As Ian Reeves chairman of GCP Infrastructure Investments approaches stepping down he explains how infrastructure funding in the UK has been transformed.
It was after the banking crisis in 2008, that the banks, which were the main providers of mezzanine finance and senior debt for projects procured through the UK Government’s Private Finance Initiative (PFI), retreated to core lending sectors, away from infrastructure, which at the time was a relatively new asset class.
The opportunity was there to set up a closed-ended fund, listed on the London Stock Exchange, which would attract investment from wealth managers and institutional sources such as pensions, insurance companies and sovereign funds. It was intended GCP would primarily finance subordinated loans secured against the value of PFI projects – and ultimately provide a mix of senior and subordinated loans secured against UK infrastructure projects with long-term, public sector backed revenues and providing regular, sustainable, long-term dividends for investors.
While the company started off refinancing existing PFI projects and started to become involved in new PFI projects, over time the UK Government decided to move away from PFI. In my view, the UK was a victim of its early innovation: the UK was one of the first countries to use the PFI model of public and private sector partnership to procure financing for new infrastructure.
Whilst early mistakes were made, the mechanism evolved in response to these mistakes and PFI (or a derivative thereof) continues to be a popular procurement model in most developed countries. Rather than capitalise on its early learnings, the level of PFI and PF2 procurement was significantly reduced.
Reduced pipeline from PFI meant that we had to consider whether there were other infrastructure assets classes that benefited from public-sector backed revenues and that could continue to provide investors with an attractive risk-adjusted return. At that time, the Government was introducing revenue support models to promote the development of renewable electricity generation.
The Climate Change Act in 2008 pointed to a structural shift towards renewables and GCP’s assessment was that this shift would require large amounts of private sector capital. The existence of public-sector support through feed-in tariffs, renewable obligation certificates (ROCs), the renewable heat incentive and latterly contracts for difference have meant renewables have become a core part of GCP’s portfolio, representing c. 60% of the Company’s investment portfolio today.
Many investors were reluctant over renewables, driven by the fact that it was a nascent asset class in the UK. However, today, renewables is a well-established asset classes with dedicated funds targeting sectors such as wind and solar.
Other asset classes came to our attention, for example, supported social housing which had strong fundamentals that benefited from a well-protected, central government funded, housing benefit budget.
Supported social housing caters to the needs of those with mental, learning, physical difficulties, or some combination of these. Historically those tenants who benefit from this form of housing were supported in institutions.
Several very public issues with institutions, combined with the availability of supported social housing offering a lower cost alternative with proven healthcare benefits, led to the promotion of supported social housing under the Supporting People programme. This represented, and continues to offer the potential for, attractive inflation-linked, risk-adjusted returns.
The investment case for infrastructure projects is against long-term cash flows, forecasts based on realistic and conservative assumptions. Key to the process is to not adjust forecast assumptions with more aggressive perspectives to support valuations, ensuring the cash flows driving valuation have the same, or reduced, risk profiles to when the original investment decision was made. It is these cash flows that ensure the payment of interest and amortisation of loan principal over the life of a project.
Whether the investment comprises senior secured loans or subordinated debt, this value sits ahead of any equity investment. If a project underperforms relative to cash flow forecasts, equity is impacted before any lender will suffer reduced cash flows.
For investors diversity is also key to success in the sector. Today, assets classes such as carbon sequestration, flexible generation, electric vehicles, biogas, hydrogen and more recently geothermal, are part of a large and attractive pipeline of investment opportunities. Investing across them all removes the risk of being tied to the continued attractiveness of any given single asset class.
An increased focus on the environmental, social and governance (ESG) aspects of investments presents an opportunity for investors. Whilst most funds and companies are seeking to quantify, reduce and report their negative environmental and social impacts, the ideal target is a position where all its investments have a positive environmental or social contribution.
This includes reducing emissions through the renewable investment portfolio or contributing to core social needs, such as supported social housing or community leisure and healthcare facilities.
As the UK embarks on the largest transformation of its infrastructure in recent history in achieving the transition to Net Zero, there will be a significant private sector investment requirement to support this, and the need for public sector support across a range of asset classes. In this context, the future is hugely exciting – infrastructure debt is well and truly on the map.
