Dissecting the Asian infrastructure opportunity

The government started this trend as a reaction to the GFC, and industry experts like Jing Ulrich, managing director and chairperson of China equities and commodities at JPMorgan, believe that infrastructure spend was a great contributor to China’s GDP growth at the end of 2009.

So too was the country’s massive RMB4 trillion ($586 billion) stimulus package of 2008-09, an estimated 80% of which was targeted on the construction of new capacity or the upgrade of existing infrastructure. The government’s moves and its effect on the economy are proof positive that infrastructure investment can equate to serious returns, for the private sector as well.

Empowering a miracle

 “Many first-time visitors to China marvel at the progress and growth of the country’s roads, highways, ports and airports – to take just some examples,” Ulrich says. “But veteran China-watchers know that the country is still mired in considerable poverty.
“The earlier rounds of infrastructure investment brought huge benefits to the coastal regions and set off a wave of urbanization. The new focus, however, is to extend these benefits to the country’s vast interior. That will involve solving long-term problems like transportation bottlenecks, power difficulties and so on, particularly dispatching it over long distances.”

Other key opportunities exist around the long-term shift of China’s rural population into tier three, four and five cities and the supply-demand gap for services and facilities this will create. Dong Tao, Chief Regional Economist for Non-Japan Asia at Credit Suisse, pointed out that satellite photographs of China at night still show the hinterland as dark, unlike the rural areas of the US and other major developed economies. To change that picture will require massive expansion of power generation infrastructure.

Furthermore, the bulk of China’s power is still coal-generated. And the country’s coal deposits are far removed from its industrial heartland, so expanding rail capacity is another crucial area. This is also driving the urgency in developing clean, renewable energy.

Taken together, these explain the vast scale of China’s current rollout of power production. As Andrew Yee, joint CEO of the Standard Chartered IL&FS Asia Infrastructure Growth Fund noted, China has been adding capacity at roughly 100,000MW per year (or two thirds of India’s total capacity) for four to five years now, resulting in its current 800,000MW aggregate total – the world’s second biggest after the US, which has around 1 billion MW. And this is projected to continue, as Jing Ulrich explains, because China has four times the population of the US.

Full spectrum growth

The same trend is evident in other infrastructure sub-sectors, but access to deals is very much dependent on whether firms are local or foreign. Domestic firms have little in the way of barriers, but international firms will see a number of regulatory restrictions that limit access, depending on the sector. One deal that got caught up in red tape was the Carlyle-Xugong Industrial Machinery Group saga, which was only settled and scrapped in July 2008.

According to Jing Ulrich, however, China’s restrictions on international investors don’t amount to anything like a shut-out: ports, for example, can be a very promising area.

“These are very different than transportation or power, because they’re fully open to foreign investment. [Foreigners] are allowed to take a majority stake or even fully own port facilities. But, it must be borne in mind that the efficiency of Chinese ports has [already] been dramatically improved. That’s the underlying factor in China as of 2009 becoming the largest exporter in the world, surpassing Germany.”

But, it is well understood that transportation, and in fact the whole range of infrastructure will be crucial if China is to sustain its remarkable growth trajectory.

“Speaking as a representative of the banking sector, I believe this will not only benefit China, but will rather amount to viable and attractive diversification for foreign and domestic investors alike.”

The opportunities this presents are being viewed favorably by the private equity community. Deven Karnik, managing director and portfolio manager of Morgan Stanley’s Asia infrastructure investment team says, “Globally and regionally, infrastructure allocations are increasing, not decreasing. That’s because infrastructure assets offer investors the opportunity to deploy capital in predictable and long-term businesses; and those in Asia have shown resilience through the GFC.”

Ways and means

There are various access routes. The simplest way, of course, is to buy shares either in Chinese infrastructure companies listed in Hong Kong or Shanghai, or Indian peers on the National or Bombay Stock Exchanges, says StanChart’s Andrew Yee.

“In China, most big infrastructure companies are SOEs. So you can get exposure, say, to the power sector by investing in something like China Resources Power, or in the same sector in India, in a company like National Thermal Power. But both of these stocks, because they’ve already come through the development stage leaving them with a lot of operating assets, and are having to undertake larger and larger projects to sustain their growth rates, are probably not going to generate the super-sized returns some people are looking for.”

A more sophisticated strategy – and one way to get an introduction to the emerging market infrastructure space, particularly for institutional investors or pension funds – is via the limited number of regional infrastructure funds in Asia.

“We’re one of just two pan-Asian infrastructure plays,” Yee told AVCJ. “We could have just done a China infrastructure play a few years ago when we set up. But we chose to offer an emerging market basket to provide investors with diversification across China and India plus a bit of Southeast Asia. That way the pension funds and other big institutional investors can get up the learning curve with relatively low exposure over several years.”

But Yee also notes that there are also lots of Indian infrastructure-only private equity funds, and an increasing number of the same in China. In general, however, they’re 8-10 year funds investing in projects that run for 20-30 years, so there is something of a mismatch he contends.

Funds also offer the investor the chance to co-invest, giving larger LPs access to infrastructure dealflow, and once they are comfortably entrenched in the system, can even go out on their own.

“We’re now seeing evidence of such a shift” to LPs as direct investors in Asia, Yee says, “but only among the biggest players who have been in Asia for some years.” Canada Pension Plan Investment Board is perhaps the key example, with several direct investments in Australian infrastructure already behind it.

Risk factors

At the same time, there are risks. As one banker, who asked to remain unnamed, said it, “The biggest risk is regulatory, which means government risk.” In India that implies that while the government is democratic, it’s also heavily bureaucratic, meaning slow as regards land titles and approvals. “That’s the chief downside there,” he adds.

In China, the story is the opposite. The government is hugely helpful, but its motivation is clear: for years SOEs were underperforming drags on the economy which couldn’t be dispensed with because of the huge numbers of people they employ. So providing them with large-scale protected infrastructure activity offers an ideal way to get them making a meaningful contribution.

At the same time, though, there remain real issues for foreign private sector businesses in the PRC. “The other key risk is the private individual, the entrepreneurs you invest with,” AVCJ’s anonymous banking source says. “And that’s unavoidable because you always need a local partner. So your deal is as good as the entrepreneur you back.”

From an Indian perspective, IL&FS Investment Managers CEO and Executive Director Archana Hingorani, concurs and sheds some light on the issues. “Few developers have the capability and experience to take a project from concept to commissioning.

Furthermore, infrastructure projects require a plethora of approvals and government interfaces. Land acquisition and environmental clearances are key hurdles,” she told AVCJ. “Thus, the capability to assess opportunities beyond concession agreements and the financial model is critical.”

“Equally important is the access to quality deal flow. Country risk, inclusive of political, regulatory, accounting and contractual considerations may lead to higher risk premiums, but are nonetheless risks which in our experience are completely addressable.”

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• Topics
• South Asia
• Greater China
• Infrastructure
• Infrastructure
• Infrastructure
• IL&FS Investment Managers