NEW YORK (S&P Global Ratings) May 6, 2019--As difficult as it often is for developed economies to build large-scale infrastructure projects, the hurdles that emerging markets face can seem insurmountable. From unfavorable political environments to funding shortfalls, the challenges that many projects must overcome is significant. Many investors see the risk-reward ratios on merchant or greenfield construction as inordinately high--which makes infrastructure projects costly to fund. This is particularly true for emerging markets, despite an abundance of private-sector capital.
Still, there are solutions in the offing, according to investment bankers and multilateral development bank (MDB) officials, and government representatives working with the U.N.-affiliated Closing the Investment Gap Initiative (CIG) who spoke at a roundtable of about 20 participants hosted by S&P Global Ratings in New York on April 26, 2019.
One key to emerging markets' success in developing sustainable infrastructure is to build a pipeline of projects—preferably similar in size and structure, and with some commonality of design—that make risk assessment and due diligence easier for institutional lenders.
To the extent that a project is developed in a rigorous way--ith solid contracts, etc.--the more likely it is to succeed. In the words of one roundtable participant, "the more baked it is and the more robust way it is put together, the easier it is for you to do your due diligence on that."
CIG is working directly with emerging markets countries to establish mechanisms to identify areas in which essentially the same project can be replicated in more than one country. For example, finding collections of cities across countries that need to swap out their old-world streetlights for more energy-efficient ones. Standard solutions easily blueprinted across regions can reduce investor due diligence, aid in speed to market, and provide potentially economies of scale.
Another challenge is developing projects with a target size that is big enough to draw investors' interest. "Where is the threshold that makes the effort more than just a bespoke engagement?" a participant asked. CIG is looking to set up groups of investors to share the risks of projects, and to build on characteristics of infrastructure investment and create a pipeline to facilitate liquidity.
Another way to gain scalability is through the bundling of infrastructure assets--an approach that is gaining momentum, driven by the needs of the diverse group of stakeholders involved in the supply, funding, construction, and maintenance of infrastructure. This includes governments, institutional investors, and contractors—each of which has different needs and motivations. (See "Bundling: A Growing Trend As Stakeholders Look To Unlock The Potential Of The Infrastructure Asset Class," published Jan. 31, 2017.)
We've seen instances in which governments have packaged assets into a single financing to meet scale requirements or to improve credit strengths by attracting larger, more experienced contractors. And while bundling can complicate the credit analysis of a transaction, we've observed that it can also, when executed, lead to the opening of new sources of capital for infrastructure.
At the same time, "you have to sell it to the bankers and investors—but you have to also sell it to the governments, and that doesn't always work," one roundtable participant said.
For emerging markets solving these problems could open up a deep source of investment capital. From a distance, it may seem that infrastructure is an asset class that investors are uniformly wary of, but it's more the barriers to investing that pose problems rather than the long-run riskiness of the asset, at least in developed markets. Infrastructure investing offers a number of attributes that institutional and private investors find attractive, such as comparatively lower default rates and higher recovery rates than those on corporate bonds. (See "2017 Inaugural Infrastructure Default Study And Rating Transitions", published Nov. 20, 2018, and "1995-2016 Global Bank Loan Unrated Project Finance Default And Recovery Report, published Nov. 20, 2018.).
But while there is significant capital interested in infrastructure, the perceived credit risk of many opportunities in emerging markets may not be attractive for institutional investors--and they have, as a matter of course, stuck mainly to investing in developed countries. S&P Global Ratings sees the comparatively elevated risks in emerging markets as including political and regulatory uncertainty, currency exchange risk, and policies that are often less developed and somewhat unpredictable
Financial ingenuity can also be key. Bankers have a talent for coming up with creative credit enhancements to get deals done, one roundtable participant said, and this poses an opportunity to encourage the private sector to deploy capital allocated to infrastructure across a wider spectrum of projects and geographies. Credit enhancement aims to mitigate specific risks of a project that may weigh on its overall credit profile and therefore make that project less appealing to private-sector participants (see "It's Time For A Change: The Role Of Credit Enhancement In Mobilizing Private Investment In Infrastructure," published Sept. 28, 2018).
As a first step to, it might be worthwhile for MDBs to explore the sale of some assets on their balance sheets to the financial markets to create liquidity in emerging markets make room to finance more bespoke projects in higher-risk countries. However, there are challenges to this for MDBs, and this idea has yet to gain much traction. Still, it may be necessary for many sustainable projects to succeed, one participant said.
For now, some banks are wary of doing emerging markets project finance because it's not economical to put their bankers on those deals given the limited pipeline, associated risks, and relatively high transaction costs. To address this, some MDBs are trying to build a debt pipeline of capital efficient cost-effective projects that together may justify banks' allocating those expensive resources, because the costs will be spread over a pipeline of projects rather than just a handful.
In short, identifying projects and financing mechanisms that will attract funding from the global investment community to put capital to work on the ground for real assets in developing countries is crucial.
Writer: Joe Maguire
This report does not constitute a rating action.
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