Why does hedging get short shrift?

How did the firm get involved in risk hedging in the infrastructure space and why?

JR: We have provided hedging and risk management advice to the commercial property and private equity sectors for 20 years. About 10 years ago a banker with whom we had worked, took on a new position with a leading public-private partnership (PPP) advisory firm and requested our advice on whether his client was receiving fair value on a hedging transaction. They were not. It was apparent that the pricing of hedging on these transactions contained no transparency to the procurer, and more crucially, there was no effective control over the pricing being charged by the bank.

Could you outline your typical approach to risk hedging in PPP/PFI transactions?

JR: We produce a transparent pricing process through an agreed protocol with the hedge providers in order to achieve the best pricing for our clients. We then undertake a significant amount of benchmarking with the hedge provider(s) in advance of financial close to ensure a smooth and efficient process. Our extensive experience affords us significant contact with the majority of bank treasury departments across Europe and North America. These banks are aware of our proven ability to calculate accurate market pricing, affording us the unique opportunity to challenge the banks’ pricing where appropriate. This experience brings a high degree of confidence to a transaction as well as troubleshooting problems early and thus avoiding delays that otherwise may hinder a project’s financial completion.

Could you explain how your approach to infrastructure differs from the way you approach property and private equity, where you also provide the same kind of service?

JR: The service that we provide can be split into two parts. At the outset, we work with our clients to devise the most appropriate hedging strategy that supports their business plan and accommodates how that plan may change in the future. In addition to protection of the business plan, the strategy will also allow benefit to be taken of favourable movements in the interest rate market. The second part of the service is to negotiate with the bank hedge providers to ensure our clients are able to implement the chosen hedging structure at the best possible pricing. 

Infrastructure covers a wide area and, like the property and private equity sectors, has its own sector-specific nuances that are important to appreciate when structuring a hedging solution.  Infrastructure, for example, is intended to be a much longer-term investment than a typical private equity deal which may be ‘flipped’ within a couple of years or even sooner. Avoiding potential hedge termination costs is given much greater focus in property and private equity deals than in infrastructure. At the same time, this longer-term nature of infrastructure transactions means the delta value of a hedge profile will be substantially larger, making the case even stronger for accurate price benchmarking.

PPP transactions are different as they do not involve any strategy considerations. The debt profile is pre-defined and is habitually swapped. Similarly, any inflation hedge requirement or return on short-term cash investments is based on a known exposure and simply requires best pricing to be achieved.

What do you make of the PFI debate in the UK?  Are you worried about the model’s future?

JR: One could rightly be accused of apathy if one claimed to not be concerned about the future of PFI/PPP. However, it is very difficult to see how a government which is committed to growth while also dedicated to reducing the budget deficit can achieve its objectives without sponsoring the economic activity that is generated through PFI/PPP projects. There may well be a change in the way in which projects are approved, but it would be nigh impossible just to turn off the taps.  As the current government professes to admire the way in which Canada controlled and brought down its deficit, they may like to copy how this was achieved while still undertaking major infrastructure projects.

What scope for growth for your business do you see in the infrastructure space?

JR: We are involved in a very large proportion of PFI/PPP transactions undertaken in Britain and Ireland, and expect this to continue going forward. We have worked on PPP/PFI transactions completed in many other European countries including France, the Netherlands, Portugal and Slovakia. We believe there is considerable scope to expand regionally and to increase penetration in existing markets.

However, PFI/PPP is just part of the infrastructure/project finance market and we perceive that our service can be used across a much wider range of transactions. In particular, we intend to build up our relationships with infrastructure funds to gain instructions from them directly and to work for their investee companies. We have already made progress on this front, having worked on mandates provided by infrastructure funds both in our New York and London offices.

Are there aspects of risk hedging that infrastructure funds tend not to give enough consideration to?

JR: We find that almost all funds regard hedging as the bit that needs to be done at the end of a transaction and, therefore, its implications are normally given short shrift while the deal is in the negotiation process. This leads to a lack of recognition of the full (often hidden) exposure any project or company has to foreign exchange risk. Secondly, it leads to inaccuracy in projecting income levels, often resulting in a debt hedging structure that is too inflexible.   

At our recent Infrastructure Investor: Europe forum in Berlin, currency risk was a hot topic for investors in infrastructure funds.  What sort of hedging agreement do you think should exist between GPs and LPs?

JR: It would seem that some GPs in the infrastructure area take a rather more cavalier view on foreign exchange exposure than funds in other sectors. This is rather surprising given that infrastructure investment is purported to be a long-term investment with secure income flows.  This is simply impossible to achieve where a fund invests outside its base currency denomination without hedging that exposure.

It is difficult to understand why LPs should regard their exposure to be anything other than the denomination of the fund they are investing in and to then manage it in the same way as any other investment category in a foreign currency. 

The main problem arises when the GP does not have a pre-determined and declared policy for managing the equity investment made in a currency other than that of the fund. Many funds automatically hedge their foreign currency risk as stated policy, others offer sub-class vehicles that allow investors to opt for the currency in which they want to invest and the fund will then manage the exposure taken within the sub classes.

The LP investor has a simple choice. If it decides to invest in a fund that does not have a pre-determined hedging policy to remove or control risk, it is placing as much trust in the GP to manage foreign exchange risk as it is to invest its funds wisely. If the GP subsequently destroys returns through failing to control its foreign exchange risks, the LP has only itself to blame.    

You’ve had an office in New York for the last couple of years.  Do you expect much progress there on PPPs anytime soon?

JR: We have seen strong growth in North America, primarily from the Canadian market, where we have been involved in a large number of transactions.

Although there have been fewer P3 transactions, as they are known in the US, than the market has expected, there are legitimate reasons for the slower activity. The P3 financing structure was not initially acceptable in all jurisdictions. As a result, states are going through a process to attempt to change the system, thus preventing more rapid development but, so far, the legal and cultural challenges have all been resolved favourably for the P3 concept. As Americans see the visible success of the P3 structure and become more comfortable with the concept, we expect this financing mechanism to grow in popularity.

We expect the P3 market to be almost fully developed by 2013 and we will be in a very strong position to pitch successfully for these mandates. Our expertise in similar transactions in Europe and Canada, as well as the resources of our US team in the derivatives markets overall, makes us well placed to lead the charge as the P3 market becomes established.