Indonesia infrastructure: Proceed with caution

When Singapore-based mezzanine provider UOB considered investing in an Indonesian coal mine concession, one of its first steps was to contact the owners of the license. That proved easier said than done. It wasn't that nobody had the license; rather, multiple people did, thanks to Indonesia's unwieldy regulatory bureaucracy.

"The district level gave one, the province gave one, and the central government also gave a license," Wee Yap Yeo, head of UOB's mezzanine capital unit, recalls. "They actually licensed the same coal mine to three different companies. So they had to work out who was the real owner."

It is generally agreed that Indonesia's electrical grid, roads and ports are in serious need of improvement. The government has promised a massive boost in infrastructure investment, and it is also taking steps to make the country more attractive to foreign investment.

However, despite this consensus for upgrading, Indonesia's still-cumbersome bureaucracy and fears of political instability make private equity investors skeptical about getting involved in the infrastructure sector. Many feel more progress must be made before the government's growth goals can be achieved.

Promises, promises

With all its shortcomings, the sector does not suffer from a lack of projects. In his first budget since taking office last year, Indonesian President Joko Widodo proposed a record $22 billion in infrastructure spending in 2015. The government is only part of the solution to years of neglect - it will contribute only 30% of the total target. Widodo intends for the rest to be made up by foreign investors, and has appealed for such investment on his trips abroad.

Firms that take him up on his offer can choose from a variety of options. Toll roads, power plants and port facilities, especially important in an archipelago nation, are all up for modernization. From 2007 to 2014, the World Bank has consistently ranked Indonesia far below neighboring Malaysia, a nation with a broadly similar geography, in terms of quality of port infrastructure.

All of these projects will need infusions of cash from foreign investors - including the likes of CapAsia, which targets infrastructure projects in emerging markets. The firm is currently investing in Indonesia out of its Islamic Asia Infrastructure Fund, focusing on smaller projects that have been overlooked by the larger market. In its current portfolio is a significant stake in an operator of toll roads, along with a smaller investment in a telecom infrastructure company. The firm is also considering companies in the energy and transportation sectors.

"We are typically not chasing large, headline-grabbing projects that the government may announce, or other strategic players may be following," says Devarshi Das, co-CEO at CapAsia, who manages the Islamic Infrastructure Fund L.P. and the CapAsia ASEAN Infrastructure Fund III L.P. "The space where we operate is typically at the lower end where, maybe, an investment bank has not tracked them, or maybe it's too small for them to consider."

Saratoga Capital is another private equity firm that has made headway in Indonesia's infrastructure sector. Infrastructure is not the Jakarta-based GP's sole area of focus but one in which it expects to be increasingly active. Saratoga also has highways in its portfolio, having participated in a debt financing round for a toll road operator alongside OCBC's mezzanine unit.

CapAsia and Saratoga aside, Indonesian infrastructure remains a tough sell for most private equity firms. Typically a project cannot deliver returns right away; power plants and port facilities, for instance, may need several years of construction before they can begin operations. Toll roads offer a quicker return since a completed section may be opened and start generating revenue before the other sections are finished. Investors may also consider selling an asset prior to completion of construction, though realizing a profit in this way could be difficult.

This is not to say that infrastructure is a losing bet for PE firms. But it does require a different approach than other sectors. CapAsia maintains an active role in its investee companies so that they can stay competitive in the constantly changing market.

"Typically our most successful partnerships have resulted in scenarios where we were able to offer something more than just capital to growing companies," Das says. "This could be in the form of assisting them in improving their capital structure and technical know-how in specific sectors. In infrastructure, and in particular Indonesia, project-level debt is a key component, and we can help optimize the senior debt, as well as any additional layers of capital."

Sourcing deals is another area where firms have to be prepared to work hard. CapAsia and Saratoga both originate their deals through personal connections. For example, Saratoga's $112 million purchase of a majority stake in electricity producer Medco Power International came about through the firm's relationship with the company's owners. However, networking is no substitute for proper due diligence.

In addition, firms need to think about the kind of LPs they want in their funds. Due to the time management circumstances of infrastructure investments, investors have to be comfortable waiting longer for payback. Also, the returns that funds like CapAsia and Saratoga get, while respectable, are not at the same level as some of emerging markets private equity's more spectacular successes. On the other hand, steady returns and reliability hold their own attraction for certain kinds of investor.

"The yield on infrastructure projects is very fixed income-like. It's an 8-9% IRR, at most 10%, on the equity," says Mohammad Afdal Pamilih, president director at Danareksa Capital. "Some investors like this because they know that it is long-term and it provides stability, and they're not very bothered by the return. So there are pockets of investors who are looking for this."

One way of improving returns and making infrastructure investments more attractive is through structured financing. This was the objective in Saratoga-OCBC toll road deal: to use a mezzanine structure to provide an equity-type return. CapAsia is also familiar with mezzanine facilities - with or without equity-like kickers - and a variety of other devices such as common equity, preferred shares convertible products.

"If you are a private equity investor, you have to be prepared and have the flexibility of using different types of products and structures to mitigate the risks," Das says. "At the same time, in a lot of cases you find valuation-expectation gaps, and so you may have to introduce earn-out structures or other sort of ratchet structures to ultimately get to a common middle ground with the counterparties."

Regulatory problems

Despite the best efforts of fund managers, investing in emerging markets does present significant risks that investors must take into account. For Indonesian infrastructure projects in particular, operators should consider that a sudden change in government could lead to new priorities and policies. In some cases, projects that seemed well in hand have been delayed, or cancelled outright.

An example of this difficulty is the Cilamaya port project, launched in 2010. The previous administration had planned to build the port in West Java to ease traffic at Jakarta's Tanjung Priok port, which handles about two thirds of the country's maritime traffic. The administration had expected to raise about half of the needed $2.6 billion from foreign investors.

