Australia infrastructure: Size matters

"You so have to scratch your head and wonder how you could ever get comfortable with a price so high," says Tim Bryan, a partner at KPMG Australia.

The topic is the A$10.26 billion ($7.5 billion) valuation for New South Wales government electricity network operator TransGrid, which was recently sold to a consortium including Hastings Fund Management, Caisse de dépôt et placement du Québec (CDPQ) and the Abu Dhabi Investment Authority (ADIA). But the observation could equally apply to any of the large-scale infrastructure privatization deals completed by various Australian states have pursued over the last half decade.

From the $3 billion sale of Queensland Motorways to QIC in 2010 to Transgrid, with the likes of Port Botany & Kembla - a $5.3 billion acquisition in 2013 by IFM, ADIA and AustralianSuper - in between, investors have shown a readiness to write big checks for brownfield assets.

A lot of the smaller or mid-tier infrastructure players are now thinking about not participating in those auction processes that really are a cost of capital shootout - Tim Bryan

The high prices are welcome news to the sellers, of course. Since 2013, starting with the sale of Port Botany & Kembla by New South Wales, state governments have looked to sell off brownfield assets in order to fund construction of greenfield projects. However, despite the enthusiasm from all parties involved in such transactions, the valuations have left some members of the investment community in danger of being squeezed out.

"A lot of the smaller or mid-tier infrastructure players are now thinking about not participating in those auction processes that really are a cost of capital shootout," says Bryan. "They're starting to talk about how to get further up the risk curve in terms of sourcing deals and assets with a little bit more operational risk attached to them."

With privatized infrastructure assets expected to continue to hit the block, investors with pockets deep enough to afford them and investment strategies to make use of them will continue to take advantage of the opportunities as they come up. Others must find more creative ways to turn the deals to their advantage.

Patchy deal flow

Despite the interest in Australian infrastructure privatizations, the deals have been relatively few and far between. AVCJ Research reports only nine such transactions in the last 10 years, though the majority occurred in the last five. These data do not include the TransGrid sale.

Valuations have climbed much faster than the rate of deals. The three privatizations before 2010 had a combined valuation less than the smallest two deals since, and those two were the only transactions for less than $1 billion in that time period. In total the nine privatization deals since 2005 represent over $14 billion in capital.

The relative rarity of infrastructure deals is the commonly accepted reason for their high price, as infrastructure-focused investors compete to take advantage of assets that are available. As for the rarity itself, that is commonly blamed on the hesitance of governments to pursue privatizations, due to fear of backlash from voters - as was demonstrated recently in the case of Queensland.

"Probably the major disappointment in 2015 for many infrastructure investors is that none of the Queensland privatizations happened," says Mark McLean, Australia head for Morgan Stanley Infrastructure Partners. "They didn't happen because the Queensland government unexpectedly lost the election - partly because the public was not convinced of the benefits from the privatizations."

Skepticism is an understandable reaction among voters considering the sale of public infrastructure assets, but it does not fix the dilemma that many governments face of having to pay for maintenance of existing assets while raising money to build new ones. The asset recycling programs may represent a way around this political risk by linking one to the other.

However, there are continuing questions of which investors will be able to take advantage of the opportunities. Infrastructure privatizations tend to feature big ticket players like sovereign wealth funds, superannuation funds and pension funds. Many of them have far more capital than places to deploy it.

"Capital availability has never been a problem here, it's just that the opportunity to deploy has always been quite patchy and limited," says Michael Hanna, head of infrastructure for Australia at IFM Investors, which participated in the Port Botany & Kembla deal and the sale of the Port of Brisbane in 2010. "If you're not willing to develop the opportunities to absorb that capital, that capital is highly mobile, and it will go to where it can find a home."

Not only resources separate these large players from the mid-tier or low-cap infrastructure-focused funds. A sovereign wealth fund or pension fund does not need to exit after a five year holding period, unlike a private equity firm; this makes these players well-suited to a long-term asset like infrastructure.

Moreover, the size of the larger players actually forces them into a dominant role in many cases, simply because their commitments have to be large in order to ensure healthy returns. "The larger players ultimately need to deploy capital, and it's very difficult to do that by writing smaller transactions that may be riskier," says KPMG's Bryan. "They really need to be playing in these large auction processes with $10 billion price tags attached in order to deploy capital."

The thought of continued high valuations raises the prospect of a bubble forming. In some ways the thought of a potential future correction could be a relief to the smaller investors. However, industry observers believe that a crash is unlikely.

"There's quite a degree of confidence in that high quality investors are the ones winning these bids," says Bill Napier, partner at Jones Day. "These are substantial funds, and some private investors, both local and offshore. And they know what they're doing when they're bidding for these assets, they're paying prices after full due diligence, and the assets are well prepared."

