Commentary on the Markets Related to PPP

Just when PPP was gaining strong momentum in Canada, along comes a market condition so challenging that no one is absolutely certain what impact it will have on the Canadian PPP market. There are some who are concerned the restricted access to debt markets will slow things down or drive the costs up beyond proof of value thresholds. There are others who speculate that when the dust settles, investment must go on and infrastructure’s long term nature will provide a very attractive destination.

The following has been written by Daniel Roth, Managing Director, Infrastructure Advisory Services, Ernst & Young Orenda Corporate Finance Inc., and begins an on-going dialogue for our CCPPP members.

Internationally, leading commercial and investment banks are going bankrupt or being bailed out and nationalized. Corporate profits are down and investment is slowing dramatically. Recession is threatening, as is inflation to a lesser extent.

Until now, Canada has been relatively immune to these global developments, thanks in part to strong commodity exports, limited exposure to high-risk debt and a banking market recently rated as the strongest in the world. But the financial market meltdown and credit crisis are gripping all of the world’s major economies to some extent.

Equity flotation is out of the question. Securitization and most forms of bond financing are severely curtailed. Ratings agencies are under scrutiny. Commercial property has hit bottom. And banks aren’t taking significant syndication or underwriting risk.

So isn’t it just a matter of time before the Canadian P3 market is slowed by these developments? The provincial and federal governments are accelerating their pipeline of P3 projects. Will they be able to achieve their objectives of value for money – and sheer volume of investment – in this environment?

The evidence is encouraging – in Canada as well as the UK and other P3 markets. In fact, we believe that Canadian projects, even in the short term, will continue to get financing and reach closure. But governments will have to temper their value-added expectations somewhat, and will have to adapt their procurement processes to the current situation. In the mid-term, markets will stabilize, although the good, cheap times of recent years won’t return any time soon.

It’s no longer only about pricing

While the cost of debt has rapidly increased, the bigger problem right now is the uncertainty surrounding its pricing and its availability.

Ernst & Young’s P3 team in the UK reports that the average margin for availability payment-based P3s, in that very mature and competitive market, has increased from around 60 bps to break past the 100 bps mark. P3s involving volume risk, such as waste processing facilities, have seen similar margin increases, and now reach over 150 bps.

Recent Australian transactions in which Ernst & Young has been involved show similar 50-plus bps increases in margin compared to similar projects before the credit crunch, whether in transport or social infrastructure. Construction financing margins are approaching 190 bps.

Our recent Canadian health sector transactions are following this trend. Our experience has been that, despite the relative immunity of the broader Canadian banking sector, the increase in spreads has been even greater. The increase in debt pricing is being driven by the tightening of liquidity. Banks by and large remain comfortable with project risks but can no longer sustain lending at a level below their own funding cost. In early 2008 pricing on many of the Canadian P3 deals was at the sub-100 bps level, and following a nervous move into the summer we saw a slide of around 30-50 bps. With the onset of the growing financial crisis, we’ve seen a similar increase in the third quarter, with spreads now in the range of 100% higher than they were less than a year ago.

Yet it’s useful to put this into perspective. As a rule of thumb, the financing costs of a P3 project rarely exceed 25% of the total NPV. With an underlying rate of, say, 6%, a margin that has doubled from, say, 80 bps to 160 bps represents less than a 15% increase in financing cost, which translates to less than a 4% increase in project NPV.

There is also a sense among central banks now that recession is a greater risk than inflation, which means core rates may be cut further. And central banks are intervening heavily to stimulate inter-bank lending, which should help keep down the rates that underpin P3 lending rates.

The uncertainty around margins and rates, caused by their rapid movement from week to week, has resulted in an increase in the spreads included in consortia bids. Whereas consortia would previously usually take margin risk between bid submission and financial close, a period that could last from three to six months, their funders can no longer commit the terms and will increase their margins repeatedly, so that consortia are building in a bigger risk buffer. Some consortia are also having to take greater hits to their equity return.

For the time being, the syndication and infrastructure bond markets are effectively closed. The only way to successfully raise funds – especially for a larger project over $500M – is via a club deal. Even then, the transaction’s success is dependent on having enough banks on board and the club holding together. For smaller deals, we are still seeing single-bank financing, but also new sources such as direct financing from insurers like Canada Life and Sun Life.

The changes in debt packages go beyond margins and fees. Gauging the overall increase in financing cost requires an understanding of the implication of changing covenants. For example, lenders have increased their scrutiny of construction subcontractors, leading to a requirement for more third-party liquidity support (e.g., performance bonds, letters of credit). Of course, while this may increase the time and cost of reaching financial close, it is improving the quality of projects to the benefit of both the public and private sectors.

Indeed, some observers predict that once the worst of the liquidity crisis is over, debt capital flows to P3s may increase as part of a “flight to quality” with investors attracted to the government-backed and tangible infrastructure assets. This will be given a boost by countries like Australia and Mexico, which have announced accelerations of national infrastructure development, a traditional move to stimulate their economies, employment and financial markets.

