Overcoming the fear factor

It should be easy: simply follow the arrows from reception and you will find your way to the first-floor boardroom of London’s Grosvenor House hotel. And yet, while all six invitees to Infrastructure Investor’s European infrastructure financing roundtable manage to locate the appointed venue on time, a number reflect that they have had to make their way through something akin to a maze. The route has baffled some of our assembled infrastructure experts with its twists and turns, apparent dead-ends and occasional lack of signage.

The hope of serene progress dashed by unexpected complexity turns out to be a theme of the day. “There was increasing optimism building in the early months of 2010, but has that now changed?” is a question posed to those around her by Cheryl Fisher, head of project finance, Western European department, at the European Investment Bank in Luxembourg. Whether intended as a rhetorical question or not, it nonetheless elicits several responses – all coalescing around the position that, yes, some of the positive aura generated by the sense of a corner having been turned is indeed beginning to ebb away.

One of the responses comes from Raj Rao, a partner at fund manager Global Infrastructure Partners (GIP) in London: “Thoughts of double-dip recession were not common four or five months ago,” he says. But now they are. “And certain governments have taken steps that have had a negative impact – for example, in the Spanish renewable industry, where they’ve proposed changing the tariff regime. The action has impacted risk appetite for some equity investors.”

Shortly after the roundtable gathered, the Spanish government revealed that it would be reducing subsidies to new solar photovoltaic plants by up to 45 percent. Furthermore it had not, at press time, ruled out the much-feared prospect of retroactive cuts against existing plants.      

One of the major preoccupations of infrastructure investors today is the emergence of unanticipated risk factors. Many of these are linked to hard decisions forced on governments as economic stimulus programmes give way to austerity measures aimed at cutting public debt down to size. Hence, the controversial moves in Spain as well as increased scrutiny of the cost of social infrastructure projects in the UK – dramatically highlighted by the recent decision to axe the £55 billion (€65 billion; $84 billion) Building Schools for the Future programme.

The discussion around the table is studded with observations in relation to these risk factors – and we shall return them periodically below. But, as the saying goes, let’s start at the beginning – with various reflections on the current state of financing for infrastructure deals and projects.

Birth of the club

According to Gershon Cohen, managing director and head of project finance at Lloyds Banking Group, the UK’s M25 motorway widening project, which reached financial close in June 2009, marked “the birth of the club deal”. Referring to it as a “landmark” transaction, he says: “It demonstrated that even if you don’t have underwriting appetite or a syndication market, you could still put together a large number of banks in a club.” In the case of the £6.2 billion M25 deal, no less than 16 banks came forward. Other large UK private finance initiative (PFI) club deals have followed – Birmingham Highways and Bristol’s Southmead hospital among them.

The ability to form sizeable clubs is seen as evidence of continuing appetite for infrastructure lending on the part of a smaller but committed group of banks. “There were about 30 to 50 banks participating in deals at the peak of the market, now there are about ten core banks operating across borders, plus the locals,” says Spence Clunie, a senior managing director at Macquarie Capital Advisors in London with responsibility for UK and European debt finance. “But those banks that are still around are quite keen to participate in large tickets in new deals, given that not many new deals have been done in this financial year.”

This view is backed up by Rao, who worked on another of last year’s landmark deals – GIP’s £1.5 billion acquisition of the UK’s Gatwick Airport, which included the provision of £1.1 billion of debt from 12 banks. This [Gatwick] was widely viewed as a major achievement given the size of the financing and the lack of options at the time. “Sentiment today in the financing market, both the bank and capital markets, is definitely better. Stable, regulated assets will be attractive for bond investors,” says Rao.
There is a proviso, however. While liquidity in Europe’s developed markets has slowly but surely headed back towards normal, emerging markets still remain hamstrung by the effects of the financial crisis. “Fiscal issues are vitally important in emerging markets,” says Thomas Maier, managing director of infrastructure at the European Bank for Reconstruction and Development. “Look at the D1 [a Slovakian highway PPP, which is currently on hold as aspects of the deal are scrutinised]. What will happen to that? The new government that came in a few weeks ago doesn’t seem to be sure. In Hungary and the Baltics, a number of motorway deals have had to be postponed as they were designed for a world that no longer exists.”

