FORUM: Creating value and managing risk in emerging market infrastructure

April 2018 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2018 Issue

Geoff Haley, founder and chairman of the IPFA, moderates a discussion on creating value and managing risk in emerging market infrastructure between Richard Fechner at GHD Advisory, Heru Mardijarto at Makarim and Taira S., Oliver Irwin at Milbank, and Joanne Emerson Taqi at Norton Rose Fulbright (Middle East) LLP.

Haley: What factors are currently driving infrastructure investment in emerging markets? What regions and sectors seem to be particularly active?

Irwin: We expect activity levels in this sector to continue to increase as project sponsors in the solar and wind sector look to take advantage of recent technology advances that give rise to increased efficiencies, and host governments look to take advantage of strong competition among project sponsors, which has led to a noticeable reduction in pricing for renewable energy projects. In recent years, we have seen extremely competitive tariffs on renewables projects in a number of emerging markets, most notably in South Africa, Abu Dhabi, Dubai, Saudi Arabia, India and Turkey. In addition, cheap natural gas has led to the development of combined-cycle gas turbine (CCGT) power plants in a wide range of emerging markets. Latin America is developing into a new market for US liquefied natural gas (LNG), with a wide variety of LNG to power projects now well underway.

Mardijarto: One of the factors driving infrastructure investment is of course government policy. For example, in Indonesia, in order to boost investment in infrastructure projects, the Indonesian government has formed the Committee for the Acceleration of Priority Infrastructure Delivery (KPPIP), the main function of which is to coordinate decision making in order to facilitate the settlement of issues caused by the lack of effective coordination between various stakeholders. The formation of the KPPIP was followed by some deregulation to simplify investment procedures. The most active investment sector in Indonesia at the moment, following the changes to government policy in the field of electric power, is the energy sector.

Taqi: Ageing infrastructure and a decline in oil prices since 2008 are creating opportunities for infrastructure investors in the Middle East and regional governments are currently pursuing relatively non-traditional ways in which to procure such infrastructure. These include design, build, finance and operate (DBFO), build, own, operate and transfer (BO(O)T) and (BO(O)T)/engineering procurement construction (EPC) conversion procurement models. In light of a softening international infrastructure market, investors are increasingly looking at opportunities in the region, particularly those supported by strong government support in some regional jurisdictions, bankable documentation and reasonable equity returns. The markets in the region which are particularly active at the moment include Saudi, the UAE and Oman, and active sectors include transportation, such as the Gulf Cooperation Council (GCC) rail link, water and social infrastructure, healthcare and schools in particular. Renewable energy projects also present opportunities, particularly in Jordan, Egypt, the UAE and, most recently, in Saudi Arabia.

Fechner: Though the need for infrastructure in emerging countries has perhaps never been higher, governments and agencies are typically unable to access capital to fund new construction or renewal activity. The number of quality infrastructure investments, including public-private partnerships (PPPs) in Organisation for Economic Co-operation and Development (OECD) countries, does not currently satisfy demand for both improved services and available finance. The global need to invest in infrastructure and associated activities is driven by the continued growth of debt and equity funds. As a consequence, opportunities to extend consideration from Core strategies to Core+ or Core++ in many funds now includes either infrastructure-like opportunities in OECD countries – offering long-term stable returns with manageable risks – or infrastructure in emerging countries. As such, developing countries with needs for improved infrastructure should mobile to provide the opportunity and climate to attract these funds and expertise.

“While it depends on the jurisdiction, investors are continuing to look at a limited range of sources of capital, mainly commercial banks – conventional and Islamic – and multilateral development banks.”

— Joanne Emerson Taqi

Haley: At a time when many governments are strapped for cash, what methods are being utilised to source capital and attract infrastructure investment into emerging markets?

Mardijarto: To attract investors to invest in infrastructure projects, governments implement policies which lead to deregulation, easier licensing, tax incentives and, where relevant, government guarantees. In addition to private investment, the involvement of banks is essential as most financing for infrastructure projects in emerging markets is provided through bank loans. The data from the World Bank shows that in the first half of 2017, 72 percent of finance for infrastructure in emerging markets was debt financed.

