At a roundtable in Sydney fund managers talk to New South Wales treasurer Gladys Berejiklian about how infrastructure deals need to be structured.
Can you please outline the New South Wales government’s infrastructure investment strategy?
Gladys Berejiklian: In the budget we handed down a month ago we allocated A$68.6 billion ($50.2 billion) to be spent on infrastructure over the next four years. On top of that are the proceeds from the lease of electricity distribution assets, which is now underway. This is the largest pipeline we have ever had in NSW and we want to team up with the best and brightest from around the world to deliver on our plans. We welcome partners on the delivery side and the investment side.
There are a lot of opportunities to be explored here and our track record with major transport deals over the past two years shows that we are able to attract large-scale investors and project sponsors from Asia, North America, and Europe. We expect this global interest to continue. We will look to the investment community, particularly our neighbours in Asia, for innovative solutions on how to invest, how to structure our finance vehicles, and how to maximise the returns for our taxpayers.
Tell us more about your plan to recycle the proceeds from the electricity sale?
Berejiklian: We expect to raise about A$20 billion from the lease to spend on infrastructure projects. In preparation, we are currently accelerating the planning and feasibility studies on several projects to make sure they are shovel ready when the proceeds come on to our books. We now have Australia’s largest rail project and largest road project underway and recently we announced our first public-private partnership for a new prison in Northern NSW.
What is the estimated infrastructure backlog in the state? Can you put a figure on it?
Berejiklian: When we came to government in 2011 we talked about a A$30 billion backlog. The A$20 billion in proceeds from the electricity lease will be spent across a 10-year period and we are confident that if we maintain our fiscal discipline and continue to be innovative in how we structure these projects, that we will be able to reduce the backlog significantly.
Turning to the investors around the table, how do you view opportunities in NSW over the coming years?
Michael Hanna: There is a lot to like about NSW, which has become the flag-bearer for other Australian states. It is the most active and is taking the most sophisticated approach to delivering new infrastructure. We like the flexibility that the NSW government is displaying, where every project and funding approach is assessed on its merits. Key ministers within the government understand how the private sector operates and what needs to be done to attract long-term investment funds.
Angela Karl: From an investor’s perspective, it is refreshing to have the opportunity to work with an engaged counterparty, like the NSW government, that is open to different ideas and approaches. Asset recycling is a fantastic concept because our investors like the stability and reliability offered by brownfield assets.
What challenges do you foresee as the government moves forward with its infrastructure plans?
Hanna: The focus needs to be on delivery. There is a significant programme of proposed works and greenfield projects are notoriously hard to keep on track. Timely delivery is ultimately the responsibility of the contractors, but the success of a project also depends on how efficient the government is as a counterparty.
Michael Cummings: Momentum is also important. The private sector wants to see the government committed to a long-term pipeline of deals. We don’t want a situation where there is a change of strategy and they decide to hold on to assets longer or not to recycle them. This would cause the market to lose confidence.
Karl: On balance there is less investor appetite for greenfield exposure versus brownfield assets that have an established income stream and track record. We hope the government continues to offer a mix of investment opportunities to the market, including adding more assets to its asset recycling programme, beyond the electricity transmission and distribution businesses.
Another possible challenge is ensuring that risk-adjusted returns remain palatable to long-term investors. How can this be achieved?
Cummings: There has been a lot of competition, especially at the large-end for the most recent asset sales in Australia, and there is a view that we may be at the top of the cycle. Long-term investors need to be mindful of this when considering if they want to invest or not. When you talk to superannuation funds, who are often the ultimate end investors in these assets, they assess infrastructure relative to other potential investments including cash, fixed interest, equities, property, and private equity. So while over time infrastructure may be more expensive than several years ago, its risk-adjusted returns relative to other investment options may have even improved.
Jordan Kraiten: We have a sole purpose test which is to create the best possible return we can for our members. Our capital is very mobile and can go offshore or to other asset classes. Our members identify with infrastructure and they get pride out of owning part of a toll road or an airport that they use, but with such high prices being paid for assets we have to ask whether now is the right time to invest. We would also welcome other states to follow the lead of NSW and develop some investment opportunities, so that we may spread the demand that currently exists.
Hanna: Superannuation fund money is highly mobile and will go to the best asset class with the best risk-adjusted return. When governments start to talk about selling assets at such high prices it can spook the end investors, making them more cautious about committing to the sector. Not having Australian industry and government superannuation funds, who represent over six million workers, to invest in infrastructure would be a huge loss.
