Infrastructure updater: New opportunities and challenges for 2012

January 2012

Contacts

Introduction

As we enter 2012, many governments are looking to infrastructure development as a means of kick-starting economic growth. In the UK, for example, the National Infrastructure Plan published in November 2011 boasts a pipeline of 500 projects with a combined value of £250 billion. Having analysed the plan, we share our thoughts on where the opportunities really lie for contractors and private equity investors.  

The Eurozone crisis and the need to reduce government borrowing within and outside the EU is also driving a privatisation programme in many countries in Europe. This, and a reduction of liquidity in debt markets, may present interesting opportunities for private equity investors with an appetite for the infrastructure assets of distressed sellers if they are able to source acquisition finance.

Regulatory change and the enforcement of existing and new competition rules are having a significant impact. We provide an overview of two high profile examples in the infrastructure space.   We also consider how closed-ended, listed infrastructure funds can solve some of the issues experienced by investors in secondary infrastructure assets with the traditional, “private equity” fund model.

Of course, the challenge of securing sufficient finance to fund development of infrastructure remains. Governments and sponsors will need to be ever more creative. We have reviewed some of the models being used to fund infrastructure around the world and consider their attractiveness and potential for use in other markets as well as lessons learnt from the Canadian infrastructure bonds market.

Lastly, given the significant need for infrastructure development within the resources sector, particularly in Africa, we consider some of the options for funding and development of this infrastructure.

A new pipeline for UK infrastructure projects?

National Infrastructure Plan 2

On 29 November 2011, HM Treasury and Infrastructure UK (IUK) jointly published the National (NIP 2), which is an update of the first National Infrastructure Plan issued in November 2010. This coincided with the Chancellor’s autumn statement to Parliament, and was timed to show the Government’s clear commitment to support investment in major infrastructure, as a means of both maintaining the country’s key assets in line with international standards whilst providing a welcome boost to the economy in this sector.

Through NIP 2, the Government has sought to give the market comfort that there is a long-term pipeline of projects which will secure an improvement in the national infrastructure in a number of key areas, namely:

  • new and improved transport connections in the road and rail sectors;
  • a more reliable UK energy supply;
  • increased availability of superfast broadband and mobile coverage;
  • improvements to performance and security of water and sewerage systems;
  • a move toward a “zero waste” economy.

As good as it sounds?

In all, the published pipeline sets out details of over 500 projects with a combined value of over £250 billion to be invested up to 2015 and beyond. In addition, the Government announced a list of 40 “priority” projects of particular strategic importance, which would receive special attention from the Government to ensure that they progress smoothly and that any potential roadblocks might be dealt with quickly.

In principle, this sounds like good news for those operating in the beleaguered PFI/PPP sector in the UK who are keen to hear that the currently reduced pipeline for such deals might be opened up. On closer examination, however, the breadth of the published pipeline is somewhat deceptive.

Firstly, the vast majority by value of the major infrastructure projects quoted are private sector projects. This reflects, for example, that there is fully privatised energy sector, where infrastructure investment is essentially a commercial decision based on business requirements against a regulated asset base. All the Government is doing with the pipeline list is summarising what it currently understands these requirements are likely to be in the medium term. Notably, roughly 40 per cent of the £250 billion quoted reflects the anticipated expenditure on nuclear new build and offshore wind energy alone. A lot of this is, in fact, budgeted to be spent after 2015 (hence the oblique reference in NIP 2 that the amount to be invested relates to the period up to 2015 “and beyond”).

Also, although NIP 2 attempts to paint the picture of a pipeline looking forward 10 years, the pipeline list itself includes a large number of expenditure allocations for projects which are already working their way through procurement, such as the IntercityExpress Programme, Mersey Gateway Crossing and Thames Tideway Tunnel, not to mention a number of existing, operational projects (eg Nottingham Express Transit 1 PPP, Birmingham Highways PPP etc). This inclusion of these projects affects the view of how much of NIP 2 actually represents new pipeline opportunities for investment. Over 60 per cent of the amount allocated for the transport sector reflects the anticipated cost of only two projects - Crossrail and HS2 - so the size of the pipeline (in terms of total number of new projects) is further constrained.

Some new projects have been announced with the launch of the NIP 2. These include some new road improvement or rail connection projects. However one would expect these to be let through conventional procurement procedures by Network Rail or the Highways Agency, rather than through a PFI/PPP model. There is however mention that some new road projects might potentially be structured on a concession (tolling) basis, such as the proposed improvements on the A14 or the possibility of a new lower Thames crossing to relieve congestion on the M25 crossing at Dartford and neighbouring junctions. However, details as to how these may be structured (and timescales for implementation) are sketchy. In any event, tolling projects with market risk have been falling out of favour in the PFI/PPP sector across Europe, given the risks of exposure to traffic reductions (and the Chancellor himself used the opportunity of the Autumn Statement to write off half the debt of the Humber Bridge concession, emphasising this point).

