. The first phase is regarded as the riskiest, as the expenditure, possibly millions of dollars, has to be incurred with a very high chance of complete failure.

A group that bids for these projects has to invest in an infrastructure of its own comprising the necessary staff, due diligence research facilities and other related resources, constituting a heavy outlay. The risk of bidding for any one project and then failing becomes prohibitively large unless there is an ongoing stream of opportunities available within the country and the market. A firm would hesitate to set up a facility in, say, Hungary, unless there is a likelihood of a stream of similar investment opportunities. Similarly, a company would baulk at putting together hospital expertise unless it had the chance of bidding for several hospitals to make it worthwhile.

The next phase is the construction phase, in which the winner of the bidding in the previous phase will be given a long-term contract by the government to build the facility. During this phase they are subject to various operational and cost control risks.

Once the project is completed, then operating the facility is an ongoing task, and can be contracted out to a specialist firm. At this stage the risks reduce considerably. For instance, after a toll road is built the operator will have reasonably assured revenue from motorists, while maintenance and operating costs become more predictable.

Two types – public-private partnership or fully privatised

Infrastructure investments come in two different forms. These various projects can be partly in the private sector and partly in the state sector, (for example, hospitals and schools), or can be privatised fully (e.g. airports and roads). Interestingly, Macquarie Bank, recognised worldwide as an infrastructure pioneer and a leading expert in this sector, has preferred fully privatised projects. Barclays Capital, on the other hand, has focused on projects involving partnerships with governments.

The latter is often referred to as a Public-Private Partnership (PPP) or Private Finance Initiative (PFI) in the UK. It should be noted that all PPP operations do not necessarily involve infrastructure. For instance, if a local authority contracts out cleaning services then it is a PPP exercise but is not infrastructure. In the UK, PFI is the terminology used to denote private finance being introduced for a government controlled infrastructure project. However, these terms are used fairly loosely in industry terminology. Many investment institutions focus on one or the other of these types.

Investor choices

Investors come in at phases two and three referred to above, namely the primary, construction phase and the secondary, ongoing operational phase. The former is the riskier and therefore the original consortium begins by having a financial partner, typically a bank. As the construction phase gets under way the risk reduces and external debt can be issued, typically through issuing bonds, both guaranteed and non-guaranteed.

Once the construction phase is over and the operations phase begins, the investors tend to take equity stakes.

During the primary, construction phase, the returns need to be higher to allow for the risk of failure. Frequently there are penalties involved should the contractor fail with cost and time targets, as with private equity investments.

The secondary, operational phase returns are lower, but so are the risks. In the UK, moreover, as PFIs have matured, a market for established contracts, known as secondary contracts, has emerged. This financial model is believed to be gaining popularity elsewhere in Europe. There are specialist lenders - for example, the Dublin-based bank DEPFA - that focus on arranging and underwriting the holding of assets through the riskier construction phase.

A popular way of passing on project risk is through bonds guaranteed by monoline insurance companies. To date more than 90% of PFI projects in the UK have been financed on this basis. The guarantee brings the cost of borrowing down but discourages institutions seeking a better risk/reward ratio.

Monoline deals have supported distribution and liquidity but, with more investor comfort, transactions without guarantees might increase. In the UK, the financing of projects started as a banking market, then evolved into an institutional form as UK institutions became equipped to carry out complex credit analysis.

An institutional investor in selecting an infrastructure investment has a chain of decisions to make as follows:

1. Select either a fully privatised operation, or a public-private partnership (PPP) structure
2. Invest in debt or equity
3. Invest in either the primary or the secondary phase
4. Select the sector, e.g. airports or hospitals
5. Invest directly or in a fund run by an experienced operator, such as Macquarie

One advantage of investing directly is that they do not have to exit from a particular investment, unlike when they invest with other parties who might decide to sell out. Pension funds bidding on their own behalf are attractive to both the managers of infrastructure projects and to regulatory authorities, who are usually unenthusiastic about ownership changes.

Investment attractions

A growing number of pension funds worldwide are now attracted to investing in infrastructure. These have several positive features from an investment perspective:

• The typically very long-term nature of infrastructure investments, some of which are as long as 75 years and can even be regarded as perpetuities, sits very well with pension funds, particularly the ones with a long liability stream of similar duration. This long-term nature is common to both fully privatised entities such as airports or PPP projects where the government has an ongoing involvement.
• The revenues are implicitly linked to inflation, either as a government promise built into regulatory provisions or the business being a basic consumer service which can easily be linked to inflation. Quite often, the charges are increased explicitly with reference to retail price inflation or a wage index and are backed by the government.
• Since infrastructure investments often concern basic consumer or government activities, the cash flows are reasonably stable and have a low elasticity of demand, conferring defensive characteristics.
• They involve monopolistic or quasi-monopolistic activities, and at the least the large scale of the investment required represents a strong barrier to entry.

