Simon Holden, Head of Investment Advisory Services at Lloyd's Register, writes that cool heads will prevail when trying to get energy projects off the ground in emerging economies.
Many emerging market economies are keen to develop energy and other infrastructure assets and, in the process, like to involve local content and knowledge transfer from foreign investors.
At the same time, these economies often lack the financial resources to contribute to major infrastructure developments. Their expectations about the equity value of their starting positions can also be unrealistic when seeking to secure foreign investment.
One solution is to secure relatively cheap credit from either foreign multi-lateral agencies with strategic interests or from state sponsored construction and equipment supply companies.
This article will discuss an alternative way in which emerging economy sponsors of energy or any infrastructure projects can improve their funding options. Following this approach, sponsors can enhance and leverage the existing equity value of their propositions in a cost-effective way.
Preferred financing models
Expanding populations, growing middle-classes, and migration along value chains to refined products from extraction are some of the many reasons for the need to develop infrastructure projects, particularly in the energy sector.
At least a couple of times every quarter, I receive calls or requests for proposals seeking advice and solicitation of external finance to develop such projects. The requests are usually detailed and in many cases well-thought out.
The common thread between these proposals is that the sponsor (usually government or a state-owned company) has an attractive opportunity for a financial or strategic investor to expand its business in the country in question.
Sensibly, in order to satisfy state procurement rules and ensure maximum competitive pressure, bidding is encouraged from multiple parties. Despite the chequered history of Public-Private Partnerships or Private Finance Initiatives in more mature economies, these are the preferred models that are often cited in the requests.
I say chequered, because, among several reasons for questioning their effectiveness, one is the tendency for over-prescription that leads to a loss of opportunity in allowing the outside private sector to help develop potentially more novel solutions.
The benefits and drawbacks of PPPs/PFIs are material for another discussion: for now, we shall stick to the challenges of the equity proposition faced by emerging economy sponsors.
Sponsors’ expectations
After parsing the detailed and well-thought out requests for proposals, another common theme is the level of expectation from the perspective of the equity sponsors. Access to a unique piece of land or authority to bestow concessions provides the sponsors with the assurance needed that much value has been created already which can be leveraged.
Non-recourse or project finance is envisaged and equity is sought not just from a partnership but also to fund the emerging economy’s sponsor’s share of equity too. At the same time, naturally, control remains an important issue, leading to the desire to retain a majority stake.
Pretty soon, the potential investors are faced with the following proposition: 100% of the financing with rights to 49% of the dividends in an emerging market economy. Such a proposition could still provide attractive returns, assuming the volume of operating income is (very) high.
However, in most cases, such volumes do not reasonably exist and so the economic evaluation does not bear scrutiny from a foreign investment perspective, unless there is some over-riding strategic objective.
Baby steps
Faced with this conundrum, what courses are open to the emerging economy sponsor? The ideal solution is the ‘hole in one’: time is usually of the essence and if a proposal can be secured in one (big) step, so much the better. But for the reasons (such as value proposition) described above, embarking on this one big step carries with it the risk of disappointment.
A different option is to take a more gradualist approach. There are many, smaller and relatively straight-forward steps in development within the control of the sponsors (but not the outside equity investors).
These steps do not necessarily require expensive outlays or access to foreign expertise, but nevertheless build a platform of value to ‘sell’ to external investors. At the same time, this platform frequently covers issues that are of most concern to those external investors.
The two most common areas of value building are land and consents. The business model is also important, especially where the fiscal regime can make it more attractive (such as with Economic Development Zones).
De-risking proposals
However, too much money and effort is often put towards modelling of financial returns which assume a business model that outside investors may wish to have a hand in developing or adapting (this topic refers back to the issue of overly-prescriptive PPP/PFI).
The steps to be taken within land and consents are not rocket science, yet, they are frequently ignored in the requests for proposals I read. The rigour and attention to detail around title documents for land are a simple but crucially important example of early de-risking to increase the attractiveness of projects.
The issue of land can be extensive, because it often covers not just an immediate site but any access rights or wayleaves for supporting infrastructure such as roads and pipelines. So, although the issue is fairly simple, the amount of documentation can be time-consuming (but effectively done by the emerging market equity sponsors).
Similarly, consents are another building block of value to make the initial proposition as bulletproof as possible when due diligence by outside investors occurs. Consents can be a more complicated issue than land because occasionally the existing legislation may not cover the activities desired and needs to be developed.
Either way, a clear, legally-derived, consenting path previously enacted can be another cost-effective step to existing equity value before requests for proposals and solicitation of external finance is undertaken.
Of all the most difficult pieces of advice to receive, the gradualist approach seems to be it. Perhaps it is the technocrat’s answer to a politician in a hurry and therefore is not ‘good news’. But experience of infrastructure development and financing tells me that in the longer run, it succeeds.
In summary, there are many ways to build equity value in infrastructure asset developments relatively cheaply, but these are frequently overlooked, perhaps in the desire to reach the objective as soon as possible.
In the longer term however, the more gradualist approach, while slower to begin with, is more likely to yield a successful financing more quickly, especially if the big step approach hits the buffers and has to be adjusted mid-way through the programme.
