A burst of energy

Confidence comes in different degrees. When it comes to the US energy sector, what you’ll find from fund managers targeting the space is a clear-headed certainty of riches that lie in wait.

“In our view, energy is a strong area for infrastructure investment,” says a decisive Mark Florian, managing director and head of the debut energy infrastructure fund at First Reserve. “There are many new projects, especially in midstream. There are shale plays where new deposits are being discovered, and now they need infrastructure to move the resource. Renewables have been huge for the last 10 years and now developers are wondering whether they need to own the portfolios they have built. Chances are, many of those assets will be recycled, creating opportunities for investment.”

Florian is one of five experts who have gathered at the Hilton Manhattan East hotel in New York to discuss current themes and trends in US infrastructure. And he’s not the only one to express excitement at prospects within energy – an excitement that builds each time a new shale deposit is discovered, or an existing deposit is found to be more extensive than previously estimated.

Shale is, in the words of Jeff Neil, a partner at Balfour Beatty Infrastructure Partners, “changing the shape of the entire energy scene” in the US. There’s another big talking point – the market for public-private partnerships, widely referred to in the US as P3s. Here, confidence is harder to detect. At least, it’s not the ebullient variety that characterises discussion of the energy opportunity. Yes, most around the table say, progress is being made – but asked to consider the rate of progress, responses are invariably cautious.

“Is the P3 glass half-empty or half-full?” ponders John Veech, managing director and head of Morgan Stanley Infrastructure’s investing activities in the Americas. “It feels like there’s positive momentum compared with two years ago, so I’d say I have a half full view.”

Sudden affluence

But let’s start on a strident note, and put all thoughts of macro-economic gloom behind us for once. Let’s start with energy, and the sudden affluence that has sprung up in remote parts of America as the shale boom proceeds apace. “In the old days you would drill a well and hope the oil was there,” says
Florian. “Now you know it’s there, due to improvements in technology – generally it’s not a case of ‘will you find it’, but ‘how much you will find’. Drilling costs are coming down so productivity is much higher. And those who explore the Marcellus Shale [in eastern North America] and in other plays are finding new layers of resource – so the resource is expanding all the time.”

For infrastructure investors like those around the table, the opportunity lies in all the accompanying infrastructure that comes in the train of the new ‘black gold’ rush. “There’s the opportunity in upstream
plays and the infrastructure to support it but it goes beyond that,” asserts Neil. “With shale changing the energy mix in the US, itis creating transmission and distribution opportunities in the north east, construction of gas-fired generation, a need for transmission upgrades, you need new sub-stations, and a move toward development of infrastructure supporting LNG exports. So the opportunity is through the whole energy chain.”

Adds Christopher Voyce, a managing director at Macquarie Capital: “There are opportunities to repurpose gas import facilities for export into Asia and Europe. For example, there is strong demand from Japan for US shale due to the impact of the recent tsunami on its nuclear power industry.”

This range of opportunity [in the energy sector] means that fund managers can afford to be selective
in determining which particular types of investment best suit the risk/reward profile they are seeking.
“You’ll have general infrastructure investors, energy infrastructure investors and private equity investors
all pursuing energy investments,” says Veech. “It’s a space where all these folks can play. Pure infrastructure will get priced to perfection. But there are elements of risk that ripple through the space and each manager develops their own style. For example, the classic private equity/venture capital investor will often play more in upstream where there is a higher risk/return. You’ve got to define where you sit in the spectrum. But the sheer scale is intriguing.”

Diversity of opportunity

As part of that diversity of opportunity, energy can offer GDP protection, notes Florian. “Energy investments can be structured to isolate you from the economic fluctuations,” he says. “For examplewith capacity payments [whereby energy generators are paid at fixed prices for supplying power during peak demand periods], GDP and power demand in the short term don’t matter, because you still get paid. It doesn’t apply to all energy investments – there are lots of different types of risk you
can take – but you can be conservative if you want to be in the investments that one makes.”

