Quality assets are not cheap, but those prepared to finance greenfield sites in Latin America can be well rewarded for taking diminishing risk, writes Cécile Sourbes

Travelling around Latin America is certainly quite an experience. It is also, without doubt, an adventure. Imagine having spent more than 10 hours on a plane. Your first impression of the continent will come from the airport itself - where you will certainly recognise a significant lack of infrastructure financing over the past decades. But just wait until you get onto the rail network - which is, for want of a better expression, virtually non-existent. Those first impressions will be confirmed.

The situation is clearly improving, however. Local pension funds have started to provide capital for infrastructure projects across the continent, encouraged by governments willing to focus on economic stimulus through public spending.

High returns but….
As Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management, points out, investing in infrastructure as a response to economic crisis has revived a 1930s debate when governments looked to develop transport projects to boost their economies.

"Unlike developed countries, where infrastructure projects consist of replacing the existing facilities, emerging markets are more demanding of greenfield projects, especially in the transport and utility domains," says Turner. "These projects will require larger capital commitments and higher risk exposure due to the construction phase - but they also imply greater returns for pension funds willing to invest here."

According to Michael Barben, partner and head of private infrastructure at Partners Group, the spread between greenfield infrastructure projects in South America and Europe can reach several percentage points. Both European and North American pension funds are now looking to invest in Latin American infrastructure as part of their diversification strategy.

"If we take the wind farm project in Mexico we were bidding for several months ago, for example, the return premium over a comparable project in Europe was approximately 300bps on a long-term buy-and-hold basis," explains Barben.

Nominal returns for greenfield projects can easily reach 16%, decreasing to perhaps 13% for projects already under operation with contracted, inflation-adjusted revenues, confirms Nick O'Neil, a Mexico-based managing director in the Macquarie Group.

"From there, you have to add return for the additional risks you take on, such as traffic risk for a toll road, and so on," he says. "And the good thing about Mexico is that you get risk-adjusted returns."

But, a shadow is clearly looming over this attractive scenario: one of the downsides for European pension funds is currency risk.

Barben says: "In Brazil, for instance, European pension funds may be attracted by high yields, but if you take into consideration the hedging cost, the return premium left is in most cases too low to make the investment attractive for a foreign investor. That is the reason why you have to go for well-structured greenfield projects with higher risk, projects that include development and/or construction phases."

Barben says the Partners Group is currently looking for a premium over returns available from similar infrastructure projects in developed countries of 200-400bps - after currency hedging. "Below 200bps, it becomes difficult to justify such an investment," he concedes.
However, the need for a currency-hedging strategy is questioned by some fund managers. In countries such as Mexico economic forecasts seem favourable to foreign investors and the risk of currency devaluation remains small, as O'Neil points out.

"Hedging the capital investment is a very costly exercise and, depending on the period you are going through, it might be impossible for an investor to implement such a strategy," O'Neil insists. "In addition, the economic forecast has never suggested a depreciation of the peso and, historically, the currency has never headed down the forex curve."

Opportunities
For European pension funds not willing to bear the risks associated with greenfield projects in Latin America, the region still offers some opportunities in the brownfield sector - but while the choice is becoming more diversified, particularly as some European contractors seek to divest their investments in South American utility companies, the valuation of such assets remains high.

The latest example - Morgan Stanley Infrastructure Partners (MSIP) exiting its 50% interest in Chilean electricity distribution, transmission and generation company, SAESA, to Alberta Investment Management Corporation (AIMCo) - proves that prices are likely at least to stay at their current level over the coming months.

"The fact that MSIP sold its stake in SAESA at 70-times EBIDTA restricts opportunities for some European investors to step into the brownfield infrastructure market," Barben observes. "Clearly, if valuation comes down, we will consider taking greater exposure."

MSIP divested its interest in SAESA three years after it acquired the stake alongside the Canadian pension fund, Ontario Teachers' Pension Plan (OTPP). MSIP said that its investment thesis for SAESA had been proven, after it worked with management to implement operational changes and make additional investments that should allow the utility company to continue its growth.

Valuations remain high partly because the pipeline in this type of brownfield investment is limited. While some European private investors are willing to exit, most of them continue to invest in the market which offers greater potential than in their home market.
But foreign institutional investors are not the only sellers. One option for European pension funds could be the privatisation projects currently underway in some countries. Last year, the Mexican government invited infrastructure funds to tender for several packages of road.

"Usually, when the government makes a step towards privatisation, it is always combined with greenfield elements," O'Neil notes. "The government asks private investors to finance the construction of new roads, using the cash flow coming from the privatisations."

Brazil is also offering many opportunities, with several fund managers expecting more
privatisation projects in the water sector in coming years. Recently, the Brazilian government also decided that it would privatise the country's five largest airports. The injection of private capital into these facilities might also help the government to head off concerns that the nation's transport infrastructure will not cope with the massive influx of visitors for the 2014 World Cup and the 2016 Olympic games. But remember your touchdown moment: these airports need a serious upgrade.

Stable regulation
Many fund managers and pension funds have pointed their fingers at the complex regulatory framework in place in Brazil and other Latin American countries. Turner says pension schemes getting exposure to Latin America mainly look at the region opportunistically. "The potential lack of transparency means higher risk premiums, which will be compensated by greater returns," he says.

But, while the regulation has long been regarded as non-transparent and unstable, it seems now to fall into line with the European standards. Private investment together with the growing middle class, which drives the demand for existing infrastructure assets but also the construction of new projects across the continent, have pushed countries such as Brazil, Colombia and Peru to open up their regulation.

"The regulatory issues are not so much of a problem," Barben explains. "The rules in the region are close to Spanish concession laws and this is something pension funds in Europe should be comfortable with. Overall, compared to some markets in Asia, Latin American economies are way ahead. Similar infrastructure projects in India, for instance, are still suffering long delays, while China has failed to implement a stable regulatory framework."

Within South America, however, Chile clearly stands out. Its well-established pension system, as well as the long tradition of attracting private capital from institutional investors, has helped successive governments to improve the regulatory framework. The country could therefore play a leading role for its neighbours, who remain aware that financing their infrastructure cannot only rely on local private capital.

In the meantime, European pension funds will be encouraged to look more attentively at alternative investments in emerging markets given the current market turbulence in developed economies.

"Pension schemes in Europe are still overweighting their own market," concludes Barben. "The trend might change and a few have already decided to start on the journey. But, at the moment, investing in a relatively new asset class, miles away from its own territory, is still seen by many European pension schemes as a very risky bet."