Navigating the perceived risks of emerging market infrastructure

by Martijn Proos and Nazmeera Moola | 28,May,2024 | Investments, Ninety One, Q2 2024

George Brown

Infrastructure investments have grown exponentially over recent years. Currently valued at around US$1 trillion, this amount is expected to grow to over US$1.9 trillion by 2027.

 The potential growth of this relatively new asset class brings with it compelling investment opportunities, especially for institutional investors wanting a steady income stream at relatively low risk. Added to this, infrastructure investments are by their very nature structured to deliver long term economic, social and environmental benefits, typically through public-private partnerships. Therefore, the private provision and financing of infrastructure is potentially very beneficial for governments that lack the necessary capital or resources to develop and maintain their own infrastructure networks. Given the high impact of infrastructure investments, less developed economies such as those found within emerging markets would seem an obvious destination.

However, this hasn’t necessarily been the case. The vast majority of global infrastructure capital is currently allocated to developed markets, despite the fundamentals for emerging market investments being remarkably supportive. Emerging markets have high urbanisation rates, a growing need to transition, and significant funding shortfalls, all of which make for a great investment opportunity.

 The reason for this lack of interest is largely based on the perceived risks associated with emerging markets. However, in our view these risks are compensated for by higher returns. In fact, investors within emerging markets can expect a pick-up of around 200 to 300 basis points over that of developed markets.

 This begs the question, if the relative returns are attractive and the investment case strong, what are the misconceptions preventing investors from allocating a higher proportion of their capital to emerging market infrastructure?

 Project risk

A good starting point when evaluating the risks of any infrastructure investment is to look at the project being financed.

 One of the first aspects to look at is the project’s commercial proposition. In other words, the return that the portfolio stands to gain by funding or investing in that project relative to the associated risks. But commercial viability is not the only factor. Investors should also look at the sustainability factors and the impact that the project will have on the broader community. A good project should also have a high impact.

 Risk mitigation is what ensures the creditworthiness of a project. Having a clear idea of the project’s outcome in terms of its impact on the planet, people, market transformation and the wider economy helps service the creditworthiness of these projects.   

 While the socio-economic impact of a project is important, it is equally important to ensure that it does not have any adverse effects on the biodiversity within a region. If there are clear benefits to the people, broader environment, economy, and if the project is financially viable, the project risks are significantly reduced.

 Default risk

History shows us that the cumulative default rates for infrastructure projects measured over 20 years are very similar for both developed and emerging markets. Default rates are understandably highest at the start of the term as projects enter the operational phase, where factors such as structural risks, cost overruns and supplier delays are at their highest, and then begin to stabilise.  

 Within developed markets, default rates peak at around 4% and remain flat until the end of the term. It’s a similar story in terms of timing for emerging markets, where the rate peaks at around 6% before stabilising. Although there’s a marginal increase in cumulative rates over time, these typically remain flat once projects are in their operational phase.

 Recovery rates

The counterargument to low default rates is that investors still take on more risk given that the cumulative default rates in emerging markets are marginally higher. While this is true, the risk of permanent capital loss is largely mitigated. Recovery rates on infrastructure investments for both developed and emerging markets are similar at around 75% – 80%, which means that investors will still experience a high recovery rate regardless of whether they invest in developed or emerging markets.

 The role of blended portfolios

A further buffer comes in the form of blended finance structures to cover first-loss positions. Blended portfolios allow investors who are more risk averse, such as those looking for investment grade exposure or those not wanting to take on local currency risk, to access infrastructure investments within emerging markets.

 At a certain point, infrastructure assets start to display similar characteristics to that of investment grade securities, regardless of whether the investment is in developed or emerging markets.

 In conclusion, the investment case to finance infrastructure projects within emerging markets is compelling and the realised risks are relatively low. Investors have an attractive pick up over what they would get from public markets, with only marginally higher default rates. Added to this, emerging markets have high recovery rates, and investors can mitigate losses by taking up first loss positions within blended finance portfolios.

 The combination of these factors suggests that the perceived risks associated with emerging market infrastructure investments can be mitigated, and are likely to be a fair bit lower than most investors expect.  As investors begin to better understand the actual risks associated with these types of investments, the hope is that a greater allocation of global infrastructure capital will be directed towards emerging markets, especially to areas where the need for investment is often greatest.

George Brown
Martijn Proos
Co-Head of Emerging Market Alternative Credit at Ninety One | + posts
Nazmeera Moola
Chief Sustainability Officer at Ninety One | + posts