Five years ago, the regulated infrastructure investment world changed. Seemingly in answer to the lingering question of whether, post-Global Financial Crisis (GFC), infrastructure might remain an oasis of stability amid the general chaos, the Spanish government retroactively cut subsidies for solar projects. What had been agreed was effectively shredded – along with the notion that infrastructure investing could remain immune to the forces that were reshaping economies and societies.
Since then, multiple examples have followed – in numerous countries and sectors – of regulatory and governmental actions (leaving aside for a moment the question of whether there is any meaningful distinction between the two) that have left investors perplexed. A word this article will return to is “capriciousness” – defined by Dictionary.com as “subjecting to a sudden, odd notion or unpredictable change”. Many investors believe the actions of governments and regulators have become increasingly capricious.
Capriciousness is joined by “dynamism” as a word often used to describe today’s regulated infrastructure investment scene. If you’re thinking that neither of these two words sit easily with the notion of infrastructure as a safe, stable investment option then – rest assured – you’re not alone. Jeffrey Altman, a senior adviser at European financial advisory firm FinAdvice, describes what this [dynamism] means in practice:
“There have been a great number of changes over the last decade impacting certain sectors – and those changes are being introduced with increasing frequency and come with greater complexity. The old model of assessing an opportunity via its regulatory track record underpinned by a legal framework is now being challenged by dynamic political, social, technological, financial and environmental forces. The viewpoint has gone from two-dimensional to something like six-dimensional.”
Post-GFC, infrastructure has been not so much a victim of its own success as a victim of its stability. “You’ve had increasing state intervention through things like quantitative easing and ultra-low interest rates – and consequently a shift in relative value perception,” points out Thomas Pütter, chairman and chief executive of London-based consultancy Ancora Finance Group. “Anything offering stability and attractive investment features was bound to receive attention. Money has piled in and competition and volatility have gone up. Risk has been identified that was hitherto ignored.”
While one kind of dynamism took the form of investors racing to take advantage of the perceived infrastructure opportunity, another was regulators and governments realising that in a new age of austerity it would no longer be acceptable for owners of infrastructure assets to make outsized profits – and dashing to try to close the gap between what investors had been raking in and the much smaller profit margin that the public would be comfortable with.
“The financial crisis affected consumers deeply,” reflects Regina Finn, a director at UK regulation consultancy Lucerna Partners, who was formerly chief executive of Ofwat, the England and Wales water regulator. “Investors piled into infrastructure and made good returns on the back of rising prices, while at the same time real incomes were on the way down. That drove a social backlash against utility businesses. The anti-capitalist Occupy movement raised the profile of utilities, for example by pointing to offshore holding companies and alleging they were not paying tax. The whole thing showed an ability for the public to mobilise rapidly and pressurise politicians and regulators to produce a timely response.”
This dynamism has left the infrastructure investing environment looking a little more daunting than it did when the wall of capital first started shifting towards it. “Infrastructure funds were looking stable but they don’t look quite as stable now and energy infrastructure investors have had a particularly tough time due to regulation changing sharply in some countries,” says Ian Pearson, the UK’s Economic Secretary to the Treasury from 2008 to 2010, and a current independent non-executive director of Thames Water. “Social pressure resulted in political pressure. Some of it was foreseeable, some of it was not.”
This speaks to an important point: Should investors have foreseen the backlash, read the signs of a more capricious and dynamic environment? And were those signs subtle or writ large in flashing neon? Overall, Pearson thinks investors should have expected regulatory change of some kind. “They had a right for that change not to be too abrupt, but, on the other hand, you always need to be careful when presented with a gift horse. Politicians have to respond first and foremost to the general public, not to investors.”
Pütter has a strong view: “Over the last ten years, we have seen a combination of intellectual dishonesty and naivety,” he declares. He believes that investing in infrastructure on a highly leveraged basis and increasing EBITDA, at the same time as the so-called ‘cost of living crisis’ was hitting the general public in the pocket, was never likely to be sustainable. “People had to learn what a backlash means, and pressure has been exerted in a very public manner.”
