Infrastructure Investing: In a class of its own?

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1 Infrastructure Investing: In a class of its own? Infrastructure Investing: In a class of its own? Investing in infrastructure assets is a relatively new strategy that many non- Dennis Martin U.S. institutional investors are now pursuing to improve total returns and perhaps more importantly, stabilize long term investment yield. With few infrastructure investment options currently available to investors in the United States, the asset class could be considered in its formative stages in this market. Director So what is the attraction of investing in the infrastructure sector, how does it compare to more traditional real estate, and what should institutional investors consider before adding it to an existing real estate or private equity investment program? Infrastructure assets include a wide range of assets that provide essential services to a community and can generally be broken down into two broad categories: economic infrastructure and social infrastructure. Economic infrastructure projects are typically assets that directly support the economic vitality of a community, and are often the best suited for outright sale or privatization because they are generally funded and maintained by user-based RREEF fees that can be scaled to the benefits they provide and associated costs (e.g. the tolls paid on a toll road or bridge). These economic infrastructure assets include transport infrastructure, such as toll-roads/ bridges/ tunnels, airports, seaports, and rail networks, as well as common utilities such as gas distribution networks, electricity and renewable energy production and distribution, and water treatment and distribution. In most economic infrastructure transactions, the acquiring party typically buys the asset outright or acquires a long-term operating lease or concession, over which the selling government or agency retains a degree of control through regulatory oversight or contract/lease provisions including operating covenants and maintenance obligations. Social infrastructure assets on the other hand tend to support the social fabric of a community and are generally funded and maintained through the collection and allocation of tax revenues or a mix of user fees and tax-based subsidies. These social infrastructure assets include schools, health care facilities, prisons and intra-city railroads. These assets tend to be less wellsuited to outright sale or privatization because governments are reluctant to cede control and because they don t have a separate and readily identifiable revenue stream to make them attractive to would-be investors. As a result, social infrastructure transactions often take the form of public/private partnerships (PPPs) in which the public agency retains ownership of the underlying asset but a private operator is brought in to provide management and related services. 1

2 Real Estate Investing Fall 2005 With increasing economic development and population growth, governments around the world are facing increasing demands from their constituencies to improve the quality and scale of economic and social infrastructure. However, with many governments also facing fiscal pressures (including the growing pressure to fund retirement needs of aging populations), few can afford to provide these infrastructure improvements without the use of private funding. In taking that step, most governments are keen to pursue a model that has long-term stability. Recent experience in Australia and Canada suggests that institutional investors such as pension funds can be an ideal capital source for these ventures, because they have the scale, financial objectives, and long investment horizon that are an excellent fit for the scale, and steady, long-lived income streams of these assets. The Evolution Infrastructure Investing To date institutional investors in Australia and Canada have the most experience with infrastructure investing. Their early entry into this market was prompted by a number of factors, including a spate of large, high-quality and highprofile asset privatizations in a short period of time, coupled with a cash rich pension fund market seeking tangible alternative assets that could deliver attractive and predictable income streams. In Australia, infrastructure investing has developed to the extent that it is now considered as a separate asset class, with pension funds, on average, allocating 5% of portfolio assets to the sector and larger funds committing more. Industry funds (i.e. public sector funds with members specific to particular industries) which represent nearly one-tenth of the total pension fund assets in Australia, have committed over US$2.3bn to infrastructure investments. Insurance companies have also invested substantial sums; however, these are difficult to quantify due to limitations in their required reporting. Some large individual pension funds have made particularly sizable allocations to the sector. By way of example, as of June 30, 2004, the Motor Trades Association of Australia Superannuation Fund had more than 20% of plan assets invested in infrastructure. In more recent years, Canadian pension funds have become increasingly active in the infrastructure sector. While detailed data on their allocation to infrastructure assets is not readily available, a number of the large funds are known to have at least 5% of plan assets invested in infrastructure, and the number of funds pursuing infrastructure investments continues to grow. While infrastructure is now firmly established in the investment allocations of institutions in the relatively small markets of Australia and Canada, it remains relatively new and novel in other developed markets such as the United States and United Kingdom. Recent fiscal and regulatory changes, however, suggest that may be about to change. With respect to the U.K., the potential coupling of pension capital and infrastructure assets was pre-empted by Thatcher Era policies that led to the direct privatization of infrastructure assets into publicly-listed companies throughout the 1970s and 1980s. These listed company privatizations have had mixed success and, as a result, a number of these early privatizations are now returning to the market as secondary sales. In addition, there are increasing opportunities for private capital to participate in early stage transport projects (such as the M6 toll-road, providing a bypass around the city of Birmingham), which was previously a government-only domain. With supply increasing, a wider range of investment options is being launched and, while U.K. pension fund investors have been characteristically cautious to act, interest in the infrastructure sector appears to be growing. For the United States, the greatest constraints to the growth of the section have stemmed from (i) the regulatory landscape, (ii) government budgetary conditions, and (iii) limitations upon the financing tools available to the sector. Historical underinvestment in crucial 2

