China infrastructure: PE to the rescue?

The RMB4 trillion ($633 billion) stimulus package China's government unveiled in late 2008 was intended to stimulate an economy temporarily devoid of an export sector and consumer confidence. It worked.

The capital, complemented by a massive spike in bank lending, was put to work on the country's roads, railways, airports, power stations and other utilities. Exports shrank nearly 16% year-on-year in 2009 but urban fixed-asset investment rose by 30%. There are plenty of vanity projects - notably an imitation of the Beijing's Bird's Nest stadium in Jinan, Shandong province - but about half the stimulus package is thought to have gone directly into the infrastructure roll-out that the government has been driving for some years.

Limited access

With China accounting for over 50% of the estimated $8 trillion required to address Asia's critical infrastructure shortages, the story is far from finished. The frustration for foreign investors, however, is that there are precious few ways to get exposure to this build-out. With the exception of occasional opportunities around the fringes - typically businesses that indirectly enable the program - private equity is shut out.

"The Chinese government has funded most of these infrastructure projects from their balance sheet," says L.N. Sadani, chief investment officer at Nomura Infrastructure Investment Managers. "They have privatized state-owned enterprises (SOEs), which have helped with this process so that at state level there is ample availability of capital. This makes it difficult to get the kinds of returns we would be looking for."

The mismatch between risk and return is exacerbated by the fact that government investors don't approach infrastructure projects from a purely financial perspective. In addition to enabling future commercial growth, an infrastructure development might be about, for example, providing employment. This plays into decisions on which infrastructure projects to proceed with. An airport or highway for which there is not yet sustained demand for them could therefore still be generating depreciation costs when private equity investors want to exit.

China infrastructure deals came to $9.7 million in 2007, says AVCJ Research, then spiked to $206.4 million in 2008 before dropping to zero in 2009. Investment rebounded to $55.6 million in 2010.

A sea change?

According to some in the industry, however, the balance is changing. Over the course of 2011, the Chinese government ratcheted up efforts to rein in asset price inflation, imposing tighter monetary policy and restricting bank lending. Although infrastructure expansion remains a long-term goal and can often rely on considerable state backing, there has been a marked change of mood in many companies.

Andrew Yee, Singapore-based global head of infrastructure with Standard Chartered Bank, the sector is opening up for determined, well connected private sector investors, Chinese and international alike.

"As an example, the black market cash rates for lending in China are extremely high, on the order of 20% per month," Yee tells AVCJ. "It's a sharp contrast with the situation that prevailed for years, where China's growth was fuelled by easy or low-cost debt, extended mostly by state-controlled banks."

This era of easy credit saw governments at provincial, municipal and local level raise funds directly through bank loans and bond issues, and then create trust structures that enabled them to borrow even more. The fundraising channels are so varied and opaque it's difficult to capture the scale of the debts.

In June, the National Audit Office (NAO) made its first attempt to put a number on it, stating that local governments were RMB10.7 trillion in debt at the end of 2010, equal to 27% of the country's GDP.

The 6,576 local government investment vehicles (LGIVs) in operation - local authorities have limited scope in terms of direct borrowing so they set up special purpose vehicles - accounted for RMB4.97 trillion of the total. Nearly two thirds of this funding went to infrastructure projects, 80% of the debt was held by banks, and 70% had a maturity of five years or less.

Stephen Green, head of Greater China research at Standard Chartered, concluded in a report published the following month that about 10,000 LGIVs and their local government sponsors are sitting on RMB10-14 trillion worth of loans. Preliminary figures released by regulators around the same time indicated that RMB2-3 trillion of LGIV loans were already in trouble.

Green noted that, unlike previous non-performing loan problems, the current wave of debt was not created by commercial loans turning sour due to an asset bubble bursting, an economic downturn or poor lending decisions. "These were loans to infrastructure projects arranged by bankers and LGIV borrowers assuming local government support, given that the projects themselves were not commercial. This was public infrastructure financed through the banking system."

He warned that LGIV financing was tightening as it became clear that older loans weren't being serviced and the bond market was growing cautious. A government bailout was deemed necessary to prevent lasting damage to the banking system and the wider economy.

It is a cycle that Beijing has yet to bring under control. According to Bloomberg, 231 LGIVs had issued RMB3.96 trillion in bonds, notes or commercial paper as of December 10. This means 3.5% of the LGIVs the NAO claimed to be active in June account for nearly 80% of the total debt. In 2011 alone, the 231 LGIVs had raised a combined RMB354.1 billion and had credit lines from banks of at least RMB2.3 trillion that had still to be drawn.

Silent auctions

Yee says a lot of discussions are taking place among entities holding a significant number of projects, some of which aren't generating sufficient returns to even pay the interest on the various bonds and bank loans. They face the prospect of having to sell assets to pay down debt.

"And what do they have to sell?" Lee asks. "They can't sell something that's half built or at the planning stage, because such projects aren't yet very valuable. This means they have to sell some of their better operating and profitable assets, their crown jewels. We see opportunities in gaining access to a whole range of opportunities that are far greater quality than we've seen over the past few years during the boom."

Assets are creeping onto the market "quietly and confidentially" because their government owners don't want to highlight the role fiscal recklessness has played in the situation. Investors that have been around for a while and have dry powder are looking at the sector with increasing interest. Adding to the allure is the fact that possible buyers for these assets are limited - domestic firms can no longer turn to the banks or capital markets for cash to support acquisitions.

Ben Way, senior managing director of Macquarie Infrastructure and Real Assets, Asia, shares Yee's view, citing the impact of tighter monetary policy and reduced bank lending as project developers seek alternative forms of capital. In addition, provincial governments are under pressure to recycle capital as cash from land sales and central government allocations has fallen below historic levels.