Peter Taylor: Spreads are coming in on all asset classes, whether we talk about fixed income, equities, property, or real assets. Infrastructure is no exception. We are in the middle of a low-rate, low-growth environment and the high prices achieved on recent sales certainly makes people nervous. Recently I have been fielding questions from investors about whether there might be another infrastructure bust like we saw post 2005/6. My answer to this is that the last bust was driven by a global leverage glut when people were using double and triple layers of debt to buy assets. The picture isn’t the same now. However, with every fund manager around the world focused on infrastructure, it is certainly moving out of the alternative space to become more mainstream. A decade ago we struggled to get two consortiums to bid for Sydney Airport and now we get up to six or more consortiums bidding for much bigger deals. There is a lot of equity capital out there.
As infrastructure becomes mainstream what returns can investors expect?
A Cummings: Several years ago it was possible to buy core infrastructure assets with an average return of around 12-13% and the expectation was that some projects could even deliver in the high double-digits. These days, with more deals and more players in the market, core infrastructure returns are more likely to be in the single digits. An investment that pays 12% is now considered a higher-risk core-plus investment, that requires much deeper due diligence before acquisition and ongoing active asset management.
Karl: Risk-free rates are historically very low, so some investors are locking in equity returns that are reasonable on a relative basis but low on an absolute basis. Therefore unless the debt funding on the project has an equal term, which often doesn’t exist for all of the capital structure, they are taking a macro bet. On balance, infrastructure is a slightly higher-risk asset class and will remain that way as the market adjusts to longer-term interest rate norms, so it is important to ensure that any investment is robust to these long-term changes.
Kraiten: As returns compress we have to educate ourselves and our board of directors about the changing market conditions. If you have come to expect a 12-13% return it is hard to imagine taking a 7-8% [internal rate of return] on an infrastructure opportunity. But we are getting the message across and come to the realisation that if we are being offered 14% on an asset it is more likely to be private equity disguised as infrastructure. We also recognise that Australia is a very mature infrastructure market and, in some ways, we are leading the globe in price compressions due to the amount of foreign competition for our local assets.
Is it any surprise, then, that finding institutional investors who want to take greenfield risk is hard. How do we overcome this challenge?
Taylor: It depends on how the projects are structured. At one end we have the traditional PPP model and at the other end we have innovative models like the one used on NorthConnex, where residual values on existing concessions have been used as capital. The key to attracting long-term money to these projects is finding a way to offer continual efficiencies both on delivery and as the asset evolves over time, and through peaks and troughs in consumer demand. The recent Thames Tideway Tunnel deal in the UK used a hybrid PPP and regulatory model that will ensure consumers enjoy the benefits of efficiencies over time. We have to keep looking globally for models that are more attractive to long-term investors.
Karl: The attractiveness of a greenfield project depends on how the risks are transferred. At the beginning of any project the government holds 100% of the risk and, then, as negotiations with the private sector progress, the risk is pushed out to other parties. The best outcome is to push enough of this risk to ensure commercial viability while also keeping the government at the table so it can take the risks that none of us in the funds industry will take.
Kraiten: We recently invested in a greenfield project in Sydney’s Darling Harbour via a 50/50 joint venture with Capella Lend Lease. Greenfield risk can be overcome by aligning yourself with the right long-term investment partners that have a track record in execution. Importantly, we don’t want to take patronage risk. We aren’t in the business of forecasting how many people attend an event or catch a train from point A to point B. We see availability payments in partnership with government as very attractive structures for our members. PPPs for social projects, such as schools and hospitals, often don’t have the scale to attract super funds.
Treasurer, do you have any comments about managing the peaks and troughs over the life cycle of a project?
Berejiklian: We’ve been listening to the market and developing structures that help to balance the risks on greenfield projects. The risk profiles on the WestConnex and NorthConnex projects are very different from traditional projects, with the government bearing a lot more of the up-front risk. And on our light rail and heavy rail projects we have removed patronage risk so the private sector is incentivised by how well they manage the asset, not by how many people travel on the rail services. On the North West Rail Link there are three major contracts with different risk profiles: one for building the tunnels, another for the above-ground infrastructure, and another for the operation of the rail line, which is where the PPP comes in. We realise it is difficult to get one player to raise all of the capital needed for a project and this is a good example of our flexibility.
The funds industry has been hinting at “inverted bids” for some time, whereby the government selects its preferred equity partner first and then construction contracts are awarded. How is this progressing?
Hanna: In many ways these deals are already being done. The A$400 million M5 widening project was an inverted bid type model where the natural, long term owners – IFM, AMP, and Hastings along with Transurban – took a project proposal to the NSW government. We had been pushing this idea for the best part of a decade and not getting anywhere until we were finally able to strike a deal with the current government. The fundamental underpinning of inverted bids is aligning the long-term interests of equity funds with government rather than letting short-term construction interests or other misaligned intermediaries lead the way.