However, the increase in the cost and complexity of securing financing, together with changes to covenant structures, is putting pressure on promoter and investor equity returns, as well as introducing time and risk into the government procurement process.

Market flex and procurement flexibility

Procuring authorities are suffering from the higher financing costs and bank fees, as well as greater transaction costs from procedures and negotiations that are taking longer to conclude. One risk is that final bids that were thought to have committed financing are reopened as debt continues to be re-priced. It’s no longer realistic to insist on committed financing at the bid stage – most lenders require price flex, or indeed market flex clauses (in which most terms, not just pricing, can be adjusted). This makes it impossible to conclude the financial evaluation of private partner proposals until much later in the process, and sometimes not even until days before financial close.

This creates significant headaches for procuring authorities. How can a preferred bidder be selected if the financial proposal is not known with great certainty? How can competitive tension be maintained in final lending negotiations until well after preferred bidder selection? Should government share the pricing risk to which the preferred bidder is currently exposed? In one current UK social infrastructure P3, the c. $150M debt package has been re-priced twice since April this year, and closing has been delayed.

One obvious remedy is to considerably shorten the time between price proposal and closing. That could mean allowing a later price proposal submission followed by a rapid evaluation and subsequent announcement of preferred bidder. Keeping the final negotiation and closing phase to a minimum may require additional work in earlier phases, much like the European “competitive dialogue” process we’re increasingly seeing, where no negotiations are allowed after final priced bids are submitted. But this requires a change in mindset and a careful adjustment of procurement procedures.

Another path to delaying the pricing of debt is to use a method developed for other reasons: the “preferred bidder senior debt funding competition.” In this procurement variation – which has been tried with varying degrees of effectiveness in the UK – the authority plans for (or reserves the right to) a competition among lenders after the selection of preferred bidder. The idea was that they could get the best technical team and then squeeze further value from competing the debt. Needless to say, lenders were not very favourable to this approach even before the credit crisis. Depending on the size and complexity of the deal, it may be worth governments’ consideration, but even this would be challenging as long as liquidity remains a problem.

Opportunity to rebalance the partnership?

Beyond procedural changes, several other solutions should be considered which involve adjusting the balance of risk-sharing to deal with the new market reality. We’ll mention two main approaches here.

The use of refinancing to generate value and lower funding costs in a project, particularly after the riskier construction and start-up phases, is nothing new. Indeed, refinancing clauses have been standard in most P3 contracts, and governments generally assure themselves of 50% of the gain at refinancing.

However, as discussed earlier, in the current environment, authorities are having to evaluate costlier bids and accept deals whose costs may further increase before closure. Both trends stem from the scale of uncertainty in the current funding market. In return for this greater risk exposure, we’re rightly seeing gain-sharing agreements giving governments a greater share of subsequent refinancing gains.

UK government guidance, for example, now specifies that authorities gain share scale up to 70%. In addition, authorities (not just shareholders) should be allowed to initiate refinancing if conditions so justify. It may also be quite sensible to deliberately plan for refinancing, where greenfield project construction financing is priced at a premium or if, and when, long debt tenors become scarcer.

As the market’s current woes increase the cost of capital for P3s and eat away at value for money, we have begun exploring more fundamental adjustments of the financing equation. The reality is that most P3s enjoy the implicit, if not explicit, backing of government. If things were to go badly wrong for the private partner, the asset would revert to government, and the public service would likely continue to be provided in one way or another. Some authorities have therefore argued that they are paying too much for “private finance,” and that they should leverage the more attractive government credit rating directly by using their own borrowing capacity.

Using government debt does not mean that private sector risk-management and project delivery skills (and consequent cost advantage) are insufficiently harnessed. The trick is to know where to set the mix of public and private capital so that there’s enough private capital at risk (both equity and debt) to foster motivation and discipline.

If the government agency (e.g., a special-purpose authority or public corporation) has the authority and the capacity to borrow, the deal can be structured using tranches of public and consortium debt. For projects with riskier construction and start-up phases, government can take a larger tranche of the funding package initially than in later stages, since it pays a lower premium to absorb risk.

For larger projects, typically in transportation, which are well over $500M or are measured in the billions of dollars, more sophisticated project delivery structures should be included to share financial pain and gain during the construction lifecycle – particularly if the project also has many interfaces with existing public infrastructure. This may be the case, for example, of major highway refurbishments within a complex existing network.

Looking forward to the mid-term, when the market finally improves, infrastructure will be seen as a relatively high-quality tangible-asset home for investors. But it’s not likely to revert to the days of historically inexpensive financing, easy syndication and highly leveraged bond financing, with the occasional equity flotation.

Meanwhile, in the short term, with an increasingly limited number of project finance banks with the balance sheet capacity to lend for long tenors, we expect a further increase in pricing, tighter covenants and possibly a push for shorter tenors.

The lack of availability, together with the overall increase in the private finance cost, will require both the public and private sectors to reassess how they tackle funding. We believe that greater consideration will be given to the use of co-financings and other structures where the public sector acts as a liquidity provider on projects.