Investing in infrastructure: if you build the right financial structures, will investors come?

No one has ever said that investing in infrastructure was sexy. Funding the Thames Tideway Tunnel (London’s ‘super sewer’) or building toll roads across rural Virginia does not have the same allure as investing in the latest app out of Silicon Valley. But infrastructure as an asset class has risen in prominence in recent years as investors see the benefits in stable long-term yields and low volatility.

This should come as a relief to everyone: the McKinsey Global Institute estimates investment of about $57,000bn will be required to meet the world’s infrastructure needs between 2017 and 2030. About 4% of global output is currently spent on infrastructure, or $2700bn a year; upwards of $3700bn is needed.   

As governments struggle with deficits and their populations continue to grow, the need to fix ageing transport systems and out-of-date utilities – as well as build much-needed infrastructure for the developing world, including everything from hospitals and roads to power lines – becomes ever more apparent.

To attract the investment that creates jobs, locations must prove that their infrastructure is up to scratch. A 2016 survey by the Site Selectors Guild found that infrastructure remains one of the three most important factors in FDI site selection globally, alongside labour skills and cost.  

Let’s get together

To fill the infrastructure funding gap, public authorities are increasingly collaborating with the private sector for the design, build, finance and operate aspects of projects. Intelligence provider Preqin reports that private equity firms alone have raised a total of $250bn for infrastructure spending, up from $9bn a decade ago. Public-private partnerships (PPPs) are rapidly increasing in number around the world, because both sides reap the benefits of a model that capitalises on private entities’ expertise to balance risks, improve efficiency and cut costs.

“You absolutely need the private sector – we see infrastructure investment by the private sector more and more,” says Mattia Romani, managing director for economics and policy at the European Bank of Reconstruction and Development (EBRD). “That is the only way we will be able to fill the infrastructure gap in emerging markets and developed countries.”

The benefits of PPPs are well known. They transfer operational and project risk to the private investor, who has more cost-containment experience, as well as ensuring higher standards and shorter completion times, because these factors determine profit. If a company will be responsible for maintenance 30 years down the road, they are more likely to make smarter decisions at the outset.

Financial consultancy Probitas Partners writes: “Historical experience with PPP methods around the world has demonstrated 15% to 30% lifecycle cost savings; 75% that occur in the design build and 25% in the operations phase of the life cycle of an infrastructure asset.” 

Against the clock

Challenges abound, however, across sectors in which PPPs are increasingly prevalent. Transportation infrastructure, a common PPP target, can face resistance to rising costs for users or environmental obstacles. Road tolls are a particular problem, a 2015 McKinsey report states, leading the firm to predict that “half of all proposed road projects will go unfinanced and thus unbuilt in the years ahead”.

Telecommunications infrastructure dates more quickly due to the pace of technological change, requiring greater returns to cover the increased risk. Yet telecommunications is often cited as a model for attracting investors, even in capital-poor countries, “because it offers a clear return on investment and predictable cash flows”, according to McKinsey. Robust telecoms infrastructure is vital for attracting FDI and supporting local businesses; a lack of it will turn away about half of potential business investors, according to an EY survey.

The PPP structure itself has opened the door to myriad sources of private financing: increasingly, institutional investors are warming to infrastructure projects. London’s Thames Tideway Tunnel, a £4.2bn ($5.47bn) project, is being supported by a number of pension funds, which, alongside insurers, endowments and sovereign wealth funds, have more than £50,000bn to invest, according to The Economist.

“Across the developed world, investor demand for infrastructure projects has never been stronger,” says Graham Matthews, chief investment officer at Wilhelm Capital.  “Institutional investors see the strong and stable investment returns offered by quality infrastructure projects as beneficial for their investment portfolios.” The problem, investors say, is not a lack of money but a lack of well-structured deals.  

An alternative source

Many pension fund experts complain that there is little clarity regarding investors’ yield after project completion. The onus is on governments to guarantee a minimum rate for certain services to assure private parties that their investment will be worthwhile.

“There have been several examples globally where excessive risk was evident not from development and construction itself but because usage of the asset after construction was not as expected. Several greenfield toll road developments, for example, have suffered from this,” says Mr Matthews.

“Governments can assist with this by recognising that they are best placed to take this initial usage risk. They can then sell the asset to long-term investors once it is up and running, and then use that recycled capital to develop new projects.” The Australian government does just this, giving state governments an additional 15% of the capital recycled from current assets and reinvesting in new infrastructure.