3 Infrastructure Investing: In a class of its own? infrastructure (such as roads) in the United States has prompted growing congestion and capacity constraints at a time when government budgets can not keep pace. Pressure to find fiscally sound solutions to infrastructure requirements has prompted a series of recent legislative developments, including the Transport Infrastructure and Innovation Act of 1998 and the Safe, Accountable, Flexible, Efficient Transport Equity Act of 2003 (SAFETEA). Both of these pieces of legislation are directed at allowing greater flexibility in the financing of transportrelated infrastructure, including access to tax exempt bond finance from state and local governments for infrastructure projects; relaxation in the rules surrounding tolling of interstate highways; and allowing greater flexibility with regard to how private and public partnerships can be formed, managed, and projects approved for the provision of infrastructure. Further, on August 10, 2005, President Bush signed the Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users Act ("SAFETEA LU"). This bill allows up to $15 billion worth of private activity bond financing to be used for transportation projects with a private equity funding component. This move will allow privately-funded projects to compete on a cost of capital basis with projects financed using municipal bonds. These supply factors, together with strong demand from many institutional investors for investment opportunities that can reliably offset long term liabilities suggests that the infrastructure investment market is likely to expand rapidly in these two large capital markets, potentially following the lead of the Australian and Canadian experiences. The Anatomy of an Infrastructure Transaction Infrastructure projects normally originate at the local municipality level where a response to increased demand or a development objective is driving the local authorities. In many cases, budgeting constraints or a desire to link the private sector to the delivery and operation compel the municipality to procure the project on a private basis both for the financing as well as the ongoing operation. A typical infrastructure transaction will have several government and private parties involved. Often times there will be one government entity responsible for the procurement, with others having a seat at the table to protect their respective interests. As an example, a local rail authority may be the lead for procurement of a light rail project but the city's department of transportation will likely have a key role as the project will have an effect on the assets under its control, e.g. local roads. Once the government entities have decided the basic scope of the project, they will initiate a tendering process to determine who will be awarded the project. This is usually a bidding process open to all (prequalified) bidders. On the private side, a typical infrastructure transaction will involve engineering and construction firms, operating and maintenance companies, finance investors, commercial lenders, and sometimes multilateral institutions such as the EBRD or the European Investment Bank. In most cases, the tenders for infrastructure investment have a capital component as well as an ongoing operating/maintenance component. Because of this, construction and operating companies will take the lead in responding to the tender. If there will be a substantial equity component, the contractors will often bring a pure financial investor into the process collectively. The contractors and investors will form a consortium (usually through a newly-formed special purpose vehicle) and are often called the project "Sponsors." As part of a qualifying bid, the sponsors will most likely have to demonstrate that they have obtained a firm financing commitment from reputable lenders. Depending on the nature of the project, most of these transactions are highly levered with project debt accounting for 60% to 90% of total capital. With respect to the 3

4 Real Estate Investing Fall 2005 Exhibit 1 Lifecycle of Infrastructure Assets Source: RREEF Infrastructure remaining equity a combination of contractor equity ("skin in the game"), private equity from institutional investors, and in some cases, mezzanine debt, will be employed. Underpinning the financial structure of the transaction will be a series of interlinked contracts between the government authority, the sponsors, and the lenders, which establish exactly how the project will unfold. In most cases, the negotiation of these contracts is the most important and the most time-consuming element of the transaction. It is at this stage that key elements of risk are identified and allocated to the party most capable of mitigating them or valuing and paying/charging for them. Similar to traditional real estate transactions, infrastructure deals usually have rounds of bidding as well. Multiple sponsor consortia will submit initial bids with a short list of two to four moving on to a "preferred bidder" stage. It is during the preferred bidder stage that the detailed scope of the project will be established through a series of negotiations with the sponsors and the government. Once the scope is well established, the bidders are in a position to prepare a final bid on the transaction. After this, a winner can be selected. Although the price is a key component to selection, other factors can come into play such as confidence in the contractors, robustness of the financing package, and commitment to the project. Investment Characteristics of Infrastructure Infrastructure assets represent investments in tangible assets and associated businesses that can deliver attractive capital growth opportunities (particularly if an investment is made early in the life of a project) and importantly, consistent and often inflation-linked income streams. Their key characteristics include the following. Very stable, inflation-linked income returns, particularly in later stages of an asset s life. Large scale of investment required per asset; for example, it is very common for assets in the infrastructure arena to be valued well over US$1 billion, placing them out of the league of individual institutional investors. Very long life of each project or asset concessions to operate or provide infrastructure services will typically span more than 35 years, so the income stream that they can provide is not only appealing (typically at a premium to most other asset types) but consistent over very 4

