The Reckoning

Not so very long ago, infrastructure investment was a sleepy little backwater populated predominantly by Canadian pension funds and Australian banks. Considered too arcane for mainstream investors, and a lot less interesting than those exciting whiz-bang mortgage-backed securities, the infrastructure specialists were left to their own devices.

A few years ago this all started to change as European asset managers woke up to the opportunities provided by the privatisations of old state assets in Eastern Europe and the redevelopment of ageing infrastructure in the West. This year the story is all about infrastructure needs in emerging markets – and following the implosion of the credit derivatives market, real assets suddenly look a lot more appealing.

Christophe Nagy, manager of Edmond de Rothschild Asset Management’s new

Infrasphere fund, sees infrastructure as a defensive investment, which benefits from long-term relatively visible trends in both emerging and developed countries. “These companies may also have guaranteed returns on assets or index-linked tariffs, and that’s a significant advantage in the current environment as inflation becomes more of a concern,” he says.

Returns squeeze

Infrastructure is said to have performed well in the 1970s against a backdrop of stagflation, and with the big US pension funds such as CalPERS and CalSTRS planning allocations, the flows are expected to keep on coming. But this rise in interest has begun to squeeze returns at the top end of the direct market, as the stiffer competition is making it harder for the biggest funds to secure the high returns of yesteryear. Whereas $2-3 billion was once considered a sizeable fund, the largest direct funds are now weighing in at $7-8 billion, forcing teams to scour the globe and bid aggressively for deals in auctions.

Steve Jacobs, global head of infrastructure asset management (IAM) at UBS, believes that these mega funds may not get invested very quickly as they are forced to focus on the biggest, headline deals, and there aren’t that many of them out there. “We want a meaningful but manageable-sized fund that we can get invested quickly,” he says. “In our core fund we are targeting OECD investments because we want to mitigate the regulatory, legal and economic risks and OECD countries have transparency over the economy and a proven rule of law.”

The most recent investment is a 28 percent stake in Saubermacher Dienstleistungs, an Austrian waste management company. UBS’s stake will produce an IRR of over 15 percent, and allows UBS to take an active role in developing the business. Vincent Gilles, head of infrastructure AM, EMEA at UBS, sees strong growth opportunities for Saubermacher as Central Europe is binning more, so the company will benefit from the EU directive to treat more waste by 2012.

“People will increasingly have to pay to get rid of their rubbish, and you can make money out of recycling the components of some household appliances,” he says. “Saubermacher has a refuse derived fuel strategy to take advantage of this – for example, when oil is over $80 a barrel it’s economic to make fuel by burning plastic bags.” Gilles sees the best opportunities in mid-sized cities in Eastern Europe: “There is no point going up against the big French companies when it comes to auctions in the major cities.”

Around UBS’s core fund it is planning a number of satellite, regionally-focused funds, of about US$500 million in size. As well as a MENA fund, coming in September, Jacobs says UBS is bullish on China and Latin America, but it won’t do ‘me too’ funds.

UBS already controls a full-service domestic bank in China, so is aiming to launch a direct infrastructure fund in 2009, with a sector bias. “We will look to take a quality operational local partner and we will offer something quite different from the rest of the marketplace,” Jacobs promises.

UBS also has an interest in a large Brazilian bank, which invests in infrastructure, and is hoping to leverage this towards the back end of 2009. “There is a lot of demand for Latin America due to the commodity-driven boom. We’ll be focused on green-field sites,” says Jacobs.

Style drift

But it is not just direct investment that has taken off in the last 12 months. A raft of infrastructure equity investment funds have also launched – not surprising perhaps, as direct investment requires a significant amount of industry expertise and the ability to manage operational risk. But Jacobs believes that such funds are at the risk of style drift: “Either they don’t have the experienced teams or they lack the deal flow, so you get funds investing in shipping, airlines or lotteries – that might be allied to infrastructure, but they don’t pass the simple test of an economic downturn.”

Christophe Nagy’s fund is strictly infrastructure, and focused on industries that are relatively uncoupled from the business cycle; operating natural monopolies; or in sectors that are highly regulated, such as infrastructure management, production or concessions. The maintenance and construction businesses, which are subject to greater variation in their orders, or shorter contracts, are excluded.

Nagy tries to strike a balance between electricity, transport, and water and gas, to offset interest rate effects and the commodity impact. “Water, gas, and waste management are stable but also subject to movements in long term interest rates,” he explains. “But transportation, which is very cyclical, performs well when rates go up. Adding the two together hedges the interest rate sensitivity and mitigates commodity exposure.”

He is currently keen on the transmission theme in the US, warning that it needs to ramp up its investment or face the prospect of power shortages in many areas: “By 2015 it could be very serious. They need to reinvest, but depending on the state, there are different regulations and you have to be very careful at picking the right states.”

Check the contract

A real understanding of the regulations and drivers in each market is crucial, especially as contracts can vary. Jacobs warns that wind farms can be over-priced in America but offer value in Europe. “Gas storage is the same – in Europe you can get long-term contracts but in America they might only run for two or three years, so it is less of an infrastructure play.”

Philippe Guigny, senior emerging markets manager, CAAM, which has just launched an Indian infrastructure equity fund, says that investors also need to think hard about the portfolio mix, as some investments, like energy, deliver more quickly than others. “Valuations need to be looked at on a stock specific basis as expectations are sometimes too high and may not be realised. Investors should also scrutinise the types of contract that companies are securing.”

Some companies work on a cost-plus basis so that they are not exposed to rises in input prices – this means that whoever has commissioned the project agrees to bear any increase in the cost of materials and energy. Conversely, some Indian and Korean companies working on infrastructure projects in the Middle East have seen their margins squeezed as energy and materials prices have risen.

He is also wary about some of the new Chinese railway stocks that have attracted attention, such as China Railway Group, China Railway Construction and China Communications Corp. “The Chinese have long term plans for their railways but these stocks are relatively expensive,” he says. He prefers the electricity generating companies in Brazil, and Asian companies which are benefiting from the construction boom in the Middle East, such Korean desalination stocks.

Nagy adds that you can still pay a premium for the visibility on earnings of the developed market companies. “But surprisingly you can buy Chinese highway stocks at 15x earnings, which is cheaper than those in Europe, and they will grow at 15-20 percent earnings. So on a P/E to growth basis these are much cheaper than their European counterparts.” He suggests that this may be because there is still some reluctance from investors to go into this area. “But they are listed in Hong Kong so they have visible earnings, and it is high quality infrastructure.”

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