Investing in Infrastructure: The Legacy

1
Investing in Infrastructure The Legacy
Lessons of Distressed Failed Projects

• Ryan J. Orr, Ph.D

2
Five big picture research questions

• Why are infrastructure funds on the rise today?
• What is the infrastructure privatization
  paradigm?
• What factors led to distressed failed projects
  in the 1990s?
• How is risk allocation/mitigation different
  from strategic management?
• Other approaches to enhance infrastructure
  investments?

3
Understanding infrastructure backgroundWhat is
infrastructure? It depends on who you ask!
4
Understanding infrastructure backgroundSpectrum
of infrastructure provision public to private
Source Guasch (2004)
5
Understanding infrastructure backgroundTwo-by-tw
o of different kinds of goods
Excludable?
Yes
No
Private Goods (hamburgers, 747 jets, houses)
Common Resource Pool Goods (fisheries, forests,
open grazing land, aquifers)
Yes
Subtract- able ?
Toll Goods (toll highway, computer software,
wireless network)
Public Goods (interstate freeways, state park,
defense)
No
Source Ostrom (2005)
6
1. Why are infrastructure funds on the rise?In
the first 6 months of 2006, more than 15 new
funds!

• Macquarie, 964M infrastructure fund, South
  Korea
• Alinda Capital Partners, 1B infrastructure
  fund, USA
• Infra. Devt Finance Corp., (IDFC), 350-450M
  infrastructure fund, India
• Carlyle Group, 1B fund, USA
• Dubai International HSBC, 500M fund, Dubai
• Emerging Mkts Partnership, 730M fund, Islamic
  Dev. Bank countries
• Goldman Sachs, 3B global fund, USA
• KB Asset Management, 1.2B fund of funds,
  Korea
• Carlyle Group Riverstone, 685M renewable
  energy fund, USA
• GE Credit Suisse, 1B fund, international
• JP Morgan Asset Management, undisclosed amount
• Morgan Stanley, multi-million UK Pounds
  Sterling
• TOTAL 10.8 Billion in Equity (x 4 43
  Billion in New Projects)

Source Orr, 2006, Infrastructure Journal
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1. Why are infrastructure funds on the rise? 1
billion newcomers to the planet insatiable
demand?
Global population
2016
Source United Nations
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1. Why are infrastructure funds on the rise?
Unprecedented risk adjusted profits?
45
Annual Return
25
Source Clark Evans, 2000, Pension Fund
Capitalism, pg. 213
5
Risk
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1. Why are infrastructure funds on the
rise?Macquaries success jumping on the
bandwagon?
Macquarie Bank has achieved a 19.4 return over
11 years on a growing pool of capital that now
includes many billions of dollars in
infrastructure investments...
Source Macquarie Website
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2. What is the infrastructure privatization
paradigm?

• 1) Governments
• New source of cash A solution to decades of
  neglect of antiquated infrastructure
• Banks, pension funds, investors
• New, long-term, inflation-linked asset class
  Alongside private equity real estate Hard
  assets visible long-term earning streams
• Multilateral devt agencies
• A tool to resolve economic ills in Africa, Asia,
  emerging mkts Brings poverty alleviation,
  economic growth, social change

• 1a) Need/Demand Side
• 20-30 trillion in Asia (need) over 10 yrs
  (ADB)
• 8.5 trillion worldwide (demand) over 10 yrs
  (WB)
• 1.6 trillion in US (need) over 5 yrs (ASCE)
• Source CRGP Global Projects Blog

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2. What is the infrastructure privatization
paradigm?

• 1) Governments
• New source of cash A solution to decades of
  neglect of antiquated infrastructure
• 2) Banks, pension funds, investors
• New, long-term, inflation-linked asset class
  Alongside private equity real estate Hard
  assets visible long-term earning streams
• Multilateral devt agencies
• A tool to resolve economic ills in Africa, Asia,
  emerging mkts Brings poverty alleviation,
  economic growth, social change

• Pension fund trustees ? 7 to 15 of assets
  invested into real estate
• Glut of capital looking for returns in real
  estate and related activities but limited
  investment opportunities at attractive
  valuations
• Definition of what actually constitutes
  permissible real estate investments has slowly
  been widening (eg. Tata, GMR in India)

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2. What is the infrastructure privatization
paradigm?

