Improving returns by investing in concession infrastructure funds
The recurring, long-term nature of cash flows from operational concessions is a characteristic shared with fixed income assets. But active management that strategically considers all aspects of the investment can lead to capital appreciation and improved income yields.
An infrastructure concession is a contract through which private partners have exclusive rights from governments to operate and maintain public assets and benefit from the returns associated with the fees paid by users of the facility or service.
The nature of these concessions or public-private partnerships (PPPs) as highly-structured project financings, typically utilizing limited recourse structures, does by its very nature limit the envelope of risk and return available to investors. Nevertheless, the historical investment experience of our investment management team allows us to identify the opportunities in the current market environment and seek to drive returns beyond those delivered through the initial structuring of the fund investments.
As fund managers, we aim to anticipate when market prices for secondary assets may increase during the life of the fund. We base our analysis on the fact that there is a finite pipeline of new PPPs assets coming through procurement, while at the same time a broader universe of investors seem attracted to the asset class.
Additionally, as new exit routes become apparent, this can improve pricing. Most notably, there is increasing demand for listed infrastructure products among retail investors, where yields are typically in the 6.0 - 7.0% range.
The potential positive impact on base case returns through the fund’s life is illustrated in chart 1.
Detecting refinancing opportunities
Our management approach will typically utilize full life project finance debt in its investments whenever possible. This means there is no need to refinance during the life of the investment. However, refinancing can be a useful means of extracting additional value from an investment, typically where one or more of the following criteria are met:
i) Once a project has a proven track record during its operational phase, the risk associated with the project decreases significantly. This decrease in risk allows the project to be more highly geared.
ii) The current credit environment has resulted in lenders setting terms that are considerably more expensive than prior to the credit crisis. As a leading fund manager of concession infrastructure, we have demonstrated how refinancing can deliver meaningful uplifts in returns.
Optimizing ownership structures
As managers, our aim is to make sure that complex ownership structures are simplified to help distributions flow from the investment to the fund without restriction or leakage. Gaining access to available fiscal reliefs through grouping jointly owned investments can further enhance value via appropriate ownership structures.
Saving operational costs through strategic contractor partnerships
A clear benefit to shareholders over the whole life of the investments accrues where the manager oversees active management of sub-contractors. Examples include ongoing facilities management and life cycle profiling reviews through a focus on delivering partnership and building trust. This goes to the heart of analyzing the entities’ costs with a view to engineering cost savings while ensuring service levels remain unimpaired. Cost savings can be achieved through reviewing operational costs to assess whether they are on market, identifying synergies such as grouping underlying entities, or a portfolio approach to the purchase of insurance premia, just to name a few. Consolidation of service agreements results in a fuller understanding of deliverables, reporting formats and investor knowledge.
Effective cash management
By reviewing the surplus cash available in each investment and, if it is prudent to do so, the manager can extract the cash from a concession earlier than planned dividends, which require distributable reserves to be built up over the concession life. The manager can also extract the cash earlier through appropriate directors’/management fees or shareholder loans as positive reserves are not required.
Restructuring the profile of the shareholder loans/subordinated debt in a particular investment can also improve returns.
Taking opportunity of variations funding
Concession variations, if permitted by provisions on modifications, subject to size of variation, can allow existing investors to make a follow-on investment at the investment’s original internal rate of return (IRR). This also facilitates the variation, which itself will attract a risk margin and development fee. In the current economic climate, there is likely to be an increased requirement for shareholders in concessions to fund variations. This is because under the new capital funding programmes from central government, local counter-party variation funding is very much restricted. These opportunities arise throughout the life of the concession.
Pre-emption investment opportunities offer the fund a non-competitive acquisition, with limited due diligence costs, low transaction costs and incremental investment returns. Construction contractors and co-investors often seek to recycle capital, given their balance sheet constraints. It is at this point that the manager will consider exercising the fund’s pre-emption rights subject to project performance and pricing. Co-shareholders may have different views and conflicting priorities. Holding a significant majority - or indeed 100% - allows the manager to focus on the specific fund’s drivers, like yield or IRR.
In summary, two decades of investment and asset management experience demonstrates that concession infrastructure funds can be capable of delivering enhanced returns for significantly less risk than would typically be assumed in comparable return propositions.
View the full Global Outlook publication below:
- Strategic Asset Allocation Outlook
- Corporate profits drive equity performance
- Value in the global energy sector
- From Smart Beta to Smarter Beta
- Improving returns by investing in concession infrastructure funds
- Gender Diversity: an economic and strategic imperative