Australia s B20 2014: Infrastructure Investment Options Coordinating Chair: Michael Smith Chief Executive Officer, ANZ Bank Co-Chair (West): Peter Sands Group Chief Executive, Standard Chartered
MEASURES TO FACILITATE PRIVATE SECTOR INFRASTRUCTURE INVESTMENT Countries will use a variety of methods to finance their infrastructure needs that reflect their specific circumstances. The risk-return profile of an infrastructure project will determine the extent of private sector involvement. Government decisions and policy actions can have a significant influence on this calculation. Institutional investors such as insurance companies and pension funds are naturally disposed to making long-term investments in productive real assets given their liability structure. By assuming a larger role in intermediation of long-term capital, insurers in particular can enhance their existing risk-transfer function and market stabilising role. Infrastructure debt would meet many of the needs of institutional investors through regular cash flows, risk-adjusted yields, and better credit quality versus other comparable loan or corporate bond classes. 1 However, there is a lack of adequate financial market instruments for institutional investors to easily access the infrastructure asset class. Global infrastructure market Investors evaluate an infrastructure opportunity in relation to other asset classes, such as government bonds, equity markets and private equity. Investors are evaluating not just how but whether to invest in infrastructure at all. Private finance represents a diverse group of equity investors and debt providers. Any one investor can utilise both types of financing and a number of different financing techniques can be employed to ensure an optimal financial structure. Long-term institutional capital represents the biggest source of untapped private finance for infrastructure. The combined assets of pension funds, insurers sovereign wealth funds and endowment total about USD50 trillion. These investors continually do not meet their target allocations for infrastructure. Developing the right investment structures will unlock this source of capital. Bank funding: Banks have undertaken the bulk of infrastructure financing, particularly in emerging markets where corporate bond and securitisation markets are relatively undeveloped. From 1999 to 2009, commercial banks provided an estimated 90% of all private debt. Post GFC, bank capacity to invest has been constrained by Basel III capital requirements. The cost of private project finance is high and this is exacerbated by the frequent need for multiple lenders, increased loan covenants and shorter tenor on offer by banks. There is a growing mismatch between the amount and time horizon of available capital and that of infrastructure projects. Banks may increasingly provide only short-term financing for the construction phase of an asset, selling the debt to institutional investors after the asset has an established track record. Capital market funding: Bonds are issued by the private sector targeting investors with long-term liability structures and regulated rating requirements for their investments. For 1 SwissRe and Institute of International Finance, Infrastructure investing. It matters 1
pension funds and insurance companies, project bonds represent a natural match for their long-term obligations. Infrastructure debt raised by corporates or by projects form an estimated 10% of global private infrastructure debt funding. An important prerequisite for accessing capital through bond markets is securing an investment-grade credit rating from a rating agency. Certain investors, such as many pension funds, also require bond insurance before investing in infrastructure bonds. Bond volumes are not yet a viable alternative to bank finance, particularly in emerging markets. To facilitate corporate bond issuance, local market development, with bond enhancements to mitigate credit risk and support ratings, is needed to stimulate major capital flows into infrastructure bonds. It is estimated that 20% of all project finance lending in 2012 came directly from institutional investors. Insurance companies accounted for 7% of total project finance lending, and pension funds accounted for 3%. Fund managers, an alternative channel for pension funds and insurers, accounted for 8%. 2 For liability-constrained investors, such as insurance companies and defined-benefit pension funds, infrastructure investment matches their long-term annuity-type liabilities. As such, these investors prefer brownfield equity investments in developed markets with established cash flows. Governments focus on greenfield projects to add to the infrastructure stock. In emerging markets, the need for greenfields investment is much higher given the need for economic development. Transactions structured to reduce construction and demand risks would be more attractive to long-term private investors. Creating an attractive market for investors In terms of attracting private sector finance, governments can remove impediments and create an environment for private investment through: Providing investors with confidence that there is a conducive environment for investment that provides certainty, commitment to property rights and measures to address political risk, including renegotiation risk Adopting a range of institutional arrangements to develop a market for investments such as a public/private partnerships for particular investments or through a government trading entity Adopting a range of measures, such as guarantees and availability payments, that can be tailored to the infrastructure investment that is proposed. Actions to attract long-term investors Governments need to determine how much risk relating to the investment they are willing to bear. The costs and risks of using different types of financing mechanisms should be properly identified and weighed against the potential benefits. Governments need to consider what will provide institutional funds with the confidence to invest. The long-term nature of these investments, whether it is the construction stage or the operating stage, amplifies issues relating to confidence. 2 World Economic Forum, 2014, Infrastructure Investment Policy Blueprint 2
