Q&A: Infrastructure M&A

April 2024  |  SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2024 Issue

FW discusses infrastructure M&A with Seth Miller Gabriel at BDO, Clint Vince at Dentons, Emma Stones at Herbert Smith Freehills and Fritz Lark at McDermott Will & Emery LLP.

FW: Could you provide an overview of the key themes dominating infrastructure M&A? How would you characterise activity levels?

Vince: In the US, recent legislation has directed unprecedented amounts of money and tax incentives toward infrastructure projects. Funding is still in the early stages, but we are seeing growth in new businesses and technologies. A major focus is on investments to create the infrastructure ‘foundation’ for future investments, and energy storage to help power the new technologies and meet the anticipated huge increase in demand for electricity. Major consolidation in conventional, upstream and, to a lesser extent, midstream oil and gas appears to be a US-centric phenomenon. Hydrocarbons are particularly profitable in the current environment, and likely to remain so given Russian sanctions and tensions in the Middle East. There is investment in renewables, but large-scale M&A still faces challenges with profitability and the regulatory environment. A change in presidential administrations could challenge implementation, but the long-term trend of electrification and a build-out in electric vehicle (EV) charging infrastructure and EV cars is likely to continue given ongoing investments in the private sector. What we are not seeing, disappointingly, is more investment in critical minerals and mining required to sustain the energy transition, and clean energy investments.

Lark: One of the major themes in infrastructure M&A right now is energy transition investment. While different market players have different definitions of what is included in energy transition, in its broadest sense it encompasses traditional renewables as well as hydrogen, battery storage, climate tech and other related areas. The demand for investment in this area continues to grow, and as the sector has expanded beyond traditional wind and solar renewable investments, investment opportunities are ramping up as well, which in turn is driving increases in deal flow. Other key themes include growth in the digital infrastructure sector, particularly with respect to fibre networks and a renewed interest in data centres, and more broadly, a steady push by many infrastructure owners to build scale, to take better advantage of asset-backed financing alternatives. Overall, activity levels seem to still be off the highs of a few years ago, but are steadily increasing.

Miller Gabriel: There is currently a lot of activity within the renewable energy space, driven by a political and social focus on reducing carbon emissions. This in turn is driving significant M&A activity within solar, wind, hydroelectric and hydrogen. We can see the impact of this activity in power generation and in increased development of energy storage, especially batteries, not only in the residential space but also on a larger scale for communities and corporate needs. Further, the proliferation of remote and hybrid work that began during the pandemic has heightened the need for enhanced digital infrastructure. However, while the infrastructure space remains active, increased interest rates have slowed the market.

Stones: Infrastructure M&A weathered interest rate and inflationary challenges better than many other asset classes in 2023, as a result of the distinctive downside protection and high barriers to entry provided by entrenched customer bases, strong market positions and regulatory protections. With globalisation and population growth driving change in both developed and emerging markets, unprecedented investment is required for the development and renewal of crucial infrastructure. As governments continue to face fiscal headwinds, they need innovative solutions and partners to deliver the infrastructure required for sustainable growth. Looking at the 12 months ahead, capital raised in the core space is expected to make auction processes extremely competitive. Core-plus and value-add assets offer opportunities for greater returns, with digitalisation and the energy transition expected to remain major areas for capital expenditure. In addition, opportunities are increasing in novel areas such as energy storage, or where the characteristics of infrastructure apply to assets not always seen as such historically, such as in healthcare, housing and education.

FW: In the current macroeconomic environment, what opportunities are available to infrastructure investors? How would you describe the level of capital being directed toward major infrastructure projects?

Lark: In addition to typical M&A activity, one area where we have seen a significant uptick in deals is in structured equity – joint ventures, preferred equity, minority interests and similar equity investment transactions. Given the increased interest rate environment and the negative impact that has had on pricing for M&A sale transactions, this type of transaction can sometimes work as a bridge between investors and sellers where they would not otherwise be able to agree on a price for a sale transaction. Overall, there appears to ample capital available for investment in the infrastructure sector, but the deployment has slowed due to the economic environment and pricing mismatch.

