The phrase infrastructure finance gets used a lot, often with subtle but important differences in meaning. Nevertheless, the area is now sufficiently well established that it is possible to make some broad generalisations about how it works, and how it differs from other fields such as private equity.
To begin with, there is the heavy reliance on discounted cash flow modelling. While public investors still tend to rely heavily on multiples of earnings when picking stocks, most infrastructure analysts pride themselves on paying little attention to the price of something in the public markets.
Instead, they attempt to model revenues, costs, investment requirements and cash flows for a particular business well into the future, and then work out what those cash flows are worth today. The final figure gives an indication of what an asset might be worth, and how much debt it can support. In both cases, the answer often differs significantly from the view of the stock market.
The most striking recent example of this was the auction of BAA, the British airport operator, which saw its share price double amid a fierce battle which was eventually won by Ferrovial of Spain. But infrastructure investors tend to stick with the DCF analysis, even after they have bought an asset.
Having identified an asset, the next step is to put in place the financing. Investors often buy assets with a useful life of 20 years or more. But nobody, apart from governments, can borrow money over such a long timeframe.
Sometimes, the answer is to seek shorter-term financing but hedge the risk that interest rates or exchange rates move significantly using the swaps market. Alternatively, investors will sometimes use shorter-term debt, known as a bullet facility, to provide initial financing. They then hope to refinance on better terms after five or seven years, once they have paid down some of the debt.
Ultimately, the idea of infrastructure finance is to leave enough cash flow – after the investment needs of the business have been met and the debt has been paid off – to pay investors a dividend. “Our product is yield,” says one senior executive.
Yet this does not always happen immediately. As the price of infrastructure assets has risen, returns have not only declined, they have been pushed back. As a result, executives now acknowledge that some investments make little or no return in the first few years, but only begin to pay a healthy dividend later on, once some of the debt has been paid down.
There is also a suspicion that some infrastructure investors are gambling on being able to sell the business for more than they paid for it, or on refinancing the debt at better rates in the future, in order to provide their investors with a decent return.
For the bank that handles the investment, however, the picture may look significantly different. This is because many banks charge a series of fees to their investors on deals they have arranged. They might take an advisory fee, a fee for arranging the financing, and performance fees for managing the asset in the future.
These fees can prove extremely lucrative for the bank involved, but should be deducted before investors calculate their returns.
One of the drivers for the rapid growth in infrastructure financing has been the emergence of a class of investors looking for long-term assets that offer stable returns.
However, investors are also eager to exit their investments. As a result, some infrastructure investors have developed a system of listing their funds as soon as they are fully invested.
The idea is to let investors take back some or all of their capital, without waiting for the investment to run its full course. Stock market rules in the UK and the US mean these listings are still relatively rare, but they are well established in Australia.
Macquarie Infrastructure Group, a long-established fund that holds most of the Australian bank’s investments in toll roads, went public in 1996 and now has a market capitalisation of almost A$8bn. In the UK, Macquarie may look at floating its first European Infrastructure Fund next year.
HSBC already operates a listed infrastructure fund that invests on British projects launched under the private finance initiative.
Another factor in the growth of infrastructure financing has been the availability of large amounts of cheap debt. Low interest rates and the willingness of lenders to reduce risk premiums have allowed infrastructure investors to borrow larger amounts on more favourable terms than ever before.
But this raises the question of what will happen to the business if interest rates rise. In an industry where returns are driven by assumptions based on long-term financial forecasts, even a small change in the cash flows can lead to dramatic changes in the projected returns.
Infrastructure executives argue that many of their investments have built-in hedges against inflation. Water companies and other utilities are subject to regular reviews by regulators in which their prices are set according to inflation. The same is true for many toll roads.
However, these cannot protect investors from other shocks, such as a spike in the oil price, which could diminish road usage. Infrastructure groups argue that they subject their models to substantial stress tests before launching bids for concessions or companies, in order to see what would happen to their investments if things go differently than expected.
Nevertheless, the point remains that this relatively young asset class, which has grown extraordinarily quickly in recent years, remains largely untested in a severe credit downturn. Whether pension funds would then be as eager to invest in these assets, and whether infrastructure groups would be as good at finding good investments, remains to be seen.