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Capital Markets: Talking Points The Rise of Non- Project 3 Contents

Executive Summary 1 Introduction 2 Some Have Steadily Reduced Exposure to the Market 3 The Rise of Infrastructure Project Bonds and Non-bank Lending 4 Four Prerequisites 6 Market Segmentation 10 Green 11 Amber/Green 17 Amber 18 Red 20

Conclusion 22 Contacts 23

4 Executive Summary

governments and project sponsors about how best to access the capital markets for infrastructure projects.

This paper seeks to provide some clarity to the project concept. Firstly we have identified four critical preconditions that we think must exist for a project bond In recent years we’ve all seen market to take root: significant changes to the financing available capital outside of the of large-scale infrastructure projects 1 banking system; around the globe. The traditional route of long-term bank debt is still 2 sufficient governance and available in some markets. But transparency in financial reporting; with stiffer banking regulation, 3 Balanced tax and commercial it is questionable whether it can policies; and keep up should the project pipeline 4 project specific mechanisms to significantly expand. In many support credit quality. regions, institutional project debt may fill this need. Delineating this list allows governments to see where policy reform is required We believe that capital markets and how they should prioritise their involvement in financing infrastructure efforts if they wish to create a stronger projects outside of North America has now environment for infrastructure project reached a tipping point and will steadily bonds. In addition, we have categorised increase. Already in 2013 there have markets around the world by these been landmark transactions in Brazil, factors, so that bidders can identify the Spain, Holland, the UK and France. But most promising areas in which to tap markets around the world have varying the capital markets. We also set out degrees of receptivity to institutional some areas where investors may need to debt and different norms. There remains flex their approach in order to meet the a great deal of confusion among both specific needs of infrastructure projects.

1 Introduction

There is a growing need for large-scale Demand for large-scale investment has infrastructure projects around the world. been complicated by the fiscal constraints In 2006, the OECD1 estimated that around in many countries. With shrinking 3.5% of global GDP, or approximately budgets, governments are increasingly USD2trn needs to be invested in electricity forced to choose between competing distribution, road and rail transportation, priorities. Economic infrastructure in telecommunications, and water particular can have a positive multiplier infrastructure annually or USD 53trn from effect on output and productivity. The 2010 to 20302. Adding in sectors such as challenge is finding innovative ways for ports and airports pushes the figure even value-adding infrastructure to be funded higher: including another USD11trn makes and financed4 in a manner that is the annual requirement USD3trn plus per sustainable for both governments and annum. In 2012, the World Economic infrastructure users. In this paper we Forum (in a report3 prepared in focus on the latter challenge, but note that collaboration with PwC) estimated global the former is top of mind for financiers as annual infrastructure investment and they evaluate the quality of infrastructure maintenance needs in excess of 4% of GDP. project opportunities. The needs are more concentrated in developing countries. If the OECD and Eastern Europe are removed from the average, the World Economic Forum figure rises to over 6% of GDP. In Africa and South Asia the estimated need is higher still at c10% of GDP.

1 OECD, Infrastructure to 2030, Vol 2: Mapping Policy for Electricity, Water And Transport. 2 OECD Infrastructure to 2030. 3 World Economic Forum, Strategic Infrastructure Steps to Prioritize and Deliver Infrastructure Effectively and Efficiently. 4 Financing is the time-shifting of infrastructure costs incurred, whereas funding is how the costs are ultimately repaid.

2 Some Banks Have Steadily Reduced Exposure to the Market

Admittedly, the end of bank financing for Where governments are not directly infrastructure projects has been predicted involved in financing projects (e.g. in the past, and banks are still making regulated utilities) in some countries, . But it is clear that many banks government is nevertheless providing which have provided the bulk of private support through enhanced tariff project finance through long-term loans structures and potentially providing before the Global Financial Crisis (“GFC”) guarantees for investors and debt have steadily reduced their exposure to providers. the long-term infrastructure market. If this level of support drops away because Some governments have got deals closed of continued strains on government by reducing the bank debt required, finance, insufficient risk transfer or often by committing to significant because the transaction size and deal milestone payments (i.e. 40% to 50% of pipeline increase significantly, that will the capital value of the project) either increase the natural underlying pressure during construction or when the project to seek non-bank finance routes. is built out. This structure effectively prepays some of the availability charge that would otherwise be paid to the concessionaire, reducing the required whilst attempting to retain a suitable risk transfer. In other cases, governments have more formally co-lent into deals, or taken on project risk by offering guarantees to the lenders. In still others, reliance on multilaterals such as the European Investment Bank has significantly increased.

