China infrastructure: Fringe benefits

"Any deregulation announcement on foreign capital is a good thing. However, this announcement does not necessarily benefit private equity firms who are focused on higher yield infrastructure and energy investments."

This is the response given by Greg Karpinsky, co-head of energy, resources and infrastructure in Standard Chartered Bank's principal finance division, to the revelation made earlier this year that China would open up 80 infrastructure projects - spanning transport, IT systems, energy, coal and petrochemicals - to private capital. The sentiment is shared by numerous PE participants.

While there have been successful PE investments in Chinese infrastructure, they are not easily won. Many assets are state-controlled and even where there are openings foreign private equity faces fierce domestic competition.

According to AVCJ Research, PE investment across infrastructure, transportation and distribution, and utilities stands at nearly $3.5 billion so far this year, following a bumper 2013 in which $6.3 billion was deployed.

The totals include a number of sizeable transactions that would never fall into the hands of foreign players, notably Guolian Industrial Investment Fund Management's $3.9 billion commitment to PetroChina Tubes Union, a pipeline spin-out engineered by PetroChina.

Nevertheless, the State Council's infrastructure project announcement is not alone in hinting at reform. For example, a pilot program has been launched that is supposed to see six state-owned enterprises introduce private investors and improve corporate governance as part of efforts to boost economic efficiency.

These initiatives have been linked to local government debt pressures, but there is also a growth agenda on the infrastructure side.

"Basically, the government has made a lot of announcements to encourage more private capital and this is not a new thing," explains Stephen Ip, head of government and infrastructure at KPMG. "The government is showing more determination to explore different ways to increase private capital involvement in the development of infrastructure."

Whatever motivation there may be to open up SOEs - GaveKal Dragonomics estimates the average return on state-owned assets is around 4.6%, compared to 9.1% for private companies - it is countered by a reluctance to cede control. Indeed, there are many proposals for improving efficiency that don't involve privatization.

"One of the barriers to entry in the energy and infrastructure sector is that there are many well capitalized state-owned companies that have access to cheap capital and good quality projects," says Karpinsky.

The answer for private equity investors is to seek opportunities within the system or on its fringes. Success depends on a GP having a value proposition that sets it apart from the competition. A number of firms found traction in energy-related infrastructure, with Christophe Bongars, CEO of SustainAsia, noting that the dynamic in China is not dissimilar to other markets. "You simply can't work alone; you have to work with the government. This is because the energy market is highly regulated. It's a regulated environment, whether it is in China or in Hong Kong. It's the same everywhere," he says.

Not so small

Even if private equity has to pick around the edges of the sector, away from the state-dominated mainstream, these pickings could still be rich. The Asian Development Bank estimates that the region requires investment of $8 trillion between 2010 and 2020 to address infrastructure shortages, and half of that is needed in China.

One example of a successful niche strategy is perhaps Zhaoheng Hydropower, which has received $300 million in private equity backing from Morgan Stanley Infrastructure Partners, Fountainvest Partners and Olympus Capital. The company focuses on small and medium-sized hydropower assets and is pushing towards 1 gigawatt of installed capacity. This is dwarfed by China's 1,250 GW in total electricity capacity, but it isn't necessarily grounds for concern.

"How much power generation capacity is owned by the private sector? Practically none," a source familiar with the investment observes. "Zhaoheng is one tenth of 1% of the market, but that is still pretty big in China."

Standard Chartered has a similar approach. It currently sees a lot of opportunities in specialized areas such as liquefied natural gas transportation infrastructure and waste and water treatment plants. Both are closely aligned with China's development objectives yet offer scope for a foreign private equity investor able to offer technology and expertise from abroad.

And in the background, the debate about private participation in Chinese infrastructure can continue. It is worth noting that the State Council didn't specifically refer to private equity in its announcement and there any number of foreign or domestic players that could benefit from reforms, should they be introduced. Private equity will simply follow the opportunities as they arise.

"Over time you will have more private players in infrastructure. These private players, as they grow, will provide more investment opportunities," adds KPMG's Ip.

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• Topics
• Infrastructure
• Regulation
• Greater China
• regulation
• China
• Infrastructure