jakarta-ku!

Financing solutions for the Infrastructure development

by: David O'Brien, Jakarta

The recent infrastructure summit has provoked plenty of discussion. Much of the focus has been upon the framework required to restore private sector investors' confidence. Little has been written about creating an environment that will help lower the overall costs to Indonesia.
These cost savings can be largely achieved by transparent competitive tendering, reducing exchange rate exposure and creating asset classes best suited to different investor risk profiles.
Appropriately structured infrastructure projects offer long term, secure, measurable cash flows. The very nature of the investments (comparatively low risk) means there will not be spectacular returns but the stability provided should be a necessary part of any well weighted investment portfolio.
The risk is usually lessened by the government providing a concession or a government entity being the off taker. The security and term has the potential to appeal to both institutional and retail investors.
The long term nature of cash flows is particularly suited to pension funds and insurance companies. These funds face liabilities to fund pensions/pay life assurance over a similar (long) time period. A pension fund needs to protect its members' capital. It is doing a disservice if the earnings generated on that capital are consistently below an appropriate risk based return.
It is true that historically equity investments have provided the greatest return on invested capital as an asset class. However these investments have also been subject to significant volatility. The stream of cash flows in the short to medium term cannot be assured, leaving the ability to meet its commitments in doubt. As a proportion of assets for a pension/insurance fund portfolio it should not predominate.
In the current Indonesian case the split of asset classes is 10 percent in equities, 10 percent property, 60 percent cash deposits and government bonds and 20 percent in other bonds. These latter bonds are likely to be in local companies and of a higher risk bearing class than that proposed for infrastructure assets. The 60 percent held in deposits and government bonds does however seem too risk averse to cover potential volatility in the balance of asset classes.
The Association of Indonesian Pension Funds (ADPI) has announced that it wishes to have more exposure to the sector (The Jakarta Post, Jan. 27, 2005). However they discuss equity investments in the firms that are developing assets. As an asset class this is the same as equity and shares all the same risks, albeit the particular company develops infrastructure.
ADPI would be better off to consider investing in the underlying assets which have security over the underlying cash flows. The developer of the infrastructure is best treated as a separate entity to best match different investor risk profiles. The Indonesian capital markets need to consider the development of new products that split the risk of asset developers and asset managers. A potential structure I describe below.
This is whereby separate listed vehicles are created to reflect the different risk profiles of development/construction and management. One vehicle will hold the project assets and make distributions based upon the project cash flows. These distributions can often be tax advantaged due to the large depreciation allowances associated with such major infrastructure.
The second vehicle is responsible for successful development and management/operation of the assets constructed. This entity therefore has a higher risk profile as it is responsible for successful, timely completion of project (s) and their ongoing operation. It may be that this second entity can develop and or manage other facilities. This may provide for a growth premium which can be ascribed to this component of the entity. The management fees earned are usually subject to performance targets being bettered.
It is the first vehicle that is ideally matched to an investor with a long term liability horizon and need for stable, secure returns. They may still hold a much smaller proportion of their portfolio in the development/management company to ensure an appropriate risk based weighting.
The wonder of infrastructure investments to generate cash flows for investors is further enhanced by financial engineering. The quality of cash flows inherent in the asset allows for high levels of gearing. This in turn creates an interest tax shield that reduces tax liabilities and creates additional value for investors.
Using the "lazy" capital of local institutions will also reduce project costs via the reduction in exchange risk. Revenue streams for infrastructure projects are denominated in local currency terms, unlike mining/oil projects where output has an international price.
The infrastructure is fixed in place and although tariff mechanisms linked to exchange rates and inflation are often implemented (as was the case with Indonesian electricity rates pre crisis) the ability to pass on extremely large increases in a single quarter is not possible.
The ideal environment is to have a liquid capital market in local currency terms. Such a market allows debt to be raised in the currency denominated by cash flow. If raised in foreign currency terms, the liquidity of the market would allow all or a portion to be swapped for local currency via the use of derivatives. Overall improvement in the regulation and oversight of the financial sector should allow people to be confident enough to invest locally rather than abroad.
An article written in the The Jakarta Post of Jan. 20, 2005 by Tan Sri Francis Yeoh Sock Ping, CEO of YTL Corp in Malaysia was very informative. He explained how YTL had achieved local Malaysian ringgit financing for over 12,000 MW of power generation projects (US$10 billion). YTL initially dealt with a single pension fund for an initial development. Upon successful completion of that deal a new asset class was acknowledged. Contrary to existing thinking YTL was subsequently able to finance significant investment all in local currency terms.
Malaysia with a population 23.5 million and GDP/capita of $9,000 is a substantially smaller economy than Indonesia with 220 million and GDP/capita of $3,200. Development of such a robust local fund would help stabilise the rupiah and set in chain a virtuous circle of Indonesian investors having confidence to invest in Indonesia and not seek opportunities abroad as is often the case.
An ideal first step in Indonesia would be for a pension fund to support a major development through a structure that quarantined risks for the fund. Utilise the style of fund mentioned above whereby construction risk sits with an infrastructure development company. Once this has been proven as a concept it would be hoped that others will follow, both funds and other investors that see such an asset class as perfect for a well weighted portfolio.
The writer is a Technical Advisor at CSA Strategic Advisory. CSA helps businesses through a combination of "soft" behavioral and "hard" financial advice. He can be reached at dobrien@csadvisory.com -------

posted by dwiAgus @ 2:50 AM