Refinancing Risk

Infrastructure November 2012 Update Refinancing risk The funding environment for infrastructure PPP projects is much less favourable than it was two years ago. Whilst the increase in margins since pre-financial crisis continues to a large extent to be offset by the reduction in base rates, the real issue is that capacity for long tenor debt is extremely limited. When the terms on which debt is available no longer match those of the underlying project, the issue of refinancing risk arises. If only shorter term debt is available, assumptions must be made at financial close that the project company will in the future be able to refinance its debt within certain parameters of timing, price and other terms, and there is a risk that those assumptions will not be adhered to in some respect. There are various manifestations of be fully attainable (for example where refinancing risk – the cost of finance there is no liquid market). As may be higher than assumed, or it between the lender and the sponsor, may be unavailable, or only available it is standard for the finance on terms that are not compatible with documents to include provisions the existing transaction structure which reallocate the risk between or documentation. In the absence of them, for example cash sweep measures to mitigate or reallocate provisions which require cash to the risk, it naturally falls in the first be retained by the project company instance on the project company/ which might otherwise be available sponsor (inability to refinance will to pay distributions, thus improving result in default, and a refinancing on financial cover ratios and making the more onerous terms will affect the project company a more attractive sponsor’s return and may necessitate proposition for any potential the injection of additional equity), and refinancing lender. The causes of on the incumbent lenders (who must refinancing risk include credit issues weigh up their potential exposure such as poor performance by the on contractor default termination project company as well as changes against the prospect of continuing to in market conditions. fund the project perhaps at a loss). Before the financial crisis the Depending on the circumstances it issue of refinancing risk was rarely may also fall on the public sector: considered: the tender documents although it is a key principle in most required committed long term PPPs that if the project has to be financing consistent with the retendered due to project company financial model from the outset, and default, the effects should not be because this was readily available, adverse for the authority, in some the risk did not arise. However the circumstances that objective may not contraction of liquidity which followed the onset of the (iii) bank to institutional investor solutions, i.e. bank credit crisis threatened to derail projects that were nearing finance during the construction phase refinanced by financial close such as the UK Highways Agency’s DBFM institutional debt in the operating phase project for the expansion and maintenance of the M25. In None of these solutions is without significant complexities. that case, adherence to the requirement for long tenor debt In relation to the first, the main issue is conditions in the resulted in the lenders requiring sufficient margin step- secondary market. On the supply side, the cost of funding ups and other enhancements for them to feel comfortable of many project finance banks is higher than the interest that if the project company did not refinance in the rate under the loan, however they are reluctant to realise medium term as intended, the unitary charge would still a loss by selling at a discount, and in the case of hedging be sufficient to support their cost of funding for the full banks there may also be concerns about orphaning a term of the loan. In effect, the authority bore the premium swap exposure. Portfolios have been sold in individual associated with a full assumption of refinancing risk by cases where the seller has for specific reasons not been the lenders. subject to the sale constraints, including to institutional It was recognised that the future condition of the capital investors – e.g. the Bank of Ireland’s sale of a portfolio of markets was highly uncertain and that if the situation UK infrastructure loans to Aviva Investors in June this improved the conventional 50/50 allocation of refinancing year was specifically sanctioned by the regulator. In the gains would be inappropriate, so the authority’s proportion longer term, as the costs of Basel III start to be introduced was increased, and the authority was given the right to and escalate, project companies may also start to feel initiate a refinancing to reflect the importance to it of the pressure, as in most cases banks are entitled to pass obtaining cheaper funding if and when it became available. these costs on to the borrower. However the exit route for the borrower in these circumstances would normally be Since then, it has become apparent that for a number of to refinance the debt, and the resulting refinancing gain reasons significant levels of liquidity for long tenor bank would have to be shared with the authority. debt are unlikely to be restored in the foreseeable future, although banks are likely to remain an important source In relation to the second model, many commentators of short term capital, and the agenda has shifted towards have argued in favour of a solution based on enhanced accessing institutional investors as a possible alternative credit/performance support from the building contractor. source of long term finance on the assumption (yet to be However this is likely to be difficult to achieve in an fully tested) that private finance will still be capable of environment where contractors’ balance sheets are under providing value for money on a risk-weighted basis. Given increased pressure, and from a policy perspective any the fundamental nature of this change, it has generated intervention designed to promote this approach would questions and issues at a number of levels. However, have to be weighed against potential adverse effects in refinancing risk has remained integral to the debate at terms of market access and the costs associated with several of these levels. the additional support. In relation to support directly at borrower level, IUK has recently provided some details of One approach which many commentators have naturally the approach it will be following under the UK guarantees focused on is to seek to identify short term impediments scheme to be enabled by the Infrastructure (Financial to institutional investor participation. Construction Assistance) Bill which is currently being fast-tracked risk is a particular area of concern as the construction through Parliament. Although there is a considerable phase involves a higher degree of risk than the operating amount of flexibility in terms of the products to be made phase, and even amongst those investors who see a high available, the most natural application is likely to be degree of correspondence between their risk appetite and providing a monoline-style comprehensive credit wrap that of project finance banks historically, many argue with a view to achieving a high investment grade credit that institutional investors need to develop their risk rating and thereby accessing the wider capital markets, management resources and expertise before they take on rather than targeting specific risks. It is also possible that a significant exposure to construction risk. the scheme could be used to provide a construction phase A variety of possible models exist for addressing these guarantee for the benefit of institutional lenders. IUK has concerns about construction risk, principally: explained that the Treasury has been in correspondence with the European Commission and is confident that no (i) mitigation through a portfolio approach (i.e. allowing state aid is involved as the pricing will be set to satisfy the a limited proportion of construction phase assets in a market investor test, however potential beneficiaries are portfolio of predominantly operating phase assets) likely to want to explore the position in detail as the risk (ii) credit enhancement, either through guarantees of an adverse finding would fall on them rather than the or other credit support, or the provision of aid provider. subordinated debt The third model has a number of attractions, particularly to make fixed price takeout financing available for 70% because it makes use of short term bank liquidity. However of the senior debt. In order to access competitive pricing the issue of refinancing risk has generally been seen as the from pension funds the government offered to apply impediment. It might be possible to build a safety margin RPI indexation to up to 70% of the portion of the unitary into the unitary charge (to be recovered through the charge corresponding to senior debt service and bids refinancing mechanism to the extent of any surplus), but with different indexed and fixed rate components were in the absence of committed (and collateralised) fixed price compared with each other based on prevailing swap rates. takeout funding there is always a risk that the refinancing Bidders were also required to submit bids based solely will fall outside the assumed parameters leaving a residual on bank debt, in order to demonstrate that any financing risk with the sponsors and/or with the authority. Applying plan they submitted involving pension fund debt produced a conventional value for money analysis to the allocation a lower cost of funding. The index linked portion was of this risk it could be argued that it is essentially capped in order to retain the oversight expertise of the outside the sponsors’ control (with the exception of project finance banks.

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