Infra a shock

(This feature is taken from Private Equity Europe - the pan-European publication from the publishers of unquote")

Private equity involvement in the infrastructure sector was becoming ever-more conspicuous before the announcement by CVC Capital Partners and the Carlyle Group that they were to raise dedicated infrastructure funds. However, this move by two of the giants of the private equity world seemed to confirm that the industry was missing a trick by dabbling only at the margins of the sector. LP appetite for infrastructure is clear – as well as CVC and Carlyle, US group Alinda Capital Partners raised $3bn for an infrastructure fund last summer, a significant feat considering it was the firm’s first offering – and taking into account various public-private partnership schemes operating in both developed and emerging markets, opportunities to deploy this cash appear numerous. That said, although the reasons for optimism seem evident, there a number of unanswered questions surrounding the sector which should dampen this expectant mood.

In announcing dedicated funds, CVC and Carlyle have joined a select but growing group of private equity firms with dedicated funds active in the infrastructure space, which includes 3i, Axa and Barclays Private Equity. Although these dedicated funds have drawn attention to the convergence of the two asset classes, the lines between a traditional leveraged buyout and an infrastructure deal have been blurring for some time.

Private equity groups have long invested in deals with an infrastructure angle but held them within existing funds. 3i has been undertaking infrastructure deals for two decades and prior to the establishment of its listed infrastructure arm held its infrastructure assets within its growth capital portfolio. UK firm Terra Firma is a keen investor, often competing with Australian infrastructure powerhouses Macquarie and Babcock & Brown for desirable assets. Terra Firma portfolio companies include East Surrey Holdings, an owner and operator of regulated infrastructure businesses and Tank & Rast, which owns 90% of German motorway concessions for service stations. Terra Firma acquired Tank & Rast in late 2004 from Apax Partners and sold half of the company last summer to RREEF, Deutsche Bank’s alternative investment arm, reaping a $1.34bn profit. Although this was an extremely successful partial exit for Terra Firma, the returns realised had little in common with an infrastructure deal, which would typically target returns of between 10-12 per cent over a significantly longer hold period. To achieve returns such as these within a contracted timeframe requires a blend of project finance and leveraged finance. It is this hybrid package which has some industry participants concerned.

Private equity as infrastructure

Terra Firma financed the original deal with a leveraged package and refinanced it on better terms – the price fell to a range of 125-150 basis points compared to the original range of 212.5-262.5 basis points. A refinancing on generous terms at the height of the liquidity bubble isn’t news, but the way in which the banks presented the deal to the market was unusual. Royal Bank of Scotland, Barclays Capital, Société Générale and West LB marketed the refinancing as an infrastructure deal when in reality it was a pure private equity play. Doing so enabled the arranging banks to emphasise the infrastructure qualities of the asset – predictable cash flows and guaranteed majority market share – whilst employing a structure alien to most infrastructure deals. ‘It should not be assumed that an asset with a monopolistic market position which is generating stable cash-flows and projected to do so over the long-term is suitable for a package of debt with a highly leveraged project finance portion and a more flexible, covenant-lite, private equity portion,’ says one UK-based banker. Applying a leveraged package of debt, where multiples are market-driven, to an infrastructure asset where debt capacity is typically decided on the basis of discounted cash flow could leave the business more exposed as the economic cycle turns.

A recent report by Standard & Poors warned of the credit risk posed to the infrastructure sector by this new breed of debt being pushed onto the market by banks anxious to satisfy sponsor demand. More significantly, the report notes that recent hybrid-debt backed deals have been for assets without the operating and cash flow strengths which have, until now, been characteristic of deals in the infrastructure space. ‘New assets are being brought under the infrastructure umbrella - car parks, motorways, service stations and motor vehicle certificates now claim to be “strong” infrastructure assets,’ says Paul Lund at Standard & Poors.