Before any consideration to financing arrangements occurs, private sector investors assess the soundness of the investment environment. This primarily relates to issues of political risk and governments capability to deliver the projects. Governments need to: 1. Develop a long-term planning of infrastructure needs which identifies a pipeline of priority projects and creates a deal flow. 3 2. Increase the headroom in their budgets to allocate more capital to infrastructure spending through more efficient use of current and future infrastructure. Project funding reforms based on flexible funding assistance are needed to help project proponents during the start-up phase. 3. Implement a series of structural reforms at the project level to encourage private-sector funding. This would involve taking a flexible approach in mitigating project risk through various financing arrangements. The criteria for assessing alternative financing mechanisms relies on three factors: risk management, transaction costs and exposure to market or other disciplines. 4 Risk management is the key determinant of the efficiency of the financing mechanism. The particular project strategy used by government for infrastructure will seek to allocate the project risk between the parties in a way that encourages private sector investment, while at the same time minimising risk for the government in terms of costs and project completion. In effect, risks should be managed by whichever party is best placed to do so. These risks can be mitigated for Governments and private sector participants by judicious use of insurance instruments. The market has developed arrangements which can reduce the financial risks involved in these transactions by transferring them to the private insurance and reinsurance sectors. An effective risk management program will have well considered performance security requirements that ensure asset completion and performance; the necessary level of liquidity during the construction phase; and forward cost-effective insurance program requirements. Addressing these risks provides investor comfort to the capital market which may in turn attract experienced investors willing to provide capital at favourable terms. Modes of investment Private investment through equity and debt Private infrastructure funds are a significant source of infrastructure finance. This occurs through three mechanisms: a public bond issuance, private placement, and bank loans. Investors buying equity directly in a specific project have greater control and visibility over an asset. Other models can involve pension funds pooling their resources to make direct investments. 5 Infrastructure equity funds have been the main source of funds. Infrastructure debt funds, i.e. raising funds through private placements and bank debt, are an emerging class of investment. 3 The creation of Infrastructure Australia in 2008 to encourage private financing by improving certainty in the project pipeline and PPP framework 4 Above, n 2 5 UK pensions' investment platform represents about 1,200 pension entities with assets of $1.3 trillion. Industry Funds Management (Australia) which pools a range of likeminded global investors and invests them directly in infrastructure projects with a view to generating long dated, inflation-linked returns through its open ended fund structure. 3
Projects could also raise equity on financial markets through an initial public offering. Usually, primary equity investors are directly involved in decisions regarding the construction of the infrastructure asset. Large pension or superannuation funds can invest directly in equity at the start up, greenfield phase of the project. Once projects are in operation with a proven revenue stream, equity is often sold in the secondary market to investors with a lower appetite for risk; infrastructure funds and pension funds generally prefer to invest at this stage of the project. Selling proven assets allows primary investors to free up capital to invest in new infrastructure projects. Debt providers have been the major providers of infrastructure finance. The two primary sources being, commercial bank debt and capital markets. Debt funding is made up of loans although some private projects can be partly funded via bond issuance in capital markets. Inflation linked bonds are seen as a good fit for infrastructure projects for the issuer since the pricing of infrastructure services is often linked to inflation as well as for investors, such as pensions given the sensitivity of their long dated liabilities to inflation. Co-funding by government and the private sector Governments should consider sharing financial risk when adverse credit markets hamper the obtaining of long-term debt funding for commercially sound projects or when financing cannot be accommodated by the government. Risk sharing should not be regarded as a free incentive but should be seen in the context of cost benefit and value for money. Infrastructure financed by the private sector can be commissioned by governments in public private partnerships (PPPs). A PPP is a long-term contract between an approved party and a government agency for providing a public asset or service for which the private party bears a significant risk and management responsibility. In PPP arrangements, risk is transferred to varying degrees between the public and private parties. Construction costs will be fully or partially funded by the private sector. Payments for infrastructure services used to repay private financing costs over the life of the asset can either come from the government via budget transfers or from the users of the infrastructure through user charges such as tolls. Governments can use mechanisms to shield private parties from some of the downside risk of infrastructure projects, e.g. in the form of guarantees. The effectiveness of PPPs largely relates around the appropriate risk sharing between the private sector and government. 6 Depending on the level of risk transfer assumed by the private sector, these arrangements may impact on the government s fiscal position. Financing through government trading entity A government trading entity (GTE) could be established as legally independent but partially owned and overseen by government. GTEs finance their infrastructure investments through several sources including retained earnings from user charges and fees for access to infrastructure, capital contributions or payments from government for non-commercial services that GTEs are directed to provide, bond issuance, or borrowing from banks. Governments and GTEs can also link borrowings to specific infrastructure projects. A company may be set up to carry out the project and issue bonds. This debt is serviced from 6 For example of these arrangements see the United Kingdom s Private Finance Initiative 4
