Infrastructure as a Growing Asset Class
As we discussed in a separate article, infrastructure is growing as an asset class. Owing to the characteristics of infrastructure versus fixed income – long-life nature of infrastructure assets (a bridge can last 50 years versus a 5-10 year bond), higher returns (even the safest, and we will elaborate on this later, infrastructure will offer 6-9% internal rate of returns or return to equityholders), and price protection (real bond returns are hurt by inflation while infrastructure often has inflation step-ups) – asset managers, pensions, insurers and private equity is increasingly boosting the asset allocation weight of infrastructure in their portfolios.
Additionally, due to the social benefit of certain types of infrastructure， there are government incentives for construction either through tax rebates, convenient permitting or direct and indirect subsidies. For example, a developed mass transit system or effective subway lines can easy traffic congestion and improve productivity – highways and freeways can shorten the time of commutes from one hub to another.
As project finance continues to evolve, projects that are too risky to be funded via equity alone can be put together through a derisking process by lenders, advisors and project managers. Higher project finance volumes and larger bank balance sheets will also lead to infrastructure becoming more attractive.
Infrastructure investing is very difficult as an individual investor – the closest many people can get is buying shares in something such as Brookfield Asset Management. However, we all have infrastructure exposure through pension funds that manage our future wealth distributions and endowments that help fund the growth of institutions that benefit the broader community.
So plenty of buy side investors look at infrastructure – the question for investment bankers is how do infrastructure private equity funds make investment decisions?
To be expected, infrastructure investors look at projects via IRR in line with other financial sponsors. There is no merger math – returns are simply looked at as an acceptable IRR relative to the risk that is being taken.
Unlevered, Before-Tax IRRs or Levered, After-Tax IRRs for Infrastructure
Now this is where it starts to differ for various infrastructure investors – different funds have different mandates.
Insurers are focused on long-life assets for asset-liability matching – they are taxable entities. Pension funds and state funds are non-taxable entities (in their own jurisdictions) that may look at returns on a pre-tax basis (which means the IRRs are higher, all things equal) – however they may not be willing to pay for potential growth and just want to pay for the contracted cash flows.
Private equity firms and the infrastructure arms of these PE funds may have higher IRR expectations – but they may also have a view on the space as an operator instead of a passive investor and may be more willing to pay for growth. Finally, infrastructure only funds may be somewhere in between.
So not by any means a representation of what infrastructure investors are willing to pay for, but it could look something like this:
- State Investment Funds & Pension Funds 7-12% IRR
- Infrastructure Funds 8-12% IRR
- Infrastructure Private Equity 11-15% IRR
And yet, when firms are marketing infrastructure or investment bankers are marketing infrastructure for them, they need to figure out what the appropriate clearing price is – and the price is determined by or solved for through the IRR instead of the other way around. So for example, an infrastructure fund would be thinking if I need a 12% unlevered, pre-tax IRR, what price does that imply?
So if there is a broad process, it may be too difficult to solve for all of the IRR expectations of the firms (as well as what their individual assumptions are for the infrastructure – are they paying for an expansion option or just the cash flows that they perceive are secured?). The investment bank may just look at before-tax, unlevered IRRs and see where firms will bid based on the cost of capital.
Now often, a selling firm has an idea of what price they are looking for (and the concomitant IRR that that implies) – investment banks will need to figure out an appropriate buyers list based on that. If it is a very solid asset with stable, contracted returns and very little risk involved, this may price out private equity firms because of their higher cost of capital. If it is a riskier asset with development upside, this means that investment bankers may want to identify likely buyers and run the math around the assumptions the PE firm would have (levered, after tax returns with good assumptions around how much debt that this could carry).
Infrastructure Value Drivers
Infrastructure will remind students a lot of real options in 300 level finance courses. For this example, let us use a chemical storage terminal that a private equity firm is in negotatiations to buy from a basic materials company that is looking to crystalise value through a sale but maintain use of the premises.
Contracted Volumes and Tolls
The private equity firm will store materials for a predetermined amount of cubic meters of this chemical. They agree to a dollar value per cubic meter. It is common for infrastructure firms to demand a certain amount of capacity that must be paid for regardless of whether or not it is utilized – commonly known as a take-or-pay agreement. The higher the take-or-pay volume and toll, the higher the guaranteed cash flow of the asset and the lower of an IRR an infrastructure investor is willing to accept. The less guaranteed cash flow, the higher the IRR must be – for a more volume based contract that is subject to the fluctuations of the economic cycle, expect investors to risk these cash flows at a higher discount rate as it cannot be depended on for debt service.
Private equity firms may see potential to use third party volumes from chemical producers and industrial firms, which can boost returns. However, pensions and other risk averse firms will not be willing to pay for these cash flows.
Counterparty Credit Risk for Infrastructure
The returns can look great on paper, but if the entity that the infrastructure depends on is under financial distress, this may be problematic for receiving the required cash flows. Letters of credit help, but conducting sector analysis that there will be enough throughput should the primary supplier go belly up is important. A riskier counterparty means that IRRs must be higher and vice versa.
Tenure and Extension Options for Infrastructure
The longer the term of the agreement, the higher the total cash flows of the project that are guaranteed. Afterwards, there is recontracting risk. Options to extend are helpful, but depending on whether it is at the option of the infrastructure operator or the counterparty.
Capacity and Expansion Options
As the economy grows, usually it makes sense to expand an existing project (brownfield) than construct a new one (greenfield). In positive scenarios, volume demand can increase and expansions can be constructed resulting in higher volumes and better cash flows.
Maintenance Capital Expenditures and Operating Costs
These are common cash outlays required with infrastructure projects. Now ultimately, whether the burden ultimately falls on the operator or the counterparty does not matter. If the operator is forced to pay these expenses, the IRR goes down, so the price they are willing to pay must drop in order to meet their IRR requirements. So for most projects, the costs will flow through to the counterparty as a simplification so the cash flows are easily seen for the potential infrastructure buyer.
Infrastructure Operating Risk
For earthquakes and other items that could stop commercial operation, banks will usually require the infrastructure operator to purchase adequate insurance.
Infrastructure Development Risk
An infrastructure asset that is up and running is already derisked – sale-leaseback transactions are good examples of this. However, a project that needs to be constructed still or is halfway done will see valuation jumps at each completion milestone (a “promote”). This means higher IRRs, because the risk is higher.
Scenario Analysis for Infrastructure
Now with all of these factors involved, PE firms investing in infrastructure will generally run a bare bones case that just has the contracted, guaranteed cash flows and immediately making cash flows go to zero once the contracted term is up with no positive options being executed. This generates the lowest IRRs given an assumed price. It can also be solved vice versa for price, by assuming an IRR given the bare bones cash flows.
From there, various options can be run (higher volumes, longer tenor, different tolls) to see what IRRs that would imply.