SWFs Tread Carefully with Infrastructure Investment

September 20, 2013 by Mary Watkins

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FROM LONDON to Moscow to New Delhi, governments are sending forth suitors to woo sovereign wealth funds. Officials are looking to the funds to help finance large-scale public and private infrastructure projects that they believe will help boost the ailing global economy.

When George Osborne, Britain’s chancellor of the Exchequer, traveled to Beijing in January 2012 to talk with then-chairman of China Investment Corp. Lou Jiwei about CIC’s possible involvement in U.K. infrastructure and energy projects, the massive sovereign wealth fund was already looking at potential investments. Projects in the spotlight included the High Speed Two (HS2) rail line, which aims to provide a superfast train link between London and Birmingham and eventually will expand to Manchester and Leeds. Shortly after Osborne’s visit CIC bought an 8.68 percent stake in Kemble Water Holdings, the private company that owns Reading, U.K.–based Thames Water Utilities.

Similarly, the Indian government has recently begun courting sovereign wealth funds by allowing them to buy tax-free bonds issued by state infrastructure companies, including New Delhi–based India Infrastructure Finance Co. Meanwhile, Russia is attracting sovereign wealth funds from Abu Dhabi, China and Qatar to invest in its infrastructure. In October 2011, CIC agreed to set up a joint investment fund with the Russian Direct Investment Fund (RDIF), a state-sponsored private equity company established by Vladimir Putin. In June of this year, Abu Dhabi’s Mubadala Development Co. agreed to coinvest as much as $2 billion with RDIF; that commitment was followed this month by a pledge from Abu Dhabi’s Department of Finance to invest as much as $5 billion alongside RDIF.

Opportunities for sovereign wealth funds to invest in infrastructure abound. The European Investment Bank (EIB) is supporting a host of projects across Europe, including a road connection between Bruges and Knokke in Belgium that will provide better access to the port of Zeebrugge. In Brazil, which will host the FIFA World Cup in 2014 and the Summer Olympic Games in 2016, the government is offering concessions for a host of transportation deals, including airports in Brasília, Campinas and São Paulo.

A January report by New York–based McKinsey Global Institute, the business and economics research arm of consulting giant McKinsey & Co., in conjunction with the firm’s infrastructure practice, estimated that through 2030, $57 trillion will be required to sustain projected economic growth. Although sovereign wealth funds collectively manage trillions of dollars, to date they have mostly been equity players in existing infrastructure projects and assets. The question is whether they will follow insurers, pension funds and asset managers in moving to the debt side of the infrastructure funding market. But if they do, will there be enough new projects?

Sovereign wealth funds prefer existing infrastructure assets to project finance, notes Colin Smith, a partner and infrastructure specialist in transaction services for PwC (formerly PricewaterhouseCoopers) in London. "The former [asset group] is a ready market," Smith says, "and a lot of [sovereign wealth] funds are keen to invest in infrastructure that already exists because it provides a good long-term asset base — in turn providing reliable long-term yield."

There’s a big difference between investing in existing and high-performing infrastructure assets such as airports and water companies and allocating to new, or greenfield, projects, he explains. "To persuade sovereign wealth and other funds to invest in new schemes," Smith says, "there would need to be government support or a high degree of confidence in the investment case."

The need for such investment has grown urgent since the financial crisis. Not only are governments short of money, but European banks — long a reliable source of funding for large infrastructure projects — are unwilling to lend as much for as long.

Five years ago there were at least 70 banks involved in lending on a project finance basis to new infrastructure and energy developments around the world, says Matthew Vickerstaff, London-based global head of structured finance for Paris-based Société Générale. Today, he says, only half that number offer such debt.

There are several reasons for this retreat. After U.S. money market funds — which once provided heavily relied-upon short-term dollar loans — pulled out of the euro zone in 2011 and 2012, some European banks found it harder to fund dollar-denominated project finance deals. Meanwhile, those lenders most affected by the European sovereign debt crisis, such as German regional banks and Italian and Spanish banks, stepped away from funding projects and have yet to return.