3 The Rise of Infrastructure Project Bonds and Non-bank Lending

Given the market conditions we’ve central bank support, yields on quality described, we think there is a clear sovereign debt are still historically low. opportunity for the private sector to In turn, this creates demand from asset provide infrastructure financing via managers and investors seeking higher project bonds and non-bank lending. yield options, particularly where they After a number of false dawns (at least are trying to match longer duration or outside of the Americas, where project or inflation-linked obligations. Project bonds municipal bonds have been the norm for and non-bank lending could provide a infrastructure project finance), that trend flow of suitable highly rated assets direct is finally beginning to gather momentum. to pension plans and life companies. One contributing factor is that activity in the overall corporate bond market has A major reason for the slow uptake of been high. For example, the second half of infrastructure project bonds is a lack 2012 saw record levels of corporate bond of clarity (amongst both governments issuance. Even in the context of reducing and project sponsors) regarding the

Global volume by source of funding 2005 – H1 2013

US$bn 170 450 160 150 400 140 130 350 120 110 300 100 90 250 80 200 70 60 150 50 40 100 30 20 50 10 0 0 H105 H205 H106 H206 H107 H207 H108 H208 H109 H209 H110 H210 H111 H211 H112 H212 H113

IFI Govern loans Bank loans Bonds Equity Deal Count Source: Infrastructure Journal

4 feasibility of bond finance relative to No dominant project bond model has 2 A logical infrastructure project the “tried and tested” route involving yet emerged, and local conditions debt market would use short-term one or more of bank debt, multilateral will always vary. There are numerous bank debt markets e.g. construction finance and capital contributions. We financing solutions that are competing finance, with refinancing into the believe that infrastructure bonds have for investor and procurer attention, each long-term institutional markets, as substantial potential to expand beyond with different benefits and challenges. seen increasingly in the regulated the jurisdictions they are currently used, While the specific deal structure for each infrastructure utilities and leveraged but each such financing is still relatively market is likely to remain in flux, we think infrastructure acquisition markets. new and tied to the specific conditions the financing source for infrastructure The key risk with this model is what within individual markets. will increasingly transition from bank refinancing risk arises and who takes debt to institutional investors. While this it – users, investors, government, etc. Another traditional impediment – transition unfolds, we believe that both If this market were to evolve it would construction risk – is increasingly governments and project sponsors would reduce the need for institutional debt to being mitigated by targeted credit gain from a clearer understanding the take construction risk; and enhancements or (in some cases) priced prerequisites needed for such a market to A return, if any, of the securitisation in by sophisticated investors who consider take root. 3 market whereby banks would package the increased yield to be good value project finance loans and sell them relative to the risk taken on. This is A couple of words of caution: into the institutional markets, may particularly true of private placements obviate the need for institutions but increasingly public bond investors are Some of the institutional appetite is 1 to invest/lend directly to projects showing willingness to take construction driven by absolute return strategies themselves. The typical credit quality risk. We would recommend that investors whereby the low returns offered on of the infrastructure sector should consider the risk return profile carefully government bonds make infrastructure make this possible in future, provided in the context of actual recovery rates and bonds look attractive. If sovereign the worst excesses of the pre GFC available credit mitigation. In addition, yields increase sharply e.g. due to securitisation market are not repeated. construction risk might not be completely reversal of quantitative easing, the new for investors already taking this risk relative attractiveness of long-dated indirectly through the corporate bonds infrastructure debt will decrease; of (say) companies undertaking major capital projects.

5 Four Prerequisites

In most markets there is a considerable This effectively precludes investment in demand for infrastructure project finance. infrastructure that does not carry a The key issue is structuring and funding guarantee from government. This, in projects to a level where they become turn, undermines the rationale for a financeable. Moving to the supply side of specific project bond. Government has infrastructure project finance, there are little incentive to create a new, less some key criteria that need to be met in deep/liquid class of its own bonds and order to unlock the capital markets. pay a premium for its own covenant i.e. We have identified four main areas: where government is the counterparty as opposed to users. As such, an 1 Available capital outside important precondition for a project of the banking system bond market is a domestic capital market that has the flexibility to invest In most cases, this implies a stable and in a broader category of highly rated well-structured private, public or securities beyond just AAA/ third-sector insurance and savings government paper5. industry, with retirement savings and pension funds managed by investment 2 Sufficient governance professionals. Such a system creates a and transparency in competitive pool of capital which financial reporting generally seeks a wide range of debt investment opportunities. In some A functioning bond public market jurisdictions, institutional investors – not just for project bonds – requires require a domestic AAA rating for a significant amount of financial portfolio holdings which most infrastructure, including (at a infrastructure projects cannot achieve. minimum) adequate disclosure and

5 Notwithstanding this, suitably long duration government securities are important to provide a pricing benchmark for long-dated corporate and project bonds.

