Global Private Equity – Industry Spotlight
Although investing in infrastructure is an attractive opportunity, investors should be prepared to mitigate the risk inherent in major construction projects.
Private investment in infrastructure, especially renewable energy projects, is increasing across the world. In fact, total new renewable energy investment hit an all-time high in the first half of 2021. The resulting competition among investors has led funds to invest in riskier projects in hopes of securing higher yields.
Infrastructure project risk takes many forms. One of the most difficult risks to manage is the potential for cost overruns during construction, and the larger the project, the greater the risk of overruns. According to McKinsey & Company, 98% of megaprojects (projects with a total cost of more than US$1 billion) experience cost overruns of more than 30%, and 77% of them are completed with at least 40% delay. Such cost overruns will significantly threaten an investor’s return, but this risk can be mitigated by ensuring that the project owner properly manages their relationship with their contractor. To this end, investors should bear in mind the following:
Take the time to have a sturdy front end design. The more design work done before putting a project out for tender, the more defined the scope will be for the project. This will reduce the risk of unforeseen conditions and growing quantities of material and equipment.
Shift the cost overrun risk onto the contractor. A fixed price or guaranteed maximum price contract will provide the project with greater cost certainty than a cost reimbursable contract. Although a contractor insists on a higher price to bear the risk of cost overruns, it may be better for investors to have that price negotiated up front in exchange for greater cost certainty in the future. .
Demand an engaged management team. Problems on construction projects tend to snowball if left to fester. During the project, the owner must employ dedicated internal project management personnel to track costs, schedule and, most importantly, hold the contractor to the terms of their contract.
Understand international dispute resolution. In the event that the owner and contractor cannot resolve their dispute over delays and cost overruns, they will be forced to have their claims decided in court. International projects often use arbitration for disputes, with the International Chamber of Commerce being the most popular venue. The advantage of these procedures is that they allow the parties to avoid the idiosyncrasies of a local court, the final award is generally kept confidential and it is enforceable internationally.
The decision to invest in a capital project does not always take into account the complexities of the construction process, even though it can torpedo key cost assumptions. A little diligence and discipline during this phase can help ensure an investor’s targeted rate of return.
© 2022 McDermott Will & EmeryNational Law Review, Volume XII, Number 35