As the gap continues to widen between required infrastructure spending and actual dedicated funds, according to the G20, private infrastructure projects represent a strong opportunity for institutional investors.
Speaking at TD Asset Management Inc.’s institutional investment symposium in Toronto on Wednesday, Matthew Press, the firm’s vice-president of infrastructure investments, said the funding gap in the G20 countries is projected to reach $15 trillion over the next 20 years.
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The gap has emerged as successive global governments have proposed extensive infrastructure spending, often during election years, to promote economic growth and job creation. The long timeframe required to build these projects often means they outlast a government’s electoral mandate, causing them, in some cases, to fall by the wayside. Also, infrastructure spending is often downloaded from federal and state or provincial ministries to municipalities that are cash-strapped and lacking the experience to get projects built, said Press.
“This represents a fantastic opportunity. Just to put it in perspective: that’s the equivalent of all listed equities combined, all of their market caps combined.”
Global institutional investors are already ramping up in a low-yield environment, noted Press, with more than $80 billion in capital raised for infrastructure projects in 2018, a 20 per cent increase over the previous year. In 2019, TDAM projects more than $100 billion will be raised.
Infrastructure — covering physical assets such as toll roads, light rail transit, solar and wind farms and pipelines — is a relatively young asset class, said Press. However, these projects all have a similar return profile of generating stable streams of cash flow for the long term.
While investors can gain access to these projects through the public markets — either through equity investments or pubic debt and rated bonds — TDAM believes the right approach is through a private investment, noted Press.
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In the case of private equity, investors are able to negotiate transactions at valuations that often come below the market valuation for those assets and achieve lower risks through heavily negotiated transactions with mitigating clauses in place. In addition, a private equity deal would see lower volatility than investing in the public market, can protect against inflation and diversify the portfolio as “these assets often exhibit low correlation relative to other parts of the portfolio.”
Louis Bélanger, private debt portfolio manager at TDAM, said investors would see similar benefits from a private debt infrastructure investment, including better yield than what could be achieved in the public market and the ability to add security and a comprehensive set of covenants to the debt package during the negotiation period to mitigate risk. “The bond market in Canada is a senior unsecured market and you’re lucky if you have a couple of covenants thrown in there.”
In addition, private debt infrastructure deals give investors access to names and sectors that might be underrepresented in their portfolio or in the public market.
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Using the example of a wind farm with a 25-year useful life and an existing private purchase agreement, Press noted both private equity and debt investors could expect to see small but steady increases in returns over time as cash flows increase. Debt investors, which typically make up between 60 and 80 per cent of a project’s financing, see their return profile of principal and interest steadily increase until the debt is fully repaid, usually months or years before the PPA contract expires. Equity investors would see a different return profile.
“The difference as an equity investor is that we’re not just looking in cash flows over the course of the contracted period but potentially we could look at cash flow over the useful life of the asset, and that could continue after the contract expires,” said Press.
However, Bélanger and Press noted, both private debt and equity investments are complicated for institutional investors because they must do thorough due diligence on any project risks to guarantee risk-adjusted returns.
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Press referred to TDAM’s 2016 equity investment in a southern Ireland wind farm, noting the firm took eight months to complete the deal. This included analyzing the project’s risk; environmental, social and governance factors; how it helped to diversify the firm’s portfolio and more. To assess risk, TDAM brought in third-party experts, including a power advisor to assess the wind resource, lawyers to go through the existing power purchase agreement and engineers to analyze the technical condition of the turbines. It also conducted a full credit review and default analysis of the power purchaser.
On the private debt side, Bélanger discussed an offshore wind project in the U.K.’s North Sea with 174 wind turbines and 1.2 gigawatts of power. The transaction went through a thorough credit research process involving 11 analysts who looked at rated counterparties on the public side, as well as six analysts specializing in private debt terms who analyzed the deal. The firm also looked at ESG factors, scored the quality of the covenants in the deal and conducted a qualitative and quantitative analysis of business and financial risk.
Among the potential business risks the company identified were the wind power and potential for other wind farms in the area stealing the project’s wind. Bélanger said independent engineers analyzed the possibility and the strong results, combined with the equity support for the project, made the firm comfortable with going forward. It also reviewed the existing power purchase agreement, which was fixed-price and take-or-pay, determining the risk of the purchaser being able to “turn off” the power if a cheaper option came along was low. The construction risk was also low, as the major equity investor was executing the construction of the project and had a contract with comprehensive liquidated damages provisions if there were delays or other issues.