Risk wrap key to Europe’s infrastructure ambitions

On the same Monday morning last month that London unveiled its latest shiny new infrastructure asset – the western concourse of King’s Cross railway station – the UK news media was full of prime minister David Cameron’s plans to boost private-sector investment in the country’s infrastructure. It is clear that this asset class is high on both politicians’ and the market’s agenda. Cameron declared that: "Every transforming generation in our history has left a legacy like the Victorians. Now we must get out, be bold and create our own."

The UK government – like other governments around the world – is, however, now faced with the vexed question of how to fund that legacy. Cameron is far from the first leader to latch on to infrastructure as a route to growth, despite the spur to action that hosting the 2012 Olympic Games has provided. President Barack Obama touted a $50 billion infrastructure plan for the US back in 2010 while governments across the globe have set up infrastructure funds to stimulate investment – and jobs.

There is no shortage of willing investors to realize this strategy: record numbers of infrastructure and sovereign wealth funds are now chasing these assets. "There is much more capital chasing infrastructure now," says Daniel Wong, senior managing director and head of infrastructure and utilities at Macquarie in London. "Equities are too volatile and bond returns are too low. Investors are looking for the kind of stable returns that real estate used to provide but no longer does." Indeed, according to data provider Preqin there were 144 infrastructure funds in the market in the first quarter of 2012, with an aggregate fundraising target of $93 billion. So for once there is a happy alignment of investor appetite and funding need. But in these markets nothing is that simple. "The demand for investment is strong and the supply of deals is strong," says Wong. "But in some countries, debt is the problem." And it has been for a long time. Persistently dysfunctional debt markets since the financial crisis began mean that many infrastructure projects now face an uphill struggle to get financed even with healthy equity appetite for the assets. "Financing structures need to incorporate 70% to 80% debt to achieve the returns that the infrastructure funds are looking for," says Spencer Lake, co-head of global markets at HSBC. "When debt gets down to 50% or 60% the funds are not interested. A shortage of debt means we are seeing projects simply not get financed – things are either being put on the back burner or cancelled."

According to Washington DC-based CG/LA Infrastructure, the top 100 global strategic infrastructure projects for 2012 have a total estimated value of nearly $800 billion. This is double the value of the equivalent projects in 2010. Some $205 billion-worth of these projects are in the Middle East and North Africa, $187 billion are in North America, $150 billion in Europe, $94 billion in Asia Pacific and $79 billion in southeast Asia. If 80% of this total needs to be funded via the debt markets, infrastructure finance is facing one hell of a problem.

This problem is the same one that many other asset classes, such as real estate, also face: the retrenchment of the banks. This is particularly painful for infrastructure because of the nature of the risks being financed. These are long-term assets against which many – predominantly European – banks used to be happy to make long-term loans. The number of banks that are now prepared to lend to these projects for longer than around seven years can probably be counted on the fingers of one – or maybe two – hands. "Before the crisis there were probably 40 to 50 banks prepared to lend long term to greenfield project finance at 100 basis points over," says Richard Abadie, global head of infrastructure finance at PwC in London. "Now they are barely double digits in number and they will lend starting at mid-200s and rising. On pure number of banks, we have seen capacity at least halve since pre-crisis."

This is hardly surprising given the capital constraints of the many banks that were long-term lenders. Pressure to delever – intensified by the European Banking Authority stress tests – means that many European banks are shedding infrastructure loans rather than writing them. At the end of last year SMBC bought a €590 million portfolio of public finance initiative school and hospital loans from Bank of Ireland at 84 cents on the euro; at the end of 2010 RBS sold off a £3.8 billion ($6 billion) portfolio of natural resources, power and other infrastructure assets to another Japanese lender, Bank of Tokyo Mitsubishi UFJ (BTMU), at roughly 94c. Indeed, in the current market the Japanese banks seem to be the only lenders prepared to take on long-term infrastructure risk. The result of this is that the infrastructure bank lending market is now a short-term mini-perm market, with five-year to seven-year loans the norm. For infrastructure assets, which tend to have a life span of 20 or 30 years or more, this means refinancing risk – and lots of it. And while banks might be prepared to lend for the short term, there are fewer of them actively chasing this business. The global quantum of lending has, however, held up as those banks that are active are making larger loans, and because of the growth in business from the emerging markets: top of the ranking of lead managers of global infrastructure finance loans for 2011 is State Bank of India, which arranged more than $9 billion-worth of deals.

