Due Diligence.

Infrastructure investments, due to their high complexity and longevity, stand apart from other asset classes. This complexity necessitates the need for investors to either develop or engage advisers with specific legal and sector-specific technical expertise to conduct due diligence. This process of due diligence is crucial to understand the potential risks and rewards associated with the investment.

Infrastructure due diligence involves several unique elements that are not typically found in other types of investments. These include:

Specific jurisdictional, legal, and regulatory considerations: For instance, a hydroelectric power plant in Brazil would have different legal and regulatory considerations compared to a toll road project in the United States. These considerations are unique to the location and legal framework of the infrastructure project.

Detailed technical issues: These are associated with engineering, procurement, and construction contracts. For example, the construction of a high-speed rail line would require a deep understanding of the technical aspects such as the type of rail technology to be used, the procurement of materials, and the construction timeline.

Details, scope, and commercial terms of the concession agreement: These are the terms under which the project will be developed and operated. For instance, a concession agreement for a port might include details about the lease period, the fees to be paid to the government, and the rights and responsibilities of the operator. They are unique to each project and require careful scrutiny.

Like other private markets, investors use a variety of sources to gather information about factors affecting the asset’s future economic use. This includes forecasting demand and long-term growth. For example, an investor in a toll road project might look at population growth forecasts, traffic patterns, and economic growth projections to estimate future toll revenues. However, unlike private equity or real estate, where asset appreciation over a several-year period of restructuring or development drives a greater focus on the market or real estate cycle, infrastructure investors seek to ensure the protection of a project’s long-term viability over multiple cycles. This requires a greater focus on both jurisdictional and legal issues, as well as performance and default risk of the multiple parties involved.

Three key areas of importance for infrastructure due diligence

1. Jurisdictional, Legal and Regulatory Framework

In infrastructure projects, understanding the jurisdictional, legal, and regulatory framework is of paramount importance.

Public Authorities’ Involvement in Infrastructure Projects

Public authorities play a significant role in infrastructure projects, both directly and indirectly. For instance, a government agency might be directly involved in a highway construction project, while a regulatory body might have an indirect role in setting the standards for the project. This necessitates a comprehensive understanding of the host country’s laws and a detailed knowledge of regulations specifically related to the project.

Key aspects to consider include the grantor of property use, the right to construct and operate the asset under an associated concession, and key commercial terms. For example, in the case of a wind farm project, the grantor might be the government agency responsible for land use, and the concession might be the right to operate the wind farm for a specified period.

The legal status of the grantor and laws governing its authority are crucial considerations for investors. For instance, if the grantor is a government agency, investors need to understand the laws that govern the agency’s authority to grant property use rights. Investors must also consider the means of dispute resolution and potential issues related to sovereign immunity. For example, if a dispute arises between the investor and the grantor, the investor needs to know how the dispute will be resolved and whether the grantor has sovereign immunity, which could limit the investor’s legal recourse.

Financial Recourse

Lenders must thoroughly investigate financial recourse, such as the ability to assume control or take possession of project assets, cash reserve accounts, insurance proceeds, or other assets. For example, if a project fails, lenders need to know whether they can take control of the project assets to recover their investment.

They must also consider the right to take corrective action via negative covenants or other means when a project is in trouble. For instance, if a project is not meeting its financial targets, lenders need to know whether they have the right to enforce negative covenants, such as requiring the project to maintain a certain level of cash reserves.

When investing in developing markets, investors also consider the degree of technical and financial support from global or supranational financial institutions, governments, and globally active developers and operators. For example, an investor might consider investing in a solar power project in a developing country if the project is supported by a global financial institution like the World Bank. They also consider the existence of currency controls or limitations on the repatriation of returns or capital investments. For instance, an investor might be hesitant to invest in a country that has strict currency controls that could limit the investor’s ability to repatriate profits. Compliance with anti-corruption laws, ESG (Environmental, Social, and Governance) issues, and reputational risk issues also require evaluation. For example, an investor might avoid investing in a project if the project is associated with a company that has a history of violating anti-corruption laws.

2. Engineering, Procurement, and Construction Contract Issues

Investment in any project requires a meticulous evaluation of various aspects, including its technical feasibility and compliance with legal and regulatory requirements. This evaluation process involves a detailed examination of the project’s engineering, design, and construction plans. For instance, if a company is planning to construct a new manufacturing plant, the investors need to ensure that the design is robust, the engineering is sound, and the construction plans are achievable by the project developers. Moreover, these plans must adhere to all safety and regulatory requirements, which could be local or international standards like ISO or OSHA.

