Where cash is king(3)

The more stable yield characteristics of regulated infrastructure are well known but new investment opportunities in this sector are becoming increasingly rare.

Social infrastructure public-private partnerships (PPPs) offer many of the benefits of this traditional infrastructure class, but with lower counterparty risk and negligible regulatory risk. Additional benefits include choice, diversification and long investment terms.

CASH IS KING

Institutional investors are faced with limited options in the current investment climate. With no end in sight to stagnant equity markets, record low bond markets and a property market going backwards, we look set for an extended period of tight returns from traditional investments.

Access to higher and more consistent absolute yields, plus little or no exposure to downside market corrections, looks extremely attractive in such an environment.

Social infrastructure PPPs can offer these benefits as an emerging sector which complements traditional infrastructure investments. They comprise long-term contracts with government agencies to develop and maintain essential social infrastructure assets.

Typically, the government takes patronage risk on these facilities while the private sector contracts to ensure they remain fit for purpose over the life of the contract.

Social infrastructure PPPs are distinctive in that returns consist almost totally of yield. Net returns are typically greater than 12 per cent per annum for projects in construction and approximately 10 per cent per annum for operating projects.

Operating projects look the best pick in the current environment, as they do not tie up cash during the construction period.

On a risk-adjusted basis, yield returns of around 10 per cent per annum for an asset post-completion can be attractive compared with alternative yields available in the market for comparable risk.

WHAT IS SOCIAL INFRASTRUCTURE?

Social infrastructure provides essential social and community services. It covers the provision of services and facilities such as:

* Educational facilities, including schools, colleges and student accommodation;

* Healthcare facilities, including hospitals and clinics;

* Transport support facilities, including train stations, bus depots and associated parking stations; and

* Other administration and public entertainment facilities, including law courts, prisons, convention centres and sporting facilities.

Such social infrastructure facilities have traditionally been developed by state and municipal governments under conventional procurement methods.

The UK pioneered the PPP approach under its PFI, or Private Finance Initiative, from the mid-1990s. PPP structures transfer much of the ’whole-of-life’ risk of these assets to the private sector.

Subsequently, governments in many countries have begun to recognise the advantages of this approach in achieving both budgetary and policy outcomes.

In Australia, these contracts have delivered significant benefits to the public with documented life cycle savings in the order of 35 per cent. Benefits compared with traditional procurement include:

* An excellent track record of delivering facilities at a significant saving in cost and time;

* Facilities which are often rated as being of either a higher quality or being more fit for purpose; and

* Facilities which are better maintained, at a lower cost, than similar facilities managed by government agencies.

IS THERE A CATCH?

Social infrastructure PPPs have tended to fly under the radar of investment managers and institutional investors in the past because, individually, they are relatively small compared with larger traditional infrastructure investments (as illustrated in the previous chart).This has resulted in a perception that acquisition costs per dollar invested would be too high.

Social infrastructure PPP deals make up for their lack of scale with a high deal volume relative to conventional infrastructure.

The availability-style payments and stronger counterparties mean that gearing levels can be relatively high when compared with traditional economic infrastructure, typically around 80 per cent. However, this underscores the long and stable nature of the cash flows, and the high percentage of yield on PPP returns.

One benefit of being small and highly geared means that the equity component of each project is also small – so entry levels are achievable for smaller institutional and pension fund investors.

The flipside to small project sizes is that it can take time and resources for investors to accumulate a social infrastructure PPP portfolio of significant size.

Alternatively, such portfolios can be accessed through pools managed by specialists in the social infrastructure sector. Moreover, the relatively small asset size in this sector can benefit pool investors through greater diversification benefits.

With such long contract periods, projects (such as those in Australia) may be exposed to one or more refinancing events. On a portfolio basis, this risk is ameliorated by diversification of debt source and tenor, and by the quality of yield these assets generate (which is attractive from a debt financing perspective).

Investing with a specialist social infrastructure manager can reduce the average costs of participation as asset management requirements are intensive. A pooled investment approach offers the benefits of economies of scale across the acquisition and investment management lifecycle.

For an investor, the small individual deal size means that investment in a specialised fund offers both convenient access and high levels of diversification. Investors should consider whether they want exposure to completion risk, or prefer the more secure cash flows associated with an operating PPP project.

ASSESSING THE BENEFITS

Social infrastructure assets are tightly held, but as more social infrastructure PPPs are being developed, a significant pipeline is developing in both the greenfield and secondary market areas.

The number of funds offering specialised access to social infrastructure PPPs is still limited, but we anticipate supply will expand as the benefits of PPPs and investing in social infrastructure becomes more widely recognised.

Schools: Long-term cash flows with a social return

The NSW Schools II project in Australia provides a typical example of a progressive social infrastructure PPP project.

For infrastructure investors, it is an excellent example of how the availability model can be applied to social assets, with long-term cash flow benefits, government-grade credit and inflation hedging.

Commissioned in 2005, the project covers the design, construction and maintenance of 11 new public school facilities including seven primary schools, three secondary schools and one school for specific purposes, with a total operational capacity supporting over 6,000 primary and secondary students.

The contract runs until 2035 and has the AAA-rated New South Wales (NSW) government as the counterparty. Like most social infrastructure PPPs, the revenue is ‘availability’ based. This means that the revenue is consistent, and is not dependent on student enrolments at the schools. In addition, the monthly revenue payments are inflation-linked providing a valuable hedge for investors.

The NSW Department of Education provides the principals, teachers and support staff and sets the education curriculum.

The private sector provides non-core services such as general maintenance and lifecycle capital upgrades which are subject to, and monitored against, key performance indicators (KPIs). These services are sub-contracted to reputable service providers who are engaged under a back-to-back contract with the same concession end-date and the same KPIs, for the full term of the concession.

AMP Capital’s focus on social infrastructure PPPs has been developing a pooled investment approach which invests in schools, TAFE colleges (tertiary education facilities), communication networks, hospital car parks and a convention centre. This naturally spreads entry costs, provides diversification by sub-sectors and geography, and diversifies cash flow profiles as different assets mature at different times.

Investing in projects that have reached practical completion and entered the operating phase allows for more robust forecasts on cash flows, and consequently, more predictable returns and yields.

Greg Maclean is head of research, infrastructure, at AMP Capital in Sydney