By this point in the discussion, what we’ve clearly established is the wide and deep potential of US energy investment. But, like all things, taking advantage depends on good old fashioned virtues like
experience, wisdom – and knowing when to let caution get the better of enthusiasm. “A risk [one of the big risks] of energy infrastructure investment is that stuff breaks,” Florian asserts bluntly. “Gas turbines are designed to run at high heat and pressure for 40 years, but they can break when you don’t expect it. But new investors might come into the space, assume that this stuff runs perfectly, and price deals accordingly.”

Adds Neil: “One of the overheating risks is that of people who can’t handle the ownership of energy assets putting in bids. There is an issue of discipline there.” Florian points to the credibility of
counterparties as another investment risk. “The counterparty might be a smaller E&P [exploration and production] company,” he points out. “You need to be certain thatyou know what assets they have and what resources they have in the ground. You have to ask yourself whether they can be a good partner over a long period and is there alignment of interests.”

One possible setback to the shale exploration boom comes from opposition from environmental groups, particuarly given the controversy surrounding the environmental impacts of the fracking technique commonly used to extract deposits. Thus far, opposition has been more vehement in Europe – in France, for example, where new President Francois Hollande recentlyannounced that a fracking ban would remain in place during his five-year mandate. This does not mean US investors can afford to be complacent about the issue, however.

50 countries

“The US is effectively 50 little countries,” says Veech. “Those with a fossil fuel history will tend to be supportive [of shale], others which lack the history may be less supportive. You may see some standardisation of environmental best practices, and that might be a good thing because a strong
safety record benefits everyone.”

Neil says the problem is not resistance on the part of the investor community to the concerns of environmental groups – rather, having to work within an uncertain climate. “Investors are not against rational environmental regulation,” he maintains. “What we’re against is inconsistency. When
the rules are constantly changing, it’s bad news for everyone.”

When talk turns to opportunities in renewable energy, another concern emerges. This time, it’s a familiar one – political will (or lack of it). “You have to analyse the subsidy regime, which is different
from one country to another. In the US, we do it through taxes,” says Veech. “But the big question is always the same – is the political will there to maintain it?”

A further issue to ponder is whether the US has yet achieved the critical mass necessary to make it a magnet for private capital. “Solar panel prices have come down and solar is getting closer to grid parity,” says Veech. “In the case of distributed solar generation, the business is already at grid parity,
and the main issue for investors such as ourselves is scale. There are lots of small projects. How do you scale up? With scale, distributed generation becomes a hugely interesting opportunity.”

Some think the bigger opportunity alluded to is on the horizon asdevelopers decide what to do with the
renewable assets they have accumulated to date. “The opportunity in renewable energy is not mainly about new-build but the portfolios that have been created already,” asserts Florian. “The big energy
developers have done a lot of great work. But is there further growth for them in the US? We believe that many will decide to form partnerships or start selling assets to rationalise their portfolios, given uncertainty in future support for renewable, particularly in the US.”

Waiting for floodgates to open

As mentioned at the outset, energy is one of the two big talking points in the US infrastructure
market today. The other one – guaranteed to generate just as many talking points – is P3s. While investors have been flocking to energy, given the abundance of deal flow, P3 investors are still waiting for the floodgates to open. But the signs are generally positive.

“This year is the strongest for P3s for some time but the deals have been in the market for a while,” says Macquarie’s Voyce. “There is a lot of demand for infrastructure assets from the bond market and that has forced people to act and get deals closed.”

He also points to the evolution of an improved image for P3s, which can only be helpful. In the past, they have been closely associated with privatisations that deliver upfront cash to patch up states’ budget
holes. But now “the P3 debate has changed,” insists Voyce. “Before it was ‘we’ll privatise and use the money’. Now it’s about transportation funding, efficient procurement and budget certainty. There is more focus on the benefits of P3s, but monetisations may still play a role in some states, but as part of a broader programme.”

On the same point, Veech adds: “Historically, maximising upfront proceeds was a primary priority for the public sector partner. On a go-forward basis, I believe that there will be increased emphasis on
operational efficiencies and that we will start to see more structures which reflect an ongoing economic partnership – for example, a revenue split or other such formulas. Also, although it has not been done to date, there is no reason why a structure, for example one which provides for a mandatory co-invest offer to the local pension funds, could not be implemented. This would enable the local communities to see the benefits in several different ways.”

