INFRASTRUCTURE FINANCE

The Amazing Growth Of Global Infrastructure Funds: Too Good To Be True? Primary Credit Analyst: Michael Wilkins London (44) 20-7176-3528 mike_wilkins@ standardandpoors.com

Both investors and lenders need to be fully aware of the credit risks arising from the recent breathtaking rise of global infrastructure funds. The rise of funds in the sector has led to banks, private equity groups, and investment managers alike struggling to buy suitable assets in the sector. Simultaneously, infrastructure deals are becoming increasingly highly leveraged, reflecting what Standard & Poor’s Ratings Services believes to be a pricing bubble caused by the wave of new funds chasing limited assets. Despite this increased appetite, however, full risk analyses of assets must always be carried out, because not all will boast the strong, stable features assumed typical across the global infrastructure sector. Credit quality is coming under downward pressure as a growing number of infrastructure assets—especially utilities, airports, ports, and toll-road operators—are being privatized or sold or auctioned by existing owners that wish to take advantage of the voracious appetite of infrastructure funds. It is estimated that $100 billion-$150 billion of fund money has been raised globally and is waiting to be placed in suitable assets in the infrastructure sector. So far in 2006 we have seen more than $145 billion of M&A activity in the sector, representing a stunning 180% increase since 2000. There are no signs that 2007 will be different. Valuation and debt-to-EBITDA multiples in infrastructure M&A deals have been soaring, while equity contributions have generally been decreasing. As a result, credit quality is suffering across the sector as infrastructure assets adopt aggressive balance sheets in an attempt to fend off private equity players. This was recently demonstrated by the defense of U.K. airports operator BAA PLC (BBB+/Watch Neg/A-2) against a takeover by the Airport Development And Investment Ltd. consortium in the spring of 2006. With debt-to-EBITDA multiples in recent deals ranging from 12x to 30x, it is clear that, as a result of rampant demand, the infrastructure sector is in danger of suffering from the

RatingsDirect Publication Date Nov. 30, 2006

dual curse of overvaluation and excessive leverage—the classic symptoms of an asset bubble similar to the dotcom era of the last decade. When that particular bubble burst many investors lost out. Those who cannot remember the past are condemned to repeat it: Due diligence and

The Amazing Growth Of Global Infrastructure Funds: Too Good To Be True?

robust credit analysis of assets should be undertaken in the infrastructure sector to prevent similar mistakes occurring again.

The Attraction Of Infrastructure: Strong And Stable Yields Infrastructure funds are managed vehicles through which investors are able to gain exposure to the underlying characteristics of a portfolio of infrastructure assets. The global trend toward investing in such assets was started in Australia and Canada with large, dedicated funds being launched in the sector by such established players as Macquarie Infrastructure Group; Babcock & Brown Ltd.; and large pension funds including the Canadian Pension Plan Investment Board and Borealis Infrastructure Trust (senior secured debt A+; senior unsecured debt A-), part of the Ontario Municipal Employees Retirement System (AAA/Stable/A-1+). Pension funds in particular have been driving demand for infrastructure assets, attracted by their essential long-term nature, strong competitive position, and stable and relatively strong yield returns. Infrastructure assets have also demonstrated a low correlation to equity markets and other major asset classes, helping to provide valuable diversification to fund managers. Therefore, the long-life, inflation-indexed returns provide a very good match for the long-dated liabilities of pension funds. Increasingly these Australian and North American funds have turned their attention toward European infrastructure assets. They have been attracted by the favorable regulatory systems for utilities and transportation infrastructure companies and opportunities to invest in the growing public private partnerships (PPPs) market. The U.K., with the most established PPP sector in Europe, and Italy have seen the most substantial amount of investment, claiming 26% and 20% of all infrastructure activity since 2003, respectively (see chart 1). Breakdown By Country Of Total Infrastructure Investment In European OECD Countries January 2003 to February 2006 The Netherlands (7%) Denmark (2%) Other (8%)

Germany (8%)

France (9%) Belgium (9%)

Spain (11%)

Italy (20%)

U.K. (26%)

Sources: Macquarie Equities Research and Thomson Financial. © Standard & Poor's 2006.