Miller Gabriel: Infrastructure projects currently offer several unique and beneficial opportunities for investors, such as the ability to invest in long-term hard assets backstopped by public sector owners that can fund repayment using taxes and fees. Opportunities for investment can be found in every asset class: water, transit, housing, schools, office, broadband and more. We are seeing an increased level of capital being directed toward major infrastructure projects in the US. This capital is both from governmental sources – largely federal – and from infrastructure investors eager to get involved in the expanding opportunities in the space. The magnitude of this investment is substantial, reaching into the trillions, including funding from the Infrastructure Investment and Jobs Act.

Stones: Capital continues to flow into infrastructure, supported in many areas by government policy. Although 2023 was the slowest year in a decade for fundraising, early signs suggest investment in Q4 outstripped the rest of the year combined, indicating improving levels of confidence or optimism. While there is a continued concentration of limited partner investors into a smaller number of larger funds, with mega funds continuing to attract capital and drive investment into large, high-value opportunities, in parallel the increasing number of smaller funds and specialised managers allow investors flexibility to focus on specific strategies. This includes certain aspects of digitalisation and energy transition, whether in the mid-market or earlier-stage opportunities. Despite high levels of investment over an extended period, a continuing driver for investment is the vast, unmet and growing need for infrastructure investment. The United Nations-backed Global Infrastructure Hub estimates that the gap between government spending on infrastructure and the amount needed will be $500bn in 2024 alone, and will reach $15-18 trillion by 2040. True major greenfield infrastructure projects present more complex challenges to sources of private capital, owing to their scale, novelty and the political and regulatory risks to which they are often subject. Notwithstanding these challenges, governments are increasingly finding innovative ways to allocate risk so as to draw in private investment.

Vince: There are numerous opportunities for infrastructure investors with huge amounts of public and private capital that are being directed at infrastructure. Nevertheless, challenges including bankability, cost management and execution risk are of concern. Lawsuits by citizens of adjacent communities and non-governmental organisations, along with permitting, siting and regulation challenges all create additional risk. Federal courts end up acting as policymakers of last resort, which is suboptimal in terms of coherent policy, timing of projects and investor confidence. Also, a rise in interest rates could have a dampening effect on activity, and high inflation and supply chain issues continue to hinder project development.

FW: To what extent are trends such as decarbonisation, digital transformation and declining privatisation impacting the infrastructure M&A market?

Miller Gabriel: There is a lot of activity in the energy space as a function of decarbonisation. This trend will likely continue in the coming years as new developments in technology and alternative power sources spur more and more investors to shift their portfolios away from fossil fuels and into renewables. Consumers are also expected to move away from gas-powered vehicles in favour of EVs and hybrids. Digital transformation will be a key area for further investment. It has received significant investment in recent years, which is expected to continue given the overabundance of data and connected devices. We will likely see more equity investors taking an interest in the space. Meanwhile, declining privatisation presents both challenges and opportunities. These trends are reshaping investor and governmental priorities, which in turn is impacting valuations and investment decisions.

Vince: Widespread interest in decarbonisation and lightning-paced advancements in technology are making their effects felt on all infrastructure sectors in the US. Decarbonisation goals are driving investments in all industries, accelerated by the amount of federal funding that is currently available. There also is intense interest in technologies like artificial intelligence (AI). Many companies are bullish about the promise of AI, but customers and workers are uneasy. Declining privatisation is not a significant trend in the US. However, one trend that executives should not underestimate is the impact of social demands, especially by communities directly impacted by projects.