Fastest growth, biggest needs

Emerging markets such as those across Africa – which need an estimated $90bn in infrastructure investment over the next decade and will be home to 25% of the world’s population by 2050 – are keen for more PPP deals in infrastructure, according to Rosalind Kainyah, managing director at Kina Advisory, which advises investors in Africa. “Outright privatisation is often unpopular in sectors with strong labour unions such as railroads and power companies. The PPP model is an easy way of bridging that concern,” she says. Recent examples include Uganda’s Kampala Expressway and a waste-to-energy plant, facilitated by the country’s passing of its landmark Public-Private Partnership Bill in 2015, which introduced a regulatory framework for PPPs.

African companies are gaining prominence in the market through these partnerships. Ms Kainyah says: “With growing FDI and PPP investment, we are beginning to see African partner companies to these international investors coming onto large-scale projects, which they would not have been able to do on their own. Significant knowledge and technology is being transferred to them, enabling them to become bigger players in their own right.” 

Of course, emerging markets present their own risks. Ms Kainyah encourages investors to conduct what she calls "due diligence plus", “taking the time to understand the political and socio-economic terrain while having good on-the-ground advisers”. Land issues, for example, can be very sensitive because they often require negotiations with local tribes or families. Political instability, civil strife, currency risks and contract rejection are also greater risks in emerging markets; governments must actively work to instil confidence in private investors.

This requires maintaining a stable environment. A 2016 World Bank report on PPPs found that private infrastructure investment is “highly sensitive to conditions such as freedom from corruption, rule of law, quality of regulations and the number of disputes in a sector… A robust institutional and regulatory framework is critical in attracting private investment for infrastructure projects”.

In 2013, China made the promotion of PPPs part of state policy as it sought private investment in state infrastructure. However, a survey of private companies involved in PPP projects conducted by China Confidential, a Financial Times research service, found that “only 48% said they would invest in such developments again. Government interference, poor enforcement of investors’ rights and low returns were cited as reasons for their hesitance.”

International intermediaries

When there is insufficient equity to match the debt required to finance a transaction, development banks play an increasingly important role filling the gap. The World Bank’s International Finance Corporation (IFC), for example, invests more than $1bn in infrastructure equity annually and in 2013 launched a global infrastructure equity fund for emerging markets, raising $1.2bn. The African Development Bank and Inter-American Development Bank, among others, also have targeted infrastructure funds.

The World Bank’s International Development Association recently introduced the Risk Mitigation Facility (RMF), allocated to catalyse more private investment in large-scale infrastructure and PPP projects in low-income countries by providing liquidity support and political risk insurance. 

“It is specifically to address the risk of political interference,” explains Bernard Sheahan, director of infrastructure at the IFC. “This is a brand new thing that for low-income countries we think will make a big difference.”  

A new entrant is the Beijing-based Asian Infrastructure Investment Bank (AIIB). With more than 70 member countries, the AIIB provided over $1.7bn in loans in 2016, co-financed with other multilateral institutions. 

“The AIIB recognises that in order to be transformational, it’s not about billions in capital but about bringing in the trillions from the private sector,” says the EBRD’s Mr Romani. “We believe the AIIB will be instrumental in that.”

National and local governments must continue working with partners in developing sound deals to attract the crucial private capital needed to support their populations. Attracting these investors, Mr Sheahan concludes, boils down to one thing: “It’s like anything else. Investors only respond to one incentive: that the return is adequate for the risk.”

In focus: the global PPP picture

The UK pioneered PPPs in the 1990s and has reaped the benefits: more than 15% of all public infrastructure investments in the country are made via this model. In some EU countries, PPP deals are quadrupling in number each year. Emerging markets, such as Brazil, China, Mexico, India and Turkey, account for 54% of the global PPP investment total, the World Bank reports. In areas such as transport, telecoms and energy, cash-strapped governments are actively pursuing private sector funds and expertise.

According to the World Bank, from 1991 to 2015, developing countries ambitiously mobilised PPPs “for the construction of roads, bridges, light and heavy rail, airports, power plants, and energy and water distribution networks”. In this period, “investment commitments totalled $1500bn in more than 5000 infrastructure projects in 121 low- and middle-income countries”.

The US, meanwhile, is rather late to the game: despite the estimated $3600bn needed just to bring US infrastructure into 'good repair', government still shoulders the vast majority of infrastructure costs, and PPPs are only allowed in half of US states. But they are gaining traction nonetheless. Acts passed by Congress in 2015 and 2014 concerning water and transport infrastructure have expanded permit and credit access to PPPs. States such as Florida and Virginia have been leading the way: in 2014, the Florida Department of Transportation closed a $2.3bn interstate highway deal, at that time the largest availability-based PPP contract in the country. Private investment in US public works projects is predicted to reach $15bn by 2018.