By Marc Frishman '98
Partner, Conduit Capital Partners


Private Equity Opportunity - “Hard Assets” in Latin America

In the year and a half since the start of the global financial crisis, many investors and professional capital managers came to the harsh realization that they had been operating without a valid concept of risk/reward, which is critical to any investment decision. Exotic derivatives had been created, analyzed, rated, and traded that often times neither the seller nor the buyer fully understood. Many of the assets that the trusted rating agencies reviewed and classified as investment grade incredibly plummeted in value overnight.

At the same time, numerous investors achieved impressive returns based on the overheated market combined with the extreme debt liquidity being offered by lenders. Private Equity and Leverage Buyout funds were able to acquire assets using very little equity based on high leverage levels never before experienced. As a result, a small increase in asset value resulted in an enormous return on investment.

While the market continued to rise, managers looked like geniuses; while an appreciation was lost that a small downturn could result in severe financial distress and render the equity investments worthless. With the resulting losses from the market crisis and correction, the actual risk that had been taken by investors quickly became apparent and surprised many. As a consequence, investors gained a new appreciation for risk/reward and began to turn with increasing interest to tangible assets with stable revenues and transparent risk profiles.

Power and Infrastructure assets fit this investment strategy perfectly and, when combined with the enormous global capital need, offer a substantial investment opportunity to interested investors. While stable returns of the power and infrastructure sector are of great interest, the rate of return can vary significantly depending on the perceived risk. Developed markets offer stable returns at lower returns than those of similar assets in the emerging markets were there is a higher perception of risk.

Those Private Equity and Infrastructure Fund investment managers with the experience to structure projects to mitigate risks in the emerging markets can achieve higher returns while reducing the real risk below the market’s perception, thereby creating a very attractive investment opportunity. Within the emerging markets there also are meaningful differences in risk and reward by region and country and one of the most important markets where success has been achieved and which continues to offer impressive opportunities is Latin America and the Caribbean.

Structure to manage project risk

First, it is important to examine how investments in the power and infrastructure sector can be structured to reduce risk before addressing opportunities for its application in different investment environments. Power and infrastructure assets are by nature long-term businesses which can expect long-term, stable revenue and carry the obligation for long-term operational and maintenance investment.

As an example, a hydroelectric power plant when well maintained can be expected to be competitive and operational for over a hundred years. This long-term business and stable revenues of power and infrastructure assets allow for a financing structure in which lenders rely solely on the asset and its expected business as collateral for the debt. Thus, critical to the financiers is the soundness of the business and the company’s contracts which allow it to operate successfully long-term.

This financing structure is known as Non-Recourse Project Finance and it is one of the most commonly used techniques to structure power and infrastructure projects. The investor’s guarantee ends with its equity participation in the company and there is no recourse back to the investor. This gives opportunities to private equity and infrastructure funds to participate in this business that otherwise would require corporate guarantees typically not possible or economically feasible for a fund. Since the independent viability of the project company is vital, the project finance structure requires strong contracts which allocate all risks to parties best able to ensure performance.

Following the example of the hydroelectric plant, if it is a new construction (“greenfield”) project, significant project risk is present in the construction of the plant. For this reason, typically a contract is realized with a creditworthy company that will guarantee a turn-key installation with date certain completion and performance guarantees. This type of contract transfers the construction and completion risk to a creditworthy third party and away from the equity investors and debt lenders. Similarly, a contract is concluded whereby an experienced company will guarantee proper operation and maintenance of the assets, once again to meet the commercial obligations of the project. The project company also requires surety of the fuel or commodity supply necessary to run the asset. The company can be sure that it will generate only, for example, if a hydroelectric plant has a long-term contract or concession for water use, a coal-fired power plant has a long-term contract for coal supply, or a natural gas pipeline has a long-term contract with a gas supplier.

The other vital contract is a strong, bankable, long-term revenue contract (Power Purchase Agreement “PPA”) with a creditworthy consumer. With a power plant or a gas pipeline, governments and/or large industrial customers such as mining, steel, and beer companies often sign long-term contracts to secure a reliable and cost-effective energy or fuel source. The optimum contracts require the consumer to pay for the contracted commitment regardless of their usage level. The commodity cost risk of the fuel, such as natural gas or coal, is often passed through to the end consumer, thus mitigating commodity risk away from the project company.