By sector, it has been electricity and transmission distribution that has reaped the most investment in Europe (see chart 2). We anticipate continued growth in these areas globally, as well as in the airports, transport, and toll-road sectors. Regulated infrastructure has also proved significantly popular.

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The Amazing Growth Of Global Infrastructure Funds: Too Good To Be True?

Breakdown By Sector Of Total Infrastructure Investment In European OECD Countries January 2003 to February 2006

Gas transmission and distribution (13%) Transport and toll roads (11%)

General utilities (16%)

Communications infrastructure (3%)

Airports (4%)

Sources: Macquarie Equities Research and Thomson Financial.

Electricity and transmission distribution (53%)

© Standard & Poor's 2006.

A Wave Of New Funds Fuels Demand… The astounding rise of new private infrastructure funds is illustrated by the sheer number being raised: 10 have been raised so far this year alone, and another 17 yet to be closed. New names have joined the established Australian and North American players, including the likes of The Goldman Sachs Group Inc. (AA-/Stable/A-1+), ABN AMRO Bank N.V. (AA-/Stable/A-1+), 3i Group PLC, The Carlyle Group, and Henderson Global Investors PLC. The average size of the funds is similarly growing, rising from £150 million in 2000 to £350 million in 2006. A key trend amidst this growth has been the rise of consortium deals, with private equity companies, infrastructure funds, pension funds, and banks joining forces. This has been demonstrated in the acquisition of such large infrastructure assets as Thames Water (Thames Water Utilities Ltd.{BBB+/Watch Neg/—} and RWE Thames Water PLC {BBB-/WatchNeg/A-3}), BAA, and Associated British Ports (not rated).

…But Private Equity Involvement Raises Important Issues Interestingly, the line between private equity companies and established market participants is becoming blurred as the former diversify away from core businesses and establish their own infrastructure funds. As a result, private equity firms accounted for 50% of the deals in 2006 (see chart 3). It is worth considering, therefore, specific credit issues related to the behavior of private equity companies when they act as investors in the infrastructure sector. Regulated infrastructure assets do not typically lend themselves to operational turnaround or financial restructuring within the three-to-five-year investment period typically adopted by such players.

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The Amazing Growth Of Global Infrastructure Funds: Too Good To Be True?

Breakdown Of Global Infrastructure Deal Volumes By Type 1998 to 2006

Nonprivate equity (left scale)

Private equity (left scale)

Private equity deals as a % of total (right scale)

(Bil. $)

(%) 45

120

40 100 35 30

80

25 60 20 40

15 10

20 5 0

0 1998

1999

2000

2001

2002

2003

2004

2005

2006*

*Year to date. Source: Thomson Financial. © Standard & Poor's 2006.

One important aspect to consider is public-policy issues that might flare up under private equity ownership given investment strategies and highly leveraged acquisition structures. Infrastructure companies are typically regulated monopolies providing essential public services and, as such, often benefit from strict supervision and oversight by government or public sector entities. There could, therefore, be a conflict between the interests of the private equity owner and the governments or regulators that are trying to protect the interests of the consumer. Another key concern is the escalation in acquisition prices, fuelled in part by cheap debt in a highly liquid bank market, which could negatively affect credit quality. The acquisition of BAA by Airport Development And Investment, a consortium of bidders led by Spanish concession and construction group Grupo Ferrovial S.A. (not rated), in February 2006 has been the largest deal since 1998 (see table), valued at $30.2 billion and with a total-debt-toEBITDA multiple of about 16x.

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The Amazing Growth Of Global Infrastructure Funds: Too Good To Be True?

Largest Global Infrastructure M&A Deals Since 1998 Date

Target (and country)

Activity

Acquirer (and country) Deal value (Bil. $)

Feb. 8, 2006

BAA PLC (U.K.)

Airports and airportterminal services

Grupo Ferrovial S.A. (Spain)

30.2

April 23, 2006

Autostrade SpA (Italy)

Inspection and fixed facilities for motor vehicles

Abertis Infraestructuras S.A. (Spain)

28.4

May 29, 2006

Kinder Morgan Inc. (U.S.)

Natural gas transmission and distribution

Private equity consortium 27.5 (U.S.)

Jan. 18, 2000

Coastal Natural Gas Co. (U.S.)

Natural gas transmission and distribution

El Paso Corp. (U.S.)