Despite portfolio sales such as those by RBS and Bank of Ireland, many banks in existing syndicates are still rolling loans over even if they are not committing themselves to new infrastructure business. In February this year Macquarie-owned French construction firm Eiffage signed two new loan facilities totalling €3.5 billion to replace the debt used to fund the acquisition of toll road operator Société des Autoroutes Paris-Rhin-Rhône (APRR) in 2006. The refinancing, which entailed a €2.765 billion five-year loan at 300bp over Libor with step-ups in years four and five together with a €270 million revolving credit, was an impressive demonstration of the level of bank appetite that exists – albeit only at a five-year tenor. "Five-year loans for infrastructure are still very healthy," says Wong at Macquarie. "The shape of bank support for the market is changing – but for every bank that pulls out another one replaces it." But elsewhere in the market bankers question if such volumes could have been raised from a new syndicate rather than banks that were already locked in. "Most banks involved in the APRR refinancing were already in the deal," says one. "The [original] deal was very tightly priced, so they were simply happy to improve their situation."

It is thus clear that if those $800 billion of key global projects are going to get financed, the capital markets will have to be persuaded to step up to the plate and get involved in greater size and earlier in the lifetime of infrastructure deals. And that entails tackling an issue that has bedevilled the project bond market since its inception – how to make construction risk palatable to capital markets investors. "For as long as infrastructure finance has existed the market has been looking for a way to get the bond markets to take construction risk," muses the chief executive of one large infrastructure fund. Before 2007 this problem was solved by the monoline guarantors, firms that wrapped this risk to a comfortable triple-A that bond investors were happy to buy. Those days – and those firms – are now gone, so what will or should replace them? That is an extremely vexing question, which effectively boils down to a public- and private-sector standoff over who is prepared to shoulder construction risk and at what price. But what both sides do agree on is that the bond markets are key to the solution. "Projects are either faced with perpetual bank-loan refinancings or go to the institutional market," says Abadie.

The first question is whether or not sufficient institutional debt appetite is there. "Infrastructure assets are attractive for conservative investors," says Georg Grodzki, head of credit research at Legal & General in London. "They are less exposed to cyclical risk, they often have cashflows contracted and guaranteed by highly rated third parties and are implicitly asset backed. But they are not a no-brainer. You can destroy any solid credit by funding it the wrong way and overleveraging it." Grodzki warns, however, that assumptions about the capacity of insurance companies to replace bank lending are optimistic. "The Association of British Insurers (ABI) has estimated that at most £25 billion to £40 billion additional funding can be mobilized [from its members]," he says. "That is a far cry from the volumes that a bank like RBS was doing. We cannot leverage our capital base, we cannot go below triple-B, we have to lend at fixed or index-linked rates rather than floating, we have to be fully drawn down from day one and we cannot accept early redemption. These are just some of the reasons why banks will be needed also in future." With the means by which infrastructure risk was made palatable – a monoline wrap – having gone, the size of the challenge becomes apparent. "There is a specific question as to whether many institutional investors will build the expertise to analyse and invest in project bonds," says Duncan Brett, executive director at Goldman Sachs. "Senior infrastructure loans have historically not been a focus of debt funds because of their relatively tight margins – those funds that do invest in the asset class are generally focused at the mezzanine level."