It should also be noted that NIP 2’s list of 500 projects excludes all projects under £50m. The PFI/PPP sector in the UK has historically been supported by a pipeline of smaller-scale projects, e.g. in the health, education, social housing and justice sectors. Notably none of these sectors is expressly mentioned in NIP 2 itself (which in this regard is very much a plan for national infrastructure rather than a national infrastructure plan), but they are mentioned in a separate “Government-funded” pipeline list, published simultaneously with the 500-project pipeline. This includes:

  • a mere 14 projects in the health sector (PFI/LIFT - many already in procurement)
  • 14 projects in the justice sector (courts/prisons - with a very small total expenditure)
  • a number of MOD projects (all of low value)
  • a reasonable allowance of over £1bn annually for affordable housing/regeneration projects for the next 3-4 years (but few details as to how this money will be allocated)
  • reducing the entire education sector to a single line in this plan, showing overall expenditure of £2.5bn (2011/12), £1.6bn (2012/2013) and £486m (2013/2014). This presumably includes the new Priority School Building Programme anticipated to be launched in 2012, but the sharp tailing-off of funding suggests a relatively quick capital spend through conventional D&B arrangements rather than longer term PFI/PPP arrangements
  • a healthy list of 38 span title="Private Finance Initiative" class="abbr">PFI/PPP projects in the waste sector (again none of those listed represent “new” projects and all these projects are expected to be closed in the short term)

In summary, the medium to longer term pipeline for PFI/PPP projects in the UK remains unclear.

Where does this leave contractors and private equity investors?

Contractors

Contractors would appear have plenty of work in the short term, albeit concentrated in specific sectors. The pipeline for new business in certain sectors may be further constrained to the extent that this is earmarked for spending through existing frameworks (such as Procure21+ or the Partnerships for Schools D&B framework) which reduces market opportunities to parties not already on those panels.

Private equity investors

Private equity investors with experience in the previous PFI/PPP pipeline may need to be inventive in the type of project they select to invest in. There will still be need for external investment for projects, as the Government anticipates that private sector balance sheets may suffer pinch points in handling the required levels of investment anticipated by the NIP, hence the need to unlock new means of investment available to the market given debt funding is expected to remain constrained as a result of new regulation such as Basel III and risk averse credit committees.

There may be a role for equity investors to assist the Government with placing and managing the proposed £20bn involvement by UK pension funds and insurance industry investors, who unlike their counterparts in Canada and Australia are less familiar with infrastructure as an investment asset class and the associated due diligence requirements and risks. Given our direct experience of major PPP projects offices in Canada and Australia we are well placed to advise on the issues that the introduction of this new investor class is likely to raise.

Other PPP equity investment opportunities may also open up at a local level outside the scope of NIP 2 with the Government committed to permitting local authorities to fund local infrastructure requirements by borrowing against future funding allocations or local taxation, a model that is apparently being used to fund the new London Underground Northern Line extension to Battersea. This will require novel contract structures which, not being Treasury-funded, can be tailored to the individual requirements of the transaction rather than by assuming a rigid adherence to SOPC principles. Given our long-term involvement in PFI/PPP projects, we can draw on longstanding experience to provide the optimal contract structures.

For further information contact:

Andrew Buisson

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Current market conditions create opportunities for buyers with an appetite for the infrastructure assets of distressed sellers?

The effects of the financial crisis and the need to reduce Government borrowing within and outside the EU is driving a pick up in the privatisation programmes in many countries in Europe. At the same time, this coincides with scarce financing opportunities and these factors may present interesting opportunities for buyers with an appetite for the assets of distressed sellers if this is coupled with an ability to source acquisition finance.

Another feature of the picture in Europe is that transactions are being driven by regulatory change and the enforcement of existing and new competition rules. There are currently two high profile examples of this in the infrastructure space - the first which is a current process and the second, relates to regulations that will come into force at the end of Q1 2012.

Competition Commission break up of BAA plc

Under powers conferred by the 2002 Enterprise Act, the UK's Competition Commission (CC) continues to pursue the forced break up of BAA plc which owns a portfolio of UK airports including Stansted and Edinburgh. BAA continues to fight the fact of and timing for the sale of Stansted Airport. In light of the latest round of the judicial review and appeal process, the CC has ordered that a Scottish Airport be sold first and BAA has elected to sell Edinburgh Airport. The deadline for completion of this transaction has not been made public although the date has been rumoured to be as early as summer 2012. The CC's stipulations about the identity and characteristics of an acceptable buyer are contained in undertakings given by BAA in early November 2011. In summary, a proposed purchaser must produce evidence to the CC demonstrating the following:

Intention and ability to operate as a competitor - The proposed purchaser must produce such evidence directly to the CC and not to BAA or any other competing third party airport operator or proposed purchaser.

Independence from BAA - The proposed purchaser must show that its operation does not depend on BAA (in terms of information technology systems for instance and or due to significant ownership and economic relationships with BAA).

