Commentary ✤ Analysis
Project Finance International Magazine - PFI Issue 555 - June 17, 2015
Infra financing faces new challenges
Infrastructure project financing has largely been in the hands of commercial banks but the industry and the risk variables are changing. The result is that lenders, sponsors, institutions and governments are adopting new financing structures to meet future challenges. Paul Finn, formerly Global Head of Project & Structured Finance at ANZ Banking Group, explains.
For several decades, the commercial bank market has successfully met the financing needs for infrastructure projects around the world. These projects range from natural gas liquefaction in Papua New Guinea to wind farms in California and just about everything in between. The finance has generally been secured, senior (or at least effectively pari passu with the large amounts of export and multilateral finance that’s also been a very big source of funding) with thorough documentation of heavily negotiated risk allocations and denominated in US dollars. It’s a model that’s proved successful for a long time; continuously refined and adapted to meet the needs of borrowers and local conditions, and to reflect loan performance and operating experience from comparable transactions to maintain adequate returns for lenders.
For the last few years, change has been sweeping the finance sector as more stringent regulation increases banks’ costs of the long-term funding essential for economically financed infrastructure. Naturally this has made banks more conservative, magnifying differences in regimes of national regulation and banks’ cost of funds, hindering the supply of project finance in the process. There’s an irony here, in that even as governments call for more and more private sector capital to deliver their infrastructure programmes, so their regulatory functions are constraining what has been a very reliable source of private sector capital. While there’s general agreement that infrastructure is a safe class of financial asset – providing strong underpinnings for economic growth through essential basic services that have no ready substitutes – it’s also been suggested that regulators are very concerned by the securitisation element. For example, servicing a power plant’s debt through the monthly bills of its owner’s customers doesn’t look so different from a pool of mortgages being serviced by borrowers’ monthly repayments. True as that might be, at least at a very high level, those utility bills are surely a better credit risk than low-quality mortgages.
The problem is the lack of data to clearly establish the quality of infrastructure loans. While the majority of loans that default suffer no losses, where losses occur they’re often substantial and create a distorted impression of the true performance across the asset class. Certainly, banks could do more to help their cause by maintaining better loan performance data, and in many cases this would likely satisfy the requirements of Advanced IRB capitalisation under Basel III regulations. In the past, that data collection has been expensive, and the business side tends to emphasise the unique features of each transaction rather than the more performance characteristics common to a particular class of infrastructure, such as wind farms. As it stands, the vast majority of project finance is capitalised using the Slotted approach due to lack of data to demonstrate that of the proportion of loans that do default, the bulk (estimated at around 75%) do not result in any loan loss.
As technology reduces the cost of gathering and analysing data, services will emerge to help banks address this issue with their regulators, allowing them to move capitalisation to the Advanced-IRB approach, potentially releasing very valuable capital and significantly improving returns. Another major shift is financial institutions looking to invest more of their funds in infrastructure debt. In those countries that are becoming wealthier, the amount of savings in the hands of non-bank institutions – insurance companies and pension funds – is growing strongly and will continue to do so for at least the next 20 years. Infrastructure is an attractive class of asset for institutions, offering (generally) stable cashflows and long life matching well with their long-term liabilities. However, the established metrics of commercial bank infrastructure finance are at odds with those of institutional investors. Conventional greenfield project finance involves multiple drawdowns and high levels of amortising debt, with borrowers having a free prepayment option (interest rate hedge breakage costs aside). In contrast, institutions are used to injecting all funds immediately (as when buying a bond) with a single, bullet, repayment at final maturity. They’re comfortable with much longer maturities than commercial banks and prefer limited prepayment options to ensure funds remain deployed for the full nominal term of a loan.