6 reporting rules. This is related to our pre-default) and even managing to a lack of clarity around tax first requirement in that a country normal-course waivers (especially exemptions. This was a key reason for very likely cannot have one without during the construction phase) can be the year’s delay in the Rodovias do the other. But for the purposes of this awkward. Options include private Tiete BRL 650m 12 year bond issue argument, we have separated them. placements, bank/bond hybrids originally planned for the summer of Even in developed markets such as the (where the bank adopts its traditional 2012. The delay necessitated rolling UK, the first generation of monoline agency role as well as funding/ over the bridge debt and, together with wrapped transactions often had little guaranteeing construction risks), slowing economic growth in Brazil, this underlying investment information expanded roles for bond trustees, use pressured the company’s ratings flowing to investors. This became of the electronic voting system and outlook at the time. In terms of level problematic for investors when the new-generation monoline wraps with playing field, withholding tax6 provides monolines’ credit quality deteriorated greater transparency for investors and on example as the treatment isn’t as there was little information with downgrade triggers. always level as between bank and which to manage the investments. The bond. For example, in Turkey, interest answer isn’t always more information, 3 Balanced tax and paid to foreign banks attracts zero though. Provision of additional commercial policies withholding tax, but interest paid to information for investors needs to be foreign bondholders that do not qualify balanced against public market The key needs here are clarity of policy as “financial institutions” attracts a information disclosure rules which and whether there is a level playing 10% rate (although it does taper down require timely dissemination to all field between bank debt and bonds. to 0% for maturities of 5 years or market participants. As such, an The importance of policy clarity can be more). This means the bond interest effective means of managing seen in Brazil’s project bond initiative rate needs to be higher than the bank confidential information (especially (Infrastructure Debentures or IDs) debt for the same project risk unless which was initially slow to take off due there is a bilateral tax treaty that

6 Some jurisdictions have rules in place regarding the treatment of interest paid to foreign investors. Such interest is commonly tax-deductible for the payor, and if the bondholder is in the same country, the recipient will be within the same tax system. But when the interest crosses borders and goes to foreign investors, governments are generally not able to tax the other side of the transaction. As a result, many governments opt to levy withholding tax against foreign recipients of interest.

7 reduces the rate. Credit support in a may be a gap between what these Where infrastructure is privately termination also differs between bank investors require and the project’s financed, it is often done so through and bond (discussed in greater detail underlying credit quality. Lower corporate guaranteed loans or bonds below). In terms of overall regulatory naturally helps, but there (either until completion or throughout treatment of bank vs. bond, France may still be a gap to be closed by the project life), meaning there is no provides an even broader example: bonding/letters of credit, state explicit reason to enhance the beneficiaries of the cession Dailly7, a key provided credit enhancements stand-alone credit quality of the component of infrastructure project (typically less than outright project. However, we can see countries finance in France, can only be banks. guarantee)8, commercial de-risking of currently dominated by a corporate/ This necessitates the use of a fronting projects and additional risk capital sovereign finance approach moving to bank or similar structure for either from either private sources or a more limited recourse model, institutional investors seeking to (increasingly) multilateral initiatives particularly where sovereign and/or finance projects. such as the European Investment contractor balance sheets become Bank’s Project Bond Credit stretched due to the scale of pipeline. 4 Project-specific credit Enhancement (“PBCE”) mechanism. A good example is Brazil where the support national development bank BNDES For many markets (including Brazil, has signalled that it can no longer The degree of credit support for India, Turkey and several countries in fund the majority of infrastructure. infrastructure projects varies Central and Eastern Europe) project As such, BNDES has been supportive dramatically by market. Not all level credit enhancement is not of Infrastructure Debentures by markets have a class of investors currently relevant. In these markets, sharing . seeking highly rated (but not a significant amount of infrastructure sovereign-guaranteed) infrastructure is either built by government directly debt. Even in markets that do, there or funded by state owned banks.

7 The Dailly tranche benefits from the public sector waiving the ability to make payment deductions on finance related to c80% of the project cost, meaning related debt service is essentially guaranteed post construction completion. 8 Such as the UK government’s Infrastructure Guarantees.

8 We believe these four criteria are generally necessary. However, they may not be sufficient as individual markets have their own characteristics. However, for governments looking to establish a private infrastructure project bond market in order to get infrastructure ventures financed, these four areas represent clear priorities.

Even where these four criteria are present, institutional investors will need to be flexible on certain points in order to present viable alternatives for public procurers and compete with bank solutions. In general, these include an increased tolerance for construction risk, offering deferred drawdowns to reduce negative carry9 and increasing flexibility on make-whole/prepayment penalties.

9 Being the shortfall between interest earned on deposit and interest paid on the bonds. As many bonds (in particular public bonds) are drawn down in a single instalment, to the extent the bond proceeds are spent over time - such as when an asset is being constructed – this shortfall can be substantial. As the project generally does not earn a return until completion, this shortfall generally needs to be borrowed up front, increasing the size of the bond. Some bonds however offer the flexibility of deferred drawdowns, eliminating the negative carry cost.

