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Watch the Cycle

Can the upward swing in global power infrastructure investment be sustained?

Fortnightly Magazine - February 2007

The pace continued in 2006 with the value of proposed acquisitions through the first half once again outpacing the previous year’s levels. The value of project-finance transactions in the sector grew to $56 billion in 2005 compared with $25 billion in 2001, and an additional $42 billion in projects were financed during the first three quarters of 2006. Private investment is expected to remain high based on strong demand-growth forecasts, in particular in emerging markets. M&A activity in the United States and Europe also is expected to continue apace due in large part to the vast amounts of committed capital in pursuit of infrastructure investments. A recent S&P report estimates that global infrastructure funds currently have committed capital of between $100 billion and $150 billion in search of projects, and a large part will be invested in power.

Highly Competitive Financing Environment

The past few years have seen an amazing rise in the amount of capital available for investment in the global-power sector. This influx of capital has led to a shift in the investment environment in a number of important ways. Banks, institutional investors, and project financiers have relaxed financial performance covenants and borrowing base formulas across every major geographic market. Currently, market liquidity far exceeds deal flow. As a result, loan-pricing margins have become increasingly thin as capital competes for projects, and the equity returns being accepted by investors are falling. At the same time, asset valuations are rising and power utilities and projects once again are becoming highly leveraged.

While positive for borrowers, the aggressive underwriting environment implies an increased risk profile for capital providers and borrowers alike, and it likely is causing project sponsors to take on more debt than they otherwise might. In this environment, prudent investors might take pause in their assessment of the potential behavior of the sector going forward. The risk of course is that the power-investment cycle could compress and become more volatile than is good for the overall financial health and stability of the sector.

Not all investor classes are alike. Pension funds and infrastructure funds are attracted by the long-term and relatively stable returns profile of the sector. Their investment time horizon is in line with the regulated nature of the power-utility sector. Private equity funds’ investment time horizons range from five to seven years, more or less. This generally is a good match, though financial turnaround or restructuring at the lower end of that time frame is potentially at odds with the sector.

Hedge funds (primarily a U.S. investment vehicle) number in the hundreds and are responsible for a significant and growing level of total funds invested in the sector. Their participation, which has grown sharply over the past two to three years, has been primarily via Term-B lending. Term-B loans are medium-term, variable rate, collateralized loans from non-bank lenders with rates historically in the range of Libor+250 basis points (though they have narrowed to below Libor+175 basis points in recent power transactions). They resemble bonds with back-end amortization, but with bank-type covenants. They also are bought and sold on