Investor interest in infrastructure has grown considerably over the past 20 years. As an asset class, it offers the potential for predictable long-term cash flow returns, strong counterparties and controlled risk. But, as interest in this asset class has grown, so has the competition for deals, creating pressure on yields.
For investors, the natural next step is to look for exposure to emerging market infrastructure as a way to capture similar risk profiles with an enhanced yield. Certainly, there is a critical need for infrastructure in emerging markets — the International Finance Corp. estimates that emerging markets need twice the investment in infrastructure than what is currently available.
However, the attractive elements of infrastructure as an asset class, including stability, contracted revenues and expenses, and controllable risks, do not always map well in emerging markets. Currency risk, government instability, volatility and poor credit ratings all threaten the core attractiveness of infrastructure in emerging markets. Does the premium justify the risk? Or does it change emerging market infrastructure into a different asset class altogether?
We believe emerging market infrastructure can be a valuable, uncorrelated piece of an investor’s portfolio. However, to see any benefit, investors should not view emerging market infrastructure as “infrastructure with premium return,” but as a hybrid strategy that also offers exposure to the potential premium return of an emerging market, with a strong link to underlying GDP growth.
This approach requires a more private equity style of investment strategy with a broader definition of infrastructure, and thinking of emerging markets infrastructure as emerging market private equity with controllable risk.
This strategy allows investors to not only address risk, which is commonly the main focus for managers in developed market infrastructure investing, but to also seek an appropriate return to compensate for the inevitable emerging market risks.
THE CASE FOR AFRICAN INFRASTRUCTURE
One way to achieve investment strategy is by including traditional industrial investments under the infrastructure label in Africa, a continent whose greatest need is not just for traditional infrastructure, but for industrial infrastructure as well, such as basic industry, petrochemicals and logistics. These are the building blocks of development and industrialization, which are key to countries transforming from agricultural to middle-income countries. Successful investing in emerging markets usually has strong development implications, and nowhere is that more evident than in helping Africa to industrialize.
These investment opportunities in Africa are often overlooked. Africa is not highly leveraged with private debt financing, and it is not overly exposed to global financial market conditions. Liquidity is also available, as development banks continue to drive investment flows into industrial infrastructure, and EXIM financing is available for greenfield projects.
The drop in commodity prices has diminished government budgets across the continent, but it also has exacerbated the funding gap and created a “buyer’s market.” For example, oil producers are focused on monetizing gas assets, which requires local investment and projects, opening up interesting investment plays in brownfield industrial projects. It also has forced governments to move away from building and controlling infrastructure to paying for infrastructure services on an ongoing basis.
Industrial projects can offer an upside that is missing from more traditional infrastructure investments. Once built, a portfolio of industrial plants and projects offers a long-term cash flow yield profile similar to infrastructure projects, albeit with a more cyclical exposure. This can be structured to allow for hard currency cash flows through export markets, but also premium pricing through domestic sales with lower transport costs and better domestic access. Industrial investments can have an element of monopoly protection, as with infrastructure. This is occasionally from the pure size of an investment, but also can be a result of contracted access to raw materials, such as gas, metals and so forth. Finally, the return on these projects is not completely dependent on government performance, in comparison to developed market investment where the backstop of government credit is a key driver.
With weaker government credit ratings, it is key that all our eggs are not in one basket, and that commodity pricing offers higher returns for the political risks taken. The contractually fixed returns from a traditional infrastructure project in emerging markets leaves limited upside, and retains much of the downside from domestic and regional government risk.
CONTROLLING RISKS
The case for allocating to African industrial investments is compelling, but managing the risks is critical to realizing higher returns. Infrastructure investing in emerging markets cannot be the same as the passive, contract-based strategy in developed markets.
It is key that projects are analyzed on a case-by-case basis, because each one has unique complexities and issues, both tangible and intangible. Partners, regulation, the product market, technology and key input-supply contracts all need to be understood in the local context. As the risks can change throughout the life of a project, they need to be actively managed, versus the more passive management of developed market infrastructure.
It is also key to work with an experienced manager, great local partners and strong industrial partners to assemble the necessary expertise to identify the right projects, and to understand the changing risks and needs of a project. The manager must be able to work across that lifecycle, and to understand the different risks related to project development, construction, commissioning and, ultimately, operations and exit.
A manager’s internal knowledge is critical to achieving this, but also its ability to mobilize partners is essential, as well. Local partners must meet developed market environmental, social and governance (ESG) standards, have on-the-ground knowledge and a solid network of local business partners to overcome high barriers to entry.
Finding the right industrial partners is equally important. Standard & Poor’s estimates that more than 20 percent of the infrastructure projects it has rated which “failed” did so due to construction and technology issues. Having the right industrial partner, who has global experience, best practices, and the ability to mobilize and manage projects is critical to addressing this controllable risk in markets that come with higher political risks and other risks.
Collins Roth is managing director of MPC Capital.