However, when Widodo took office, the project was put under review, and earlier this year the government announced that the port would have to be relocated, citing concerns about its proximity to offshore oil and gas facilities. Now a new location will have to be found, which means several more years of feasibility studies and planning.

While the government considers the safety benefits worth the delay, it means investors that committed money to the project have to wait even longer to see a return - and a delay of this kind could be disastrous for private equity firms in particular, which normally need to see a return in a time span of less than a decade.

This unpredictability is seen in another part of the planning process: land acquisition. Until recently, Indonesia didn't have a comprehensive eminent domain policy whereby the government can compel landowners to sell their property for the benefit of public projects. Individual landowners have the final say and if some are not willing to sell, a project may have to be relocated. For some projects, such as roads, this can be especially burdensome, given the number of properties a road might cut through.

"When someone builds a toll road, you've got to negotiate individually for each owner to buy all the properties you want," says UOB's Yeo. "And if you have, say, 1,000 individuals, it's not easy. If you get 950 signed, but the 50 stuck in the middle refuse to sign, then you've got a problem."

Attempts to ease the burdens of land acquisition have had mixed results. The 2012 Land Law allowed the compulsory acquisition of land for projects in the public interest, provided that a reasonable amount of compensation was paid. But investors have seen little benefit due to extensive grandfathering of existing projects.

Earlier this year Widodo announced new regulations to simplify acquisition. Two major revisions have attracted praise from investors. First, all projects, both new and existing, will be subject to the new law - previously, existing projects that had obtained more than 75% of the required land were governed by the previous 1960 regulation, while those that had less than 75% had to start over under the new one.

Second, private sector companies can now use their own money to pay for land, rather than waiting for the government to disburse the funds, a measure that is expected to speed up the process. They will be reimbursed by the government once the purchase is complete.

Widodo's actions have been welcome, but they highlight another common issue with development in Indonesia: the complex, often contradictory web of regulations. Developers have to answer to bureaucrats at several levels of government, from the national down to the city level, a burden due in part to the decentralization of power following the fall of Suharto in the 1990s. Regulators, for their part, have to construct policy based on laws passed by multiple legislative bodies, which often conflict and are in any case likely to be quickly replaced by new laws.

Presidential decrees like Widodo's land acquisition announcement can help to smooth out these areas of conflict, but they create their own layers of complexity as well.

The regulatory environment has a stifling effect on doing business in Indonesia. In 2014, the World Bank ranked the country 153rd in ease of dealing with construction permits, with 17 separate procedures and an average waiting time of 211 days. This contrasts with several of Indonesia's Southeast Asian neighbors; Malaysia (ranked 28th), with 13 procedures and 74 days; Vietnam (22nd), 10 procedures and 114 days; and Singapore (2nd), 10 procedures and 26 days.

In this area, again, the central government is attempting to make things easier. Shortly after his election, Widodo proposed moving permits from various ministries including mining, forestry and transport to a single board, creating a "one stop shop" for licensing. He also directed regional governors to set up similar arrangements in their jurisdictions and threatened penalties if they did not comply. While the president can do only so much on his own, these actions at least show an understanding of the problem and a commitment to addressing it.

Boots on the ground

A reliable local partner is a great advantage in helping foreign investors navigate the unreliable landscape of emerging markets. Local managers understand local issues and can smooth out any issues that might come up. They can also serve as a conduit to suppliers of raw materials for construction projects, and even insulate foreign backers against shifts in the local currency - a particular danger in Indonesia, where the rupiah continues to fall in value against the US dollar.

Harold Tjiptadjaja, managing director at government-backed non-bank financial institution Indonesia Infrastructure Finance, says that investors based in foreign countries - even as close as Singapore - will have a very hard time working in Indonesia without a reliable hand on the scene.

"You have to be ready to have people on the ground who can be always contacted, seven days a week and 24 hours a day, and who should be able to meet, even if it's on a daily basis or at short notice," says Tjiptadjaja. A good partner can be meeting with stakeholders to deal with problems while foreign investors are still getting on the plane.

Local knowledge and networks were fully brought to bear in what remains one of Indonesia's most successful private equity deals - coal supplier Adaro Energy, in which Saratoga invested $50 million in 2001 for a 51% stake and then guided to an IPO, and a market capitalization of $3 billion, seven years later. Saratoga's founders invested alongside members of several leading Indonesian families.

An unreliable local liaison, by contrast, can be the downfall of an otherwise promising deal. In one case, a 2007 coal mine investment by Quantum Pacific years to get underway, and was eventually scuttled in 2012 when local partner IMN transferred the mining license to another entity without the knowledge of Quantum or its investee, Intrepid Mines.

That deal, incidentally, also highlights the problem of changing regulation. Intrepid entered the arrangement with IMN at a time when foreign companies could not hold mining and exploration licenses. When the law changed two years later, Intrepid was stuck in a disadvantaged position.

Despite the idiosyncrasies of the country, there are opportunities in Indonesia's infrastructure sector for firms that are willing to take the risk. Thanks to the lack of competition from other PE firms, it is not hard to find a good project to invest in. Investors that have gained a foothold in the country - and cultivated a local presence - like Saratoga and CapAsia, are doing well.

"In emerging markets, whether it's due to the macroeconomic risks, or the political, regulatory risks that you need to address, or specific market conditions or business risks, you need to take an active ownership," CapAsia's Das says. "By taking that active role, you're able to add value to the company, and that should ultimately make the company more attractive at the time of your exit."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Infrastructure
• Infrastructure
• Infrastructure
• Southeast Asia
• Infrastructure
• Southeast Asia
• Growth capital
• CapAsia
• buyout
• Saratoga Capital Group
• Indonesia