Some experiments look under control at the outset, but end up going badly wrong.
In 1998, when UK developer John Laing and outsourcing firm Serco Group were awarded a £130 million (€157 million; $216 million) Private Finance Initiative (PFI) project to build and manage new headquarters for the National Physical Laboratory – a cutting-edge facility to measure time, length and mass – it didn’t look as if they were out of their depth.
Yet six years later the cash-strapped joint venture had abandoned the contract, the project was already three years late, and its backers had altogether lost a combined £100 million. The main cause of headaches: the contractors’ failure to comply with specifications needed for scientists to carry out their work, including temperatures controlled within a margin of plus or minus 0.1 degrees centigrade.
That this episode is still being discussed a decade later shows how aware market players remain of the pitfalls associated with a project’s construction phase. But equally telling is the fact that, when asked to recall other construction fiascos, it takes a while to think of more recent examples.
“Instances of infrastructure projects not being built, and where construction completely failed, remain few and far between,” says Mark Woodhams, a partner and head of business development at UK fund manager InfraRed Capital Partners.
A contradiction seemingly arises when looking at investors’ attitudes to construction risk. Michael Wilkins, a managing director at Standard & Poor’s, recalls prompting the audience at a recent seminar to raise their hands if they thought construction risk represented the biggest risk in project finance. Nobody did.
But privately many voice a different opinion. “Of all the risks, the key one requiring the most focus, particularly in greenfield, is construction and its associated risks,” says Gershon Cohen, director of infrastructure at UK asset manager Scottish Widows Investment Partnership.
Part of this apparent contradiction lies in the ambiguity surrounding the notion of construction risk.
At its heart, it seems very easy to define. “Construction risk is the risk of building a cash-generating asset on time and on budget,” says Wilkins. “In many cases, in the absence of external sources of funds, until that asset is built you’re not going to receive the cash flows you need to repay the debt to lenders and the equity investment to equity providers.”
Delays and cost overruns can ensue from a variety of different events. One potential pitfall is the technical complexity of the project – from its structure and technological content to ground conditions and contamination risks. A straightforward road project, for example, becomes much trickier to complete if it involves digging tunnels through mountains.
Logistics also have to be carefully thought through, particularly when undertaking construction work in complex, urban environments. Woodhams recalls the example of London tube upgrades, which can only be carried out overnight, or hospital extensions, where new facilities are often being built while existing ones keep functioning.
In practice these “inherent” construction risks are rarely a reason for a project to default, says Tim Conduit, a partner at Allen & Overy. “Construction risk, in reality, is all about the strength of your counterparty. Projects tend to fail because the contractor fails, not because it is impossible to complete the asset.”
And while investors say history counts few examples of failing contractors, some think the risk has grown stronger over recent years. “Contractors have suffered a blow after 2008, when construction activity slumped. Some of them are now in weaker positions,” says Jos Heemelaar, international asset director at John Laing.
For investors, however, construction risk seems to have become a less scary beast than it was.
For one, says Cohen, yield-hungry investors understand they can get a significant premium for taking on construction risk. Most practitioners agree that an additional return of 300 to 400 basis points is often warranted when backing a project in its greenfield years.
Investors have also come to understand that, in a world where everyone is hunting for operational assets, being able to buy assets early in the process provides a sizeable competitive advantage. “Investors taking greenfield risk in a long-term infrastructure fund will gain access to the long-term brownfield cash flows,” says Cohen.
Several studies have helped buttress confidence. Empirical research by the EDHEC Risk Institute, which hosts a chair on infrastructure investment backed by Meridiam Infrastructure and placement agent Campbell Lutyens, recently showed that construction risk in project finance is overall well managed – and that only in exceptional cases should cost overruns be expected.
A March report by Moody’s also found that the 10-year cumulative default rate for the infrastructure sector was 6.6 percent in the decade to 2013 – far less than levels displayed by similarly-rated corporates.
Yet where investors have really progressed, observers say, is in their understanding of how construction risk can be efficiently managed.
Private investors generally see risk mitigation as a two-step process: the tight framing of a developer’s obligations and commitments in a fixed price, day-certain contract, followed by the deft monitoring of these arrangements throughout construction.
Michael Dinham, head of infrastructure at ING, concurs that construction risk is mostly about pinning down what he calls the “pinhole risk” – the developers’ ability to identify and exploit any contract loophole whenever something goes wrong.
THE RIGHT TOOLKIT
Yet Woodhams underlines the need to strike a fine balance between being well protected and remaining competitive during auctions – which implies avoiding overburdening partner contractors with covenants and specifications.
One key aspect investors have learnt to focus on, he says, is whether the money drawn down from the funder is being deployed directly in the project – or diverted elsewhere in the corporate structure. He also sees provisions that enable sponsors to swiftly replace a failing contractor as particularly crucial.
Potential for external shocks remains. Macro risks, such as inflation or commodity risks, can impact construction costs substantially – for example if labour or raw material costs rapidly inflate. Pinpointing and structuring them correctly at the outset, Dinham says, helps avoid nasty surprises further down the line.
Yet perhaps the greatest challenge is to harness what he calls “commissioning risks”.
“Getting an infrastructure asset built is rarely a problem. But getting it to work to required specifications is a different matter.” Often this involves dealing with sophisticated technology – but not always. Dinham says wastewater treatment plants, for example, have often been a source of unforeseen problems.
Complicating these matters, argues Heemelaar, is a recent yet sustained lowering of liability caps. “There is a commercial limit to what you can push down,” he reckons, which now stands at between 20 percent and 30 percent of Capex.
According to Phil Adam, head of EMEA project bonds at HSBC, capital markets are responding to such concerns through innovation. “Over the last 12 to 18 months, we’ve seen Infrastructure UK prepared to wrap risk, Assured Guaranty back smaller deals, the European Investment Bank offer its credit enhancement product and banks willing to provide liquidity to boost project credit during construction phase.”
The rebuilding of London Heathrow’s Terminal 2, Conduit points out, is being almost entirely funded via capital market debt.
Meanwhile equity providers try to mitigate residual risks through portfolio diversification, tightened relationships with developers and guarantees from their parent companies. Massimo Fiorentino, a senior investment director at Meridiam, explains that active engagement with local communities and authorities helps assuage conflicts when things turn sour.
Like in most experiments, however, having the right tools is only one condition of success. “Perceptions of construction risks are changing because the means to managing it are better understood,” says Cohen. “[But] this understanding is highly dependent on whether the initial analysis is robust and if those performing it have demonstrable track records.”