Stones: Political agendas and social expectations are shaping the delivery of infrastructure. Governments alone cannot meet the financial needs of infrastructure investment, with the private sector needed to bridge the gap. Digitalisation and the energy transition are the two most important drivers in the infrastructure M&A market right now, and funds are increasingly targeting assets in those areas. The demand created by phenomena such as AI and the internet of things mean that digital infrastructure will continue to attract enormous investor interest, with some asset types, such as data centres, also feeding into increased energy demands and decarbonisation strategies. An increasing number of specialised funds with an energy transition focus are being raised, and over 80 percent of infrastructure investors consider energy transition to be part of their fiduciary duties, as well as a new investment opportunity. How this dynamic develops in the public policy sphere will be interesting to monitor in 2024 as elections near in many parts of the world.

Lark: Decarbonisation and digital transformation are certainly driving transactions and deal flow in the M&A market. Given the forecasts of the aggregate investment needed in these sectors, it appears that transaction volumes in these sectors will only continue to increase. To take one example, if vehicle electrification rolls out in line with some of the more aggressive targets, the investment that will be needed in the next 10 to 15 years for the additional power and electric grid upgrades to support the projected number of EVs is truly staggering. With respect to declining privatisation, the impact on the infrastructure M&A market is not as clear – it depends in large part on what is replacing those transactions – in many cases, the ultimate need for infrastructure investment is still there.

FW: To what extent are public-private partnerships (PPPs) being used to deliver infrastructure projects? What considerations need to be made to ensure PPPs are beneficial to both parties?

Stones: Public-private partnerships (PPPs) continue to be an important approach in many jurisdictions, although they remain out of favour in others. Building infrastructure requires careful assessment, thorough planning, and significant amounts of time and capital – all of which carry risk. For projects to attract private investors, risk must be effectively allocated and mitigated to bankable levels. Finding the right approach to balancing risk and responsibility is key. The private sector can bring an understanding of managing and pricing risk while generating efficiency gains throughout a lifecycle, supported by the public sector’s ability to take a long-term view and interest in the project, with the potential to absorb or mitigate certain risks which would otherwise carry a premium. For very large or complex projects, certain risks, such as construction risk, may be so great that it becomes better value for the consumer and taxpayer to offer a risk share in order to reduce the base price. While challenges remain and PPPs are not a panacea for every project, they can be an effective tool to deliver effective, cost-efficient projects and associated services – and present an attractive option to help plug the global gap in investment.

Lark: PPP transactions continue to have a role in financing infrastructure investment, particularly in cases where it is more difficult to make a compelling case for a pure private investment or where continued government ownership provides other non-economic advantages. Where we have seen many of these types of projects is in transportation infrastructure, such as airports and roads, and social infrastructure, such as universities. Key considerations in these types of projects include balancing the risks and rewards of the project so that, ideally, each party is bearing the risks that it is best suited to manage and is being held accountable for its performance in those areas. This can be challenging to determine upfront in many cases, so a good working relationship between the principals is an important element of success as well.

Vince: PPPs are not used in the US as frequently as they are elsewhere. At the state level, only a few states have dedicated governmental units that support PPPs, while many lack the technical capacity, expertise or experience to consider this structure. The few examples where PPPs have been used successfully in the US include municipal infrastructure modernisation or economic development, primarily transit corridor and housing-related projects in large metropolitan areas in California. There are very few examples at the federal level. The US Department of Energy is actively promoting PPPs through direct loan awards to advance fusion energy and as part of its Clean Cities Coalition to develop alternative fuels, EVs and fuel-saving strategies.

Miller Gabriel: PPPs are playing an increasing role in the delivery of much needed infrastructure projects and improvements in the US. These partnerships, which had traditionally been focused on transportation projects in the US, have increasingly grown into the social infrastructure space. New projects for schools, government office buildings and other public-facing facilities are being launched throughout the country. To help ensure that PPPs benefit both the public and private sector, as well as the end users, certain considerations are important from the outset. Most importantly, the public sector must know what it wants out of the project and make sure that those needs are aligned with the private sector’s ability to deliver. Partners must also have a comprehensive understanding of all risks involved with a project and determine who is best able to mitigate those risks.