15.7

Oct. 16, 2006

Thames Water* (U.K.)

Water supply

Macquarie Bank Ltd. (Australia)

14.9

Feb. 27, 2006

KeySpan Corp. (U.S.)

Natural gas distribution National Grid PLC (U.K.)

11.9

June 27, 2002

Railtrack PLC (U.K.)

Railroads and line-haul operating

Network Rail Infrastructure Finance PLC (U.K.)

11.5

Oct. 2, 2006

AWG PLC (U.K.)

Water supply

Osprey Acquisitions (Canada)

10.3

Source: Thomson Financial. *Includes the entities RWE Thames Water PLC, Thames Water Utilities Finance PLC, and Thames Water Utilities Ltd.

As infrastructure funds enter ferocious bidding wars, the valuation and debt multiples are rapidly increasing, while equity shares are becoming ever slimmer. This has also been illustrated by BAA’s recent acquisition of Budapest airport at a ratio of 23x debt to EBITDA, and the more recent acquisition of London City Airport by a consortium of American International Group Inc. (foreign currency —/— /A-1+; local currency AA/Stable/A-1+), General Electric Capital Corp. (AAA/Stable/A-1+), and Credit Suisse (AA-/Stable/A-1+) at a debt-to-EBITDA ratio of more than 20x. Standard & Poor’s has also identified a similar negative credit issue: The adoption of increasingly aggressive balance sheets by potential target infrastructure assets in an attempt to stave off predatory private equity investors. This was exemplified by BAA’s recent defense tactics, announced on May 25, 2006, which included a special shareholder capital return in 2007 of £750 million. Another important credit issue is the growing trend toward deep-future concession financing. We have previously discussed this issue in the article titled “Assessing The Credit Quality Of Highly Leveraged Deep-Future Toll-Road Concessions,” published on Feb. 23, 2006, on RatingsDirect, the realtime Web-based source for Standard & Poor’s credit ratings, research, and risk analysis, at www.ratingsdirect.com. The article identifies the increasing ambition of funds such as those managed by Macquarie Bank Ltd. (A/Stable/A-1) to extend structures beyond those typical of project finance. The blending of corporate and structured-finance solutions allows for much higher levels of leverage within the transactions. Macquarie Motorways Group Ltd. (senior secured debt and bank loan ‘BBB’), the financing vehicle behind the M6 toll-road refinancing project in the U.K., is a classic example of this.

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The Amazing Growth Of Global Infrastructure Funds: Too Good To Be True?

Not All Roads Are Paved With Gold So, it appears there might be a pricing bubble forming within the infrastructure asset class, with investors seeking stable returns by investing in infrastructure funds. Those investors, however, could end up being exposed to overpriced and overleveraged assets, with valuations and debt driven upward by the fierce competition among infrastructure funds. As advisory fees climb—hitting a total of $830 million in 2006—it is feared that this might push fund managers toward inappropriate private equity strategies in order to justify these fees. Furthermore, Standard & Poor’s recognizes that the performance of some infrastructure funds has dipped: Macquarie Infrastructure Group recently announced reduced net profits, signaling price stagnation for its specialist funds, and has decided to cancel the float of its fund, Macquarie Growth Income Group. The Goldman Sachs $3 billion fund has similarly been experiencing a difficult environment. The fund has struggled to acquire assets, with Associated British Ports remaining its only significant win in Europe, although it has had more success in the U.S. The fund has since increased to $6 billion in equity following its second closing. These difficulties demonstrate that the infrastructure fund template originally established by Macquarie Infrastructure Group—that is, to make very strong long-term assets attractive by borrowing or refinancing using cheaper debt to make short-term dividend payments—might be put under pressure should interest rates start to rise. Highly leveraged deals might become less attractive to investors as the lending climate changes and liquidity dries up. Standard & Poor’s believes that the current creation of infrastructure assets and projects will remain strong and many more assets are likely to come to market as privatization spreads and regulatory regimes become increasingly stable throughout Europe. As infrastructure owners come under escalating pressure to sell their assets, however, due diligence processes and whole risk analyses become paramount—otherwise the credit risk involved in each transaction will not be fully appreciated. If risk parameters weaken, the infrastructure sector will increasingly lose its key attractive feature of relatively strong and stable yield returns.

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