9 Market Segmentation

With these four prerequisites in mind, we have analysed the current conditions in markets around the world, and clustered countries and regions by the relative feasibility and attractiveness of financing infrastructure projects through the capital markets.

Green Amber Red Regions and countries where the Regions and countries where Regions and countries that still market conditions are largely in place governments are taking the necessary have significant hurdles before an already for an infrastructure project steps to implement an infrastructure infrastructure project bond market bond market: project bond market: is likely to develop, but where pilot initiatives are being developed: • Canada • Amber/Green: Middle East, Asia • Australia • Amber: Spain, Turkey • India • U.S. • Amber/Red: CEE • Africa • Mexico • Latin America, notably Brazil • UK • France, Benelux, Germany

10 Green

Canada is the country that most relies Traditionally, infrastructure project on the capital markets to finance finance in theUnited States has relied infrastructure projects. Historically, on municipal bonds. However, Canadian domestic banks did not lend infrastructure project bond activity has beyond five to seven years, regardless of been growing with programmes such as sector. For a time, European banks the Transportation Infrastructure Finance provided long-term debt for Canadian and Innovation Act (“TIFIA”) and Private projects, but they retreated to home Activity Bonds (“PAB”). While TIFIA is a markets after the GFC. With a number of low cost federal programme for up to Public Private Partnership (PPP) projects 49% of the cost of PPP and conventional in procurement at that time, sponsors transport infrastructure projects, it still turned to the bond market. From a requires the underlying project to be process perspective, it was a short leap, investment grade. This requirement helps given the existence of numerous Canadian bring discipline/viability to the project life insurance companies and asset selection and development pipeline, and managers who were experienced buyers also mitigate the reputational risk inherent of infrastructure/project finance bonds. in such a high profile programme. TIFIA Infrastructure bonds are also common in has supported long tenors/average lives Australia with recent issues in airports (including a 34 year loan on Virginia (Perth) and roads (ConnectEast), albeit Midtown Tunnel, alongside a PAB) and generally unwrapped post GFC. The AUD pricing akin to Treasuries. The 3.7bn Victoria Desalination project is government’s position is subordinated presently considering partly refinancing until an event of default, at which point it into the bond market. springs up. PABs are one way of making up the 51% not funded under TIFIA, but

11 (as for TIFIA) only transport projects are renewables sector, which will require (in 2011) a MXN7.1bn nonrecourse bond eligible. In addition, there is a ceiling on about USD150 billion in new construction related to Sarre and Papagos prisons, the PABs of USD15bn at present. USD4bn has through to 202213. MidAmerican Topaz first fully commercially financed been issued and another USD4bn is – one of the world’s largest photovoltaic greenfield15 social infra concession in allocated to projects10. As with municipal solar farms – raised USD850m in privately Mexico. More recently, Banobras acted as bonds in general, PABs have tax advantages issued 144A/Reg S 5.75% project bonds credit guarantor on the Red de Carreteras whereby the interest received is tax-exempt (due 2039) in February 2012, and another de Occidente concession sold to domestic to the investor and therefore the borrower USD250m in April 201214. and foreign institutions for USD1.16bn in can offer/pay a lower interest than would be long-term, peso-denominated notes to pay the case. This is effectively a tax allocation In Mexico, the central issue is for the FARAC I toll road, and Mexico from the federal tax base to the municipality insufficient pipeline as there is currently Generadora de Energia (“MGE”) issued and the infrastructure users. more funding available than projects. The USD575m of long-dated BBB paper for country has a sizable life insurance and two gas turbines at T+388bps. Outside of the transport sector, there is pension industry and government policies presently debate around introducing a implemented in the mid and late 2000s Brazil needs some USD50bn per year in structure similar to TIFIA for potable increasingly encourage funds to invest in infrastructure investment. As noted water and wastewater projects11 and, infrastructure projects. Since roughly above, the size of this pipeline is more generally, development of a loan 2008, state-owned Banobras has funded pressuring BNDES (funded by the federal and bond guarantee facility to states, the relatively small number of projects, government) which has recently had very local governments and non-profit and subsequently syndicated the debt. high lending levels. For example, in 2010 infrastructure providers in respect of That said, as the project pipeline grows, they disbursed around BRL168.4bn. transportation, energy, water, it is unlikely that Banobras will be able communications and educational facility to meet rising demand and increasingly infrastructure projects12. Lastly, much of there are long-dated project finance the market’s growth potential lies in the bonds. Notable recent issues included

10 http://www.fhwa.dot.gov/ipd/finance/tools_programs/ federal_debt_financing/private_activity_bonds/#current 11 See Title X of: http://beta.congress.gov/bill/113th- congress/senate-bill/601?q=%7B%22search%22%3A%5B% 22water+infrastructure%22%5D%7D. 12 http://beta.congress.gov/bill/113th/house-bill/2084 13 http://blogs.wsj.com/environmentalcapital/2008/08/29/ obamas-green-dream-would-his-renewable-energy-plan- make-a-difference/ 14 http://www.bloomberg.com/news/2013-06-13/buffett-s- midamerican-plans-700-million-solar-bond-deal.html 15 The project benefits from a priority budget allocation of the Mexican federal government. Minimum payments are at least equal to debt service, meaning the bonds are essentially sovereign credit.

