Financing solutions for the Infrastructure development<\/p>\n
David O'Brien, Jakarta<\/p>\n
The recent infrastructure summit has provoked plenty of
\ndiscussion. Much of the focus has been upon the framework
\nrequired to restore private sector investors' confidence. Little
\nhas been written about creating an environment that will help
\nlower the overall costs to Indonesia.<\/p>\n
These cost savings can be largely achieved by transparent
\ncompetitive tendering, reducing exchange rate exposure and
\ncreating asset classes best suited to different investor risk
\nprofiles.<\/p>\n
Appropriately structured infrastructure projects offer long
\nterm, secure, measurable cash flows. The very nature of the
\ninvestments (comparatively low risk) means there will not be
\nspectacular returns but the stability provided should be a
\nnecessary part of any well weighted investment portfolio.<\/p>\n
The risk is usually lessened by the government providing a
\nconcession or a government entity being the off taker. The
\nsecurity and term has the potential to appeal to both
\ninstitutional and retail investors.<\/p>\n
The long term nature of cash flows is particularly suited to
\npension funds and insurance companies. These funds face
\nliabilities to fund pensions\/pay life assurance over a similar
\n(long) time period. A pension fund needs to protect its members'
\ncapital. It is doing a disservice if the earnings generated on
\nthat capital are consistently below an appropriate risk based
\nreturn.<\/p>\n
It is true that historically equity investments have provided
\nthe greatest return on invested capital as an asset class.
\nHowever these investments have also been subject to significant
\nvolatility. The stream of cash flows in the short to medium term
\ncannot be assured, leaving the ability to meet its commitments in
\ndoubt. As a proportion of assets for a pension\/insurance fund
\nportfolio it should not predominate.<\/p>\n
In the current Indonesian case the split of asset classes is
\n10 percent in equities, 10 percent property, 60 percent cash
\ndeposits and government bonds and 20 percent in other bonds.
\nThese latter bonds are likely to be in local companies and of a
\nhigher risk bearing class than that proposed for infrastructure
\nassets. The 60 percent held in deposits and government bonds does
\nhowever seem too risk averse to cover potential volatility in the
\nbalance of asset classes.<\/p>\n
The Association of Indonesian Pension Funds (ADPI) has
\nannounced that it wishes to have more exposure to the sector (The
\nJakarta Post, Jan. 27, 2005). However they discuss equity
\ninvestments in the firms that are developing assets. As an asset
\nclass this is the same as equity and shares all the same risks,
\nalbeit the particular company develops infrastructure.<\/p>\n
ADPI would be better off to consider investing in the
\nunderlying assets which have security over the underlying cash
\nflows. The developer of the infrastructure is best treated as a
\nseparate entity to best match different investor risk profiles.
\nThe Indonesian capital markets need to consider the development
\nof new products that split the risk of asset developers and asset
\nmanagers. A potential structure I describe below.<\/p>\n
This is whereby separate listed vehicles are created to
\nreflect the different risk profiles of development\/construction
\nand management. One vehicle will hold the project assets and make
\ndistributions based upon the project cash flows. These
\ndistributions can often be tax advantaged due to the large
\ndepreciation allowances associated with such major
\ninfrastructure.<\/p>\n
The second vehicle is responsible for successful development
\nand management\/operation of the assets constructed. This entity
\ntherefore has a higher risk profile as it is responsible for
\nsuccessful, timely completion of project (s) and their ongoing
\noperation. It may be that this second entity can develop and or
\nmanage other facilities. This may provide for a growth premium
\nwhich can be ascribed to this component of the entity. The
\nmanagement fees earned are usually subject to performance targets
\nbeing bettered.<\/p>\n
It is the first vehicle that is ideally matched to an investor
\nwith a long term liability horizon and need for stable, secure
\nreturns. They may still hold a much smaller proportion of their
\nportfolio in the development\/management company to ensure an
\nappropriate risk based weighting.<\/p>\n
The wonder of infrastructure investments to generate cash
\nflows for investors is further enhanced by financial engineering.
\nThe quality of cash flows inherent in the asset allows for high
\nlevels of gearing. This in turn creates an interest tax shield
\nthat reduces tax liabilities and creates additional value for
\ninvestors.<\/p>\n
Using the "lazy" capital of local institutions will also
\nreduce project costs via the reduction in exchange risk. Revenue
\nstreams for infrastructure projects are denominated in local
\ncurrency terms, unlike mining\/oil projects where output has an
\ninternational price.<\/p>\n
The infrastructure is fixed in place and although tariff
\nmechanisms linked to exchange rates and inflation are often
\nimplemented (as was the case with Indonesian electricity rates
\npre crisis) the ability to pass on extremely large increases in a
\nsingle quarter is not possible.<\/p>\n
The ideal environment is to have a liquid capital market in
\nlocal currency terms. Such a market allows debt to be raised in
\nthe currency denominated by cash flow. If raised in foreign
\ncurrency terms, the liquidity of the market would allow all or a
\nportion to be swapped for local currency via the use of
\nderivatives. Overall improvement in the regulation and oversight
\nof the financial sector should allow people to be confident
\nenough to invest locally rather than abroad.<\/p>\n
An article written in the The Jakarta Post of Jan. 20, 2005 by
\nTan Sri Francis Yeoh Sock Ping, CEO of YTL Corp in Malaysia was
\nvery informative. He explained how YTL had achieved local
\nMalaysian ringgit financing for over 12,000 MW of power
\ngeneration projects (US$10 billion). YTL initially dealt with a
\nsingle pension fund for an initial development. Upon successful
\ncompletion of that deal a new asset class was acknowledged.
\nContrary to existing thinking YTL was subsequently able to
\nfinance significant investment all in local currency terms.<\/p>\n
Malaysia with a population 23.5 million and GDP\/capita of
\n$9,000 is a substantially smaller economy than Indonesia with 220
\nmillion and GDP\/capita of $3,200. Development of such a robust
\nlocal fund would help stabilise the rupiah and set in chain a
\nvirtuous circle of Indonesian investors having confidence to
\ninvest in Indonesia and not seek opportunities abroad as is often
\nthe case.<\/p>\n
An ideal first step in Indonesia would be for a pension fund
\nto support a major development through a structure that
\nquarantined risks for the fund. Utilise the style of fund
\nmentioned above whereby construction risk sits with an
\ninfrastructure development company. Once this has been proven as
\na concept it would be hoped that others will follow, both funds
\nand other investors that see such an asset class as perfect for a
\nwell weighted portfolio.<\/p>\n
The writer is a Technical Advisor at CSA Strategic Advisory.
\nCSA helps businesses through a combination of "soft" behavioral
\nand "hard" financial advice. He can be reached at
\ndobrien@csadvisory.com
\n-------<\/p>",
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