The last few years must have been a strain for human resources chiefs at financial services groups. As a mix of macroeconomic woes, fresh regulation and legal onslaughts forced the industry to adapt to straitened circumstances, many were tasked with downsizing staff while retaining talent.
Yet Moody’s has lately faced a different kind of challenge. Over the last 12 months, the rating agency has had to beef up its project and infrastructure finance team by more than 30 percent, to cope with what senior vice-president Andrew Davison calls “a structural shift” in capital markets.
The move, he explains, came in response to fast-growing demand for private indicative rating – the feedback a prospective issuer can seek before going ahead with a hypothetical transaction. “It’s a leading indicator of bond issuance coming to market,” he says.
Securities, however, seem to be only one option available to investors wanting to access an asset class increasingly flush with cash. “We’ve seen quite a substantial return of liquidity and risk appetite,” notes Peter Jacobs, head of project finance for Western Europe at the European Investment Bank (EIB).
The mood stands in sharp contrast to a few years ago, when project sponsors rang the alarm bells over a potential credit crunch in infrastructure markets. But such a pick-up in lending appetite shouldn’t come as a surprise, says Bob Dewing, head of infrastructure debt at JP Morgan.
“The credit characteristics of infrastructure and project finance are amazingly attractive to investors, because they involve a steadily declining probability of default. And they continue to give you great risk-adjusted return.”
Yet he concedes margins have come down: while the returns he promised to investors used to near the upper end of the 200-to-300 basis points (bps) range, they now tend to stand towards the lower end of that bracket. And he sees one obvious culprit for this – toughening competition.
BACK IN BLACK
Conventional wisdom says institutional investors got sucked into infrastructure debt to fill the void left by withdrawing banks, which have strived to repair their balance sheets and recycle capital more quickly in the aftermath of the Crisis.
That’s not so much the case anymore, argues Alistair Higgins, a director at ING. While lenders still have Basel III capital constraints in mind, he sees a number of banks ready to pursue infrastructure debt opportunities anyway – and competing aggressively for them. Japanese and German banks stand chiefly among them, with French lenders also making a comeback.
Darryl Murphy, an infrastructure partner at KPMG, recalls a project in Scandinavia last year where a handful of “good old-fashioned bank lenders” offered to underwrite a €200 million cheque for about 200 bps above LIBOR. “Most of them said they wished it was 10 times the size rather than €200 million.”
Observers caution, however, that long-term lenders only represent a limited part of the banking universe, which by and large is proving less active in the infrastructure space.
Deborah Zurkow, chief investment officer and head of infrastructure debt at Allianz Global Investors, thinks banks nowadays come in three approximate strands: the few that can still afford to lend long term, those that have completely pulled out, and the ones that want to retain exposure – but lack the capacity to do so on their own.
This last category is being forced to innovate. “Some banks are moving to a new model where they advise institutional investors or shift to funding short term ahead of a scheduled institutional long-term refinancing,” says Jacobs. Philippe Benaroya, a managing director at BlackRock, adds that a number of banks also seek to co-invest, or form part of a pool of lenders, alongside institutions.
A RISING FORCE
Admittedly, few of these arrangements have actually been formalised. Higgins says that the only lender to have crafted permanent partnerships with institutions is France’s Natixis, which has formed co-investment platforms with insurers Ageas and CNP Assurances over the last two years.
But such associations still show how banks have come to acknowledge the growing role played by private investors in their formerly well-guarded territory. “A number of these institutions – at the leading edge of the asset class – have built up the teams to originate and execute their own debt exposures on terms that suit them,” says Davison.
Some of these investors, which include insurers like Allianz, Legal & General (L&G) and AXA, have become very credible challengers to commercial banks. Murphy cites two recent public-private partnerships (PPPs), one won by Prudential and the other by L&G, as examples of how competitive such investors can be.
Yet Zurkow reckons institutional investors able to invest directly remain a rare breed. “This is not an asset class where you can go to bed Tuesday evening thinking ‘tomorrow I will invest in infrastructure’ and wake up Wednesday morning and invest. A lot of intellectual effort goes into creating a working operational platform.” Scale is also crucial to attract the attention of borrowers and build diversification, adds Andrew Wiggins, head of institutional distribution at Allianz Global Investors.
That’s why most institutions would rather invest via asset managers – often in a separate managed account. Which doesn’t mean asset managers don’t have varying strategies: Allianz Global Investors, which invests third-party money alongside capital from its parent group, tends to focus on greenfield infrastructure; money managers, such as BlackRock, mostly target brownfield assets.
But an alternative channel is proving increasingly attractive to investors and borrowers alike: capital markets.
