Rod Morrison: Right now, given what the banks are offering, are bonds competitive with bank loans in terms of the long swap curves, that sort of thing?
Marc Bajer: Well, it depends what you call a long-term bank loan. Large projects, it’s not really long-term lending, is it? Smaller ones, yes, you are getting 20, 25-year terms. We will be doing 30 and 35-year deals, which is a bit longer. The relative value in terms of cost is very competitive at the moment. That’s because where bonds are trading versus where bank loans - with the exception of what happened last week - bond pricing has been tightening down quite a bit in the last year.
So at the moment the offering that we would be able to provide, and I believe any solution like us would be able to provide, would probably be able to deliver something like a 30-year financing at something around anywhere from 10 to 50 basis points cheaper than bank financing. Now, as we all know, what is long-term bank financing in large projects? It’s not really long term, is it? There’s step-ups, there’s sweeps, there’s break clauses, there’s all kinds of things, so you wouldn’t really characterise it as long-term finance.
So, my view is that even if a bond solution that is deliverable; can be delivered to a large project and equal to or even greater than bank financing, the cost is still lower because the all-in cost of bank financing is not really reflected in the headline numbers that we all talk about every day.
Rod Morrison: Martin, the Pru is an investor in both debt and equity …
Martin Lennon: It is, yes. I’m focused on equity now, but for my sins I was responsible for all things infrastructure in the past, and, you know, have done direct lending into projects and into corporate structures in the infrastructure space, and in fact my debt following has continued to do that.
We’re focusing on PPPs. PPPs aren’t particularly spaced within the infrastructure sector, which sort of drives the SPV structures that we’ve talked about and drives the sort of lending structures that we have talked about.
I can understand why many sponsors like the banking product, because they are bored of rank relationships, etc. It’s interesting that even in the worst times of the crisis, and going back to about 18 months ago, the capital markets were flying, they were lending to corporates, they were lending to utilities. They were issuing record amounts of capital, so the value is there.
The challenges it has had in really establishing itself as an alternative form of finance for PPPs have been some of the things we’ve talked about. We are quite atypical as a house in that we do have resources, we understand the space, we have committed people who can analyse structure and do these deals, so it is very, very unusual in the UK. It is unusual worldwide, frankly, and because of that, it facilitated what you would call the monolines seizing an opportunity to become an intermediary, to provide those houses that didn’t have the resource with a sort of subcontracted credit capability. The other thing they did was to enabled the pool of investors attracted to infrastructure to be greater, because they increased the credit rating, and it’s interesting to hear your views earlier, Mike, about the BBB rating of the standard contract.
The only thing you did not say was what role does the capital structure play in the rating, because the contract just sets out the risks. If you find it’s at 100% or 10% debt, the credit rating would be tremendously greater than it is at the 95% debt levels that we’ve seen. That’s been a factor, really, of the issues that we’ve faced and the kind of markets that have been competing with the banks.
The banks have been very, very good in giving success there. Then they were concluded in terms of an unwrapped product with the monoliners, and so it became very, very tough to develop an unwrapped product. Going back again 12 to 18 months when people were concerned about where the money was going to come from to continue to invest in infrastructure, we received lots panicked enquiries saying: “Well, you guys can do it all now, can’t you?”
We’d love to, and we can do some, but it is not a tap that you can just turn on because we’re just one house, we’re not a market, and the issues about having credit capabilities, having people to manage the assets and the books are very real issues.
I suppose a bit of it comes to forward planning, and I think we all know and have different beliefs about some of the challenges that the banking market will have over the next few years. They are substantial challenges, whether or not Basel comes in; the unwinding of the government supports, the de-leveraging, the fact that there are competing assets that the banks have to invest in. All these issues are going to make it very, very challenging for banks.
That’s not to say they won’t overcome them and that’s not to say the government won’t do things to make sure the money goes to where it is needed. But it would seem to me to make sense that wouldn’t you want to do some structural planning now to say: well, it must be a good idea to see broad sources of capital available for this asset class?