Where the emerging markets experience dovetails with that of developed markets is in a flight to quality. Maier points out that, even in embattled Eastern Europe, companies with investment grade credit ratings face few problems raising finance. As an example he points to Russian Railways, the state-owned railway company, which in March this year sold seven-year dollar bonds in the first foreign currency offering and the longest maturity by a Russian non-energy company in almost two years.

Rao takes up the theme of a flight to quality, arguing that where an asset is considered attractive – wherever in the world it may be located – banks would look to finance the asset. European banks are very active in the financing market. “Earlier in the year, GIP/El Paso financed a project in the US [the $3 billion Ruby natural gas pipeline] and there was significant appetite among the banks. Initially, we went to seven banks based on our – and our partner’s – existing relationships. In the end, we had around 20 banks that committed to the deal, with a significant majority being European banks.”

Momentum in France

Fisher points out that no one should be drawn into generalisations about levels of activity. While some markets have taken a knock, she says that activity in France, the Netherlands and Belgium has been strong. In France, there is a specific reason for this, with the government last year having introduced generous debt guarantees as part of economic stimulus measures. With the guarantees only available until the end of this year, the rush to reach completion is on.

“Some [French] projects should close before the end of the year and they are closing as quickly as they can,” says Fisher. “There are the likes of Tours-Bordeaux [the €7.8 billion high-speed rail line contract awarded to VINCI, AXA Private Equity and Caisse des Dépôts in July] and CDG Express [the Paris airport rail link which awarded preferred bidder status to the same three firms, also in July]. But given the complexity and size of the projects, this could be challenging.”
If there’s a consensus mood around the table in relation to European infrastructure lending, it’s caution rather than outright optimism or pessimism. “The European market had got quite strong on a local basis, but now there’s a question mark over that,” says Martin Pugh, head of the UK and Ireland concessions/PPP business at German developer Bilfinger Berger. “We saw quite a contrast with a deal we did recently in Canada where there was strong interest. Mind you, there’s huge government support for deals there so it’s a different profile.”

The mood of caution is understandable given that the roundtable assembled only two weeks after the announcement that the UK coalition government, elected in May, would be scrapping the previous Labour government’s plan to refurbish all of England’s state-backed secondary schools under the Building Schools for the Future programme. The move involved the cancellation of 715 projects.

“The UK social space has been badly hit,” says Fisher. “But this is not unexpected given the Conservatives’ position prior to the election and that children will still be educated even if the school rebuilding programme is delayed.” 

Cohen believes that while areas such as schools and hospitals will almost certainly see a reduced level of activity in the period ahead, there may also be areas where a strong pipeline of projects will continue to be seen – such as social housing, highways maintenance and prisons, for example.

Value for money

He does not believe that UK PFI is under any kind of existential threat, despite the new government’s “value for money” agenda which has seen the PFI model carefully scrutinised. For example, in May the government’s National Audit Office (NAO) announced it would be analysing the M25 widening deal to see whether the procuring authority had “selected a cost-effective option to deliver its objectives and value for money” given that the contract was signed at the height of the credit crunch.

The NAO recently reported that PFI deals struck in 2009 had indeed represented value for money in the context of helping to reactive the UK economy even though they were costly to the public sector and involved less risk transference to the banks. The report also said that such deals would not necessarily represent value for money today.

The UK also witnessed the highly controversial Tube Lines public-private partnership (PPP) contract for the upgrade of parts of the London Underground network. The partnership came to an unsatisfactory conclusion when, in May, private partners Bechtel and Amey sold their stakes in Tube Lines back to the public sector. London mayor Boris Johnson declared that the deal meant London was “freed from the perverse pressures of the Byzantine PPP structure”.