Appropriate expertise - This means the experience of operating at least one major international airport or otherwise has access to the necessary expertise and an ability to provide a management team with comprehensive experience of operating and developing airports and of how it intends to apply this expertise to Edinburgh airport. If the intention of the proposed purchaser is to employ the existing BAA airport management team, that team will need to be supplemented by other management with appropriate strategic, regulatory and financial skills to fulfil the functions currently resourced at a group level.

The proposed purchaser must also satisfy the Civil Aviation Authority’s Safety Regulation Group regarding management proficiency and must satisfy the Department of Transport regarding security regulations. It must provide the CC with:

  • a comprehensive business plan demonstrating the purchaser’s intentions and abilities to operate and develop the Airport and giving a sound basis for long-term financial projections with accompanying sensitivity analysis; and
  • clearly defined governance arrangements, setting out management processes, voting rights, reserved matters and other governance arrangements.

Appropriate financial resources - This means access to sufficient financial resources to acquire, develop and operate the airport. The proposed purchaser must provide robust long-term financial projections, including sufficient headroom in the finance facilities, or the capacity to raise capital, to cope with significant adverse conditions.

The new energy market rules

The second major change stems from the fact that the European Commission's Third Energy Package setting out new regulatory rules for European energy markets is due to come into operation in March 2012.

Under the new rules, there are several transmission unbundling models, but the most restrictive, which is likely to be implemented in many countries in the EU, is full ownership unbundling (OU), whereby the ownership of the transmission system and its operation must be fully separated from any production and supply operations.

The effect of this is that a company cannot control a transmission system or a TSO and at the same time control or exercise any right in a production or supply company; or visa versa control a production or supply company and at the same time control or exercise any right in a transmission system or TSO. There are also certain restrictions on board representation.

“Control” for these purposes can include holding a minority shareholding where there are significant rights attached (e.g. veto rights over budget/business plan, major investments, or appointment of management).

The “exercise of any right” is a lower threshold including the power to exercise any voting rights, no matter how limited (i.e. even if they do not amount to control) and the power to appoint any board members, as well as the holding of a majority share.

Various aspects of the new regime have yet to be clarified but essentially the position appears to be as follows:

  • Where an investor controls a relevant asset, it will need to ensure that any interest it has in a conflicting asset is so limited that it does not even amount to the exercise of any right in respect of that other business.
  • Where, on the other hand, an investor has an interest in a relevant asset which amounts to the exercise of any right but falls short of control, the interest it will be permitted to have in a conflicting asset, while not amounting to control, can extend to the exercise of any right in respect of that other business.

There are also two further principles to note. First, the unbundling requirement will apply across both gas and electricity markets - an interest in electricity production/supply could preclude the holding of an interest in a gas transmission system or TSO.

Secondly, the full OU model will apply taking account of companies’ interests across all EU countries - an investor with an interest in an electricity or gas production/supply company in any other EU country (not just the country in question) could be prevented from having an interest in a transmission system or TSO in the country in question.

Offshore transmission is covered for the above purposes, although certain other new infrastructure may be exempted.

The implications for existing and prospective energy investors

The restrictions on investors participating in transmission/TSO on the one hand and production/supply on the other have potentially significant implications for investment strategies.

Issues which investors may need to consider carefully, and on an EU-wide basis, include the following:

  • whether their existing asset portfolios comply with the new rules;
  • the extent to which those existing investments will limit the ability to invest in new assets (and whether any potential new investment will likewise limit the ability to invest in other assets subsequently);
  • in the context of consortium acquisitions, whether proposed partners’ investment portfolios will create any problems for making the new investment;
  • the extent to which separate investment vehicles can be used to avoid triggering the OU restrictions; and
  • what structures are acceptable where the OU restrictions apply.

On the last point, the full implications of the new rules are not yet clear. We anticipate that there will be viable structures which allow an investor to hold interests in both transmission/TSO and production/supply. However, it is likely that in order to achieve this investors will have to limit their interest to economic rights and to forgo control and voting and management rights.

For further information contact:

Jill Gauntlett

Mark Jones

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Listed infrastructure funds

Investments in infrastructure funds focused on secondary assets offer exposure to a stable yield generated from inflation linked, government backed revenues. However, recently a large number of private funds have failed to close successfully. Two key factors in this are that many institutional investors with allocations focused on the sector have increased the size of their investment teams, and so have greater ability and more capacity to transact for assets directly, whilst at the same time they have become increasingly disillusioned with the alignment of interests offered by the models of many collective investment products being marketed to them.

Closed-ended, listed infrastructure funds solve some of the issues investors have with the traditional, “private equity” fund model as, for example, there is no incentivisation of the manager based upon “churn” of assets and shareholders have liquidity rather than being locked into the fund for a lengthy duration. Broker research also suggests listed infrastructure funds compare favourably with listed funds focused on other sectors, since the listed infrastructure funds offer low net asset value (NAV) volatility and little correlation with other asset classes. Moreover, unlike private funds, listed funds are able to be sold to retail investors and there is no minimum investment size once securities are traded on the secondary market.