This is not an advert, apologies, but we at M&G have a fund called the UK Company’s Financing Fund, which we established just over a year ago, focusing on the corporate sector. We were concerned and we would know the Treasury are concerned, that as corporates were looking to refinance their positions, the banking market was squeezing and they were going to find challenges - certainly some of the smaller corporates would find challenges.
Here we are providing an alternative source of capital to try and meet that challenge. That is now starting to make investments - it’s taken a bit longer than we expected, but actually we’re starting to see some momentum in that. I do think insurance companies, pension companies are good long-term investors in infrastructure. I take your point about the flexibility, but what that leads you to is actually a combined source of capital where you can tap the bank markets, you can tap the capital markets at the same time, and that’s kind of the ideal solution.
The project-by-project procurement group doesn’t lend itself to the corporate structure, and it is apples and pears. I welcome initiatives such as Marc’s - that’s my equity hat on, the more sources of capital I can have the better, and the more competition we can have for capital the better.
Just to echo a couple of things in particular on the banking side. We have seen that relationships have really mattered in the last 12, 18 months from a bank lending point of view, and you have a need to understand that. If I broaden the sort of geographical remit, local bank lending to local markets has been a very important thing as well. Some of the internationalisation, the cross-border lending has been greatly restricted, although that seems to be changing a little bit now.
So those things have continued, but there are some very good banks out there, there are some very good capital market houses out there. There is capital, the focus seems to be now on the quality of the projects and the sponsors more than it has ever been.
It is interesting the amount of conversations I’ve had with lenders who say: “I’m going to lend this much this year and these are the things I’ve targeted and anything else that isn’t on that list will have to go somewhere else.” I think that is improving. There are some very real challenges ahead, but I’m heavily optimistic and I think we will get through it.
James Butters: I think you made a very good point, because there is a pre-disposition towards going to the banks, not simply because we are completely tunnel-visioned or blinkered, but simply because of the construction period. It is much easier to negotiate with a relationship bank, or a bank that you have with some understanding of your core business, because simply going out to people who are uninformed becomes much more expensive.
Furthermore, our end-client, the end-user in the public sector, are wanting us to take more and more risks, even though the banks are tightening up on their credit and their analysis, their requirements through subcontracting or whatever else. We are being asked to look at things like demand risk, we are being asked to look at different elements of risk and transfer that we would like to accommodate.
We have banks that have the capability and track record of analysing risks, understanding the basic model. It is much easier for them to take that further step forward to accommodating a new risk than some of the investment houses, real money investors we go to - it is quite clear there is a manifest efficiency. I think there is no longer an intermediate step between them other than what you are offering.
Martin Lennon: I totally agree. The other thing I should say is - it has been picked up before - we have competing pressures for where our money is going to be allocated and we are relative value buyers as a house; equity and debt. So, frankly, if the conditions in the environment for PPP or infrastructure improve to such an extent that it becomes a very attractive asset class, then that problem will be solved in time. It is not a tap you can turn on overnight. If it becomes a very attractive asset class in a large-scale sense, then I think the market will react.
James Butters: That leads to an awful lot of compromise in the end-user and the client. That’s where we, obviously, then as service providers; we’re trying to accommodate their desires. We don’t want to end up in a situation where the financing put in place is driving the product that’s being produced at the other side.
Martin Lennon: Yes.
Marc Bajer: There’s no question - in our investigations over the last year we have confronted the whole issue of flexibility - in the banking market versus the lack of flexibility in the bond market as far as terms and conditions are concerned and possibly day-to-day operations as well. You can’t really mix and match the two: a bond is a bond and a bank financing is a bank financing.
A bond financing is not flexible in terms of its coupon and its maturity. Once it’s issued, it’s a long-term bond, it’s a 30 or 35 year bond, it has a coupon, it amortises and that’s it. You can’t refinance it, none of that can happen, right. Essentially, what borrowers have to do on a day-to-day basis is make the decision, right, what do they want? Do they want certainty of financing or possibly cheaper financing in the bond market, or do they want flexibility?
Now, I think that actually comes down to a project-by-project problem, in particular when you are talking about small projects versus large projects. There is no question that when you go to banks, you know - if you are only using banks, flexibility is a big advantage. The problem that exists, and I think the problem that all banks will confront, particularly as we approach Basel III, is it won’t really matter that much how flexible they are when they are no longer able to provide the finance at all.
