(July 16, 2013) — Pension funds, insurers, and sovereign wealth funds should not let the risk of default and construction failure put them off investing in infrastructure, a white paper has claimed, and should instead embrace the risks presented.
Business school EDHEC’s latest report into infrastructure investment focuses primarily on project finance debt, and analyses the benefits and pitfalls compared to traditional corporate debt.
The authors found that project finance initiatives were a better bet for long-term investors, because by their nature they were single purpose, time-bound and self-contained, minimising the moral hazards that would normally be associated with other corporate finance deals.
Investors who want to act as lenders and invest in infrastructure debt have control over the terms of the loan. By tinkering with the elements such as the maturity and repayment profiles, investors can make the resulting premium and risks more attractive.
The paper also blows holes in the perception that the construction risk associated with infrastructure projects should put institutional investors off putting their money in: EDHEC found the risk is often not as high as investors fear and could actually be seen as a welcome diversifier of credit risk in infrastructure debt portfolios.
Default rates in project finance are much lower than perceived, and recovery rates very high, the paper said. Indeed, as the project loans mature, they become systemically less likely to default.
Conversely, the earlier years of project development, during which project debt is more likely to default, is better remunerated, providing diversification potential across a portfolio of infrastructure debt.
Therefore, investors should look to invest in so-called green field projects, as well as brown field ones, to capture the benefits across the whole lifecycle of infrastructure projects, the paper said.
P Morgan’s portfolio manager for infrastructure debt Bob Dewing welcomed the report as “an excellent piece of work”.
“The authors recognise many of the facets of project finance, both structurally and financial, but may not have fully recognised the benign credit characteristics,” Dewing told aiCIO.
“[The benign characteristics are] not just because of the contractual structures and undertakings, but because the participants are knowledgeable parties that have an implied cooperative arrangement or partnership to achieve success.
“This arrangement more easily accommodates the inevitable problems by allowing for what would be principal risks to become term risks, by adjusting contractual terms and repayment profiles. A basic tenet of project finance is ‘Project finance investors accept term-risk and avoid principal risk’,” he concluded.
The full paper can be read here.
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