Portfolio valuation is the principal driver of a fund’s NAV. Most listed infrastructure funds undertake a semi-annual valuation principally using a discounted cash flow methodology. An independent third party audits the valuation process and where appropriate provides an opinion. Key inputs and assumptions included in the process are:

  • The underlying contracted cash flows of each asset;
  • An assumption on long-term inflation;
  • A discount rate; and
  • Evidence taken from comparable transactions.

Other factors which impact the fund’s value include, inter alia, the results of the active management of the assets, deposit rates, tax rates and foreign currency exchange rates.

Inflation protection is an important issue for infrastructure funds and is arguably one of their attractions. Revenues and operational costs in relation to the fund’s assets are often RPI or CPI linked, whilst finance costs are usually fixed. The sensitivity of each asset depends on a project’s structuring and the nature of the asset. Projects which have a greater proportion of fixed versus inflation linked operational costs, for example, should have a more positive correlation to inflation. A project may include an RPI or CPI swap to minimise the overall exposure to inflation.

A typical structure for such funds is a Channel Island incorporated closed-end company that will hold, usually via Luxembourg subsidiaries to take advantage of double tax treaties and the EU parent subsidiary directive, the fund’s interests in the underlying infrastructure SPV project vehicles. These companies typically have an unlimited life but are subject to periodic continuation votes.

Whilst it is possible for such funds to be “self-managed”, with internalised executive management teams, listed investment companies typically have boards of independent directors whose duty it is to govern the company to secure the best possible returns for shareholders within the framework set out in the company's constitution and who would typically have the final say on investment decisions. The board then oversees a third party fund manager who makes the day to day decisions about the management of the investment portfolio.

An advantage of the closed-ended structure is that investors trading in the company’s shares have no effect on the underlying investment portfolio, so that the investment manager is not affected by redemptions or the term of the fund in relation to its management of the assets. The stock exchange listing provides a mechanism for the sale and purchase of shares, which then trade at a market price which will either be a premium or discount to the fund’s NAV.

Investment companies may be listed on the Official List of the London Stock Exchange (LSE) or any other exchange such as the Channel Island Stock Exchange, on the LSE’s Alternative Investment Market (AIM) or on the LSE’s Specialist Fund Market (SFM). The most common UK listing for investment companies is on the LSE's Main Market. Each exchange will have different rules and regulations which the company must adhere to. For example, companies which list on the LSE's Main Market need to be admitted to the Official List by the UK Listing Authority (UKLA), a division of the Financial Services Authority, whereas to list on AIM, SFM or on another stock exchange different rules will apply.

Whilst this model is unlikely to replace the private secondary infrastructure fund, the models for which are themselves evolving, it is likely to make an increasing impact on the market and especially in current conditions.

For further information contact:

Michael Newell

Ian Fox

Mark Lloyd Williams

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Responses to the global liquidity problem - Infrastructure projects

The impact of the 2008/2009 credit crunch and in particular its impact on liquidity in the debt markets has been well documented. The focus at the time was to put in place measures, in some cases drastic, in order to maintain large parts of the international banking market as a going concern. The latest round of financial turmoil, mixed in with many leading economies struggling to emerge from a recession, has brought renewed focus on infrastructure development as a means of kick-starting economic growth. However, the key issue of securing sufficient financing to fund such development remains. We provide a brief overview of the steps which have and are being taken in a number of countries.

UK model

With the demise of the monolines which offered a wrapped bond financing alternative, traditional commercial bank debt financing is currently the sole source of financing in the UK market. A number of measures to address this have come, gone or are in the pipeline.

The Infrastructure Finance Unit (TIFU)

In 2009 HM Treasury established TIFU, a financing capability within government with a £750m budget and a mandate to act as a lender of last resort on PFI projects. The rationale was that a government backed lending unit would prevent unreasonable members of bank clubs from demanding onerous repayment terms for the whole group. A state lender which is concerned with getting projects going rather than turning a profit will increase competition allowing for more reasonable debt pricing thereby stimulating liquidity. However, whilst the PFI pool of lenders shrunk considerably as a consequence of the credit crunch, enough financing was in the end available to service the number of projects actually closing during 2009/2010. Ultimately, TIFU lent into only one project, Greater Manchester Waste. However, there is certainly an argument that the mere existence of TIFU helped ensure deals closed during that period. TIFU has now been disbanded as an active lending unit although retains its interest in Greater Manchester Waste.

National Infrastructure Plan 2 (NIP 2)

As part of its recently published NIP 2, the UK Government has announced £30 billion of investment in various infrastructure projects. Alongside NIP 2 the Government has also announced that it has signed memoranda of understanding with the following groups:

  • National Association of Pension Funds (NAPF) and Pension Protection Fund (PPF); and
  • a group representing pension plan and infrastructure fund managers including Meridiam Infrastructure, the Greater Manchester Pension Fund, the London Pensions Fund Authority and Hermes GPE.