So, the idea is really creating a balanced portfolio of financing among all projects, so that you have access to multiple markets in order to produce certainty of financing and cost-competitive financing. So I don’t think you have to make any bones about the fact that a bond is less flexible than bank financing: it is, but there are substantial advantages that accrue to it as well.
Chris Elliot: Sorry if I was misquoted, I don’t think pension funds and institution investors are not the natural home. I think the structures that we have in place at the moment don’t make it easy for them to invest in.
Marc Bajer: Absolutely. We hope to solve that problem by our solution.
Chris Elliot: If you look at the overall economics, the long-term stable cashflows, they are the people they should be wanting to invest. The structures we put in place just don’t make it easy for them. The traditional view: we’ll do a bit of bank and do a bond for 20 years is not right.
Marc Bajer: You are right, the rating is not right for them and the way the deals get structured is not right for them.
Gershon Cohen: Can I ask a very quick question to clarify a point that Richard raised and was mentioned by Martin and James. My observation as to why certain banks that have some state intervention have been very active is really around the point that Martin and James have made: there has been a retrenchment into domestic geographies.
If you look at the UK, the current providers of capital into the market are those that are clearly focusing very heavily on their domestic market, and who are supporting long-term customers, customers they hope to be doing business with for a very long time through the cycle. This is actually, in my view, not driven by the state intervention but by those two factors. Indeed, if you look at the trend, you will also see those banks supporting those customers outside of the UK because of the very strong relationships.
Rod Morrison: David.
David Lee: To pick up on Richard’s point, that he doesn’t think TIFU will actually ever lend. There has always been an expectation that if you can identify it and if it has the right features, you will see TIFU lending. So probably a defence deal where you couldn’t have the ID, a big number involved, and for some reason having other unique features that have been talked about in the context of, say, SAR-H, which is, for other reasons, not going to happen. But also in some of the rolling stock deals as well. There is still an outside chance of TIFU doing something, from my perspective.
On the international side, stepping back, looking at how we see the international deals that we’re working on panning out, there is a much greater role for ECAs and multilaterals. We really have seen a big step up in those as an essential component on deals that five years ago we would have financed without their involvement at all. Seeing the EIB step up from €35bn to €50bn of lending in a single year has made a tremendous difference to deals being done.
Jumping about a bit, but on the bond side, it’s very interesting to hear the remarks about the North American deals getting done. We were approached by a number of institutions last year saying: “We think there are huge legal impediments to doing a bond finance in a greenfield infrastructure project.” Actually, when we looked at it, there aren’t, and that’s been proved by a deal that we did in Canada, the RCMP deal. There weren’t any insurmountable legal issues at all to getting a bond deal away. So for me, obviously, the answer as to where the impediments lie is on the commercial market investor appetite side.
One final remark to make, really, which is adjacent: It’s a point, I think, that Gershon picked up, the OFTO deals. For us, one of the fascinating things about being involved in the OFTO market is that the process and the understanding of our clients replicated almost precisely the approach that we see in other countries to PPP. So looking at OFTOs, the PPP structure was used as a benchmark for the risk allocation, not to achieve an identical structure to a PPP transaction, but actually to see what the differences were, where the deals were tougher, where they were less tough just to give people an orientation.
I think that is one of the points about PPP that’s definitely worth making, when it comes to delivering the World Bank US$71trn of infrastructure needs before 2030 - who knows where that number comes from, it might only be US$70trn, it might be US$72trn.
For us, the clear message we’re getting from governments and other countries is that PPP is really the only viable game in town to deliver greenfield infrastructure on a large scale, and that doesn’t necessarily mean following the single SPV approach in every single country. That’s where I think some of the good ideas as to how to unblock some of the blockages we’re seeing in the UK will come from, because I think the deal flow here isn’t going to increase as it has done before.
Rod Morrison: Is that on a corporate finance basis or a project finance basis?