Another critical aspect that investors need to consider is the project cost estimates. These estimates should be reasonable and should be paired with a realistic timeline. For example, if a tech startup is developing a new software product, the investors need to ensure that the cost estimates are not inflated and the timeline for development, testing, and launch is practical. This timeline should also factor in the time required for obtaining necessary permits and approvals, as well as potential delays, risks, and contingencies. Understanding the likelihood and consequences of cost overruns and project delays is also crucial for investors.

Procurement and contracting arrangements for the project must adhere to specific guidelines and regulations. These may include local labor laws, potential environmental and community impact, and compliance with zoning and land use regulations. For instance, if a real estate developer is planning a new residential complex, the investors need to ensure that the project complies with local labor laws, does not have a negative environmental impact, and is in line with zoning and land use regulations.

Investors are also required to review the procurement strategy, evaluate contracts and sub-contracts, and assess the reputation, track record, and financial stability of developers and contractors. This is to ensure that the project is carried out smoothly and successfully, without any legal or financial issues. For example, if a company is outsourcing a part of its operations, the investors need to review the contracts, assess the reputation of the outsourcing partner, and ensure that the partner has the financial stability to deliver the services as per the contract.

3. Concession Scope, Specifications, and Term

When investing in infrastructure projects, it is essential to have a comprehensive understanding of the specific size and timing of revenue flows, as well as any contingencies. This goes beyond the general distinction among fixed or availability-based, commercial, or regulation-based payment schemes. For instance, consider a toll road project. The concessionaire, the company granted the concession, may be obligated to meet certain maintenance or operating standards to receive full compensation. This could include maintaining the road surface to a certain standard or ensuring the availability of emergency services.

Moreover, the concessionaire might also be required to renew or upgrade assets or increase capacity as the concession term approaches its end. For example, towards the end of the concession period for a port, the concessionaire might be required to upgrade the port facilities or increase its capacity to handle more ships. In some instances, the total project receipts may not cover operating costs or additional investments. This necessitates the grantor, typically the government, to establish alternative forms of cost recovery, which could include subsidies, taxes, or other government sources.

Infrastructure Investment Valuation

When it comes to the valuation of private infrastructure assets, a widely accepted method is the Discounted Cash Flow (DCF) approach. This method is particularly useful in the context of infrastructure assets where there is a lack of comparable transactions, limiting the use of relative value techniques. The DCF approach takes into account the periodic equity distributions, often in the form of dividends \(D_t\), and discounts them using a series of discount rates. These discount rates are a combination of risk-free rates \(r_t\) and an asset-specific risk premium (\(\gamma_t\)), which contains relevant risk factors. The intrinsic value of the asset is then calculated using :

$$\text{Intrinsic Value} = \sum_{t=1}^{T} \frac{D_t}{(1 + r_t + \gamma_t)^t}$$

The asset-specific risk premium (\(\gamma_t\)) is essentially a summation of all relevant risk factors. It can be represented as:

$$\gamma = \sum_{k=1}^{K} \text{Risk Factor}_{k,t}$$

Where \(\text{Risk Factor}_{k,t}\) represents the kth risk factor at time t

For instance, consider a toll road project. The risk factors could include traffic volume risk, operational risk, and regulatory risk. Each of these risks would be quantified and included in the calculation of the asset-specific risk premium.

While the DCF method is predominantly used, the alternative of a replacement cost approach is often overlooked. This is because it fails to consider a project’s underlying business model, source of cash flows, and life cycle timing.

Risk Factors

When it comes to the valuation of infrastructure assets, a common approach is the buildup method. The buildup approach is a method used to calculate the required rate of return on an investment, especially when there are no directly comparable publicly traded companies or the investment is considered to be more complex, such as infrastructure assets. This method is particularly useful for private company valuation or projects where traditional models like the Capital Asset Pricing Model (CAPM) may not be directly applicable due to the lack of market-based beta or comparables. This method combines several risk factors due to the limited applicability of the capital asset pricing model when using public company comparables. The risk factors considered in this approach include:

Size: Size refers to the scale of the infrastructure assets. Larger assets, such as a nationwide railway system or a major airport, are less liquid, leading to a higher liquidity premium associated with owning such assets. This factor typically rises under adverse market conditions when investors seek greater liquidity. For instance, during the 2008 financial crisis, large-scale assets were harder to sell due to their size and complexity.

Leverage: Leverage is the use of borrowed capital to finance an investment. Higher leverage generally commands a higher risk premium. However, falling leverage ratios over the life of an infrastructure project contribute to lower future discount rates. Projects with a contractual, fixed cash flow business model, such as toll roads or power plants, can often support greater leverage than those with merchant payment schemes.