the income stream of the infrastructure project user charges or government/gte payments without recourse to general government or GTE revenue. In addition, GTEs can operate with the benefit of an explicit government guarantee which usually results in these institutions taking on a credit rating that is in line with that of government. This can allow lower funding costs than those offered by private banks in their jurisdiction. Depending on the size of the GTE, the fund can contribute to the development of greenfield assets. Then, on maturation as a brownfield asset, the assets could be sold to the private sector with the proceeds recycled into the fund for future projects. The GTE could raise capital for large projects, e.g. through the issuance of tradable bonds structured in a way that could be attractive to long-term investors. It can also potentially leverage contributions to infrastructure projects from smaller private sector investors through pooling their funds and thereby addressing concerns about undiversified investments being too risky. 7 Risk sharing mechanisms to attract private sector investment Project-specific infrastructure bonds Project-specific infrastructure bonds can be secured on an asset or against the revenue stream arising from the asset. To enhance the attractiveness of the bonds, a partial credit enhancement is made to attract capital market investors. This provides the project with credit rating uplift. The mechanism of improving the credit standing of projects relies on the capacity to separate the debt of the project company into tranches: a senior and a subordinated tranche. The provision of the subordinated tranche increases the credit quality of the senior tranche to a level where most institutional investors are comfortable holding the bond for a long period. The subordinated tranche the project bond credit enhancement provided by a sponsoring public sector bank (e.g. European Investment Bank) can take the form of a loan which is given to the project company from the outset, or a contingent credit line which can be drawn upon if the revenues generated by the project are not sufficient to ensure senior debt service. The support will be available during the lifetime of the project, including the construction phase. Conditions can be set to ensure that the assistance is appropriately targeted e.g. a maximum size of a transaction and the target uplift of the project s credit rating. Infrastructure loans and bonds meet several needs of institutional investors, such as regular cash flows and attractive risk-adjusted yields. Approaches using a combination of these tools to mitigate risk exposure for long-term investors have been adopted in some markets: the use of infrastructure bonds with insurance guarantees in Chile, structured products in Mexico, collective trust structures in Peru and jointly-owned infrastructure companies in Brazil. Guarantee schemes 7 See Indian Government s Infrastructure Finance Company Limited (IIFCL) and India Infradebt Limited established to sell bonds to long-term investors, the proceeds of which are used to refinance bank loans for PPP infrastructure projects that have completed at least one year of operation. The IIFCL is piloting a scheme whereby it provides a partial credit guarantee to enhance the credit ratings of bonds issued by infrastructure project companies 5
Under the scheme, the government will provide a guarantee tailored to the specific financing needs of approved infrastructure projects in return for a fee. Government can leverage their balance sheet and effectively guarantee the credit risk of longer-term loans for selected projects. Credit guarantees also can apply to specific time horizons of the project such as the construction period. 8 Demand risk insurance Governments underwrite the financial performance of future projects. Governments provide an insurance policy against the patronage forecasts contained in the project proposal being significantly lower than expected. This model charges a commercial premium to the project and would pay out an agreed sum calculated according to the shortfall in custom. Availability payments Governments take responsibility for any downside departure from agreed patronage outcomes and share in any upside outcomes. Under the model, the private sector designs, builds, finances, operates, and maintains the asset for the concession term. The government funds the asset developer/operator for the life of the concession period, which only commences once the infrastructure has been delivered and is operational. These payments are used to repay the private sector finance and provide a return to equity providers. The payments are reduced if the asset is not available in the contractually agreed condition throughout the concession. In the case of commercial services, a flow of revenues is generated that can be returned to government to offset the availability payments. Government as a minority co-investor The private party is largely responsible for financing and constructing the infrastructure project. The public sector acts as a minority co-investor. Potential conflicts of interest for the government would need to be carefully managed in order for the arrangement to be an attractive investment for the private sector. Once the project becomes operational and is performing to the required standard, the public sector partner pays a regular and predetermined unitary charge to the private party which covers the maintenance costs and repayments on debt over the life of the contract, typically 25 30 years. Equity investors receive all remaining cash flows once the project has paid off its debt, including the potential sale of the asset at the end of the contract period. Market facilitation measures International Financial Institutions and Multilateral Development Banks would assist in developing a conducive environment for long-term investors by developing best practice for bond documentation and due diligence, and by encouraging procurement processes that meet globally recognised standards on the environment, safety and sustainability. In terms of regulatory reform to facilitate the long-term investor market, there is a need to review the risk weighting of Solvency 11 standard formula and other regulatory capital charges. Infrastructure bonds are subject to the same capital charges as corporate bonds. This does not reflect market reality, given lower default rates for infrastructure debt and higher recovery rates after the construction phase compared to corporate loans/bonds. 8 A credit guarantee scheme can be established whereby nationally significant projects that meet specific criteria are eligible to leverage the government s national credit rating 6
