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

Infrastructure Investing

A presentation to the Canadian Institutional Investment Conference
by Marcus Turner
October 19, 2011

© 2011 Towers Watson. All rights reserved.

Background

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What is infrastructure?

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

SOCIAL
ECONOMIC INFRASTRUCTURE
INFRASTRUCTURE
TRANSPORTATION UTILITIES COMMUNICATION GOVERNMENT
SERVICES
Airports Electricity Wireless Towers
Hospitals
Bridges Gas Cable
Prisons
Railroads Water Satellites
Transport
Toll Roads Bio Fuels
Schools
Ports
Social Housing


Stages of investment

ECONOMIC INFRASTRUCTURE SOCIAL INFRASTRUCTURE

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

Maintain and Operate: Consortium collects Maintain and Operate: Private Public
revenue from the asset for a fixed period of Partnerships (P3s) are typically partnerships
time (often a very long term lease) between the private and public sector
 Provision of services typically remains the
 User fees typically inflation indexed
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


Types of infrastructure

GREENFIELD BROWNFIELD
 Projects are new developments  Infrastructure has existed for some time

 Relatively high level of business risk  Predictable income stream (often linked
including construction risk, uncertain to inflation)
growth rates and early term operational
risk
 Typically no cash flows until about fourth
or fifth year (J-curve effect)

 Typically have greater capital  Moderate capital appreciation is possible
appreciation opportunity (usually through capital improvement),
but mainly purchasing long term cash
flow
 Investors are expected to be  Return expectations are lower than
compensated for the risks associated with greenfield investing although income
new development
projections are more reliable


Why Infrastructure?
Manager return projections are in the mid to
Potential for attractive equity- high teens, but even 8% to 10% would
like returns, but with much compete well with equities over the long-
lower risk term. Attractive premium (>4%) over bonds
backed by tangible assets

Long-term investments in regulated and/or
Reliable cash flow and less contracted industries with mostly inelastic
sensitive to economic user demand
downturns

Cash flows mostly insensitive to changes in
Inflation Protection 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
Diversification
inflation and low correlation with equities
and nominal bonds. Complementary to
real return bonds


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  Experienced managers/consultants are essential to budgeting
impair projected returns process as is robust sensitivity analysis

Political Risks: Political instability may lead to asset  Managers can invest with local governments and other domestic
repatriation. With Social Infrastructure there is a risk the partners having ex-policians as part of the consortium to help
government counterparty may default on its obligations navigate political process
 Experienced managers can use established relationships to
manage risk more appropriately
Interest Rate Risks: High degree of leverage exposes  Seek longer term debt financing
infrastructure to adverse interest rate movements
 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  A currency hedging program can mitigate this risk
revenues in currencies other than the investors domestic
currencies.
Liquidity Risks: Investment locked-up typically for 10 - 20  Proper legal documentation can define the terms of entry and exit
years, although cash flows are received during this period
 Liquidity is a lower order consideration as infrastructure is a long
term investment and many pension plans may not need to be fully
liquid


Types of Infrastructure


What do we want from core economic infrastructure
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 monopolistic
Operational and robust

Realistic and sustainable High single digit, risk-adjusted returns
target returns Significant 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-taking
eg. No carry/or carry on yield

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

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

PPP / PFI – too good to be true?
Lowest risk Public Private Partnerships (PPP) / Private Finance Initiatives (PFI) are concessions
assets within provided by the government or a quasi-governmental agency to provide an essential
infrastructure
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


PPP/PFI – the risks
Highest Stage Risk How are these risks mitigated for our clients
risk
Bidding risk The risk that either you do not win the project in Our clients usually are not involved in at this
the competitive process undertaken or that the stage
project you are bidding for does not even go
ahead
Construction The risk that there are cost over runs in the Water-tight contracts, where payment is only
risk building of the asset, or that the asset is late provided once the asset is complete. Penalties
being delivered, resulting in 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- The risk your sub-contractor goes bust, and the Credit analysis is key. However, most contracts
contractor cost to replace them is greater than what has have a 5 year review mechanism to ensure that
risk been budgeted. affordability is maintained over time
Financing As highly geared projects, there are risks that This is a real risk, however given the
risk small deviations in cashflow can significantly management of the other risks discussed here,
affect equity holders returns deviations of cashflow are usually minimal.
Some level of buffer is provided within the capital
structure
Deduction The risk that the concession holder does not Water-tight contracts, where these deductions
risk perform the required duties at the standard are passed onto sub-contractors. Credit analysis
required, resulting in deductions. is key
Lowest Usage risk The risk that the asset, once constructed, is not Not relevant to the equity holder, this risk is
risk needed anymore taken by the government


