Thursday, August 1, 2019

The changed nature of infrastructure financing and its consequences

As we discussed in the oped, asset stripping has become a common feature of infrastructure PPPs. The story is same everywhere - water, railways, airports. It is true on both sides of the Atlantic, United Kingdom and United States. In fact, it is pervasive across the alternative investments world in general - Greybull Capital and British Steel, Carlyle and ManorCare nursing home chain, Thomas H Lee Partners and Simmons Bedding, Edward Lampert and Sears etc are only some of the recent examples.

It is instructive to look at the evolution of the global infrastructure financing market. Some time back, I had blogged describing its evolution,
The first phase was about simple long-term post-construction (with public finance) concessions, especially in countries like Latin America. Then countries like Australia, Canada, and England led with PPPs involving bundling of construction and O&M to initially construction contractors, then construction-cum-O&M consortiums, and finally finance-construction-O&M consortiums. The area of project finance and public bond issuances emerged to support PPPs. Then the likes of Macquarie created exit opportunities for construction contractors and a secondary market for infrastructure assets using privately raised infrastructure funds. Gradually, the private equity players found infrastructure assets a source of stable and reasonably attractive income stream, with ample opportunities for asset-stripping and pass-the-parcel game over the asset's long life-cycle. Now, there is a growing realisation in the developed economies, especially in Europe and the US that private participation is not only not cost-effective but also fraught with problems, and much greater public participation and strict regulation may be necessary in infrastructure projects. The full circle has been completed.
And in another context,
There is a growing trend of "pass-the-parcel" deal making (or secondary deals) in private equity space, where one PE firm sells stake to another. Last year the industry did a record 576 such deals. The trend has been associated with successive owners paying themselves large dividends, leveraging up, skimping on investments and maintenance, piling up unpaid pension obligations, and passing on to the next firm when they have squeezed out all the juice they can. In industry lingo, the existing owners "sweat" the asset as much as they can before passing it on.
There used to be a time when infrastructure projects were owned/operated by large infrastructure contractors/firms. They raised finance directly from banks and long-term or patient investors like pension funds and insurers who would subscribe to capital market issuances to finance infrastructure projects. The returns on these investments used to be moderate, the investments relatively illiquid, and the risk lower. Infrastructure was the boring, low-risk, and low-return area.

Then we had a period of financial innovation and engineering. When we look at PPPs in infrastructure today,  these assets are largely operated/owned not by infrastructure companies but by financial investors. The entities which operate/own and finance infrastructure investments are financial investors, alternate investment funds (AIFs) - infrastructure funds and private equity. The pension funds and insurance capital, instead of directly investing in bonds and the capital market, have come to channel their funds through the alternative investment vehicles.

This shift has had the perverse effect of distorting incentives in the market for infrastructure assets. By their very nature (and the examples from the mainstream PE world above illustrate this), the incentives of private equity etc are excessively aligned towards short-term and profiteering for their investors, and passing the parcel along.

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