Industry players agree that there has been a broadening of the term "infrastructure" and point to one of the oldest players in the game. 'Macquarie is a good example of a firm which pushes the boundaries - but this is not necessarily a bad thing. Like any infrastructure investor they will look primarily at the economic features around the cash-flow and asses risk and reward against this,' says Paul Woodbury at Henderson Equity Partners. Others say that by pushing the boundaries, risk management has been compromised. ‘In combining project finance and leveraged finance techniques, investors have been able to trade favourable debt terms against the management of risk. Acquisition hybrids may pose a significant credit risk to infrastructure market players because many have grown comfortable with the sector and assume it boasts mainly strong, stable assets,’ believes Lund.

Problem of supply

Macquarie's deal for the car park arm of UK firm NCP Services fits the widened definition of infrastructure. The acquisition also revealed the continued convergence of private equity and infrastructure - Macquarie bought the business from 3i, which in turn had acquired it from Cinven in 2005. Both the widening definition and the convergence of the asset classes can be seen as the inevitable outcome of a barren infrastructure market. 'The supply of infrastructure investment opportunities with the return characteristics we are looking for seems to be relatively limited. Our concern is that too much money is flowing into infrastructure investments with too few deal opportunities available,' says Jens Bisgaard Frantzen at alternative investment firm Private Advisors. ‘Although the number of assets is set to increase as governments seek to privatise their infrastructure to raise funds, this will be a gradual process and supply is therefore unlikely to meet demand in the near-term, giving little depth to the market,’ says Lund.

This lack of supply does not bode well for private equity firms raising infrastructure funds for the first time. Opening a new business line is difficult when times are good. When times are bad, a lack of experience becomes an even keener problem. ‘Some are confusing infrastructure situations with buyout situations. Traditional private equity firms will not enjoy dealing with regulators and an infrastructure deal requires expertise in this area. Private equity firms will have to hire whole new project finance teams,’ believes Dominique Senequier at Axa Private Equity. ‘Infrastructure deals can be more time-consuming and more complex than a private equity deal. You are often dealing with a number of counter-parties, typically government departments,’ agrees Michael Queen at 3i. Senequier also notes that the skills required for a successful deal aren't the same. ‘Private equity is first about picking managers, picking teams - for infrastructure investments it would be a second priority,’ she says.

Anne Gales at C.P. Eaton, which acted as placement agent for Alinda Capital’s $3bn fund, also warns that the skills required are very different. ‘You need to structure a deal extremely efficiently from the beginning. You can’t move things around or restructure once you have bought the asset.’ Allied to a lack of experience, private equity firms may also suffer from the increasing caution from banks in the post credit crunch era. ‘Investors will be tightening up their definition of infrastructure assets. Corporate style deals such as Autobahn Tank & Rast, which was marketed as vital infrastructure, are likely to become a thing of the past,’ says Paul Lund at Standard & Poors.

Wrong type of risk

Regulatory issues and political risks are often central to an infrastructure deal. Across Europe, partnerships between the public and private sectors, driven by central governments, often in tandem with EU directives, have drawn criticism from opponents who resent profiteering from what are often essential services. Supporters argue that reform of ageing infrastructure would be possible without private involvement. In Europe, the UK has been at the forefront of private investment in the infrastructure space, thanks in large part to the Private Finance Initiative and Public Private Partnerships. Defenders of privately-backed infrastructure projects maintain they offer the taxpayer greater value for money than publicly funded works. ‘PFI and PPP projects have delivered huge benefits for the UK. They have changed the efficiency of public procurement and transferred risk away from the taxpayer as cost overspend is incurred by the private company,’ says Queen. Although Queen concedes that PFI activity has likely passed its peak in the UK as ‘these projects have addressed the backlog in government spending in the UK and as a result we are not going to see the same absolute level of projects as we have done in the past 10 years,’ he is bullish about the prospects for infrastructure investment globally predicting that, ‘in value terms, infrastructure investing will be bigger than private equity in ten years.’