"In battling for finite pools of capital - domestic and international - China realizes that some asset classes make sense in terms of attracting the foreign private sector," he adds. "They have adjusted policy to encourage foreign investment into infrastructure."

Nevertheless, opinion remains divided on the extent to which private equity players can capitalize on this situation.

More skeptical industry participants expect local companies and their state-linked sponsors to adapt to the current situation - and avoid handing out equity stakes at all costs. They argue that structured financing will play a greater role, with companies turning to debt and mezzanine solutions that offer higher fixed rate returns with no equity upside in order to tide things over.

Potential misalignment of interests between foreign and local partners also remains a concern. An investor who enters a joint venture project primarily because they are the only, or cheapest, form of capital runs the risk of being forced out in a later round of refinancing on terms that weren't originally budgeted in the investment case. Even if the foreign investor remains involved, a dominant SOE partner might dictate the growth direction of the business, the distribution of returns or the ultimate exit point.

As a consequence, infrastructure investor Equis Group Funds focuses on sectors where there is a prevalence of private sector participation, and where the sector itself is undergoing some form of positive economic transformation as opposed to simply reacting to an imbalance of demand over supply.

"There is too much focus on the Chinese macro story and the scale of infrastructure under development, and not enough debate around how the risk-return requirements of private-sector investors can be sensibly incorporated into the provision of infrastructure services in a manner the Chinese public sector can afford," says David Russell, Singapore-based CEO of Equis.

He also sees a valuations disconnect, among SOEs and private players, even in a capital-constrained environment. Company management teams are all too willing to price assets based on the biggest success story - regardless of relevance or comparative size and risk - and this leads to unrealistic expectations.

Areas of interest

For those who do participate, roads and power are perhaps the most obvious areas, simply because they are the biggest sub-sectors in the space. But over the past 2-3 years, opportunities have sprung up wherever China has committed capital and policy support: renewable energy, particularly wind and hydro; waste water treatment and increasingly water supply; and, even more recently, waste-to-energy.

With projects across so many areas, the challenge is sorting the wheat from the chaff. For example, certain provincial governments have built thousands of kilometers of roads, but only a small percentage of these assets are really economically viable. Identifying the best deals requires strong connections within the public and private sectors and, above all, patience and perseverance.

Yee's team at Standard Chartered has made seven investments - and a further three were expected to close before the end of 2011 - all involving multi-assets.

"What we generally try and do is find, say, two or three operational assets in a given area, such as roads," Yee explains. "When you've brought them all together, looking to the future it's far easier to sell a platform company or portfolio of assets, especially if a few of them are operational, rather than one or none."

The competitive landscape has changed with an increasing number of private equity houses in the market alongside infrastructure investors. In the past these firms have steered clear of the sector - infrastructure seldom offers better than a 2x multiple and a mid-teens IRR while standard corporate PE players have been uncomfortable with IRRs below 20. Despite this disinclination, the wider variety of opportunities has drawn in more investors, although local participants still dominate.

Targeting value

Yee advocates avoiding the major Chinese markets, where the competition is intense and the sheer scale of projects means a $50-100 million investment only warrants a small minority stake. In second- and third-tier markets, however, foreign investors can have a greater presence and therefore a better strategic position.

On particularly large transactions, Standard Chartered is also open to club deals and co-investments, partnering with LPs or even rival pan-Asian funds. On particularly large transactions, Standard Chartered is also open to club deals and co-investments, partnering with LPs or even rival pan-Asian funds.

An interesting example is Indian toll road operator ITNL's recent purchase of a 49% interest in Yu He Expressway from Chongqing Expressway Group (CEG) and Chongqing State-owned Assets Supervision and Administration Commission. The Standard Chartered IL&FS Infrastructure Growth Fund - a joint venture between Standard Chartered and ITNL's parent, IL&FS - invested in ITNL ahead of its 2010 IPO and retains a stake of around 4.4%.

For all the talk of China's infrastructure sector opening up to foreign investment there has been little action so far. As a result, industry participants are wary of premature forecasts of impending broader, long-term change. In many cases, interested parties are still testing the water.

Conrad Yan, a Hong Kong-based partner with Campbell-Lutyens, says that his firm is still researching China at this point in order to establish whether the market is deep enough and whether it offers demonstrably attractive opportunities for private investment. Whatever the conclusion, investors must understand the nuances of China's infrastructure space. While infrastructure investments in the West are regarded as essentially a coupon-clipping event, Asian projects promise much but deliver no instant cash flow.

Private sector involvement will also follow its own path. The level of government control aspect is important but not the sole mitigating factor. As infrastructure becomes more accessible to private enterprise, domestic insurers are expected to lead the way. These companies - state-owned but operating with a reasonable degree of autonomy - are attracted by the steady, long-term returns typically associated with the asset class, but they are have little experience investing in it. GP expertise will therefore be required, along with the necessary enabling regulations which have yet to materialize in detail.

There is every hope this will happen as other inherent difficulties in the market, such as the costs, uncertainties and complex approval processes, are gradually removed. Some infrastructure investors point to the progress made in facilitating the entry of foreign corporate private equity to China as an indicator of future developments.

The government knows what to do and has tentatively opened the door to other investors; it's only a question of when the same access will be granted to the private sector. And when the turning point comes, there will be no shortage of demand.

"As urbanization escalates in China, the various governments involved will need to build more core and social infrastructure to manage the process," Maquarie's Way says. "Hence re-cycling capital in brownfield assets to build more stable power networks or extend road networks or medical services simply makes sense; especially when there is less debt capital available."

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• Topics
• Infrastructure
• Infrastructure
• Infrastructure
• Greater China
• Infrastructure
• China
• regulation
• Standard Chartered Private Equity
• Macquarie Group
• Nomura Principal Finance