Karl: This is an important point for governments to consider when comparing bids and wondering whether to go with the highest price. We live in a fluid market and the government has a good view on the cost of capital, so the focus needs to be on the true value of a project and the private sector’s ability to offer good stewardship throughout its life cycle. Sometimes there isn’t a lot to be gained by sharpening the pencil that last little bit.
Hanna: True value comes with the alignment of interests. If agreement can’t be reached on who should take which risks then a profit-sharing model might work. This is what we negotiated on the M5 widening project. The deal gives the NSW government and taxpayers a share in the profit over a certain level.
Treasurer, what do you say to investors’ concerns around delivery of the government’s ambitious project schedule?
A Berejiklian: We are always trying to reduce the time it takes to progress a project from a line on a map to an operating service. On one recent PPP we ran the market sounding process and the planning approval process at the same time, allowing us to reduce the lead time by nearly 18 months. We realise that getting our house in order and providing efficient planning approval is key. We now have some very experienced professionals in the Treasury department who know how to deliver efficiently and foster productive engagement with the private sector.
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Would the development of a long-term Australian dollar debt market with decent volumes be appealing to investors?
Taylor: We invest long and at the moment the Australian dollar market only offers short-dated credit, which is why investors go offshore to the US [private placement] market. At the short-end there are plenty of opportunities to access [European Central Bank]-funded lending. The number of European banks lending short-term money into Australia is astounding.
Karl: Despite this, yes, we would be interested in seeing a long-term debt market develop here if the price is right. The demand is there.
Tom Mazzaferro: Our research tells us the interest is there and not just from superannuation funds but from retail investors and self-managed super funds. I have spoken directly to many high-net-worth investors who want fixed-income exposure to infrastructure assets. Australia’s commercial banks can play a role in this market combining lending at the short end with arranging long-term debt from non-bank investors.
Kraiten: As prices on the equity side get bid down, the attractiveness of fixed-income securities increases. But the idea of having a 99-year lease on a port asset is much more appealing than a five-year bond. After doing all the due diligence on an asset, we don’t want to be in a position where the money comes back after five years. Only when tenors get out to 15 to 20 years would we be prepared to seriously consider investing the time to review the investment opportunity.
Returning to the equity side, how difficult is it for Australian funds to compete with offshore funds on deals?
Cummings: Good question. As vendors, state governments look to maximise returns for taxpayers, so how do they compare a bid from an Australian fund, which might represent the interests of local superannuation members, versus a bid from overseas, which may be offered at a higher price?
Taylor: This is a big political challenge for governments, particularly when the highest bid may be from a consortium that has single-party foreign control.
Berejiklian: Attracting competitive bids is always going to be important for us but we want quality bids too. We like to support local firms but we want the best outcome for our customers and our taxpayers and often that means bringing in world-class contractors and fund providers. Of course, we aren’t just focused on price. Our evaluation teams are tasked to respond in this way.
Do foreign firms see the benefit in partnering with local firms or do they like to go it alone?
Taylor: When we bought Newcastle Port in 2014 we partnered with China Merchants in a 50/50 joint venture because we thought both parties brought unique and specific skills to the table to make the bid successful and balanced the political considerations.
As more mum and pop investors wake up to infrastructure will superannuation funds be compelled to invest deeper into the asset class?
Kraiten: We are experiencing a surge in demand for exposure to real assets that carry a nation- building hallmark. Last month we launched a new investment option called IFM Australian Infrastructure which gives members access to a portfolio managed by IFM. Within a week of launching, and with no direct marketing, we gathered almost A$1 million in funds, which is significant when you consider the average balance of our accounts is approximately A$18,000. Members like the idea of owning tangible assets that they use in everyday life, whether it be electricity and water utilities or toll roads and public transport.
So which brownfield assets currently hold the greatest appeal?
Taylor: After the current round of privatisation my next pick would be existing water assets. There is a chance for Australia to mirror some of the large-scale water deals done in the UK. Water supply is possibly politically sensitive, so we could start with waste water, which is a sector that needs a lot of investment amid tighter regulatory focus.
When will the NSW government be ready to announce the next assets earmarked for its recycling programme?
Berejiklian: I’m not making any announcement today about what assets might be leased or sold. I will flag, however, that we have introduced a new category of bid which we are calling “unsolicited proposals”. This is where the private sector can come to us with new projects that they have identified as investible or existing assets that can be run better under a public-private model. We are inviting you to come to us with a fresh proposal.
