PPs become increasingly well honed tool for infrastructure
The role of the US private placement market in infrastructure project finance has expanded in recent years as investors have become more accommodating, competing with traditional sources of project finance in an effort to place vast amounts of capital amid scarce supply and low rates. Richard Metcalf reports.
The election of President Donald Trump, who has promised to expand and modernise US infrastructure, has fed hopes that there will be more opportunities for private placement investors to place cash with big projects in the next four years.
In some sectors, notably including roads and railways, subsidised forms of finance such as private activity bonds under the Transportation Infrastructure Finance and Innovation Act make it more difficult for the private placement market to compete. Nevertheless, private debt has proven that it is able to compete with tax-exempt financing options in areas like municipal redevelopment, as recent transactions have shown.
The shift of focus toward project finance among institutional investors, and their determination to develop the expertise and structures to make such investments possible, is driven at least in part by slim pickings elsewhere in the capital markets.
“I think that it’s the willingness of non-traditional project finance buyers to look at and embrace the space, and the reasons for that are two-fold,” says Frederick Echeverria, an executive director on MUFG’s New York private placement desk who focuses on energy, utilities and project finance. “I think it’s the lack of overall corporate supply coupled with the historically low rate environment, and the higher risk-adjusted return that is generally associated with these types of transactions.”
At the same time, many commercial banks have retreated noticeably from offering long term project finance, opening up a space for private placement investors to play in.
“On the one hand, there’s a fundamental change that’s driving this — a lot of the banks that have been long-dated project finance bank lenders are under increased capital constraints and so that’s putting more PF transactions into the private placement market,” says Richard Thompson, head of debt private placements at Mizuho in New York. “But also it’s just a natural fit because the life insurance investors want to go long and they have the capacity to really understand structures like this.”
It is an enduring myth that construction risk is anathema to institutional investors, and one that market participants are understandably eager to dispel.
“I think that’s always been bit of a misnomer,” says Echeverria. “Institutional investors are willing to take construction risk if it’s properly mitigated.”
Mitigants include signing an engineering, procurement and construction agreement with a strong contractor and allowing for a comfortable construction schedule. But this is standard practice among responsible developers, so it does not explain why private placement investors have only quite recently begun to get involved.
To capitalise on the project finance opportunity, private placement investors have gradually begun to offer more bank-like terms. The crucial innovation that has allowed institutional investors to compete with banks to provide construction financing is the gradual lengthening of the time over which funds can be disbursed through delayed draw features.
Delayed draw allows the developer of a project to borrow under a line of credit a little at a time to pay the costs of construction as and when they are incurred.
“We see longer delayed draw, with some investors offering on specific deals sometimes more than a year,” says Siobhan Duffy, managing director for private placements at NatWest Markets.
Furthermore, because of the nature of greenfield project financing — which often begins with multiple developers competing to obtain a concession or offtake contract — investors have also had to develop a willingness to commit funds to a bidder that has not yet won the rights to the project.
Once private placement investors put their minds to it, they soon found a way to pull this off.
“Today you can bid on a greenfield project with a private placement as your primary financing, market it during the bidding period, and have private placement investors circling and signing docs as part of a bid submission,” says Michael Pikiel, a New York-based partner at Norton Rose and the firm’s US head of infrastructure, mining and commodities. “The market’s come quite a way.”
Such flexibility also opens the door to the use of fully committed private placements as the primary financing tool for acquisitions of operational projects in the secondary market, which are typically the results of multiple-stage auctions run by investment banks. One such deal — thought to be the first of its kind—was expected to close in March.
“Because they’ve been facing increased competition from banks and a general lack of deal supply in North America, when you look at the capital that’s available, it has forced investors to become more flexible,” says Pikiel. “Now they’re able to do things that are very similar to what banks would do, but with the long term component.”
The increasing flexibility and competitiveness of the US private placement market also makes it attractive to public-private partnership (P3) project sponsors, where it was recently used for the first time as part of a construction financing package.
