With the recent purchase of nine percent of Thames Water (a UK utilities group) by China Investment Corporation (CIC, a sovereign wealth fund), many observers are asking if this is the start of a new and more active era of outbound Chinese investment into infrastructure.
Will the Year of the Dragon bring a flood of Chinese investment into western infra markets?
Unlike their wicked western cousins, Chinese dragons are considered to be divine creatures, astute and benevolent, bringing prosperity. They are also said to have power over water, in particular the ability to control rivers, seas, rain and floods.
In the run up to the arrival of the Year of the Dragon we saw a number of high profile Chinese transactions in European infrastructure, such as China State Grid into Portugal’s REN and, rather appropriately, China Investment Corporation (CIC) into UK’s Thames Water. As a result, many infrastructure stakeholders in mature markets are looking east to try and determine exactly how much wealth the Chinese dragon will bring in this auspicious year.
The answer will depend in part on which type of investment we consider: greenfield/project investment, strategic investment or financial investment.
Greenfield activity will remain challenging
The Chinese have been investing in key international infrastructure for many years, from the 1,870km Tanzania-Zambia Railway in 1970, to the USD1.4bn Hambantota Port in Sri Lanka currently being built. However, most investment has been in the developing world, commonly using a combination of engineering, procurement and construction (EPC) and debt finance structures. They are also often politically driven or part of larger deals to secure natural resources. Most Chinese infrastructure companies still consider Africa, Latin America and South East Asia as core markets due to their continually high construction margins.
However, increasingly open competition and the introduction of Public Private Partnerships in certain developing markets, as well as the increasing awareness of political risk (due in part to some losses resulting from the Arab spring), is resulting in much greater consideration being given to entry into mature markets such as the UK and US. It is hoped that such a move will also help the development of key procurement, project and risk management skills that are important to remain competitive in markets globally.
This trend is being supported by political initiatives such as the ‘Memorandum of Understanding on Enhancing Cooperation in Infrastructure’, signed in September 2011 by the UK and Chinese governments, which is hoped will lead to increased Chinese investment into UK infrastructure projects.
Despite much optimism in the West, many challenges still exist – particularly around adapting to the planning, regulatory and procurement idiosyncrasies of mature economies, which can act as a major barrier to entry in the short-term for Chinese entrants. The Chinese will become major players in western greenfield infrastructure markets, but probably not this year.
Strategic investment will be where the action is
An important part of China’s ‘going out’ strategy (as encouraged by the 12th Five-Year Plan) is to create global leaders. In the oil and gas sector, the big Chinese petrochemical companies have, for a long time, been respected global market players. The focus of many mergers and acquisitions have recently moved to power, with deals by Huaneng into Intergen, State Grid into a portfolio of grid assets in Brazil then REN in Portugal, and Three Gorges into EDP also in Portugal. With all these deals, key considerations were the synergies that the investments could bring – selling in products and services or jointly entering new markets.
The Chinese will certainly continue to take advantage of the ongoing financial crisis and resulting sell-off in Europe. This should bring opportunities to secure strategic assets at advantageous valuations. We are likely to see significant strategic investment into non-power sectors, including ports and airports, while the construction companies may well start acquisition programs to secure local technical experience and expertise in target markets.
However, the lengthy approvals process for equity investment by State-owned entities will continue to be a challenge where sales processes are rapid. Further, given the requirements of the State-owned Assets and Supervision Commission (which supervises the activities of all State-owned enterprises) for effective risk management, substantial overseas equity investment will likely continue to be driven by the most trusted of the State-owned enterprises.
Sovereign funds will continue steady portfolio expansion
The real success story is sovereign funds, particularly CIC. These funds are developing into sophisticated investors, modeled in part on the Canadian pension funds and focused on taking stakes in investments which generate long term inflation linked to stable cash-flows. The funds are likely to go from strength to strength as their portfolios expand and their confidence increases.
Their greatest challenge could well turn out to be identifying sufficient suitable investment opportunities to meet their voluminous appetite and capacity to invest and therefore maintain their target returns.
Overall, this will almost certainly be a year of intense outbound activity for the various Chinese infrastructure investors across the world’s markets. However, though the dragon is wealthy, it is also wise, and investment into mature infrastructure markets will only come at the right price and terms. Many deals will certainly be done; but it is likely that we will still see more smoke than actual fire from the dragon in the west this year.
By Alison Simpson, KPMG in China