12 In 2012 they lent around BRL156bn, BNDES participation. In this case the infrastructure programmes. This policy around 1/3rd of it on infrastructure16 BNDES participation will be structured as choice resulted in a package of measures While this remains a significant sum, it is a project bond, albeit via the same public and tools (including political pressure) to now reducing. tenors in bank used to disburse SUDAM funding. facilitate and stimulate pension fund Brazil are short, and Brazilian pension involvement. For instance, Columbia funds can generally only invest in assets In the rest of Latin America, as in and Peru have recently made changes rated A+ (local) or higher. As such, bridge Mexico, capital is generally available and to their legal framework to spur finance is common but there is a the problem is a lack of bankable projects. institutional investment into significant underlying demand (as well as Chile is seen as a relevant model for the infrastructure. However, the lack of a supply) for long dated infrastructure region; it established a project bond pipeline has meant that institutions have bonds such as IDs. In the first half of 2013, market in 1999, and prior to the GFC generally not had the business case to notable issues included the Triangulo do institutional investors were funding develop project finance structures Sol refinancing, Ecorodovias, CART, CCR significant deal volumes in this fashion further. Recent issues in Peru include and also Rodovias do Tiete’s re-launch of – as much as 50% of the total Terminales Portuarios Euroandinos Paita the planned 2012 issue. infrastructure pipeline. However, the which raised USD110m of long dated BB/ retraction of monoline bond insurers BB- paper at c350bp over, and also the PwC recently advised a toll road operator significantly impacted Chile, and the Peru Hospital PPP (USD320m). The latter on raising BRL 60m of bridge debt with country has not seen any project bond is a quasi-sovereign issue secured by two to eight year tenors across three issuances since then. EsSalud. This issue also mitigates tranches. The debt was rated BBB+ by construction risk for investors through Fitch to facilitate refinancing in the The governments of several countries in milestone based issuance of EsSalud’s long-term debt market. Following the region, such as Argentina, obligations. In July 2011, Invepar issued completion of public bank approvals Uruguay and Peru consider pension PEN1.17bn in inflation linked, private processes (which can be lengthy in funds as one of the key financing sources placement bonds to finance the 30-year Brazil), the bridge will be refinanced via a for enabling and accelerating the Via Parque Rimac toll road concession in mix of 20 year SUDAM17 funding and execution of their current or future Lima at VAC +650bp.

16 Source: BNDES 17 Being the federal development fund for Brazil’s northern and middle eastern regions. The fund is disbursed via three publicly owned banks.

13 the Edinburgh, Leeds, Salford and Alder In the UK, after a long hiatus, the first The Benelux countries (Belgium, Hey transactions, giving us unparalled half of 2013 has seen numerous Netherlands, and Luxembourg) insight into recent project bond issues. greenfield (i.e. with construction risk) and Germany are very advanced in their project bond issuances in the university application of project finance. Whilst The UK Treasury has also sponsored a accommodation, social housing and traditionally bank funded markets, cGBP40bn guarantee scheme. The scheme healthcare sectors. Notable issues in there is active exploration of capital was initially set up to provide credit student accommodation include markets solutions. To date, authorities’ enhancement to financiers where Uliving@Hertfordshire (GBP143.5m of procurement rules (particularly in the long-term lending was expected to no A- rated index-linked priced at 235bp Netherlands) have required committed longer be available. The significant over index linked gilts) and University of finance and this does not sit easily with decline in the volume of infrastructure Edinburgh which sold GBP31m each of public bond “” where the projects in the UK has meant that banks monoline-wrapped, index-linked and bond spread is only known just before the have so far been able to finance most of fixed rate tranches with spreads of 190bp launch. As such, the market is evolving the projects. The future use of the and 215bp over gilts respectively. In more towards private placements (where guarantee scheme is unclear, as project social housing, the Leeds Little London investors have offered greater price activity declines and capital markets and Holbeck Housing PFI sold GBP102m certainty) or bank to bond structures. innovate to plug the bank gap. It is of monoline-wrapped, fixed rate bonds at Over the last 12 months, two out of three possible that the guarantee will be 235bp over gilts. In addition, the Salford bids on Dutch projects have included targeted as projects that cannot be Pendleton Social Housing project issued such structures. The N33 road in the financed on a stand-alone basis due to size senior fixed rate bonds (at 190bp over Netherlands features a EUR78m index- or cost, hopefully without over exposing gilts), supported by a subordinated linked tranche which will partially the tax payer to project risk. tranche. In healthcare, the Alder Hey Children’s hospital raised GBP110m via a private placement bond. PwC advised on

