With increased demand for integration of environmental, social and governance considerations into financial strategies, the expected upturn in spending on sectors that lay practically dormant due to the pandemic (i.e. travel), a positive outlook for project finance and the likelihood of rising interest rates, we look ahead to the rest of 2022 and share some of our key predictions for banking and finance.
Real estate development finance
We expect 2022 will be another busy year for development financing, across all classes. Build-to-rent and residential development, particularly land subdivision, are likely to drive deal volumes and headlines for the short to medium term. Banks continue to chase senior debt deals that are within bank tolerances and major non-bank lenders report strong inflows and transaction volumes across the capital spectrum.
However, there are some headwinds expected with the spectre of rate rises and cost of funds increases throughout the year and construction cost increases and material shortages to remain a drag. The fall of ProBuild (following the demise of Grocon and others last year) is a timely reminder of the vulnerability of the construction sector. Against this, the reopening of borders and return to offices may result in fresh demand.
At this stage, our prediction is that demand will remain strong, and lenders will have plenty of capital to deploy, sustaining growth for most of 2022.
Towards the end of 2021, Australia’s corporate leaders were expecting the economy to boom in 2022 – despite the threat of skills shortages, cost pressures and supply chain problems.
While 2022 may not be off to the smoothest start, given COVID-19, the situation in Ukraine, Australia’s current relationship with China and increased general uncertainty, Australian CFOs still seem optimistic about the year ahead. According to the latest edition of Deloitte’s biannual CFO Sentiment survey, 58% think now is a good time to be taking on increased balance sheet risk.
Nevertheless, we expect that CFOs will generally maintain their prudent approach to balance sheet management and headroom in their funding lines, to ensure sufficient financial resilience to cope with whatever the year may bring – including the expected rise(s) in interest rates.
As always, high on the agenda for corporate treasurers will be enterprise risk management. The corporate treasury is key to driving diversification and flexibility across sources of debt financing, shoring-up financial risk management in the face of potential business disruption (including through financial risk management products to lock in low interest rates and mitigate cash-flow uncertainties) and funding increased corporate spending needs in areas such as technology infrastructure and digital transformation.
Corporate Australia clearly recognises that nearly all stakeholders (including debt and equity providers) want action on environmental, social and governance (ESG) matters. As a minimum, many corporates are looking to embed ESG actions as ‘business as usual’. In respect of corporate finance, the rise in ESG-focussed debt products is gaining much more momentum. Notably, Sustainability-Linked Loans (SLLs), under which borrowers are incentivised to achieve predetermined ESG-related targets to benefit from improved pricing or potentially other advantages (such as in relation to covenant packages), are becoming increasingly common. Significantly, SLLs can be used in a range of financing types and for various corporate purposes. The key to making SLLs work is being able to achieve an agreed, objective ESG outcome.
We anticipate that the integration of ESG into corporate financial strategies will continue apace, despite concerns in some quarters about lack of capability and resources in relation to ESG initiatives.
The 2022 outlook for project finance in Australia is off to a promising start, with a number of tailwinds underpinning this segment of the Australian debt markets. In the short term, strong commodity prices are driving interest across all project types, including more traditional natural resources. In addition, the continued emphasis on net zero and the rising important of ESG is a focal point, as projects that will assist in achieving ESG outcomes are particularly sought after. We consider this demand will only grow over 2022 and each year thereafter until ambitions of net zero are achieved.
In terms of project subsets, there will be a continued focus on the Built Environment Sustainability Scorecard (BESS) and other battery related projects, as well as continued support for solar and wind projects due to their shorter timeframes for development and relatively proven technology – although they still have challenges in terms of getting operational. This year will also give rise to a particular focus on responding to capacity and network restraints in the National Electricity Market (NEM), as the market responds to the continued announcement of early closure of coal power stations. This will give rise to particular focus on Renewable Energy Zone projects, which are being supported by generous State government incentives and grants. Similarly, there will be a continued focus on transmission projects, in particular those identified as priority projects by Australian Energy Market Operator (AEMO) in its 2022 ISP Plan. The CopperString 2.0 project to connect the North West Minerals Province to the NEM in Northern Queensland is likely to be a key focus, as its development, regulatory and procurement activities are well advanced.
There is growing enthusiasm for waste projects on the East Coast of Australia. Western Australia pioneered the Australian market nearly five years ago through several large-scale projects, but equivalent projects on the East Coast have been beset by policy and planning barriers – which have delayed those projects gaining any significant traction. This looks to be shifting for the commercial scale projects as both the New South Wales and Victorian governments have provided or are working towards providing greater policy certainty for these projects. We also consider there to be a promising year for more bespoke biogas and bioenergy projects. However, those projects due to their bespoke nature will largely be underpinned by concessional funding, sourced from Australian Renewable Energy Agency (ARENA), the Clean Energy Finance Corporation (CEFC) and state governments, until their can satisfy commercial lenders of their project’s viability. These projects will benefit from obtaining long-term offtake from credible counterparties.