David Lee: I think we’ll see a mix actually, we’ll see a real mix, when it comes to issues such as, can we give refinancing guarantees in respect of mini-perm arrangements. We agonised over that for a long time, yet other countries have found different solutions as to whether they will or they won’t and how they would do it. I think that’s only a good thing for our markets. I think some of the solutions that we have been skirting around we have found elsewhere, by using, as the OFTOs do, using PPP in the UK as a benchmark, an orientation for different markets.
Chris Elliot: Project finance is a great way of getting projects built on time and on cost. I think it’s questionable whether it’s a great way of actually operating for 30 years, and it is also a question of whether it is a great way to deal with very small projects. If you look across the whole infrastructure place, everything is not big and complex.
James Butters: I think one of the important factors is the market is changing and it’s becoming more operationally driven. I think this is probably where you are seeing more similar trends, which is simply we’re being asked to do more and more operations attached to smaller and smaller elements of capex.
So really these structures are becoming slightly more risky because they are becoming operational heavy. Maybe the mechanics behind measuring performance could be simplified or structured in such a way as to lend themselves to a larger corporate, financing itself, managing its business as a portfolio and providing services. You know, borrowing some of the best of what’s already within the SoPC, because actually the way in which we have to perform and the way we’re disciplined to perform is quite good.
Mike Gerrard: We still have the £20m capex threshold. Do people around the table think that should go up for the adoption of project finance, PFI-structured solutions?
Gershon Cohen: My observation is it probably should, because the expectation was that project development costs would reduce, but they didn’t. So that threshold was probably set at a time when people thought: maybe that’s appropriate given the trend of production and procurement costs. But if anything it’s a straight line, flat line, so maybe that wasn’t thought about.
Richard Abadie: I think there is a different challenge that James is raising, though, Mike. I think it’s a question of when we did the Birmingham Highways maintenance deal. If you look at the total cost of the project over the lifetime of the project, it’s about £2.7bn. The upfront capex, if you want to call it that, which is really refurbishment of existing roads, is about £300m.
What you had in the structure of that deal was project finance banks driving the commercial deal which - with no disrespect to the banks, we’re delighted they funded the deal - but, back to James’ point, project finance is not a great bedfellow when you have massive operational costs and transaction relatively low capital costs.
Those are the type of transactions that need to have another careful look from the government perspective as to whether funding it on a traditional project finance basis is the best route to take them forward. The cover ratios, the sensitivities, the covenants that have to be met are structured around protecting £300m of debt, whereas the total project costs dwarf them hugely. It’s an age-old problem; operational leverage is a problem with many projects around the world.
Mike Gerrard: It could have been corporate finance. It’s a question of who the bidders were.
James Butters: But the beauty of corporate financing is when you are a corporate, you have an income stream made up of thousands of little contracts, not one contract where one client can terminate you. That’s where we get very nervous, then, looking at corporate financing, because for a big, strong company that is actually a possibility, to come in and take the problem away, but nobody would be comfortable with doing that where you have one contract, one client. In a wider business with ordinary activity spreading across a lot of contracts, there’s a lot less chance of just losing that one.
Rod Morrison: Just one point, Chris. It is incumbent on you either to say we need a new model, or a variation of a model, or to actually bundle your projects up together and become a corporate yourselves?
Chris Ellliott: I don’t think we want a model. I think we want a variety of models to try and solve the problems we’ve got. It’s possible that we ourselves or other people who have portfolios and projects can begin to introduce corporatisation to that.
Rod Morrison: But you have been around for a long time.
Chris Elliot: Sadly, yes. Financially I think it would be incredibly difficult to do now, if you just look at the cost of finance. You would be off your head if you unwound some of the stuff done seven or eight years ago and put it into the market now. There’s got to
be an economic climate when it is right.
Rod Morrison: Graham, we haven’t talked about the price of equity and sub-debt yet, Debt margins have gone up. Has the same happened in your market in terms of - I am not asking about your individual return - your primary and secondary investments.
Graham Beazley-Long: I will talk about that. I just wanted to make a few comments about the general discussion, if I may, which are different from anyone else’s comments.
