Investment Moats

Macquarie defends its infrastructure model

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By Robert Wright in London

Published: May 19 2008 17:47 | Last updated: May 19 2008 17:47

A senior executive at Australia’s Macquarie has said that the bank’s business model for infrastructure investment is “alive and kicking”, in spite of some analysts’ fears about its vulnerability to constrained credit markets.

Stephen Allen, an executive director of Macquarie Capital Advisers, said infrastructure investment had been less affected by the credit crunch than any other financial sector. Funds continued to be needed to fill gaps in the public sector’s infrastructure investment budgets.

Mr Allen queried whether business strategies for Macquarie’s 35 funds’ were sufficiently similar – or different from other companies’ strategies – to amount to a single business model.

But he went on: “The so-called model is alive and kicking. We’re raising billions of dollars at the moment in different funds. It’s the fundamental point that there’s a huge need for infrastructure in lots of states and that there’s not enough public funding. There’s no doubt about that.”

Critics have questioned the sustainability of aspects of Macquarie’s business model. RiskMetrics, a US-based corporate governance group, has been critical of the model behind the group’s listed infrastructure funds, pointing to their heavy indebtedness, relatively high prices paid for assets and excessive draining of cash from assets to pay dividends at the funds.

RiskMetrics’ research has come on top of already steep falls in the share prices of many of the listed funds managed by Sydney-based Macquarie, one of the pioneers of the trend for private investors to put money into infrastructure assets.

Mr Allen accepted it was more expensive to raise finance for infrastructure projects than it was a year ago – but said markets had been at their peak then. “The infrastructure sector is probably the least affected by the banking problems and the banks still see it as a core business for them,” he said. “It’s a kind of medium-risk, medium-return business.”

Mr Allen said credit conditions would hit some Macquarie units, but he played down the likely impact. Investors might have to put slightly more equity and less debt into deals to buy assets such as toll roads.

“Some of our funds took advantage of the [previous] credit climate to borrow at cheap rates – it means they don’t need to roll it over [for the moment],” he said. “What you’re going to see more of is people who … need to roll over debt and a year ago would have been confident that money would have been available. Today it might be a slightly lesser quantum or the terms might be a little bit different.”

Meanwhile, aspects of the current tough economic and financial conditions could actually help infrastructure investors, Mr Allen suggested. The poor state of many rich countries’ infrastructure was not beginning to affect citizens’ daily lives, but it would not prove possible, he forecast, for the public sector to finance their repair. That would leave private investors as the only realistic option.

“People are not going to be willing to pay the taxes involved,” Mr Allen said.

Assets Divestments at Macquarie Group, Babcock & Brown and Allco

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Dividend & Income investors in Singapore would be scratching their head recently by the drastic fall in share price of Babcock and Brown Global Investment and Macquarie International Infrastructure fund.

BBGI dropped drastically to its current price of 29cts, a far cry from the 1 dollar it was trading at a year ago.

MIIF plunge from 76cents recently to as low as 62 cents. I am vested in MIIF. MIIF is tracked at my Singapore Dividend Stock Tracker.

Investors would be wondering if this fall is due to the broad gloabl economic fall in stock prices or are there unsystematic information that causes such a fall.

The financial times did highlight this in their recent article dated 24 AUGUST 2008:

By Sundeep Tucker

Published: August 24 2008 20:57 | Last updated: August 24 2008 20:57

The rush by Australian-listed infrastructure funds to divest assets is in danger of turning into a stampede.

Three such high-profile announcements last week have shone an unwelcome spotlight on a sector that until recently was a darling of the stock market.

The pioneer of the specialist fund model was Macquarie Group, although several local rivals including Babcock & Brown and Allco Finance joined in with gusto. The model involved buying infrastructure assets in sectors such as energy, ports, utilities and property, and bundling them into listed satellites and taking fees.

It worked a treat in the days of cheap credit, as buyers could borrow heavily and pay top dollar for assets that were themselves always rising in value.

The global credit crunch has changed the game for the infrastructure funds, with funds scrambling to reduce their average weighted cost of capital.

Some have divested to slash net debt or are pre-emptively selling assets well ahead of renewal of debt contracts. Several others have decided to change policy and only pay distributions from operating cash flows, thereby cutting debt but also dividend yields to investors.

Last week’s divestments began with Babcock & Brown Power, the country’s biggest listed generator, which booked A$425m (US$373m) in writedowns and announced the sale of the Tamar power station back to the Tasmanian government for a knock-down price of A$100m. The fund has slashed its gearing levels in recent weeks.