• 1) Governments
• New source of cash A solution to decades of
  neglect of antiquated infrastructure
• 2) Banks, pension funds, investors
• New, long-term, inflation-linked asset class
  Alongside private equity real estate Hard
  assets visible long-term earning streams
• 3) Multilateral devt agencies
• A tool to resolve economic ills in Africa, Asia,
  emerging mkts Brings poverty alleviation,
  economic growth, social change

World Bank
Catalog of Learning Activities
Performance Evaluation and Best Practice of PPP
in Korea, 07 Nov 2006 to 08 Nov 2006 PPP in
Highways in Romania, 27 Nov 2006 to 29 Nov
2006 PPP for Urban Transport in Thailand, 05 Dec
2006 to 07 Dec 2006 PPP in Infrastructure in
Guatemala, 05 Dec 2006 to 07 Dec 2006 PPP Policy
Dialogue Session in Kazakhstan, 12 Dec 2006 to 14
Dec 2006 Sub-Saharan Africa Road Financing and
Management, 08 Jan 2007 to 10 Jan 2007 Infra.
Regulation/Reform for Consumer Assoc. in Central
America, 10 Jan 07 to 12 Jan 07 PPP Development
for Transport and Logistics Sector in Brazil, 25
Jan 07 to 27 Jan 07 Financing PPP Projects in the
Electricity Sector in Senegal, 13 Feb 07 to 16
Feb 07 Policy Dialogue for PPP Development in
Infra.in Indonesia, 13 Feb 07 to 15 Feb 07 PPP
for Urban Transport in China, 20 Feb 2007 to 22
Feb 2007 PPP in the Power Sector in Lebanon, 03
Apr 2007 to 05 Apr 2007 PPP in the Transport
Sector in Madagascar, 01 May 2007 to 03 May 2007
13
2. What is the infrastructure privatization
paradigm?

• 1) Governments
• New source of cash A solution to decades of
  neglect of antiquated infrastructure
• 2) Banks, pension funds, investors
• New, long-term, inflation-linked asset class
  Alongside private equity real estate Hard
  assets visible long-term earning streams
• 3) Multilateral devt agencies
• A tool to resolve economic ills in Africa, Asia,
  emerging mkts Brings poverty alleviation,
  economic growth, social change

Each of the major players in the system, acting
in self-interest, reinforces the trend towards
more private infrastructure!
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2. What is the infrastructure privatization
paradigm?

• 1) Governments
• New source of cash A solution to decades of
  neglect of antiquated infrastructure
• 2) Banks, pension funds, investors
• New, long-term, inflation-linked asset class
  Alongside private equity real estate Hard
  assets visible long-term earning streams
• 3) Multilateral devt agencies
• A tool to resolve economic ills in Africa, Asia,
  emerging mkts Brings poverty alleviation,
  economic growth, social change

Each of the major players in the system, acting
in self-interest, reinforces the trend towards
more private infrastructure!
15
3. Distressed failed projects in the 1990sA
few examples

• 360networks (Worldwide) Telecom
• Radical technological changes made installed
  technology obsolete demand forecast
• Cochabamba (Bolivia) Water
• Social movement over pricing, government
  couldnt keep promise, legal breakdown
• Dhabol (India) Power
• Expensive technology, unsustainable pricing,
  incomplete consensus in host government,
  international arbitration award unenforceable in
  local courts, etc.
• Paiton III (Indonesia) Power
• Change in government, political assets ?
  political liabilities
• Chunnel (UK-France) Tunnel
• Contractor-only consortia (not in it for the
  long haul)
• Dulles Greenway (USA) Road
• Demand forecast, traffic never materialized
• Kumagai-led Consortium (Thailand) Road
• Govt balked at 30 baht toll, motorists angry,
  govt forced road open, expropriation

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3. Distressed failed projects in the 1990sTwo
important studies (from emerging markets)

• Author J.Luis Guasch, World Bank, 2004
• Sample 1000 infrastructure investment
  agreements
• and concession contracts, Latin America,
  1988-2002
• Finding 40-50 cancelled or renegotiated!!
• Study Erik Woodhouse, PESD, Stanford, 2006
• Sample 33 investment agreements for independent
  
• power projects, developing countries, 1990s
• Finding 65 cancelled or renegotiated!!

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3. Distressed failed projects in the
1990sGuasch Latin America, 1988-2002, N1000
Incidence average time to renegotiation?

