The world of infrastructure should be an exciting place to be in the UK. The coalition government has made clear that it views the sector as a key driver of the economy, and has made commitments and plans to back this up.
Published in 2010 and then updated in November 2011 to provide "investors, builders and operators of infrastructure with the transparency and commitment which they lacked for a decade," the National Infrastructure Plan would appear to be a promising step.
Chief Secretary to the Treasury, Danny Alexander, openly admits that UK infrastructure has had "long standing weaknesses," while Chancellor George Osborne claims that investing in infrastructure is "a key part in this governments strategy".
Perhaps more impressively, the government appears to have grasped the way changing financing markets will affect the industry. With capital constraints and regulatory requirements forcing banks to lend less and for shorter durations, new sources of financing are required.
The Treasury estimates that the infrastructure pipeline includes over 500 projects and programmes worth over £250bn. It expects that almost two thirds of investment will be privately funded, with the remainder either partially or fully funded by the government.
In his speech on financing capital infrastructure made at the London Stock Exchange Centre Forum on September 10, Alexander acknowledged that the government "should recognise that the days of cheap and readily available bank originated debt finance are over".
For once, government and industry are in agreement: pension funds and other institutional investors will have to get involved.
"The natural home (for infrastructure deals) has to be the capital markets and the banks role has to be increasingly to facilitate this financing in to that market," says James Miller, head of secured debt products at Royal Bank of Scotland.
As it attempts to entice the institutional investor base into infrastructure, the government has teamed up with the National Association of Pension Funds and the Pension Protection Fund to establish the Pension Infrastructure Platform, which will be able to invest directly in UK infrastructure assets and projects.
As long as the credit quality is high enough, and the instruments do not carry redemption options for the borrower, pension funds should be interested in the asset class in a variety of forms, according to Georg Grodzki, head of credit research at Legal & General Investment Management.
"Not everything has to come to the bond market," Grodzki says. "Private placements are acceptable for pension funds and insurance companies, and bilateral lending is an option too. Pension and annuity funds are less in need of liquidity than corporate bond funds, so they can accommodate the lower liquidity of loans."
Danny Alexander said in September that he expected the platform to have raised its target of £2bn by January; seven UK pension schemes have already committed to funding start-up costs and made soft commitments for initial capital allocations.
In addition, July saw the opening of a scheme through which the government can guarantee private investment in infrastructure.
"By allowing high priority projects to benefit from the UK Governments balance sheet credibility, we will be able to accelerate and bring forward up to £40bn of major projects that are struggling to access private finance," said Alexander in September.
Solving a problem theyve failed to create
The ideas receive good reviews from market participants. But there appear to be few thrills in day-to-day debt market activity. Bankers say the infrastructure space is dominated by a refinancing spike caused by the five to seven year deals signed before the crisis maturing and the three year deals signed since the crisis began.
"New event-driven dealflow is the lightest Ive ever seen it for some time, which is a concern, although we are very busy because of the high number of deals that require refinancing," says RBSs Miller.
And so far these refi deals have gone well, with borrowers including BAA, Gatwick and Associated British Ports having completed successful bond transactions.
"There is nothing like a recession to test whether infrastructure assets live up to their name of being non-volatile, cashflow generative asset class," says Miller.
So although Danny Alexander talks of "£40bn of major projects that are struggling to access private finance," the struggle is not yet visible to many debt market participants. The large corporate infrastructure deals such as those mentioned above appear to be popular with the bond markets already, but the arguably trickier project finance deals that might benefit from the new schemes are not yet forthcoming.
"We should applaud the fact that the government recognises the importance of infrastructure to the growth story, and have come out with the guarantee scheme to help get deals over the line," says Chris Heathcote, head of project finance at Lloyds Banking Group. "But to a certain extent they are solving a problem that hasnt really hit so far: we do not have a significant number of deals out that are failing to find finance."Although the National Infrastructure Plan outlines several key investments (see table on page 76), banks are not seeing the projects flow quickly enough. As one banker says, there is a difference between having a wish-list of projects on a document, and having them ready to finance.
