“In spite of increased investor interest in infrastructure, we still aren’t seeing as much take up of opportunities in developing markets as one might expect.”
The momentum keeps building for infrastructure investments.
Last year private equity funds and infrastructure-only funds raised a record $85 billion for infrastructure projects globally, surpassing 2017’s record fundraising in this sector by $10 billion, according to alternative investment research firm Prequin.
The impressive increase in infrastructure fundraising is partly driven by infra-focused funds expanding their mandates into sectors like healthcare and education.
At the same time, investors are increasingly attracted to infrastructure because of its reputation for providing steady, long-term income streams. With infrastructure’s popularity on the rise, PE and infra firms are expected to raise 10% more in capital for infrastructure projects in 2019, Prequin predicts.
But even as funds seek to capitalize on infrastructure opportunities, some parts of the world are missing out. In a World Bank 2018 survey of CEOs, chief investment officers, and other top executives at 34 global institutional investors, many said they considered infrastructure investments in emerging markets as “problematic,” citing “regulatory and political uncertainty.”
“In spite of increased investor interest in infrastructure, we still aren’t seeing as much take up of opportunities in developing markets as one might expect,” said Rob Dixon, a V&E Mergers & Acquisitions and Capital Markets partner.
The risks in investing in infrastructure in emerging markets are real. Investors have reason to be concerned about such matters as government interference, uncertain tax regimes, and corruption. Nonetheless, with the proper legal and strategic planning, PE and infra firms can protect themselves and reap the potential benefits.
Dixon, as well as Jenny Doak and V&E Mergers & Acquisitions and Capital Markets partner Federico Fruhbeck — all of whom advise on infrastructure investments in Africa, Asia and Latin America — recently shared five hurdles PE and infra firms might encounter when investing in infrastructure in emerging markets and what these firms can do to overcome those hurdles. Here’s what they had to say.
Protect yourself from unwanted government involvement
First the good news: Infrastructure assets — whether they are telecom towers, railroads, or natural gas pipelines — are considered somewhat less vulnerable to government or rebel interference as they are often essential to a country’s operations.
Nonetheless, an emerging market government might interfere with an infrastructure project in any number of ways, from refusing to grant consents, to taking such extreme actions as expropriating property.
In addition, because infrastructure assets can’t simply be uprooted and relocated to another jurisdiction, foreign governments might seek to take advantage and impose heavy taxes.
An important strategy to consider is treaty planning, where investors structure their holdings to gain investment treaty protection.
Investment treaties are agreements between two or more countries whereby the countries agree to meet particular standards on how they will handle investments by investors from each other’s country. These agreements typically include an agreed upon framework for resolving disputes between the investor and the host country, usually giving an investor a direct right of action in arbitration against the country itself.
The vast majority are bilateral investment treaties (BITs). BITs are agreements that are signed by two countries and protect companies from one country that invest in the other country. Another type of investment treaty, the multilateral investment agreement (MIA), involves multiple countries and is often focused on a particular geographic area, or industry.
“Investment treaty planning is best done before making an investment and should be conducted in conjunction with tax-treaty planning,” Doak said.
Newcomers to a particular country might also consider co-investing with a PE or infra firm that has experience navigating in emerging markets or alongside local partners or entities that they know well, and that primarily operate in the region. Structuring contracts to include protections from government interference, including material adverse change provisions, is also advised.
Corruption is a real risk, all the more reason to have a best-in-class compliance program
PE and infra funds with UK or U.S. investors are required by law to institute anti-corruption programs in order to comply with the UK Bribery Act and the U.S. Foreign Corrupt Practices Act respectively.
But even PE funds that aren’t subject to anti-bribery laws can benefit from setting up anti-corruption and whistle-blowing procedures and training programs.
It has become common practice for PE and infra firms investing in foreign infrastructure projects to conduct extensive due diligence on prospective partners, agents, and other third parties, particularly when investing in developing markets. PE and infra firms can further protect themselves by insisting on appropriate OFAC, FCPA, UKBA and other representations, warranties, indemnities and audit rights.
Going global? Think local
A host state in an emerging market might require that a foreign investor include local owners or use local suppliers. It’s important to factor in these potential requirements when setting up procurement systems and strategies.
Keep in mind, if you will be working with a local partner, it’s important to conduct extensive diligence, particularly if the partner is a government-owned entity.
“Ultimately, finding the right local partner with knowledge on the ground could be beneficial,” Fruhbeck said. “But this is not something that should be done in a hurry.”
Moving money in and out of emerging markets can be complicated and costly but proper planning can ease the pain
Injecting cash into infrastructure investments, and distributing profits, can be far more complex in emerging markets than it is in developed markets.
Certain host countries might impose exchange control restrictions in an effort to deter speculation against their currencies. This adds a level of complexity to managing infrastructure assets that might require capital infusions.
At the same time, a developing country might impose offshore dividend taxes that can cut into investment profits.
Incorporating proper safeguards into customer contracts from Day 1 is critical to the success of any infrastructure investment. Such safeguards should seek to minimize the potential of revenue erosion that might occur in the event of changes in the relative values of relevant currencies, or from inflation.
At the same time, it’s important to build flexibility into debt agreements so that restrictions to accessing cash do not impede a debtor’s ability to meet its debt obligations.
Finding the right legal, accounting, and business advisors who can advise on injecting and extracting cash, and on the key contracts, is critical. An experienced international tax lawyer, for instance, can advise on the availability of relief under tax treaties to mitigate taxes that a foreign country might impose on the repatriation of income.
Exits can get rocky, so it pays to think ahead
Will I be able to successfully exit this investment? Liquidity is a legitimate concern for private equity firms circling emerging market infrastructure investments.
In 2018, the number of PE exits in Africa declined to 46 from 52 in 2017, according to the African Private Equity and Venture Capital Association. Just 2% of those exits were IPOs and other capital markets transactions.
There are many ways to improve the chances of a successful exit. One strategy is to diversify holdings across multiple countries, thereby spreading risk.
PE and infra funds that invest in a single country opportunity can seek to spread risk by including “flip up” rights in their contracts. In so doing they can reserve the right to “flip up” their investments to a future holding company that has assets spread across multiple countries.
“When entering an infrastructure investment in an emerging market, investors should carefully consider tailored contractual protections,” Dixon said. “Being thoughtful at the outset can significantly boost your chances of a smoother exit down the line.”