The news led to a dramatic 45 per cent fall in the share price of parent company Babcock & Brown last week, prompting the departure of chief executive Phil Green.

Macquarie Airports followed, unveiling the sale of stakes in Brussels and Copenhagen airports for A$1.5bn. Management, frustrated by a share price that does not reflect the underlying value of the fund’s assets, hopes that the de-leveraging and a A$1bn share buyback will boost the fund’s stock.

On Friday, Macquarie Communications Infrastructure disclosed the $363m sale of a flagship asset: its 28.7 per cent stake in Global Tower Partners, manager of 3,000 communications towers in the US. The fund plans to use the proceeds to repay convertible debt.

Luke Macnab, infrastructure analyst at ABN Amro in Sydney, said that individual funds’ divestment and capital management strategies were driven by the specific state of their balance sheet. This in turn often depended upon whether or not the fund concerned acquired assets at the peak of the credit cycle and so was caught out by the sudden downturn.

Mr Macnab added: “Some infrastructure funds are selling to reduce debt levels, while others are divesting assets because they have found willing buyers prepared to offer a premium to their current share price.”

Ultimately, he said, the test was whether the sell-off action improved the stock price. Investors are proving hard to convince.

Like its parent, Babcock & Brown Power fell by more than 40 per cent last week, while Macquarie Communications’ stock price dropped 18 per cent on Friday. Macquarie Airports fared better closing up 9 per cent and so reversing some of this year’s decline.

The stock prices of the funds are expected to be volatile in the coming weeks, as investors further scrutinise debt levels and asset values, with further sales and capital management changes in the pipeline.

Philip Wensley, an infrastructure analyst at Morgan Stanley in Sydney, noted that Macquarie Infrastructure, Babcock & Brown Infrastructure and Asciano, an owner of port and rail assets, were among those to have flagged divestments of local or overseas holdings.

However, he cautions: “Finding buyers for these assets will not be easy because potential investors – including those who control unlisted funds – see that valuations are still falling.”

Infrastructure Funds: Building on strong foundations

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From the Financial Times [Thursday , March 13, 2008]

The appetite for infrastructure funds looks set to increase again this year

This year pension funds and other institutional investors allocate new or larger commitments to an asset class they see as delivering attractive, steady, inflation-adjusted returns over a long duration. The turbulence in equities market and the sub-prime fallout have also helped to bolster interest.

Global infrastructure fundraising topped $34bn (£17.2bn) last year – nearly double 2006’s level – and nearly seven times the $5.2bn raised in 2005, according to Probitas Partners, a fund management firm in San Francisco.

The world’s 20 largest funds have nearly $130bn under management, 77 per cent of it raised over the past two years, with about 63 per cent from new entrants, according to McKinsey & Company. These amounts, though, may be even higher since many pension funds and sovereign funds have made allocations to internal infrastructure teams that are not publically announced.

About two-thirds of the funds are focused on the US, Europe, the Middle East and North Africa, as well as India, according to the Collaboratory for Research on Global Projects at Stanford University. Approximately half of the new funds follow the private equity model, raising money primarily from large institutional investors.

The demand for capital by the infrastructure sector results from aging structures, the rapid pace of technological change, an increase in population, the emergence of mitigation and adaptation responses to climate change, urbanisation, China’s explosive growth and the rise of a middle class in developing and emerging market countries.

As a result of these trends, more than $53 trillion in infrastructure investment is needed worldwide over the next 25 years. The US alone is estimated to require $1.5 trillion just within the next five years. The Organisation for Economic Cooperation projects that infrastructure needs worldwide will consume at least 3.5 per cent of global gross domestic product each year through 2030.

Government resources to cover these record-breaking costs will increasingly lag, creating an ever-widening gap between needs and resources, the OECD concluded: "Failure to make significant progress towards bridging this infrastructure gap could prove costly in terms of congestion, unreliable supply lines, blunted competitiveness and growing environmental problems, with clear implications for living standards and quality of life."

Private investment is seen as playing a key role in bridging this gap. The Global Real Estate Center of Ernst & Young estimated that private sources could account for 10 per cent to 15 per cent (US$240bn to US$360bn) of the capital needed annually for infrastructure projects worldwide.

Ryan J Orr, executive director of Collaboratory for Research on Global Projects for Stanford University, saw several factors conspiring to attract investors.

Cash-strapped governments are enacting legislation to allow public-private partnerships in infrastructure, he observed. Fund managers are building on their success in other sectors to create new products that tap the opportunities in infrastructure.