This year will also see strong support for Australia’s dominant participator in the project finance debt markets, the mining sector. The pipeline of projects entering the development pipeline is growing, as well as those projects which may be bought back online to take advantage of higher commodity prices. With commodity prices high across the board, there will be activity across the market. We expect that the critical minerals sector will receive greater policy and regulatory support, as well as benefit from access to various government funding sources such as Export Finance Australia’s newly established A$2 billion 10 year facility. Stemming from discrepancies in (liquefied natural gas) LNG production and production across Australia, resulting in significant pricing differences between the states and territories, there is also a particular interest in building LNG import terminals on the East Coast. These projects are being supported by well-funded industry players, such as AGL and Viva Energy, however they still remain very much prospective projects as it is unclear at this stage whether they will obtain the necessary community support and environmental approvals.
In addition to the A$2 billion allocated to Export Finance Australia for critical mineral projects, we expect an even busier year for the Northern Australia Infrastructure Facility this year. In its now seventh year of existence, it has committed A$3.2 billion of its A$5 billion to domestic projects and moving forward will benefit from an increase of its funding to A$7 billion. This increase was announced in February 2022 and complements an extension of NAIF’s statutory life by five years, which occurred last year. The CEFC should also have another busy year as it continues to support clean energy projects, critical minerals and agriculture. We also expect the CEFC to have a particular focus, working alongside ARENA, on supporting pilot and pre-commercial stage hydrogen projects.
Notwithstanding, the strong tailwinds for project finance in 2022, a significant barrier will be overcoming supply chain disruptions as well as significant pipeline of large-scale projects in Australia creating unprecedented demand for contractors. It is unclear when these pressures will ease, but with the recent collapse of national builder Probuild (who had a particular focus on high rises as opposed to infrastructure and mining projects) and recent ownership changes in Australia’s limited number of tier 1 and 2 contractors this remains a key risk for new projects.
Debt capital markets and securitisation
While the ongoing impact of COVID-19, the situation in Ukraine and the upcoming federal election will continue to drive a level of uncertainly, strong GDP and employment numbers should ensure another positive growth year for the Australian debt capital markets.
We expect ESG and energy transition to continue to be at the forefront of that growth. 2021 saw a record year for sustainable debt issuance, exceeding 10% of global market bond issuance. While the focus on ESG has been building over recent years, the United Nations COP26 climate talks are seen as having raised global awareness of climate risk and climate finance and played a key part in driving increased inflows into ESG-focused funds.
Sustainability Linked Bonds from leading Australian issuers in 2021, including Wesfarmers, Worley Parsons and Woolworths, have shown that in addition to ESG appetite in the loan markets, significant appetite exists in the debt capital markets. As a further positive sign for the Australian domestic medium-term note market, it is notable that large benchmark issuance have been undertaken in both Euro under euro medium term note programs and also in Australian dollars and placed in the Australian domestic market.
The outlook for the Australian securitisation market in 2022 is also positive, driven by a continual growth in lending volumes. Despite COVID-19, 2021 saw the continued proliferation of fintech and other non-bank lenders funding new originations through warehouse securitisations. While the AOFM’s Structured Finance Support Fund supported the market by buying mezzanine tranches in 2020, real money investor demand returned strongly in 2021 with the AOFM not writing new transactions and actively selling down mezzanine positions taken on in 2020.
We expect this trend to continue in 2022, with the return of offshore senior bank lenders and a growing number of mezzanine investors providing the demand required to support the continued growth of the warehouse market and term out transactions. We also expect sustainability to be a significant theme in the securitisation market in 2022, coming off the back of the Clean Energy Finance Corporation’s support of the first green home loan securitisation by Firstmac last year.
While the outlook for syndicated loans in 2022 continues to be favourable, the likelihood of rising interest rates, inflation and sustainable lending will impact financings. 2021 showed that there was a strong appetite in the syndicated loan markets to support corporate Australia, with funding coming from both domestic and foreign lenders. However, ‘trickier’ credits or borrowers in industries out of favour (such as fossil fuels) found raising facilities harder. These issues will continue to be at play in 2022, but with a sharper focus in what will arguably be a less benign environment.