The inherent uncertainty of such long tenors creates a preference for better quality – if not investment grade – structures, compared with the BB range of many commercial bank infrastructure financings. Refinancing operating assets – avoiding the complications of construction – is the easiest way to enter the market, and is already well under way. Inevitably, there will be significant changes in structures used to financing infrastructure so that borrowers can accommodate the needs of these two important sources of finance and benefit from their distinct strengths. That’s a longer-term prospect. For the past few years a combination of a global glut of capital and projects being awarded by competitive tenders have driven returns – for both equity and debt providers – to what many investors now describe as unsustainably low levels. At the moment, the situation is partly masked by the fact that, as bad as it might be in project finance, some other financial assets are delivering negative returns. Consequently, major European banks are reopening their project finance desks in places such as Australia because returns remain attractive, if only relatively. This clearly isn’t sustainable over the long-term but is a material factor in the current market. For example, French and Spanish banks have returned to the market, participating in some of the bigger recent infrastructure projects. They are not the only ones, with Canadians and others seeing the Australian market as attractive; frequently supporting their major home market relationships as sponsors and equity investors in these projects.
On the equity side, some investors are turning their focus to unsolicited bids and negotiated deals in search of better returns. Transurban has been particularly active with its unsolicited and winning bid for the NorthConnex tunnel project in Sydney and its recent unsolicited bid to build the Western Distributor in Melbourne. This shift poses a different challenge for governments, as they’re often required by regulation to award business via tender. Understandably, tenders appeal as the best way to ensure value for money, and satisfy the transparency demanded by voters.
Ironically, just as some countries finally have managed to build the administration to conduct robust public tenders, investors are looking for directly negotiated outcomes on unsolicited proposals! Fortunately, in the face of these challenges, financial markets continue to do what they always do: innovate. In the last year in Australia, there has been a refinancing of an operating wind farm via the US Rule 144A market and one of the domestic banks has issued a Green bond with proceeds committed to sustainable development.
There’s been innovation in financing rooftop solar panels with structures that eliminate any upfront installation costs to users and there’s market talk of an impending securitisation of solar power receivables. Institutions are getting to grips with the issues of construction, including funding multiple drawdowns and extended periods of no operating cashflows until the infrastructure is up and running. The classic idea of commercial banks funding construction followed by institutional take-out at completion continues to be explored, but it does present some serious hurdles. For example, if for any reason a bank is left holding a loan structured for a very long-term bullet maturity, the contractual revenue stream might not accommodate restructuring into a conventional term loan, amortising within an acceptable period of time. Should a project fail to meet its performance thresholds or be significantly delayed, an institution might be facing a major overhang of uninvested cash earning negative carry.
The problem has been neatly described as banks looking for a 'put' option while institutions want a 'call' option. Bridging that gap will be quite a challenge but one possible solution is for banks and institutions to jointly capitalise a funding vehicle to ensure aligned interests – or at least the prospect of shared pain. Though it seems workable, it’s not the most elegant concept and implementation is unlikely to be straightforward.
The comforting news is that so long as infrastructure remains an attractive class of financial asset, so funding will continue to find its way to the sector. In keeping with global growth, demand and supply are strongest in the rapidly growing nations of Asia. There are a number of themes operating as these markets evolve.
Presently, there’s a lot of liquidity in the hands of domestic banks. They’re attracted to the yield of longer-term lending and able to provide domestic currency funding. This is attractive to borrowers as it addresses the foreign exchange risk that has been a significant cost for many past projects. However, domestic banks in evolving markets are often less experienced in ensuring appropriate risk allocation for non-recourse or limited-recourse loans. They also might have to consider broader relationships with key home- country sponsors, which make it tempting to assess the credit of projects beyond their stated terms. And, of course, credit standards can come under pressure when the market is flush with liquidity.
Marginal projects have secured financing in the past and there’s no doubt this will happen again. Though the long experience of international project finance banks might make them more discriminating, with less access to these domestic currencies and a preference to use their liquidity for shorter-term business, they’re less of a force in a lot of markets. There’s an awareness in organisations such as the ADB of the potential risks, and one solution is to engage experienced financial advisers to help ensure appropriate risk allocation while accessing domestic bank liquidity for attractively priced funding without foreign exchange risks.