Profitability: Profitability is inversely related to risk and is often believed to have a smaller impact on the discount rate than other factors. Higher profits lead to a lower and typically negative risk premium, while lower profits have a higher risk premium. For example, a profitable toll road project would have a lower risk premium compared to a struggling retail complex.

Investment: High capital expenditures as a proportion of project assets typically indicate an asset in the development phase of its life cycle, which is associated with the highest risk. This factor tends to be higher for greenfield investments (new projects) than for brownfield investments (upgrades or expansions of existing projects).

Country Risk: Country risk refers to the economic, political, and social risks associated with investing in a particular country. Developing markets, such as those in Africa or South America, have higher project risk than do developed markets like the United States or Western Europe.

Currency Risk: Currency risk arises when long-term project cash flows are in a foreign currency and remain unhedged. In such cases, a currency risk premium should be incorporated to address the risk of depreciation in the foreign currency cash flows and its impact on investor currency returns. For example, a US investor in a project in Mexico would face currency risk if the Mexican peso depreciates against the US dollar.

These aggregated risk factors are combined with each respective risk-free rate to derive a periodic discount rate used for valuation purposes.

Uncertainty Analysis

• Scenario Analysis:
  Scenario analysis is a technique used to predict the outcome of an investment by evaluating different possible scenarios. It involves creating a “base case” scenario which is considered the most likely or standard path for the project’s financials. In addition to this, analysts develop alternate scenarios which may be more favorable (“upside” scenario) or more adverse (“downside” scenario) than the base case. These alternate scenarios could include a range of factors such as economic growth, interest rates, regulatory changes, or technological advancements. Each scenario is assigned a probability reflecting how likely it is to occur. The expected value is then calculated using the average of these scenario values, each weighted by its probability. This method helps in understanding the range of possible outcomes and the risks associated with them.
• Sensitivity Analysis:
  Sensitivity analysis is used to understand how the variation in the output of a model can be attributed to different variations in the inputs. Essentially, it measures how ‘sensitive’ the outcome is to changes in one variable while keeping other variables constant. This method is particularly useful when assessing the robustness of a financial model. Sensitivity analysis helps in identifying which variables have the most influence on the final investment value, which can be crucial for decision-making. For example, in an infrastructure project with variable merchant-based cash flows (such as a power plant selling electricity at market prices), sensitivity analysis could reveal how changes in electricity prices or fuel costs could affect the project’s profitability.

Both scenario and sensitivity analysis tools help investors and risk managers gauge the impact of changes in key value drivers but may also raise shortcomings of simplified model assumptions that warrant further refinement.

Practice Questions

Question 1: An investor is considering an infrastructure investment and is preparing to conduct due diligence. The investor understands that infrastructure investments are characterized by their high complexity and longevity, and that they require specific expertise. In order to ensure the protection of the project’s long-term viability over multiple cycles, which of the following elements should the investor focus on during the due diligence process?

1. Forecasting demand and long-term growth, focusing on the market or real estate cycle.
2. Specific jurisdictional, legal, and regulatory considerations, detailed technical issues, and the details, scope, and commercial terms of the concession agreement.
3. Only the financial aspects of the project, such as the projected return on investment and the financial stability of the parties involved.

Answer: Choice B is correct.

When conducting due diligence for an infrastructure investment, the investor should focus on specific jurisdictional, legal, and regulatory considerations, detailed technical issues, and the details, scope, and commercial terms of the concession agreement. Infrastructure investments are complex and long-term in nature, and they require specific expertise. The investor needs to understand the legal and regulatory environment in which the project operates, as well as the technical aspects of the project. The concession agreement, which outlines the terms and conditions under which the project is to be developed and operated, is also a critical element of the due diligence process. By focusing on these elements, the investor can ensure the protection of the project’s long-term viability over multiple cycles.

Choice A is incorrect. While forecasting demand and long-term growth and focusing on the market or real estate cycle are important aspects of due diligence, they are not the only elements that the investor should focus on. Infrastructure investments are characterized by their high complexity and longevity, and they require a more comprehensive approach to due diligence that includes legal, regulatory, technical, and contractual considerations.

Choice C is incorrect. Focusing only on the financial aspects of the project, such as the projected return on investment and the financial stability of the parties involved, is not sufficient for due diligence in infrastructure investments. While these are important considerations, they do not provide a complete picture of the project’s long-term viability. The investor also needs to consider jurisdictional, legal, regulatory, technical, and contractual issues to fully understand the risks and opportunities associated with the investment.