Aviva Investors was one of just 15 infrastructure funds raising debt finance last year via its Hadrian Capital Fund, managed by Hadrian’s Wall Capital. The fund is interesting in that (in addition to senior debt) it will provide subordinated funding to projects to enable them to achieve a rating sufficient to entice senior capital markets investors. As such it is effectively acting as a private-sector credit enhancer – perhaps no surprise given that Hadrian’s Wall Capital is headed by Mark Bajer, former head of monoline insurer Assured Guaranty in Europe. However, most bond funds simply do not have the capacity to analyse infrastructure risk in the way that the banks do; in the UK just three insurance companies – Prudential M&G, Aviva and Legal & General – are deemed to have the resources to properly assess these deals. But not all infrastructure risk is the same, and recent structures that effectively package it as corporate risk have proved very attractive indeed to bond investors. "For project finance deals that involve a single asset, construction phase and concession payments, refinancing risk is a big issue unless the project is financed to term," says Ben Green, managing director at Goldman Sachs. "But for corporates with permanent assets, as long as there is a sensible overall debt maturity profile investors are comfortable with this risk."

This concept has been applied particularly successfully in the UK, where water utilities, airports, and rail and port operators have all been regular visitors to the secured bond markets. Thames Water, Wales & West Utilities, Anglian Water, Southern Gas Networks, EdF, Gatwick Airport and the UK rolling-stock companies all tapped the secured bond markets in 2011 alone. A growing realization by infrastructure operators that they must diversify away from bank lending has led to the establishment of issuance programmes that tap both sources of funding – most notably by BAA in 2008 and more recently by Associated British Ports (ABP) last December.

"Diversification of funding sources is the way in which secured corporates get comfortable with refinancing risk," says Andrew Paulson, managing director at RBS, which dominates this market segment. "For example, BAA has different funding programmes at different levels in the capital structure which mitigates this and achieves the most efficient funding cost." ABP established a £2.36 billion funding programme at the end of last year to refinance the outstanding debt from its 2006 acquisition by a consortium of Borealis, GIC, Goldman Sachs and Prudential. Chief financial officer Sebastian Bull commented at the time: "We now have a long-term capital structure to match our business model and support our contracts and revenue streams. We have successfully diversified our funding and consolidated our key banking relationships to 11 from over 40." But the constraints of institutional appetite are already beginning to show. "We are anything but complacent," admits one banker. "There are deals out there where we are getting investors saying that they are already full on this risk."

This might be a sensible solution for corporate borrowers but is hard to apply to one-off, single-asset deals with construction phases to finance.

Investors need to be very careful. One source tells Euromoney of a Portuguese toll road project for which traffic levels are now just 10% of what was forecast when the deal was done. "With, for example, the UK’s High Speed 2 project [the proposed construction of a high-speed rail link between London and Birmingham] you are asking private debt investors to back the track record of the government to deliver on time and on budget," muses the infrastructure fund chief. "That track record is not good – just think Eurotunnel. You can get institutional investors into this type of project, but they won’t come quickly. This needs to be very well thought out."

The UK’s first high-speed rail link, between London’s St Pancras station and the Channel Tunnel, did achieve a bond take-out in 2003 with a £1.25 billion two-tranche deal arranged by Barclays Capital, Citi and UBS. But this was only after the first section of the rail link was complete and the second section half-finished. Another big UK rail infrastructure deal – the Intercity Express Partnership project to provide rolling stock for the West Coast mainline – is likely to involve long-term bank commitments of around £1 billion behind a £1 billion commitment from JBIC. The Agility Trains consortium building the trains comprises Hitachi, Barclays Private Equity and John Laing, while the banks understood to be involved – BTMU, SMBC and Mitsui – are relationship lenders to Hitachi.

"Funding, for example, a road deal through construction and then ramp-up is essentially the job of a bank," says Macquarie’s Wong. But could that change?

"What risk bondholders are and are not prepared to take is an evolving issue," Paulson explains. Thanks to high-profile failures such as London Underground contractors Metronet and Tubelines, the old PFI/PPP model has been roundly discredited and is being quietly dropped by the UK government. A recent Treasury select committee report calculated that in the case of Royal Liverpool and Broadgreen University Hospitals NHS Trust the government could have saved £175 million by borrowing directly from the capital markets rather than through a PFI vehicle. The question is: what replaces it?

