In European Infrastructure Boom, SWFs Navigate Minefields

March 11, 2015 by Loch Adamson

SWFs are financing much-needed European #infrastructure projects
Shifting regs pose risk to Sovereign wealth investors in European #infrastructure
ADIA and Singapore’s GIC are teaming up on a reported €7 billion bid for Fortum Corp.
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Sovereign Wealth Funds are financing much needed infrastructure projects

Across Europe, sovereign wealth funds are financing much-needed infrastructure projects — and realizing big profits. But shifting regulations pose risks.

In Spain, a huge infrastructure deal is close to completion. New York investment bank Morgan Stanley has put its Madrid-based natural gas distribution company Madrileña Red de Gas on the market for around €1.8 billion ($2 billion) — and demand is off the charts. Three separate investor groups are reportedly battling for the assets, with two sovereign wealth funds in the fray: the Abu Dhabi Investment Authority (ADIA) and Gingko Tree Investment, a unit of China’s State Administration of Foreign Exchange (SAFE).

The Madrileña sale is just one of a series of big European infrastructure deals in the pipeline. In Sweden, ADIA and Singapore’s GIC are teaming up on a reported €7 billion bid for an electricity distribution business owned by Helsinki-based energy company Fortum Corp. The Qatar Investment Authority (QIA) meanwhile, reportedly has plans to spend up to £10 billion ($15 billion) on British infrastructure, with an intercity high-speed railway among the projects the fund is discussing with the U.K. government.

"Sovereign wealth fund activity in infrastructure is increasing significantly," says Mike Wilkins, a managing director on the infrastructure team at Standard & Poor’s Ratings Services. "Sovereign funds like the steady capital growth on infrastructure assets, and economic infrastructure — telecoms, utilities, transport — is the flavor of the moment."

So-called economic or hard infrastructure — including everything from motorways and airports to electric transmission lines — generates revenue based on usage, and can deliver relatively stable cash flow over decades. This makes it a good fit for sovereign funds, with their intergenerational investment horizons. And the returns available often exceed those of other asset classes, particularly bonds. At a time when European government bonds are trading at negative yields, the double-digit returns on infrastructure assets are a big draw.

Rising Prices

So far in 2015, sovereign wealth funds have been targeting existing assets rather than those under construction. In January, for instance, ADIA bought shares at the initial public offering of Madrid-based Aeropuertos Españoles y Navegación Aérea (AENA). The deal saw a late surge of interest that pushed up the share price, valuing the airport operator at €8.7 billion — making it Europe’s biggest IPO since 2011.

Competition is pushing up valuations across the asset class. The reported asking price for Morgan Stanley’s Spanish gas distribution business, for instance, is more than 15 times 2014 earnings before interest, tax, depreciation and amortization (EBITDA) of $149.2 million.

Bigger, more established companies will fetch more. Hong Kong-based conglomerate Hutchison Whampoa is reportedly set to pay £10 billion for O2, the British mobile phone company, which it wants to merge with its Three Mobile network — and several sovereign wealth funds, including the China Investment Corp. (CIC), QIA, GIC and Temasek Holdings are rumored to be vying for a multi-billion dollar slice of the merged business.

Despite rising prices, experts discount the notion of an infrastructure bubble. Giles Frost, CEO of London-based Amber Infrastructure Group, says current prices reflect the long-term yields likely to be generated in the asset class. "There’s certainly strong competition, and prices are rising, but that makes sense in the current environment," he says. "In a world where lower yields are the norm, people are going to pay higher capital prices for yielding assets. Higher valuations reflect the fact that investors expect the low interest-rate environment to continue for some time."

"Second Hand Cars"

Funds that want better value and higher yields, however, are looking at a more direct approach — partnering with construction firms to invest in as-yet-uncompleted projects, so-called greenfield assets. The idea is that by taking on an element of construction risk, they can generate better returns. And in Europe, there is certainly no shortage of construction projects to choose from.

Since the financial crisis of 2008-’09, European governments have drastically cut public spending, and that’s left holes in infrastructure networks. According to Standard & Poor’s, Europe will need almost $200 billion above pledged government spending each year between now and 2030 to meet its infrastructure needs. "Across Europe, there is a pressing need to refurbish creaking and decrepit infrastructure, and sovereign funds are helping to fill the funding gap," says Wilkins.

