Written By: Andy Matthews
Andy Matthews of Infracapital helps identify periods just before or during construction that could offer investors in infrastructure the best returns
Europe needs vast amounts of new infrastructure in order to sustain solid economic growth over the coming decades. In the not-too-distant past, most of this development would have been financed by governments. But the scale of expected investment needs means the private sector will increasingly be called on to fill funding gaps and steer projects to completion. This, in turn, opens the door to attractive opportunities for institutional investors able to mobilise large amounts of capital, like pension schemes and sovereign wealth funds.
The Organisation for Economic Development estimates that its 34, mostly European, member states will need to invest a total of $30 trillion in infrastructure by 2030. The European Commission’s Juncker infrastructure investment plan has targeted €315 billion over just the three years to 2017.
This vast expected expansion of infrastructure at a time of general fiscal austerity has left governments casting around for alternative sources of funding. For instance, the UK government’s infrastructure plan assumes private financing will make up nearly two-thirds of the country’s £411 billion infrastructure pipeline over the next five years. Yet British private sector infrastructure investment averaged just £4.6 billion a year between 2000 and 2010.
Governments increasingly recognise this represents a significant hurdle. And there are signs politicians recognise that private sector involvement will need to be encouraged with various incentives that allow investors to mitigate some of the risks associated with infrastructure projects. These could include guarantees or subsidies on certain types of developments, such as renewable energy generation.
Brownfield or greenfield?
Rather confusingly, when infrastructure investors talk about brownfield and greenfield stages of a project, they don’t necessarily use the terms in the sense that some people know them. While in other areas the definition of greenfield is of an undeveloped site, usually either farmland or other form of greenbelt, in infrastructure investment, greenfield refers to the development stages of a project’s lifespan. Once it becomes operational, it’s known as brownfield. So a greenfield infrastructure investment will often refer to a project that’s being built on a previously developed, or brownfield, site.
The distinction between different types of greenfield is important for infrastructure investors. Capital employed at a project’s earliest development stages, usually within the first couple of years, is most at risk but also potentially posts the highest returns. As planning and other permissions are granted and financing is organised and construction begins, the “late development / construction stage”, the average expected return for new investors declines at each point until, finally, the project goes live. From this point, most infrastructure projects then have an operating lifespan lasting from a decade to a quarter of a century.
Pension funds have tended to invest in brownfield infrastructure. The very early stages, during which planning and other approvals are being sought, tend to be the preserve of specialist investors such as developers. But there’s a sweet spot during the later development period, soon before or during construction, that offers investors early access to these attractive, predictable infrastructure assets at better expected annual average returns than were they to enter at the brownfield stage, yet with less volatility and more manageable risks than during the early development stages. Because at this point the project is still in construction, investors will likely forego yield for a short period, which is then rewarded with the prospect of premium to yields on offer to those who wait for the project to become operational.
A manager that participates in project structuring prior to construction of assets, which typically lasts a year, will usually expect an internal rate of return in the mid to high teens, depending on the project’s forecast lifespan. Coming in at construction phase gives investors greater security, albeit with slightly lower performance – they could see returns in the region of a few hundred basis points lower than were they to invest in the project’s very earliest stages. Both, however, would deliver a return well in excess of that expected on an equivalent brownfield portfolio.
Need for experience
For investors, the challenge to investing in projects at a greenfield stage is mitigating construction and associated risks. The skills required at a greenfield stage are very different to brownfield. Often managers are expected to bring much more than capital. Greenfield fund managers need a portfolio of skills, including the ability to coordinate between construction contractors, to arrange financial structuring and to manage and incentivise all parties to ensure projects are delivered on time, if not earlier.
Because of their scale, longevity and significance to local communities and economies more generally, infrastructure projects are politically sensitive. As such, before they sign up to a project, greenfield fund managers need to have a good understanding of its regulatory and political background. Once developers have the necessary approvals and support, there is more visibility on these considerations and the revenue model. Although this means sacrificing some potential returns, investors gain comfort from the fact that passing these thresholds goes a long way to ensuring the project is more viable and asset forecasts are more resilient – hence the greenfield sweet spot.
Another way to mitigate greenfield risk is to diversify portfolios. Different infrastructure sectors have different characteristics and varying degrees of risk. For instance, utility infrastructure assets often have resilient income streams and low correlation with economic growth. On the other hand, transport is more correlated with the wider economy and can deliver higher growth. A diversified portfolio that combines assets from various sectors and geographies is important in creating a balanced risk profile.
Greenfield infrastructure in action
The Bioenergy Infrastructure Group (BIG) platform launched in October 2015 to invest in the construction of biomass and Energy from Waste (EfW) plants.
BIG has been established to invest in greenfield renewable energy projects that will support jobs and economic growth across the UK. Supported by government subsidy, it will help satisfy growing demand for reliable and environmentally sustainable power generation and waste management, which reduces landfill.
Its first project is a new £87 million 21.5MW biomass plant in Cheshire in the UK’s largest resource recovery park to provide enough electricity to power 40,000 homes. Infracapital, M&G’s infrastructure investment arm, initially acquired a 70% stake in the platform providing access to future development projects, and has already made a second investment in Hull.
This platform offers investors exposure to a diverse set of greenfield projects that can offer high long-term yields and predictable, often inflation-protected cashflows.
Broadening investment horizons
As Europe rebuilds over the coming years, private investors will increasingly be called on to fill a funding gap. Unlike during the past, when governments were the primary, if not sole, sources of finance for major infrastructure projects, they are likely to make up a smaller proportion of an increasingly larger investment landscape. Instead, institutions like pension funds with significant funding capacity will need to step in and make up the shortfall.
As they do, they will look for the best risk-adjusted returns – investment sweet spots like greenfield infrastructure.
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