April 3, 2023

Is Emerging Market Infrastructure Investing Still Appealing?

The need is still there, but investors must evaluate a wide variety of factors, including geopolitical ones, in selecting the right fit.

Reported by Debbie Carlson

Art by David Plunkert

The need for emerging-market-infrastructure investing is great, and there are opportunities for institutional investors to profit from build-outs, but the alternative asset class has suffered lately following last year’s plummeting stock markets and rising global interest rates.

Compounding concerns about the sector are headlines detailing defaults by some countries on some Chinese-funded megaprojects, which has led to some caution by both sovereign nations and private investors. Emerging-markets-infrastructure investing has its challenges—bureaucracy and politics are perennial issues—but the need is real. The World Bank estimates that emerging-market nations need $1 trillion in annual infrastructure investment to meet development goals.

Current struggles aside, market participants say there are bright spots for allocators, particularly in the renewable-energy sector, as countries seek to reach net-zero goals, and in telecommunications, as digital infrastructure becomes as important as toll roads and airports. As usual, it takes due diligence to find the right project.

Challenging Environment

Ashwin West, the head of sustainable infrastructure investments at BlueOrchard, a member of the Schroders group, says until recently, institutional interest in emerging-market infrastructure was strong, because allocators saw it as a resilient asset class that has performed through previous crises. During the COVID-19 pandemic, certain classes, such as the power sector and digital infrastructure, went through boom periods.

But in 2022, when the Federal Reserve sharply raised interest rates, liquidity issues struck private investments and affected allocator interest specifically in infrastructure and emerging markets.

“The denominator effect is having a real impact now on institutional investors,” West says, referring to when the value of one portion of a portfolio falls sharply and leaves the portfolio out of alignment with its policy allocation .

Higher interest rates are having other influences beyond last year’s portfolio impact. West says developed markets are becoming an attractive alternative to emerging markets, especially if allocators can get returns of 6% to 8% on less-risky developed markets projects.

“A lot of capital allocators are having to grapple with [the question], ‘Do we really value the premium that we could earn in emerging markets? Or should we just take a safer bet and put our capital into the developed markets for now?’” he says.

Despite the liquidity issues allocators faced last year, some interest remains in emerging-market infrastructure, and the investment needs of those parts of the world continue to grow, West says. The difficulty is finding bankable private projects with structures suitable for an institutional asset owner.

Not all projects have the risk management profiles an allocator needs, such as construction contracts on so-called greenfield (startup) projects in which risks are appropriately divided to the parties best suited to manage those risks, West says. Ideally those would be balanced between the construction contractor, the private sector and perhaps the government.

Financing conditions are also volatile at the moment, as investors do not have a clear sense of when and where the Federal Reserve’s tightening may peak, says Jose Perez Gorozpe, head of emerging markets credit research for S&P Global Ratings. Even though the Fed sets short-term rates, long-term rates have also moved because of persistent inflation, another variable.

“To get capital flowing to infrastructure projects, you need to have long-term clarity about key variable trajectories,” Perez Gorozpe says.

China’s Impact

Recent headlines about some emerging-market countries defaulting on projects as part of China’s 10-year-old Belt and Road Initiative have grabbed investor attention. The US$1 trillion-plus program funded infrastructure projects in nearly 150 emerging-market countries. Defaults crept up because several countries are facing financing issues related in part to the economic impact of the COVID-19 pandemic and in part to the U.S. dollar’s strength, which increased as the Fed hiked rates, hurting these nations’’ ability to service the projects’ mounting debt.

“The involvement of China has proven difficult for global investors,” says Nathalie Marshik, a Latin America sovereign strategist at BNP Paribas, noting China’s unwillingness to participate in the Group of 20 Common Framework or to restructure the external debt of some low-income countries that received loans from the Asian nation.

“When a country has a lot of exposure to China or Chinese Commercial Bank debt, the resolution is rarely easy because … China is not keen on taking haircuts,” Marshik says.

The Belt and Road Initiative certainly made sense to the developing countries at the time they accepted, , says Lee Gao, a portfolio manager for emerging markets equity at Harding Loevner. China’s domestic infrastructure is high-quality, and many of the countries were ignored by traditional financing providers.

