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10. Intermediating Infrastructure Finance: Market Contours

© New York University/Stern School of Business, CC BY 4.0

Historically, barriers to entry into the project and infrastructure finance market have been significant. Many deals in this arena are highly complex and require sophisticated legal, tax, accounting, financial, and engineering skills. Furthermore, the size of many infrastructure project financings requires both large equity checks on the part of sponsors and large balance sheets on the part of project lenders. Although most project debt has been rated investment grade, the credit analysis involved, with its heavy emphasis on contracts and covenants, requires a skill set more commonly found in the high-yield or private equity markets.

10.1 Changing Sponsors and Infrastructure Funds

In recent years, the ranks of traditional project sponsors (i.e., governments and corporations) have expanded to include dedicated infrastructure funds managed by private equity firms (e.g., Alinda Capital Partners, Brookfield Asset Management, and Global Infrastructure Partners) as well as commercial and investment banks (e.g., Citi Infrastructure Investors, GS Infrastructure Partners, and Morgan Stanley Infrastructure). Most of these funds target an internal rate of return of 8% to 15% or higher, and they charge both management fees (typically 1% to 2%) and performance fees (usually 10% to 20%).

Many of these private equity-style funds compete aggressively for project and infrastructure deals. For example, in January 2005, the Macquarie Infrastructure Group (MIG), an infrastructure fund managed by Australia’s Macquarie Bank, was the high bidder on the 12.5-kilometer elevated Chicago Skyway Toll Bridge System, a concession that included responsibility for paying all operating and maintenance costs, as well as the right to receive all toll revenues, during a 99-year lease period. MIG’s $1.8 billion all-cash bid, submitted through a joint venture with Spain’s Cintra (a private developer of transport infrastructure), was roughly double the amount of the cover bid on the Chicago Skyway concession. The MIG fund was subsequently converted into a listed fund, Macquarie Atlas Roads Limited.

Listings by infrastructure fund managers have become common, particularly in the United Kingdom, Canada, and Australia. At present, there are roughly 50 listed infrastructure funds outstanding. Sovereign wealth funds, such as the China Investment Corporation, and government investment arms, such as Singapore’s Temasek Holdings, likewise participate in project equity syndicates, either directly or indirectly through fund structures.

10.2 The Market for Project and Infrastructure Debt

From 2003 through 2015, the market for project finance debt (loans and bonds) roughly tripled in size, from $100–150 billion to approximately $350–400 billion. This growth came from a combination of aging infrastructure and public services in the developed world, strong economic performance and pressing development needs in the emerging markets, and fiscal constraints along with new government-sponsored initiatives in the area of renewable energy development.

The project loan market ($362 billion in 2015) was roughly 10 to 13 times larger than the project bond market ($27 billion in 2015), accounting for some 90% to 95% of total project finance debt issued from 2003 through 2015.

Most project loans and bonds were structured as amortizing secured debt and rated investment grade, either explicitly or implicitly, so as to minimize the required interest coupon. Sometimes credit enhancement products — such as insurance provided by companies such as Assured Guaranty, which guarantee the timely payment of interest and principal — were used to achieve targeted investment grade ratings.

Based on default and recovery rates tracked by Standard & Poor’s from 1992 through 2014, investment-grade project finance debt experienced lower default rates and significantly higher recovery rates than equally rated senior secured and unsecured corporate debt.

The energy and electric power infrastructure sector accounted for nearly half of all project finance debt issuance (47%) from 2003 through 2015, with renewable projects (e.g., wind and solar power, ethanol, and biofuels) constituting an additional 13%. Renewable energy and power represented a growing percentage of the project finance debt market during the second half of this period, as an increasing number of governments implemented “green” policy mandates such as renewable power and renewable fuel standards.

Despite their high-profile government connections, renewable energy projects involve a unique set of risks for credit investors. For example, although solar and wind power have proven effective on a commercial scale, other green technologies remain commercially unproven. Another risk stems from the need for continuing political and fiscal support in the form of subsidies, tax credits, and/or “mandated” demand such as ethanol content in motor fuel to preserve projects’ economics. The 2015 Paris Climate Accord, however, should increase incentives in the case of renewable power and distributed grids, reducing this risk.

Beyond traditional and alternative energy, the next-largest sector of the project and infrastructure finance debt market from 2003 through 2015 was shipping and transportation. This sector, including airports, roads, rail, and marine ports, accounted for roughly 21% of new debt issuance. The next 15 years are likely to see significant investment in water infrastructure worldwide, especially in arid regions, cities, and emerging economies.

Total project finance debt issuance was roughly evenly split between developed (52%) and emerging markets in Asia Pacific, Latin America, Africa, and the Middle East (48%). Emerging market countries constituted a growing portion of overall volumes, as the Asia Pacific region (excluding Japan, Australia, and New Zealand) grew from 15%–20% during the 2003–2005 period to 30%–35% of all project finance debt during the 2010–2012 period, before declining to 20%–25% during the 2013–2015 period, mainly on the back of increased deal flow originating in China and India.1

10.3 The Key Role of Commercial Lending

Commercial banks constituted roughly 80% of the global project and infrastructure loan market, with supranationals (3%) and sovereign agencies (17%) accounting for the remainder.

The commercial bank loan segment of the infrastructure finance market has been dominated by large European and Japanese financial institutions. It has also been highly fragmented. The top 20 lead arrangers constituted only 40% to 45% of total loan issuance from 2003 through 2015, with most deals heavily syndicated.