In closing, it’s worth noting that shifts in the technologies that deliver some services are disrupting business models that have underpinned infrastructure’s economics for more than a century. As mentioned above, not only is the 'how' of infrastructure finance changing, but so is the 'what'. A combination of energy efficiency, the appeal of solar power and falling prices of renewable technologies generally, is challenging the economics of large-scale generation and high voltage transmission. Rapid advances in batteries will add further pressure. And driverless vehicles will see far more efficient use of existing road capacity and delay the need for more. Climate change will (in all probability) radically change the water sector.
As in many industries, this shift fundamentally alters the scale at which infrastructure becomes economic. From an individual perspective, distributed generation in the form or rooftop solar is the obvious example. The implications for financing are profound and as smaller projects become viable the cost of structuring, negotiating and closing financing will need to fall. These costs are largely fixed in conventional project financing, so simpler, more standardised products, such as lease-type structures, will likely become more common. That’s potentially welcome news for borrowers without the resources to undertake the sometimes daunting task of a full-blown project financing.
Nevertheless, commercial banks are sure to remain significant lenders to the infrastructure sector. In addition to core lending, they’re the sole providers of many financial products and services essential for business, from transactional accounts to short-term working capital. Institutions will become increasingly important as providers of core capital since the generally strong credit performance and economic life of infrastructure closely parallels their needs. In short order, many projects will probably incorporate tranches of both bank and institutional funding in their capital structures. That’s not to make light of the significant change needed to accommodate institutional growth in this sector. Inevitably, the period of adaptation will provide opportunities for advisers to sell their expertise in matching the shifting sources and uses of finance.
There can be confidence this will happen in one form or another because there’s no doubt the overall demand for infrastructure isn’t falling. A few years ago, a major report estimated Asia’s infrastructure investment needs at US$8trn for the subsequent decade. A more recent estimate by a leading international project finance bank put the figure at US$11trn, over a 10 to 15 year horizon (as an aside, the difference in time horizons could well reflect experience of the length of time to actually get infrastructure projects under way, rather than any change in demand). When it comes to infrastructure: the more we have, the more we want.
___________________________________
Infra financing faces new challenges
Infrastructure project financing has largely been in the hands of commercial banks but the industry and the risk variables are changing. The result is that lenders, sponsors, institutions and governments are adopting new financing structures to meet future challenges. Paul Finn, formerly Global Head of Project & Structured Finance at ANZ Banking Group, explains.
For several decades, the commercial bank market has successfully met the financing needs for infrastructure projects around the world. These projects range from natural gas liquefaction in Papua New Guinea to wind farms in California and just about everything in between. The finance has generally been secured, senior (or at least effectively pari passu with the large amounts of export and multilateral finance that’s also been a very big source of funding) with thorough documentation of heavily negotiated risk allocations and denominated in US dollars. It’s a model that’s proved successful for a long time; continuously refined and adapted to meet the needs of borrowers and local conditions, and to reflect loan performance and operating experience from comparable transactions to maintain adequate returns for lenders.
For the last few years, change has been sweeping the finance sector as more stringent regulation increases banks’ costs of the long-term funding essential for economically financed infrastructure. Naturally this has made banks more conservative, magnifying differences in regimes of national regulation and banks’ cost of funds, hindering the supply of project finance in the process. There’s an irony here, in that even as governments call for more and more private sector capital to deliver their infrastructure programmes, so their regulatory functions are constraining what has been a very reliable source of private sector capital. While there’s general agreement that infrastructure is a safe class of financial asset – providing strong underpinnings for economic growth through essential basic services that have no ready substitutes – it’s also been suggested that regulators are very concerned by the securitisation element. For example, servicing a power plant’s debt through the monthly bills of its owner’s customers doesn’t look so different from a pool of mortgages being serviced by borrowers’ monthly repayments. True as that might be, at least at a very high level, those utility bills are surely a better credit risk than low-quality mortgages.