Taqi: While it depends on the jurisdiction, investors are continuing to look at a limited range of sources of capital, mainly commercial banks – conventional and Islamic – and multilateral development banks. Commercial bank lending traditionally makes up the majority of lending to infrastructure projects in the Middle East, although we are recently seeing an increase in mini-perm structures and a squeeze on debt tenor. With a number of significant mega projects likely to be launched in the region shortly, there is likely to be some impact on commercial bank liquidity and appetite for these types of projects. We are not currently seeing any appetite for bonds or sukuks for infrastructure financing, although these sources of capital are likely to become more prevalent in relation to renewables projects due to the low construction risk and sustainable credentials of such projects.

Fechner: PPPs are growing as a delivery and investment mechanism in emerging markets, and in a number of scenarios, procurement, management and expectations are maturing. This is balanced by rising middle class incomes and education levels, and subsequent aspirations for improved infrastructure and services, including power, water, sanitation, transport, communications and healthcare. In many emerging markets, regulation and environmental protection are increasing, creating significant opportunities for water and sanitation projects. Developing countries should also consider opening opportunities for privately funded turnkey build-own-operate style ventures.

Irwin: It is a major goal of all governments to attract new capital investment to their territories from beyond their borders. Project financings, to the extent funded by loans from overseas lenders and equity capital provided by foreign investors, can increase the flow of capital into the host countries substantially. In less economically developed countries where first-in-country major international projects are proposed, it may be necessary for host governments to legislate in respect of areas such as taxation to give private equity and debt investors the necessary comfort to participate. In many cases, host governments, particularly in less economically developed countries, will provide more subtly for better equity returns by applying generous taxation regimes to major projects. Governments may also be motivated to provide subsidies or supplements – including the tariff regimes that apply to certain renewable energy projects such as wind farms and solar parks – to promote investment in a particular source of energy from a broader political perspective.

Haley: How do infrastructure projects in emerging markets compare to those in developed markets, in terms of potential returns, sourcing projects, expected time frames, exit opportunities, and so on?

Taqi: It is generally accepted, and it is fair to say, that infrastructure projects in emerging markets can be challenging for some investors compared with projects and opportunities which they may be more familiar with in developed markets. There have been unfortunate instances of long delays and cancellation of some infrastructure projects in the Middle East which has dented investor confidence. There can also be difficult and unfamiliar risk allocation issues to be addressed, as well as onerous lock-in provisions, making short-term investor exits practically impossible. Some governments in the Middle East have, however, identified these issues and sought to offer more generous risk allocation profiles as a form of mitigation.

Irwin: To attract private foreign investment, host governments in emerging markets may need to afford investors greater equity returns than are available in other, more developed, markets internationally. Some sponsors, in particular trading companies and government affiliates and state-owned enterprises in the natural resources sector, are motivated to invest in projects in emerging markets so as to secure the long-term reliable supply of, or a market for, certain resources – such as oil, gas/LNG, iron and other metals – for, or from, their home jurisdictions. Mining and oil and gas projects in emerging markets will often have a minority government ownership stake, and in some cases the government does not have the necessary financial resources to fund its participation, and so private international sponsors are therefore reluctantly forced to carry the cost of the government’s participation as a ‘carried interest’.

Fechner: Emerging markets can be less contested, potentially delivering higher returns. Yet, greater emphasis must be placed on project initiation phases to ensure the full investment context is understood. This involves deeper exploration of opportunities and strong appreciation of the political landscape – recognising that procurement processes may be protracted and accepting higher levels of sovereign risk. This is not entirely unique to emerging markets though, and is also encountered in more mature investment locations. Where large, multidisciplinary teams are required, emerging markets may have less sophisticated local partners, leading to delays in procurement processes and project delivery, and difficulty identifying firms to operate and maintain assets. Additionally, emerging market governments and agencies may be hesitant to introduce private investment into some service provision areas, due to concerns over employment and loss of control. As emerging markets are not as well understood by investors and operators, exit is a higher risk, and as such, more detailed planning is needed. By including partners with a local footprint, the risk can be better managed towards time of exit, however unless the markets continue to develop, the lower level of interest and competition on entry may remain at exit.

Mardijarto: Infrastructure projects in emerging markets present additional challenges compared to developed markets. One of these is that the economy and financial system in emerging markets may not be as sustainable as that in developed markets, which usually results in it taking longer to obtain a return on the investment (ROI).

“To attract private foreign investment, host governments in emerging markets may need to afford investors greater equity returns than are available in other, more developed, markets internationally.”