The importance of concrete benefits is one of the reasons why Voyce believes the turning of the corner for US P3s depends on key projects going live over the coming period. “The next two years will be exciting,” he says. “P3 projects such as Texas’ SH 130 highway segments 5 and 6 and the Capital Beltway [Interstate 495 surrounding Washington, DC] will be complete, and public officials should be able to point to improved outcomes. If these projects are seen as successes by public officials, there
could be an increase in acceptance of P3s and greater deal flow over the next four to five years.”

About hiring not selling

Rick West, executive vice president at parking management firm Central Parking and a man with long experience of P3s, says: “Are politicians just plugging budget deficits? That’s the perception. But Ohio did a great job of explaining that, as a result of the deal, the university could hire more academics and offer more scholarships – and that it was not about selling off an asset.”

The deal being referred to by West is the groundbreaking Ohio State University (OSU) campus parking transaction, which completed in June this year. It saw Australia’s Queensland Investment
Corporation (QIC) team with Parking lot operator LAZ to pay $483 million for a 50-year concession agreement for the university’s campus parking.

In the US, the view is often expressed that just one or two completed deals in a sector can pave the way for a significant number of imitators. West believes this may be the case with campus parking.
“As well as the precedent of OSU, tuition fees have gone up and there is high college debt etc – meaning that university revenues have hit a ceiling. OSU completed the process at a good price point [the university’s floor price was reported to be $375 million] and there is recognition that universities
must focus on core competencies – and parking is not one of them. So, in my view, university parking deals will happen quicker than city parking deals.”

Adds Voyce: “Many university boards can now enter negotiations without legislative approval as long  as it’s in the interests of the university. Overseas pensions are definitely interested in these kinds of deals, not least because there is a paucity of opportunities for direct investment of this type in Europe.”

West points out the more or less captive nature of the customer base in certain locations. “If you live off-campus, in many cases the car is the only way you can get to the university. There are some places where you can use mass transit, but in many places people will drive.”

Sore point

Having considered the merits of parking deals, the conversation turns to the financing of P3s in general. In Europe, the lack of debt for infrastructure projects is a sore point. In the US, however, the story is very different.

“The institutional debt capital markets are more sophisticated in the US than in Europe,” says Veech. “Currently, the capital markets are very strong. You could put a sign up in Times Square and sell an investment grade utility bond issue. But the banks are a mixed bag. A fully underwritten bank
deal with long tenors would still be a challenge, but you can get to the finishing line with big clubs, as we’ve seen in Puerto Rico.”

Adds Florian: “For good projects, there is debt availability albeit with wider spreads and bigger clubs than in the pre-crisis era. However, some deals are complex and for those it’s more difficult to raise debt. As a result, we have been investing in some assets with no debt at all.”

Voyce points out that there is quite a lot of variability depending on the type of project involved. He says that, for projects based on availability payments, the debt finance can be heavily oversubscribed.
But for those projects where new capacity is being added to an existing asset – and where revenues are more volatile – there is “very limited” capital available.

Where the provision of debt is at its most competitive, Neil hopes the brakes will be applied earlier than they were in the pre-Crisis days. “Discipline is really required now,” he says. “You’ve got to make sure the debt is sustainable.”

Voyce, however, thinks there is little danger of too much froth. “It’s different now because sponsors are more sanguine about their own business cases than prior to the financial crisis, so the approach is
different. There is a different attitude to market risk.”

Measured approach

As we approach the conclusion of the discussion, Voyce says he sees this same measured approach to procurement these days. “The public sector is looking at the challenge that it faces and thinking about
how it can use P3s to help it meet its objectives,” he says. “It is more effectively tailoring solutions and, aided by a better understanding of risk, is pinpointing where the private sector can add value.”

This process is likely to outlast any given electoral cycle, incuding the outcome of the presidential vote in November. “The need to cut budgets and use capital more efficiently will survive any election and any
possible change of administration,” says Neil. “The states and municipalities will have to look at different funding options.”

“We’re in a stalemate and, if we can’t get out of it, the economy won’t grow,” reasons West. “Whether you’re a Republican mayor or a Democrat, you have the same problem. So it’s an apolitical issue.”