Even the European banks that emerged relatively unscathed from the crisis remain reluctant to provide funding beyond about seven years, according to several bankers and analysts; they’re often only willing to fund new projects until the initial construction phase is completed. This conservative stance reflects banks’ efforts to meet tough new Basel III regulations that require them to hold more capital as a buffer.

To satisfy demand for infrastructure investment from sovereign wealth funds and other long-term investors, governments will increasingly need to complement traditional sources of funding, such as the banking market, with new sources of financing, such as project bonds, says Donald Chan, COO of Clifford Capital, a Singapore-based structured-finance group that counts Singaporean sovereign wealth fund Temasek Holdings among its backers.

In the U.S. investors have long tapped the capital markets to fund domestic infrastructure projects, but deals in Asia, Europe and the Middle East have largely relied on bank funding. As the banks have withdrawn in those regions, the expectation is that construction, technology and other companies involved in developing and operating new infrastructure projects will increasingly turn to the capital markets.

Spying an opportunity, other financial institutions are already moving to offer debt as well as equity services. For example, Allianz Global Investors in 2012 brought in a team from a unit of MBIA, the Armonk, New York–based financial services group, to identify and manage infrastructure debt for Allianz’s Munich-based parent company and other investors. New York–based BlackRock, the world’s biggest money manager, recently established a division in London to target the market for infrastructure debt.

The project finance market is moving away from a straight bank funding model to something more diversified, says Jim Barry, CIO of renewable power and infrastructure in BlackRock’s London office. Infrastructure projects are attracting a range of nonbank institutions, but investors are not going to deal at any cost, he says. Export credit agencies and quasigovernment institutions continue to play a pivotal role in providing support for new projects — as do organizations like the Asian Development Bank, the European Bank for Reconstruction and Development and the EIB.

Even without the types of guarantees that monoline insurers provided before the collapse of Lehman Brothers Holdings in September 2008, investors have flocked to recent bond issues. Pension funds, insurers and agencies piled in to buy the €1.4 billion ($1.85 billion) bond supporting an underground gas storage project in Spain for privately owned Castor Gas Storage. The transaction was the first to secure funding under the EIB’s Project Bond Credit Enhancement (PBCE) scheme, which provides a line of credit that improves a deal’s overall rating, making it more palatable for investors.

Michael Wilkins, a London-based senior credit analyst for infrastructure finance at rating agency Standard & Poor’s, says the strong appetite for Castor and other recent projects financed in the capital markets shows how interested yield-hungry investors are in well-structured projects.

For investors with long-term liabilities, like sovereign wealth funds, pension funds and insurers, the rationale for investing in long-term infrastructure projects is clear. Those funds that invest their money safely are making virtually nothing, and the risks quickly accumulate when investors target higher-yielding assets. Government bonds such as U.S. Treasuries, U.K. gilts and German Bunds all pay very little, so fixed-income investors are searching for higher-yielding assets. Sovereign wealth funds are no exception.

"Investing in infrastructure or real estate is therefore an attractive alternative, as long as you get comfortable with the risks," says Robert Ohrenstein, London-based global head of private equity and sovereign wealth for financial services and accounting firm KPMG, which is headquartered in the Netherlands.

Sovereign wealth funds certainly have the money to invest. They managed an aggregate $4.1 trillion in assets at the end of 2012, up from $2.4 trillion in 2007, according to Institutional Investor’s Sovereign Wealth Center. Although still relatively modest, the proportion of that total invested in infrastructure is significant and growing.

"Sovereign wealth funds are clearly moving more capital into the infrastructure financing space," Ohrenstein says, adding that they are relatively cautious investors. "Capital preservation ranks fairly high on their list of concerns, so they will select how they deploy capital carefully."

That may be so, but since sovereign wealth funds’ disappointment in the performance of their external managers during the financial crisis, an increasing number of the largest funds are expanding their internal asset management capabilities and choosing to make direct investments.