FW: What general advice would you offer to companies on negotiating, structuring, financing and closing infrastructure deals in today’s market? What key areas need to be addressed?

Lark: It is always good to look ahead at the next steps when making an infrastructure investment. What is the financing plan? Where will future growth capital come from? Will the company be making follow-on investments? The more flexibility that can be built into the transaction documents, and the more a company can anticipate, the better off it will be, although sometimes this is not possible, particularly in a competitive situation. One key area to keep in mind when investing in infrastructure is the regulatory overlay that exists in many infrastructure sectors. In some sectors, regulatory approvals can be substantive and time consuming, so it is important to identify those early in the process to ensure they are built into the deal execution strategy.

Vince: In the US, any infrastructure project will implicate numerous federal and state laws relating to antitrust, land use, and environmental concerns, to name a few. It is critically important that stakeholders understand the myriad legal considerations facing a project, as well as the layers of regulatory approvals involved. There is no ‘one stop shop’, and one small element of a project – such as utility pole attachment rules in an energy project – could very well compromise timely project execution. It is critical to engage with community stakeholders early on. Failure to do so may lead to litigation longer term that could delay implementation to the point that project economics are compromised due to changes in the cost curve, business cycle, the availability of contractors and raw material costs. Community engagement is also critical to ensure an effective project design that satisfies the needs of the community and can be executed in a manner that is also affordable, particularly where the community will be asked to pay for it.

Miller Gabriel: We would advise any company getting involved in the infrastructure market in the US to know their market. The US is not just one infrastructure market – it is at least 50 states, the District of Columbia, Puerto Rico, and all federal agencies. Beyond these categories, there are several thousand counties, cities and special districts. Any firm getting involved in infrastructure investment should focus on a particular geographic area or infrastructure asset class to help maximise the impact of its business development activities. This will also allow those companies to gain knowledge within specific sectors – a requirement for any firm that hopes to be successful as it gets involved in addressing the nation’s infrastructure needs.

Stones: While for certain asset classes there remains a valuation gap, beyond pure financial drivers, dealmakers are increasingly focused on broader risk management and liquidity. Environmental, social and governance (ESG) remain key issues – with ESG considerations likely to grow further in importance and drive strategy. Understanding funding needs, whether from equity investors or third-party sources, remains crucial, particularly in greenfield projects and where assets require significant capital expenditure – with corresponding development protection and rights built into the risk allocation. Given economic headwinds and ongoing legal developments, mitigating political risk and maximising downside protection is also key. From a practical perspective, investors should look to secure strong management teams, with aligned incentives. In parallel, investors are establishing and utilising platforms to scale up investments in evolving technologies and create value.

FW: What challenges typically arise in connection with an infrastructure transaction? How important is it to perform robust due diligence and deploy effective transactional risk management practices?

Stones: Specific challenges vary based on the size of stake, risk profile of the asset and risk appetite of the investor. But fundamentally, investors need to understand key revenue streams and risk factors and seek to maximise downside protection. This is particularly relevant for greenfield projects and where growth opportunities require significant capital expenditure, as well as in asset classes where revenue is predominantly derived from a small number of material contracts.

Miller Gabriel: Infrastructure transactions typically require longer-term investment horizons, given the long lifespan of the underlying infrastructure assets. It is therefore very important to consider macroeconomic conditions and have robust financial forecast models when evaluating such transactions. Infrastructure transactions also involve high costs due to the inherent size and scope of infrastructure projects and the committed ongoing maintenance requirements of underlying assets. During due diligence, companies should thoroughly assess the historical and expected future costs, as well as long-term contracts and commitments. Moreover, infrastructure projects or assets typically involve material environmental impacts and are often subject to a wide range of regulations. Due diligence assessments should include environmental impact risks and mitigation plans, regulatory requirements and compliance history, and any political and community risks.