ESG considerations will continue to be a key consideration for lenders. This will mean that some borrowers who do not meet lenders’ ESG requirements will find it harder to raise money in the syndicated markets and may even have to seek funding elsewhere. To date, the most visibly impacted borrowers have been those where lenders have had environmental concerns. However, we expect to also see an increased focus on social and governance compliance.
Another area where we expect to see ESG related developments is in the ESG provisions in credit agreements. In 2021 these were increasingly common and the coming year should see a more uniform approach to the drafting of ESG provisions, as the market becomes more sophisticated and as the impact of greater regulation in Europe filters into the drafting of Australian credit agreements. We also expect to see more key indicators focussed on addressing social and governance issues, in addition to environmental concerns.
2022 will also likely see a greater focus on the impact of rising interest rates. Many deals over the past couple of years have not had a requirement for interest rate hedging. In addition, some strong credits have been able to negotiate financial covenant packages without an interest cover ratio. We expect hedging and coverage ratios to be under a renewed focus in the event that interest rates start to rise during the course of this year.
We still believe that there will be a strong appetite for lending in 2022. However, in light of the above, it will be important for borrowers to allow sufficient time to negotiate with lenders, particularly so for borrowers who are weaker credits or who potentially have ESG considerations that need to be addressed.
The outlook for leveraged finance in 2022 is positive. While 2021 continued to be impacted by the pandemic, government programs like JobKeeper and JobSeeker combined with a coordinated response from the Federal Government and the Reserve Bank of Australia (RBA) on fiscal and monetary policy underpinned the economy and avoided what might have otherwise been a sharp economic downturn.
Against this backdrop, private equity acquisition activity continued at pace. Investment activity shifted focus from industry sectors that were impacted, such as leisure and hospitality, to industry sectors that were either not impacted or which stood to gain from changes in public policy and consumer behaviour, such as social infrastructure, healthcare, online retail and information technology.
With the pandemic hopefully receding, sectors that lay practically dormant should come back into focus. For example, we expect the travel and leisure industries to be beneficiaries of the A$260 billion Australians have saved during the pandemic. Other underlying factors that suggest 2022 will be another good year for private equity investment include:
- overall superannuation assets totalled A$3.4 trillion as at 30 September 2021, representing a 17.5% increase on the previous year. Australia’s compulsory superannuation, whereby employers must contribute 10% of each employee’s salary to a complying superannuation fund, underpins year-on-year increases in the size of the investment pool. About 5% of superannuation funds are directed to investment in alterative asset classes such as PE;
- each of the ‘Big 4’ Australian banks are active in leveraged finance, along with other domestic banks like Macquarie Bank and a large number of offshore banks that have a local presence in Australia;
- private credit managers, sometimes referred to as debt funds, have expanded both in number and in terms of funds under management. For example, Metrics Credit Partners has grown from managing A$2.7 billion in 2018 to A$10 billion today. Several smaller funds have launched (such as Epsilon Direct Lending) and some of the global players have opened up credit offices in Australia (such as Blackstone Credit);
- superannuation funds are lending directly into the market, either through their own office (like Aware Super) or via industry fund pooling (like IFM);
- Australia’s Term Loan B (TLB) market continues to expand. In 2021 AUD TLBs eclipsed TLB borrowings in all other currencies for the first time, with an overall share of 58% (up from 20.2% in 2017 and 37.5% in 2019). TLBs and unitranche facilities represent an increase in overall funding available for private equity transactions; and
- funds raised by private equity sponsors have seen year-on-year growth. While numbers for 2021 will not be available until later in the year, in 2020 A$4.3 billion in capital was raised which was almost 2.8 times the funds raised in 2019 (A$1.55 billion). Private equity dry powder in 2020 was A$11 billion (with numbers for 2021 to be determined). It is also interesting to note that A$3.6 billion has already been raised by BGH for Fund II, so 2022 numbers are looking strong (Corrs acted as Australian counsel for BGH).
On inflation, an emerging theory is that much of the recent inflation is ‘transitionary’ and attributable to increases in product prices as a result of supply lines being disrupted during the pandemic. According to this theory, supply lines will recover and consumer sentiment will shift to services, including healthcare (elective surgery), leisure (particularly travel) and education (international students), which were forcefully shut down as a result of the pandemic. The net effect of this will be a cooling of inflationary pressure. Perhaps the only likelihood here is that if interest rates do rise lenders may once again require as a term of their financing that borrowers hedge a percentage of their floating rate exposure.
Similar to corporate finance, we also expect the appetite for loans that satisfy ESG criteria (ESG loans) and SLLs to be present in the leveraged finance market. To this end, loan agreements will likely contain provisions that will permit the borrower and the lender to seek certification against the relevant criteria such that the loan can be categorised as either ESG or SLL.