Question 2: An investor is preparing to conduct due diligence on an infrastructure project. The investor understands that infrastructure investments are unique and require a deep understanding of various aspects. Which of the following is NOT a unique element of infrastructure due diligence that the investor should consider?

1. The specific jurisdictional, legal, and regulatory considerations of the project.
2. The detailed technical issues associated with engineering, procurement, and construction contracts.
3. The projected return on investment and the financial stability of the parties involved.

Answer: Choice C is correct.

The projected return on investment and the financial stability of the parties involved is not a unique element of infrastructure due diligence. While these factors are indeed important in any investment decision, they are not unique to infrastructure investments. These are standard considerations in any investment due diligence process, regardless of the type of investment or the sector in which the investment is being made. The projected return on investment is a fundamental aspect of any investment decision, and the financial stability of the parties involved is a key risk factor that needs to be assessed in any investment due diligence process. Therefore, while these factors are important, they are not unique to infrastructure investments.

Choice A is incorrect. The specific jurisdictional, legal, and regulatory considerations of the project are indeed unique elements of infrastructure due diligence. Infrastructure projects are often subject to specific jurisdictional, legal, and regulatory considerations that can have a significant impact on the project’s feasibility, risk profile, and potential returns. These considerations can include things like planning and zoning laws, environmental regulations, and the legal and regulatory framework for public-private partnerships.

Choice B is incorrect. The detailed technical issues associated with engineering, procurement, and construction contracts are also unique elements of infrastructure due diligence. These contracts are often complex and technical in nature, and understanding them requires a deep understanding of the specific technical issues involved in the project. This can include things like the technical feasibility of the project, the reliability of the technology being used, and the capacity and capability of the contractors involved.

Glossary

• Infrastructure Investment: An investment in the basic physical systems of a business or nation. Examples of infrastructure investment include roads, bridges, airports, water and sewerage systems, and telecommunications.
• Due Diligence: An investigation or audit of a potential investment to confirm all facts, such as reviewing all financial records, plus anything else deemed material.
• Concession Agreement: A negotiated contract between a company and a government that gives the company the right to operate a specific business within the government’s jurisdiction, subject to certain conditions.
• Grantor: The entity that grants property use rights.
• Concession: The right to operate an asset for a specified period.
• Sovereign Immunity: A legal doctrine that prevents a sovereign state or its political subdivisions, departments, and agencies from being sued without its consent.
• Negative Covenant: A promise or contract that restricts a company from doing certain things.
• ESG: Environmental, Social, and Governance factors are a set of standards for a company’s operations that socially conscious investors use to screen potential investments.
• Technical Feasibility: The measure of the practicality of a specific technical solution and the availability and reliability of the technology needed to implement it.
• Regulatory Requirements: The rules and regulations that businesses must follow, which are often associated with the type of industry or the specific type of service or product they offer.
• Procurement Strategy: The plan that is put in place to dictate the expected direction of all procurement activities within an organization.
• Cost Overruns: When the actual cost of a project exceeds its estimated cost.
• Concessionaire: The company or entity that is granted the concession or right to operate a business.
• Grantor: The entity, typically a government, that grants the concession.
• Private Real Estate Portfolio: A collection of properties that are directly owned by an investor.
• Subsidies: Financial aid provided by the government to support businesses or economic sectors.
• Regulation-based payment schemes: Payment plans that are determined by regulatory authorities.
• Discounted Cash Flow (DCF): A valuation method used to estimate the value of an investment based on its expected future cash flows.
• Intrinsic Value: The perceived or calculated value of a company, including tangible and intangible factors, using fundamental analysis.
• International Finance Corporation (IFC): An international financial institution that offers investment, advisory, and asset management services to encourage private-sector development in less developed countries.
• Export Credit Agencies (ECA): Institutions that offer trade financing, insurance and other services to companies doing business in emerging markets.
• Liquidity Premium: An additional yield that investors demand when any given security cannot be easily converted into cash, and converted at the fair market value.
• Risk Premium: The return in excess of the risk-free rate of return an investment is expected to yield.
• Greenfield Investment: A type of foreign direct investment where a parent company builds its operations in a foreign country from the ground up.
• Brownfield Investment: The purchase or lease of existing production facilities to launch a new production activity.
• Scenario Analysis: A process of analyzing possible future events by considering alternative possible outcomes.
• Sensitivity Analysis: A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions.

Private Markets Pathway Volume 2: Learning Module 7: Infrastructure; LOS 7(d): Discuss the due diligence and valuation processes for infrastructure investments