The Barriers to Bridging the Infrastructure Gap through Private Financing

Highlighting a projected $15 trillion global infrastructure investment gap by 2040, the focus is on the inefficiency and insufficiency of current expenditure. Exploring private sector infrastructure funds, the emphasis is on the appeal to investors and the substantial unallocated capital, with a proposal to address risk management through innovative public-private partnerships to unlock essential project funding.

Unveiling the Gap in Global Infrastructure Financing 

In the middle of the Nevada desert, among the monolithic structures used for bygone military tests, stand the remains of the Yucca nuclear waste facility. Its main body is a 5-mile-long tunnel bored into the side of Yucca Mountain, a far cry from the planned 40 miles of storage. Its completion, anticipated since 1987, would have made it the US's first and only permanent nuclear waste facility. Nevertheless, following losses of more than $15 billion, the project has all but collapsed.

This is but a localized symptom of a global issue. International infrastructure expenditure is both inefficient and insufficient. The Global Infrastructure Hub has forecast the worldwide gap in infrastructure investment to reach $15 trillion in 2040. This figure, which illustrates the difference between required investment and investment trends in the sector, is nothing to sneeze at. Electricity and road infrastructure urgently need funding to address the deficit, accounting for two-thirds of the gap.

This issue naturally raises the question of financing. Traditionally, and according to the pre-1990s trend, one would expect the state to fund these projects. However, seeing the magnitude of the bill they face, it would be completely unreasonable to expect individual governments to front these expenses. If the British government were to fund the entire 2024 national investment gap of $68 billion, this would entail more than a doubling of their infrastructure budget, which stood at around £21 billion in 2020. Clearly, at a fiscal level, this is not a sustainable approach to financing, especially when considering other urgent investment gaps and the country’s heavy debt load (the UK stands at a 97.2% debt-to-GDP ratio).

Optimizing the Private Sector’s Role in Funding Infrastructure

Private sector investment firms seeking to invest in projects within the sector are known as infrastructure funds. These funds manage the equity stake, the capital contribution, of investors known as limited partners. The general partner, the entity running the fund, allocates this capital to profitable infrastructure projects. Typically, financing from limited partners would contribute to approximately 20-40% of the expenditure on these projects, with the rest being debt-financed.

The appeal of infrastructure as an asset class to private investors can be broken down into its characteristics. Operations typically entail a monopolistic market and inelastic demand, offering stable cash flows over extensive timeframes. Despite the attractiveness of these investments, much of the capital managed by infrastructure funds has yet to be deployed to address the investment gap.  Dry powder, a jargon term which simply means cash and cash equivalents, stood at an aggregate of $298 billion in 2021 for all infra funds, which, in relative terms, presented an increase in unallocated capital.

To understand the high level of free capital within these funds, it is important to understand their operations. Infrastructure funds are profit-maximizing vehicles, with an incentive structure designed to align the interests of general and limited partners. As a result, when an infrastructure fund values prospective projects, one of the primary metrics they seek to maximize is the Internal Rate of Return (IRR). The IRR is the discount rate which sets the future cash flows of the project equal to the upfront cost. It tells limited partners the annual return they can expect to make on a dollar.

An infra fund will only invest in a project if it stands to make more than a specified rate of return. This baseline rate is often called the hurdle rate. At a basic level, we can see the hurdle rate as the minimum return that a limited partner would be willing to accept for committing their capital. As we currently observe, the hurdle rate should increase with interest rates. By committing their capital to the fund, an investor forgoes a higher interest rate, representing a larger opportunity cost. This translates into a higher hurdle rate, as investors demand a higher return on their capital. As a result, an infra fund has fewer investment options, as those projects with insufficiently high returns cannot be funded. This partly explains why dry powder levels would be abnormally elevated. However, this only holds for recent years, where rates have been high, rather than explaining the persistent under-allocation shown in the data. Diving into economic literature may help explain some of the longer-term drivers for these large cash reserves.

The concept of the planning fallacy, developed in 1979 by Daniel Kahneman and Amos Tversky, says that people tend to ‘ignore distributional information.’ In essence, they understate the potential risk of exogenous shocks and are therefore inclined to make estimation errors. This framework has been applied to infrastructure projects by experts like Bent Flyvbjerg. His investigation into megaprojects (schemes valued over $1 billion) provides the alarming statistic that 9 out of 10 such projects experience cost overruns. He concretizes this fact in his “Iron Law of Megaprojects” – “Over budget, over time, under benefits, over and over again.” The trend he exposes is one of information failure, where less valuable ventures are being financed due to poor risk assessment, while fairly valued projects are being selected out. This, of course, is a massive economic problem. Especially given the impact of megaprojects, which stand to affect millions of people.

We can examine this market failure through the lens of private financing. Limited partners are wary of the risk that megaprojects pose to their capital. The financing structure of these deals places their equity as the lowest priority, meaning all debt must be paid in full before limited partners see a penny. They account for this additional risk by inflating the hurdle rate with a premium. This means that fewer projects, especially essential megaprojects, will be privately financed.

Solving this risk management problem is easier said than done. But working towards it would unlock much-needed capital flows. A proposed path is to build new project delivery methods based on public-private partnerships (PPPs). These partnerships, between infrastructure funds and the state, serve to spread the risk incurred by both parties while maintaining the efficiency sought by private financiers. Putting theory into practice has been arduous, with novel challenges such as uncertain regulatory frameworks and incentive alignments. However, the upside to this framework is within reach. Success in this endeavour could completely reinvent the model for infrastructure financing, ultimately leading us to a more efficient and better-regulated environment for funding the projects of the future.

Written by Romain Perusat