Real assets: the widening search for stable returns

July 2019 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

July 2019 Issue

Tech and data-driven M&A grabs headlines, but unprecedented levels of fundraising in 2018 demonstrated the continued attractiveness of real assets such as infrastructure, energy and real estate. In an uncertain world, the predictability of real asset returns has renewed their appeal for a broadening range of investors. With developed infrastructure markets perceived as less certain, institutional investors are looking further afield for opportunities. Competition for assets is increasing, with new players entering the market. Increasing competition requires investors to have well-defined strategies and an ability to maximise the attractiveness of deal terms. Some of the notable trends and opportunities are outlined below.

The search for stability

In the hunt for long-term revenue streams at acceptable risk levels, investors are seeking to invest record-breaking amounts of capital. These investors include large corporates and traditional private equity players with new dedicated infrastructure funds. As demand outpaces supply in developed markets, high multiples for assets have led investors to broaden their geographic horizons.

Investors from across the world are participating in competitive sale processes for sought-after assets. Consequently, local and regional market norms regarding deal terms are being challenged and are becoming more consistent across geographies. In Latin America, for example, pricing mechanisms and liability regimes are becoming more like those seen in developed markets.

In addition to stable returns, investment in certain sectors, including offshore wind and senior living, has been driven by other factors, such as changing demographics and governmental policies designed to encourage the development in particular markets of certain technologies. Governments are increasingly active in driving infrastructure investment. The US has doubled the budget and expanded the investment scope of the International Development Finance Corporation (formerly known as the Overseas Private Investment Corporation or OPIC) and China has made significant pledges to its ‘Belt and Road’ project.

2018 saw a surge in government scrutiny of transactions aimed at protecting sensitive or critical assets from foreign ownership. This trend is likely to continue as laws to strengthen foreign direct investment regimes in the US, the European Union, the UK, Germany, France, the Netherlands, Hungary, Switzerland and Australia were passed or considered throughout 2018. Governments are increasingly scrutinising deals, not only on the basis of buyer nationality, but also on the wider concern that a target’s technology and research and development (R&D) might not be maintained. All investors in tech-related infrastructure should take note.

Opportunities in 2019

Kenya and Uganda have each launched billion-dollar toll-road public-private partnership (PPP) projects, which are currently under tender. Both countries have significant infrastructure spending deficits, which have been outpaced by economic growth and development, and which cannot be met through public finance alone due to existing levels of sovereign debt. As trade with land-locked neighbours in East and Central Africa grows, road projects will become increasingly critical to the progress of these economies. Considerations for potential investors will include the use of political risk insurance and guarantee products to protect revenue streams and guard against currency devaluations.

Because of its well-established political and predictable legal systems, Europe remains attractive for overseas real estate investment, particularly in the logistics market, which is one of the hottest real estate sectors. The growth of e-commerce and rampant supply chain reconfiguration will continue to drive demand for the logistics space in the coming years. Logistics and industrial portfolios are expected to come to market, as well as opportunities to develop new sites close to large cities (‘last mile logistics’). Successful investments will include joint ventures with key operators, platform acquisitions of assets with management teams, and co-investment opportunities with asset managers.

Australia will continue to present attractive M&A opportunities as its five-year Asset Recycling Initiative scheme tails off at the end of 2019. This may include secondary trades in recently privatised transmission and distribution networks, listed energy companies being taken private, and a smaller number of privatisations, including back-up power generators.

In Brazil, president Bolsonaro announced last year that he wants the country to attract up to US$20bn from privatisations through concessions and grants, including US$1.9bn through privatising 12 airports, four port terminals and several railways. This began in March with the successful auction of the concession rights to three airport blocks. Bids for the three regional blocks came in well above the initial asking price and the government will collect fees of around US$630m, about 10 times the minimum initial fee. The Brazilian government recently announced a new block of 22 airport concessions for auction this year and a final round with approximately 20 airports in 2022. Bidders will be interested in the administration’s identification of the relevant assets, its ability to bring them to market and its attitude to private sector involvement, including bidder rights, concession extensions and restrictions on international investment.

Taiwan has set aggressive renewable energy targets, including the development of 5.5 gigawatts of offshore wind to be fully implemented by 2025. It has awarded gigawatt level projects and is now the fastest moving commercial offshore wind market in the Asia Pacific region. The programme in Taiwan is supported by rewarding feed-in tariffs, which have attracted interest from leading offshore suppliers and international investors. New entrants will need to familiarise themselves with the developing legal and regulatory framework around tariff and offtake arrangements.

