Hands-on infrastructure investment
August 2013 | EXPERT BRIEFING | SECTOR ANALYSIS
A quiet revolution is brewing among portfolio managers at institutional investors across the globe. In June 2013, the insurer AXA announced a new €10bn (US$13bn) fund to invest in debt for infrastructure projects. Allianz Global Investors, Ageas and Swiss Re have all committed to infrastructure debt allocations of their own in the last year. Pension funds, insurance companies and sovereign wealth funds are all increasing their alternative asset exposure to infrastructure investment. Limited returns on traditional investments and increasing capital requirements on banks have combined to stimulate appetite among institutional investors to fill the funding gap.
Traditionally, this community’s exposure to infrastructure has been in the form of indirect investment in managed funds or direct equity stakes in corporate assets, such as regulated water or power companies. But increasingly, investors are considering the potential benefits of seeking the enhanced returns offered by greenfield (new build) infrastructure projects in which they invest directly.
To do this, however, requires not merely understanding the risks involved in designing, constructing, operating and maintaining a new asset, but how best to deliver the maximum risk-adjusted returns. To achieve this, portfolio managers at institutional investors need to actively manage their infrastructure assets.
Such a proactive approach goes against the grain of the traditional philosophy at institutional investors. But portfolio managers who do not take a proactive approach – actively engaged in strategic, operating, HR and capital decisions on their infrastructure projects – may not be delivering the maximum risk-adjusted returns to their investors. It is in optimising construction, completion and operation that they can help to improve the odds of on-time/on-budget project delivery plus maximise the performance of the asset and thus drive up rates of return.
Institutional investors are broadening their infrastructure investments in every direction. New country markets are being tapped, more and more players are entering and direct investment in the capital structure of projects, debt and equity, is slowly overtaking indirect investment. Given the infrastructure sector’s huge capital requirements in the years ahead (a report by McKinsey this year estimated the global need in the years to 2030 at US$57 trillion), this is to be welcomed; but it is very much an embryonic market, and not every potential investor has the skillset, or the structure, required for this asset class.
One corner of the illiquid asset investor community provides a valuable model, however. The leading lights in the private equity industry have broadly embraced – or are moving towards – establishing operational capabilities in their portfolio management groups. At its best, their approach can teach infrastructure investors a lot. To understand why, it’s first worth considering the challenges.
Investing for life
For investors seeking to get comfortable with the infrastructure asset class, it is not enough simply to look at the financial model and weigh up risks and premiums. A deep understanding of how projects work (for example, construction, operations, regulatory, financial and counterparty risks) over a very long time in real life is essential, not merely to minimise the risk of project failure, but to optimise the project every step of the way.
How easy would it be to replace a technology supplier if they drop out of the project? Your costs may be secured with fixed-price contracts, but could this put quality at risk if the contractor’s costs escalate? If you are providing debt, you may have security over the project; but the chances of finding new sponsors to take on a stricken asset, or to attract a good price for it, are limited in practice. Your contracts may appear rigorous, but how has the contractual model performed under pressure? And how can you be sure your constructors, who may seek to flip their equity early on, are optimising the project for low lifecycle costs? In fact, the construction sector has shown very little of the growth in productivity of other industrial sectors in recent years, as our analysis makes plain.
Unnecessary costs are not the only threat to rates of return. The last decade has seen a revolution in the investor community with the realisation that infrastructure project risk is not only acceptable, but positively welcome. As more players pile in, competition to finance assets has increased and in developed markets, there can be too many financiers chasing too few assets with too inflated a value. The result is that returns are being squeezed. Meanwhile, while the downsides of every project are well documented, the upsides are often capped by revenue sharing with contractor and regulators.
Where asset managers can really make a difference is therefore firstly having the expertise to understand these challenges, secondly ensuring that adequate risk management is in place, and thirdly driving productivity and efficiency gains in design, construction, ramp-up, maintenance and operation. Our studies of leading practice in building and operating infrastructure projects have yielded a toolkit of techniques, ranging from lean construction and design-to-cost to the total cost of ownership approach to maintenance. More efficient delivery of new assets alone, we estimate, can reduce whole-life investment in infrastructure by 15 percent (seeInfrastructure productivity: How to save $1 trillion a year, McKinsey Global Institute, January 2013).
Unfortunately, not enough investors entering the market are equipped to grapple with the task. Financiers with deep understanding of debt and equity capital markets are well represented as portfolio managers at institutional investors; experts in operations, logistics and engineering less so. Knowledge is not the only obstacle for portfolio managers to really drive improvements in their infrastructure investments. Expertise needs the right structures, incentives and support. Capex and operations specialists need to be as valued as deal originators if the asset is to perform optimally over a 30-50 year lifetime. How best is this to be achieved?
Active ownership works
And here we return unapologetically to private equity. In seeking to draw up a model for what a hands-on asset manager should look like, the PE portfolio management group offers close parallels. Our studies show that best practice in these groups revolves around building dedicated operational capability that works side-by-side with the investment professional to get involved in the key elements of driving risk-adjusted returns in portfolio companies.
The most successful portfolio group doesn’t just look at financial metrics, but the whole range of operational and strategic metrics on a regular basis. They value functional expertise, such as procurement, lean operations and pricing, in their professional staff, which they use to introduce productivity-boosting techniques such as outsourcing and lean operations. And crucially, their operations team working at the coal face of businesses are an integral part of the group, as welcome as the deal partners and with real decision-making power. Our studies show that such active ownership choices tend to lead to the most successful deals.
It’s not hard to see why an infrastructure project, with a tight set of covenants and a matrix of KPIs to meet every month, would benefit from this approach.
Investing in capability pays for itself, but it need not imply a vast increase in fixed costs for an asset manager. It will always be necessary to complement in-house expertise with an ecosystem of external technical advisers to provide the most specialised knowledge, for example for specific types of project or technology. Whether a particular role is to be delivered internally, externally or in partnership with a co-investor depends on the investor’s strategy and objectives.
Infrastructure projects are an excellent investment proposition for institutional investors, and their risk of actual failure is low as ratings agency research shows. But when it comes to optimising performance over their life cycle, asset managers can and should make a difference. Their structure and capabilities are built around the asset, not the other way round. The returns, in the form of decreased costs and increased IRR, should more than justify going to the trouble of not just investing in your project, but managing it too.
Robert Palter is a director at McKinsey & Company. He can be contacted on +1 (416) 313 3774 or by email: firstname.lastname@example.org.
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