More than one game in town(2)

Outstanding global government debt stands at $42.9 trillion. World economic output will need to grow faster than debt for the world to become better off. This has not happened in recent years. On top of this, the levels of some individual countries’ indebtedness are at breaking point.

The realisation of the looming problems this causes has resulted in periodic volatility if not turmoil, as we have seen over the last four years and again right now. It is not only that some major developed countries’ indebtedness is at levels of between 70 percent to 100 percent of GDP, but also the fact that the rate of indebtedness has been increasing, in some cases at a rate of double digit percentages per annum.

The global government indebtedness figure is, by coincidence, approximately the same as the estimated global infrastructure investment requirement. Developing countries need to continue to build out their economic infrastructure and the developed world needs to replace its aging infrastructure. A failure to invest in global infrastructure will result in a failure to grow and develop our economic and social fabric. Add to this a fundamental shift in our economic approach, particularly with respect to energy generation and sustainability, and it is easy to see why the infrastructure arena provides plenty of investment opportunity.

According to the UK Treasury, in the UK alone, infrastructure investment requirements may add up to some £40 billion (€46 billion; $66 billion) to £50 billion per annum right up to 2030. The National Infrastructure Plan of 2010 identified five sectors – energy infrastructure, transportation infrastructure, digital communications infrastructure, water and waste management infrastructure and intellectual capital – as areas of particular focus.

Seventy-five percent of the required investment volume is expected to be provided by the private sector. It is accepted that what is required to attract such investment capital is stable, long-term planning horizons, political certainty, regulatory certainty, in some cases government contribution, and a reliable and stable economic environment.

Obvious attractions

The attraction for private sector involvement in infrastructure investment on the surface is evident. At a time when traditional long-term investment classes (in particular bonds) are yielding record low returns and where long-term liabilities (pension liabilities and life insurance policies) increasingly demand matched investments and higher returns, it is not difficult to see the attraction of investment in infrastructure.

In the early days there was limited competition for assets. Valuation scenarios based on discounted cash flows (DCF) in a falling interest rate environment promised equity valuation gains merely by locking in long-term cash flows, leveraging appropriately and waiting. If the long-term stream of relatively predictable income benefitted from quasi-monopolistic characteristics and offered degrees of inflation protection with a coupling to long-term GDP growth, then no wonder that, in an age of easy leverage, more and more investors were drawn to the asset class. Rising share prices on the back of multiple expansion in vibrant stock markets were helpful too. The negotiation of credit agreements, the ability to analyse and model cash flows and the art of DCF on top of market timing, were all seen as value-adding skills.

Over time, everything with apparently long-term cash flow characteristics was labelled “infrastructure”. Hospitals and police stations in public-private partnership schemes, airports and water companies, waste management businesses, toll roads, bridges and tunnels, gas networks and electricity grids  – all have become targets for the participation of private investor capital in meeting the needs of the infrastructure world.

Clear view needed

Today’s environment is somewhat different, however, from the environment at the “beginning of infrastructure”. The market has progressed and infrastructure is establishing itself as an asset class in its own right. It is within the context of this evolution that it is important to have a clear view of the role of infrastructure within an economy, the risks (economic, regulatory, political and social) that go along with that role, the returns that can rightfully be expected, and the role of the asset manager or investor and, in particular, that part of his contribution that investors like to call “value add”. Moreover, investing institutions should be clear in their minds as to what they expect by way of return (which should always be a risk-adjusted view) and tenure or maturity profile of their engagement.

We may well benefit from a low interest rate environment for some time to come. But we will not benefit from a falling interest rate environment the way we might have 10 years ago. The analysis of what type of infrastructure investment is appropriate for an institutional investment portfolio, how the investment return is generated, and for what length of time the investor should be prepared to hold the investment, has never been more important than today.

Broadly speaking, one should distinguish between “two games in town”. They require different skills, different risk assessments and make different demands on the investor. They are also equipped to perform different roles in an investment portfolio and can be assessed only over quite different time frames.

At one end of the spectrum are investments in what are really asset-intense operating businesses. Airports and seaports, but also water utilities, are a good example. They are critical parts of the transportation infrastructure or utility infrastructure for any country. The latter tends to be taken for granted by its customers (a degree of social risk!). But they are run like businesses. They are managed to provide a return on the capital employed, to optimise operating cost efficiency, to reduce working capital, and to keep the service offering attractive by reinvesting in plant equipment and property.

The businesses aim to increase revenue through a combination of pricing policy and operating competitiveness in terms of the service offering. They may or may not be regulated. There is a constant quest for additional sources of income, such as airports turning into shopping malls, ports focusing on passengers or freight, container or bulk carriers offering storage and ancillary services.  These activities are all expressions of the dynamic management inherent in any operating business. It is for this reason that business-like valuation methods are employed and why public market IPOs are deemed to qualify as exit channels for these investments by their investors. 

At the other end of the infrastructure investment spectrum, is for example, the private sector-financed public sector building under a long-term maintenance contract, such as a portfolio of police stations. Contractually agreed maintenance terms have to be fulfilled, the return for which gets added to  an appropriate real estate rental and, with appropriate inflation index clauses, can provide a long-term revenue stream called lease payment that is determinable and not at all subject to the vagaries of commercial competition or demand risk. The skill for this type of investment is clearly somewhat different than for running a seaport.

Continuing evolution

In the final analysis, it doesn’t matter what investors wish to include under the umbrella of infrastructure. What does matter is that investors, GPs and asset managers (whether GP in-house or sub-contracted) are clear about the significant differences in the types of investments that today are considered to fall within the infrastructure domain. These differences pertain to: revenue risk or the stability of customer demand for the particular type of service; the quite different ability for asset managers to add value; the different suitability of leverage for the one type of infrastructure investment versus another; and to the ability to plan really long-term cash flows. Not all infrastructure may be perfect for an institution’s asset liability-matching ambitions.

The infrastructure asset class will continue to evolve and new definitions will be created. Core infrastructure has lately become one definition, economic infrastructure another, and social infrastructure a third. There are “free-market” assets and “regulated” assets.

As enormous amounts of capital are being mobilised to take advantage of the investment opportunities, investors will do well if they make the appropriate differentiation in investment characteristics and understand what is suitable for the investment purpose. Investors need to discern what opportunities are effectively leveraged buyouts of asset-rich businesses, the projections of whose revenue streams beyond a traditional LBO horizon, however, may be more challenged; and what are the investments in assets generating long-term, partly or fully regulated income streams, possibly derived from quasi-monopolistic circumstances with significant degrees of long-term certainty.  

In any market where the investment need is so immense and the investor appetite for higher yielding, part cash-pay long-term investment assets so high, it would be easy to see the potential for a bubble. When superficial labelling runs the risk that it may lead to mispricing, it would be a shame to see the evolution of this new asset class interrupted too early.

Thomas Putter was chief executive of Allianz Capital Partners (LBOs, growth and mezzanine capital); managing director Allianz Alternative Assets Holding GmbH, co-responsible for Allianz Group’s alternative asset investment programme (direct and indirect private equity, renewable energy infrastructure and general infrastructure) until 2009; and chairman of Allianz Capital Partners Group until July 2010. He holds board and advisory positions with a number of companies, both private and public, and is in the process of setting up his own investment firm activities.