This is remarkable because it shows that private placements are able to compete, especially for long dated maturities, not only with bank loans but even with the tax-exempt financing structures available to such projects in the US.
The introduction of P3 development and financing structures for public infrastructure projects happened quite recently in the US. The first such project was Meridiam Infrastructure’s Long Beach Court House in California.
The Court House project was initially financed in the bank market in 2010 with a seven year mini-perm loan, a structure common in project finance, with the banks taking their customary role — providing short term construction lending with a view to a capital markets take-out once the project is operational and therefore lower risk.
That is precisely what happened in 2013, when the Court House was refinanced with a 34 year private placement.
Since then, however, the market has progressed to the point where, when the next Long Beach P3 project came along in 2015 — a new civic centre including a city hall, port authority, library and park — the developer, in this case Plenary Group, opted for a hybrid bank and private placement financing to cover the construction phase, sidestepping other options that might at first have appeared more promising.
“When we first looked at this project, because of the affordability constraints the city had — they didn’t want to pay more than they were paying for the existing buildings — we looked at tax-exempt financing,” says Stuart Marks, senior vice-president at Plenary Group. “We looked at a range of tax-exempt bonds including lease revenue bonds, but as we got into the process we ended up switching to a taxable private placement.”
Despite the tax advantages of the lease revenue bond structure, the private placement market was more cost-effective for the project, tenor and structure the developer wanted.
“It was right at the time the US private placement market was becoming and still is becoming more competitive,” says Marks. “We knew there was growing investor appetite for projects of this nature, with a strong public counterparty as part of the overall credit risk.”
One of the key elements of the deal was the willingness of the private placement investor — in this case Allianz Global Investors — to allow the developer to lock in a credit spread in advance of financial close to obtain price certainty early on in the process when the market was competitive.
PP garners green credentials
Private placement investors tend to pay attention to sustainability, so it makes sense for them to participate in renewable energy project financing.
One such innovative renewable energy deal in the last year was a $163m private placement backing a portfolio of 192 rooftop, ground-mounted and carport solar arrays in four US states, with a combined capacity of 85 megawatts, owned by independent power producer Exelon.
Although the portfolio had been operational for more than two years and therefore carried no construction risk, the nature of the small scale solar projects, which are separately contracted under 37 power purchase agreements, made credit analysis tricky.
BNP Paribas, the placement agent for the deal, believes it was the first distributed solar transaction in the US private placement market. The deal was 1.2 times oversubscribed at the clearing level.
“I think we’ll see more of those types of transaction — long-dated wind and solar assets getting done in the US private placement market, both utility scale and distributed generation,” says Peter Pulkkinen, head of US private placements at BNP Paribas in New York.
While private placements such as this are gathering pace in the US, traditional private placements for renewable projects in Europe and Australia are at a more nascent stage. “We haven’t seen a lot of that in the cross-border space,” says Brian Bates, a London-based partner at Morrison & Foerster, who focuses on private debt. “But I’m sure there are deals and will be more.”
Private placement investors are putting in the hours to do the credit work and innovate the structures they need to be able to invest in projects in the renewable energy and social infrastructure sectors, but there are always likely to be some projects left to the bank market.
Michael Pikiel, parter at Norton Rose in New York, and the firm’s US head of infrastructure, mining and commodities, says in reference to PJM Interconnection, the regional transmission operator that manages the deregulated electricity market in much of the northeastern US: “It is dependent on credit, and I think one of the challenges you see in financing some projects in the US power market is risk around incentives in the PJM market in the US.”
Several new gas-fired power plant projects have been financed in that region in recent years, mostly in the commercial bank market, on the basis of three year capacity contracts auctioned off by PJM and hedges provided by commodity trading firms like Morgan Stanley, Macquarie and EDF.
“There’s not really a long term contracted off-taker and so it’s taken the bank market a long time to get comfortable with the hedging strategies,” says Pikiel, adding that, while it would not surprise him if the private placement investors eventually got to the same place, it posed a challenge in the near term.