Bankers praise the Department for Transport for having made the most progress with their projects, engaging with advisors, and achieving a budget to push deals forward. But they say other government departments have not been nearly as enthusiastic.
Easy option still available
Part of the problem is that, in general, the bank lenders still in the market are still capable of financing the fairly thin dealflow. Although some banks have exited project finance lending entirely, new entrants from Japan, China and Canada have given further support to the market.
Attention has turned to the rebuilding of childrens hospital Alder Hey in Liverpool a deal which some bidders are understood to be proposing to finance through the institutional market.
"Alder Hey is the first deal Ive seen for a long time where I would expect there to be several innovative financing options being put forward," says Miller of RBS.
However, having innovative options on the table does not necessarily mean innovative options will be taken, especially as the total debt financing for the £250m project is likely to be under £150m. Some bankers say that, although margins on project finance loans have increased significantly since before the crisis, they still under-price risk and are hence more attractive for the borrower than the bond markets.
"My concern is that if Alder Hey just goes down the bank market route it would be another lost opportunity in a [debt] market with very little project dealflow to show there are alternative funding sources."
A key aspect of the Alder Hey deal is that it requires the financiers to take on construction risk something that has historically been very difficult for the institutional market to accept.
While it is not yet clear what innovation the Alder Hey project might use to entice institutional investors, market participants already have several potential ideas.
"To overcome construction risk, you could have a guarantee from the government or a well rated bank, or a higher equity portion that can later be taken down by senior debt," says L&Gs Grodzki. "Alternatively you could have subordinated debt that would provide credit enhancement for the senior tranche."
But more equity can be expensive and unattractive for the sponsor, while banks are not highly rated enough to be guarantors of construction risk, according to Heathcote at Lloyds.
It is also not yet clear what will happen to the Public Finance Initiative (PFI) model that has financed public infrastructure projects with private capital since the early 1990s. Investors are still waiting to hear what will come of the governments reforms of the model, which has lost popularity as it is seen by some, including the Treasury Select Committee, as potentially expensive and inefficient for the borrower.
"In principle, social infrastructure is still attractive but it depends a lot on what government will tell us about their plans for reforming PFI," says Grodzki.
So until there is an absolute need to move away from the bank model, it will be hard to see where exactly the funding shortfall might come and how it could be resolved.
It is down to sponsors, as well as the government, to enforce the change in funding sources. This is not always easy when the banks are the tried and tested method.
"It takes some resolve and innovative mindsets for sponsors to make the transition to stronger institutional involvement, which most people would agree is inevitable in the long run, but is easier said than done," adds Grodzki.
"Many sponsors, especially outside the public sector, are willing to accept the refinancing risk associated with using the bank market, so they would have to consciously want institutional investors to come on board in order for that to happen from day one."Grodzki believes the next few months could give some clues as to what extent sponsors are willing to go down the institutional route. Until this happens, it will be difficult to tell whether the UK is able to construct a new funding model for infrastructure to match George Osbornes bold claims that the UK is building infrastructure "fit for the 21st century".
"If banks are not seeing project flow, part of this may be because they are expecting to see national infrastructure programmes," says Dan Gregory, author of a report by think tank Respublica titled Financing for Growth: A new model to unlock infrastructure investment. "Yet there is lots of scope for a more local market."
The report proposes what it calls "community infrastructure bonds", which would look to attract households, private businesses and the community sector as investors. These bonds would be issued through an independent, not-for-profit, special purpose vehicle, which would have a remit to work for a particular community of interest, created with the support of, but not owned by a public authority.
Respublica believes that they could find popularity and be cheaper if tangibly linked to local projects.
"Not all financing has to be done on a national level, or require the guiding hand of the Treasury," adds Gregory.
Respublica says there is growing interest from investors in the "blended returns" offered by social impact bonds where financial return is sacrificed for social benefit, also making funding cheaper and the business more viable. Local businesses, too, could be incentivised to invest in their local infrastructure, the report says.Gregory sees the bonds as potential sources of financing for local projects such as tram systems, schools, sports stadia or community hospitals.