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Hot money floods infrastructure

By Tony Jackson

Published: October 17 2006 03:00 | Last updated: October 17 2006 03:00

Infrastructure investment, it is now abundantly plain, is the new big thing.

Hedge funds may be jaded and private equity has lost its novelty. But the value of infrastructure deals worldwide this year is six times last year's total - and this is only October.

For its fans, the appeal of infrastructure, especially for pension funds, is irresistible. It offers a magic combination of low risk and rising returns - a kind of index-linked Treasury bond with a growth kicker.

In the long run, and in some cases, there may be an element of truth to that. But as was made clear at a packed conference on infrastructure in London last week, the short run could be trickier.

One big worry among delegates was the looming imbalance between supply and demand. In theory, the global need for infrastructure is far too big for governments to fund alone. Therefore, they must turn to private finance.

But even in the UK, where public-private partnerships are long-established, their use for schools and hospitals is stubbornly unpopular. And in the US, one American delegate observed, local communities can prove surprisingly reluctant to give up control of their power supplies.

As a result, the torrent of cash flooding into infrastructure funds may have trouble finding a home. Either that or it will push prices too high.

Because of that scarcity, the definition of infrastructure is getting rather loose. For a true long-term inflation-proofed risk-free cash flow, you need a natural monopoly such as a water company. But what about a merchant power station, or a shadow toll road, or an airport with the bulk of its revenues from retail or real estate? They are all exposed to the vagaries of the market. For investment purposes, they are arguably not infrastructure at all. Even with monopolies, the risk-free inflation-proofed argument wants watching. As a Dutch pension fund manager said at the conference, what matters to her is Dutch wage inflation - and that is not necessarily matched by increases allowed by a US regulator.

A Spanish banker raised another problem. A recent motorway deal in South America promised investors the consumer price index plus 3 per cent over 25 years. What matters there, he said, is not what the contract says, but whether in the long run the electorate will tolerate it.

It is also worth noting that infrastructure funds are often private equity funds wearing another hat. Of this year's $145bn (78bn) of deals, according to Thomson Financial, over half by value have had at least some private equity involvement.

This has some interesting implications. For a start, the investment is not as long-term as all that. Private equity funds aim to cash in within five to seven years.

On the plus side, there is less management risk in a utility than with most private equity investments. Even if the managers mess things up, the asset is still there.

On the other hand, there may be less scope for financial engineering under the eye of the regulator. In the US, the Federal agencies are apparently becoming more permissive as a means of attracting capital. While they once insisted on 60 per cent equity, they might now settle for 50 per cent. But that still limits the refinancing on which private equity depends.

In the UK water industry - now a particularly hot spot for deals - the regulator is bringing in rules barring the transfer of cash out of the operating company. So while the water company cannot go bust, you can if you overpay for it.

This is the exact opposite of the usual private equity deal, where the company can go bust and - with luck - you can still walk off with the cash.

None of this changes the long-term argument for true infrastructure assets, such as an established toll bridge or a water company. These have limited or no sensitivity to the economic cycle, and thus have low correlation with other asset classes.

Another great advantage is that you can be fairly sure what they will be worth in 10 or 20 years' time. This distinguishes them from, say, real estate, where there are no barriers to entry and thus no guarantee that the asset will hold its value.

So if my pension fund were to invest in such assets for the long haul, I would be relaxed about it - even at today's prices. But in the meantime, there is too much hot money in the game. I foresee accidents ahead.