— Oliver Irwin

Haley: To what extent do regulatory compliance issues, corruption, swings in local currencies and political instability impact the risk profile of infrastructure investment in emerging markets?

Fechner: The core risks lie in areas of changing or unclear regulation, sovereign risk and political instability, and integrity and corruption. These risks dictate where global funding and expertise will be directed, in many cases posing limitations on infrastructure investment in a country or region. Market forces can dictate company policy regarding investment and activity. As quality investments in OECD countries continue to meet market needs, there will continue to be less reason for funds to direct activity to emerging markets unless a mandate for potentially higher returns is sought, with associated risk. Currency swings generally have less significant impacts, as infrastructure is a long-term investment and fluctuations or volatility will normally be smoothed out over the asset lifecycle. Interestingly, in some instances, infrastructure investment may actually improve risk profiles when emerging market governments acknowledge that issues in their regulatory and political systems must be addressed in order to attract foreign investment.

Mardijarto: In Indonesia, regulatory compliance issues in infrastructure investment are mainly related to vague and conflicting regulations, as well as the different policies of Indonesian ministries and government institutions, which, along with rampant corruption, negatively impact Indonesia’s infrastructure investment risk profile and therefore its investment climate. However, to improve the investment climate for infrastructure, the Indonesian government has demonstrated a commitment to improving infrastructure development and investment through, among other things, anti-corruption measures and Presidential Regulation Number 58 of 2017 – which amends Presidential Regulation Number 3 of 2016 – on the Acceleration of the Implementation of National Strategic Projects. The projects listed in this Presidential Regulation include roads, ports, airports, irrigation and electric power.

Irwin: Political risk may arise from actions by the host government – whether or not arbitrary or discriminatory – that have a negative impact on the financial performance or commercial viability of a project, as is the case with acts of expropriation or the imposition of restrictions on the repatriation of a project’s foreign currency earnings. As a threshold matter, the nature of political risk in a country can be evaluated through its sovereign credit rating. There are a wide variety of means which may assist in the mitigation of political risk. The involvement of local investors in the sponsors’ consortium may be helpful and many projects will rely on a variety of direct governmental undertakings, treaty arrangements and insurance to help mitigate political risk. The risks associated with a project receiving its revenues in a different currency to its finance, capital and operating costs include revaluation, convertibility and transferability. These risks are generally more of a concern in emerging markets, where the local currency may not be as strong or established as an international currency.

Taqi: Investors have told us that current geopolitical, economic and social reforms in some parts of the Middle East are causing concern. Currency fluctuation and repatriation are also critical risk issues for investors and, in some jurisdictions, this has had a significant impact on investor appetite. Despite these issues, however, there remain high levels of interest from both international and domestic investors for regional infrastructure projects. In our experience, sponsors and their lenders are looking more closely and critically at risk allocation, particularly issues such as a change in the law and broader force majeure event relief, as well as termination and exit rights. Investors are also working with their insurance brokers and advisers to monitor insurance capacity for emerging market risks. With the right advice, experienced investors are likely to be able to successful manage myriad issues in the current environment.

“The economy and financial system in emerging markets may not be as sustainable as that in developed markets, which usually results in it taking longer to obtain a return on the investment (ROI).”

— Heru Mardijarto

Haley: Based on your experience, what strategies can be used to overcome the transactional risks and mitigate potential downside?

Mardijarto: Infrastructure sectors are well-known to have high transactional risks, for example in the electric power sector, when an off taker fails to pay the agreed-to tariff. We learn from experience that to overcome these transactional risks, investors should conduct a comprehensive, yet careful, due diligence on the infrastructure sector which they wish to participate in. Due diligence is important not only because it can reveal which transactional risks investors should focus on, but also which financing structure may be most suitable and through which identified risks can be mitigated.

Irwin: The business of project financing is founded upon the identification, assessment, allocation, negotiation and management of the risks associated with a particular project. Indeed, the whole basis for project financing revolves around an understanding of the future project revenues and the impact of various risks upon them. The risks that will typically be identified, considered and, in due course, mitigated will vary across industries, as the risk profile will differ, depending on the nature of the project financing. In a project to build and operate a concentrated solar power solar plant, the technical requirements of this relatively new technology will present a greater risk than, for example, the construction of a gas-fired power plant using proven CCGT technology.