Concerns that demand for assets are increasingly outstripping supply have been raised frequently in recent months. However, with Europe feeling the full effects of the credit crunch and pessimism regarding growth prospects rife, infrastructure investors may find a growing pool of assets in which to invest. Earlier this year, Luxembourg's Prime Minister Jean-Claude Juncker, who chairs the Eurogroup of euro zone finance ministers, said that growth could fall to around 1.8 percent in 2008, significantly below previous forecasts. An economic slowdown, allied to barely-controlled government spending and widening budget-deficits in many euro zone countries, will present treasury departments with little option but to turn to the private sector to overhaul vital infrastructure. Although the EU has made privatisation of public services a priority, progress has been slow. However, moves towards privatisation may have to take on new urgency should slowing growth become a trend.

US & Asia

Private equity firms looking to invest in infrastructure should not rely on the slowing of European growth to provide them with a new stable of assets to invest in. Outside Europe, the US and developing markets of Asia offer potential for asset-starved investors and a number of firms have been looking in this direction to deploy capital. 3i did its first infrastructure deal in India in October last year, investing $227m from its dedicated India infrastructure fund for a minority stake in power generation company Adani Power. In the same month, Global Infrastructure Partners (GIP) acquired a 74% stake in India-based liquid storage services provider East India Petroleum Limited. This was not its first deal in the country. In the summer of 07, GIP took a 25% stake in Chennai Container Terminal, a container terminal in Chennai on India’s south-east coast.

However, such suitable brownfield projects are limited. Much infrastructure is not of the standard which would attract investors and greenfield developments are unlikely to tempt private equity firms looking for guaranteed returns at low risk. In the US, the landscape is different and many believe this is where the best infrastructure prospects are to be found.

Carlyle recently raised a $1.15bn fund to invest in infrastructure in the US and Canada. With a projected budget deficit this year of $410bn, the US is in desperate need for private finance to ease the pressure on public spending. ‘The US can’t finance the numerous public works projects with the budget deficit it is running. One road project alone, the New Jersey turnpike, has an equity need of $5bn and if it goes for the P3 option it will be a $20bn contract,’ says Queen. Gales agrees. ‘The US is the next big opportunity for infrastructure investors. With limited government funds to repair and run essential infrastructure projects, the private sector has a great opportunity to step in.’

Roads are often cited as one of the biggest opportunities for investors looking at the US for deals. Macquarie led the first privatisation of an existing road in the US when it paid the city of Chicago $1.83bn in 2005 for the right to operate the 7.8 mile Chicago Skyway toll road. The following year, Macquarie teamed up with Spanish firm Cintra SA to acquire a 75-year concession from the Indiana Department of Transport to run the Indiana East-West Toll Road. Since then, the Capital Beltway, which encircles Washington DC, has attracted private financing from the US developer Transurban, which will provide capital for the construction of two new toll lanes. Many European countries have a well established toll road system, some operated privately and others publicly run.

Uphill struggle

Although road projects in Europe and the US offer some comfort in the hunt for suitable infrastructure assets, these schemes have also attracted much criticism, underscoring how contentious the issue of privatisation of essential infrastructure can be. For infrastructure investors, privitisation plans are central to their ability to deploy capital and ultimately their success, especially in Europe and the US. The argument for expanding private involvement in infrastructure projects in Europe and the US may be compelling, but politically it is difficult to sell. From a consumer perspective, infrastructure should always be a “success” – unlike other services, they often have no choice over usage and expect it to be well run and maintained. Consequently they are less willing to accept that private companies should profit from what is an essential service.

In addition to political and regulatory complexities, banks are now hesitant to lend against projects with less-than-convincing infrastructure characteristics. The liquidity bubble came to define what was classed as infrastructure and made it easier to pull off deals. This is no more. Under these conditions, the less developed markets of Asia and Eastern Europe offer an attractive option. However, in these markets, quality of asset is the fundamental problem which could lead investors to turn reluctantly to greenfield projects to get money away. Private equity firms considering an infrastructure investment or dedicated fund should tread carefully - it is not the certain bet it may appear at first glance.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Infrastructure
• UK / Ireland
• DACH
• Nordics
• France
• Southern Europe
• Benelux
• CEE
• Infrastructure