Capitalizing on Infrastructure Projects in Canada – How Do Mid-Market Institutional Investors Gain Exposure to This Asset Class? - Presentation: Towers Watson

© 2011 Towers Watson. All rights reserved.

Infrastructure Investing

A presentation to the Canadian Institutional Investment Conferenceby Marcus Turner

October 19, 2011

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Background

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Infrastructure assets are the physical structures, facilities and services needed for the proper functioning of a community or society

Economic Infrastructure: User is willing to pay for service

Social Infrastructure: User expects government to provide service

ECONOMIC INFRASTRUCTURE

TRANSPORTATION UTILITIES COMMUNICATION

Airports Electricity Wireless Towers

Bridges Gas Cable

Railroads Water Satellites

Toll Roads Bio Fuels

Ports

What is infrastructure?

SOCIAL INFRASTRUCTURE

GOVERNMENT SERVICES

Hospitals

PrisonsTransport

Schools

Social Housing


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ECONOMIC INFRASTRUCTURE

Build: Government or private company sells the opportunity to build an infrastructure asset to a private investment consortium

Maintain and Operate: Consortium collects revenue from the asset for a fixed period of time (often a very long term lease)

User fees typically inflation indexed

Stages of investment

SOCIAL INFRASTRUCTURE

Build: Government sells the opportunity to build an infrastructure asset to a private investment consortium

Maintain and Operate: Private Public Partnerships (P3s) are typically partnerships between the private and public sector

Provision of services typically remains the responsibility of the government

Income stream is provided by the government as a payment for making the asset available for a defined period of time at an acceptable standard

Income stream is often inflation indexed

Transfer: After the fixed period of time the consortium will transfer the asset and all operating responsibilities to the government


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GREENFIELD BROWNFIELD

Projects are new developments

Infrastructure has existed for some time

Relatively high level of business risk including construction risk, uncertain growth rates and early term operational risk

Typically no cash flows until about fourth or fifth year (J-curve effect)

Predictable income stream (often linked to inflation)

Typically have greater capital appreciation opportunity

Moderate capital appreciation is possible (usually through capital improvement), but mainly purchasing long term cash flow

Investors are expected to be compensated for the risks associated with new development

Return expectations are lower than greenfield investing although income projections are more reliable

Types of infrastructure


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Why Infrastructure?

Potential for attractive equity- like returns, but with much lower risk

Reliable cash flow and less sensitive to economic downturns

Inflation Protection

Diversification

Manager return projections are in the mid to high teens, but even 8% to 10% would compete well with equities over the long- term. Attractive premium (>4%) over bonds backed by tangible assets

Long-term investments in regulated and/or contracted industries with mostly inelastic user demand

Cash flows mostly insensitive to changes in expected inflation. Agreements allow general partner to raise user fees at a minimum to cover inflation increases

A real return asset with high correlation to inflation and low correlation with equities and nominal bonds. Complementary to real return bonds


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What are the key risks?

Risk are not greater than that of other asset classes; they are manageable and can be mitigated with proper controls:

Risk Risk Mitigations

Demand & Usage Risks: Overly optimistic user forecasts can impair projected returns

Experienced managers/consultants are essential to budgeting process as is robust sensitivity analysis

Political Risks: Political instability may lead to asset repatriation. With Social Infrastructure there is a risk the government counterparty may default on its obligations

Managers can invest with local governments and other domestic partners having ex-policians as part of the consortium to help navigate political process

Experienced managers can use established relationships to manage risk more appropriately

Interest Rate Risks: High degree of leverage exposes infrastructure to adverse interest rate movements

Seek longer term debt financing

Can hedge some exposures

Inflation linked revenues mitigate this risk

Investments are generally high quality assets that are critical to the economy and can thus justify leverage

Currency Risks: Infrastructure investments generate revenues in currencies other than the investors domestic currencies.