Governments are keen to tap state-owned investors’ vast pools of capital for a range of infrastructure projects. The U.K., for instance, has been encouraging sovereign wealth funds to invest in British water infrastructure since 2012, when it succeeded in persuading CIC and SAFE to allocate a combined $3.2 billion to water facilities. And now other sovereign wealth funds, including QIA and ADIA, are reportedly involved in bidding for the £4.2 billion ($7 billion) Thames Tideway Tunnel, a massive sewer construction project that will run beneath the streets of the British capital.

"Funds are realizing that there’s profit to be made for getting in first on big infrastructure assets," says Frost at Amber Infrastructure, which is leading a consortium bidding for the Thames Tideway alongside several large institutional investors. "In infrastructure, the saying goes, second hand cars are more expensive than new ones — people pay a premium for not having to go through the development stage of a project, with the associated risk."

Water Works

On the Thames Tideway bid, Amber is taking an active role, negotiating with regulators and drawing up plans, while partnering with big institutional investors that provide the bulk of the capital. Increasingly, this is the model for how sovereign wealth funds are investing in infrastructure.

This way of partnering makes sense for state investors, which share the long-term investment horizons of dedicated infrastructure companies. In addition to higher profits, it allows them to gain more control and flexibility over their investments than they normally would by allocating to infrastructure funds. "One of the benefits of being a long-term investor, with different liabilities from more-traditional investors, is the tremendous flexibility you have to buy and sell when the time is right, not when you are forced to," ADIA’s Global Head of Infrastructure John McCarthy told the Sovereign Wealth Center last year.

Partnerships also let funds leverage infrastructure companies’ specialist expertise and spread construction risk. But construction risk is not the only hazard funds face in the current environment — political and regulatory issues are big concerns, too. "The main risk that we see in infrastructure is related to politics and regulation," says Wilkins. "Governments have changed the rules of the game, reneging on promises and implementing tariff changes, for example. That’s one of the biggest issues in European infrastructure right now."

Many investors perceive Europe to be safer and more stable than emerging markets — but it is not as simple as that. Last year the Alberta Investment Management Co. (AIMCo), which manages C$80 billion ($64.5 billion) for 27 pension and endowment funds based in the Canadian province, including sovereign wealth vehicle the Alberta Heritage Savings Trust Fund, told the Sovereign Wealth Center that emerging markets such as Chile have stabler, more consistent regulation on infrastructure than many European countries. AIMCo said the U.K. is one of the less consistent jurisdictions, citing the government’s recent changes the regulatory framework for water works.

A Pen Stroke

But at least those changes left existing arrangements in place. Some other countries — including Spain and Italy, two of the countries keenest on attracting infrastructure investment — have introduced retroactive changes, cutting already-agreed upon tariffs in the solar power industry, for example. This has affected the profitability of existing assets — and burned investors in the process.

Regulatory change is Europe-wide issue. In December 2014, French Environment Minister Segolene Royal called for motorway operators to rip up their contracts and freeze tariffs (although no legislation has been issued yet). And even Norway, once a beacon of legal stability and transparency, has had a tendency to move regulatory goalposts. Last year Stavanger-based Solveig Gas Norway, an infrastructure company backed by ADIA and other large institutional investors, launched a legal challenge to the Norwegian government’s decision to reduce by 90 percent the tariffs that Gassled, Norway's undersea pipe network, can charge for bookings from 2016. The case will be heard at the Oslo District Court in April 2015.

For some market participants, regulatory risk is, to an extent, unavoidable in the infrastructure sector. "With infrastructure, the negatives are the flipside of the positives, in a sense," says Frost. "The advantages are that it’s a key, long-term asset and therefore has to be maintained by governments — but by the same token, governments can be inclined to meddle in it, because it’s so politically sensitive."

What’s certain is that, as funds look for profit in the increasingly competitive European infrastructure market, they should stay attuned to political shifts — especially when considering sinking billions into a deal. Sometimes the long-term profitability of such investments can be compromised by the stroke of a legislator’s pen.

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