Introduction: Infrastructure’s new reality

Author: | Published: 1 Dec 2012
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A new year means a new approach to infrastructure funding, explains Julia Prescot, non-executive director at the International Project Finance Association and chief strategy officer at Meridiam Infrastructure

2012 marked a year of transition in the world of infrastructure. As the effects of the global financial crisis (GFC) continued to be felt, there were developments in the European and north American public-private partnership (PPP) and infrastructure world, in both the public and private sector. Economic policies veered towards growth rather than austerity, and with infrastructure seen as an engine of growth, there was greater focus on developing new projects that would have a positive impact on jobs and expenditure. However, while the desire for development was certainly apparent last year, fiscal constraints and uncertainties about available sources of private sector funding – allied to uncertainties about the most cost effective outcomes across governments – resulted in pipelines of new projects growing only very slowly.

We have many hopes for 2013 as a year of new certainty, not only in respect of decision making by governments as to where they wish to focus their infrastructure activities, but also as a year in which new techniques for funding and new investors begin to enter and drive the market. A number of these techniques are new and unproven. They need careful structuring by sponsors and the legal profession to be made acceptable to the marketplace, and essentially to be shown to work within complex contractual packages. This applies to both debt and equity instruments within infrastructure. If this can be achieved, a new paradigm for funding infrastructure will have been created and will constitute the sector's so-called new reality.

"The legal profession can only benefit from this period of exploration "

Is there really a need for a change in the approach to infrastructure funding? For some time, there was an expectation that the changes wrought by the GFC were merely a blip in a continuum of low funding costs, abundant bank debt, and wide use of leverage – not only at the project level but also within investment funds There was a view that if we only hold on, normal service will resume. From this vision, came the idea that mini-perms would be the way forward – loans that could be refinanced in that glowing upland of the supply of cheap money. The higher cost and scarcer availability of funding was only a short term event and costs associated with projects would naturally decrease over time.

It is not entirely clear why this view was so entrenched. It was only some six to seven years prior to the GFC that had margins begun to decrease – in the UK the Glasgow Schools project finance initiative (PFI) deal in 2000 being one of the first PFI deals in which margins declined significantly below one percent. Some three years before that, lending in excess of 15 years' maturity was considered on the edge of acceptable. Likewise, the first infrastructure equity funds were most tentative in the terms and conditions they were prepared to offer.

While there is still some long-term bank debt to fund projects, the aggressive positioning by banks in the provision of long-term and low cost funding has retreated. Increasing regulatory pressure from the introduction of Basel III r for funders plus central bank pressure to deleverage balance sheets has largely, except in some limited circumstances, removed bank appetite for long-term infrastructure debt and resulted in sustained increased costs.

At the same time institutional investors have been looking for alternative instruments in which to invest, as sovereign debt yields have fallen or become significantly more risky. Creating structures that allow utilisation of institutional investor funding, and at the same time fulfill the needs of governments, meant 2012 saw a number of experiments with new forms of debt. These range from the European Investment Bank's (EIB) project bond concept, to Hadrian's Wall credit enhancement product, to PEBBLE. It also includes the insurance companies such as Allianz and pension funds such as APG deciding to focus directly on infrastructure debt – an asset that provided long-term stable defensive cash flows that could be relied on to provide the required level of asset to liability match. The coming year is likely to see this experimentation settle as new solutions are realised within projects, and the newly created instruments become the new normal. The first set of projects to be closed with institutional investors will form the paradigm for the future.

Changes in equity

In the equity field, 2012 also saw experimentation as institutional investors struggled with the aftermath of a number of failed structures for infrastructure funds. Institutional investors became increasingly allergic to infrastructure funds being offered to them on the basis of 2/20, as per private equity funds, and the charging of upfront fees on a project by project basis that go direct to the manager. Real concern was voiced regarding alignment and value for money for such investors. As a result, investors started looking at going it alone, without a manager, or alternatively focusing on co-investment rather than fund subscription. Indeed the background to the UK's Pension Infrastructure Platform was a desire for pension funds to create a vehicle that did not rely on a manager and paid much lower fees, thereby limiting the erosion on return for investors. Again, these new model funds will need robust structuring to fulfill the requirements of all parties.

"2013 seems likely to be the year when the new reality takes shape "

2013 is likely to stabilise this position. Funds are now offering a better alignment, and pension funds may find it more difficult than they thought to work on infrastructure projects without a significant in-house capacity to execute. However, the relationship between investors and infrastructure funds has changed significantly in terms of engagement of the two parties.

2011 and 2012 were also years in which the public sector, beset by fiscal strain, also reviewed the relationship between private finance and the provision of public infrastructure. Extensive consideration has been given to the best value relationship between the public and private sector in delivering infrastructure. To a large extent, the overall structure of the relationship – with the public sector initiating projects, organising competitions for winners that represent the best value for money, and funding such projects with long-term private sector equity and debt – has been retained. In the UK, closer consideration has now been given to the potential for public and private sector to share equity participations. This approach will allow participation by both sectors and reduce the potential for conflict, and increase understanding and transparency.

2013 seems likely to be the year when the new reality takes shape. The legal profession can only benefit from this period of exploration. And as a final thought – 2013 should be a year in which the period of transition begins to move towards the new reality of infrastructure. This is a reality where investment should be focused on long-term development and growth, not short-term profit, and where investment periods match the life of the infrastructure asset they have funded; where infrastructure is not seen as a series of fungible cash flows, but rather as businesses that need to be nurtured for both the public and the private good.