In June, at a dinner to celebrate the 60th anniversary of the Kuwait Investment Office, the London outpost of the Kuwait Investment Authority (KIA), Osama al-Ayoub, a former banker for Goldman Sachs Group who heads the KIO, announced that the fund planned to make direct investments totaling as much as $5 billion in infrastructure, predominantly in the U.K. His comments came just weeks after the U.K.’s Severn Trent rejected a third bid, of £5.3 billion ($8.3 billion), for the water group by KIA, British pension fund Universities Superannuation Scheme and Canada’s Borealis Infrastructure, which is part of pension fund OMERS. Coventry-based Severn Trent’s board said the consortium’s offers failed to reflect the company’s "long-term value and future potential."

Other sovereign wealth funds are seeking to follow KIA’s lead by expanding their infrastructure investment capabilities. In May the Abu Dhabi Investment Authority (ADIA) hired John McCarthy, former head of infrastructure at Deutsche Bank, as its global head of infrastructure. In a press release ADIA said McCarthy would play an important role in developing the fund’s infrastructure strategy.

ADIA bought a 9.9 percent holding in Kemble Water, the holding company for the U.K.’s Thames Water, two months before CIC purchased its stake in the British utility. The Abu Dhabi fund also owns part of Australia’s Sydney Airport Holdings and has a stake in the country’s Port of Brisbane. Last year an ADIA subsidiary was part of the consortium that acquired 24.1 percent of Gassled, which owns the integrated gas transportation grid and processing facilities on the Norwegian continental shelf.

CIC, which in 2012 bought a stake in the company that owns and operates London’s Heathrow Airport, told China’s official Xinhua news agency earlier this year that it was eyeing further infrastructure investment in Europe and the U.S.

So far, sovereign wealth funds have largely chased equity stakes in existing infrastructure assets, for which governments offer a high degree of certainty and security. British utilities, for example, are attractive to investors hunting for safe assets with good returns because the regulatory regime in the U.K. has been so stable.

"Funds want to deploy capital and get a decent return," says PwC’s Smith, commenting on the rush into U.K. infrastructure assets. "For a core infrastructure water project, that could mean an 8 to 10 percent internal rate of return."

Still, it remains to be seen whether sovereign wealth funds will seek to become key players in funding new infrastructure projects. For good reason, they may be reluctant to shoulder the complexities and risks involved in developing a highway, airport or rail line. Analysts point out that like many asset managers, sovereign wealth funds don’t like to assume construction risk, preferring to take over a project’s debt from banks once a facility has been built.

Given that sovereign wealth funds in general are unwilling to accept the key risk at the start of an infrastructure project and that some of them lack expertise in putting together highly complex infrastructure transactions, banks will still play a crucial role in getting deals funded.

Right now on the debt side, the expectation is that pension funds and insurers are more likely than sovereign wealth funds to plug the gap in project finance. "But as this market becomes more established, sovereign money may well come into play," says BlackRock’s Barry.

However, inefficient pricing could thwart all investors’ push into infrastructure. On the high-quality, established core infrastructure side, there’s no shortage of capital, but the fundamental issue is a lack of assets, which is driving prices up and returns down. And although the so-called project finance funding gap has received plenty of attention in recent years, bankers like Société Générale’s Vickerstaff complain that the real problem now is not enough new projects to satisfy demand.

Although the grumbling about a lack of projects is a common one, it may be overplayed. Initiatives such as the EIB’s PBCE program are designed to help deals attract funding. At the same time, credit agencies are stepping up to get new projects moving.

What the infrastructure market lacks isn’t necessarily a pipeline of projects but a wealth of creditworthy financing proposals, points out S&P’s Wilkins. That means sponsors and their advisers must come up with innovative solutions to bring deals to market. "Since 2008 there has been a certain amount of inertia by financial intermediaries," Wilkins says. "They haven’t been prepared to go out and proactively put deals together; rather, they have waited for municipalities and governments to come to them."

Sovereign wealth funds are clearly interested in infrastructure, but not all projects will offer the prudent risk-return profile they seek. "When you look at the funds’ approach to investing, it’s about capital preservation," says KPMG’s Ohrenstein. "I don’t see a wall of money being deployed globally and certainly not without careful thought and consideration."

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