Pütter believes that, as a result, attitudes have changed considerably. “There is more honesty now. People are smarter in pricing risk and know that they have to balance political expediency. It’s a tension that just has to be dealt with.”
REGULATORS ‘WOKE UP’
Finn agrees that the days of extracting hefty profits from the use of leverage are long gone, because “regulators woke up and smelt the coffee. The ability to make that kind of return lasted longer than it should have done; a combination of lower allowed returns and the fact that companies have maximised their gearing by taking on as much low-cost debt as they can, means it’s no longer possible.”
Finn says regulation these days, while clamping down on inappropriate ways of making an excessive return, will seek to reward operational out-performance. Higher returns will be permitted where management teams are prepared to step up to the mark, differentiate their offering, and ultimately deliver a better service to the end-user.
This does, however, beg the question as to how successfully regulation can play that role – and whether doing so is even appropriate. Pütter doubts whether regulation can effectively price in improvement metrics. “Investors will say ‘what I work for, I work for and I want whatever return that delivers’. You can’t put that into a regulatory assessment,” he asserts.
“I don’t agree,” Finn responds. “Regulators have always factored in efficiency targets. And there is a sharpness to [regulatory] incentives now; they are much more targeted and specific. It’s no longer a ‘one size fits all’ approach. If management teams are confident that they can out-perform, they will find the regulators will be prepared to allow them to be rewarded for driving greater efficiency.” ??
BETTER COMMUNICATION NEEDED
While this may offer encouragement, investors still dizzied by the speed of change may wonder whether any particular regulatory stance will stand the test of time. Will today’s apparently appropriate regulatory environment become completely inapplicable to whatever the situation may be tomorrow?
“We used to see a prudent band of out-performance and downside protection,” reflects Altman. “But with respect to downside protection, that all changed with retroactive taxes which in many cases were initiated to correct market distortions created by technological innovations and/or enormous consumer uptake. Can the regulator fully appreciate these very fast changes – and can investors? There needs to be better communication between the two because the risk complexity – driven by social and technological risks – will only increase.”
Pütter agrees that investors and regulators need a better understanding of each other and what their respective roles are. For investors, the benefits of having effectively “out-smarted” governments in certain cases by investing on highly advantageous terms is being taken away and investors “have a risk that they didn’t appreciate was there”. The future has other threats, he points out, such as the likelihood at some point of a rising interest rate environment.
But, at the same time as investors are being subjected to what Pütter believes may be a “new modus operandi” on the part of governments, Finn thinks better engagement with regulators will offer “real opportunity” for investors. “There is a perception of unfairness but if investors have a good dialogue with regulators – and indeed politicians – it can help them to take steps that will help protect against retroactive measures. If they engage, understand what the regulator is trying to achieve, and help deliver that, then good performing companies will not be demonised.”
This prompts a discussion of political influence over the investment world – including some consideration of whether it’s right for politicians to take the side of the public against investors.
“Politicians reflect societies becoming angry at what is going on,” says Finn. “It comes back to the point that investors need to be more proactive with stakeholders. They have to engage and talk about the value proposition.”
But do politicians sometimes over-react to pressure when that pressure does not come from a large segment of society? Pearson, the former politician, gives one example of where he believes this to have been the case: “With onshore wind farms [in the UK], you had a narrow protest group. All the evidence suggests that the public at large are quite comfortable with onshore wind but a small protest group got it [a pledge to halt the spread of such farms] into the Conservative manifesto.”
Altman has a further example of how protest groups can shape political behaviour – even in situations where, he believes, this goes against the public interest. “Look at what’s happened with fracking in Europe. It has the potential to bring energy independence and new jobs. It’s a great value proposition in Europe but social pressure has stopped it dead in the water.”
Pütter agrees, and asks why the public relations battle over fracking has been so one-sided: “Why has engagement been so abysmal? The whole thing has been completely emotional. Why is there no field marshal planning the battle?”
Pütter raises the question of whether infrastructure fund managers are largely powerless when it comes to influencing debates over the merits or otherwise of assisting the growth of a particular industry. “It’s a huge challenge for fund-based investors, which I’m not sure is surmountable,” he says. “Big corporates can make the case but infrastructure funds want to be out of the limelight. It may be that they simply have to delegate it to corporate entities to make the case.”