All of these contracts together provide surety to the lenders and the equity investor that the plant will be completed on time and at certain specifications, that there is a definite fuel supply to operate the plant, that there are experienced companies guaranteeing proper operation and maintenance of the asset, and that there is a creditworthy, long-term consumer obligated to pay for the product. As can be seen from the graph below, the project finance structure mitigates risks and provides for steady revenues thereby reducing risk to the investor.

Each investment situation is different and it can be often challenging and sometimes impossible to structure a pure non-recourse project financing for a power or infrastructure project due to certain specific risks that third parties are unable or unwilling to take. However, when the model is achieved, it serves as a powerful risk mitigate for investors and is straight-forward and transparent. For power and infrastructure assets already in operation, the same principles apply. In some cases, such as highways in the United States, historical consumption (toll traffic) is a reliable predictor of future revenues for lenders and equity investors if a consumption contract is not present. Both with greenfield and operating power and infrastructure projects, an investor can clearly identify the tangible asset and quantify the associated risk.

Strong demand for infrastructure investment

With the basic investment structure explained, it is next appropriate to consider different environments where it can be applied successfully. In the U.S. domestic market over the past several years, investors’ interest in stable infrastructure investments combined with several states’ and municipalities’ desire to raise capital to meet deficits. Large private equity funds were raised by managers like the Carlyle Group, Goldman Sachs, Macquarie Group, Morgan Stanley and several others to take advantage of this opportunity.

Private investment in infrastructure has a long history dating back to ancient Greece, but in more recent times the practice gained popularity in the United Kingdom under Margaret Thatcher. U.S. infrastructure investing really began in 2005 with the Macquarie Group teaming up with Spain’s Cinta for the $1.8 billion lease of the Chicago Skyway toll road bridge and the $3.8 billion lease of the Indiana Toll Road the next year. In 2008, a group led by Spain's Abertis Infraestructuras SA and Citigroup Inc. agreed to pay $12.8 billion to lease the Pennsylvania Turnpike for 75 years. In another infrastructure transaction, Morgan Stanley’s infrastructure investment group won a 75-year concession to operate the Chicago Parking Meters system.

Associated with the perception of low risk and stable cash flow in the domestic U.S. market, infrastructure investors can normally expect to achieve returns in the high single digits from operating cash flow. Some investors interested in the stable cash flow infrastructure investment model, who wish to take additional risk to achieve higher returns, have turned to the emerging markets. As mentioned, distinct risks and opportunities exist within these markets.

When targeting markets for infrastructure and power investment opportunities, in addition to basic demand, it is important to analyze where capital is needed the most. Those countries and regions that have a very high savings rate such as Asia, have significant local capital available that will not demand a premium for taking political risk. As demonstrated by the graph below, Latin America in particular has a low savings rate and thus there is a scarcity of local capital competing for investments.

Demand for infrastructure in Latin America is growing. The World Bank estimates that in order to meet expected growth in demand for infrastructure from firms and individuals, maintain existing infrastructure and achieve universal coverage in water, sanitation and electricity, at least 2.5 percent of GDP in Latin America must be invested in infrastructure, without accounting for rehabilitation or required investments in transport, ports and airports.(1) This results in investment requirement of over US$ 15 billion a year in the Latin American electric sector alone.(2) The graph below demonstrates the capacity requirement within the region.

For the international infrastructure investor, power in particular offers substantial advantages for risk mitigation over other assets. Most countries in the region operate their electric systems on a marginal dispatch basis. This means that the marginal plant (the least efficient plant in the system operating at any time) sets the price of power for all generators operating at the time.

In most countries, the marginal plant uses fossil fuels which are U.S. dollar denominated. Thus, the generators that usually set the price of electricity are considering a U.S. dollar-based commodity and in turn, price their product at a margin above this cost. As a result, in most markets in the region, power is a U.S. dollar denominated commodity. This structure does not necessarily represent a 1 to 1 foreign exchange match, but it serves to mitigate much of the currency risk typically taken by a foreign investor. Many power purchase contracts between generators and consumers in the region are paid in U.S. dollars. For example, the entire successful Mexican Independent Power Producer program involves long-term contracts in U.S. dollars between the private producer and CFE, the Mexican government-owned electric company. 

Evaluate political and regulatory risk

Given the huge demand for infrastructure investment and the requirement for foreign investment to realize projects, it is important to examine the political and regulatory regimes as well as investment environment. The first country to begin privatization in the Latin American region was Chile with the 1987 privatization of the state-owned power company, Endesa. With private participation, Chile set out to create a market-based, marginal dispatch system, which favors more efficient, cheaper producers and at the same time established clearly defined regulatory rules for participants. With competition, the end consumer benefitted as prices began to fall as seen in the graph below.  

