Not many investments in what is essentially highly rated government debt offer returns of more than 20 per cent. Yet this is what the raft of new infrastructure funds launched in the Middle East and North Africa (Mena) claim to do.

Whether these claims will stand in the long term remains to be seen. So far, actual investment from infrastructure funds into regional projects has been slow, despite most funds insisting for some time that they are close to arranging their first deals.

Several infrastructure funds have emerged over the past three or four years, offering investors a diversified portfolio of exposure to assets in the Middle East. Initial investors range from sovereign wealth funds and wealthy locals, to US and European hedge funds.

First investment

The most significant of these funds are Instrata Capital, established by Kuwait Investment Corporation (KIC) with an anonymous Saudi investor; the Mena Infrastructure Fund, a venture by HSBC; and Dubai International Capital & Oasis Leasing Company, which is thought to be on the verge of announcing its first investment. Joint venture funds from Abu Dhabi Investment Company (Adic) and UBS, and Macquarie and Abu Dhabi Commercial Bank (ADCB), have also been launched this year.

The Infrastructure & Growth Capital Fund, a $2bn fund managed by private equity company Abraaj Capital, had its first transaction in June 2007. However, the fund had only raised $1.2bn by October last year, and only about $800m has been invested since it launched in May 2006. This does put it ahead of the competition, though, which, apart from a seed investment in the Queen Alia Airport expansion project in Jordan by Adic, has been slow to get started.

Despite only a small number of investments being made, infrastructure funds are promising high returns from taking small equity stakes in several projects across the region. However, rising construction costs and interest rates on debt are taking their toll on project returns, with returns for some independent water and power projects (IWPPs) dropping into single figures for the first time. Projects in other sectors around the region are also experiencing some erosion of returns, although from a higher base.

This could threaten the promised returns of these funds, which all expect to return to investors an additional 20 per cent, and could mean they have to work much harder than they expected to keep their investors happy.

However, Simon Monk, head of infrastructure investment at Instrata Capital, still sees plenty of opportunity. “We are confident that our 20 per cent return rate is achievable,” he says. “We will invest across a number of different sectors. Some sectors exceed that level of return, others will not.”

Profit margins

“I am concerned about EPC contract prices, and the project economics have to stack up or we will not invest,” says Robert Swift, chief executive of the Mena Fund.

However, even people within the industry remain sceptical as to how they will achieve such levels of return.

Selling down stakes offers some uplift in profit margins, as does leveraging investments, But the market is not looking as profitable as it was a few years ago when many of these funds were being launched.

“There are opportunities out there to generate returns in the 20 per cent region, but it will be a long, hard slog to get them,” says one banker working at an infrastructure fund.

Some in the industry say that taking short-term equity stakes during the initial construction phase of projects that have strong government support offers the best chance of maxi-mising returns, while minimising risk.

There are also concerns about exactly what niche these funds will carve out for themselves in the market. It remains unclear whether their role will be in small projects or larger ones.

“There is certainly interest in [the different infrastructure funds] joining together, and we have talked about it on some transactions, so I think we will see the funds working together,” says Monk.

Instrata, which has not officially announced the size of its capital base but is understood to have about $400m at its disposal, also has the possibility of leveraging its ties with KIC to become co-investor on projects that demand a larger capital injection. This could help it play a role in bigger projects.

Most infrastructure funds range from about $500m to $1bn in size, which gives them about $20-60m to invest in projects. “These funds can make equity investments of around $50m, which has a place in the project market, but it is probably not in the $10bn petrochemicals projects in Saudi Arabia,” says one industry source.

Clubbing together to take large equity stakes in projects may sound attractive for project companies now, but once they are up and running, having to manage a larger pool of investors could become time consuming. Also, given the length of time it has taken many of these funds to complete their first transaction, working together does not promise to make deals any easier or less complex.

The difficulty for these funds is that while most projects would welcome more debt investors given the tight credit markets, raising equity is not a problem for them, says the source. This raises the question of what exactly these funds can offer to the projects they invest in, other than capital.

Swift admits that the region is not short of equity. “Infrastructure funds have added liquidity to the project finance market,” he says. “Not that it was short of equity, but we provide flexibility in terms of additional financial support and our other resources. That includes experience with projects in certain sectors or in specific countries.”

Despite not investing much of their capital yet, most funds are still looking for more. Swift says that although the first Mena Fund is closed, he can see a successor fund being opened to new investors in the future.

Instrata is still welcoming new investors, Macquarie and ADCB are hoping to raise $1bn before their fund closes, and Abraaj still has an additional $800m to raise. The pressure will then be on for these funds to achieve what they promise, which could be more difficult given that while debt costs are high, sponsors may concentrate on only the most vital projects.

“Most funds have a life of six or seven years,” says one director at an infrastructure fund. “Some people in the industry thought that managing these would just be a case making a lot of investments in year one, then sitting back and monitoring them until the fund ends. Now I think most funds will be lucky to invest all their capital in the first three years.”