The Government has also signed a memorandum of understanding with the Chinese Government (through the Chinese Investment Corporation) pursuant to which it will establish an Infrastructure Task Force to facilitate greater cooperation between UK and Chinese enterprises in the field of infrastructure development. The Government is targeting £20 billion of investment through these initiatives. Attracting investment in infrastructure from pension funds has long been a sought after solution to bridge funding gaps. Whilst these announcements have been received as positive news, the details of how such investment can be structured in a way that will work for pension funds (who for example are not comfortable with the construction risk associated with greenfield projects) remains to be seen.

Green Investment Bank

The establishment of a government-backed Green Investment Bank was first confirmed in the 2010 Budget speech and was due to be open for business in April 2012 with £3 billion available to help leverage private sector investment in environmental projects. In mid-December 2011, it was confirmed that the Bank would operate independently from the Government but would agree its strategic priorities for each Spending Review period with a focus on:

  • offshore wind power generation;
  • commercial and industrial waste processing and recycling;
  • energy from waste generation, including gasification, pyrolysis and anaerobic digestion for the production of heat and/ or power;
  • non-domestic energy efficiency, including onsite renewable energy generation and heat; and
  • support for the Government’s “Green Deal” scheme to support energy efficiency measures in households.

The Government still has to cross the hurdle of obtaining EU state aid approval before it can fully launch this initiative and this is not expected until early 2013. Until then it is proposing to establish a unit within government, UK Green Investments, with a £100m fund to invest in waste projects. A step in the right direction but a small amount when compared to the tens of billions of investment in infrastructure which it is acknowledged almost universally will be required over the coming years.

Canadian model and exporting it to the UK

Unwrapped bond financing

Canada has been the leading proponent of the unwrapped project bond model where investors seem comfortable with the structure and associated risks. Canadian procurement law requires all bidders to have committed finance in place and the party providing this finance generally underwrites the note issuance making the structure more robust for investors. The most important risk analysis measures in the North American market are the:

  • credit rating of the issuer;
  • credit strength of the construction contractor; and
  • quality of the overall security package.

The underwriter almost replaces the monoline insurer in satisfying the rating agencies that the issuance is investment grade. However, there also appears to be greater general market confidence in this structure in North America - perhaps mainly because it reflects longstanding practice.

Exporting the Canadian model

There have been suggestions that the most effective solution to the global liquidity problem within the infrastructure sphere is to export unwrapped project bonds into other markets. The main problem is investor confidence. In the UK there is no risk appetite for unwrapped bonds amongst investors.

Indeed if there is to be any benefit derived from the National Infrastructure Plan, the only structure which can possibly take advantage of the huge pools of liquidity offered by the pension and insurance sectors is one which is reliant upon unwrapped project bonds. Analysts are extremely sceptical as to whether this structure will work in the UK without some form of government support.

An unwrapped project bond was used in Europe in 2010 on the SunPower/SunRay 51MW Andromeda solar park in Montalto di Castro, Italy. However, this would not have been possible without a guarantee provided by SACE for one class of notes and purchase by the European Investment Bank (EIB) of the other class of notes.

The EIB are trying to open infrastructure to capital market investment from pension funds and the insurance sector through their Project Bond 2020 initiative. To encourage investment in project bonds the EIB plans to offer subordinated debt to projects as a buffer to raise the credit rating of notes to investment grade. According to Tom Barrett, director of structured finance and advisory at EIB, the response to the consultation phase which recently ended, including from project financiers, has been positive.

French model

France uses a guaranteed debt model whereby up to 80 per cent of the total capital expenditure for the project is underpinned by the public sector.

The use of capital expenditure rather than debt finance is seen as more robust from a lenders’ perspective.

This model provides an incentive for higher gearing ratios and many are still willing to commit long-term funding to infrastructure projects (even 25 years) provided they can get the level of underpinning required.

Australian model

Australia uses a supported debt model whereby commercial banks provide debt financing during the initial project phases, taking the construction risk and the government steps in and retires this commercial debt once the project is operational.

The private sector provides all of the initial financing for the project (debt and equity).

Upon the project reaching an operational phase, the public sector will step in and provide around 70 per cent of the funding by way of first ranking senior debt.

This model was first utilised in the South East Queensland Schools PPP project in 2009.

Dutch model

The Dutch Government has made plans to encourage pension funds to invest in PPP project debt by offering inflation indexing for debt financing and the fees that will service it.

The project is structured to allow funds to offer index-linked financing in return for index-linked availability fees.

However, this is a refinancing initiative with the initial debt financing to be provided by banks and up to 70 per cent of the debt to be refinanced by pension funds post-construction.

This model provides banks with a guaranteed short-term exit strategy and allows pension funds to avoid construction and inflation risk.

