Navigating the perceived risks of emerging market infrastructure

Infrastructure investments have grown exponentially over recent years. Currently valued at around US$1 trillion, this amount is expected to grow to over US$1.9 trillion by 2027.

The potential growth of this relatively new asset class brings with it compelling investment opportunities, especially for institutional investors wanting a steady income stream at relatively low risk. Added to this, infrastructure investments are by their very nature structured to deliver long-term economic, social and environmental benefits, typically through public-private partnerships. Therefore, the private provision and financing of infrastructure is potentially very beneficial for governments that lack the necessary capital or resources to develop and maintain their own infrastructure networks. Given the high impact of infrastructure investments, less developed economies such as those found within emerging markets would seem an obvious destination. However, this hasn’t necessarily been the case.

Speaking at Ninety One’s In Perspective Infrastructure Forum, Martijn Proos, Co-Head of Emerging Market Alternative Credit at Ninety One, points out that the vast majority of global infrastructure capital is currently allocated to developed markets, despite the fundamentals for emerging market investments being remarkably supportive. According to Proos, “emerging markets have high urbanisation rates, a growing need to transition, and significant funding shortfalls, all of which make for a great investment opportunity.”

The reason for this lack of interest is largely based on the perceived risks associated with emerging markets. Proos explains, however, that these risks are compensated for by higher returns. In fact, “investors within emerging markets can expect a pick-up of around 200 to 300 basis points over that of developed markets.”

This begs the question, if the relative returns are attractive and the investment case strong, what are the misconceptions preventing investors from allocating a higher proportion of their capital to emerging market infrastructure?

Project risk

A good starting point when evaluating the risks of any infrastructure investment is to look at the project being financed.

From a Ninety One perspective, Proos notes that one of the first aspects that the investment team looks at is the project’s commercial proposition. In other words, the return that the portfolio stands to gain by funding or investing in that project relative to the associated risks. But commercial viability is not the only factor, “we also look at the sustainability factors and the impact that the project will have on the broader community. In our view, a good project should also have a high impact.”

Chief Sustainability Officer at Ninety One, Nazmeera Moola, expands on Proos’ sentiment. “Risk mitigation is what ensures the creditworthiness of a project. Having a clear idea of the project’s outcome in terms of its impact on the planet, people, market transformation, and the wider economy help service the creditworthiness of these projects.”

The Emerging Africa Infrastructure Fund (EAIF), which Ninety One manages, has this approach at its core. The Fund recently helped finance Senegal’s first-ever all-electric bus rapid transit network. In addition to creating employment, the project essentially halved the time that it would take for commuters to travel from the outskirts of Dakar to the city centre, while also increasing urban mobility. Proos explains that while the socio-economic impact of the project was important, it was equally important to ensure that it did not have any adverse effects on the biodiversity within the region. If there are clear benefits to the people, broader environment, economy, and if the project is financially viable, the project risks are significantly reduced.

Default risk

History shows us that the cumulative default rates for infrastructure projects measured over 20 years are very similar for both developed and emerging markets. Default rates are understandably highest at the start of the term as projects enter the operational phase, where factors such as structural risks, cost overruns and supplier delays are at their highest, and then begin to stabilise. Proos explains that within developed markets, default rates peak at around 4% and remain flat until the end of the term. It’s a similar story in terms of timing for emerging markets, where the rate peaks at around 6% before stabilising. Although there’s a marginal increase in cumulative rates over time, these typically remain flat once projects are in their operational phase.

Recovery rates

The counterargument to low default rates is that investors still take on more risk given that the cumulative default rates in emerging markets are marginally higher. While this is true, the risk of permanent capital loss is largely mitigated. Recovery rates on infrastructure investments for both developed and emerging markets are similar at around 75% - 80%, which means that investors will still experience a high recovery rate regardless of whether they invest in developed or emerging markets.

The role of blended portfolios

A further buffer comes in the form of blended finance structures to cover first-loss positions. According to Nadia Nikolova, Lead Portfolio Manager at Allianz Global Investors Development Finance, a financial services company that has provided capital to EAIF, this can be done through various banks, public institutions, or through credit insurance and guarantees, with some credit agencies able to provide up to 100% guarantees.

Nikolova adds that blended portfolios allow investors who are more risk-averse, such as those looking for investment-grade exposure or those not wanting to take on local currency risk, to access infrastructure investments within emerging markets. She adds that “blending has been one of the very few ways in which Allianz Global Investors have tapped into emerging markets infrastructure.”

Proos expands on this point, noting that at a certain point, infrastructure assets start to display similar characteristics to that of investment-grade securities, regardless of whether the investment is in developed or emerging markets. EAIF, for example, is a B+ rated portfolio that invests across Africa, with a loss rate of around 15 basis points over time. This is what investors would normally receive from portfolios with a BBB rating.

In conclusion, the investment case to finance infrastructure projects within emerging markets is compelling and the realised risks are relatively low. Investors have a nice pick-up over what they would get from public markets, and although default rates within emerging markets are marginally higher, as Proos puts it “they are not out of the park as people normally would expect.” Added to this, emerging markets have high recovery rates, and investors can mitigate losses by taking up first-loss positions within blended finance portfolios.

The combination of these factors suggests that the perceived risks associated with emerging market infrastructure investments can be mitigated, and are likely to be a fair bit lower than most investors expect. As investors begin to better understand the actual risks associated with these types of investments, the hope is that a greater allocation of global infrastructure capital will be directed towards emerging markets, especially to areas where the need for investment is often greatest.

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