12/25/2015 The growing role of institutional investors in infrastructure finance — Financier Worldwide

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The growing role of

institutional
investors in
infrastructure
finance
January 2016  |  EXPERT BRIEFING  |  FINANCE & INVESTMENT

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The need for infrastructure investment around the globe far BY

outstrips the funds available from banks – historically the only
David Carter
organisations able to fund new infrastructure without direct
recourse to the balance sheets of governments or major corporates. Norton Rose
Governments, commentators and corporate sponsors of Fulbright LLP
infrastructure projects have long held up institutional investors as
white knights able to fill this funding gap. The ability of institutions to
provide debt more cheaply than banks has made the elusive
possibility still more attractive.

Banks have been able to invest on a limited recourse basis because

of their expertise in using project finance structures; a form of
lending in which almost all risk is transferred away from the
borrower to other parties involved in a project (for instance
construction contractors, operating contractors, suppliers and/or
offtakers). If the borrower is able to transfer project risks to these
parties at an efficient price, it can make a sufficient surplus from the
income stream of the project to service loans from banks. This
means project finance lenders do not assess the strength of a
borrower’s balance sheet. Rather they assess the robustness of the
risk transfer in the project’s contractual structure, and the projected
income stream of the project.

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12/25/2015 The growing role of institutional investors in infrastructure finance — Financier Worldwide

This is not a passive process. Banks’ deal teams take an active role is
establishing deal structures, based on their appetite for and
assessment of the relevant risks. Once a structure is established
these risks continue to be monitored and actively managed,
especially during the construction phase when a project is most
vulnerable and rarely income generating.

Once constructed, project financed infrastructure has a number of

characteristics that make it highly attractive to institutional investors
– particularly to pension funds or insurers looking for long term
predictable yields to match their liabilities. Long term stable returns
are also attractive to sovereign wealth funds, sometimes also
motivated by political considerations. For these reasons, institutional
investors have long participated in the secondary market for
infrastructure – buying out bank positions once construction is
complete. The downside of this approach for institutions is that once
a project is operational, its reduced risk profile means it provides a
lower return.

Put the other way round, higher returns are available to lenders
prepared to take infrastructure construction risk. In the low interest
rate climate of recent years, this incentive has pushed a number of
institutions to try and take construction risk where previously they
wouldn’t have.

There are, however, problems with this approach. The need for
intense deal team scrutiny explained above (the Decision Making
Problem) and the credit risks inherent in lending to a project in
construction (the Credit Risk Problem) present issues for most
institutional investors. The traditional solution was provided by
monoline insurers, which solved both issues by insuring the
institution’s debt and in return for the risk, taking on the task of
structuring the deal. Although the model worked, most monolines
were heavily exposed to US subprime mortgages and their offering
became less available after 2008.

In the gap the monolines left (and against a background of

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retrenching banks and public need for infrastructure) a number of
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state and quasi-state actors came forward to provide alternative
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credit enhancement structures. The most notable of these in Europe
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were the Project Bond Credit Enhancement (PBCE) product offered
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by the European Investment Bank (EIB) and the Infrastructure UK
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(IUK) Guarantee. Both of these offer a solution on terms roughly
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analogous to the historic monoline model – the EIB (in the case of
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PBCE) or UK government (in the case of IUK) take a portion of the
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credit risk and in return a portion of project control.

Search Site Eight PBCE transactions have now closed and more are in the
About pipeline. Assured Guaranty continue to offer monoline style
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products and the IUK Guarantee have successfully taken projects to
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close in the last 12 months. The Juncker Plan – the infrastructure
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package that the President of the European Commission, Jean-
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Claude Juncker has promised to deliver through the EIB – looks set to
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JOIN MAILING LIST roll out credit enhancement on a grand scale.

Each of these structures have enabled institutional investors to

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participate in greenfield infrastructure projects, by externally solving
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the Decision Making and Credit Risk Problem. Of equal and
potentially greater significance over the longer term, are the few
Search projects backed by institutional investors that have closed without
any credit enhancement at the project company level. In the UK,
these have included major greenfield roads and hospital
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These have been made possible by a number of structural and

institutional developments which have helped to overcome the
bondholder Decision Making Problem, as well as other structural
issues, such as the negative carry on a complete ‘day one’ drawdown
of bondholder funds.

The most significant of these developments is the emergence of

investment managers with the depth of experience necessary to
overcome the Decision Making Problem internally. In the past, in
Europe as in the United States, a wide range of institutional investors
purchased monoline protected project bonds directly. In post-2008
deals, investments have increasingly been made through the funds,
or as co-investors relying on an investment manager to make leading
decisions. For instance, the London Borough of Haringey Pension
Fund has invested through Allianz GI’s UK Infrastructure Debt Fund
while the Anglian Water Pension Fund has co-invested with Allianz
directly.

The approach also sits well with a private placement structure and
will likely become even more prevalent if private placements begin to
supplant listed offerings as investment mechanisms.

Another enabling development has been the emergence of joint

lending between institutional investors and banks. While project
finance bank lenders retreated in the immediate wake of the 2008
crisis, a number remain strongly committed to the market and are
actively seeking investment opportunities. Basel III, however, and
particularly the liquidity ratios it is introducing, will make it
increasingly difficult (or expensive) for them to fund for the full tenor
of project debt. This can sit well with the needs of institutional
investors, who are often focused on finding long term returns to
match their liabilities. An approach which has been used on a few
deals is that banks and institutional investors co-invest as senior
lenders, with the bank debt amortising ahead of the institutional
debt. Some banks and institutions have also entered into framework
agreements, based on lending together on a repeat basis – this has
the advantage of helping to solve the Decision Making Problem (by
placing some structuring responsibility with the bank partner), while
enabling the bank to bid for deals with the advantage of a significant
co-lender.

Whichever structure is followed, it appears that institutional

investors are becoming accustomed to lending into construction
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12/25/2015 The growing role of institutional investors in infrastructure finance — Financier Worldwide

phase infrastructure projects. The investors that have begun to

access the greater yields available from this participation are unlikely
to revert to the more limited secondary market in future. The trend
seems set to continue.

David Carter is an associate at Norton Rose Fulbright LLP. He can be

contacted on +44 (0)207 444 3306 or by email:
david.carter@nortonrosefulbright.com.

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