14 take out (at a pre-agreed price) the Arguably the recent developments of bond In France, bank financing has been able banks financing the transaction upon financing were possible only because to fund the pipeline of current projects practical completion. In addition, the the bond investors became flexible on thus far. However, the market may be EUR300m Zaanstad prison project in the parameters that traditionally were deal- at a tipping point, particularly given Netherlands reached financial close in breakers for this type of project, namely the recent financial close of the Cité September 2013. The hybrid structure make-whole provisions and drawdown Musicale (July 2013) where the Dailly includes an institutional investor tranche periods. PwC advised the public sector on tranche of the debt will be subscribed alongside a subordinated, shorted dated Cite Musicale and is currently advising by an institutional investor who will senior bank tranche. PwC advised the the public sector on L2. refinance out the three banks providing government on N33 and the consortium construction loans. Most institutional bidder on Zaanstad. investors in France require relatively high

project credit ratings, which are often The A11 road in Belgium (currently at tough to achieve given construction risks preferred bidder) is actively evaluating and other factors. On Cité Musicale, the capital markets solutions, either directly investor coming in for the Dailly tranche or via a bank to bond structure. In post completion means the credit risk they Germany, projects considering the capital take is essentially local government rather markets include the A7 road and UKSH than project. However, institutional hospital, and PwC is advising bidders investors have demonstrated willingness on both projects. In addition to the to take construction risk in the French committed finance approach described market. For example, the Valence/Riom/ above, the Netherlands is expected to Lutterbach Prison PPP closed in January launch a preferred bidder debt funding 2013 with an insurer providing EUR100m competition pilot project in the next of the debt from financial close, and 12 months. The rationale for this is to L2 Marseille bypass may also feature increase the depth of competition in a allocation of the construction risk to the constrained financing market. institutional investor.

15 16 Amber/Green

Before the GFC, bank tenors in the The depth of corporate bond markets Middle East were long. Most projects varies considerably across Asia, making it were backed by government or difficult to categorise the entire region. In government owned sponsors, making particular, Malaysia has a vibrant bond bank debt accessible at relatively low cost. market which contributed approximately There have been some significant project half of the country’s private infrastructure bonds to date18, but compliance costs investments between 1993 and 2006. The associated with numerous securities laws Malaysian government took some notable and exchange listing have discouraged steps to spur this market, including some sponsors. mandating the use of credit ratings for corporate bonds as of 1992. In addition, Post GFC, bank margins for 10+year the Republic of Korea has a substantial tenors remain high and tenors beyond 15 corporate bond market which has years are a challenge. In response, some previously financed infrastructure. Other procuring authorities have relaxed regionally significant corporate bond committed finance requirements, markets include China, Japan and allowing the use of mini-perm financing Thailand20. Export credit agencies and to support bids. However, large scale multilaterals such as the Asian project finance in the Middle East now Development Bank are active in requires support from external credit supporting infrastructure finance, agencies, other forms of financing such as including through credit guarantee Islamic lending, and other multilateral programmes. However, with the lending agencies which means the process exception of Malaysia, Singapore and the is not as simple as it used to be. Republic of Korea, the OECD estimates Considerable guarantees and contractual that total assets held by pension funds, commitments are required before such life insurance companies and mutual financing can be secured, and these funds are small relative to GDP in East factors are increasing the attractiveness of Asian economies21. As such, in many Asian project bonds. In August 2013, Shuweihat countries the preconditions are not yet in 2 IWPP19 in Abu Dhabi became the first place to support private project bonds. project to be refinanced in the bond 18 Such as the USD3.4bn Ras Laffan Liquified Natural Gas Company issue, Dolphin Energy’s USD1.25bn issue and the market with a USD825m A- rated 6% 2036 2011 Saudi Aramco Total Refining and Petroleum Company 144a/Reg S issue. project sukuk (Shari’a compliant project bonds). 19 Independent Water & Power Producer 20 http://www.bis.org/publ/bppdf/bispap63.pdf, pg.6 21 http://www.oecd.org/daf/fin/public-debt/45811325.pdf, pg 52.