What are the risks?

1. In the primary phase, failure by the contractor to meet time, cost and performance targets can lead to penalties
2. Regulation is the most important risk at the secondary stage.
3. Political risk. For example, investors need to rely on deals made with the government being honoured. For instance, if a thirty-year agreement is entered into and the government, possibly a new one, pulls out, then recourse to court should be possible.
4. Physical risk e.g. earthquakes, landslides.
5. Interest rate risk. PFI and PPP deals are often highly leveraged. Any rise in interest rates would therefore directly affect borrowing costs. It could also lead to a higher discount rate being applied to the long-term cash flow from the scheme, reducing the value of the project accordingly.
6. Liquidity risk. One of the main disadvantages has been that infrastructure is considered a relatively illiquid investment. But liquidity is expanding significantly as many of the early primary stage investors are now selling out to funds that prefer to invest in established assets with long-term low-volatility investments.
7. Capital risk. In some circumstances, the capital value could be at risk.

These risks will be discussed in more detail, with reference to the current situation worldwide, in the next instalment of this two-part article, which will be available with EDHEC-Risk’s November newsletter.

Valuation and returns

Stock markets traditionally have viewed infrastructure investments such as ports as low growth and hence have accordingly priced them at a low multiple of earnings. But the specialist infrastructure investors adopt a different approach using discounted cash flow models and consequently come up with a higher present value. The availability of cheaper debt has also contributed to this upward rating but this picture could change should interest rates rise.

The forces behind growth

There are several factors behind the growth of private sector infrastructure opportunities worldwide.

In most OECD countries government expenditure has been constrained for decades producing a knock on effect to the infrastructure, much of which has undergone decay and ageing without adequate maintenance or replacement. They are now causing a drag on overall economic activity.

In addition to these historic factors, twenty-first century problems are also coming into play. As mentioned earlier, massive investment in environmental facilities is required as well as new types of investment in energy production, transmission and distribution.

This requirement for infrastructure spending outstrips the public sector capital available, even taking into account the massive reserves of some newly emerging nations. In almost the entire developed world governments are forced to consider bringing in private capital to plug the gap.

However, the more compelling argument is that the latter is able to save costs and increase efficiency. This of course depends on the acceptance of a private sector orientated ideology, which is not universal. For instance, in the UK, Unison, the large public sector union, has been a fierce critic of projects involving privatisation.

According to the CEO of AIG Capital Partners, $1 trillion will be needed just in the next 5 years to build and update global infrastructure. This estimate looks conservative compared with a report by Merrill Lynch claiming that infrastructure spending in emerging markets alone will reach $2.25 trillion by 2011. To cap it all, Mike Davis, CEO of the Swiss mining company Xtra, has forecast that emerging market infrastructure spending will total $22 trillion over the next 10 years, implying as much as nearly $7 trillion in the next 3. The consensus seems to be that annual spending will exceed $2 trillion a year until 2015.

In the US, the infrastructure is crumbling, with water, sewage plants, bridges, roads and airports all badly needing attention and investment. It is reported that in Canada, foreign direct investment is inhibited due to the poor state of its vital infrastructure. European infrastructure is also in a poor state, requiring gigantic investment. It is recognised that Europe has a rapidly growing infrastructure gap, which needs to be filled by the private sector. The new EU states are also planning many privatisation projects. In the UK, important social institutions such as schools, hospitals and prisons have suffered long-term neglect and now require massive expenditure.

The infrastructure story is not confined to the developed world. It is believed that three-quarters of the projected expenditure globally in the next 3 years will occur in China, Russia, India and the Middle East, and that China will account for 43% of the expected $22 trillion deluge in the next decade.

The economic and political justification for all this spending, if not the likely accuracy of the figures, is compelling. It is believed that the emerging markets, though accounting for 80% of the global population, have only 15% of the infrastructure, which is failing to keep pace with their recent rapid economic growth.

The economic prosperity created by infrastructure spending is simultaneously a cost and a benefit. It is a cost because, as people’s living standards rise, they demand better facilities, such as roads and airports, which have detrimental effects on the environment. At the same time, lack of these facilities acts as a bottleneck to further growth. The program of roads and railways in the nineteenth century played a substantial role in the industrialisation of the Western economies and their continued prosperity.

Current developments and the future

Infrastructure investments are now well on the way to becoming accepted as an important asset class, attracting both institutional and retail investors on account of its attractive risk-reward characteristics and being considered as comparable to real estate.

The total infrastructure investment expected in the next 20-30 years, might even exceed $50 trillion, according to some estimates. Even the more conservative figure of $22 trillion would put the total size of this new asset class in the same league as global equities, currently at less than $30 trillion.

However, it will not be all roses and there remains considerable political opposition to private involvement in public projects. How this and other risks are affecting the sector, as well as recent short-term developments, will be discussed in the second part of this article in EDHEC Risk’s November newsletter.