Altman points out that two infrastructure industry organisations have been launched recently in the form of the Long-Term Infrastructure Investors Association (LTIIA) and the Global Infrastructure Investor Association (GIIA) – and that they need to play a role in getting the voice of the asset class heard.
“They have been formed to engage governments, but they also have to engage societies,” says Altman. “The case has to be stated as to why private infrastructure investment is so important – namely, that governments can’t pay for all the required infrastructure going forward. Investors, industry bodies and portfolio companies all need to work collectively and act or the perception of the industry will only get worse.”
So far, the talk has focused largely on risks and threats. Does this mean the current situation is all doom and gloom for infrastructure investors? Not necessarily. Indeed, for astute investors able to fathom the increasing complexity, this could be the perfect opportunity as it allows the smart money to rise to the top and the dumb money to sink to the bottom.
Investors should be keeping track of global trends and Altman thinks they only have themselves to blame if they fail to do so. “From my travels in the US, there is not much awareness of what’s happened with renewables in countries like Australia, Germany, Spain, Italy and the Czech Republic. But if you don’t follow how these markets evolved, then you’re potentially setting yourself up for what you will ultimately claim is capricious intervention. Those who look at the evolution of other markets and perform deep-dive analyses of all the dynamic factors we discussed earlier with regular reassessments of the ‘known unknowns’ should not get hit by this so-called capriciousness.”
Pütter points out that, while capital is a “shy animal” that has the capacity to flee in the face of adversity, not everyone has quit Spain in the wake of the solar photovoltaic debacle. “Some think what happened there won’t happen again and that it’s now a great investment opportunity,” he says. “Who’s to say that those staying as others flee will not be recognised ultimately as the smart ones?” However, Pütter’s assertion that “the jury is still out” is the only thing that can be said with any certainty at this point.
Finn insists that smart investors are marked out by a willingness not just to sit down with regulators but to listen carefully to what they are being told. “I think you need more intelligent due diligence around the political and regulatory environment,” she says. “There have been times when I have explained the risks to investors and they didn’t want to hear it. And then they express surprise when those risks are realised. There are some investors who need to engage much more thoroughly and face up to the reality of assessing and managing risk in these sectors.”
There is a counter, however, to the argument that investors only need to become more attuned to the subtleties of the regulator’s message. And that counter is provided by the example of Spain where investors insist to this day that, aided by blue-chip advisers, they conducted as much due diligence – and of as high a quality – as could reasonably have been expected. Yet still they got burnt.
Pütter thinks there is simply no way of knowing for sure which way the regulatory winds will blow. “It’s a judgement call. Due diligence is of limited value and you have to factor it into your pricing. What we’ve definitely seen – and will continue to see – is the cost of capital going up.”
As the infrastructure asset class enters an evolutionary phase you sometimes hear referred to as the “new normal”, it’s worth keeping the risks and threats in perspective. Pearson does just this: “The ‘new normal’ is very different but the world has huge infrastructure opportunities and, because governments can’t provide all the money, they must look to ensure they have the right regimes to make investors want to come to them.”
Pütter acknowledges there is a “multi-trillion funding gap” but thinks investors may be forced by risk factors to be selective in their choice of investments. “As a result of complexity, investors will target certain businesses and sectors where they feel they have a better grip. They will find some too difficult. But, with interest rates unlikely to shoot up any time soon, what else do you do with your money? Infrastructure will continue to be very popular.”
Altman thinks the technological changes that threaten the stability of traditional infrastructure investment may open up new opportunities. “Through new technologies such as solar panels and batteries there are now interesting investment opportunities that you can make alongside traditional infrastructure.”
Perhaps the most significant result of greater complexity within the infrastructure investment world will be the arrival of a larger universe of funds with sophisticated approaches in niche sectors.
Or, as Pütter reflects: “Poor investments have been covered up by the rising tide and the low interest rate environment. That party is over, and the ‘new normal’ is all about the operational skill set. Some will win, some will die.”