Financing solutions for the Infrastructure development

Financing solutions for the Infrastructure development

David O'Brien, Jakarta

The recent infrastructure summit has provoked plenty of
discussion. Much of the focus has been upon the framework
required to restore private sector investors' confidence. Little
has been written about creating an environment that will help
lower the overall costs to Indonesia.

These cost savings can be largely achieved by transparent
competitive tendering, reducing exchange rate exposure and
creating asset classes best suited to different investor risk
profiles.

Appropriately structured infrastructure projects offer long
term, secure, measurable cash flows. The very nature of the
investments (comparatively low risk) means there will not be
spectacular returns but the stability provided should be a
necessary part of any well weighted investment portfolio.

The risk is usually lessened by the government providing a
concession or a government entity being the off taker. The
security and term has the potential to appeal to both
institutional and retail investors.

The long term nature of cash flows is particularly suited to
pension funds and insurance companies. These funds face
liabilities to fund pensions/pay life assurance over a similar
(long) time period. A pension fund needs to protect its members'
capital. It is doing a disservice if the earnings generated on
that capital are consistently below an appropriate risk based
return.

It is true that historically equity investments have provided
the greatest return on invested capital as an asset class.
However these investments have also been subject to significant
volatility. The stream of cash flows in the short to medium term
cannot be assured, leaving the ability to meet its commitments in
doubt. As a proportion of assets for a pension/insurance fund
portfolio it should not predominate.

In the current Indonesian case the split of asset classes is
10 percent in equities, 10 percent property, 60 percent cash
deposits and government bonds and 20 percent in other bonds.
These latter bonds are likely to be in local companies and of a
higher risk bearing class than that proposed for infrastructure
assets. The 60 percent held in deposits and government bonds does
however seem too risk averse to cover potential volatility in the
balance of asset classes.

The Association of Indonesian Pension Funds (ADPI) has
announced that it wishes to have more exposure to the sector (The
Jakarta Post, Jan. 27, 2005). However they discuss equity
investments in the firms that are developing assets. As an asset
class this is the same as equity and shares all the same risks,
albeit the particular company develops infrastructure.

ADPI would be better off to consider investing in the
underlying assets which have security over the underlying cash
flows. The developer of the infrastructure is best treated as a
separate entity to best match different investor risk profiles.
The Indonesian capital markets need to consider the development
of new products that split the risk of asset developers and asset
managers. A potential structure I describe below.

This is whereby separate listed vehicles are created to
reflect the different risk profiles of development/construction
and management. One vehicle will hold the project assets and make
distributions based upon the project cash flows. These
distributions can often be tax advantaged due to the large
depreciation allowances associated with such major
infrastructure.

The second vehicle is responsible for successful development
and management/operation of the assets constructed. This entity
therefore has a higher risk profile as it is responsible for
successful, timely completion of project (s) and their ongoing
operation. It may be that this second entity can develop and or
manage other facilities. This may provide for a growth premium
which can be ascribed to this component of the entity. The
management fees earned are usually subject to performance targets
being bettered.

It is the first vehicle that is ideally matched to an investor
with a long term liability horizon and need for stable, secure
returns. They may still hold a much smaller proportion of their
portfolio in the development/management company to ensure an
appropriate risk based weighting.

The wonder of infrastructure investments to generate cash
flows for investors is further enhanced by financial engineering.
The quality of cash flows inherent in the asset allows for high
levels of gearing. This in turn creates an interest tax shield
that reduces tax liabilities and creates additional value for
investors.

Using the "lazy" capital of local institutions will also
reduce project costs via the reduction in exchange risk. Revenue
streams for infrastructure projects are denominated in local
currency terms, unlike mining/oil projects where output has an
international price.

The infrastructure is fixed in place and although tariff
mechanisms linked to exchange rates and inflation are often
implemented (as was the case with Indonesian electricity rates
pre crisis) the ability to pass on extremely large increases in a
single quarter is not possible.

The ideal environment is to have a liquid capital market in
local currency terms. Such a market allows debt to be raised in
the currency denominated by cash flow. If raised in foreign
currency terms, the liquidity of the market would allow all or a
portion to be swapped for local currency via the use of
derivatives. Overall improvement in the regulation and oversight
of the financial sector should allow people to be confident
enough to invest locally rather than abroad.

An article written in the The Jakarta Post of Jan. 20, 2005 by
Tan Sri Francis Yeoh Sock Ping, CEO of YTL Corp in Malaysia was
very informative. He explained how YTL had achieved local
Malaysian ringgit financing for over 12,000 MW of power
generation projects (US$10 billion). YTL initially dealt with a
single pension fund for an initial development. Upon successful
completion of that deal a new asset class was acknowledged.
Contrary to existing thinking YTL was subsequently able to
finance significant investment all in local currency terms.

Malaysia with a population 23.5 million and GDP/capita of
$9,000 is a substantially smaller economy than Indonesia with 220
million and GDP/capita of $3,200. Development of such a robust
local fund would help stabilise the rupiah and set in chain a
virtuous circle of Indonesian investors having confidence to
invest in Indonesia and not seek opportunities abroad as is often
the case.

An ideal first step in Indonesia would be for a pension fund
to support a major development through a structure that
quarantined risks for the fund. Utilise the style of fund
mentioned above whereby construction risk sits with an
infrastructure development company. Once this has been proven as
a concept it would be hoped that others will follow, both funds
and other investors that see such an asset class as perfect for a
well weighted portfolio.

The writer is a Technical Advisor at CSA Strategic Advisory.
CSA helps businesses through a combination of "soft" behavioral
and "hard" financial advice. He can be reached at
dobrien@csadvisory.com
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