Vince: Because the payback periods are long – often 20 or 30 years, or more – it is critically important to understand both the terms and complexities impacting the short-term transaction, as well as the broader socioeconomic, regulatory and infrastructure trends that will shape project performance. Failure to execute comprehensive due diligence can result in unexpected risks and delays in financing, constructing and operating an infrastructure project effectively over the longer term. Diligence in a long-term investment in large infrastructure also needs to be ongoing, as the assumptions underlying the viability of the project can change during the course of its development. A large project will involve numerous agreements among numerous entities. A change in assumptions, economics or regulatory landscape, among other conditions, related to one agreement may have ripple effects that impact the viability of the project as a whole.

Lark: The challenges that arise can vary even among the subsectors within infrastructure. Understanding the backdrop of regulatory approvals, particularly in rate-regulated businesses and in businesses with national security implications, is important to minimising surprises in the transaction timeline. As in many other sectors, robust due diligence is critical, and in infrastructure particularly, because it is often the case that much of the value is embedded in hard assets, so on-site due diligence with engineers is frequently needed. In addition, because representation and warranty (R&W) insurance has become a common risk management feature of deals in the sector, as well as many other sectors, the due diligence review should be conducted with the understanding that it will also factor into the underwriting process for the R&W insurer.

FW: What steps can infrastructure companies take to capture the full value-creation potential of a deal? Fundamentally, what elements are key to M&A success in this sector?

Miller Gabriel: In any transaction, the buyer’s value creation and integration strategy as well as post-close activities need to be aligned with the deal rationale and focus on the deal value drivers. In infrastructure transactions, deal value drivers are typically related to realising cost synergies or cost reduction opportunities, protecting long-term demand stability, securing earnings visibility, and defending and expanding market position. Value creation opportunities should be validated as soon as possible, ideally during due diligence. Once validated and agreed upon by the key stakeholders, they should be prioritised and pursued in a deliberate and organised manner post-close. Buyers should also minimise value loss which can come with transactions. In infrastructure transactions, this can involve mitigating risks related to development and construction, operations and maintenance, pricing and offtake, environmental concerns, and regulation, among others.

Vince: Infrastructure companies need to understand the big picture: the details of the good provided, the customer base, cost constraints, potential long-term uncertainties, profitability risks, relevant regulatory agencies and associated requirements, obligations to investors, shareholders and employees, as well as the timeframe and conditions determining return, tax implications and so forth. It also is important to understand whether there are any associated investments that must be realised to make the project work, and if so, who will make these investments. Stakeholder engagement early and often is also a best practice. Additionally, investors need to be patient and flexible, as adjustments and delays are inevitable.

Lark: Successful transactions frequently include two key factors. The first is thorough due diligence, so that the investor knows the investment and can make reasonable assumptions and accurately model the economics to come up with an appropriate price. The second is to have a strong team managing the asset or business after the closing, a team that is able to execute the plan on which the investor’s model is based. Because debt financing tends to be a significant part of the overall financing plan – and often value creation – for infrastructure assets, confirming the ultimate debt financing plan upfront can be very helpful to ensuring the success of the acquisition.

Stones: Securing best value for investors is always paramount. Infrastructure investments, delivered with strong risk management and operational expertise offer potential for steady yielding income, with potential inflation protection, and attractive capital returns. However, given that challenging economic conditions remain, it is important for assets to demonstrate downside protection as well as flexibility to adapt to prevailing economic conditions. Investors should fully understand the underlying asset and key revenue streams, and secure governance rights commensurate with the level of investment to protect the underlying exposure. Given that, ultimately, investors are seeking maximised returns, opportunities for value creation should be identified and developed with executive management, and suitably incentivised. Securing liquidity and exit rights and maximising downside protection are also crucial.

FW: Looking ahead, with persistent headwinds causing tremors in the global economic outlook, what are your predictions for infrastructure M&A activity in 2024 and beyond?

