In addition to funding their own projects, companies with healthy balance sheets are set to increase their investment in projects that would previously have been funded from state coffers. In this article, we look at the evolving world of project finance.
PwC’s Capital project and infrastructure spending outlook to 2025 report estimates that annual infrastructure spending will grow from $4 trillion in 2012 to more than $9 trillion by 2025, with $78 trillion spent globally between 2014 and 2025. The firm says private investors may be called upon to foot a higher proportion of costs, even for traditional public sector projects.
However, project finance is also attractive to private sector organisations because they can fund major projects off balance sheet. Project finance is the financing of long-term infrastructure and industrial projects where debt and equity used to finance the project are paid back from the cash flow generated by the project. In other words, it is a loan structure that relies primarily on the project’s cash flow for repayment. A review of global project finance deals in 2014 conducted by Dealogic values total investment at $407.8 billion, the third highest full year volume on record. More than 1,100 deals were completed last year – the second highest full year activity on record – with energy-related projects accounting for one third of global volume.
In a working paper on project finance published in August 2014, the Bank for International Settlements (BIS) observes that it depends on a sensible transfer of risks and returns and that if done properly, the involvement of the private sector can improve infrastructure project efficiency.
Doug Segars, Associate Managing Director of Moody’s EMEA project and infrastructure finance team, explains that bank lending has picked up through Japanese banks, some European banks returning to the market and a number of new banks that are more significant now than before the financial crisis. “Public bond issues appear sporadically, but the real story is private debt – both for new projects and as a source of refinancing for existing bank loans,” he notes.
Segars refers to significant appetite for greenfield projects, with investors with defined mandates chasing well-structured projects in sectors such as renewables. “Even demand-risk projects (where there is a risk that a demand forecast may not meet the actual demand) are once again financeable as long as sponsors are realistic. It is very much a borrower’s market at the moment and – barring countries that present clear political and economic risk – we see interest from investors for projects across the world.”
There is very strong appetite in the capital markets for infrastructure project exposure (both equity and debt) says Michael Wilkins, Managing Director Infrastructure Finance ratings at Standard & Poor’s. “Commercial banks have been interested in debt exposure since the early days of project finance in the 1990s and this level of interest has risen in recent years. The other source of finance is institutional, including pension funds, insurers, sovereign wealth funds and asset managers who are looking for long-dated exposure with stable cash flows,” he notes. Banks (commercial, multilaterals and export finance) account for 80% of total project finance, with the remainder made up mostly by project bond issues, he adds. “Banks like projects with strong sponsors, such as an oil and gas project backed by one of the oil majors.”
Investor considerations
Yield pick-up relative to comparable asset classes is one of the factors investors will take into account when considering whether to back a project, concludes Wilkins. “The average yield on a sovereign bond is around 2%, whereas infrastructure projects generate 3.5-4%.”
Most of the assets in the infrastructure space have behaved in a very predictable way, generating steady returns over a long time horizon. That is the view of Giles Frost, Chief Executive, Amber Infrastructure, who describes one of the benefits of project finance as being that the returns are largely (or in some cases completely) uncorrelated to wider economic factors.
According to the BIS, it is necessary to broaden the potential group of investors beyond direct equity investors and banks. When considering the appeal of infrastructure investment, Frost draws a distinction between the relatively small number of treasurers who have access to long-term cash – for example, those working in insurance companies who are looking for assets to match their long-term liabilities – and the much larger group who are focused on efficient cash management.
“For the latter, listed infrastructure funds are a good way of accessing this asset class. These funds show many of the characteristics of the underlying assets but can be easily traded in and out of.”
He states that treasurers tend to favour investment in their domestic market, with those in the UK and US displaying the most international tendencies. “The profile of London as an international financial centre and the access to a variety of experts that this entails means UK treasurers tend to get offered a wider variety of investments.”