The problem is the lack of data to clearly establish the quality of infrastructure loans. While the majority of loans that default suffer no losses, where losses occur they’re often substantial and create a distorted impression of the true performance across the asset class. Certainly, banks could do more to help their cause by maintaining better loan performance data, and in many cases this would likely satisfy the requirements of Advanced IRB capitalisation under Basel III regulations. In the past, that data collection has been expensive, and the business side tends to emphasise the unique features of each transaction rather than the more performance characteristics common to a particular class of infrastructure, such as wind farms. As it stands, the vast majority of project finance is capitalised using the Slotted approach due to lack of data to demonstrate that of the proportion of loans that do default, the bulk (estimated at around 75%) do not result in any loan loss.
As technology reduces the cost of gathering and analysing data, services will emerge to help banks address this issue with their regulators, allowing them to move capitalisation to the Advanced-IRB approach, potentially releasing very valuable capital and significantly improving returns. Another major shift is financial institutions looking to invest more of their funds in infrastructure debt. In those countries that are becoming wealthier, the amount of savings in the hands of non-bank institutions – insurance companies and pension funds – is growing strongly and will continue to do so for at least the next 20 years. Infrastructure is an attractive class of asset for institutions, offering (generally) stable cashflows and long life matching well with their long-term liabilities. However, the established metrics of commercial bank infrastructure finance are at odds with those of institutional investors. Conventional greenfield project finance involves multiple drawdowns and high levels of amortising debt, with borrowers having a free prepayment option (interest rate hedge breakage costs aside). In contrast, institutions are used to injecting all funds immediately (as when buying a bond) with a single, bullet, repayment at final maturity. They’re comfortable with much longer maturities than commercial banks and prefer limited prepayment options to ensure funds remain deployed for the full nominal term of a loan.
The inherent uncertainty of such long tenors creates a preference for better quality – if not investment grade – structures, compared with the BB range of many commercial bank infrastructure financings. Refinancing operating assets – avoiding the complications of construction – is the easiest way to enter the market, and is already well under way. Inevitably, there will be significant changes in structures used to financing infrastructure so that borrowers can accommodate the needs of these two important sources of finance and benefit from their distinct strengths. That’s a longer-term prospect. For the past few years a combination of a global glut of capital and projects being awarded by competitive tenders have driven returns – for both equity and debt providers – to what many investors now describe as unsustainably low levels. At the moment, the situation is partly masked by the fact that, as bad as it might be in project finance, some other financial assets are delivering negative returns. Consequently, major European banks are reopening their project finance desks in places such as Australia because returns remain attractive, if only relatively. This clearly isn’t sustainable over the long-term but is a material factor in the current market. For example, French and Spanish banks have returned to the market, participating in some of the bigger recent infrastructure projects. They are not the only ones, with Canadians and others seeing the Australian market as attractive; frequently supporting their major home market relationships as sponsors and equity investors in these projects.
On the equity side, some investors are turning their focus to unsolicited bids and negotiated deals in search of better returns. Transurban has been particularly active with its unsolicited and winning bid for the NorthConnex tunnel project in Sydney and its recent unsolicited bid to build the Western Distributor in Melbourne. This shift poses a different challenge for governments, as they’re often required by regulation to award business via tender. Understandably, tenders appeal as the best way to ensure value for money, and satisfy the transparency demanded by voters.
Ironically, just as some countries finally have managed to build the administration to conduct robust public tenders, investors are looking for directly negotiated outcomes on unsolicited proposals! Fortunately, in the face of these challenges, financial markets continue to do what they always do: innovate. In the last year in Australia, there has been a refinancing of an operating wind farm via the US Rule 144A market and one of the domestic banks has issued a Green bond with proceeds committed to sustainable development.
There’s been innovation in financing rooftop solar panels with structures that eliminate any upfront installation costs to users and there’s market talk of an impending securitisation of solar power receivables. Institutions are getting to grips with the issues of construction, including funding multiple drawdowns and extended periods of no operating cashflows until the infrastructure is up and running. The classic idea of commercial banks funding construction followed by institutional take-out at completion continues to be explored, but it does present some serious hurdles. For example, if for any reason a bank is left holding a loan structured for a very long-term bullet maturity, the contractual revenue stream might not accommodate restructuring into a conventional term loan, amortising within an acceptable period of time. Should a project fail to meet its performance thresholds or be significantly delayed, an institution might be facing a major overhang of uninvested cash earning negative carry.
