Infrastructure financing: A new role for corporates and banks

By Cassandra Mascarenhas

Discussing new investment opportunities and financing structures for Sri Lankan private sector entities to enter the current government dominated infrastructure financing in the country, Fitch Ratings Lanka hosted a seminar titled ‘Fitch Perspectives’ last week, featuring Fitch Ratings New York Global Infrastructure and Project Finance Director Cynthia Howells who spoke on the topic ‘Infrastructure Financing in Developing Countries: A New Role for Corporates and Banks’.

An energy analyst in infrastructure projects primarily, Howells in her work focuses on all types of energy projects which includes wind, solar, coal, gas and geothermal. Fitch formed the global infrastructure finance group in 2007 in order to consolidate the many and various infrastructure analyses that were going on at Fitch into one consistent methodology.

“It is extremely surprising to me that there are no Fitch infrastructure asset analysts in Sri Lanka, given that there are huge infrastructure needs in this country,” she observed in her opening remarks.

Out of the hundreds of analyses that are done globally, Fitch has found that commercial bank loans and capital market bonds have become the model for infrastructure debt financing in the so-called developed world.

“I already have experienced extreme power outages and there seems to be demand for high traffic roads and bridges, particularly outside Colombo, expanded rail travel is needed to cross the country, additional airports, more and improved ports and additional schools, hospitals, libraries, public housing etc.,” she added.

Howells noted that many of these projects are in the planning or construction stages in Sri Lanka currently and the method of financing is predominantly international borrowings – foreign government loans, international aid and the like.

“The question that I like to pose to investors, financiers, bankers, civil servants, regulators and others is why is private, corporate and local bank capital not entering the infrastructure market in Sri Lanka? Can the Sri Lankan business and financial sector apply the financing structure which is being successfully used in the rest of the world, to attract capital for needed infrastructure in Sri Lanka? From what I’ve read, heard and understand, there is very little reason why this is not possible.”

Advantages of private sector investors

Howells commenced her presentation by listing out some of the advantages of involving non-governmental banks and private investors in infrastructure financing. Firstly, it provides attractive investment opportunities in Sri Lanka that could retain local and foreign capital and it would strengthen the local economy by fostering common goods that underpin the future growth of every economy such as roads and bridges, airports, power plants, things that every business needs.

Furthermore, it may actually accelerate the process of infrastructure development if many entities support different infrastructure projects at the same time and the fact is that the government cannot do it all. Howells pointed out that private investment frees up the government to focus on the most difficult projects whilst more straightforward yet still important projects can be financed by the private sector.

Some disadvantages do also surface during this transition, she cautioned, and that includes higher financial risk which is always going to accompany financing not backed by sovereign credits. Additional expertise is going to be needed to evaluate and to mitigate the additional financial risks for the investor.

Based on Fitch’s track record rating capital markets’ financings, she proceeded to outline how Fitch defines infrastructure projects, sketched out some of the typical terms that Fitch has seen in infrastructure financings, discussed the key rating drivers of Fitch’s infrastructure analyses and outlined the specific criteria that Fitch has published for capital markets on infrastructure assets.

Howells finally presented two examples of two existing infrastructure projects that Fitch has rated that are not dependent on government aid.

How Fitch defines an infrastructure project

Howells stated that the defining characteristic of infrastructure projects is the nature of the expected cash flows to repay the debt. The debt repayment is dependent on the cash flows of standalone projects for infrastructure facility, there is no diversification.

A project can also encompass several project facets in different locations or simply one location but that they all be financed together and only the cash flow from those assets is what is relevant.

Cash flows are generated from the operation of standalone projects. If the project does not work or does not run, it does not generate cash flows. An infrastructure project is structured to pay off the debt financing used to construct it and to earn it equity return for the equity sponsors but no additional debt or equity is expected or really able to be raised for the project.

Infrastructure projects require a project vehicle to permit the segregation of the project cash flows, the sponsor or the developer does not have access to these cash flows – they go directly to the vehicle and are only used to repay the debt. Examples of such vehicles are an enterprise fund within a government entity or a single purpose remote trust.

Typical terms that Fitch has seen in projects

“Financing is typically 80 per cent debt, either loans or bonds, and 20 per cent sponsor equity but these numbers can vary,” Howells explained. “Investors are typically institutional investors, government pension funds, corporate pension funds, insurance companies, large infrastructure asset funds, forward looking corporate companies such as IT companies and the like. Or debt investors can be traditional lenders, international or local commercial banks, investment banks or other financial institutions.”

The project sponsor is typically relevant only prior to financial close. “As you recall, infrastructure projects are independent so after the equity capital is paid, it really doesn’t matter who the sponsor is. The debt is typically fully advertising over the term of the debt but Fitch has also rated many other organisation structures and the debt term is typically the whole life of the project, 20 to 30 years depending on the asset.”

