Ingredients for a healthy market

The competitive long-term project finance market consists of a handful of banks and a varied assortment of capital market participants. And, of these competing businesses, institutional investors are showing the greatest increase in appetite for infrastructure investments.

A recent survey by Preqin, an infrastructure data and research firm, revealed that 58 percent of investors were planning to raise their funding allocation for infrastructure in the long term. With nearly €74 billion of institutional funds targeted to be raised globally in 2013 – €21 billion of which is already secured – the long-term infrastructure investment market is in good shape.

While there has been only a small amount of project finance capital market debt issuance in Europe, the Middle East and Africa (EMEA) in the last five years, with banks meeting the majority of infrastructure funding requirements, the market is changing.

And while project finance offers some elements that institutional investors find attractive, we believe a number of pieces must fall into place for the project bond market to flourish – such as standard transaction structures, better transparency, and a regulatory system that encourages insurers to invest and support packages that mitigate risk.

OBSERVABLE PROJECT PIPELINE, MODEL TRANSACTION STRUCTURES AND IMPROVED TRANSPARENCY

We think the success of the public private partnership / Private Finance Initiative (PPP/PFI) markets in the UK, US, Canada, and the Netherlands can be put down to the establishment of project-specific frameworks, which have done a great deal to enhance project visibility and predictability. Therefore, for maintained project finance in EMEA, we need:

1. A wide-ranging framework for project procurement and approval including standard processes and contracts at the European Union (EU) level. Examples can be found in some member states, such as the UK, but only at the national level. Furthermore, the publication of a routinely updated pipeline of project opportunities (as already exists in the Netherlands) could aid visibility.

2. A framework to standardise project financing structures. More generally, transparency could be greatly improved by sharing infrastructure project performance data with the market. The paucity of industry data is frequently cited by would-be investors as a disincentive to funding infrastructure projects. And this is especially true for large-scale, complex projects using new technology and with no proven earnings record to speak of – such as offshore wind farms in Western Europe.

Comprehensive disclosure should aid project finance transactions in achieving better value for money.

What’s more, the lack of transparency and disclosure of risk engenders market unease. In our view, the financial reporting of European projects is at times incomplete, inconsistent, and unclear. Of special concern is the dearth of information on operations, financial statement line items, and the nature and effect of unique events and conditions, like the impact of adverse weather on a project’s operations.

Finally, we believe that all stakeholders should be given information at the same time and with the same regularity.

This greatly reduces the risk of creating a two-tier market where bond investors are significantly disadvantaged compared with private loan investors. The foundation for an efficient, liquid secondary market will be found in consistent, reliable and comprehensive disclosure.

And the final stage is for publicly available analysis of this disclosure, which is replicable and comparable across the expanding, and increasingly varied, universe of project finance debt. Indeed, S&P is currently refining its project finance ratings methodology to ensure its analysis remains as consistent, replicable and comparable as possible.

A REGULATORY FRAMEWORK THAT INCENTIVISES INVESTMENT FROM INSURERS

At present, the market harbours concerns that risk capital charges under Solvency II – an important piece of insurance industry regulation – could dampen appetite among insurers to continue providing long-term finance to the European economy.
Certainly, some market participants believe that default and recovery rates are superior among project finance transactions than corporates, and that Solvency II should reflect this in its capital allocation weighting.

Our latest default and recovery study, published in August, supports this view. Since the first rated project default in 1998, the annual default rate for corporate issuers has averaged 1.8 percent, which is above the average default rate of 1.5 percent in all rated project finance debt over the same period.
But, in spite of the strong credit qualities of project finance, the capital treatment proposed under Solvency II would appear to punish insurers for holding long-dated, low- to mid-investment grade project debt (i.e., debt rated ‘BBB’’ or ‘A’).

This is largely a result of the regulation using a corporate loan matrix as its foundation, without taking the specific default and recovery characteristics of the project finance sector into account, or other elements such as a strong security package and transaction structure.

For instance, a 12-year ‘BBB+’-rated project loan would earn a 22 percent capital charge – significantly higher than for a two-year ‘BB-‘ corporate loan. But even with these disincentives, the insurance sector continues to view the sector as attractive, at least for the moment.

SUPPORT PACKAGES THAT REDUCE CONSTRUCTION RISK

Another particular source of anxiety for market participants is the complicated nature of construction risk, which has left many avoiding investing in projects pre-completion. Indeed, alongside the complexity of construction itself are a number of connected risks, such as: project delivery, design, and technology; the competence of contractors; and the approach to distributing risk between contractors and suppliers, which can vary from project to project.

That said, these issues can be overcome. To achieve an investment-grade rating, a project with construction risk would need a transaction structure which allows the full and timely payment of scheduled debt service on the rated obligation under a relatively likely downside construction scenario.

Indeed, investment-grade rated projects generally include a robust structure with a construction credit support package providing an on-demand, unqualified, and binding letter of credit or performance bond offered by a financial institution with a minimum rating higher than the project rating.

This helps to mitigate the potentially constricting factor of a weak construction counterparty. (Our approach to construction risk analysis is further elaborated in new criteria published on November 15, 2013).

THE OUTLOOK FOR THE LONG-TERM INFRASTRUCTURE DEBT MARKET REMAINS POSITIVE

Naturally, the success of the market will also rely on yields and prices that are attractive for both lenders and borrowers.

While long-term yields for government debt sit at historic lows, and credit spreads tighten throughout the capital markets in general, all-in pricing for project bonds (i.e., the reference government bond yield added to the credit spread associated with the project itself) is at an all-time low. While the bank market can still provide attractive pricing, tenors are typically much shorter, with 15 to 20 years being the maximum available.

All-in bond yields have fallen to about 5 percent, while PFI bond spreads have tightened to around 150 basis points, bringing them in line with UK corporate bond spreads. Some recent transactions for long-dated rated project bonds were priced at credit spreads between 115 to 235 basis points (bps), according to the rating and tenor, with all-in yields of between 5.0 percent to 6.5 percent. The returns are therefore viewed as significantly more appealing by investors than the 4 percent to 5 percent yields to be had on sovereign debt with similar ratings.

In any case, we believe the outlook for long-term debt in infrastructure projects is positive. But this outlook will continue to be shaped by the on-going development of the capital markets for project finance and, particularly, how project structures are able to account for certain risks while meeting investor demands for transparency and predictability.