COVID-19 has accelerated trends already occurring in the infrastructure industry. Changes in market characteristics are expected to continue the increasing M&A activity in the sector.
In this article we discuss:
- tier 2 and 3 contractors entering into JVs to compete with tier 1 contractors
- a rise in direct infrastructure investment from superannuation funds and private equity
- distressed asset sales and a renewed focus on diversified portfolios
- specialisation giving rise to businesses repositioning themselves to remain competitive and selling off non-core assets
Contractors JV and consolidate to compete
Given the Prime Minister's commitment to fast-track 15 major projects worth A$72 billion as part of the Federal Government's JobMaker scheme, there is a need for further tier-one type contractors to deliver on large scale infrastructure projects.
The partnership of mid-tier contractors, or of tier-one contractors and mid-tier contractors, facilitates competition for larger scale infrastructure projects.
Consolidation at the tier-one contractor level has left three large tier-one contractors in Australia. It is anticipated that there will be further consolidation in the Australian market between tier-two and three contractors to compete with the tier-one contractors.
Mid-tier contractors may seek partnerships with international investors to compete at the tier-one level.
International players are likely to look to acquire second or third tier contractors to secure a platform to compete. Chinese and Japanese companies have been searching for opportunities in the Australian infrastructure sector for some time. The 2017 Kajima / Cockram tie up accelerated the investment of one of Japan's largest builders into the local construction industry, securing a platform to rival the tier-one construction companies.
Rise in investment from superannuation funds and private equity
There will be increasing pressure from the Australian Government for superannuation funds to invest in Australian infrastructure.
In July 2020, industry super owned IFM Investors announced its proposed "Building Australia Model" as a new way of financing infrastructure construction projects. With industry super capital already set to contribute A$19.5 billion to Australian infrastructure over the next three years, the additional funds committed by IFM Investors would add to the existing stimulus pipeline for the industry. This creates an opportunity to "build back better" in the aftermath of the COVID-19 pandemic.
While superannuation funds are a large contributor to private market investments such as property and infrastructure (and, increasingly, venture capital) (making up 47% of domestic investors in the asset class), IFM Investors' proposed procurement model contemplates any private infrastructure investor (not just Australian super funds).
New funding from private equity firms is also accelerating the disruption of current business models in the sector. It is not surprising that Australian private equity funds may be particularly attracted to infrastructure assets in the current economic market, given the stability of such assets and the prospect of long-term returns.
At the same time, industry funds may be looking to partner with private equity groups to unlock investment opportunities in this sector created by the COVID-19 pandemic. Alex Campbell, Head of Infrastructure at CBUS has observed that, "such partnerships raise a number of important considerations – for industry funds, we look for a reasonable fee structure and aligned investment interests."
The challenge for superannuation funds is finding access points with good risk / reward profiles. Industry insiders have acknowledged that you have to be willing to take on some risk to do more complex deals, especially if you are looking for value outside of traditional asset classes.
The challenge for super funds is deploying capital in a competitive market and according to the Head of Infrastructure of one of Australia's largest superfunds, "smart people find creative solutions to deploy capital – not in the old way of "infra like" but by really understanding the cash flows and recognising infra returns".
Distressed assets and renewed focus on diversified portfolios
Given the resilience of debt and equity markets globally during the pandemic, we have not yet seen the rise in opportunities to secure distressed assets that might have been expected (according to the Head of Unlisted Infrastructure and Timberland, Future Fund).
According to McKinsey & Company, strongly affected segments could have "40-45% of incumbent value added at risk, even when the economic fallout from COVID-19 abates". Capturing the value at stake presents an opportunity for other players in the industry who could significantly increase profit pools with strategic acquisitions.
There was an expectation that the early access to super scheme might give rise to limited partners in the Australian market selling assets but, so far, infrastructure has proved to be a resilient asset class.
However, once JobKeeper and the moratorium on insolvent trading end, voluntary administrations and insolvencies are predicted to trigger restructures and increased M&A activity in the sector.
The impact of the COVID-19 pandemic has also highlighted the need for portfolio diversification in the infrastructure industry, both by sector and by country.
Investment in infrastructure comes with sector-specific risks. In recent times, we have seen the travel industry suffer significant losses due to the COVID-19 pandemic (e.g. the recent distressed A$3.5 billion sale of Virgin Australia to Bain Capital), impacting the performance of airports and other similar infrastructure assets. One of China’s largest conglomerate airlines, HNA Group, announced that it had handed control of its operations to Chinese officials in late February due to ongoing liquidity issues which were exasperated under the tough economic conditions of the pandemic. Industry stakeholders are confident that the travel industry will recover, given the demand for leisure travel is unlikely to change (for example, when the South Australian border opened to New South Wales in late September, approximately 16,000 seats were sold in a matter of hours).
Unsurprisingly, the severe disruption caused by the COVID-19 pandemic has created uncertainty in the valuation of all infrastructure assets. In an M&A context, valuation uncertainty has made it difficult to assess future earnings when negotiating a sale of infrastructure assets. We expect to see a rise in certain deal protection mechanisms such as deferred payment structures, or post-completion performance-related contingent price adjustments (such as earn-outs).
While it is not uncommon for investors to pursue both domestic and international opportunities, we expect to see infrastructure investors considering acquisition opportunities in new jurisdictions to safeguard against "black swan" risks. Like the COVID-19 pandemic, certain risks are unforeseeable, such as the 2018 bridge collapse in Genoa, Italy and the 2018 bushfires in California, but such events are likely to have a significant impact on the shares of infrastructure companies with investments in affected areas.
At the same time, we expect that the COVID-19 pandemic will lead some infrastructure investors to adopt a conservative investment approach. Instead of embracing diversification, some investors may only pursue acquisition opportunities in sectors or jurisdictions that they are familiar with.
Specialisation, repositioning and spinoffs
To differentiate themselves and increase value for shareholders, it is expected that companies will start to specialise in niche markets.
Public and private sector developers of infrastructure are already responding to customer insights with product and supply-chain innovation, and creating spaces that can be readily adapted and repurposed as demand changes.
The need to specialise to remain competitive is likely to also give rise to spin-offs of non-core assets and repositioning.
Recently, it was announced that CIMIC has entered into an agreement with funds advised by Elliott Advisors, under which CIMIC will divest 50% of its equity interest in Thiess, the world's largest mining services provider. The transaction is said to reflect Thiess' growth and diversification strategy, as it is indicated that Thiess will pursue new opportunities in the mining sector under the joint venture arrangement.
Although, in the current economic climate, the sale of non-core assets or verticals of business may be motivated by financial distress.
As traditional "core" infrastructure assets become more scarce (i.e. airports, roads and ports), we expect to see increased interest in digital infrastructure and "infrastructure-like" assets, or assets which – like infrastructure – offer strong fundamentals in an uncertain economic climate (such as healthcare, where we are seeing more pathology businesses come to market).
Read more in Part one of this series
If you would like further information or to share your thoughts on the industry shifts we have identified, please reach out to one of our infrastructure M&A specialists.