• Source Guasch (2004)

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3. Distressed failed projects in the
1990sGuasch Latin America, 1988-2002, N1000
Who initiates renegotiation?

• Source Guasch (2004)

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3. Distressed failed projects in the
1990sGuasch Latin America, 1988-2002, N1000
Link between regulatory regime renegotiation?

• Source Guasch (2004)

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3. Distressed failed projects in the
1990sGuasch Latin America, 1988-2002, N1000
Link between contract award process
renegotiation?
Source Guasch (2004)
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3. Distressed failed projects in the
1990sWoodhouse IPPs in Developing Countries,
N33
Source Woodhouse (2006)
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3. Distressed failed projects in the 1990s
Woodhouse IPPs in Developing Countries, N33
Source Woodhouse (2006)
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3. Distressed failed projects in the 1990s
Woodhouse IPPs in Developing Countries, N33
Lack of prominent international partner?
of projects that encountered successfully
mitigated each risk
(N 17,16 respectively)
Source Woodhouse (2006)
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3. Distressed failed projects in the 1990s
Woodhouse IPPs in Developing Countries, N33
Lack of local partner?
of projects that encountered successfully
mitigated each risk
(N 20,13 respectively)
Source Woodhouse (2006)
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3. Distressed failed projects in the
1990sGeneral Counsels Roundtable Stanford
University

• GCR1 - What were the factors that led to
  distressed and failed projects during the 1990s?
  Can we divine any trends?
• GCR2 - How did the renegotiations and workouts
  unfold? Can we engineer a more stable
  legal-contractual framework for emerging markets
  infrastructure investments?

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3. Distressed failed projects in the 1990s
Investor-driven vs. host government-driven factors
Influence by investor
Less influence
More influence

• Macro shocks (Asian financial crisis)

• Poor local partners/lack of local partners

Less influence

• Irrational exuberance

• Adverse market conditions (e.g. input costs)

Influence by Government

• Overly complex/ rigid contracts

• Poor demand forecast

• Politicization of projects

• Weak regulatory framework

• Mis-alignment of project incentives

• Lack of transparent bid process

• Mis-allocation of risks

More influence

• Poor payment security

• Legal disputes resulting in arbitration

• Expropriation/Creeping expropriation!!

• Contractor-only consortia

27
3. Distressed failed projects in the 1990s
Investor-driven vs. host government-driven factors
Influence by investor
Less influence
More influence

• Macro shocks (Asian financial crisis)

• Poor local partners/lack of local partners

Less influence

• Irrational exuberance

• Adverse market conditions (e.g. input costs)

Influence by Government

• Overly complex/ rigid contracts

• Poor demand forecast

• Politicization of projects

• Weak regulatory framework

• Mis-alignment of project incentives

• Lack of transparent bid process

• Mis-allocation of risks

More influence

• Poor payment security

• Legal disputes resulting in arbitration

• Expropriation/Creeping expropriation!!

• Contractor-only consortia

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3. Distressed failed projects in the 1990s The
toxic nature of political risk

• (1) Political risk (obs. bargain) problem
• (2) Legal-contracting problem
• (3) Financing problem
• Conclusion Private investment in emerging
  markets infrastructure is extremely challenging!
• Anecdote Is infrastructure still risky? (Lou
  Wells, 1997)

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3. Distressed failed projects in the
1990sGeneral Counsels Roundtable Stanford
University
The examination thus far supports the notion
that contracts are going to fail, despite all of
the manifold, ironclad guarantees. That leads to
the question, why not design a contract for
instability? And that leads to the question,
what would such a contract look like?
-- Participant of the Roundtable
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4. How is risk allocation/mitigation different
from strategic management?

• The Risk Allocation/Mitigation Model (1990s)
• Philosophy Fix obligations benefits with risk
  allocation mitigation
• Approach Lay off key risks thru contracts
  create certainty for the lender do all of this
  ex-ante
• Supply risk (purchase ahead or hedge)
• Off-take risk (take or pay contracts)
• Exchange rate or interest rate risks (hedge)
• Technological risks (get warranties from deep
  pocket vendors)
• Political risks (Political risk investment
  insurance, guarantees)
• Emphasizes Safety-net clauses that promote
  enforceability hard-nosed contractual
  protections for maximum certainty
• Draws on Contingent claims contracts external
  bargaining model

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4. How is risk allocation/mitigation different
from strategic management?