This means that investors are looking at long term prospects for debt repayment, not just the short term market dynamics.

Interest rates are typically fixed given the higher risk of a long tenor and the single asset nature of the cash flows. A couple points to note, she added, are that Fitch rates the individual debt instrument. Fitch does not rating the project itself and rates according to the likelihood of default on infrastructure debt based on our criteria and our key rating drivers so Fitch’s ratings do not incorporate recover prospects, only the likelihood to default.

“To complete the rating, we have some terms. We know what the asset is, we know some of the general terms, so how do we complete the rating? Fitch considers six key rating drivers in infrastructure analysis,” she said. “They are completion risks, operation and revenue risks, debt structure, debt surface and counterparty risks, the legal structure and information, and the macro risks. The first four are the really important ones I think for Sri Lanka.”

Key rating drivers considered

With completion risks, if it’s a Greenfield project that is being built from scratch, you want to be sure that the project is completed on time, on budget and up to the performance standards that it was built to meet.

It needs to consider the contractors, the cost structure, the delay risks, if there are any technology risks, if it has an internal liquidity support to pay for cost overruns and if there are additional costs metered during construction. All of things are evaluated.

Operation and revenue risks address the asset’s ability to generate stable cash flows that are needed to service the debt. It looks at the legal framework and the fundamental economics of the project and it includes operating risks, cost risks, if actual costs are going to equal what was projected or if it will be higher and if that will reduce the debt service, the cash available for debt service, whether there is adequate demand risks.

“For instance, if you build a toll road and you expect a million people to travel on it for a year and you don’t meet that threshold, what does that mean for the cash flows?” she questioned.

Looking at debt structure, Fitch would consider each rated debt instrument separately, taking into account many of the different things like payment priorities, if there a senior and junior tranches, what does that mean for the junior tranches compared to the senior tranches – all these go into how risky it is that the repayment of the debt will be.

“The final thing I would like to mention on these rating drivers is on the financial cases that Fitch would develop. We develop financial cases to assess the financial flexibility of the project under reasonable stresses so we use these matrices to evaluate the liquidity profile and the overall leverage and some of the main matrices that Fitch uses are debt service coverage ratio, total cash flows divided by the total debt service in any given year – that’s basically our main matrix. Legal structure and macro risks are pretty self explanatory.”

Suite of criteria

Fitch does have many different criteria and the points discussed above were the master criteria which are Fitch’s general roadmap for evaluating this sector and it is applicable globally. The master criteria are published on the Fitch website and are widely available to the global marketplace. Fitch also publishes sector criteria and these focus on the various asset classes and provide specific guidelines that are tailored to that industry.

The suite of criteria in the infrastructure space include separate criteria for airports, ports, toll roads, bridges and tunnels, thermal power projects, onshore wind projects, solar projects, sports stadiums and availability based projects which includes schools, hospitals, public housing and libraries. These criteria are to give people a roadmap on how Fitch looks at these assets.

Caithness Shepherds Flat LLC

Howells then proceeded to give two examples of projects that Fitch has actually rated. The first one was an energy project called Caithness Shepherds Flat LLC, an 845 megawatt wind powered electric project in the Columbia River Gorge, Oregon, USA.

“This plant is a unique alternative energy project because it’s supported by loan guarantees from the US Department of Energy. Under the DoE’s financial institutions and public partnership programme, the senior debt of this project is guaranteed 80 per cent by the DoE, that is the US government, and 20 per cent of the senior debt is not guaranteed. It is the full obligation of the project alone,” she detailed.

Shepherds Flat is currently in construction and it is expected to be fully operational in September 2012. The revenue contracts that this project has are also very strong, they secure the cash flows and are provided three of the largest corporate utility companies in California – there are actually only three utilities in California and all three of them are investment grade rated so very strong revenue contracts.

Howells revealed that the total project costs for this wind farm are $1.88 billion and Shepherds Flat issued $1.2 billion of senior debt in 2011 which was sixty three per cent of the total financing costs. It was comprised of two primary parts – a $520 million 22-year fixed rate capital market bond and $675 million 14-year floating rate syndicated bank loans – it had a bond portion and a bank portion.

The five $225 million bonds are 80 per cent guaranteed by the US government and have a fixed coupon of 4.48 per cent and the 20 per cent of that tranche that is not guaranteed has a fixed coupon of 6.95 per cent.

“As you can see, the guaranteed bonds received a lower interest rate based on the irrevocable and unconditional loan guarantees of the US government which is rated triple A with a negative outlook by Fitch. The non-guaranteed portion of the bonds received a higher interest rate based on its exposure to the project fundamentals without the backing of the US government. The project was ultimately rated triple B minus with a stable outlook by Fitch based on our six key rating drivers,” she explained.

The $675 million bank loans were similarly 80 per cent guaranteed by the US government and they are based on the floating rate 10 year US Treasury plus a risk premium and the 20 per cent that’s not guaranteed of that tranche is based on a slightly higher risk premium also over the 10 year treasuries.