“PPP and PFI have had serious PR issues,” acknowledges Cohen. “The word ‘private’ has been seized upon as implying some kind of privatisation. But these deals have been happening for the last 15 to 20 years in the UK and have been adopted globally – and recent developments won’t diminish the critical role of private sector capital in public procurement. It’s right that the focus should be on smarter procurement and achieving value for money for taxpayers. The planning and cost issues associated with procurement are important, and they have come to the fore.” 

Adds Maier: “PPPs are typically three times faster to implement than conventional public sector procurement. We make that point a lot but the private sector is not always especially helpful as PPP contracts are not always healthy; some should have been structured differently. Once you get a bad one, it’s difficult to turn the image round.”

Martin Pugh points out, however, that the increased transparency demanded these days in relation to procurement may have the effect of lengthening processes for no clear tangible benefit: “Public clients are more aware of transparency and spend extra time on it and it adds another stage to the process. Can you get value out of every step? That’s questionable. It leads you to wonder whether there might be such a thing as too much transparency.”

Not so predictable

As the roundtable attendees’ thoughts turn from UK PFI to opportunities in European infrastructure in general, it’s hard to avoid further discussion of the shocks to the system served up by certain recent developments. Why are investors attracted to infrastructure? There may be many reasons, but one vitally important characteristic is predictability of cash flows. When Spain decided to revise the feed-in tariff regime for its renewable energy sector, this predictability was arguably thrown out of the window.

And yet, while there are undoubtedly concerns around the table, there is also pragmatism. “In Spain, investors had made a lot of money by taking advantage of the favourable feed-in tariffs. So when the government decided to adjust the solar tariffs retrospectively, many people understood,” argues Cohen.

But are equity financiers as accepting as this? However generous the original tariff, how easily can investors live with an effective moving of the goalposts – with expected returns based on a certain set of assumptions that no longer apply?

“It depends whether you’re in the space already!” Rao shoots back, to laughter from those present. “There’s uncertainty for the coming months and it will have an effect that has to be priced in. But the opportunity in European renewables will exist for a long time. Investors will still be interested, but the risk profile has changed.”

Nor are people necessarily running away from those countries that found themselves centre-stage when Europe’s debt crisis erupted. Cohen believes a careful, considered view is essential: no one need be scared off simply by macro economics.

“Large economies ought to be able to work their way through whatever problems they have,” he says. “But if you’re an investor or lender you might think twice about the nature of a project and who you are contracting with. Is it a local or a national entity? If it’s a local entity, what type of entity? With concessions it’s less about sovereign risk and more about the proof of the concession model under law.”

Maier agrees about the overriding importance of concession models. In Romania, he says, there are regular changes of government and the political environment is plagued by a lack of transparency. And yet, he adds, “you have very predictable business structures and reliable partners at the local level.” As an investor, this means you have to take a “detailed view” of every country, no matter what the outside appearance.

This said, however, Maier points out that the debt crisis in Greece had some disturbing ripple effects in Eastern Europe. “Greece is important in that part of the world because there is a lot of exposure to Greece and what happened there did have an effect on appetite. Of course, the Eastern European banks have their own problems as well, unrelated to Greece.”

All eyes on bond market

One thing that all are agreed upon is that, for a healthy infrastructure financing environment to exist in Europe, there needs to be a flourishing bond market. “Banks provided a lot of long-term finance [pre-crisis],” says Clunie. “There are still some providing five- to seven-year loans, but they are much more focused on the capital markets take-out so they can churn their capital.”