Manish Gupta, Head of Infrastructure Corporate Finance at EY, suggests that anyone looking to invest for a period shorter than seven to eight years should be looking for alternatives to infrastructure investment. “There are many infrastructure debt instruments that are liquid, such as government guaranteed bonds issued by Network Rail or high credit quality bonds issued by infrastructure companies such as Heathrow Airport and regulated utilities. I am aware of many institutional investors who have invested in high credit rated bonds, in some cases as a replacement for gilts.”
When it comes to investment preferences, he agrees that treasurers tend to prefer other markets where the same language is spoken, but adds that most treasurers in developed markets will have an aversion to considering treasury investment options in developing markets. “There is some nervousness around projects in less developed economies in Europe and further afield, particularly where the currency is not linked to the pound or dollar.”
It is possible now for mid-market firms to raise facilities on a corporate level to finance long-term projects with maturities of ten years or beyond, which was not the case even two years ago explains Nedim Music, Assistant Director, Corporate Finance Debt Advisory at Deloitte UK. “The project finance market is very liquid at the moment. Insurance companies and pension funds are hungry for yields and looking to deploy capital, so there is a lot of appetite for infrastructure assets.”
For corporates looking to invest in infrastructure projects that they are not directly involved in, Gavin Quantock, Assistant Director at Deloitte Corporate Finance, suggests that this might not be the most efficient way to invest surplus cash.
“Certain infrastructure assets can be an illiquid market for long-term investors, whereas a corporate treasurer would typically be looking to deploy surplus cash for as little as six and no more than 24 months. The requirement for extensive due diligence is a further reason why corporate treasurers could look elsewhere for short-term returns,” says Quantock.
Increasing appeal
One of the factors that would increase the attraction of project finance investment is where the project is of strategic importance to the company and can be financed internally until it is operational and could be refinanced. An example might be a food company financing the construction of a biomass energy facility from its balance sheet in order to create a reliable source of energy and increase the sustainability of its production facility.
Rod Morrison, Editor of Project Finance International at Thomson Reuters describes availability of finance for private sector projects as very good. “There is a lot of long-term debt available from banks and institutional investors and swap rates and loan margins are very low, which is positive for clients.”
Multilateral and export credit agencies are an important source of funding in less developed countries, but elsewhere there is a considerable volume of commercial debt available with the market having fully recovered from the effects of the global financial crisis, he continues. “Liquefied natural gas schemes and oil and gas projects in general are most favoured, although they are being impacted by falling oil prices. Renewable projects with strong tariffs or schemes with good sponsors are also attractive. Regionally, North America is doing well due to the shale gas boom, while Australia has benefited from major infrastructure projects.”
On a transactional level, there is consistent and heavy oversubscription of project finance transactions in primary phase in both bond and loan markets as well as broad and constant demand for assets in the secondary market with far fewer sellers than over the last two to three years, says Jean-Francois Grandchamp des Raux, Global Head of Energy and Infrastructure Group at Crédit Agricole CIB.
“There is strong and robust appetite amongst the leading project finance banks to underwrite transactions and we are starting to see underwritings re-emerge as a favoured strategy compared to traditional large club transactions. Furthermore, sponsors have stronger leverage and increasing diversity of funding options available to them, which provides them with a strong ability to secure more attractive terms and conditions, particularly pricing where we have has seen large reductions across the board over the last 12-24 months,” he says.
According to Grandchamp des Raux, the capital markets and institutional investors are increasing their market share particularly as the project finance bond option becomes a more mature, deliverable and readily available source of financing for private sector projects. This is particularly relevant in Europe where it has partially replaced some loss of the liquidity from those banks who exited the market in the immediate aftermath of the global financial crisis and the subsequent European sovereign crisis in 2011-12. “As the liquidity pressure on the Eurozone has receded and banks restructured their asset base as well as rebuilding their capital positions, we have seen a strong return of bank liquidity into the project finance product in 2013-2014.”
He describes export credit agencies and multilaterals as continuing to play an important ‘anchoring’ role in emerging and developing countries to bridge liquidity gaps and help facilitate private sector financiers to gain more comfort around sovereign and political risks. There is also evidence of government intervention in the form of credit enhancement mechanisms becoming less relevant for most sectors as liquidity constraints for project financing have disappeared, with the exception of specific sub-sectors of the market which remain challenging for private sector financiers, such as nuclear power.
