The early 1990s saw a proliferation of new project finance funds ? each hoping to take advantage of the boom in infrastructure projects, particularly in the emerging markets. Buying into a fund was seen as a relatively safe way for institutional investors to take part in the industry as their risk would be mitigated among a pool of project assets in the portfolio. The early 2000s herald a very different environment, with many investors having got their fingers burned on projects ? particularly in Russia and south-east Asia ? that have not yielded the returns they had hoped for. But the project finance funds remain an important and growing part of the market: their focus has just changed somewhat, with many looking for safer (if less spectacular) returns a little closer to home.

At first glance, project finance deals seem to be pretty unsuitable for private equity-type investment. Classic venture capital deals are those where investors are looking to buy in, turn the business around and make a swift and lucrative exit. This is hardly the case with project deals ? where construction periods can be lengthy and unpredictable and investment is usually required for around 25 years or more. ?The big downside of project finance is the time it takes for deals to get done,? admits Guy Pigache, director at HSBC Specialist Investments (formerly Charterhouse Project Equity Investment). ?These projects take a long time to build and it is therefore some time before you can get your yield.? But the growth of initiatives such as PFI/PPP mean that there are more and more investors willing to get involved in the industry where returns are seen as being rather more secure.

?What the sponsor is looking for is a knowledgeable equity investor who can take risk off their hands,? says Mark Thompson at advisor Impax Capital. ?Sponsors such as Enron or AMEC are prepared to take it to a certain stage but then they don't want any more risk on their balance sheets. They want a knowledgeable offtaker to then take the majority of the risk.? Pigache explains that this is where the equity funds come into their own. ?We can relieve the sponsor of cashflow issues and spread the risk around as many projects as possible,? he says. ?Our sole focus is doing a good equity deal where the sponsor has a multi-agenda.? HSBC's fund has deals completed and in the pipeline of around £200 million to £250 million over the next two years. It is a dedicated fund and just invests HSBC's money. But the team are now working on raising a new fund for which they will solicit third party investment. The new fund will be around £100 million to £150 million in size and will be launched this summer. It will be targeted at PFI/PPP-type deals ? a key selling point. ?This is a government-backed cashflow and is therefore lower risk,? says Pigache. ?The returns are attractive versus gilts but the cashflow needs to be managed. If this is successfully achieved investors can get equity returns of 14% to 18% on government risk which is very good.?

Risk mitigation
Risk mitigation is the name of the game for investors in these funds ? as they are very aware of the losses inflicted by projects in certain emerging markets when the currency crises hit in the late 1990s. ?There has been retrenchment from the emerging markets,? explains John Buehler, managing partner of US-based Energy Investors Funds Group (EIF), which was acquired by Dresdner Kleinwort Capital in January this year. EIF was founded in 1987 and was the first US private equity fund for the IPP sector. It now has six funds under management with over $730 million in investor commitments. ?Sponsors went into the emerging markets when these economies were privatising and there was not much competition. But the risks did not justify the returns,? he says, citing Enron's withdrawal from India as a clear example of what these risks can involve.Buehler explains that the retrenchment of a number of project finance sponsors is driven not only by their experience in the emerging markets but by the relative attractiveness of investment back home. ?In the US there is now a very stable and efficient secondary market in this sector ? virtually all generating assets in the US are for sale.? This means that the assets in which the funds are investing are relatively liquid ? an important feature for potential investors. EIF runs a series of 10-year private equity funds and has made over 60 investments since 1988. Since then it has liquidated around 20 and refinanced 18 projects in the capital markets. Buehler emphasises that it is the issue of liquidity that has made the US market so attractive for them. ?In a lot of cases the project sponsor was approached, rather than the other way around. These projects have proved self-liquidating and at prices that we could not have expected at the outset.?

Risk mitigation is also driving another important change in the equity investment sphere. Where investors used to be looking to invest in single-asset IPPs, many are now far keener on buying portfolios of assets and buying into generating companies rather than the individual projects themselves.

?Investors in single-asset projects have found that there is little liquidity and exits are hard to achieve,? says Andrew Aldridge, director of power at CDC Capital Partners, the UK-based government-owned private equity investor targeted at emerging markets. ?But the fact that a lot of US and European investors are now refocusing on their home markets means that there are a number of portfolios of emerging market power assets available to buy.? He says that there has been a mindshift among sponsors such as CMS and Entergy, which means that investors in the US market can now get very respectable returns of around 15% to 16% with project finance deals.