"The bond markets are a huge untapped source of finance and insurers have long been keen to find a way to channel more of the investments they manage into UK projects to help the economy fight its way back to growth," said Otto Thoresen, director general of the ABI, when the National Infrastructure Plan was announced last November. "However, without action from government we would be fighting with one hand tied behind our backs. We want to work with the government to create a new asset class of infrastructure bonds."

But that will mean one of three things: the government assuming construction risk, a new monoline or supranational entity providing a wrapper for this risk, or no attempt being made to transfer construction risk to the capital markets at all.

"If the government wants long-term infrastructure debt to be placed with insurance companies and pension funds, then either the structures will have to be materially de-risked or government will need to share in refinancing risk. Banks may lend sub-investment grade, bonds won’t," says Abadie at PwC. For government-procured deals such as hospitals the government will often take the base rate risk as a means of mitigating refinancing exposure. But in a pure mini-perm-style deal the capital structure has to accommodate this and the only way to do so is by increasing the quantum of equity in the deal – which kills the return for the bond funds. The second option of a new monoline intermediary that can form a view on the risk profile and provide a wrap is being actively pursued. The European Commission launched a 2020 project bond initiative in February last year that envisages credit enhancement being provided for senior-secured project bonds to bring them up to a single-A rating – either via funded subordinated debt or an unfunded partial guarantee of senior debt service. In October last year the Commission proposed a pilot phase of up to €230 million focusing on five to 10 projects with credit enhancement being provided by the European Investment Bank.

"We are in discussions with the Commission on this project and it is likely to be introduced in 2012," Rainer Schlitt, spokesman at the EIB, tells Euromoney. "The EIB credit enhancement will match the tenor of the project bonds issued." The scheme is similar to the risk-sharing finance facility and loan guarantee instrument for Europe’s TEN-Transport priority project programme. "Some of the triple-As are working hard within expanded mandates to fill the void left as the monolines have pulled back from this space," explains Lake at HSBC. "The idea is to come up with a template that others can follow."

Another proposal being considered in the UK is a structure whereby the government transfers less risk to the private sector at the outset of the project. "PFI/PPP was all about getting risk off the government’s balance sheet, this is the opposite – about the government retaining the risk," says a source close to the discussions. "If less risk is transferred at the outset, then the deals could be rated from the outset. Discussions are ongoing with the rating agencies over this."

But governments in both the UK and continental Europe are going to have to put their hands in their pockets for substantially more than €230 million if they want to create a sustainable infrastructure bond market to take over the funding mantle from the banks.

EU member states need to spend between €1.5 trillion and €2 trillion on infrastructure by 2020. They need to look outside Europe for solutions. These deals need credit enhancement from a triple-A – most likely sovereign – source. This is hardly unusual: more than 70% of infrastructure projects in Brazil are backed by BNDES, while the State Bank of India’s commitment to the sector is amply demonstrated by its position in the league tables. In Asia, Japan Bank for International Cooperation and the Asian Development Bank recently created a credit guarantee facility with a specific mandate to wrap greenfield infrastructure projects. In Europe the French government has been supportive of the sector, providing support through Caisse des Dépôts et Consignations (CDC) when the financial crisis hit and launching a securitization vehicle last year to finance infrastructure – albeit post-construction. The UK government, which has projects such as Crossrail (£16 billion and counting) sitting on its books, has always been reluctant to commit itself to explicit state support on the debt side.

In recent comments published on the Civil Service Live Network, Geoffrey Spence, head of Infrastructure UK (a division of the UK Treasury), commented that "the government is slightly changing its approach to risk, partly reflecting the damage that has been done to financial markets since 2007." While stating that more needed to be done to underpin construction risk in one particular project (the Thames Tideway scheme, which entails improvements to London’s three main wastewater treatment plants along with the construction of a storage-and-transfer tunnel nearly 35 kilometres long), he stated that "this is not, however, a blank cheque for people to get a guarantee from government at any point in time; it is for the government to be more realistic about what risks the government can take and what is still the private sector’s role."

That realism needs to encompass some form of state-sponsored first-loss contingency fund or subordinated debt fund if the infrastructure legacy that David Cameron is so keen on is to be set on firm foundations.