Why opportunism may be wrong

WHAT ARE YOU INVESTING INTO?

Does a laundromat or car wash belong in an infrastructure fund? What about a greenfield toll road or container terminal?

Although the answer resides with the investor’s objectives, too many managers fail to create a clear understanding with investors. Opportunistic managers under pressure to deploy capital or suffering from competition have expanded the concept of “stable, cash yielding”.

The profile of an infrastructure asset should not differ dramatically from emerging to developed markets:
? High capital investment costs;
? Long-term stable revenue (regulated or contracted) on a 10 year+ basis;
? Low operating costs;
? High EBITDA margins (60-95 percent);
? Strong day-one cash yields;
? Returns that are independent of aggressive up-front or refinancing assumptions;
? Government support in the form of concessions, subsidies, tax incentives, or regulation.

The tendency for investment drift is evidenced by investments in service businesses, construction companies and equipment suppliers (commercial conflicts do exist and tendering is positive for capital intensive assets).

OPPORTUNISTIC VERSUS TARGETED SECTORS

Investors don’t like investment drift and managers should avoid relying on a broad mandate in the hope that an active market will present opportunities. This opportunistic approach can be reactive, competitive and reliant on sponsor capital solicitation. Investors often require a dose of Alzheimer’s as the once highly touted pipeline fades into a mixed bag of minority interests in sectors that are mature, immature and only occasionally providing a marketable success story.

The discipline of benchmarking the risk/return paradigm and articulating in advance the investment rationale across each sector and country is often overlooked. Yet such a disciplined strategy can be more proactive, less competitive, enhance bandwidth and provide the best risk-adjusted returns.

COUNTRY VERSUS REGIONAL FOCUS

Being a regional or pan-Asian fund may lend itself to the same opportunistic approach. Geographic breadth may be mitigated by defining which countries and which sectors within such countries form the manager’s focus.

Alternatively, a country-specific focus is convenient for a manager with significant country specific experience. However, there is not a single country in Asia (India included) that offers an optimal selection of alpha-returning investment opportunities when compared with a portfolio comprising other transforming sectors across Asia.

CONTROL VERSUS MINORITY

The notion that emerging markets primarily offer minority positions is debatable and may be another by-product of an opportunistic investment strategy as well as team experience and fund size limitations.

As an emerging market, Asian investment opportunities tend to involve the provision of growth capital. The provision of growth capital presents an opportunity to agree a position of control upfront or over time as the investment consumes more capital.

Investment sizes in Asian infrastructure are generally smaller than in developed markets and an investment of $25 million to $100 million will often enable a control position to be acquired. A $100 million fund, however, may be restricted to minority interests as it cannot invest to achieve scale as well as support the requisite team to implement a control deal.

RETURNS

Most investors into Asia have heard “we target 20 percent-plus returns”. The developed markets are low to mid-teens, so how is Asia to attract capital unless investments offer “20 percent”?

There is little debate that timing does matter. Asia has consistently tempted investors with exceptional returns for the early mover only to close the window of opportunity within 12 to 24 months, as local investors gain confidence and governments adjust their investment incentive programmes.

Targeted investors that can identify the “window” will outperform opportunistic investors that enter the market late and have failed to proactively nurture relationships and opportunities.

Secondly, investing in stable Asian brownfield assets is a strategy designed to deliver returns to developers. Local asset owners understand the value of a high margin operating business and generally value such assets on a 10 to 14 percent long-term equity IRR [internal rate of return] basis.

Investments that may meet investor return expectations exist with construction opportunities that occur in the investment “window”, ideally where the key development risks have been resolved and the focus is on turnkey EPC [engineering, procurement, construction] contracts with creditworthy counterparties.

This is to be distinguished from the other component of “greenfield risk”, which involves early-stage project development. Emerging markets suffer from a high level of land access, permitting corruption and delay risk during the development phase, which is often magnified by the dearth of inexperienced management in the region.

The downside is material and, while returns may be higher, development risk is best considered in the context of an existing operating platform with existing experience in the relevant asset class and jurisdiction.

THE MAGICIAN’S SECRET

Unfortunately, too many investment cases presented around Asian emerging market infrastructure come saddled with enough magic tricks to make Houdini’s head spin.
Each investment case should start with:
? Unlevered long-term project returns (LTPIRR);
? LTPIRRs based on contracted or regulated revenues that exist within the business today (excluding “pipeline” value);
? LTPIRRs over the useful life or relevant concession period and not including exit / terminal value assumptions;
? The identification of long-term equity returns (LTEIRR), incorporating a sustainable and sensible level of leverage (which exists today, not based on future refinancing opportunities);
? Attractive on a LTPIRR / LTEIRR basis (as well as other investment metrics, e.g. yield) to justify capital deployment.

Now you are ready to determine the business case, which is often based on shorter-term exit scenarios that rely on return and/or yield compression due to scale and operational track record. Be conservative on your exit assumptions (e.g. a mid-market asset will often sell at a discount to the conglomerate utility) and include exit costs (which can be substantial).

Once you have a business case, you are ready to mix in all the identified goodies that made you excited by the investment. This includes tariff and volume increases, operating cost improvements that have not been contracted or implemented, and the crazy prices you hope other people will pay on exit. But make life easy for your stakeholders: each goodie, together with its valuation impact, should be separately identified.

Too often managers include goodies in the business case. This is one of the main reasons for underperforming assets in Asia and globally. Business case returns must be justifiable without multiple refinancings, compression and magic tricks.

All of a sudden that 20 percent is telling a different story. Managers should be confident, as Asia offers attractive returns for foreign investors. The approach to realising those returns and their presentation to key stakeholders just needs to be refined.