“This project is also interesting because it is owned 10 per cent by the corporate project developer which is Caithness energy and the 90 per cent equity partner is GE Financial Services which is a division of the General Electric Corporation. I think it is interested to note that GE’s participation is probably due to the fact that GE’s turbine manufacturing affiliate supplies the turbines to this project,” Howells pointed out.

An interesting development post-financial close that she emphasised on was that GE sold a majority of its equity holdings to three additional entities: Google Inc., Sumitomo Corporation and Tire Energy Corporation and GE expects to hold a minority share of this company going forward.

“Why Google? Our assessment was that this is a forward looking technology company and it wants to invest in sustainable energy projects and be a good corporate citizen. Shepherds Flat was a very high profile deal in the US and that gave Google a great deal of recognition in the renewable energy space. I think that it’s fair to say that it’s unclear if the company will continue to make these kinds of investments going forward.”

Hearing this information about this particular project, her question was if it is possible for Sri Lanka to use this financing structure to build power plants. In fact, she noted, this is a public and private partnership where both the government and the private sector share the risk of financing this asset to provide a common good.

“Is the Sri Lankan Ministry of Power and Energy an analogous entity to the US Department of Energy and would this entity be willing to work or to partner with a non-government entity to build such a project. I understand that the Sri Lankan Government recently issued 10-year sovereign debt at 5.85 coupon – is this a rate private companies would be willing to provide capital at?”

Sydney’s M1 toll road project

The second project she spoke about was a toll road. For a toll road, debt is typically issued by a private sector company with a long term concession agreement and the concession is usually provided by a government related tax authority such as a city, state or municipality to provide the necessary service such as the airport, port, toll road, bridge or stadium.

The project is managed by AMT Management Limited, a a special purpose borrowing entity for the Airport Motorway Group which is the owner of a 48-year concession with the state of New South Wales. The toll road is the M1 – a six kilometre motorway in Sydney.

The M1 links Sydney’s business district, the Sydney harbour tunnel and the Sydney harbour bridge with the city’s affluent southern suburbs and with Sydney’s airport – a very small link up road but a very important connector.

“Tolls increase four per cent annually as per the concession on this piece of toll road and traffic volumes overall appear fairly inelastic with a high concentration of commuter traffic and commuter traffic is the best kind to have on a road so that was very positive,” Howells commented.

The toll road is currently financed by 520 million Australian dollar bank loans and is provided by a group of highly rated Australian, Japanese and European commercial banks. The equity portion of this financing is not known by Fitch because it is bundled with a lot of other toll roads that this developer owns.

The interest rate is a floating rate, with the Bank Bill Swap Bid rate (BBSY) currently at about four per cent plus a fixed margin of 1.2 per cent on the three year and 1.75 per cent on the seven year tranche and the lenders are acquiring up to 70 per cent interest rate hedging on the floating portion of the debt.

“The loan structure is actually very unusual in Fitch’s experience in that it is extremely short term compared to the like of this asset – 48-year concession and it does not amortise at all,” she stated. “The sponsor, a large toll road enterprise called Transurban Group expects to refinance the loans periodically until 10 year before the concession ends and then begin amortising but it is not obligated to do so. It could actually leave the repayment of the 520 million loan until the very last year.”

Fitch however believes that this is a weaker structure and that is something that brought down the rating. The 520 million loans currently have a Fitch rating of A minus with a stable outlook and is based on the robust annual toll growth, the strong concession provider – the state of New South Wales is rated triple A with a stable outlook by Fitch.

“Again, my question is if it is possible for Sri Lanka to use this financing structure which uses a government concession with private debt to build toll roads,” she said. “Is the Sri Lankan Road Development Authority an analogous entity to the concession granted for the state of New South Wales and is this model one that could be used for the Colombo-Kurunegala-Kandy toll road that I believe is under consideration at the moment? Or could the concession model be employed in the yet to be constructed portions of the Southern Expressway?”

In her concluding remarks, Howells made a few additional observations. “Corporate and banks already play a key role in developed markets by financing a diverse group of infrastructure assets. The corporate and banking sector in Sri Lanka could have a similar role to play in the development of local infrastructure to provide public goods,” she asserted.

Governments probably should retain control over the terms of the concessions, including some terms for the debt repayment that are provided by the corporations and banks, Howells acknowledged. Roadmaps for the successful funding of non-government sponsored infrastructure projects do exist and the credit agencies such as Fitch and others all have well-developed methodologies for analysing and evaluating the additional risks of investing in infrastructure asset debt.

“The agencies have experience rating large numbers of these projects across the globe that involves both the private and government sectors and finally together with the investor and banking sector, the rating agencies may also have a role to play in evaluating the added risks of private infrastructure financing in the Sri Lankan market.”

    Pix by Upul Abayasekara