Taqi: While there are limited possibilities for overcoming all transactional risks, early and thorough due diligence, experienced advisers, pragmatic decision makers and well-developed corporate risk mitigation techniques are, in my view and taken together, effective mitigants. A keen understanding of the sociopolitical and cultural aspects of the region is also important in order to create the best possible negotiating platform. Localisation is also important. The participation of local companies in investor joint ventures, local commercial lenders in the bank group and local legal advice is likely to play an important part in ameliorating downside risk associated with specifically domestic risk issues.

Fechner: Key to managing risks is the comprehensive understanding of both up and downside potential, and then considering how best to mitigate and actively manage the risks to achieve those upsides. Careful and meticulous due diligence is critical to limiting unwanted surprises, involving understanding the market and its potential, as well as the investigation and appraisal of country-specific risks, payment regimes and, importantly, deep understanding of regulatory and technical issues. Issues should always be actively managed by those with the greatest capacity to do so and strongest appreciation of the situation, rather than transferring project and investment risk to parties with limited awareness of the solution. Overall, the quality of the team working within a given risk appetite will determine the outcome – infrastructure remains a people business.

Haley: What essential advice would you offer on making successful investments in emerging market infrastructure and generating long-term returns?

Fechner: When investing or delivering a project in emerging markets, entering the market with your eyes wide open is vital. Solid returns stem from careful consideration, with successful outcomes afforded to those who understand the full political, strategic and cultural landscape, and consider both market entry and when and how to exit. It is essential to choose the right partners, ideally with global best practice skills and the local and relevant experience required to plan, design, build, operate and maintain the asset, and be able to operate within the available technology and prevailing safety, operating and regulatory standards in the project environment. Logistics, employment and communications can be complex as well, so it is important not to assume that what has worked elsewhere will also be appropriate in a new context.

Taqi: From my perspective, the key drivers for a successful investment in this sector are thorough due diligence, experienced advisers, pragmatism, localisation and risk mitigation strategies. Generating long-term returns in the Middle East is contingent on various factors, many of which are outside the control of the investor, however, consistent, localised and forward-thinking management, and the ability to anticipate and manage unexpected events are essential. As a number of infrastructure projects, including mega-projects – for example, the Saudi-Bahrain Causeway project – are expected to come to market in the region over the next 6 to 18 months, investors will have the benefit of being able to select the best project and risk profile to reflect their particular investment strategy.

Irwin: A project’s value is based principally on its ability to generate revenue during its operating phase. Both sponsors and lenders therefore require assurances that the project is technically and economically feasible and that it will be built and operated according to the agreed specifications, and in compliance with the laws and regulations of all relevant governmental authorities. Risk cannot always be mitigated or contracted away, but it can be assessed, allocated and managed so that it is commercially reasonable. The first step is to identify the material risks and the second is to decide how they should be addressed. The guiding principle for project finance is that the party best able to manage a risk should bear that risk.

Mardijarto: It is essential to have a thorough understanding of local regulations before making strategic commercial decisions regarding infrastructure investment. It is also important to have a reputable local partner as most investments in infrastructure require a local partner. Overcomplicated regulations and lack of policy coordination between central and regional governments are often major obstacles to investment in infrastructure. These include land acquisition issues which can extend the time frame of a project.

“Key to managing risks is the comprehensive understanding of both up and downside potential, and then considering how best to mitigate and actively manage the risks to achieve those upsides.”

— Richard Fechner

Haley: What is the outlook for investment in emerging market infrastructure projects over the next 12 months or so? What are your expectations for continued activity?

Taqi: I am optimistic. As the Middle East continues to adjust to a new oil price environment and governments are looking for alternatives to traditional procurement strategies for key infrastructure projects, we expect to see more opportunities for investment in infrastructure projects in the region. These opportunities are likely to be in transportation, rail, road and ports, water, desalination and wastewater, and social infrastructure, particularly healthcare and education. The adoption by regional procuring authorities of an established and bankable risk profile from the power sector is highly recommended and anticipated. As some of the current infrastructure projects in the region achieve financial close and the current political issues subside, the confidence of international infrastructure investors is likely to further improve, heralding more competition and lower prices for regional governments.