I spent quite a long time advising government and we advised on deals that went to the bond market. Personally, I don’t think you will see a UK bond deal for a PFI type project unless someone in government decides they want to see one, because if you go to any single authority or state counterparty and say to them: what do you need out of this deal? They want certainty and they want to see someone on the other side of the table, and there is no one advising government on the financial advisory side in the market at the moment who has the balls to tell them to do a bond, with one or two very possible exceptions, possibly on very big projects at PwC. But otherwise you are never going to get that answer, and you need a UBS or a Deutsche Bank, or you need somebody on that side of the table saying we can do this. It’s just not there.
Richard Abadie: We didn’t advise on Bristol Hospital. RBC with the public sector advisers, and from what we could tell they were very keen to explore the bond solution. I think the final outcome, though, was a bank deal nevertheless,
so you had a very knowledgeable bond house advising on the public sector side.
James Butters: We were bidding against the winner there and we were asked the question, but the solution was: can’t
you just increase bonding to 30% of the construction value? Well, that’s just not an answer.
Richard Abadie: To credit-enhance.
James Butters: Yes, asking a company that has to then take money hard earned on proper contracts, little contracts, to weigh down and credit-sustain a larger contract that we could do actually cheaper then as a straight procurement is, I think, not a solution to the problem. It has to be more centralised. It has to be an enhancement from the government, or they have to get the investors to invest in it. All the investors have to get their heads around the risks that not having a wrap will involve and see if there is a market there at a certain price.
Marc Bajer: We worked very closely with the advisers on the bond solution. There were two bond solutions that were proposed. One was an unwrapped solution. That didn’t work for a variety of reasons, including the rating: they couldn’t really sell the bond at the rating. The other solution was basically ours: we were not in a position, having not closed the fund yet, to actually do the deal, but our solution actually worked, but, unfortunately, we hadn’t closed yet so we couldn’t do anything.
But the main thing that was provided was, and getting back to your point, there was a lot of activity around Bristol Hospital on the bond. The main point was that we were able to generate - and in all of our analysis - we were able to generate a Single A rating for the bond. Therefore it would have been able to have been sold at a price or a rating that investors would have bought.
David Lee: I think that is true, and we did advise them on it. None of that alters Graham’s point, because he is absolutely right: that is one deal where there is a possibility there of timetable issues. There are all sorts of reasons, but when it comes to presenting the case to a public body, unless they have some sort of buyer shifting within their brains, they will default to something that is…
Gershon Cohen: Or, the comment I would make in relation to Southmeads, on which we are a 50% sponsor, the pressure on us was deliverability.
David Lee: Precisely. There’s a particular problem there.
Graham Beazley-Long: And it’s a circular …
David Lee: Will it take longer?
James Butters: It has to be an extremely brave project manager in the public sector to say: we’re going to do a bond here.
Graham Beazley-Long: You can’t do it, that’s my point.
James Butters: A point well made.
Mike Gerrard: Answering that sort of question is, of course, part of the rationale as to why the government set up Infrastructure UK.
Graham Beazley-Long: Yes, you need …
Mike Gerrard: And you actually have a team of people in there - it is more than that. You are looking holistically across the infrastructure market, regulated and unregulated, the whole gamut, answering these questions about resources of capital, the resilience of the market to respond in the difficult circumstances we are in. So that is understood and they are on the case.
Graham Beazley-Long: I think what you will see is you will see UBS advise project finance, not a PPP deal or Deutsche Bank or whatever. You will see those deals coming back to the market, and they will come up with a structure. They will come up with pricing, and that will determine, that will give someone, some benchmarks. I think that is already happening, isn’t it?
Richard Abadie: You have it in the ROSCOs, in the trade of ROSCOs, they are not PPPs, but they have stable cashflows.
Marc Bajer: I don’t think it’s going to be that difficult in the end, because once you are in a position where you have a bond solution that actually works, every investment bank in the world will be all over it.
Graham Beazley-Long: Absolutely, but someone else will do it outside PPP.
Marc Bajer: Everybody will be advising the government to do the bond and everybody will be advising their sponsors and everybody else to do a bond. Why? Because the investment banks will then be able to distribute a bunch of bonds.
James Butters: Which is great for the investment banks.
Marc Bajer: They will be motivated once the opportunity arises.
