Western Front: Long live financial engineering

Chances are you’ve been to a conference where someone grandstands on stage about how their firm is focused on “adding value” by improving the operational efficiency of infrastructure assets. That, as opposed to the evils of “financial engineering” practiced by the ubiquitous “some people” (some of whom may seated in the audience), is the only way to deliver shareholder returns in this asset class – apparently. 

If you thought they were full of hot air, perhaps you were right.

Over-gearing, or piling too much debt onto an asset, is precisely how the fine art of financial engineering has been defined in the wake of the financial crisis. Critics point to the fallen Babcock & Brown empire or cherry-pick US highway investments like the Indiana Toll Road and say they’d never do that because they’ve got a seasoned team who will derive their IRRs from operational improvements, not financial engineering.

This type of analysis is guilty of over-simplification for two key reasons, and limited partners should be prepared explore them during their next interview with a fund manager.

First, there are many ways for a fund manager to add value to an investment. Operational expertise is certainly an important element but it is simply one of many. And, very often, if you ask a manger what types of investments they seek to make, they will provide examples where, frankly, there is very little value to be added from said operational expertise.

One self-described “value-add” manager recently told this publication he’d like to invest in the renewable sector in the US. “What kind of renewable investments?” we asked. Preferably wind farms where the land has been bought, the permits have been secured, the EPC contract has been signed, long-term contracts are in place and, you know, basically all the hard work has been done – by somebody else.

Where then is the magical “value add”? Once a modestly sized wind farm is up and running, you could argue that all it needs is a staff of one or two people riding around in a pick-up truck once a week for 20 years to make sure nothing’s blown up. In that kind of situation, the manager’s added value isn’t grand operational efficiency provided by a seasoned management team with deal experience that often includes non-infrastructure deals. Their value-add is very simply their money – or rather, your money, Mr. LP.

This brings you to the realisation that there is a second, equally important element of creating value in investing: how you structure the deal on behalf of LPs. This comes down to how you put together a capital structure, including the amount, tenor and seniority of debt; and how much equity and what kind – common or preferred shares with conversion rights, and, if so, at what conversion event. Which banking relationships can you bring to the table? And which mezzanine debt, common and preferred equity investors can you shepherd into the deal – and on what terms?

Creative juices

This is where the creative juices start flowing and the good deals get struck – as they were throughout the Crisis. Global Infrastructure Partners’ $700 million Ruby Pipeline investment and Terra-Gen Power deal, which both feature investments in preferred securities, are but two examples. You probably wouldn’t get the firm’s chairman and managing partner Adebayo Ogunlesi to admit it, but they’re great examples of financial engineering properly done.

Perhaps this is why a recent five-year outlook by Australia’s AMP Capital Investors struck a chord with our readers and went quickly to the top of our “most-read” list. It didn’t vilify financial engineering as a gimmick of the past. Instead, AMP made clear that financial engineering was always there as one way to add value – and it will only get more interesting in the future.

“The high demand for debt will . . . drive innovation in financial engineering for infrastructure projects,” AMP predicts. “For example, we anticipate a significant growth in hybrid or mezzanine debt/equity products. These will be used where they can reduce the net cost of funding, for example, by allowing a smaller but lower-priced tranche of senior debt.”

AMP also wisely cautioned that these types of debt and equity products “should be used with caution and never to over-gear a project”.

Over-gearing, it can only be hoped, is a thing of the past. But financial engineering was always here to stay.