While the demand for global infrastructure development continues to rise, the pressure on government public budgets, especially in those countries with ever increasing fiscal deficits, intensifies. In Europe, countries such as the UK and Ireland are aware of the continued need for significant investment to upgrade or replace ageing infrastructure, but government treasuries are now being squeezed by the political and economic constraints being placed upon their ability to raise taxes and increase debt.
At a time when governments are, or should be, looking for private finance to fill the gap left by government underinvestment, the collapse of the world’s financial markets has had a significant impact on the capacity to finance infrastructure development through the use of public private partnerships (PPPs).
The fallout of the financial crisis which led to the reluctance of banks to lend to each other in the interbank markets, requiring central banks to step-in to provide liquidity into the system (and in some extreme cases to rescue banks that would otherwise have failed), has reduced the appetite of lenders to finance PPP projects. The issue is not necessarily so much to do with risk transfer, but more of a liquidity concern and a lack of confidence to lend. To overcome such issues, PPP projects are going to be faced with a number of challenges in the current market.
Due to the inflexible nature of the procurement route chosen, the sudden and rapid deterioration in the financial markets has made it difficult for some projects that reached preferred bidder status towards the end of 2007 to achieve financial close. For those projects, the tender competition rules have been unable to adapt to the changing climate and have not adequately coped with requests for proposed price adjustments that were necessary as a result of some banks withdrawing from the market and others even going out of business. Looking forward, procurement rules need to be more flexible in order to adapt to the changing economic climate. The use of the competitive dialogue procedure as the preferred choice of procurement route for PPP projects needs to be re-evaluated.
Prior to the credit crisis, many large banks were willing to enter into large infrastructure deals as soleunderwriters at a fixed price. Post-credit crunch, there are now fewer active banks willing to lend in today’s market, and those that are willing, will only do so as one of a number of co-underwriters and on market flex pricing terms. This requirement for market flex is a fundamental shift and allows the banks to reserve their right to increase interest rates and other pricing terms as part of their lending arrangements.
Many banks are also capping the amount they are willing to lend on any given PPP project. Caps of between £30 million - £50 million are not unusual. For banks to obtain credit approval, credit committees are demanding a higher degree of comfort than previously required, safe in the knowledge that that they will be able to sell down the PPP project post-financial close through the syndication markets.
As a result of these various factors, any PPP project in excess of £50m is now likely to be structured as a “club deal”, where sponsors ask banks to club together ahead of financial close and hold their funding terms. Alternatively, these projects could be structured as an “underwrite and syndicate” arrangement (a structure frequently used pre-credit crunch), but such a structure will now more than likely include the banks’ requirement to market flex.
The lack of liquidity in the market and the increasing cost of funds have pushed PPP lending margins northwards. Prior to the credit crisis, typical margins on debt for vanilla PPP projects were as low as 60bps at the height of the market. Today, such margins are anywhere between 240bps and 350bps for 20-25 year debt.
This has put a significant strain on PPP projects that that were awarded preferred bidder status in the autumn of 2007 and the ability of those projects to achieve financial close status. It also raises a query as to the appropriate length of PPP tenors for future projects which have traditionally been in the region of 25-30 years. As the cost of raising funds increases, it becomes more expensive to borrow long-term.
To reduce the funding costs, a possible solution would be to reduce the length of the tenor and refinance after a period of three to five years post-construction. US styled mini-perms may be the way forward in the short term, but “who is to bear the refinancing risk?” is an issue that needs to be addressed. PPP projects have been structured such that any refinancing gains are shared on a 50:50 basis between public and private sectors. However, the recent change in the UK regulations governing the sharing of project refinancing gains between the public and private sector is likely to make life difficult for both banks and investors. Under the new guidelines, gains of up to £1 million would be shared equally, while gains from £1 million to £3 million would be split 60/40 in favour of the public sector and any refinancing benefit over £3 million would be shared 70/30. The change potentially gives the public sector a greater share of the refinancing gains on PPP projects. In light of the current market, it is a risk share that is unlikely to be acceptable to equity investors.
However, as more structures may lean towards a mini-perm with a refinancing structured into the terms of the deal, equity investors may be prepared to accept a mechanism that allows the procuring authority to share downside risk as well as upside benefit on a “mirrored basis”.
The use of infrastructure bonds to finance PPP projects has become increasingly unattractive and has resulted in only one wrapped infrastructure bond being issued since the start of the credit crisis. The bond market has played a small but important role in financing expensive, high-profile and complex PFI/PPP projects. Monoline insurers guaranteed the repayments to bond holders in return for a fee which kept overall project costs low and allowed for a broadening of the bond investor base. However, with the downgrading of the monoline insurers from their previous AAA status and no signs of any imminent recovery, this source of financing currently remains out of reach for infrastructure finance borrowers.
As an alternative, banks have been proposing a number of solutions, one of which is to get more institutional investors to buy project debt. However, most of these investors, with the exception of a few, are not geared to work on complex PFI/PPP projects so the solution may not work in practice. With monoline insurers out of the market, there may not be many takers for unwrapped bonds at this point in time and it will take some time for an unwrapped bond market to develop and mature.
In the UK, HM Treasury has recently launched a lending unit to help PFI projects that have been stalled by the credit crisis to reach financial close. An estimated £1 billion - £2 billion will be made available to the lending unit over the next year to try and ease the bottlenecks caused by the withdrawal of foreign investors providing senior debt. The new unit will co-lend alongside commercial lenders and will operate very much like a bank, with its own internal credit committee, due diligence procedures and a mandate to lend on commercial terms. Although, the UK Government’s new proposal raises a few questions which are still left to be ironed out, it is nevertheless a welcome move and one that other European countries could follow.
DELIVERABILITY OF PPP PROJECTS
As more PPP projects come to the market with fewer banks available to lend to them, banks will be increasingly looking at the ability of the sponsors to deliver a project, both from a creditworthiness perspective as well as experience. Sponsors will be expected to invest more equity into future PPP projects and the covenant strength of the proposed building contractor to design and construct the facility will become a key concern, with more onerous performance bonding and guarantee requirements to be expected to reflect the increased construction risk. In addition, project financiers can be expected to have to brush up on their syndicated lending knowledge, as long forgotten aspects of syndicate lending are set to make a return, including structural and pricing market flex, pass-through of bank cost of borrowing and market disruption events.
Although there has been a slow down in PPP projects achieving financial close as a result of the fallout of the credit crisis, the outlook is still very much a positive one. The appetite for infrastructure finance remains strong, especially for core, stable operating infrastructure. More and more PPP projects are now also actively seeking the support of the European Investment Bank. Good projects with sound commercial structures, strong sponsors and appropriate risk apportionment will always be able to secure finance. PPP projects that do not fit this criteria (examples of which have been land swap deals in a declining property market) will struggle to attract interest.
However, it is unlikely that the market will revert to the low pricing seen at the height of the market. That aspect of infrastructure finance was never likely to be sustainable and the chances of seeing such conditions materialise again are extremely remote, particularly, within the average career span of those involved in infrastructure finance.