Clunie continues: “European banks have been financing nearly all infrastructure deals globally and they’ve ended up with very large loan books using up significant amounts of their capital. They should be churning those books but have largely been unwilling to sell at the market price and take a loss – and have not been made to by regulators. Ideally, the banks should finance the construction phase of projects and then the project should be refinanced long term in the bond markets, which provide long-term fixed rate and index-linked debt without the need for swaps. But we currently have banks with 30-year debt on their books at below market pricing and they are holding on to this debt and hence not releasing capital to re-lend.”

Many market observers have pondered whether the bond market will be able to absorb the enormous amount of infrastructure debt that needs to be refinanced over the coming years. Clunie acknowledges that “refinancing will be due for a lot of projects with big syndicates over the coming couple of years. Some banks in these syndicates are not active anymore so, while extensions of facilities may be considered, some banks just want to reduce their exposure and will make an extension painful. Hence it makes sense for companies to look at the bond market or other options as alternatives for refinancing. The investment grade bond market has been resilient over the last 12 to 18 months for infrastructure names, albeit at relatively wide spreads. Many infrastructure companies looking to refinance have long-term swaps so do not benefit from the current low gilt rates”.

With infrastructure a young investment area, the real test of bond market appetite is yet to come. No one knows at this point how much debt the bond market will ultimately be able to digest. There are, however, some promising signs. “There is strong appetite and you’ve seen utilities such as Thames Water, rolling stock leasing companies [such as Angel Trains] and toll roads successfully accessing the bond market in size,” says Clunie.

Given the sheer volume of refinancing coming through the pipeline, however, there is understandable caution. Says Rao: “A two-year bridge to a bond or bridge to securitisation was pretty common a couple of years ago, but equity investors would now be wary unless it’s a highly regulated asset. Investors don’t want a refinancing gun to their heads.”

Intellectual capital

The refinancing issue is one of a number of concerns that infrastructure financiers have currently. While acknowledging that things are “very difficult at the moment”, Cohen says there is a positive aspect to being challenged in that it forces people to come up with new ways of helping the asset class to evolve – tough questions that can be overlooked in times of plenty have to be confronted in times of scarcity.

“A lot of intellectual capital is being expended,” says Cohen. “It’s interesting that infrastructure conferences always used to be primarily great networking opportunities, but now there are much more serious debates up on stage.”

The cynic might point out that there would be less time for debate if there was more action in the market. “There are some really good projects out there in areas like climate change and transport infrastructure,” says Fisher. “The supply is good. But the concern is the speed at which they will roll out.”

Just why is this “roll out” taking so long? Aside from the banking market still being in recovery mode, another reason offered is familiar to anyone who has ever experienced volatile market conditions: a mismatch in price expectations between buyers and sellers. Maier professes however, that with some time having passed since the end of the crisis, the continuing large gap in expectations “amazes me”. Perhaps it’s time for more pragmatism in order to kick-start the new deal market.

Rao fears the stability of the financial system once more being jeopardised in the event of a double-dip recession. However, an even larger bogeyman looms in his mind: the regulator. “In Australia, the authorities have challenged some private equity transactions in relation to their tax structure. When you consider actions like that, and what happened in Spain, you can only conclude that regulation is a big risk to consider while pricing assets.”

Cohen neatly encapsulates the sense of frustration that infrastructure has proved itself a resilient asset class that has not let investors down during the crisis – and yet still finds itself struggling to attract finance. “The default rates in our portfolio are negligible,” he says. “Where are banks and investors looking to deploy capital? There are tens of billions of infrastructure assets that have not lost money during the downturn. I wonder why there is not more appetite.”

Hopefully, this sense of disappointment will be a short-lived phenomenon as the undoubted potential of infrastructure as an asset class is matched by capital being directed towards it. Clunie sees this starting to happen, pointing to the “increasing pension fund allocations to infrastructure, especially in the UK and Europe, as they have seen how the asset class has performed over the last two to three years”.

If the enthusiasm of pensions proves infectious, the banks may soon start opening their cheque books too. For now, the mood remains hopeful but subdued as fear of risk too often wins out over the lure of the opportunity.