• The Strategic Management Model
• Philosophy Create conditions for active,
  adaptive, governability
• Approach Equity joint venture with the host
  government
• Co-destiny, partnership, information sharing,
  trust
• Co-ownership, co-alignment co-direction
  recognizing the world will change
• Emphasizes Shock absorber clauses that promote
  adjustments low-cost amicable renegotiation for
  maximum flexibility
• Draws on Experience with JVs, consortia,
  relational contracting

Source Orr (2006) Harvard Business Review
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4. Risk alloc./mitigation vs.strat. mgmt?Two
roads diverged in a yellow wood?
Rigid contracts, safety nets, certainty
Flexible contracts, shock absorbers, adaptability
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4. Risk alloc./mitigation vs.strat. mgmt?Two
roads diverged in a yellow wood?
Rigid contracts, safety nets, certainty
Flexible contracts, shock absorbers, adaptability
BUT WAIT!!!
Problems Brittle, falls apart!
Lenders wont lend, no deal!
(pension funds dont want to manage)
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4. Risk alloc./mitigation vs.strat. mgmt?
Balancing Act Seek certainty AND flexibility
BOTH!!
Source Stodder Orr (2006) Journal of World
Investment
Flexible contracts, shock absorbers, adaptability
Rigid contracts, safety nets, certainty
Get tough contracts, but be
flexible in practice!
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5. Other strategies to enhance the success of
infrastructure investments?
Influence by investor
Less influence
More influence

• Macro shocks (Asian financial crisis)

• Poor local partners/lack of local partners

Less influence

• Irrational exuberance

• Adverse market conditions (e.g. input costs)

Influence by Government

• Overly complex/ rigid contracts

• Poor demand forecast

• Politicization of projects

• Mis-alignment of project incentives

• Weak regulatory framework

• Mis-alignment of project incentives

• Lack of transparent bid process

• Mis-allocation of risks

More influence

• Poor payment security

• Legal disputes resulting in arbitration

• Expropriation/Creeping expropriation!!

• Contractor-only consortia

36
5. Other strategies to enhance the success of
infrastructure investments?

• Project selection
• Focus on countries that are integrated in the
  international matrix
• Avoid consortia that are primarily composed of
  contractors (Eurotunnel)
• Blend in with local investors (macro shock ? bail
  out by the government!)
• Avoid diversification in a small market, seek
  greater global diversification
• Seek independently viable projects
• Working with government
• Educate politicians on the benefits of
  infrastructure privatization
• Educate bureaucrats with new public management
  skills
• Be skeptical of reforms
• Contracts dispute resolution
• Invest under BITs that give strongest
  protections
• Prepare to renegotiate from the outset
• Use multilateral agencies for inter-governmental
  negotiations, but, understand political
  restrictions of home and host countries
• Focus on structural trends obsolescing
  bargains, fuel pricing, etc. dont worry so
  much about contractual details

37
5. Other strategies to enhance the success of
infrastructure investments?

• Project selection
• Focus on countries that are integrated in the
  international matrix
• Avoid consortia that are primarily composed of
  contractors (Eurotunnel)
• Blend in with local investors (macro shock ? bail
  out by the government!)
• Avoid diversification in a small market, seek
  greater global diversification
• Seek independently viable projects
• Working with government
• Educate politicians on the benefits of
  infrastructure privatization
• Educate bureaucrats with new public management
  skills
• Be skeptical of reforms
• Contracts dispute resolution
• Invest under BITs that give strongest
  protections
• Prepare to renegotiate from the outset
• Use multilateral agencies for inter-governmental
  negotiations, but, understand political
  restrictions of home and host countries
• Focus on structural trends obsolescing
  bargains, fuel pricing, etc. dont worry so
  much about contractual details

38
5. Other strategies to enhance the success of
infrastructure investments?