Completion grants

Completion grants involve the public sector returning a portion of the project costs to the project company upon completion.

This allows the project company to negotiate short and long-term debt financing, thus reducing the overall tenor of the debt financing.

This solution does not change the commercial banks’ exposure to construction risk.

Development Finance Institutions

Institutions such as the European Investment Bank, European Bank for Reconstruction and Development, Asian Development Bank and International Finance Corporation provide debt financing to bolster projects and bridge the liquidity gap.

An example of this is the Brittany-Loire high speed rail project in France. At the end of the construction phase, the EIB provided €552.5 million to refinance part of the loans provided by commercial banks. This EIB loan represented 54 per cent of senior debt during the operational phase and was accompanied by daily assignment of receivables.

Again this does not provide any alternative as to the apportionment of construction risk, which remains vested in the private sector.

Chinese/Asian debt

Some Asian countries, in particular China, have substantial cash reserves available for investment.

We have already seen a substantial increase in the amount of Chinese investment in international projects (especially mining/Africa) and now various Chinese entities, such as the sovereign wealth fund China Investment Corporation, have expressed an interest in investing in Western infrastructure, either directly through equity contributions, or indirectly in conjunction with fund managers.

Debt funds

Infrastructure debt funds which are not subject to Basel III or lengthy credit approval processes allow funding for long-term, stable projects to be provided by a variety of institutional investors. This is a logical progression according to many analysts.

Debt funds offer liquidity in areas not favoured by banks, in particular mid-range projects between €300-700 million which are usually too small to attract bond financing.

However, debt funds do not have the same risk appetite as banks and will not invest in projects with high risk of losses or a credit rating less than investment grade.

For further information contact:

Paul Mansouri

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Infrastructure Bonds - Lessons from Canada

As the banking sector de-leverages and regulators impose further requirements, governments facing severe balance sheet constraints are frantically seeking new sources of finance to stimulate the supply side of the economy through greater investment in infrastructure. The UK government is no exception. The “rabbit from the hat” solution they propose is using pension and other institutional investors to invest in bonds issued by infrastructure companies secured, among other things, on the receivable stream from underlying infrastructure projects. Canada is often used as an example of a successful model to follow. So what, if any, lessons may be learnt?

Canada came relatively late to the PPP market but has embraced it with enthusiasm. PPP has been developed at provincial level resulting in a variety of approaches. Early projects in the transport sector used both wrapped (guaranteed by monoline insurers) and unwrapped bonds. Some provinces did not allow monoline insurers to issue appropriate policies so in some instances they were issued offshore. More recently during 2010 and 2011, there has been a spate of issues, many in the health sector, often unwrapped (there is little or no capacity given the stressed monoline market). In contrast, in Europe the market has been non-existent.

Deal Flow

Canada and the US have developed a large industry based around sub-sovereign bond issues. Not so the UK where debt raising is a central sovereign treasury function. Consequently in Canada, pension and other institutional investors have established highly qualified teams who have been able to switch their attention from general sub-sovereign issues to project specific infrastructure bond issues. This is perhaps the biggest lesson to be drawn and the biggest hurdle for the UK to overcome. Issues to date in the UK, have, to a very large extent, been wrapped by monoline insurers. In effect, pension and other institutions have outsourced the analytical skills to the monoline insurers. As these insurers have effectively exited the market, it will be vital to create sufficient deal flow to encourage domestic UK institutions to make the appropriate investment in this market and/or to attract foreign investors into the market.

Ratings

Many of the Canadian deals have carried an A- rating for the underlying project as opposed to BBB as is typical in the UK (often no underlying rating has been sought in the UK due to bonds being wrapped). The higher rating has come about even though the underlying concession agreement is both very similar in terms of drafting and risk allocation to those seen in projects in the UK. In part, this is due to rating agencies being more familiar and comfortable with public sector backed projects.

More interestingly, the Canadian market has always been more focused on construction risk. Consequently, in many instances, letters of credit and performance bonds have extended to 30 per cent of the EPC price, well in excess of the typical 10-20 per cent seen in the UK. In some cases, the public sector has covered off some of the build cost and/or there have been discrete construction bonds which carry a higher coupon backed by mezzanine finance as an additional cushion. This extra cover during the construction period together with the lower risk profile of project operation periods has perhaps allowed investors to take a more holistic view consequently allowing a higher overall rating to be achieved. There may be lessons here for the UK market going forward.

It would be wrong to look for the Holy Grail in the Canadian market. Apart from a few tweaks here and there, the risk profiles are very similar in both the UK and Canadian markets. As is so often the case the answer more properly lies in conditioning and approach. It is not so much what is in the picture but how you view it.