A currency hedging program can mitigate this risk

Liquidity Risks: Investment locked-up typically for 10 - 20 years, although cash flows are received during this period

Proper legal documentation can define the terms of entry and exit

Liquidity is a lower order consideration as infrastructure is a long term investment and many pension plans may not need to be fully liquid


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Types of Infrastructure



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The following wish-list forms the body of a paper to be released to clients and managers

Clear, succinct definition Regulated, long-term contracts or truly monopolisticOperational and robust

Realistic and sustainable target returns

High single digit, risk-adjusted returnsSignificant yield (rather than capital appreciation)

Reasonable leverage Leverage used for tax benefits and for optimal portfolio diversification

Price discipline The reduction in expected returns should be as a result of lower risk, rather than paying more for the asset.

Strong alignments Appropriate level of risk-takingeg. No carry/or carry on yield

Longer term vehicles Open ended (evergreen) structuresLong term close ended structures

Robust no-fault divorce Well defined ability to take control of the assets

What do we want from core economic infrastructure


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PPP / PFI – too good to be true?Lowest risk assets within infrastructure

Public Private Partnerships (PPP) / Private Finance Initiatives (PFI) are concessions provided by the government or a quasi-governmental agency to provide an essential service to the community. Perfect for pension schemes with a long-term horizon because: Long term assets Stable cash-flows, with no demand risk (revenue based on government contract) Little operational risk (easy to manage assets) Inflation-linked payment streams


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PPP/PFI – the risks

Stage Risk How are these risks mitigated for our clients

Bidding risk The risk that either you do not win the project in the competitive process undertaken or that the project you are bidding for does not even go ahead

Our clients usually are not involved in at this stage

Construction risk

The risk that there are cost over runs in the building of the asset, or that the asset is late being delivered, resulting in penalties

Water-tight contracts, where payment is only provided once the asset is complete. Penalties are passed onto the construction firm. Does mean that there is counter-party risk with the construction firm, so credit analysis is key

Sub- contractor risk

The risk your sub-contractor goes bust, and the cost to replace them is greater than what has been budgeted.

Credit analysis is key. However, most contracts have a 5 year review mechanism to ensure that affordability is maintained over time

Financing risk

As highly geared projects, there are risks that small deviations in cashflow can significantly affect equity holders returns

This is a real risk, however given the management of the other risks discussed here, deviations of cashflow are usually minimal. Some level of buffer is provided within the capital structure

Deduction risk

The risk that the concession holder does not perform the required duties at the standard required, resulting in deductions.

Water-tight contracts, where these deductions are passed onto sub-contractors. Credit analysis is key

Usage risk The risk that the asset, once constructed, is not needed anymore

Not relevant to the equity holder, this risk is taken by the government

Highest risk

Lowest risk


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Does listed infrastructure provide core infrastructure characteristics?

Stability of earnings -

Sector Gearing1 Gearing2% Hedged

Toll Roads 46% 51% 69%

Airports 37% 44% 90%

Ports 14% 23% 60%

Utilities 48% 62% 82%

Communications 58% 57% 96%

Diversified 58% 70% 66%

Average 44% 52% 76%

Source: Magellan Infrastructure Fund portfolio - based on the most recent available data for companies in the portfolio (either as at 30 June 2009 or 30 September 2009.) 1 Debt to Book Enterprise Value2 Debt to Market Enterprise Value (market capitalisation used for Shareholders Equity)

Appropriate use of leverage -

Strong yield -

Source: Brookfield

Source: Brookfield


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Does provide some diversification

Limited data, but a longer history in Australia

Timeframe dependant

Better diversification before financial crisis

Beta A number of studies have suggested infrastructure assets have an underlying beta of 0.4

Does listed infrastructure provide diversification

Time period CorrelationAverage 3 years between 31/12/2002 and 31/12/2007 0.49

Average 3 years between 31/12/2007 and 30/09/2010 0.87

Total period between 31/12/2002 and 30/09/2010 0.81

Evolution of the Market

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Market opportunity

Expectations of significant long-term growth in private infrastructure finance

* Source: 1. Global Infrastructure Demand Through 2030, a study by CG/LA Infrastructure in Association with Sterne Agee, March 2008. 2. Infrastructure to 2030, Volume 2, OECD publication, 2010

Global infrastructure investment demand estimated to be between $1 trillion1 and $3 trillion2 annually.