“The fact that the BRI exists in the first place really highlights what’s there in terms of opportunities to bridge the gap in infrastructure,” Gao says.

China’s experience has lessons for other institutions interested in the asset class. David Pow, a portfolio manager on ClearBridge Investments’ emerging market infrastructure strategy team, says sovereign risks are part of investing in emerging-markets projects.

Allocators should understand a country’s financial strength and stability through economic cycles, he says. “There are risks associated with different parts of these project developments, and investors need to have a clear idea about how each party shares the risks,” he says.

Renewable Energy Opportunities

Pow sees opportunities in both listed and unlisted infrastructure investing that may appeal to different investors depending on their liquidity preference and choice of underlying asset risk exposure. His team looks at utilities or user-pay infrastructures such as toll roads, airports and cellphone towers, which generally have stable long-term, inflation-linked returns and cash-flow generation.

Pow says he’s most optimistic about downstream gas utilities in China, citing a cyclical growth rebound in natural gas consumption this year following expectations of China’s post-pandemic economic and industrial recovery.

The push toward renewable energy to meet net-zero goals by 2050 makes the build-out of renewables a potential area for investment. However, Brian Bandsma, a senior ESG analyst at Vontobel Asset Management, says the return expectations for investments in wind and solar energy projects should be tempered, as these are capital-intensive projects where returns are likely to be regulated. He sees more opportunity in transmission lines, especially for equity investors, such as one of his investments, the Power Grid Corp. of India.

“You’re not relying on the success of any one project. You’re basically benefiting from the aggregate investment across the country,” Bandsma says about investing in transmission-lines firms.

West concurs that return rates for some renewable energy projects are low because there is significant competition, and development banks often are involved in larger solar and wind farm greenfield projects. It can be difficult for institution investors to achieve the long-term returns they need on these types of projects when they partner with development banks in blended finance arrangements. Private investors seeking higher-yielding projects may want to look at smaller-scale emerging-technologies projects, such as distributed energy, e-mobility or green hydrogen.

“You have to be a little bit more patient in terms of being able to deploy capital, because you have to build it up over a longer period of time,” West says. “Those are the types of technologies that interest us.”

Countries he likes for investment include Vietnam, India, the Philippines, Indonesia and Thailand. He says South Africa is also becoming a market for renewable energy, with East Africa becoming a hot regional market for distributed energy.

Although most infrastructure projects are not growth investments, listed infrastructure such as airports have offered some higher returns for equity investors. Kevin Unger, an associate portfolio manager at Wasatch Investors, says the firm has owned Mexican airport Grupo Aeroportuario Centro Norte SAB de CV and Grupo Aeroportuario del Pacífico SAB de CV (PAC) for at least 10 years. Unger likes the stable regulatory structure and strong top-line growth, pointing to double-digit growth over the past several years.

Project Finance Growing

Allocators may also look to trade and project finance for short-term infrastructure investing. Christopher McGinley, head of the trade finance team and a senior portfolio manager at Federated Hermes, says this market offers allocators opportunities to make mostly floating-rate loans, usually with five-to-seven-year maturities directly to emerging market sovereigns for very specific infrastructure projects.

Projects vary and can include building roads, hydroelectric power plants or other structures. While some of these loans involve export credit agencies, which are low-risk and low-return, there are also commercial tranches which may include third-party insurance providers backing loans that may offer higher returns. Insurance providers’ involvement helps reduce transaction risk for allocators, since they can use the insurer’s credit rating to represent the asset in their portfolio holdings.

McGinley says Federated Hermes has investments in sub-Saharan Africa, including power ships. These are vessels moored off a country’s coast, converting natural gas into electricity, and are connected to a country’s electrical grid. These provide a power source while a country may be building its hard infrastructure.

Asset owners interested in trade finance projects need to do their due diligence on a fund manager and know the type of projects the manager owns. There is also geopolitical risk in these projects, which is why many are insured.

For allocators with sustainability goals, infrastructure investing in emerging markets offers opportunities to do well while doing good. However, Christine Cappabianca, a portfolio manager and vice president of systematic strategies at sustainable investing firm Impax, says institutions should approach the sector optimistically, but cautiously. The caution comes from governance issues. “(Political) regimes can change the investment environment at any moment,” she says.