“We’ve seen pretty much everything over the course of the last 12 to 18 months: private placements, public distributions, unwrapped bonds, guaranteed bonds. There’s been much more involvement of institutions acting as project bond investors,” says Phil Adam, head of EMEA project bonds at HSBC.
This partly stems from the much more supportive attitude adopted by public authorities. In the UK, procurers used to be less in favour of project bond solutions, Adam argues, because they were perhaps concerned about deliverability. But with bonds now among the most cost-effective financing solutions, he thinks “it’s not something you can afford to ignore anymore”.
Some issuers are clearly making the most of it. Last January, Heathrow issued as much as £200 million (€242 million; $332 million) of inflation-linked private bonds to a single investor understood to be a European insurance company. “Some investors prefer capital market execution for the simplicity, liquidity and comfort it gives them,” says Patrick Swiderski, managing director at StormHarbour, the advisory firm that arranged the issue.
Private placements continue to represent the bulk of capital market transactions. But Murphy sees an interesting dynamic in the development of public markets, for which last year was probably a turning point. Swiderski similarly thinks they’re of increasing appeal to big utilities, which have started to raise “real money” on capital markets to finance corporate needs or single projects.
Yet challenges remain. Swiderski notes that a number of investors still lack the maturity to dive into the asset class, while some issuers aren’t proving sufficiently flexible to match the liability profile of prospective lenders.
Persisting divergence between borrowers and lenders has given rise to a number of instruments aimed at easing dialogue – by relieving institutional investors from part of the risk while also allowing them to tap industry knowledge from third parties.
“In a way, intermediation is the new disintermediation,” says Higgins. “Investors now recognise that it is better to have someone deal with all the nasty bits, so that you have a clean asset when it comes to market.”
ING’s Pan European Bank to Bond Loan Equitisation (PEBBLE) offering proposes to finance infrastructure projects using a tripartite structure comprising an A note, a B loan, and a construction revolving facility. The A note, which ranks senior and typically offers a long tenure, targets institutional investors. The B loan is a first-loss, first-repayment piece – with principal paid down first to reduce the average cost of capital.
The idea, explains Higgins, is to allow institutional investors to benefit from a bank’s origination skills and liquidity prior and during construction, while offering them attractive yields after project completion.
A scheme with similar ambitions is the EIB’s Project Bond Credit Enhancement initiative (PBCE), which chalked up its first two deals last year. Under the programme, the EIB provides a subordinated loan or a guarantee of up to 20 per cent of a project’s debt, with the aim of bringing its credit rating up to more palatable levels.
Yet while most industry observers underline that PBCE could in the long run fill market gaps, many doubt the initiative will gain much traction among institutional investors. Higgins thinks it doesn’t really solve their problem of getting a better yield, since the risk premium ends up being almost entirely sucked out. “It’s probably a solution looking for a home at the moment,” concurs JP Morgan’s Dewing.
Critics have also argued that instead of supporting projects less in vogue among financiers, the bank has migrated towards the greater credit quality assets – typically Western European, availability-based – with the risk of crowding out other investors in the process. An oft-cited case study is the EIB’s recent backing of Greater Gabbard OFTO, an offshore wind farm power transmission project, which Murphy describes as a “low-risk, operating, availability-based” asset.
The EIB replies that the initiative has never been intended to exclusively focus on southern Europe or projects that would otherwise have struggled to attract financing.
This may fail to appease sceptics, who by and large remain unconvinced by the PBCE’s economic rationale. And it won’t help that the initiative is being rolled out at a time when, amid rising competition for assets, deals remain too few and far between.
“Over the last two or three years people have used financing as the problem,” says Murphy. “And I was always worried we would end up where we are – with a lot of liquidity out there and everybody wondering why there is not more going on.”
This presents the market with a clear challenge, says Dewing. “When credit spreads come down and lots of investors are chasing fewer assets, you run the risk that people will push the envelope in areas where they’ll either make credit decisions that are not sensible or they’ll push the pricing to sit where you get one year of euphoria and 24 years of remorse.”
But while no clear diagnostic emerges as to why there aren’t more deals coming through, investors have ideas about how to help build up a more robust pipeline. Dewing thinks governments need to work harder on establishing better planning and procurement methodologies, while Zurkow says industry leaders should help produce better updates on transactions and project progress, possibly in the form of an open database.
Notwithstanding these hurdles, the overall picture remains a largely optimistic one for infrastructure debt. Banks are finding new ways to provide executing capacity and liquidity in a project’s earlier stages, while institutional investors continue to learn about the asset class’s risk/return profile and earmark increasing sums to lending long-term.
“In one way that’s exactly the right perspective to have, because pension plans and insurance have long-term liabilities so long-term assets are the right economic match for them,” says Dewing. “And that’s the right moral match too: it’s better that societies should invest in their own infrastructure than in some other long-term assets.”