New Private Markets: Actis on de-risking transition investments in emerging markets

Neda Vakilian, Partner and Global Head of Investor Solutions Group at Actis, contributed a Q&A article to New Private Markets about how the firm de-risks transition investments in emerging markets. Click here or read on below for the full article.

Actis on de-risking transition investments in emerging markets

What is the scale of the emerging markets energy transition investment opportunity today?

Around 85 percent of new electricity demand through to 2026 is expected to come from outside the advanced economies, according to the International Energy Agency. Overlay that with global data centre consumption, which is expected to hit 1,000TWh in 2026 – the equivalent of Japan’s electricity consumption and up from around 460TWh today – and the scale of demand is clear.

The percentage increase of infrastructure needed in both India and Africa is 230 percent, according to data gathered by the McKinsey Global Institute. In the rest of emerging Asia, it is 135 percent, and we recognise that the biggest single factor driving these numbers is the energy transition. There is a huge amount of need and nowhere near enough capital to address it. We like to say that one third of the capital is chasing two thirds of the opportunity in emerging markets, the exact inverse of developed markets, so the investment dynamics are hugely favourable.

How would you describe investor appetite, and what is driving that?

I would divide the investor universe into two groups. Many of our existing LPs are extremely sophisticated blue-chip investors. That is because institutions that have invested with us for many years have tended to have mature infrastructure portfolios and have come to us to diversify their exposure.

However, we are now also seeing a new group of LPs becoming increasingly interested in emerging markets to generate alpha in a higher cost of capital environment. These investors are no longer content with single-digit IRRs from their energy transition infrastructure allocations, given they are getting those returns from fixed income, and so they are turning to value-add and opportunistic strategies instead.

The question then becomes whether those investors should look at riskier infrastructure in familiar territories or make investments in critical, defensive infrastructure such as that which keeps the lights on, but in emerging markets. We believe the risks are different and therefore complementary, meaning that the right allocation strategy would involve doing both.

How would you describe the risk associated with emerging markets investment, and how can this be managed?

The biggest concern that investors tend to have when considering investments in our markets is FX risk, but we believe this risk can be managed. We only hedge in very limited circumstances, for example between signing and completion. Instead, we underwrite FX to valuations in our base case, using our decades of experience operating in these markets. We also structure the underlying cashflows into hard currency and seek inflation indexation at the project level, which can function as a partial hedge against FX fluctuations.

In addition, depending on the strategy, we extract yield from the underlying investments, which means we remove point-in-time risk around entry and exit. Finally, we construct our portfolios so as to diversify currency exposure, which further serves to mitigate individual FX risk.

Another perceived risk is financing risk. Financing and refinancing risk has hit many fund managers globally because debt is no longer cheap. However, financial engineering has never been a big part of our thesis, so we don’t have the same unexpected delta that has bitten in North America and Western Europe. Instead, our thesis is built around value creation through operational enhancement and downside protection through asset management, and that continues to be true regardless of the economic environment.

The supply and demand dynamic between capital and opportunities in our markets is also a key mitigator, with the primary product we are selling – electricity – in short supply relative to developed markets. This means that there is less competition for power purchase agreements and, as a result, more certainty around off-takes.

Some investors also believe default rates in our markets to be too high. However, the reality, as found by a global KPMG study, is that default rates in the US are eight times higher than those in Africa. The reason is that when you invest into a much-needed utility or service in Africa, the optionality around those underlying projects is limited and so everyone is extremely diligent to ensure that a default does not take place.

Finally, investors worry about the unexpected in our regions – one such example being political risk. We are measured about the countries we invest in. We only invest in countries with a strong track record of accepting foreign investment and that have a stable regulatory regime that has been tried and tested.

Where appropriate, the World Bank can provide an insurance product that is essentially a non-commercial guarantee around cross-border investment. We don’t find this to be necessary in many of our markets, but it is a cost-effective option for those countries where it is required. It is also portable, meaning it stays with the project once it has been sold on.

It is important to emphasise that emerging markets are highly diverse. We do not take a binary view, and through our Actis Atlas taxonomy we have developed a more nuanced lens through which to assess the 80-plus emerging markets, rather than as a single monolithic group. This approach means we are better able to balance portfolios and risk criteria across multiple geographies.

Supportive local stakeholders such as development finance institutions can also help to de-risk private investment through grants, guarantees and the provision of debt, as well as investment into capacity such as transmission and distribution. DFIs can also support local utilities in becoming cost effective by making them bankable.

So yes, there are risks associated with emerging markets. Some, such as FX risk, we structure for. Others, such as financing risk, are less severe than you may imagine. There are then misperceptions around risk, for example default risks, and even where risks do exist, there are protection mechanisms that investors can take advantage of.

What is needed to further support the energy transition in emerging markets?

Political will is fundamental. Governments need to set ambitious targets and show long-term commitment through clear programmatic strategies.

India and Brazil are two countries where we have been long-term major investors because the long-term political will is there.

India is a fantastic case study of how this can be done well. Investors used to be cautious about investing in India. Now it is a hugely popular destination for investment, and government policy has been a major factor in that.

India currently has one of the most aggressive energy transition programmes in place, with a target of 500GW of installed renewable capacity by 2030. It also has a clear and robust regulatory model and commercial frameworks, including standardised contracts for public-private partnerships, which provide a clear and predictable legal framework for investors.

It is incredible to see how far the country has come as an investment destination over the past decade.

Where else are you seeing interesting investment opportunities?

We are seeing interesting opportunities around green and blue hydrogen in the Middle East. The solar and wind markets in that region are hugely competitive, but hydrogen is a far more complex proposition, which is where Actis’s skills come to the fore.

Mexico is another interesting area. Mexico is now the US’s largest foreign direct investment partner and, given the new Inflation Reduction Act programme and nearshoring trend, the renewables investment opportunity there has been massively re-energised.

The reality though is that we are seeing opportunities everywhere, including in Central and Eastern Europe and other parts of Asia. India certainly has one of the biggest net-zero programmes in the world, but we are also seeing programmes being launched in Malaysia and Vietnam, for example. There is an abundance of opportunity globally, so long as you are partnering with the right team.