James Butters: Which is great for the investment banks, but people need to just bear in mind that actually in the mix, here, of construction companies who are trying to undertake their activities and build product for the end-user, you are suddenly going to get penalised by virtue of a security package being enhanced way, way beyond - because already the packages within PFI are generous compared with other developments.
Graham Beazley-Long: That does work to your competitive advantage.
James Butters: It would do for Skanska, yes.
Graham Beazley-Long: On the corporate model - I think it is too late. We have 800 projects; they all have break costs. The amount of time and effort to corporatise them is so large that it’s not worth our effort, and if we do it the NAO will want 80% of the benefit, and they calculate the benefit in a way that means actually we get negative MPV. So that will never happen.
To do it going forward, you need the government to take, I think, a cost of capital risk. So you need to do shorter-term financing, which suits the construction model, and at a certain point of time you need the utilities type approach where you have a cost of capital, so you can do a refinancing and you can cope without taking long-term interest rate risk.
You need to do 30 or 40 deals at the same time, otherwise you don’t get be benefits. Simple as that, 40 deals all at the same time, all with one sponsor group, so it will never happen. It’s too late.
Now, you asked me about pricing in the equity market. I would say that in the primary equity market - the market for new deals - the pricing is primarily driven by big costs, scarcity of people who are prepared to wait three years to close a deal. You know, you are not having Goldman Sachs’ infrastructure fund with all its money thinking: yes, I’ll wait three years to put £3m into a transaction.
So you are with a very small group of either corporates that have other reasons for doing the deal, or the pure private equity guys - and there are few left prepared to put their money at risk. Their returns are dictated by what they set out in their fund documents, or: it has always been 15 so I’ll go for 13, those sorts of considerations, and the complete lack of competition because of that huge hurdle.
On the secondary markets, that is a much more competitive market. The yields certainly had come down until two years ago, and they will certainly come back up again. It depends on the size of the deal. If it is a big portfolio, you might get Goldmans, you get 3i, you get Chris, you get people interested in certain types of deals. If you are looking at one schools deal, maybe you’ve got a different type of market, and it depends who thinks who else is bidding for it.
So there may be a sort of a two-step market. If you have a big portfolio and you are selling, you might get slightly different people involved. I would say yields are currently stable, but they have been down and away in there more than halfway back.
Rod Morrison: Is infrastructure a tough sell? There has been talk about infrastructure funds in a wider sense finding it difficult to raise money because it is a liquid investment.
Graham Beazley-Long: No, I would say there is definitely an appetite for infrastructure as an asset class. I think like the bond market, perhaps investors find it difficult to find the right investment for them. If they are going into a primary fund, it probably won’t get spent for three years. They are not putting their money at risk immediately.
If they are going into a blind secondary fund, in other words the secondary fund hasn’t invested anything yet, they don’t actually know what assets they’re going to get and they are dependent on the fund manager - and some have better reputations than others, so they have to look very carefully at that.
Actually it is very difficult to put your money into the market when you want to, so if you wanted to invest in Innisfree now, or Barclays, they are not raising any funds so you can’t. It is a point of time. You have to make your mind up. The money doesn’t get invested for three years.
Mark Lennon: I think there is continuing appetite for infrastructures in asset class. Fundraising markets for lots of assets has been difficult over the last couple of years, and infrastructure is no different. I think there has been a big learning curve for many investors. I’m talking now about the sort of broader infrastructure place. PPP is well understood and has actually performed relatively well, I think, in the tough times we’ve had, even with deflation.
Some of the more GDP-linked infrastructure that was mentioned earlier has seen volatility that is to be expected. But I think some investors perhaps didn’t expect the level of volatility that they got and that was, I think, a product also of some of the extreme leverage that some people put into some of those assets.
But I firmly believe that infrastructure has proven its worth over the last couple of years, certainly selfishly looking at our own operating track record and the performance of the underlying businesses we’ve invested in. They’ve really stood the test and I think many investors see that, and now it’s a question of investors allocating it to the sort of investment strategy that suits them because investors are different - insurance companies to pension companies, from UK investors to sterling investors, etc, etc - but we are already starting to see some houses having successful closings, and I think that will continue in 2011.
Click here for Part Three of the Roundtable.