17 Amber

Spain’s fiscal challenges are well- Central and Eastern Europe (CEE) publicised, but a gas storage project falls somewhere between amber and red. (Castor) in the country has recently given Most CEE countries have virtually no the EIB its first financial close using the market for non-bank infrastructure PBCE instrument. In addition to providing project finance, and in some cases the PBCE facility (akin to a long term (particularly Russia) project finance letter of credit, ranking junior in order to remains the preserve of state-owned credit enhance the senior bonds), the EIB lenders. Many countries have low also bought EUR300m of the senior sovereign credit ratings, pension funds bonds. The project was a refinancing, that are primarily state-sponsored, a lack meaning investors did not take of well-prepared and recurrent construction risk, and reached financial infrastructure projects and political close in July 2013. The large size and long uncertainties which lead to regulatory tenor of the issue (EUR1.4bn, 21.5 year risks. While there has been significant bonds) arguably favoured the public bond improvement in putting the right enabling route. The issue was rated BBB+ at legislation in place, much of it remains launch22, one notch above Spain’s untested. In addition, multilaterals such sovereign rating of BBB. For investors as the EIB and European Bank for requiring investment grade (i.e. BBB-), a Reconstruction and Development (EBRD) sovereign rating of BBB doesn’t leave provide significant amounts of much room in the structure for project infrastructure finance in the region. risks hence the importance of PBCE or other credit enhancements. Without such In some stronger CEE countries, enhancement, investor appeal may be particularly Poland, international banks relatively narrow, suggesting that project are willing to lend to domestic projects. bond gearing levels and/or underlying Until recently, significant amounts of risk may need to remain relatively low infrastructure have been funded with EU until Spain’s sovereign rating improves. structural resource and domestic public

22 On 1st October 2013, Fitch put Castor’s bonds on credit watch negative following seismic activity in the vicinity (source: Thomson Reuters).

18 money at both the central government change if governments force pension such, bond investors have less certainty of and municipal levels. This has crowded funds to invest a minimum proportion of recovery in a default scenario than bank out private finance. This however may their portfolios into infrastructure (i.e. lenders for the same project risk. The change as EU funding principles may mandatory minimum sector limits). market remains very corporate and become more commercially/debt oriented Progress in individual countries may vary relationship driven, and when sponsors and government budgets are stretched. as significantly as their relative macro- do access the bond market they often do The demand for new sources of economic performance does. In general, so decoupled from specific projects. infrastructure finance may be potentially we expect the Polish corporate bond Turkey acknowledges the need to increase met by insurance companies, government market to grow strongly. However, from a the average life of its debt financing at a initiatives such as PIR (the Polish project bond perspective, secondary sovereign/quasi-sovereign level. Using Development Investment Fund) and markets are relatively immature and long-tenor project bonds to privately inflows from international infrastructure issuers may find the liquidity premia finance key infrastructure may be one funds that already have a foothold in the required by investors unattractive. way to deepen the market, but this will be market (e.g. power sector, sea logistics). challenged by the lack of suitably long Major infrastructure financing may also Akfen and PSA in Turkey have recently duration sovereign debt pricing come from or through large corporates, launched a seven year bond refinancing benchmarks. especially in the power and chemical Mersin International Port. However, sectors. project bonds at a PPP level have a way to go yet. There are relatively few domestic As a result, while CEE countries indicate institutional investors and the corporate that they are open to capital markets bond market is not yet very deep. In financing for infrastructure, we don’t addition, the post-termination debt anticipate that this market will take off assumption agreements that apply to PPP until the concept becomes more transactions above a certain size cover established in Western Europe. This may bank (but not bond) transactions. As

19 Red

There are however numerous policy and In India, privately funded market structure challenges. Infrastructure infrastructure is done via bank debt companies are not frequent issuers in the rather than bonds. The largest global corporate bond market, investors are project finance lender for Thomson generally unable to fund infrastructure Reuters’ Project Finance International is SPVs due to their typical structure as the government owned State Bank of unlisted private companies and investor India. The country’s 12th Five Year Plan rating requirements can preclude (which covers 2012 through 2017) widespread participation in infrastructure. considers that insurance and pension There are two broad options to overcome funds will be a key source of these challenges: one being to refinance infrastructure finance. Such funds have out banks at stable operations (although grown in the past decade due to the banks have shown little inclination to favourable demographic trends, but exit, despite Basel III) and the other to remain proportionately small. Yet there create an infrastructure debt fund for is effectively no project bond market pension funds/insurers. thus far. During the 11th plan, nearly half of all infrastructure finance came The second option is a challenge for from public-sector capital, and another greenfield projects as Indian institutions third came from commercial banks and are traditionally not comfortable with non-bank finance companies (NBFCs). construction risk. While some overseas Over the longer term, however, we do investors may be more comfortable with not think that banks will be sufficient to this risk, India’s current international fund the entire pipeline. The banking sovereign rating of BBB- leaves little to sector cannot lend more than 15% of their no headroom for project risk, particularly net worth to a particular sector (and 25% for investors that require investment to a particular group). However, bank grade23. This suggests that domestic credit to the infrastructure sector has investors will need to get comfortable reached 13.5%. with construction risk.

