Darby and Joseph

Darby Overseas Investments is one of the leading US based emerging market investment firms. It was started by Nicholas Brady, the ex-US Treasury Secretary, in 1994 and has so far focused its attentions mainly on Latin America.

In March, Darby announced that it had acquired Prumerica Asia Infrastructure Investors (PAII)from the Hong Kong affiliate of Prudential Financial. PAII manages the $246 million Asian Infrastructure Mezzanine Capital Fund and the firm is run by one of Asia's best known infrastructre financiers, Joseph Ferrigno, who has moved onto the board of Darby

It is an interesting time for Darby to be expanding into the region as growth rates rebound, necessitating new infrastructure investment. The use of mezzanine financing by both Darby and PAII gives this infrastructre investment story a new and more subtle hue than the infrastructure crazes of the past.

Why did you decide to buy Prumerica Asia Infrastructure Investors and what have you got from it?

Frank: We are the most innovative infrastructure investment firm in Latin America, having rolled out private equity and mezzanine finance as a pioneering effort. We also have technology investments, financial institution investments and a fund that only invests in emerging market bond issues. So we felt we had Latin America pretty much diced and sliced. Because we are a firm that only invests in emerging markets, we felt we had to diversify into either Asia or Central and Eastern Europe.

So two years ago we began sending scouts out to look at this region. We saw the private equity world as somewhat crowded here and so we felt that mezzanine finance was the better place to be. We really do believe that mezzanine finance is a unique tool to finance infrastructure and other corporate situations. Our board is totally in love with the product. The opportunity to acquire an existing operation with a team and leadership together with a fund that had already achieved good investments and other capital to invest made the buy or build decision very easy for us. And then we fortunately got together on the acquisition terms.

Can you reveal those terms?

Frank: No I cannot. But I can reveal that a critical decision in this for Prudential, which owned the management company, was stewardship. These are funds where investors' money is locked up for 10 or 12 years. So the important thing for Prudential and the investors in the fund was not the near term cash value of the business, rather it was who is going to look after the money.

Ferrigno: It became obvious that Prudential had shifted its strategy having decided to and then become a public company in November of last year. There is some confusion over the name because outside Japan, Korea an the US, they've now adopted the name of Prumerica Financial to mitigate confusion with Prudential of the UK.

So when they decided to change the strategy, I decided with Prudential to consider alternative new partners to take over this business. The stewardship factor was the most highly weighted factor. There were a few interested parties and other firms offered considerably more cash. But the decision was taken to go with Darby largely due to the team there who really take the fiduciary responsibility seriously to our investor clients.

We are solely fiduciary. We're not in this business to make investment banking type fees, or to shift an investment from our balance sheet and into a fund at a higher valuation to make a turn. For the team here at Prumerica in Hong Kong it was an attraction of four Cs: the collegiality of Darby; the capital of Darby; the compensation thinking of Darby; and the custodianship of Darby.

So what did Darby actually get from the purchase?

Ferrigno: Darby gets the fund management company. That company has a contract with the Asian Infrastructure Mezzanine Capital Fund. That entity remains in tact. Prudential is the lead investor with $75 million commitment. The ADB is the next investor with a $25 million investment. In addition, the Nippon Life Insurance Company also has $25 million in the fund. We have invested up to $160 million of the fund. In June we exited two Chinese power investments, aggregating $45 million. These were actually our first investments from the fund - two power plants, one in Liaoning and one in Shenyang. Our strategy from the start was to concentrate on China and India and then see how Asean develops.

So what is your overall strategy now you are with Darby?

Ferrigno: We aim to add value to our investee companies through strategic financial policies and implementation. We also add value through the quality of the senior debt we can attract. We did that with one of these Chinese companies.

We raised $150 million of limited recourse finance, half of it in RMB, half in US dollars. We substantially reduced the weighted average cost of capital of the sino-foreign joint venture company. We had invested in the foreign party, albeit controlled by mainland Chinese. So we were able to improve the terms for the fund and the fund investors. We had coordinated exits from the investee company, because it was able to attract lower cost financing to pay us off. We had originally come in to help pay off another bridge loan. Our strategy was to come in and get the company's finances organized and then we had a put option where we could stay in or get out. We got out because we felt we could redeploy the capital in other investments for higher returns, not because we did not like the company.

What return did you make on that deal?

Ferrigno: We made a gross return of about 18.5% to the fund over a period of three years. That was composed of a 13.5% current cash on cash yield and then we took the funding fee into account as well. And that was in the range that we were telling investors back in 1997 when we were raising money.

So was it these types of deals that attracted Darby? After all Asia is littered with the wrecks of failed infrastructure deals.

Frank: For us it was a demonstration of the market potential that we thought was here. We found a group that was doing it. We have known for quite some time that the financial systems of emerging markets are not that deep when it comes to debt finance or risk capital. That is why when you bring in private equity you have to aim for returns of 25% and north. You obviously cannot finance things such as a toll roads or other infrastructure projects at those rates û you would bankrupt your clients through excessive tariffs.

The senior debt component of project finance has also waxed and waned. Lenders have come in and then pulled out. I now think that banks are systemically out of infrastructure. You will get domestic bond markets working over time. But we've seen that there will be an important gap left between senior debt and pure equity.

So we see mezzanine as a gap filler. It provides a very useful bridge between the equity investors and the lenders. You have two hats on. Firstly as a lender you want all the covenants you can get. Then you try to get shareholder rights on the equity kicker features.

So when we saw Joseph's group doing deals like this, it was a confirmation of our beliefs. The transactions they're doing here are similar to what we are doing in Latin America û perhaps a little more equity orientated. We have just started in terms of seeing opportunities for infrastructure financing. It is not being used so much in the Greenfield stage. You can now pick up companies that have been privatized and the original developers do not want to put in more capital. So we are in the second or third stages of infrastructure financing.

We will start to see increasing familiarity with this product from the corporate finance world. The investment banking community is aware of it. The private equity firms bring us a lot of our transactions or they tell us about potential deals. They know that they need to leverage up their own investments somehow. The intermediaries can see the attraction of using mezzanine finance. So there are lots of options for using the instrument. It is very flexible.

You say that you are looking to finance existing assets not new projects. But back in 1997 the World Bank famously said that Asia needs $1.5 trillion of new infrastructure investment. Very little new money has come into the sector since then. For instance, we are all aware that in Indonesia the lack of investment in the power sector is likely to cause brown outs in two years time. So given the need for new infrastructure investment, why does it make economic sense to go into existing assets?

Frank: You can take a Greenfield project finance risk where there is no recourse. Or you can take a bet on a company that is expanding, which due to its concession, needs to buy an existing asset. So it is more of a hybrid risk situation.

Ferrigno: There are opportunities for us in Asia to invest in multi project companies where there are existing cash flows. In order for these companies to do, for instance, another 400MW or 500MW of power, they will need equity. Because of the shortage of capital in the markets, even the public markets, for these kinds of assets, mezzanine is a great catalyst to attract senior creditors. There is also the element of having a world-class investment group participate. It enhances the credibility. It puts them up a few notches and helps them get what limited bank financing is available. It also helps attract export credit agencies.

It looks as though we will see a lot of privatization in the Asian power sector over coming years, will you get involved in that process?

Ferrigno: We are looking, but at this stage our fund is too small to be a significant feature in the process. If we are comfortable with co-investors, we can do about $35 million. But most of these privatizations will require hundreds of millions of dollars.