For further information contact:

Chris Brown

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African Infrastructure: The Missing Link

One of the major challenges facing the mining industry today is the lack of infrastructure in resource rich locations. Without investment in infrastructure, mines cannot easily get metals and minerals to market. This has been a greater problem in Africa as there is little, if any, established road or rail transport infrastructure in many countries. This is compounded with the current crop of undeveloped finds, given the distance to be travelled to the sea, and thus the scale of finance required to complete the system. If you examine the junior mining companies with iron assets along the west coast of Africa, almost all of them will require the provision of infrastructure costing in excess of US $3 billion. In fact, the infrastructure spend now massively dwarfs that for construction of the mine itself.

Governments have two broad options in terms of developing this infrastructure. The first is to develop the infrastructure itself, and provide the mining companies with rights of use. The second is to issue concessions to develop the mines and connecting infrastructure, but provide that the infrastructure benefits from shared use arrangements with other mining projects or other users.

Infrastructure requirements

The mining companies will generally require:

  • Road infrastructure (initially for construction, then for haulage, service personnel and consumables/supplies)
  • Rail infrastructure to transport the product (depending on the volume of the product to be transported)
  • Power infrastructure to operate any process plant (for example crushing and beneficiation)
  • Port infrastructure that is suitable for appropriate sized vessels and is fully integrated with the miners’ rail/road infrastructure.

The combination of these infrastructure needs will depend to a great extent on the mineral being extracted and exported. For example, the gold ore is almost always processed at the mine, hence the transportation quantities involved, and the value of that product will probably mean the mineral is airlifted by helicopter. However, where the product is iron ore, whether direct shipped or concentrated, the millions of tonnes of iron ore required to be transported will in most circumstances, necessitate a rail system or at least a dedicated haul road. Where the mineral product that requires transporting is less voluminous, ie, in the region of thousands of tonnes per week, then the choice of infrastructure becomes dependent on the cost/distance per tonne.

Government funding programmes

Sub-saharan African governments are clearly not cash rich, and historically infrastructure development in the region has been slow. However, there are possibilities for governments to fund these investments.

PPP solution

One possibility would be for governments to adopt a public-private-partnership style scheme, and grant concessions to private partners to develop the infrastructure on a standalone basis. This would still require significant finance, and if developed independently of the mine would lack recourse to the commodities/mining licence, which is so critical to appetite amongst mining banks. The western lending market for infrastructure projects of this scale remains illiquid, so African governments would need to look elsewhere for funding.

Receivables financing solution

Governments might seekDFI to adopt a prepayment/discounting type facility to fund the infrastructure build, based on future receivables for the government in connection with the mine. Governments typically receive revenue from two sources in relation to mine developments - dividends paid in connection with a mandatory government shareholding in the project company, and/or royalties received in connection with sales of product. Finance could be obtained up front in return for the right to that future revenue stream - this type of finance is not uncommon with mining companies themselves, so governments ought to be able to obtain the same leverage. The circularity however is that such prepayment type financing is typically only available once a mine has passed completion tests and reached operational phase, which it cannot practically do until infrastructure is in place to get product to market - the infrastructure cost must be paid up front in order that the infrastructure is developed in parallel with the mine.

The other complication with this structure is that any government which receives World Bank funding will be subject to the World Bank negative pledge restrictions, which would prevent those governments from pledging/selling their rights to royalty payments and dividend streams. Of course, the World Bank may be willing to waive these restrictions if the purpose of such arrangements was in order to raise finance to develop infrastructure benefiting the wider population.

DFI solution

These multi-use infrastructure developments fall squarely into the spectrum of projects that development finance institutions are mandated to finance. DFI’s have been very active in financing sub-sea cable developments bringing greater telecommunications services to Africa, however there has been less interest amongst those same institutions in road and rail infrastructure in the region. Clearly there is a significant need for better rail and road infrastructure, both for general movement of population as well as business development, and as such these mine developments present an obvious opportunity to create better infrastructure for the region. There is an obvious role for DFIs in this regard, alone or in tandem with financing from commercial lenders.

Chinese solution

The other alternative for African governments seeking to develop infrastructure is to enter into joint venture development arrangements with Chinese institutions. China has already evidenced its willingness and ability to build and finance infrastructure projects across Africa, in return mining rights and offtake opportunities. Given the massive infrastructure needs of African governments in order to support mining projects and general development, and that fact that China remains the only viable source of funding for these mega projects, it is inevitable that we will see further Sino-African agreements on this front. We are seeing further interest in Asia for financing these types of development, particularly from Korea and India, however at the moment China is still leading the race.

Mining company funding

Governments may seek to push infrastructure development costs onto the mining companies themselves. If so this will not only test the economic viability of projects but will significantly limit the ability to fund such projects.

Reducing capital costs

Capital costs can be spread amongst more than one mining project (and possibly amongst other non-mining related users) by sharing use of the infrastructure. Clearly the abundance of mineral resources in Africa means that any rail or port infrastructure can serve a number of mining sites by adding branch lines and spurs. This solution is not free from important caveats. Whilst it can help to spread the financial burden, sharing infrastructure in this way brings with it a number of issues around commercial competition, provision of wider logistics, the pricing of access charges, early termination of access, insurance costs… the list goes on.

