The above statement could easily be a description of the Eurotunnel train link beneath the English Channel, the largest privately financed infrastructure project in history. But it actually comes from a 1987 study, Suez: Du Canal à la Finance 1858–1987, written by French economist Hubert Bonin. The treatise examines the history of the Suez Canal, which was built with private capital in the 19th century.

Ferdinand de Lesseps, the canal’s developer, was never able to deliver the returns he promised to investors. He tried again with the Panama Canal, but a French court found him guilty of mismanagement before the canal was completed. Only the elderly de Lesseps’ death saved him from jail. It ultimately took Teddy Roosevelt, using U.S. government money, to finish it.

Despite these alarming precedents, private investment in infrastructure projects is again in fashion. However, strategies have changed. Developers and fund managers now tout infrastructure finance as a sure-fire, high-return bet, mainly because they are not backing new projects (with their substantial construction risks). Instead, they are investing in existing assets that have a history of producing stable cash flows. Some of these are being sold by one private-sector owner to another. Others are public-sector facilities, such as toll roads, that are being privatized. The buyers typically use the cash flow from these assets to support leveraged recapitalizations, often recouping part of their initial equity investment by extracting a large dividend payment in the process.

Australian bank Macquarie and Spanish contractor Cintra bought the Chicago Skyway toll road from the city of Chicago for $1.8 billion in 2004, with $1.2 billion of debt and $600 million of equity. Within eight months, they had completed a leveraged recapitalization and extracted $350 million of their original equity stake as a dividend. In another transaction, Macquarie financed a $1.8 billion upgrade of the M6 toll road in the UK in 2001. This past September, it refinanced the project and reaped a $700 million gain. The Macquarie-Cintra team is pursuing a similar strategy with the $3.8 billion Indiana Toll Road (ITR), which it acquired from the state of Indiana last summer.

Macquarie has been the most active investor in infrastructure finance since the 1990s. In recent years, however, AIG, Credit Suisse/GE, Goldman Sachs, JPMorgan and Morgan Stanley have jumped in. Unfortunately, as competition for assets grows, the days of easy refinancing gains are coming to an end.

Volume Delays Ahead
Investor enthusiasm is beginning to make the sector a victim of its own success. Growth in the number of bids for assets is forcing prices up. Investors have to look more closely at whether the cash flow from the underlying asset can support the debt.

The debt structures being used may make that difficult. One popular technique is the accreting swap—effectively a low-start, mortgage-type product. Principal and interest payments are deferred for up to 10 years. The principal remains unpaid and the interest rolls up—meaning the size of the debt grows for the first decade. This technique was the driving factor behind the success of the Chicago Skyway, M6 and ITR refinancings. However, a project with a debt burden that increases over time needs a very strong and growing cash flow to service it.

Successful projects usually track the increase in economic growth. If GDP grows at a modest pace, investors seeking outsized returns need to turn to financial engineering (like accreting swaps) or change the project. For example, for the ITR project to be profitable, the owners need to double the toll in four years and increase it further in the future.

Investors should therefore use caution, especially because the infrastructure investment funds, and the banks that back them, charge high transaction fees. The Macquarie Infrastructure Gateway Investment Fund, which targets the private investor market, charges a 20 percent performance fee on returns of over 8 percent, in addition to the usual fund advisory fees. In any of these transactions, if the margin for error between predicted growth in cash flows and predicted growth in debt is narrow, investors may find themselves in the same position as de Lesseps’ frustrated backers.

Art by Matt Mahurin.

Rod Morrison is the editor of industry newsletter Thomson Financial Project Finance International.