Currently, many institutional investors are concerned with the topic of infrastructure. The current situation should perhaps be viewed less in terms of short-term thinking and procyclicality on the supply side. After all, the low-interest rate phase will accompany the industry in the longer term, and know-how in the infrastructure segment will be gradually expanded internally and externally on the investor side. Markus Hill* spoke on behalf of IPE Institutional Investment with the lawyer Jochen Terpitz (Simmons & Simmons) about the challenges that providers and investors have to face.
Hill: For some years now, there has been a lot of talk about the fact that capital accumulation points such as insurance companies, pension funds or pension schemes would be ideal investors in infrastructure – why is it not yet common practice for insurers to finance the energy turnaround and for pension schemes to finance the construction of new roads and fiber-optic networks?
Terpitz: To a certain extent, this investment activity does indeed take place, but perhaps not always to the extent and in the places that interested parties from politics imagine or that are particularly effective in terms of publicity. Investments in Germany’s high-voltage electricity grids, in offshore wind farms such as London Array or infrastructure funds with stakes in PPP projects, show that very different projects can be marketable.
Hill: Where are the difficulties?
Terpitz: Infrastructure investments often involve much more effort for investors than investing via the capital markets. In addition to individual project assessment, there are also many small pitfalls to consider. Regulation per the AIFM directive, equity capital backing by Solvency II, and then there is the regulation of the target project itself, whether in the energy market, transport or telecommunications. And one must also realize that there are very different investment possibilities and that each investor must bring the investment into line with his risk profile and his own investment rules. The learning processes take time.
Hill: Which different investment possibilities exist and are market standards developing?
Terpitz: A generally applicable classification is difficult. First of all, there is a wide range of target projects, from highways, prisons/city halls, telecommunications and power grids to railroad cars, port terminals, and then the entire power plant sector with its large and small, centralized or decentralized plants. A relevant distinction can certainly be made between, on the one hand, investment in infrastructure companies (e.g. power grids and water supply), which retain personnel, reinvest regularly and still have a value even after decades, and, on the other hand, investment in individual infrastructure projects, which are amortized over a fixed period and are to be valued at zero or a certain residual value at the end of the investment period.
Another, also risk-relevant, the distinction is made between equity investments and debt investments, whether in bonds or directly in loans; however, there are also many investors, especially in the case of medium-sized investments, who provide the entire capital requirement as equity.
Ultimately, the market can still be differentiated between projects in which individual investors invest individually and cases in which additional capital and investment decisions are concentrated via intermediary fund structures that are open to several investors. This is where specialized asset managers become active, who can make their know-how available to many investors in this way.
Hill: Does this create an additional asset management segment? Or who, as an investor, can do this themselves?
Terpitz: In our experience, infrastructure assets require a level of support that requires specialist know-how that probably only the largest companies in the industry can build up within their organization; this is much more expensive than buying bonds. In many cases, even ongoing reporting and information transparency are not exactly as expected by investors; occasionally, as can now be seen in offshore wind projects, many staff are also built up within the project companies to provide investor support, but often such services are provided by external asset managers.
After all, it is not only the proximity to the actual infrastructure project that counts, but the asset manager must be able to follow and implement developments in the area of investment regulations or Solvency II. Besides, the AIFM directive and the KAGB (German Investment Management Act) place demands on the managers, which makes it rather difficult for them to manage the project themselves. A good asset manager can probably also help to permanently reduce the “perceived investment risk” in the infrastructure sector: the more competently the investment form is explained and accompanied, the less reluctance there is to expand investments here.
One level above this, each investor must then check-in which quota the investment can be classified and how much equity capital is required to back it. That is individually completely different from the different insurers or pension funds, and to that extent, there is also none for each “Solvency II optimized” plant product. In some cases, the insurance supervisory authorities also require every investor to provide proof of specific know-how concerning project risks, which the asset manager then helps to build up.
Hill: Keyword risks – are infrastructure investments not particularly safe?
Terpitz: Investments in power plants, roads, pipelines, or railroads naturally have the advantage that these assets do not get lost so easily and that they promise a steady return over a long period. However, the higher returns expected from these forms of investment compared to government bonds are associated with a different risk profile than that of German government bonds. Yields may be delayed, or subsequent investments may be necessary. Often these infrastructure investments are very long-term. On the one hand, this is advantageous for investors who also have to invest capital on a long-term basis. On the other hand, the longer the investment horizon, the more uncertain forecasts become. Such uncertainties can relate to infrastructure demand or user volumes but also changes in the political environment.
Hill: What approaches to risk limitation are there here?
Terpitz: There are various approaches to limit project uncertainties in infrastructure investments. On the one hand, one can try to contractually assign risks to other project participants, one can reckon with stress scenarios and build in financial buffers accordingly, or, depending on the type of investment, provide for reviews and value-preserving or value-enhancing adjustments during the operating period. The division into tranches with varying degrees of risk is also a way for investors to participate in infrastructure according to their risk appetite.
Real forecast uncertainties are probably difficult to exclude as such. Extrapolating historical data is inappropriate when it comes to forecasting traffic volumes or energy consumption over the next two decades. One need only of various European regional airports or the underestimated speed of the development of renewable energy power plants in some European countries, which then led to unexpected reactions from government regulation. Here it only helps to take into account the existence of these uncertainties in the investment model and find alternative uses or sales opportunities.
Government agencies are also only willing to take on such uncertainties in some areas so that the quality of data preparation by investors and asset managers is likely to be very important. In other areas, such as construction risks or technical risks during the operating period, we can certainly see that project partner with suitable creditworthiness and the corresponding know-how can take over. In infrastructure markets that are strongly influenced by politics, it may make sense to reserve a budget within the investment for participation in initiatives by associations to actively shape these markets.
Hill: What else can those willing to invest do to participate more in the opportunities offered by infrastructure?
Tepitz: Always keep your eyes and ears open for developments in the infrastructure markets. In the coming years, it will often be a question of first working out the investment opportunities. After all, there are already fewer projects with simple, proven structures than there is investable capital available. In many places, however, our infrastructure world is undergoing radical change, which opens up new opportunities. The energy turnaround could well be complemented by a traffic turnaround, for example with autonomous electric and gas-powered vehicles. And the continuing rise in the average age of the population may require new developments and investments in many areas.
Hill: Many thanks for the interview.