Out of the Shadows: The Rise of Alternative Financing in Infrastructure
The landscape of infrastructure financing is changing. With traditional lenders such as banks and governments under severe economic pressure, infrastructure projects worldwide are increasingly turning to the shadow banking sector, sometimes tapping corporate treasury funds to finance the continued demand for growth. According to Infrastructure Journal, an industry intelligence provider, nearly US$200bn was raised in the global project finance loan market in 2012. In the US, about a quarter of all project lending last year came directly from alternative sources and institutional investors – nearly as much as from the public bond markets – with Europe, Middle East, and Africa (EMEA), along with Asia Pacific, following a similar pattern. Should this trend continue, as much as US$25bn of project finance debt will sourced from the shadow banking sector in 2013.
By providing a potential source of long-term committed capital, shadow banking could be of great benefit to the infrastructure sector. The existence of alternative sources of finance may also help to reduce the cost of borrowing for projects and introduce financial innovation into the marketplace. On the downside, the somewhat opaque nature of the shadow banking system could lead to a build-up of systemic risks within the infrastructure sector, as occurred prior to the global financial crisis of 2007-09. To date, though, this has not yet been a major cause for concern.
However, the relative levels of infrastructure risk, especially when compared to sovereign bonds (corporate investors’ staple long-term yield investments); a lack of established and tested funding mechanisms; and a dearth of performance data for new and growing industry sectors, such as renewable energy, are all acting as potential barriers to growth. Investors’ wariness about taking on construction risk in particular could prevent them from making the most of the opportunities available, while denying funding for the large-scale, complex infrastructure projects that are likely to be most in need of attracting financing.
Risks and Rewards
Shadow banking can be defined as the system of finance that exists outside regulated depositories, commercial banks and publicly traded bonds. Shadow banking participants include pension funds, insurers, sovereign wealth funds (SWFs), some large corporates and export credit agencies, alongside finance companies, private investment funds, business development corporations, asset managers, hedge funds and sponsored intermediaries such as money market funds (MMFs). Typically, shadow banking participants differ from traditional banks in three important ways:
The differences between the capital, leverage, liquidity, and transparency regulations governing shadow banking intermediaries and the stricter regime governing traditional banks effectively creates a two-tier system of regulation. This arrangement can create opportunities for borrowers and lenders to pursue the cheapest, least transparent sources of capital. Furthermore, it may result in creating incentives to maximise debt leverage, a process that has led – and might lead again – to systemic defaults and downgrades. For example, because loans and private placements from institutions do not trade through a central exchange, there is no place to observe the activity. This leaves the potential for a build-up of debt to be largely overlooked, as occurred with the overleveraging of the infrastructure sector prior to the global financial crisis.
Currently, secondary debt markets for infrastructure projects remain relatively small. And in the absence of large volumes of liquid, investment-grade securities, institutional investors’ involvement may be limited. However, as banks divest their loan books, there are increasing signs of activity in the secondary project finance bank debt market, spurred on by institutional interest. While most pension fund investment remains ‘buy and hold’ rather than active trading, asset managers are looking to capitalise on the project finance sector’s stable asset performance and favourable pricing spreads. However, neither the secondary debt or institutional private placement markets is public and therefore not transparent in volume.
Corporate Investors’ Interest in Infrastructure Accelerates
Sustained activity through the end of 2012 suggests that institutional investors are now starting to look seriously at infrastructure investment. The nature of certain infrastructure projects appears to complement the long-term liability needs of insurance companies and pension funds. Availability-based private finance initiative (PFI) schemes, for example, often combine stable fixed rate and inflation-linked cash flows, relatively low credit risk (if not overleveraged), with high observed and projected recovery rates in case of default. In addition, infrastructure debt typically provides a higher yield than government bonds.
Nevertheless, while the prospect of higher long-term yields is enticing, it is evident that potential institutional investors continue to be wary of being caught in a repeat of the asset bubble witnessed prior to the 2008 financial crisis. A perceived heightened level of risk, compared to the risk-free but lower-yield returns offered by sovereign bonds, remains a major obstacle to further investment. This risk aversion by institutional investors and pension funds was recently identified as a major impediment to private sector infrastructure investment in the UK by the National Audit Office (NAO), a government spending watchdog.
As a result of this unwillingness to take on risk, there has been a shift away from the private equity approach for capital return that was in evidence prior to the bursting of the infrastructure asset bubble in 2008. Under that approach fund managers would make equity investments on behalf of their clients, such as pension funds and insurers, with the aim of generating returns from selling the asset at a profit within a short timeframe. Now, private investors are increasingly focused on low risk, low volatility debt-type investments that generate a more predictable cash yield over a longer timeframe, are potentially more liquid, and benefit from greater security post-default.
Another key reason behind institutional investors’ failure to fully embrace infrastructure debt is the lack of information about more challenging projects. A good example is the demand for investment in offshore wind farms in Western Europe. These are large-scale, difficult projects that utilise new technology and have little proven track record of yield. Utility balance sheets and state lending organisations have been the dominant sources of funding for this relatively new asset class, but these are unlikely to be sufficient to fund the ambitious investment needed by 2020. Standard & Poor’s (S&P) estimates that the amount needed to meet UK and German government investment targets alone by 2020 is between US$117bn and US$133bn, presenting a considerable opportunity for those investors able to successfully manage the risks involved.
Construction and Operations Risks can be Overcome
Market sentiment suggests that construction risk in particular remains a specific source of anxiety. This can make it difficult, for example, to market project finance debt to a long-term institutional investor seeking low risk through a long debt tenure. Some new market entrants appear to be wary of taking on the uncertainties associated with ensuring that a project is constructed and completed on time, to budget, and capable of operating as designed.
Certainly, this can be a complicated process. Alongside the complexity of construction itself, there are numerous associated risks to be considered, including the project’s delivery methods, design and technology, the capability of contractors, and the manner in which the project contracts distribute risk between contractors and suppliers.
Nevertheless, these issues are far from insurmountable. Many can be resolved by changing the project structure or covered via insurance, given sufficient expertise and experience on behalf of investors. Equally, operations contracts are not without risks of their own. Disputes in rated public-private partnership (PPP) transactions, for example, often arise due to differences in contract interpretation with respect to service quality, and can have serious implications for lenders and bondholders.
The Transition Will be Gradual
Since they are typically funded pre-completion, economic infrastructure projects have traditionally been the most reliant on bank funding, especially in Europe and the Middle East. These include complex, large-scale, industrial, energy, and civil engineering projects, which often involve new technology – in other words, the kind of projects that institutional investors have typically been most cautious about.
By comparison, in the UK and Canada for example, the bond markets have mainly been involved in funding social infrastructure such as schools, hospitals, and government accommodation projects since the late 1990s. As a result, both the mechanisms for funding and the market participants themselves are now generally well established. Yet it’s new and heavy industry, particularly the energy and transportation sectors, that currently has the greatest demand for funding.
Consequently, bank lending is likely to remain the main source of funding for infrastructure projects. And despite the recent burst of activity from the shadow banking sector any transition will probably be relatively gradual. Nevertheless, as regulatory pressures require the banks to hold more capital for longer-term loans, lending for long-term infrastructure projects will continue to become less attractive to banks and more attractive to yield-hungry investors.