Caution in the face of opportunity
Despite the growing clamour for funding, pension funds remain cautious about investing in infrastructure. Michael Wilkins analyses some of the barriers holding back potential investors
Infrastructure project debt represents a natural match for the long-term liabilities of pension funds and currently provides a higher yield than government bonds. Interest in infrastructure investment from the alternative finance sector, including pension funds alongside asset managers, insurers, sovereign wealth funds and others, has increased dramatically over the past 18 months. Nevertheless, apart from some notable exceptions, the majority of pension funds remain slow to commit.
We identify three main causes behind this reluctance: a lack of familiarity with project risk; caution regarding the lack of historical performance data; and concerns about the potential emergence of an asset bubble.
Standard & Poor’s anticipates that up to $25bn of project finance debt will be sourced globally from the alternative finance sector in 2013. Indeed, there are already signs of accelerating interest from some institutional investors. In August last year, construction of Meerwind, the first offshore wind project to be fully financed by private investment, began in the German Bight. A month later APG became the first Dutch pension fund to provide debt financing for an infrastructure project, lending €80m for the widening of a Dutch highway.
Nevertheless, despite these activities, it is clear that many investors remain wary. In a report published in January, the UK’s National Audit Office identified risk aversion by institutional investors and pension funds as a major impediment to private sector infrastructure investment in the country.
According to Standard & Poor’s latest figures, despite the severe economic and regulatory pressure that many global banks are under, the infrastructure sector remains a bank-led market, with 63% of infrastructure projects seeking funding between January 2012 and February 2013 still funded via bank lending. In contrast, only 3% of global project finance funding was provided by pensions funds in this time.
In our analysis of the barriers preventing further investment, three main issues stand out.
Perception of risk
First, market sentiment suggests that levels of risk remain a major source of anxiety, especially in comparison to government bonds, institutional investors’ traditionally preferred form of long-term investment. Within project risk, construction risk (the risks associated with ensuring that a project is constructed and completed on time, to budget, and capable of operating as designed) is regarded as a particular source of concern.
In many ways, this anxiety is understandable. Estimating the required amount of credit support to complete a project is a complex task in itself because of the variety of potential risk factors, and banks have traditionally been better equipped to cope with managing these risks (through the provision of debt margin structures, for example).
Nevertheless, these issues are far from insurmountable. Many can be covered via insurance, or mitigated through the project structure, as long as investors have sufficient expertise and experience.
We observe that institutional investors are beginning to recruit experienced infrastructure personnel, often from companies retreating from the market, such as the banks and the former monoline insurers, and as the sector builds up relevant skills, we anticipate that levels of risk aversion might recede.
In regard to construction risk, we believe these concerns may be overstated. Standard & Poor’s takes construction risk very seriously. Indeed, we are refining our methodological approach towards it, as part of our drive to further improve the transparency of our ratings.
However, in our experience, it is actually counterparty risk that is the main cause of credit default in infrastructure projects, especially in transactions involving public sector counterparties. Again, however, this is a risk that can be analysed with the correct expertise.
Lack of data
There is also a concern among some investors regarding the lack of historical performance data for infrastructure projects that utilise new technology. A good example is the demand for investment in offshore wind farms in Western Europe. These are large-scale, difficult projects that that have little proven track record of yield. Utility balance sheets and state lending organisations have been the dominant sources of funding for this relatively new asset class, but these are unlikely to be sufficient to fund the ambitious investment needed by 2020.
We estimate that the amount needed to meet UK and German government investment targets alone by 2020 is between €91bn and €103bn. As a result, we expect economic infrastructure projects to continue to look towards bank lending as the main source of funding for the foreseeable future.
Potential asset bubble
Finally, having had their fingers burnt in 2008, investors are also wary of the prospect of another asset bubble forming. Standard & Poor’s has warned of the potential danger of systemic risks emerging in the infrastructure sector as a result of the opaque nature of the shadow banking market, although it should be stressed that this has not been a major cause of concern to date.
In addition, there has been a shift in investor appetite away from the private-equity approach for capital return that was in evidence prior to the bursting of the infrastructure asset bubble in 2008. Under that approach, fund managers would make equity investments on behalf of their clients (such as pension funds and insurers) with the aim of generating returns from selling the asset at a profit within a short timeframe. Now, private investors are increasingly focused on low-risk, low-volatility debt-type investments that generate a more predictable cash yield over a longer timeframe, are potentially more liquid, and benefit from greater security post-default.
Pensions funds and other institutional investors have the capacity to be of great benefit to the infrastructure sector by providing a stable source of funding while potentially helping to reduce the cost of borrowing for projects. However, because of the reasons listed above, Standard & Poor’s believes any transition will be relatively gradual, and we expect bank lending to remain the dominant source of funding for infrastructure projects worldwide.
Nevertheless, the trends underlying the growth of alternative finance lending to the infrastructure sector are here to stay. The need for banks to hold higher capital ratios, as a result of Basel III, is likely to make long-term financing projects such as infrastructure lending increasingly unattractive to banks, as compared with more liquidity-friendly investments. At the same time, institutional investors, such as pension funds, continue to require long-term investments that generate yield. And with project risks becoming increasingly transparent, and a track-record of safe returns being established, infrastructure investment is likely to play an increasingly prominent role in investors’ portfolios in the future.
Michael Wilkins is a managing director in infrastructure ratings at Standard & Poor’s Rating Services