Partially met by Government, but still a significant opportunity for private sector to profitably participate alongside Government or independently to stimulate supply of new assets and renovation of existing ones.

Key drivers of the infrastructure market opportunity for private capital

Direct correlation between infrastructure investment and GDP growth

Historic under-investment

Growing pressure on public finance

Aging population with more people relying on infrastructure and fewer people contributing to government budgets

Increasing urbanization, congestion and quality of life issues

Heightened energy and environmental concerns; and

Growth in emerging markets (require infrastructure investment to maintain a stable level of growth or to accelerate a country’s growth rate)


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Fund-raising

2010 saw a rebound in fundraising

Following a tough environment for fundraising in 2009, it rebounded slightly in 2010 with over USD27 billion committed to infrastructure funds.

A significant proportion of this comes from funds of over USD1 billion is size

2011 sees a number of managers coming back to market

A number of high profile managers coming back to market

Source: Prequin


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Infrastructure has shown stability of earnings over time

Robust asset performance

Over the 2008/2009 period, an environment where overall economic performance was generally poor, infrastructure assets generally produced robust operating performance

Particularly impressive was the pricing power exhibited by these infrastructure assets over the period

Poor structures has harmed some equity returns

However a number of assets in private fund ownership, despite these robust earnings, have experienced poor equity returns due to poor (or inadequate) capital structures. The use of significant leverage and optimistic growth assumptions have led to some infrastructure equity holdings not performing as expected

Note: MEDIAN EBITDA; Source: Brookfield, June 2010 Global infrastructure is the Dow Jones Brookfield Global Infrastructure Index


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Why is now a good time to commit to infrastructure

We are still in the early stages of de- leveraging in the sector.

The capital structures of infrastructure assets have come under significant stress, post crisis, as debt providers, have become less willing to provide cheap credit.

Market believes that this will lead to a large adjustment in the financial structures of individual deals (as shown on the right), while this general trend may also lead to other opportunities for the providers of capital:

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recapitalizations (including public-to-private transactions and management buy-ins

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distressed sales of assets (rather than sales of distressed assets)

•

mergers and termination of funds•

discounted secondary units in pooled funds

Other current infrastructure pros and cons include:

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Potential for strong inflation linkages in a period where inflation may be an issue

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Significant fiscal pressure on governments, with a requirement to boost public expenditure. This could lead to sale of assets or new deal-flow in infrastructure

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Asset-backed debt holders may own foreclosed assets but lack the expertise and capital necessary to maximise recovery

Source: Aladdin


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Pricing of assets offers opportunities

Asset values have rebounded off financial crisis lows…

Infrastructure equity was marked down heavily over the financial crisis. The graphic below demonstrates the historical valuation of infrastructure assets (as represented by the Brookfield Dow Jones Index) in the listed market.

…and are approaching historical norms

More assets are coming to market as vendors and purchasers of infrastructure assets alike can value assets with greater confidence.

Source: Brookfield


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The debt lent to infrastructure assets over 2009/2010 was significantly reduced on previous years

Deals slowed over 2009/2010 due to less debt being made available on similar terms to pre-credit crisis (i.e. debt was more expensive). The graphic below shows the amount of project finance debt provided to infrastructure assets over time

Debt markets seem to be responding more favourably to infrastructure projects

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Lending has resumed, but is more expensive than pre-crisis•

As confidence returns to the market, financial costs are improving

Debt is returning to the market

Source: Berwin Leighton Paesner

Infrastructure Portfolio Construction



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Investment stages and time lags

Due to the nature of infrastructure investing, the amount committed by investors will not be immediately invested in the asset class.

Underlying assets

Infrastructure manager

Client Stage 1:

• Client must identify underlying managers

Stage 2:

• Manager must identify underlying assets

• Subsequently the manager must add value and implement an exit strategy.