From 2005 through 2007, bank lending margins narrowed to roughly LIBOR +50 bps to LIBOR +100 bps for many higher-quality projects. After the global financial crisis, they settled in the range of LIBOR +250 bps to LIBOR +350 bps.

Infrastructure and project finance commercial bank loans have traditionally been originated in “tranched” format2 and then held on the lending bank’s balance sheet until maturity. (Some up-front construction loans, however, are partially refinanced with fixed-rate bonds once a project is up and running.) The regulatory response to the crisis requiring commercial banks to hold higher capital levels, as well as more stringent liquidity and stable funding requirements, have further affected banks’ critical role in providing debt financing for infrastructure projects.

10.4 The Infrastructure Bond Market

Most project and infrastructure bond financings have been sold as private placements to investment-grade investor accounts, mainly buy-and-hold insurance companies and pension funds that pursue asset-liability matching (i.e., longer-term assets to fund longer-term life insurance and pension claims). Some project finance bonds, however, are targeted toward high-yield investors such as hedge funds.

In investment-grade private placements of project and infrastructure debt, the intermediary bank serving as placement agent has typically charged a 0.875% to 1.000% fee. Distribution of the securities could follow either a traditional negotiated format3 or a more public-style format designed to reach a larger investor base.4

Some of the large US insurance companies (e.g., American International Group, Allstate, John Hancock, MetLife, New York Life, Northwestern Mutual, and Prudential) have developed in-house private placement groups that focus specifically on project finance and infrastructure credits. These firms have typically taken the lead on, and driven demand for, investment-grade project and infrastructure bond deals.

Because institutional investors remain hesitant to take on construction risk, project finance and infrastructure bonds typically are not issued until a project moves out of its completion stage and starts generating cash flow (with the exception of brownfield projects that are already generating cash). Most private project finance bonds have been fixed rate (priced at a spread off the Treasury yield curve), longer dated (a 12- to 15-year average life), and relatively illiquid.

Although some bonds used in project and infrastructure finance have changed hands in the secondary market, trading activity has historically been infrequent and usually on an “order basis” by individual institutional investors. To compensate for the illiquidity and the extra analytical work involved in up-front due diligence, as well as the need for continuing credit monitoring, project finance bonds typically carry more yield than conventional publicly-issued investment-grade bonds.

When pricing a new private project finance or infrastructure bond, the spread versus comparably rated corporate credits typically serves as the main frame of reference for relative value, along with any other visible and relevant data points from private-placement transactions.

Similar to the project loan market, the spreads on project finance bonds tightened significantly during the 2005–2007 credit boom to roughly +100 bps to +200 bps. After the global financial crisis, they widened to +200 bps to +300 bps. The regulatory tightening in the post-crisis period seems to have had a smaller effect on bonds than on bank loans.

10.5 Project and Infrastructure Debt Market Evolution

Although the supply of project financings showed few signs of slowing in the aftermath of the global financial crisis, the availability of adequate debt financing remained uncertain. Post-crisis regulatory changes affecting the global banking system in combination with bank lending’s critical role at the front end of project financing clouded the outlook for infrastructure financing.

The Bank for International Settlements (BIS) Basel III mandates, as well as tougher annual stress-testing rules in many countries, have forced banks to deleverage in order to shore up their loss-bearing capital and increase their balance sheets’ liquidity, with target ratios prescribed for both credit and liquidity risk exposures. In response to these new regulations, many banks (particularly those domiciled in Europe) have scaled back their long-term lending exposures to existing and new illiquid assets such as project loans. Moreover, because most project financings have been US dollar-based, project lending volumes were further dampened (at least initially) by key European banks’ constrained access to US dollar funding.

To plug the funding gap created by bank lenders backing away from the project finance market, infrastructure funds and sovereign wealth funds have begun to look at investments in project finance debt, mainly the more junior portions of projects’ capital structure (as opposed to senior secured bank loans). Multilateral and government efforts have also aimed to expand the institutional investor base for project and infrastructure bonds.

One supranational example is the Europe 2020 Project Bond Initiative, a joint effort between the European Commission and the European Investment Bank (EIB). As part of this initiative the EIB provides credit enhancement through a subordinated instrument (either a loan or contingent backstop facility) to bolster demand from insurance companies and pension funds for senior bonds issued to finance approved European infrastructure projects (typically PPP structures).

Another country-level example comes from the Reserve Bank of India, which in 2013 approved the regulatory framework for a system of Infrastructure Debt Funds (IDFs). These funds can borrow from domestic and international insurance companies as well as pension funds to finance investments in domestic PPP projects.

Still, no magic bullet has materialized to meet the vast prospective demand for financing infrastructure projects. The project finance market has been searching for a solution to the problem created by retreating banks — namely, finding new sources of debt capital. For this reason, the project finance debt market remains one of the few credit markets where pricing has not yet returned to pre-crisis levels.

1 McKinsey (2013) estimates that infrastructure spending in China and India (much of it government funded) averaged 8.5% and 4.7% of GDP, respectively, compared with approximately 2.6% of GDP in both the US and the European Community during 2010–2015.

2 This term refers to subordinated issues in an overall loan that vary as to currency, maturity, interest margin, and other characteristics.

3 In the US under Section 4(2) or SEC Regulation D securities law exemptions.

4 In the US under the terms of SEC Regulation 144A/Regulation S.