5 Infrastructure Investing: In a class of its own? long time periods. Monopolistic market conditions for the majority of infrastructure assets, protected by the number of service providers (e.g. one water or gas distributor to service a particular region) or the location of the asset itself (e.g. the only road or tunnel to join important transport destinations). A combination of returns from physical assets and the performance of an operating company with the licence or concession to provide an essential service for which their customers will pay. This characteristic illustrates the blend of private equity and real estate investment disciplines inherent in many infrastructure assets. Exhibit 1 (previous page) illustrates the life cycle of an infrastructure investment. Early Stage investment opportunities include greenfield projects such as new road, bridge and tunnel developments, or assets in higher risk locations or where there is no established demand patterns which can be relied upon. There will be little or no income from the asset for some significant period of time. The Growth stage typically includes expansion projects and new privatizations of existing operating assets. In these cases, there are established operating results that can be analysed and reliable forecasts that can allow for some view of potential operating growth. In this stage of development, the asset should deliver a reasonably consistent yield with attractive growth underpinning future results. In the Late Stage, infrastructure assets are considered mature, proven assets. Here, usage of the road, airport, utility or other facility will be well-established and income will be the predominant component of the investment return. In many cases, particularly in the utilities field, infrastructure businesses are regulated, with price increases on their product limited to periodic government review. This typically occurs where there are monopoly-like conditions, providing for very predictable income stream potential for investors. As a result, infrastructure assets may fall within one of these key lifestage segments due to the age of the business (e.g. a road) or the nature of the industry (e.g. regulated utility). The Nature of Risk and Return Given this picture of the evolution of infrastructure assets, what is the nature of risk and return that applies to each type of asset and how do they compare to other asset classes, such as real estate? Exhibit 2 (below) displays Exhibit 2 Estimated Characteristics of Typical Infrastructure Assets, by Stage Source: RREEF Infrastructure Estimates 5

6 Real Estate Investing Fall 2005 some of the typical characteristics of infrastructure investments through their key development stages. Early Stage investment opportunities will generally arise in the form of toll-roads, bridges, tunnels and other transport-related projects. Opportunities for private investors to participate in sectors such as airports, utilities, and social infrastructure in developed nations typically arise after the asset has been built and operating conditions have been established. As can be seen from the estimates in the table, greatest value from a risk/reward perspective will typically occur during the Growth Stage and Late Stage of an asset s life-cycle. However for transport assets (such as tollroads), the price of entry to that income stream and capital appreciation is generally participation in the early stage development of the project, as few investors will be looking to sell such an attractive asset during its growth phase. Conclusion Despite its relatively early stage of development in the United States, infrastructure investments offer some compelling benefits to the institutional investor. The opportunity to participate in very tangible, long-term assets that can deliver growth that at least matches inflation, together with attractive and predictable income streams, can be an ideal match against long-term liabilities. The risk and return characteristics of infrastructure assets differ between its subsectors and across the lifecycle of each enterprise. A diversified portfolio can, however, deliver the strong and stable returns investors are seeking, as found by a wide-range of institutional investors from Australia and Canada who have been active in the sector for a number of years. The fundamentals driving demand and supply conditions for infrastructure investments and the valuable attributes they can provide to investors in the United States have the potential to drive the growth of institutional investment in the sector. Disclosures Deutsche Asset Management is the marketing name in the U.S. for the asset management activities of Deutsche Bank AG, Deutsche Bank Trust Company Americas, Deutsche Asset Management Inc., Deutsche Asset Management Investment Services Ltd., Deutsche Investment Management Americas Inc., and Scudder Trust Company. RREEF is a full-service real estate investment advisor and is a division of DB Real Estate, the real estate investment management group of Deutsche Asset Management. The comments, opinions, and estimates contained herein are based on, or derived from, publicly available information from sources that we believe to be reliable. We do not guarantee their accuracy. This material is for informational purposes only and sets forth our views as of this date. The underlying assumptions and these views are subject to change without notice. The material does not constitute investment advice and should be relied upon as the primary basis for any investment decision. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without DeAM's written consent. Dennis Martin holds a B.A., Political Science, St. John's University J.D., cum laude, New York University School of Law 6