Irwin: We anticipate that there will continue to be a strong demand for new infrastructure projects in emerging markets in the next 12 months. As a lack of electrical capacity and transmission infrastructure continues to act as a key constraint on the growth of emerging market economies, we expect to see continued strong activity in the development of power projects in emerging markets as their governments – often with the assistance of multilateral financial institutions such as the World Bank – seek to remedy this constraint. Project finance sponsors and lenders can look forward to continued activity as they adjust to the ever-changing shift in economic and political dynamics that impact the development and financing of large-scale infrastructure projects.

Mardijarto: Investment in infrastructure continues to be a top priority for the Indonesian government. The government has launched a variety of infrastructure programmes for roads, ports, industrial states, traditional markets, dams and technology parks. This has resulted in a significant increase in government infrastructure spending in the last few quarters. Regulatory and policy reforms have also gradually been implemented to create a more conducive environment for private sector participation. However, earlier this year, several industrial accidents occurred in infrastructure projects. This has led to more routine supervision and management control by the government. We believe that public investment is set to remain high as the government continues its ambitious medium-term infrastructure programmes. However, the government should be doing better to ensure that the extra resources that are available are actually deployed and that there is better safety supervision in ongoing projects.

Fechner: The thirst for investment in emerging markets will continue to rise over the next 12 months and beyond. Maturing PPP processes and regulation in many Asian countries, along with increases in household incomes and population, will encourage growth – though as they mature, they will become more competitive. However, opportunities exist to capitalise upon this growth. For instance, while China is driving infrastructure activity outside via the One Belt One Road programme, many Chinese firms will need partners to navigate the politics, regulation and work practices in other countries. Over the longer term, Africa offers the greatest potential, while also presenting some of the greatest challenges. Yet, despite new emerging market opportunities, it is most likely that investment will continue to flow primarily to ‘known’ markets such as the US, where risks are better understood and there is greater whole-of-life asset certainty.

Geoff Haley is the founder and chairman of IPFA, the largest independent not-for-profit project finance trade association in the world. He is a solicitor with an LL.B from University of London, an MBA from Henley Business School and a Diploma in Marketing from the Charted Institute of Marketing. He has specialist experience in large and complex projects in transportation, energy, water treatment, healthcare and education. He can be contacted on +44 (0)20 7427 0900 or by email: info@ipfa.org.

Richard Fechner is a world leader in development, investment and delivery across ports, energy, government, defence and infrastructure sectors in Australasia, the Americas, Europe and the Middle East. In senior public and private sector roles, he has advised major capital recycling programmes and over AU$150bn transactions. He can be contacted on +61 (29) 239 7222 or by email: richard.fechner@ghd.com.

Heru Mardijarto is a partner in the firm’s corporate and commercial department. His expertise includes general corporate matters, energy and natural resources, construction, and IT and telecommunications. He has advised many major international clients as well as Indonesian state-owned companies in relation to power plants, as well as construction projects. Mr Mardijarto also has extensive experience in handling the procurement and tender process in both government and private institutions. He can be contacted on +62 (21) 5080 8300 or by email: heru.mardijarto@makarim.com.

Oliver Irwin is a member of Milbank’s project, energy and infrastructure finance group and specialises in advising on the development and financing of innovative and significant ‘first-of-a-kind’ cross-border projects across a broad range of industry sectors. He is a regular speaker at various industry conferences and has been recognised as “Rising Star”, “Associate to Watch” and “Next Generation Lawyer” by Euromoney LMG’s guide, Chambers, IFLR and Legal 500. He can be contacted on +44 (0)20 7615 3006 or by email: oirwin@milbank.com.

Joanne Emerson Taqi is a Bahrain-based projects partner and head of the Middle East infrastructure, mining and commodities team at Norton Rose Fulbright (Middle East) LLP. She specialises in the review, preparation and negotiation of a wide range of project and subcontract documentation on large utilities and infrastructure projects in the MENA region. Based in the region for 12 years, Ms Taqi advises governments, sponsors and lenders. She has been named in Chambers and Legal 500 since 2007. She can be contacted on +973 (16) 500 214 or by email: joanne.emersontaqi@nortonrosefulbright.com.

MODERATOR

Geoff Haley

IPFA

THE PANELLISTS

Richard Fechner

GHD Advisory

Heru Mardijarto

Makarim and Taira S.

Oliver Irwin

Milbank

Joanne Emerson Taqi

Norton Rose Fulbright (Middle East) LLP