Infrastructure is a long-term strategy – the expected life of a fund commitment can be 10-30 years


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Infrastructure fund life cycle – Timing investment

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Look for good (‘cheap’) opportunities to buy companies“J curve” impact as investments sourced, fees paid on commitments

Look for opportunities to generate current yield from cash flows and capital gains from sale

Given the timelines, it is challenging to ‘time’ investments in infrastructure


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Typical investment structure: Limited partnership

Most infrastructure investments are structured as limited partnerships

General partners (managers) are responsible for reviewing deals, making investments, and managing/monitoring those investments

General partners are compensated through a management fee (1% to 1.5% of committed capital); often also a “carried interest” of about 20% of total return

Limited partners (investors) are responsible for providing committed capital— Limited partners’ liability is limited to capital provided

— Limited partners share in a pre-determined split of the profits, typically 80%


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Fund structure

Fund structure considerations are important but should be secondary in their importance to the assessment of a manager’s skill to source and operate infrastructure assets

Historically, most infrastructure funds are ‘closed-end’ funds, which are operational for a fixed period of time (eg 10-20 years)

Some funds are structured as ‘open-end’ or ‘evergreen’ funds, where the manager does not automatically dispose of assets and investors may continue to benefit from the cash flows over the longer term.

Investors are potentially exposed to liquidity events, which may result in proceeds from asset sales being returned to investors at times that are inconsistent with their objectives

You may get your money back quickly resulting in a portfolio that falls behind your strategic allocation

Many funds have a “roll-over option” where investors have a right to switch to an ‘evergreen’ listed vehicle at the end of the closed-end fund life

The actual implementation of this structure is yet to be tested


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Fees

Fees should be commensurate with risk taken i.e. expect to pay more for development, Brownfield assets than core infrastructure

Managers’ Fees:

1.0% to 1.5% of committed capital

To cover operating expenses of Fund

Performance Fee (Carried Interest)

Typically 20% of total return on invested capital, but only after investor has received a hurdle rate of return (typically 8%)

For example: — If Fund returns 20%

– Investor gets 16%– Manager gets 4 %

— If Fund earns 8%, manager gets no performance fee

Infrastructure is expensive; however fees are coming down.


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Implementation considerations

There are a number of practical considerations that should be evaluated:

Staffing:

Infrastructure assets may require additional pension fund resources for monitoring

Cash Flow:

Infrastructure assets can generate significant cash flows that must be managed within your overall asset allocation framework

Currency:

Currency hedging may be considered as many managers will participate in non-domestic markets

Valuation:

It is essential to be comfortable with a managers’ valuation approach

Reporting:

It is important to consider the types and frequency of reports you will receive from managers to ensure it meets your requirements

Asset Mix:

Illiquid nature of the asset class means you may be over or above your target infrastructure allocation and it typically cannot be adjusted quickly


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How can it be benchmarked?

A diversified benchmark for global direct (not publicly traded) infrastructure does not exist

Benchmarks for publicly listed infrastructure companies

High correlation with public equity markets— Macquarie Global Infrastructure Index

— Moody’s Economy.com Infrastructure Index

— UBS Global Infrastructure and Utilities Index with Standard and Poors

For global direct infrastructure can consider:

An absolute rate of return (e.g., CPI + x%)

Listed index adjusted for return volatility and leverage ratios e.g. (Dex Index + %)

Absolute return (e.g. 8%)


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Infrastructure is challenging, but worth considering:

- diversification benefits

- attractive returns

- stable cash flows

- inflation protection

Advantages of infrastructure

Returns can be driven by:

Equity risk premium – albeit muted

Illiquidity premium

Activism premium

Information premium

Diversification benefits:

Less sensitive to economic cycle than with equities

Low expected correlation with other assets

Liability ‘matching’

Generation of reliable cash flows which are often linked to inflation (depends of type)

Long duration (although depends on vehicle used)

Disadvantages of infrastructure

High fees

Illiquidity

Regulatory/political risk

Concentration risk

Investment risk – this is not a bond substitute

Governance challenges

Selection risk

Unfamiliar vehicles

Speed of decision-making

Managing cash-flows

Data problems

Monitoring managers

Managers may have conflicts of interest

Summary: Pros and Cons of infrastructure

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