The growing role of institutional investors in infrastructure finance
January 2016 | EXPERT BRIEFING | FINANCE & INVESTMENT
The need for infrastructure investment around the globe far outstrips the funds available from banks – historically the only organisations able to fund new infrastructure without direct recourse to the balance sheets of governments or major corporates. Governments, commentators and corporate sponsors of infrastructure projects have long held up institutional investors as white knights able to fill this funding gap. The ability of institutions to provide debt more cheaply than banks has made the elusive possibility still more attractive.
Banks have been able to invest on a limited recourse basis because of their expertise in using project finance structures; a form of lending in which almost all risk is transferred away from the borrower to other parties involved in a project (for instance construction contractors, operating contractors, suppliers and/or offtakers). If the borrower is able to transfer project risks to these parties at an efficient price, it can make a sufficient surplus from the income stream of the project to service loans from banks. This means project finance lenders do not assess the strength of a borrower’s balance sheet. Rather they assess the robustness of the risk transfer in the project’s contractual structure, and the projected income stream of the project.
This is not a passive process. Banks’ deal teams take an active role is establishing deal structures, based on their appetite for and assessment of the relevant risks. Once a structure is established these risks continue to be monitored and actively managed, especially during the construction phase when a project is most vulnerable and rarely income generating.
Once constructed, project financed infrastructure has a number of characteristics that make it highly attractive to institutional investors – particularly to pension funds or insurers looking for long term predictable yields to match their liabilities. Long term stable returns are also attractive to sovereign wealth funds, sometimes also motivated by political considerations. For these reasons, institutional investors have long participated in the secondary market for infrastructure – buying out bank positions once construction is complete. The downside of this approach for institutions is that once a project is operational, its reduced risk profile means it provides a lower return.
Put the other way round, higher returns are available to lenders prepared to take infrastructure construction risk. In the low interest rate climate of recent years, this incentive has pushed a number of institutions to try and take construction risk where previously they wouldn’t have.
There are, however, problems with this approach. The need for intense deal team scrutiny explained above (the Decision Making Problem) and the credit risks inherent in lending to a project in construction (the Credit Risk Problem) present issues for most institutional investors. The traditional solution was provided by monoline insurers, which solved both issues by insuring the institution’s debt and in return for the risk, taking on the task of structuring the deal. Although the model worked, most monolines were heavily exposed to US subprime mortgages and their offering became less available after 2008.
In the gap the monolines left (and against a background of retrenching banks and public need for infrastructure) a number of state and quasi-state actors came forward to provide alternative credit enhancement structures. The most notable of these in Europe were the Project Bond Credit Enhancement (PBCE) product offered by the European Investment Bank (EIB) and the Infrastructure UK (IUK) Guarantee. Both of these offer a solution on terms roughly analogous to the historic monoline model – the EIB (in the case of PBCE) or UK government (in the case of IUK) take a portion of the credit risk and in return a portion of project control.
Eight PBCE transactions have now closed and more are in the pipeline. Assured Guaranty continue to offer monoline style products and the IUK Guarantee have successfully taken projects to close in the last 12 months. The Juncker Plan – the infrastructure package that the President of the European Commission, Jean-Claude Juncker has promised to deliver through the EIB – looks set to roll out credit enhancement on a grand scale.
Each of these structures have enabled institutional investors to participate in greenfield infrastructure projects, by externally solving the Decision Making and Credit Risk Problem. Of equal and potentially greater significance over the longer term, are the few projects backed by institutional investors that have closed without any credit enhancement at the project company level. In the UK, these have included major greenfield roads and hospital transactions.
These have been made possible by a number of structural and institutional developments which have helped to overcome the bondholder Decision Making Problem, as well as other structural issues, such as the negative carry on a complete ‘day one’ drawdown of bondholder funds.
The most significant of these developments is the emergence of investment managers with the depth of experience necessary to overcome the Decision Making Problem internally. In the past, in Europe as in the United States, a wide range of institutional investors purchased monoline protected project bonds directly. In post-2008 deals, investments have increasingly been made through the funds, or as co-investors relying on an investment manager to make leading decisions. For instance, the London Borough of Haringey Pension Fund has invested through Allianz GI’s UK Infrastructure Debt Fund while the Anglian Water Pension Fund has co-invested with Allianz directly.
The approach also sits well with a private placement structure and will likely become even more prevalent if private placements begin to supplant listed offerings as investment mechanisms.
Another enabling development has been the emergence of joint lending between institutional investors and banks. While project finance bank lenders retreated in the immediate wake of the 2008 crisis, a number remain strongly committed to the market and are actively seeking investment opportunities. Basel III, however, and particularly the liquidity ratios it is introducing, will make it increasingly difficult (or expensive) for them to fund for the full tenor of project debt. This can sit well with the needs of institutional investors, who are often focused on finding long term returns to match their liabilities. An approach which has been used on a few deals is that banks and institutional investors co-invest as senior lenders, with the bank debt amortising ahead of the institutional debt. Some banks and institutions have also entered into framework agreements, based on lending together on a repeat basis – this has the advantage of helping to solve the Decision Making Problem (by placing some structuring responsibility with the bank partner), while enabling the bank to bid for deals with the advantage of a significant co-lender.
Whichever structure is followed, it appears that institutional investors are becoming accustomed to lending into construction phase infrastructure projects. The investors that have begun to access the greater yields available from this participation are unlikely to revert to the more limited secondary market in future. The trend seems set to continue.
David Carter is an associate at Norton Rose Fulbright LLP. He can be contacted on +44 (0)207 444 3306 or by email: firstname.lastname@example.org.
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