Special Report - Emerging Markets: Building the emerging world
Bank disintermediation, and the opportunities it presents, is as strong a theme in emerging infrastructure markets as developed. But Jennifer Bollen finds the similarities may end there
The fast-growing demand from emerging economies for infrastructure investment, coupled with a significant gap in bank financing, has created enormous need for institutional capital.
Demand for investment in emerging markets infrastructure is expected to reach $19.2trn over the 20 years to 2030, with Asia alone requiring $15.8trn, according to a report published in March by trust fund Public-Private Infrastructure Advisory Facility and The World Bank Group.
The report, Institutional Investment in Infrastructure in Emerging Markets and Developing Economies, which cites data from the Royal Bank of Scotland, says emerging Europe is likely to require $1.3trn, Latin America – $1.2trn, Africa – $700bn, and the Middle East – $200bn.
But market participants say investment banks – traditionally important sources of infrastructure development finance – have largely withdrawn from the sector, fuelling demand for alternative forms of capital.
Jan Dehn, head of research at fund manager Ashmore, says the increased regulatory burden in recent years – particularly in the form of Basel III, which has set out rules including a requirement for banks to hold assets which are easier to exit in a crisis – has had a significant impact on the ability of banks to back infrastructure in emerging markets.
“Why on earth is it that the financial markets, full of really savvy people looking to exploit investment opportunities, are letting such an obvious opportunity go begging?” he asks. “The answer has a lot to do with the behaviours of investors but it also has a lot to do with the regulatory regime. It is extremely difficult for large institutional investors to channel funds into infrastructure investment in emerging markets. The regulatory regime is heavily biased against countries with lower sovereign credit ratings.”
Higher regulatory requirements detract from overall returns because institutions have to set aside idle capital against their investments, pushing up the costs of investing in less liquid destinations.
“You can typically get the long-term management risk financed by pension funds and insurance companies but those institutions rarely want to take development risk up-front,” he adds. “To cover development risk you usually have to go to banks. But a lot of banks, especially Western banks, have pulled out of emerging markets because of regulatory changes following 2008-09.”
Investment managers, he says, can offer such infrastructure projects the up-front development capital and long-term finance they need.
“It overcomes the finance challenges; this is an area where international fund managers can certainly step in,” he says.
According to the PPIAF and The World Bank Group report, just 1% of institutional investors’ assets have been allocated to direct infrastructure worldwide. Even when institutional investors are prepared to consider investments in infrastructure, weaknesses in the enabling environment and the lack of good projects can still be a major problem, the report explains. Sectoral policies are often badly co-ordinated and subject to unpredictable changes: “Retrospective changes to the rules are particularly poisonous for investor confidence, as is political instability or a weak rule of law,” says the report.
“There is concern around how investors will actually access and manage this exposure and that is why a significant proportion will go through an institutional manager as opposed to direct,” says Jonathan Walbridge, chief executive of the Mexican Infrastructure Fund at Macquarie Group.
Emerging versus developed
Investing in emerging infrastructure typically takes a great deal more time and effort than in the developed world.
First, the opportunities available in emerging markets are more often development projects, as opposed to acquisitions of existing infrastructure assets, meaning more intensive deal origination and detailed due diligence of potential co-investors.
“You need similar skills in terms of structuring a deal but you need additional skills to build relationships and diligence your partner,” says Duncan Hale, global head of infrastructure at Towers Watson. “The partner risk and implementation of those agreements in a joint venture are particularly important in emerging markets. Ensuring you are investing alongside someone you have a similar view of the world to is vital to success. If you are partnering up with a developer, is it watertight how they are going to extract fees from the development? Is there leakage out of the system that your partner can benefit from?”
Emerging markets also often offer more opportunities involving the supply of products to consumers – logistics, transport and food and energy storage, in particular.
Second, deploying large amounts of capital is difficult in the developing world, since equity cheques for emerging markets deals tend to be relatively small. A solution is to invest in a platform with which to target further assets, according to Benjamin Haan, head of private infrastructure in Asia-Pacific at alternatives manager Partners Group. This enables an asset owner to use the same management team to gain scale with several projects and eventually exit the investment at a higher multiple.
Haan says the investment analysis skills required for emerging markets are largely the same as in developed markets but executives engaging in emerging markets greenfield projects must also be able to evaluate construction risk. In developed countries, infrastructure investors bidding on an existing asset would focus most of their attention on valuation and financing.
“Given that EM countries are at such different stages of development, the range of opportunities is absolutely flabbergasting,” says Dehn. “It spans the lowest-income countries in the world where simple infrastructure such as roads and ports do not exist, to sophisticated middle-income countries with serious high-tech infrastructure requirements.”
Meanwhile, emerging markets provide easier geographical and currency-risk diversification – but this also implies increased complexity.
“It is part and parcel of investing in many emerging markets that you take forex risk and you need to understand and mitigate forex risk and this has clearly negatively impacted a number of investors,” says Haan.
Superior diversification in terms of exposure through different parts of the capital structure appears trickier. According to Hale, most emerging markets infrastructure investment is required through equity or equity-like products with very little debt. Haan says emerging markets capital structures can often replicate those in the developed world.
When it comes to performance, Haan says many emerging markets infrastructure portfolios have failed to reach investors’ expectations over the past 10 years.
“When the financial crisis started, the infrastructure sector in many emerging markets kept ticking along pretty well but we started seeing significant valuation adjustments from 2009 and there has been, in certain markets like India, a perfect storm of political paralysis, currency depreciation, regulatory issues, over-leverage by promoters,” he says. “Even some of the best managers in these markets have struggled.”
The other issue some people have had is they have put a lot of their emerging market eggs into one basket.
“Pre-crisis, for example, some investors would make a single fund commitment to an Indian infrastructure fund and that was their emerging market exposure,” he says.
The emerging market infrastructure opportunity is clearly a compelling one for the world’s genuine long-term investors. But there is little doubt that, for a variety of reasons, it presents a very different risk profile from that of its developed market equivalent. Experience shows that investors should embrace the diversity on offer – but gird themselves for the complexity this inevitably brings with it.