• Project selection
• Focus on countries that are integrated in the
  international matrix
• Avoid consortia that are primarily composed of
  contractors (Eurotunnel)
• Blend in with local investors (macro shock ? bail
  out by the government!)
• Avoid diversification in a small market, seek
  greater global diversification
• Seek independently viable projects
• Working with government
• Educate politicians on the benefits of
  infrastructure privatization
• Educate bureaucrats with new public management
  skills
• Be skeptical of reforms
• Contracts dispute resolution
• Invest under BITs that give strongest
  protections
• Prepare to renegotiate from the outset
• Use multilateral agencies for inter-governmental
  negotiations, but, understand political
  restrictions of home and host countries
• Focus on structural trends obsolescing
  bargains, fuel pricing, etc. dont worry so
  much about contractual details

39
5. Other strategies to enhance the success of
infrastructure investments?

• Project selection
• Focus on countries that are integrated in the
  international matrix
• Avoid consortia that are primarily composed of
  contractors (Eurotunnel)
• Blend in with local investors (macro shock ? bail
  out by the government!)
• Avoid diversification in a small market, seek
  greater global diversification
• Seek independently viable projects
• Working with government
• Educate politicians on the benefits of
  infrastructure privatization
• Educate bureaucrats with new public management
  skills
• Be skeptical of reforms
• Contracts dispute resolution
• Invest under BITs that give strongest
  protections
• Prepare to renegotiate from the outset
• Use multilateral agencies for inter-governmental
  negotiations, but, understand political
  restrictions of home and host countries
• Focus on structural trends obsolescing
  bargains, fuel pricing, etc. dont worry so
  much about contractual details

40
Five big picture answers

• Why are infrastructure funds on the rise today?
• 1 billion new people, Macquaries success, 20
  returns, privatization paradigm
• What is the infrastructure privatization
  paradigm?
• Governments, private investors and multilaterals
  all reinforce the trend towards greater
  infrastructure privatization!
• What factors led to distressed failed projects
  in the 1990s?
• Long list, See the Proceedings of the General
  Counsels Roundtable
• How is risk allocation/mitigation different
  from strategic mgmt?
• Static vs. dynamic Safety nets vs. shock
  absorbers Rigidity vs. flexibility
• Other strategies to enhance infrastructure
  investments?
• Project selection, working with government,
  contracts dispute resolution, focus on
  structural trends

41
References

• Guasch, J.L. (2004) Granting and Renegotiating
  Infrastructure Concessions Doing it Right,
  Washington, D.C. The World Bank.
• Guasch, J.L. (2003) Infrastructure Concessions
  in Latin America and the Caribbean The
  Renegotiation Issue and its Determinants.
  Infrastructure and Financial Markets Review 9,
  1-6.
• Khan, M.F.K. and Parra, R. (2003) Financing
  Large Projects, Singapore Prentice Hall.
• Metzger, B. (2004) The Legacy of Failed Global
  Projects Testing the Legal Paradigm. Anonymous
• Moran, T. and West, G.T. (2005) International
  Political Risk Management Looking to the Future,
  Washington, DC The World Bank.
• Nevitt, P.K. and Faboozi, F.J. (2000) Project
  Financing, 7th Ed., London Euromoney Books.
• Orr, R.J. (2006) Living Agreements for a Risky
  World. Harvard Business Review.
• Orr, R.J. and Metzger, B. (2005) General
  Counsels' Roundtable The Legacy of Failed
  Projects. The Collaboratory for Research on
  Global Projects (CRGP), Working Paper Series
  1-49.
• Rubins, N. and Kinsella, N.S. (2005)
  International Investment, Political Risk and
  Dispute Resolution, Dobbs Ferry, New York
  Oceana Publications, Inc.
• Stodder, S. and Orr, R. (2006) Understanding
  Renegotiation and Dispute Resolution Experience
  in Foreign Infrastructure Investment. Journal of
  World Investment.
• United Nations Economic Commission for Europe
  (2005) Governance in Public Private Partnerships
  for Infrastructure Development. Committee for
  Trade, Industry and Enterprise Development 1-50.
• Wells, L.T.Jr. and Gleason, E. (1995) Is
  Investment in Foreign Infrastructure Still Risky?
  Harvard Business Review 1-12.
• West, G. (1996) Managing Political Risk The
  Role of Investment Insurance. J. of Project
  Finance 5-11.
• Woodhouse, E.J. (2005) A Political Economy of
  International Infrastructure Contracting Lessons
  from the IPP Experience. Program on Energy and
  Sustainable Development Working Paper Series
  1-123.

42
Thank You!
Ryan J. Orr, rjorr_at_stanford.edu Executive
Director
Collaboratory for
Research on Global Projects
Stanford University