CDC Capital Partners' funds are typically closed-end with a life of around 10 years. The 100% government-owned investor will, however, be privatised over the next 12 months to 18 months and this may change. CDC has $2 billion under management with $450 million in the project portfolio. ?Certain investors are still focussed on putting money into emerging markets and project finance is a good risk/reward trade-off,? says Aldridge. Indeed, some of the larger funds in the industry are focused specifically on this sector, such as AIG's Emerging Europe Infrastructure Fund and Asian Infrastructure Fund and Scudder Kemper Investments' regional Latin America Power Fund. ?There is a lot of downside risk mitigation with a project as there is a long-term contract and it is in a regulated environment. Infrastructure provides a strong yield base to a lot of portfolios. It is far less volatile than, say, telecoms.? But in both the US and Europe and the emerging markets there is a trend towards buying into diversified generating companies rather than IPPs. CDC has invested in two generating companies in Latin America ? Haina in the Dominican Republic and Puerto Quetzal (which began life as an IPP) in Guatemala. And US-based EIF has recently invested $15 million in a Polish corporate entity from its Central and Eastern European Power Fund. EIF has also launched a renewable energy fund together with the IFC which has yet to make its first investment. The fund is $80 million equity and $25 million grant facility funding.

Far from being a problem, the long tenor of investment required by projects is ideal for their target investors: life companies and pension firms. These companies have long-dated liabilities that need to be matched with long-dated assets. But the risks of any project are clearly higher for the equity investor than the debt lender as the former is fully exposed to the risk of the project going wrong. The equity funds therefore lend their expertise to the investor and can offer diversity through their pool of assets.

?We are offering money from people that know the PFI game,? explains Jo Elliott at Edinburgh-based merchant bank Quayle Munro, which launched a £10 million PFI fund in September last year. Quayle Munro is putting up 25% of the fund and Bank of Scotland 75%. The new fund has invested in a series of school projects in Scotland and is targetted at deals of around £70 million. ?We saw that there is a gap in the small- to mid- market in the UK,? says Elliott, adding that the fund will invest up to 49.5% of the equity to a maximum of £2.5 million. It is therefore focussing on deals that the big three equity funds in UK PFI: Innisfree PFI Fund, Barclays Private Equity and Charterhouse (now HSBC) may consider too small.

Secondary debt
Project finance appetite is clearly alive and well for the equity fund sector, but there is also a growing interest among the traditional long-term investor base for secondary debt involvement in the market. This is extremely good news for the sector as ongoing consolidation in the traditional bank lending market means that liquidity for new projects will inevitably diminish. ?Insurance companies and pension funds are more natural long-dated lenders as they have long-dated liabilities,? says David Jones, director at Newcourt Capital in London. Newcourt launched Europe's first dedicated project debt fund ? the European Project Finance Fund ? a year ago. It is Eu750 million in size with lead investors Stichting Pensioenfonds ABP and John Hancock Financial Services joining Newcourt in the fund. Newcourt runs an identical project finance fund in the US, which is $500 million in size. ?Institutional funding can provide fixed-rate money more easily,? Jones continues, ?and there are certain inefficiencies in getting long-dated debt from the bank market.? He attributes the growth in such lending to a slowdown in issuance of risk-free paper, which has left institutions looking for alternatives. ?Project bonds are high-quality and long-dated ? a useful institutional tool,? he says. Two London-based institutions that have eagerly embraced the private placement market for PFI deals are AXA Investment Managers and UK Prudential Investment Management. AXA started its PFI product in January 2000 and has so far invested in three PFI school deals, taking between a half and 100% of the senior debt in the deals. ?The funds we have available are annuity and pension-type funds and we therefore have a desire to lend very long-term,? says Jon Morton-Smith at AXA, adding that one such investment runs for 39 years. ?The product carries a time opportunity ? tenor is the main advantage. There is an obvious match of our needs with theirs,? he says.

AXA is focusing on projects smaller than £100 million in size and for the moment is concentrating purely on sterling assets ? although a move into Europe has not been discounted. Gerard Donohue, investment manager at AXA, says that this type of secondary debt has a slight pricing advantage over traditional bank lending, which may also contribute to the growth of the market. ?We price off gilts whereas the bank market will offer a margin over Libor together with the credit spread on the swap. We are usually slightly lower,? he says. Morton-Smith and Donoghue emphasise that while this is a debt product with bond characteristics, it is not in direct competition with either the bond markets or a major syndicated loan.

The only potential cloud on the horizon for the growing number of PFI funds now being launched is any slowdown in the number of new PFI/PPP-type deals coming through. The majority of funds interviewed seem to favour education and local authority-type investments and will rely on a constant dealflow to keep them busy. There have been a number of new PFI funds set up [in the UK] but as yet there is no overcapacity in the market. There have been dips in PFI activity in the past and PFI has recovered. Investors have been given a chance to make sure that that happens by buying into the very organisation that was set up to smooth the whole PFI process ? Partnerships UK (PUK). A 51% stake in PUK was sold to private investors in April this year in a deal that was 30% oversubscribed. 11 investors bought into the company ? many of whom are intimately involved in funds investing in the sector: AXA, Prudential, Abbey National, Barclays, Royal Bank of Scotland, Bank of Scotland, Halifax, Serco, British Land and Group 4.