Innovative approaches

Smaller players that want to stay involved may be able to find ways to coexist alongside the giants. One example of this is IFM, which set up an infrastructure fund with no end date. The vehicle, currently in its 20th year, allows a longer-term outlook. This longer tenure has allowed IFM it to participate in deals as a partner to the likes of QIC and ADIA.

"Typically we're not working with a closed-end fund or a listed entity that has a short-term, yield-driven focus, or is looking to exit within a discrete period of time," says IFM's Hanna. "We are looking for other investors that are looking to invest for decades, not years."

Funds could also identify a space to operate in the years following the initial privatization, as well. While infrastructure assets in principle are long-term holdings with little action after the first investment, in practice there are opportunities that do come up.

The Port of Brisbane sale is one example: Three years after purchasing a 26.7% stake alongside the other investors, Global Infrastructure Partners (GIP) sold its 26.7% interest to CDPQ. In another case, QIC sold its entire stake in Queensland Motorways to a group of investors including ADIA in 2014, four years after purchasing the company.

"Even in assets that have been bought by a consortium of superannuation funds and pension funds, all of whom theoretically have an indefinite time horizon, invariably over the course of five or 10 years after a deal is done, there are shareholdings that are bought and sold. There's always trading," says Morgan Stanley's McLean.

It is not uncommon for an investor that wants an infrastructure asset to hold off on participating in the privatization deal itself. Taking part in an auction is a long and expensive process, with a great deal of effort needed for due diligence; a firm that loses out on the auction can find itself on the hook for millions of dollars in fees with nothing to show for it. Skipping the process can leave the interested party with its funds intact and a clear field on which to plan its eventual takeover offer.

The winning investor can take advantage of this tendency as well. Ross Israel, global head of infrastructure at QIC, notes that some asset buyers incorporate the chance of a post-acquisition offer into their plans for the holding.

"In some cases the buyers have a set timeframe for delivering a business plan, de-risking an asset, getting an uplift in value and then having the discipline to sell, just as a matter of course, or because they are re-weighting portfolios," Israel says. "They can find buyers because the asset has been de-risked against what they might have perceived as the risk return when the asset was privatized or sold."

Risk is a factor that may weigh on the minds of investors, particularly those that consider greenfield or less developed brownfield assets. One of the most notorious cases is Sydney's Cross City Tunnel, a toll road project that was launched as a public-private partnership (PPP) in 2005 with A$680 million in debt and equity financing.

Traffic volumes on the completed road never came close to meeting the optimistic forecasts made before the construction. This was a problem repeated by several PPP road projects in the early to mid-2000s, and like most of them, the Cross City Tunnel was never able to pay back its investors, eventually entering voluntary administration in 2013.

"Certainly pre-crisis, there were a large number of greenfield road deals," says Morgan Stanley's McLean. "Many bidders put a lot of pressure on their traffic forecasters in order to be competitive in these deals, which was a factor in traffic forecasts on greenfield toll roads being too high."

The uncertain nature of greenfield investments, which must rely on predictions that can be driven by wishful thinking rather than real data, contrasts sharply with the established nature of established brownfield opportunities, which have a history that investors can judge prior to making a decision. Again, asset-recycling programs are one way through which investors can acquire assets that are perceived as proven and reliable, while letting state governments take the risk of new construction.

No let up

With interest among investors remaining high, several industry watchers believe that further privatizations are virtually guaranteed. States that have seen their own actions succeed are likely to seek more, and those who see others succeed will probably want to get in on the action themselves.

"There are almost always six or seven true indicative bidders for a business that's being privatized," says Jones Day's Napier. "The processes are used to handling six or seven indicative bidders, reducing them to a field to go forward to final bid with the announcement of a winner then."

Along with expanded offerings by state governments, Australia's federal government is also a possible source of deals, as the nation's leadership manages its own class of railway assets. The federal government is already providing financial support to state asset recycling programs, and instituting its own program would allow it to pursue similar goals.

For the small-cap and mid-tier infrastructure investors, meanwhile, the struggle to stay relevant in a world catering to giants will continue. Funds will either need to find a way to adapt their processes to find rewarding opportunities, or cede the arena and seek investments elsewhere.

"I've even had a few clients tell me they are thinking about speaking to our private equity guys to see what deals they're currently sourcing," says KPMG's Bryan. "They may start to think about getting up towards that risk profile, because there's just no point playing in these auction processes that are heavily competitive and require very low cost of capital and returns."

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• Topics
• Infrastructure
• Infrastructure
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• Australasia
• Infrastructure
• Australia
• buyout
• Industry Funds Management
• QIC
• Morgan Stanley