“The strongest global demand from international commercial lenders is for assets structured in the investment grade arena with limited construction risks. These projects typically benefit from having strong/experienced sponsors and core developed geographies in key sub-sectors such as utility networks, energy and public-private partnership transactions.”
Geographic focus
Grandchamp des Raux says that countries experiencing substantial growth in investment are in North America (particularly in the energy sectors) and also in Latin America, which represents a considerable opportunity for sponsors and lenders given the macroeconomic outlook/performance combined with relatively under-invested infrastructure. “Banks, in particular, have become increasingly focused on their broader client relationships and geographic focus when deploying capital to projects as they have had to manage their balance sheet constraints in the face of the tougher regulatory environment.”
There is also strong interest in projects in the Middle East and Africa as well as Europe, says Quantock. “The European Commission’s infrastructure plan commits to an investment of £315 billion over the next three years, which means there are a considerable number of transport projects in the pipeline. Energy infrastructure such as solar, on- and off-shore wind, carbon capture and storage and biomass is also high on the agenda.”
According to Deloitte’s Music, lenders are looking for projects with solid sponsors and advisory teams. “Whilst there is more capital to be deployed than there was a few years ago, lenders will want to see evidence of previous successful project delivery. It can be hard to find financing for new technologies.”
The overall financial structure and visibility of earnings also impact on credit quality, adds Music. “There is greater interest in private finance initiative or PFI infrastructure assets where there is an annual government contribution – investing in a toll road where future income depends on the number of vehicles that use the road is clearly less predictable.”
Elsewhere, John-Patrick Sweny, a counsel in the project finance group at Latham & Watkins says the recent focus of multilaterals and export credit agencies appears to have shifted from developing country projects to projects in developed countries. “While the amount of capital markets debt for project finance transactions is not currently experiencing the same growth as for bank loans, project bond debt continues to make up a significant share of the overall debt mix globally and is playing an increasingly important role in the financing of projects in certain regions, for example Europe.”
Transport and infrastructure projects in certain jurisdictions (US, Australia, Mexico) continue to attract high levels of investment and there are signs of increased investment in African infrastructure projects, which historically have struggled to attract private sector investment, as investors are forced to seek out more attractive yields in a low interest environment, Sweny continues. “Recent large mining deals in Australia – such as the Roy Hill iron ore project – are outliers in a sector that has traditionally relied on corporate rather than project financing and continues to experience difficulties in Africa and elsewhere.”
When it comes to making a project attractive to investors, he refers to the importance of robust commercial and financing contractual arrangements that clearly allocate risk between the project, its commercial counterparties and its lenders. “For example, depending on the sector, lenders may not be willing to take construction risk and instead may expect a guarantee of the project’s debt by the sponsors until it is completed to the lenders’ satisfaction, or that a suitable construction contractor takes delay and pricing risk during the construction phase of the project through the negotiation of a fixed price, turnkey engineering, procurement and construction contract.
“Ensuring that internationally-reputable counterparts are engaged with respect to the development, supply and operation of the project is extremely important, as is the reputation of the project’s sponsors in many cases.”
In addition to core structuring and economic considerations, lenders will take into account a wide range of factors, depending on the sector and location of the project. Particularly for greenfield projects in developing countries, they will be concerned about the political stability in the host country and seek assurance that the development of the project is in line with the perceived strategic interests of the country to mitigate the risk of future expropriation or other government interference.
“It should be noted that a stable regulatory framework is a concern for lenders to projects in developed and developing countries alike, with the instability of the UK regulatory regime related to renewable energy over a prolonged period of time, for example, undermining investment in that sector,” notes Sweny.
“Geopolitical events can also come into play, as demonstrated by the recent sanctions imposed by the US and EU governments, which in the case of US sanctions specifically targeted the financing of gas projects in Russia, causing certain investors to suspend their involvement in, or pull out of, a number of Russian projects which have had to rely increasingly on domestic and Asian sources of financing,” he concludes.