Other countries in the region soon followed Chile’s privatization and liberalization success with Peru in 1993, Bolivia in 1994, and Argentina, Brazil, Colombia, El Salvador, Guatemala, Honduras, Nicaragua throughout the 1990s. Although private investment was initially done locally, international investors soon arrived. A snapshot of 2006 demonstrates the importance of international foreign investment into the Latin American power sector.  

A key remaining risk to address is political risk. Many Latin American countries today can be characterized as having stable governments and economies. GDP has grown in the region by 4-6 percent (in real terms) for the past several years up until the recent crisis.(3) At least four of the large countries in the region have attained investment-grade status from one of the internationally recognized rating agencies (Mexico, Chile, Brazil, and Peru). Inflation for the most part has been under control and ranges from 5-7 percent annually from the period 2003 to 2007.(4)

However, as discussed, power and infrastructure projects are long-term in nature and political and economic environments change. For instance, Venezuela’s Hugo Chavez’s anti-foreign investment actions and influence in the region cannot be overlooked. For those investors interested in insulating assets further from political risk, both multilateral agencies such as the Multilateral Investment Guarantee Agency (MIGA) of the World Bank and several commercial institutions offer political risk insurance.    

Infrastructure is a compelling investment opportunity

With the long-term, stable cash flows, growing infrastructure and power demand, adequate currency, regulatory and political risks identified, what kind of returns can an investor expect as a premium for taking the risks above those of the domestic U.S. market, which can be expected to be in the high single digit to the 11% range?

Typically, an international equity investor in a power or infrastructure project can expect somewhere in the 16%-20% range on operating cash flow prior to a liquidation event. Investment exit, all-important to the private equity fund with a definite fund life of typically 10 years, can be achieved through sale to one of many strategic energy companies historically interested in the emerging markets. Offerings in the local capital markets are also increasingly available, especially in Brazil, Mexico, Chile, and Peru, which have grown impressively over the past several years. These exits can often enhance the expected returns far above the 16%-20% range.

With the increased interest discussed in tangible assets with long-term stable cash flows, equity investors have developed a growing interest in the power and infrastructure sector. Coming out of the recent economic crisis, it is clear that investors have a new appreciation for tangible assets with stable, long-term cash flows. A significant opportunity exists not only for private equity and infrastructure fund investment in the developed markets of the United States and Europe, but also for well-structured assets in emerging markets, where additional and identified risk can often be mitigated and managed to achieve higher returns. The enormous demand for energy and infrastructure in Latin America that can be defined as tangible assets with well-understood risk profiles and attractive returns, dictate that this opportunity can be expected to continue well into the future.    

1 - Fay, M. and M. Morrison (2005). ‘Infrastructure in Latin America and the Caribbean: Recent Developments and Key Challenges.’ World Bank: Washington DC
2 - World Bank and PPIAF, PPI Project Database
3 - Global Economic Prospects 2008. World Bank: Washington DC
4 - Roldos, J. (2007). ‘Working Paper: Pension Reform and Macroeconomic Stability in Latin America.’ International Monetary Fund: Washington DC 

About the Author

Marc Frishman '98

MARC FRISHMAN '98
Partner, Conduit Capital Partners

Marc Frishman is an Investment Manager for the Latin Power Funds. Marc joined the Latin Power team in 1998. Among notable Latin Power Fund investments, Mr. Frishman was instrumental in the successful Mexhidro investment which included the origination, development, financing, operations, and sale of three medium size hydroelectric plants in western Mexico. Mr. Frishman also originated and managed the Green Energy Libramiento portfolio investment which encompassed the development, financing, operations, and sale of a 65 kilometer natural gas pipeline in Queretaro, Mexico under long-term contract with Pemex Gas y Petroquimica Basica. Other significant transactions include infrastructure projects in Chile, Argentina, Peru, and Central America. Mr. Frishman holds a B.A. degree in History and International Marketing from Tulane University and an M.B.A. degree in International Finance from Thunderbird School of Global Management. Prior to his graduate studies, Mr. Frishman worked for a Mitsubishi Group company both originating and structuring new international business ventures in the automotive, aerospace, real estate and energy industries in the United States, Japan, Europe and Latin America. Mr. Frishman has lived in Mexico and is fluent in Spanish and Portuguese.