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INFRASTRUCTURE AS AN ASSET CLASS The question as to whether infrastructure is a separate asset class revolves around whether it is a unique class of investment or whether it is just the grouping together of investments that are generally considered to be part of other asset classes. This is important as the approach taken determines whether or not infrastructure should form part of the available asset classes that are considered when investors are forming a strategic asset allocation policy. (Such decisions are taken according to modern portfolio theory s capital asset pricing model.) Infrastructure has enough different characteristics to be treated as an asset class in its own right given its unique strong inflation protection and its nature as a high-yielding asset. The infrastructure asset class represents a logical grouping of assets that share similar characteristics. Infrastructure assets should be regarded as a separate asset class and should be part of a strategic asset allocation portfolio. The alternative view is that infrastructure is simply a sub-asset class within the conventional financing vehicle in which it is contained e.g. listed stocks, private equity, and bonds. This view will have ramifications for portfolio allocations. Features of infrastructure assets Infrastructure assets display a number of characteristics that distinguish them from more traditional equity or debt investments. The assets themselves tend to be single purpose in nature with private investors participation often for a finite period. Infrastructure assets high barriers to entry and their monopoly-like characteristics mean that the assets financial performance should not be as sensitive to the economic cycle, as many other asset classes are. The strong monopolistic market position of these assets allows them to have very good earning resilience. Investors Investors who focus on yield and managing long-term liabilities, such as pension funds, should find infrastructure assets as attractive investments. Investors can use infrastructure to help match their liability profile with a predictable and partly inflation linked distribution stream. Long operational lives and high operating margins of infrastructure projects should be attractive to private capital investors. The packaging of a portfolio of these assets into pooled vehicles provides another mode of investment. Infrastructure funds can offer longer term, high yielding, defensive riskadjusted returns. A portfolio of defensive infrastructure assets is characterised by its low correlation to other asset classes and its relatively high inflation-linked cash yield. Arguably, this warrants its own allocation within an investment portfolio. Risks Specific risks include patronage/demand risk, regulatory, contractual/credit, operational/ construction risk, and financing/inflation risk. Because of the monopolistic characteristics, infrastructure assets tend to be subject to varying degrees of government regulation. This is not necessarily to the detriment of the 8
investors as it provides a level of surety regarding the income streams that will likely flow from the asset. Investment portfolio The modes of investment are direct infrastructure investment, unlisted funds, listed funds, listed stocks and funds of infrastructure funds. In terms of trends re investments, until recently infrastructure exposure mainly involved high-risk investments. More recently, core infrastructure investments, such as regulated utilities or roads, have become increasingly accessible, broadening the appeal of the asset class. The switch from largely bank funding, which was required to be rolled over at five-year intervals, to be replaced with funds going to capital markets for 20 30 year bonds and locking in debt over a long period of time, should facilitate investment. However, there are drawbacks to investment, such as the lack of corporate governance frameworks within institutional investors, especially relating to due diligence resources. High yield investments Although infrastructure assets vary in terms of the level of regulation they face, this regulation generally results in income streams that exhibit low growth. To compensate investors for this, infrastructure investments tend to be higher yielding than equity investments. In terms of capital values, this stable, high yield results in infrastructure assets that display a lower level of price volatility than equity investments over the longer term. Arguably, investors should look upon infrastructure assets as a class, like fixed interest and equities. CONCLUSION Higher levels of private investment in infrastructure will come from: Development of infrastructure plans by governments of future needs and a pipeline of projects Governments addressing political and regulatory risks Development of investor value propositions for individual projects with appropriate risk-return trade-offs. Financing risk-sharing mechanisms that can be used to attract private sector investment are: The establishment of a PPP to raise finance for a project The issuance of infrastructure bonds by the public and private sector The use of government credit guarantees for borrowings and concessional loans Demand risk insurance Use of availability payments Financing from brownfields infrastructure sale proceeds (recycling). GTE, PPP or contractual arrangements can be established to manage these mechanisms and to protect taxpayers funds. International Financial Institutions and Multilateral Development Banks should assist in developing a more conducive environment for long-term investors by developing best practice bond documentation and due diligence processes. 9