23 BBB- being the lowest category of investment grade.

20 The first option is still challenged by the revenues to secure financing. Nonetheless, South Africa has a developed bond minimum rating requirements for pension 2012 and the first half of 2013 saw market in place, and sizable life insurance and insurance managers to invest significant Eurobond issuances, notably and pension markets. Some institutional (typically domestic AA or AAA), well Ghana (USD750m 10 year bonds), Rwanda investors have bought into projects post below the typical BB structured project. (USD400m 10 year bonds), Zambia completion, but have not yet shown much Traditionally there have been no credit (USD750m 10 year bonds), Tanzania appetite for construction risk. The wrappers to bridge the ratings gap. (USD500m seven year private placement) infrastructure market in South Africa is However, the India Infrastructure Finance and Angola (USD1bn 7 year private dominated by state owned utilities such as Corporation (IIFCL) and the Asian placement). Although local capital markets Transnet and Eskom who finance Development Bank (ADB) have recently are dominated by dollar bonds, in February infrastructure on balance sheet. The signed credit enhancement documents for 2013 IFC issued a five-year, local currency largest project finance programme to date the GMR Jadcherla Expressway as a pilot NGN12bn denominated bond (cUSD75m) is to support investment in the ambitious project. The purpose of the guarantee is to in Nigeria as part of a program to deepen renewables PPP program which the raise the rating to a point that the project the domestic bond market across Africa. In domestic banks have so far financed can refinance in the bond market when September 2013, Kenya issued its sixth comfortably to the surprise of some the bank facility matures or reaches a infrastructure bond for KES20bn international investors. Nevertheless, the price reset point. (cUSD230m). implementation of Basel III in general and

a growing pipeline of projects could spur In Africa, many countries need to deepen It is important that African issuers appeal greater demand for capital markets sovereign and multilateral bond issuance to investors by focussing on the “basics” of financing. In particular, round 3 of the as a precursor to corporate and project increasing transparency in the financial renewables program will drive cZAR30- issuance. Across most of the continent, markets and coordinating more effectively 40bn across 1,000MW of capex. reforms to date have focused on getting across borders. The specific needs of each sovereign bonds issued, often to finance country vary, but commonly needed infrastructure development. Many reforms include deregulation, a lifting of sovereigns are not rated, and those with capital controls and stronger governance natural resource revenues often need to set and disclosure. up a sinking fund committing future

21 Conclusion

Following an abrupt decline since pressure to reduce levels of lending as 2007/8 and much discussion thereafter, they are not immune to capital and viability of capital markets financing for liquidity constraints, either regulatory or infrastructure has reached a tipping political. At the same time, governments point – in particular over the past 6 to 12 are looking to increase infrastructure months. Although volumes never really investment to support economic growth. declined in some markets, i.e. Canada Given the regulatory pressure on banks it and the US, there have been notable is very difficult to see them financing developments in markets such as Brazil, infrastructure at pre-GFC volumes or Spain, Holland, the UK, France and the terms should investment levels recover. Middle East. Banks are continuing to This gap will need to be filled by capital lend, but will likely be unable to meet the markets products – directly or indirectly financing demands of a growing project – continuing the recent evolution of the pipeline. New banking regulations make project finance market. It is now clear that long tenor project finance loans even less institutional investors are keen to support attractive, and sovereigns are only like to the infrastructure market where projects face continued fiscal pressure. are sensibly structured.

The decline in available long term debt In the context of these factors, (from non-government banks) has infrastructure bonds hold clear appeal coincided with declining global deal flow for institutional investors, project post GFC. Any gap that would have sponsors and governments seeking to get opened up has been financed by projects funded. Some clarity regarding multilaterals, procurers (with capital the preconditions that must be in place contributions) and state owned banks to – and the relative attractiveness of this keep infrastructure programmes on model in markets around the world – track. Nevertheless, the multilaterals and will help all three groups identify and state-owned banks are increasingly under capitalize on the opportunities.

22 Contacts

Richard Abadie David MacGray Global Capital Projects Infrastructure Director & Infrastructure Leader +44 20 7213 3557 +44 207 213 3225 [email protected] [email protected]

Regional Contacts:

Africa Middle East Shraveen Ramdhar Afaq Mufti +27 (11) 797 4552 +971 (0) 2 694 7498 [email protected] [email protected]

Central & Eastern Europe SE Asia Jan Brazda Mark Switkowski +420 251 151 296 +62 811 9523234 [email protected] [email protected]

Latin America Jorge Sere +598 29160463 Int 1470 [email protected]

23 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without performing appropriate due diligence and/or obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on this information contained or for any decision based on it.

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