History must not repeat itself

Private equity investors investing in infrastructure need to manage their public image carefully.

Last year's many controversies surrounding the ethics of private equity have made all too clear what happens if the outside world decides, however unreasonably, that the industry's moral standards are wanting.

It deserves to be said: of the many investment opportunities open to private equity today (and there still are many, despite the credit crunch), infrastructure finance is probably the greatest.

Its scope is well documented. According to the OECD, the world's infrastructure-related funding requirement to 2030, including new builds and upgrades in transport, telecoms, water and power, is a cool $2 trillion per year. On top of that, there are schools to build and hospitals to fund, assets that are often classified as “social” infrastructure – and make up another enormous segment of this rapidly growing asset class.

Much of the demand for infrastructure capital resides in North America and Europe. An arguably even bigger requirement exits in the growth economies of Asia and the Middle East. Governments have made it clear that they do not have the means to shoulder the financial burden by themselves. The private sector is required to contribute, and many private equity firms are already investing significant amounts of money in relevant projects. According to data compiled by PEI Asia, Asia-focused infrastructure funds being marketed at the moment are looking for a combined $22 billion in capital commitments – more than the fundraising target for any other region.

There are of course obstacles facing infrastructure-focused private equity operators, in Asia and elsewhere. For example, it is not easy to adapt private equity fund structures, investment horizons and compensation models to suit the long-term nature of infrastructure finance. In addition, competition for assets is ripe, with a plethora of investors invariably lining up when projects start looking for funding. Banks, pension funds, public-private-partnerships, insurance companies, sovereign investors, real estate groups and hedge funds are all active, and often armed with a lower cost of capital than private equity.

But arguably the most serious challenge facing the industry in the infrastructure space is the political risk it is taking on by replacing the public sector as the traditional provider of funding. Care homes and nurseries, even toll roads and airports are highly emotive assets, and the general public usually finds it hard to accept that they should be owned privately and run for profit, let alone generate capital gain for shareholders.

Moreover, large-scale infrastructure projects in particular tend to have far-reaching social repercussions. The building of a dam in a rural area that requires families or even entire communities to relocate has a serious social cost attached to it. Investors involved in creating this cost need to be mindful of the public scrutiny they will encounter in the process, today and in years hence when the consequences of the project will be fully assessable.

Such are the social sensitivities attached to infrastructure finance that a cavalier approach to dealing with them will not do. Last year's many controversies surrounding the ethics of private equity have made all too clear what happens if the outside world decides, however unreasonably, that the industry's moral standards are wanting. As they spread their wings in the infrastructure asset class, private equity funds must do everything they can to prevent this part of its recent history from repeating itself. A well-defined code of conduct and a commitment to transparency will be crucial. Without them, an otherwise outstanding investment opportunity could be squandered.