All those issues deserve entire articles and discussions in their own right. However, in the context of investment in African infrastructure, the key will be to strike a balance between providing for an appropriate level of investor protection on one hand and on the other, the need to provide wider opportunities for the host state and its population and other investors looking to access the continent’s resources.

Chinese solution

Even with capital cost sharing arrangements, there is still a need for significant amounts of financing. Whilst there is now a resurgent appetite to finance strong mining projects among the key western mining focused financial institutions, such as Standard Bank, Standard Chartered, Caterpillar Finance, BNP Paribas and Investec, given that there remains at this stage only a small group of active banks in the sector there are inevitably liquidity constraints in the context of the surge in new development projects seeking finance.

Consequently, junior mining companies themselves inevitably need to look to China to source finance for their mine developments. Whilst there has more recently been some consolidation, China’s focus remains on strategic resource based investments and its appetite for raw materials continues. The Chinese banks have the depth of resource to be able to fund these mega projects in their multiples, and they have a mandate to do so given the potential offtake opportunities.

So whether government funded or privately funded, these massive infrastructure developments and programmes are dependent on Chinese funding, as the Chinese state owned banks still have the deepest pockets and the strongest appetite for investment. As development opportunities are found in increasingly remote areas across the globe, this is a trend that looks set to continue, although new sources of finance from India and Korea may soon provide viable alternatives.

Considerations affecting shared access arrangements

African governments are keen to earn the royalties from the revenue generated by the mineral ore exports but many are also very keen to ensure the associated development of their countries’ infrastructure to benefit the wider population. Increased mobilisation of the population can bring even greater benefits to a country. Therefore, mining companies and investors need to consider the implications of sharing access to the infrastructure when developing projects in Africa.

Generally, a concession agreement would give the party granted the concession (“the Concessionaire”) the right to construct, operate, maintain and expand the rail and port infrastructure or to rehabilitate existing infrastructure. The position of a first mover into securing the concession or right to build the infrastructure could have significant value not only for the cost/efficiency of getting the product to market but also as a potentially profit making infrastructure provider. Therefore a mining company should generally seek to ensure that all available capacity is for its exclusive use. However this is not always possible or practical.

The mining company will look to optimise the combined use of the rail and port infrastructure with its mines so that they will operate as an integrated operating model and thus use any flexibility in the port and rail part of the logistics chain to smooth interruptions in production. What this means in practice is that the actual capacity utilisation of the port and railroad will be higher than the actual tonnages carried.

If this leaves little spare capacity in the rail and port infrastructure system, then the mining company will certainly be of the view that any additional access by any Third Party Access Seeker (or TPAS) to the rail and port infrastructure will have an adverse and detrimental impact upon the efficiency and economics of their operations. This will ultimately affect the price of production and export of its material.

If the mining development agreement/concession agreement does not provide for exclusive use of the infrastructure then the agreement should provide protection of the Concessionaire. Protections may include listing the circumstances under which it must allow access to third parties, detailing the rights of the Concessionaire to challenge such access requests and setting out the protections that the Concessionaire will receive if, by giving such access, the Concessionaire suffers loss.

It will clearly be important for African governments to balance the protection sought by foreign investors against the benefits of unlocking the wider potential for infrastructure development in their countries.

The terms and conditions for access to the Concessionaire’s rail and port infrastructure will be set out in an agreement between the Concessionaire, TPAS and the Government or Government Authority (the “Third Party Access Agreement”). The mining company would also require the TPAS to provide satisfactory “Guarantees” in support of their Third Party Access Agreement obligations and liabilities.

Access to the infrastructure can be provided in one of two ways:

  • Simply allowing access to rail, track and port facilities at designated times using time slots.
  • Providing an ore logistics transportation and port service. On this basis, the mining company would now be an infrastructure operator. Accordingly it would be required not only to allow access to its infrastructure but also to manage and facilitate the operation of that infrastructure for the benefit of itself and third parties. This would include the provision of a logistics service in accordance with a type of access protocol.

Clearly, where investors have first mover advantage in African countries, they will naturally work to ensure they protect themselves as much as possible against any adverse impact that arises through sharing infrastructure. It’s an important point to understand for any new entrant into African markets.

However, it’s also clear that being able to share a certain amount of the infrastructure costs can outweigh the limitations such sharing will likely impose. The upfront capital required to develop significant infrastructure which is available to Chinese investors for example can certainly provide opportunities for non-Chinese investors, mining companies and host states. It is essential however that the balances alluded to in this article are achieved by host governments to unlock the potential for wider non Chinese inward investment and increased social and economic mobility for the host state.

However, any miner looking to go down this road needs to also ensure it properly understands issues such as the pricing of access charges, early termination of access, insurance costs, expanding the infrastructure, etc. Those, though, are topics for a much longer conversation.

For further information contact:

Martin McCann

Mark Berry

Daniel Metcalfe

Matthew Hardwick

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