The problem has been neatly described as banks looking for a 'put' option while institutions want a 'call' option. Bridging that gap will be quite a challenge but one possible solution is for banks and institutions to jointly capitalise a funding vehicle to ensure aligned interests – or at least the prospect of shared pain. Though it seems workable, it’s not the most elegant concept and implementation is unlikely to be straightforward.
The comforting news is that so long as infrastructure remains an attractive class of financial asset, so funding will continue to find its way to the sector. In keeping with global growth, demand and supply are strongest in the rapidly growing nations of Asia. There are a number of themes operating as these markets evolve.
Presently, there’s a lot of liquidity in the hands of domestic banks. They’re attracted to the yield of longer-term lending and able to provide domestic currency funding. This is attractive to borrowers as it addresses the foreign exchange risk that has been a significant cost for many past projects. However, domestic banks in evolving markets are often less experienced in ensuring appropriate risk allocation for non-recourse or limited-recourse loans. They also might have to consider broader relationships with key home- country sponsors, which make it tempting to assess the credit of projects beyond their stated terms. And, of course, credit standards can come under pressure when the market is flush with liquidity.
Marginal projects have secured financing in the past and there’s no doubt this will happen again. Though the long experience of international project finance banks might make them more discriminating, with less access to these domestic currencies and a preference to use their liquidity for shorter-term business, they’re less of a force in a lot of markets. There’s an awareness in organisations such as the ADB of the potential risks, and one solution is to engage experienced financial advisers to help ensure appropriate risk allocation while accessing domestic bank liquidity for attractively priced funding without foreign exchange risks.
In closing, it’s worth noting that shifts in the technologies that deliver some services are disrupting business models that have underpinned infrastructure’s economics for more than a century. As mentioned above, not only is the 'how' of infrastructure finance changing, but so is the 'what'. A combination of energy efficiency, the appeal of solar power and falling prices of renewable technologies generally, is challenging the economics of large-scale generation and high voltage transmission. Rapid advances in batteries will add further pressure. And driverless vehicles will see far more efficient use of existing road capacity and delay the need for more. Climate change will (in all probability) radically change the water sector.
As in many industries, this shift fundamentally alters the scale at which infrastructure becomes economic. From an individual perspective, distributed generation in the form or rooftop solar is the obvious example. The implications for financing are profound and as smaller projects become viable the cost of structuring, negotiating and closing financing will need to fall. These costs are largely fixed in conventional project financing, so simpler, more standardised products, such as lease-type structures, will likely become more common. That’s potentially welcome news for borrowers without the resources to undertake the sometimes daunting task of a full-blown project financing.
Nevertheless, commercial banks are sure to remain significant lenders to the infrastructure sector. In addition to core lending, they’re the sole providers of many financial products and services essential for business, from transactional accounts to short-term working capital. Institutions will become increasingly important as providers of core capital since the generally strong credit performance and economic life of infrastructure closely parallels their needs. In short order, many projects will probably incorporate tranches of both bank and institutional funding in their capital structures. That’s not to make light of the significant change needed to accommodate institutional growth in this sector. Inevitably, the period of adaptation will provide opportunities for advisers to sell their expertise in matching the shifting sources and uses of finance.
There can be confidence this will happen in one form or another because there’s no doubt the overall demand for infrastructure isn’t falling. A few years ago, a major report estimated Asia’s infrastructure investment needs at US$8trn for the subsequent decade. A more recent estimate by a leading international project finance bank put the figure at US$11trn, over a 10 to 15 year horizon (as an aside, the difference in time horizons could well reflect experience of the length of time to actually get infrastructure projects under way, rather than any change in demand). When it comes to infrastructure: the more we have, the more we want.
___________________________________