By Nazmeera Moola, Co-Head of SA & Africa Fixed Income
African markets have gone through a challenging period, marked by less accommodative US monetary policy, negative sentiment towards emerging markets and the fallout from the sharp plunge in commodity prices between 2012 and early 2016. Investor sentiment towards emerging markets has improved over the last few months and many commodity prices have enjoyed a bounce. While the fundamental structural drivers of economic growth on the continent are still intact, lack of funding, especially in the infrastructure space remains a challenge.
The fall in commodity prices and the subsequent slowdown in economic growth in Africa have put pressure on both government and international private sector financing. After steadily increasing direct investment in Africa since 2000, Chinese entities have sharply reduced the number of new projects since 2013. In addition, commercial banks have withdrawn funding due to worries about the Africa growth outlook and Basel III requirements. Government finances are constrained and rising bond yields have pushed up Africa’s borrowing costs significantly since 2014.
Africa still requires at least US$93 billion in infrastructure investment per annum, with an estimated infrastructure funding gap of some US$31 billion per annum. The slowdown in economic growth has had a bigger impact on the supply of capital than on potential ventures on the continent. Many projects have been shelved. But given the lack of facilities in many countries, there are still viable projects and opportunities for business expansion. This is particularly true in the infrastructure space. However, even within the broader economies, there is a huge lack of shopping facilities, schools and accessible financial services.
We believe it is an ideal opportunity for private-public partnerships (PPPs) to provide long-term funding for African infrastructure. This should boost long-term potential growth on the continent. We are starting to see PPPs gaining traction. Investec Asset Management is currently responsible for US$1.2 billion invested in African infrastructure. Of this, US$670 million is through the Emerging Africa Infrastructure Fund (EAIF), which is managed by Investec Asset Management. The remainder is through the Investec Credit Opportunities and Africa Credit Opportunities funds. The funding comprises both project finance and corporate finance debt. The Credit Opportunities portfolios have 21 investments across Africa. EAIF is currently funding 42 projects across Africa, all of which are run by the private sector. The bulk of them rely on offtake agreements from the public sector.
The African debt markets are much less developed than those of the large financial markets, such as the US. In particular, the corporate credit markets are still in their infancy. Therefore, private sector real estate developers, infrastructure sponsors and companies are much more dependent on either bank funding or private debt funding to grow. In the last three years, both the breadth and depth of the credit market have expanded significantly as the number and size of issuers have grown.
While there is some liquidity in sovereign debt markets, this has fallen significantly in recent years. The private credit markets, which include infrastructure, are by definition illiquid. However, investors in these areas are well aware of the constraints and benefits of these investments.
In our view, insurance and pension funds need to develop asset-liability management strategies that require good quality debt instruments with long maturities to boost debt investment in the infrastructure asset class. Currently, infrastructure projects in Africa are more likely to be funded by development finance institutions (for example, the EAIF, International Finance Corporation, World Bank, African Development Bank and Islamic development banks) than by commercial banks and pension and insurance funds. In developed markets, the private sector institutions provide the bulk of debt funding for such projects. Infrastructure projects need long-term investors who can stay invested, typically for 15 to 20 years. Because commercial banks have a much shorter investment horizon, there are limitations to the funding they can provide for infrastructure.
Pension funds in Africa are still relatively small. The four countries with reasonably sized pension funds are Namibia, Botswana, Nigeria and Kenya. Namibia and Botswana are trying to channel their funds into infrastructure projects in their countries. However, the flow of projects in both has been slow. Projects have been more plentiful in Nigeria and Kenya. In those two countries, pension funds are relatively new and are therefore risk averse. They desire liquidity – which infrastructure investing does not offer.
At the same time, developed market pension and insurance funds are hesitant to invest in sub-investment grade African infrastructure debt due to their perceptions around risk. Alleviating concerns around these perceived risks is key to attracting both developed market and local African pension fund money into infrastructure funding for projects on the continent.
In order to induce private sector financing into infrastructure, it is crucial that projects are commercially and financially viable at initiation. The availability of reasonably priced debt is a key determinant of commercial viability. However, the deteriorating economic circumstances have also brought challenges that must be carefully considered with all new projects. These are primarily:
Despite the challenges, we are still able to find viable, bankable investments in Africa at this juncture. The shortage of traditional sources of funding has provided an opportunity for private sector funding to fill the gap – and to make good long-term returns. Given the high perceived risk of projects in Africa, we find that the projects that do go ahead tend to be very well structured. It is also worth pointing out that the majority of infrastructure financing is done through the project finance mechanism. A well-structured project finance transaction carries considerably lower risk than a similarly rated corporate loan. The historical default rate and loss given default rates for infrastructure project finance transactions globally are considerably lower than that for the average corporate loan.
Figure 1: Cumulative loss from infrastructure finance – the global experience
Source: Moody’s infrastructure default & recovery rates, July 2016 (redrawn).
While a corporate loan is entirely dependent on the future earnings stream of the company, whose strategy can change dramatically depending on the management team, a project finance loan comprises limited or non-recourse debt issued by a special purpose vehicle, which owns a single asset. In the case of infrastructure projects, this is the operating asset, be it the road or power station or other infrastructure. Key requirements before we provide project finance debt for an infrastructure project are:
As a result of such structures, lenders have far more visibility and control over the projected cash flow from the infrastructure that will be built.
Whether we are considering a corporate loan or a project finance loan, our decision to invest in a credit opportunity is always dependent on: (1) the fundamental assessment, (2) market conditions, (3) supply and demand dynamics, and (4) valuations.
We seek to find projects where the fundamentals are strong. In addition, challenging market conditions have resulted in less demand for credit from other providers. As a result, we have found that valuations have become much more attractive over the last eighteen months. However, we remain very cautious, making sure the fundamental assessment is solid before we consider investing.
While the fundamental structural drivers of economic growth on the continent are still intact, governments in Africa have a key role to play in attracting more private sector investment into infrastructure. In short:
At Investec Asset Management, we have found that Africa offers a number of investment opportunities which combine a favourable regulatory backdrop with well-structured projects and strong sponsors. There are attractive returns from investing in long-dated infrastructure debt, which also offers the benefit of a positive developmental impact for pension funds and other institutional investors. This is particularly true at this juncture, when the funding gap has grown due to weak government revenues and withdrawing commercial banks.
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Investec Asset Management is an authorised Financial Services Provider. Issued by Investec Asset Management, June 2017.