The role of financial investors in debt financing

Since the global financial crisis, there has been a steady increase in non-bank investors, such as insurers, pension funds and debt funds financing real assets. While this phenomenon is much more pronounced in the US, the UK and parts of Europe, it is anticipated that investor and borrower demand will also drive this trend in other markets. In addition to their own quests for diversification, non-bank investors have been encouraged by governments and borrowers to provide debt financing, as both seek an alternative to bank debt to ensure funding availability. For some, this has meant adding infrastructure to longstanding real estate portfolios.

There is, of course, a natural fit between real assets and institutional debt. Generally, the significant capital cost and long pay-back period means longer-term debt is preferred, which matches institutional requirements for long-term yield. The pricing ‘sweet spot’ for institutional debt is usually at a longer maturity than the bank equivalent. The liquidity provided by the institutional debt market is particularly vital for large projects, and most large real asset financings now approach institutional investors alongside banks. The number of interested institutions continues to grow, with many investing in focused real asset teams to originate and manage investments.

The idea that institutional investors will not take construction risks has frequently been shown to be incorrect, with many willing to take risks across a range of sectors. Mature sectors such as roads are well-covered. ‘Build to rent’ residential property, where construction risk is mitigated through a solid business plan from the developer, is also a growing area.

The UK’s Hornsea offshore wind financing, the largest renewables financing globally to date, is another construction phase project, albeit with the benefit of Ørsted support, which involved a number of institutional investors committing senior debt alongside a bank group and a pension fund providing mezzanine finance. Offshore wind is a relatively new sector for institutional investors, but they have been driven to the sector by deal volume and the potential for yield. In addition, the sector is maturing, with developed supply chains, proven technology and developers having shown an ability to manage risk, and regulated subsidy regimes providing the contracted cash flows which investors seek.

Looking forward, as subsidies across Europe tend to be reducing, the question remains whether financial investors will be prepared to bear merchant risk, or if the corporate power purchase agreement market will grow to provide sufficient secure cash flows to support the huge investment needs of renewable energy projects.

As financial investors look to put their capital to work in different markets, financing trends from one market quickly transfer into others, particularly within regions such as Europe. For example, in some large real estate financings, ‘covenant-lite’ loans have been adopted from the leveraged market. Institutions have also demonstrated the ability to provide financing for acquisitions on a ‘certain funds’ basis, fixed pricing during bid processes, and phased drawdowns for construction projects. With appetite for large commitment sizes and increasing flexibility, these institutions look set to maintain and extend their market positions.

Five practical tips to get the deal done

New entrants to the market should consider investing in different levels of capital structures or investing alongside strategic players as a way of minimising exposure to the risk of new geographies or asset classes. Successful investors continue to create ‘platform’ assets to maximise return on time invested or, where the project size is small, create scale while ring-fencing liabilities.

Investors should consider the impact on the transaction timetable and sale process of multiple foreign investment, regulatory and antitrust regimes. They should also consult advisers to address the sharing between buyer and seller of transaction risk and, where applicable, construction risk.

Longer-term holders should develop a strong understanding of the wider political landscape, not just the current regulatory regimes, including how that landscape may affect the pipeline of new assets available for development and acquisition, and the ability to successfully exit.

Sellers running competitive auction processes do not expect to bear buyer risk. Successful buyers, on the other hand, adapt their approach on issues to seller expectations, balancing their desire for protection, while maximising the attractiveness of deal terms.

Management teams with specialist knowledge, and with relationships with regulators and local stakeholders, remain at a significant advantage. In the context of competitive auctions, winning management support through appropriately tailored incentivisation can be crucial. For longer-term holders whose exit horizon may not be aligned with management’s, this may mean putting in place synthetic exit arrangements for management that minimise misalignment and funding-related issues.

David Brinton and Thais Garcia are partners and Erika Bucci is a counsel at Clifford Chance. Mr Brinton can be contacted on +1 (212) 878 8276 or by email: david.brinton@cliffordchance.com. Ms Garcia can be contacted on +1 (212) 878 8497 or by email: thais.garcia@cliffordchance.com. Ms Bucci can be contacted on +1 (212) 878 8142 or by email: erika.bucci@cliffordchance.com.

David Brinton, Thais Garcia and Erika Bucci

Clifford Chance