The move by institutional investments away from equity and fixed-income to alternative investments is another factor, with public pension funds, for example, seeing infrastructure as a substitute for long-duration bonds. Impressive returns by some of the pioneering funds have also piqued investor interest.

Mr Orr said: "We are seeing in society and the economy an enormous change with respect to how infrastructure is owned and operated. Infrastructure has moved away from being owned and operated largely by national, state and local governments to new arrangements that involve private investors, global operators and innovative financing strategies crafted by investment banks."

The US state public pension fund, California Public Employee Retirement System, announced a plan in November 2007 to shift up to $2.5bn to a new infrastructure programme. The $12bn CK Finnish state pension fund, Valtion Elakerahasto, also announced its intent to broaden holdings in infrastructure.

The world’s largest pension fund, the ABP, is committing 1 per cent of its €215bn (£165bn) in assets to infrastructure funds, with placements, for example, in ABN Amro Infrastructure Capital Equity fund and the Macquarie European Infrastructure fund.

How does an investor earn money building a bridge or water treatment plant?

Mr Orr said that typically the investor pays to build the bridge and then manages and operates it for a set period of time – such as 30 years. During that time, the investor collects user fees to recover its investment and earn a profit. Governments like the arrangement because they ultimately retain control of the infrastructure but reduce their risks and achieve efficiencies in construction, operations, and maintenance through a private sector partner.

Infrastructure assets are largely long-lived, like plants, electrical grids, toll roads and dams. The projects are also often quasi-monopolistic. There is usually only one grid or highway, which means lower barriers to entry than if there were competition among projects providing the same services.

Since many funds are new, their track records have yet to be tested. To get an indication of the return potential of infrastructure, an analysis by Standard & Poor’s of listed infrastructure stocks between 30 November 2001 and 31 January 2007, shows their producing 23.28 per cent in annualised returns with a 10.89 per cent in annualised volatility. That compares with annualised returns for bonds of 6.94 per cent and an annualised volatility of 5.76 per cent; for common stocks, the returns are 10.56 per cent and volatility is 12.34 per cent. Listed infrastructure stocks yielded 3.1 per cent, compared with 1.8 per cent for stocks and 4.3 per cent for bonds.

The S&P index is comprised of 75 of the largest companies that fall into the energy, transportation, and utilities sectors. These companies are not directly comparable to the universe of new infrastructure funds on the private equity model. These funds are very different, in that they are untraded, for the most part closed-ended and focus on making direct equity investments in infrastructure deals.

For those funds based on the private equity model, returns are heavily dependent on the availability of low rates of interest. Mr Orr said: "In the long run, should interest rates go up, cashflows, debt coverage ratios and returns on new deals would deteriorate as an increasing share of operating revenue would go to service debt. If global credit markets continue to worsen, these highly structured and leveraged acquisition loans will increasingly look less attractive. S&P has estimated that up to $34bn of leveraged infrastructure loans could be left paralyzed under present market conditions."

Kelly DePonte, an analyst for Probitas Partners, said: "Most infrastructure projects completed to date have been fairly conservatively-financed. Covenant-lite structures never gained much ground in infrastructure investing. Interestingly, those investments with well-forecast cash flows such as toll roads, have in the past been able to be heavily leveraged. But for certain of these assets that may be too heavily leveraged, they may find themselves in trouble as that leverage makes them more susceptible to small changes in revenue."

All of this interest is creating a problem for fund managers and investors seeking profitable infrastructure opportunities amid hyper-competition for those assets. S&P noted that, while the number of global infrastructure deals increased 24 per cent between 2005 and 2007, the value placed on those deals increased by 90 per cent as investors offered more and more for less and less.

"If funds follow the crowd, bidding to operate existing assets under a business-as-usual model, they run a double risk because of the sheer volume of dollars now chasing deals and driving up prices: either they lose out to more audacious competitors, or they risk overpaying and achieve suboptimal returns," Robert N. Palter, Jay Walder, and Stian Westlake wrote in an article in the February issue of McKinsey Quarterly. "Yet funds are under growing pressure to invest the money they raised. They cannot sit on the cash indefinitely.

"Infrastructure investors must raise their game in two ways. First, they should become better at extracting value from projects by improving their operational capabilities. Second, they ought to use this more sophisticated operational perspective to assess the risks of non-traditional infrastructure deals – such as those that involve complex operations, emerging markets, or new assets."

James Spellman runs a strategic communications consultancy in Washington