Lark: I believe that the outlook for infrastructure M&A is continued steady growth. Notwithstanding economic headwinds, the investment needed across infrastructure is substantial, and fundraising by investors in the infrastructure sector continues to be strong. I anticipate that these factors will continue to drive M&A transactions for the foreseeable future, and that energy transition will continue to be one of the leading areas for infrastructure investment.

Stones: Infrastructure remains an attractive area for investment. With increasing levels of capital raised by infrastructure-focused funds, 2024 is expected to be a stronger year for infrastructure M&A, despite ongoing financing challenges and valuation disparities. Given the capital available and continuing to flow – and following a relatively slower 2023 – investors are looking or needing to deploy capital, so transactions are expected across the infrastructure market. High-quality assets are expected to be particularly competitive. With increasing ticket sizes, large-scale deals may well be prioritised by the largest funds and asset managers. In parallel, strategic focuses on popular themes including digital infrastructure and energy transition, and newer sectors such as healthcare, should continue to present opportunities.

Vince: In the near term, we will continue to see the investments stimulated by the Bipartisan Infrastructure Act and the Inflation Reduction Act come to fruition, particularly with respect to carbon capture, utilisation and storage, hydrogen hubs and EV charging. These should proceed through the early 2030s. Over the next few years, there should also be an uptick in long distance, high voltage transmission lines. We should also see greater investments in niche technology segments to support these activities. Legislative and regulatory uncertainty may pose stumbling blocks, but decarbonisation goals internalised by companies will continue to drive transactions and investment as businesses seek to green industrial processes, as new technologies emerge, and as electrification becomes more prominent.

Miller Gabriel: Underlying trends in infrastructure around decarbonisation and increased digital transformation are here to stay, and therefore M&A activity is expected to continue. Many economists are predicting a reduction in interest rates in 2024 and beyond, and this in turn should have a positive impact on deal volume. However, only time will tell if the coming headwinds ultimately outweigh socioeconomic and governmental pressure to continue to adopt renewable energy sources.

Seth Miller Gabriel is co-lead of the infrastructure and public-private partnerships (PPPs) team at BDO. For more than 18 years he has been a leader in the PPPs, innovative project delivery and project governance structuring field. He has advised public owners, private sector partners or been the public owner in nearly every jurisdiction active in the PPPs space in the US. He has also advised countless foreign governments and organisations on the creation of PPP government units. He can be contacted on +1 (202) 644 5425 or by email: smillergabriel@bdo.com.

Clint Vince is chair of the energy practice at Dentons and co-chair of the global transportation and infrastructure sector for the US region. He is rated as one of the leading energy lawyers in the US and has directed the expansion of the US energy team into a premier practice that includes professionals spanning the continent coast to coast, offering a full range of services to energy industry clients. He can be contacted on +1 (202) 408 8004 or by email: clinton.vince@dentons.com.

Emma Stones is a partner in the corporate team at Herbert Smith Freehills, based in the London office. She has significant experience advising on complex cross-border mergers and acquisitions, strategic investments and joint ventures. Ms Stones works across a variety of sectors, with a focus on infrastructure, and particularly digital infrastructure, transactions. She acts for a range of clients, including financial sponsors, funds and corporates. She can be contacted on +44 (0)20 7466 2678 or by email: emma.stones@hsf.com.

Frederick J. (Fritz) Lark advises clients on M&A transactions, with a focus on energy, utilities and digital infrastructure. He represents infrastructure funds, utilities and other investors in public and private company mergers, acquisitions, joint ventures, equity investments, and debt and hybrid securities issuances, among other transactions. He has experience advising clients in transactions across a variety of sectors, including energy, power and utilities, insurance, financial services, manufacturing, chemicals and technology. He can be contacted on +1 (212) 547 5450 or by email: flark@mwe.com.

© Financier Worldwide

THE PANELLISTS

Seth Miller Gabriel

BDO

Clint Vince

Dentons

Emma Stones

Herbert Smith Freehills

Frederick J. Lark

McDermott Will & Emery LLP

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