Infrastructure finance 3.0 is financialisation gone bad

Infrastructure finance has been a major theme of this blog. I am amazed how the mainstream commentary on infrastructure finance, which advocates more of the same financial engineering that has characterised the sector in the last 10-15 years, completely overlooks the underlying trends within the sector. 

I'll characterise infrastructure finance as broadly having traversed through three phases. 

In infrastructure finance 1.0,  owners and operators of infrastructure projects were the same entity and the ownership remained locked for long years. In infrastructure finance 2.0, ownership and operations become gradually divorced, either in the form of consortiums or as concessions by the owner, though ownership and operations remained locked for long years. Both these led to the formulation of the life-cycle view of infrastructure financing, whereby investors and owners had the incentive to take a long-term view of their investments so as to ensure that the life-cycle costs are kept low. 

However infrastructure finance 3.0 upends this life-cycle view. It not only separates ownership and operations, but also disperses ownership and makes it liquid. Infrastructure funds, which exemplify this model, consists of limited partners, who are mostly even unaware of which specific projects their money is invested and have far shorter time horizons. There is no longer any incentive for the asset creators to ensure that the construction is of a quality that keeps life-cycle costs low, since no asset creator stays invested beyond a few years after construction. And no subsequent investor too remains invested long enough to have sustainability as a primary concern.

Worse still, this model attracts the wrong kind of investors. Infrastructure was long considered the boring low and stable return asset class which attracted only long-term investors like pension funds and insurers. Instead, today, it attracts private equity and other classes of high returns seeking investors with limited time horizons. Since infrastructure as an asset class, by nature, cannot generate such high returns, it's only natural that these investors engage in harmful financial engineering and encourage practices which amount to asset stripping by paying out large dividends, preferring cheaper and poor quality materials, skimping on investment obligations, loading up on debt, underpaying employee benefits and other statutory obligations, and so on. In simple terms, it's about squeezing the juice without any concern for the long-term as long as something remains to be squeezed. It's a form of pass the parcel and ensuring that you're not the last man standing when the music stops, as it must!

This is financialisation gone bad, the main theme of The Rise of Finance.

Renewable energy financing is a classic example of infrastructure finance 3.0 in action. No investor appears to be in it for anything other than a few years. There is no incentive to ensure that the best quality cells and modules are used. In many cases, the time horizons are so short as to leave no incentive beyond mere winning the bids. Its attractions are also amplified by the nature of any large emerging market - the prospects of early movers being able to grab prime assets which they can flip at premiums in a booming market. 

This evolution of infrastructure finance is outlined in great detail in the paper here. 

Update 1 (13.05.2023)

Brett Christophers has a very good article which links to several examples of infrastructure funds and private equity ownership of infrastructure assets gone wrong. Christophers writes that the number of global infrastructure focused funds rose from fewer than 100 in 2016 to more than 250 by 2020, with the total assets under management having quintipled since 2009. 

Led by Macquarie, an Australian financial services group that is the sector pioneer, asset managers began investing substantially in Asian and European infrastructure in the early 1990s. Today, in countries such as South Korea and Britain, infrastructure funds are the leading owners of major infrastructure assets in a range of sectors, among them energy, transportation and water.

The story of asset-manager-led infrastructure investment is overwhelmingly a negative one. Asset managers are focused on optimizing returns on the assets they control by maximizing the income they generate while minimizing operating and capital costs. Many users of infrastructure that has come under asset manager ownership have suffered, as service rates have risen quickly and service quality has deteriorated. Nowhere is this better illustrated than in Britain. There, numerous types of infrastructure have come substantially under asset manager ownership. This has led to consistently negative outcomes in, for example, care facilities, schools and water supply. Many observers have concluded that essential infrastructure and asset manager ownership simply don’t mix.

And in South Korea, Macquarie’s eight-year investment in Metro Line 9, part of the Seoul subway system, involved a bitter spat with the metropolitan government over a proposal to hike fares by nearly 50 percent. That led Macquarie and other shareholders in 2013 to unceremoniously sell their stake, in what commuters came to call the subway line from hell. Local critics charged Macquarie with taking excessive profits without assuming any risk, an accusation that has been a consistent drumbeat accompanying the phenomenon of asset manager infrastructure investment around the world. Macquarie said that it is committed to its operations in Korea and that its Korean infrastructure fund is a “passive financial investor” that has cooperated fully with the city of Seoul. 

The story has been much the same when housing is owned by asset managers. There have been allegations of skimped maintenance and egregious eviction practices in some areas. Such outcomes have been reported in Spain, for example, a notable hot spot of asset manager investment in housing since the global financial crisis, by a series of academic researchers. If the United States has been a relative laggard in asset-manager-owned infrastructure, it has been in the vanguard of asset-manager-owned housing.