Does listed infrastructure provide core infrastructure
characteristics?
Stability of earnings - 

Appropriate use of leverage - 
Sector Gearing1 Gearing2 % Hedged

Toll Roads 46% 51% 69%

Airports 37% 44% 90%

Ports 14% 23% 60%

Strong yield - 
Source: Brookfield 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 Value
2
Debt to Market Enterprise Value (market capitalisation used for Shareholders Equity)

Source: Brookfield

Does listed infrastructure provide diversification
Does provide Limited data, but a longer history in Australia
some
diversification

Timeframe Better diversification before financial crisis
dependant
Time period Correlation
Average 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

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


Evolution of the Market

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Market opportunity

 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)

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


Fund-raising

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

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

Source: Prequin

2011 sees a A number of high profile managers coming
number of back to market
managers coming
back to market


Infrastructure has shown stability of earnings over time
Robust asset Over the 2008/2009 period, an environment where overall economic performance was generally poor,
performance infrastructure assets generally produced robust operating performance

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

Poor structures However a number of assets in private fund ownership, despite these robust earnings, have experienced poor
has harmed some equity returns due to poor (or inadequate) capital structures. The use of significant leverage and optimistic
equity returns 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

Why is now a good time to commit to infrastructure

We are still in the The capital structures of infrastructure assets have come
early stages of de- under significant stress, post crisis, as debt providers,
leveraging in the have become less willing to provide cheap credit.
sector.
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:

• recapitalizations (including public-to-private
transactions and management buy-ins
• distressed sales of assets (rather than sales of
distressed assets)
• mergers and termination of funds
• discounted secondary units in pooled funds
Source: Aladdin

Other current • Potential for strong inflation linkages in a period where
infrastructure pros inflation may be an issue
and cons include: • 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
• Asset-backed debt holders may own foreclosed assets
but lack the expertise and capital necessary to
maximise recovery


Pricing of assets offers opportunities
Asset values Infrastructure equity was marked down heavily over the financial crisis. The graphic below demonstrates the
have historical valuation of infrastructure assets (as represented by the Brookfield Dow Jones Index) in the listed market.
rebounded off
financial crisis
lows…

Source: Brookfield

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


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

Source: Berwin
Leighton Paesner

Debt markets seem to • Lending has resumed, but is more expensive than pre-crisis
be responding more • As confidence returns to the market, financial costs are improving
favourably to
infrastructure
projects


Infrastructure Portfolio Construction


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.

Client
Stage 1:

• Client must identify underlying managers

Infrastructure manager

Stage 2:

• Manager must identify underlying assets
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


Infrastructure fund life cycle –
Timing investment
Look for good (‘cheap’) opportunities to buy companies
“J curve” impact as investments sourced, fees paid on commitments

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

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


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%


Fund structure

 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

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


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.


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


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%)


Summary: Pros and Cons of infrastructure

Advantages of infrastructure Disadvantages of infrastructure

 Returns can be driven by:  High fees

 Equity risk premium – albeit  Illiquidity
muted
 Regulatory/political risk
 Illiquidity premium Infrastructure is
challenging, but  Concentration risk
 Activism premium worth considering:  Investment risk – this is not a bond
 Information premium substitute
- diversification
 Diversification benefits: benefits  Governance challenges
 Less sensitive to economic - attractive returns  Selection risk
cycle than with equities
- stable cash flows  Unfamiliar vehicles
 Low expected correlation with
other assets - inflation protection  Speed of decision-making

 Liability ‘matching’  Managing cash-flows

 Generation of reliable cash  Data problems
flows which are often linked to  Monitoring managers
inflation (depends of type)
 Managers may have conflicts
 Long duration (although of interest
depends on vehicle used)


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