Financing Infrastructure

Infrastructure financing is an attractive asset class for many institutional investors, and their appetite is not likely to fade anytime soon
Financing Infrastructure

Infrastructure financing is an attractive asset class for many institutional investors, and their appetite is not likely to fade anytime soon

The secondary
market for equity and debt positions in P3 infrastructure projects was on the rise in 2013, and deal flow is expected to be even greater this year, as more of those P3 projects will have progressed to an advanced stage.

“There’s been more projects reach financial close in Canada,” says Colin McIver, partner at Dentons Canada LLP in Vancouver. “We’re up to 180 projects, so a lot more projects have come on stream and are ripe for equity divestiture or debt refinancing.”

“There have probably been a couple of dozen [equity] deals in the secondary market in the last few years,” says Robert Borduas, partner at Norton Rose Fulbright Canada LLP in Montreal. “The big trend is that the number of these deals is going to increase.”

As solid returns have become more difficult for institutional investors to achieve, infrastructure emerged as a more attractive asset class for their investment portfolios. Canadian P3 projects offer the combination of long-term cash flow on an operating asset in a stable country — and a return that greatly exceeds that of other asset classes.

A majority of P3 projects change hands after five years, says McIver. “There’s significant money to be made on the refinancing of a project once most of the risk factors have been eliminated through the construction period. Then it’s a revenue stream going forward.”

The equity market

Canada’s secondary market for P3 projects is older and more evolved for debt than equity. But lately there’s been an increase in the sale of equity positions, whether in their entirety or individual members of the initial consortium selling their stake. (Typically, equity accounts for 10 to 20 per cent of a P3’s financing.)

According to data presented at the annual conference last June of the Canadian Council for Public-Private Partnerships (CCPPP), over 20 equity sales were publicly announced since 2005.

London-listed infrastructure funds were the acquirers in 12 of the deals, pension funds in eight (though not Canadian pension funds, which have tended to buy equity of overseas infrastructure).

Five of the transactions occurred before financial close, six during construction and the rest during the operational phase of the projects.

Recent moves by the global engineering firms SNC-Lavalin and Bilfinger Berger to divest their concession portfolios have been adding to the deal flow.

In May of this year, SNC-Lavalin sold AltaLink, Alberta’s largest regulated electricity transmission company, to Warren Buffett’s Berkshire Hathaway Energy for $3.2 billion.

SNC said then that it has two dozen other infrastructure stakes that it plans to sell. The largest is its 16.7 per cent equity position in the 407 ETR — the toll highway just north of Toronto.

Why the turnover of equity investors?

Most P3 projects have negative income flow for the first years of what is usually a 25- to 30-year life cycle. If the initial investors don’t have other gains to offset those losses, says McIver, they’re eager to “re-purpose the money for another investment or to capitalize on the return on equity that can be made on a sale rather than a long-term ‘hold.’”

 Project agreements stipulate a retention period during which equity stakeholders cannot transfer their positions. This is usually through the construction phase.

 “More and more, P3 projects are going to move past their retention period,” says Borduas. “You’re going to see international contractors sell their equity stakes to private-equity funds and pension funds, and then use the proceeds to redeploy into new projects.”

Canadian pension funds such as OMERS and Teachers would certainly prefer Canadian holdings for familiarity and regulatory reasons, says D’Arcy Nordick, partner at Stikeman Elliott LLP. “But it’s all about returns for them. If the returns are there, they’ll participate. But right now, I don’t think there’s anything available at the right price, except the 407.”

In some projects, the lenders may have imposed conditions that certain initial equity investors must continue their participation, says Ella Plotkin, partner at Fasken Martineau DuMoulin LLP.

“It depends on the sensitivity of the lenders to who is or isn’t in the project,” she says. “They may have been lending into the project on the strength of some particular players being behind it.” Lenders want to be sure that the risk profile won’t change with new equity investors.

The original equity partners are often the financing arms of construction companies that are the contractors of the project.

Last November, for example, HOCHTIEF PPP Solutions, the German construction and engineering firm, sold 100 per cent of its equity in Alberta Schools Alternative Procurement Phase II project (ASAP II) to Concert Infrastructure, an infrastructure investment fund with which it had partnered in the consortium that designed, built and financed the schools.

Says McIver: “The appetite to take on risk and develop the P3 project brings to the market a different type of participant than somebody who is simply willing to buy the equity once a significant portion of the risk of that project has been taken out of the equation.”

Initial investors increasingly include in the project agreement a right of pre-emption on the sale of their equity. “It’s intended to limit competitors and give the original investor a say on where the equity goes,” says Nordick.

A construction company, for example, will want to exclude rival construction companies. But it doesn’t take out so many major players as to distort the market, he says. “Ultimately, economics determines what goes on.”

Some types of infrastructure are inherently more attractive than others in the secondary market. When uncertainty exists as to how much traffic will utilize a toll road, bridge or rail line, then the value and the risk for the balance of the term may worry potential institutional investors.

The cash flow is not as predictable as, say, a hospital: if all the beds are open and ready for use, a steady income stream is assured. That’s much more appealing to a long-term investor such as a pension fund.

Similarly, institutional investors would be eager for the equity in an electrical power plant if it had a long-term power purchase contract that was not tied to demand.

In recent years, the global secondary market for P3 equity has seen the establishment of a number of infrastructure funds in tax-avoidance jurisdictions, with stakes being sold from there to investors worldwide.

Bilfinger Berger transferred its P3 equity to Bilfinger Berger Global Investments, incorporated in the tax haven of Luxembourg. The new entity acquired equity and debt for the Kelowna Vernon Hospital P3 project and equity and debt for Alberta’s North East Stoney Trail highway P3 in Calgary.

Provinces take into account the taxes paid by the private P3 partner when deciding whether or not the P3 method of project development is the best approach. Those taxes are considered one of the benefits of P3s, but it’s unclear what happens if the project’s ownership is moved to a tax haven and the taxes paid decline drastically.

 

The debt market
Lenders, unlike equity investors, are not subject to a retention period in the project agreement. During the European debt crisis, for example, several European banks transferred their loans to other creditors, sometimes early in their term and at a sharp discount.

However, if the debt is being refinanced – not just reassigned among lenders – the creditor needs the consent of the government authority.

The authority wants to be assured that the refinancing will expose it to “no additional cost should it choose to terminate the project before the end of the term,” says Borduas.

 Before 2010, bank lending typically financed the short term (the construction phase) and bonds were used to finance the long term (the operating life) of a project. Since then, short-term bonds have increasingly replaced conventional bank lending for the short term, says Borduas.

The long-term component used to be provided by banks, too, but in recent years, says Plotkin, they have shied away from long-term tenor, and long-term financing now tends to be via bonds. “What we’ve seen transferred on the debt side are bank interests in the short term and some of their older positions in the long term,” says Plotkin.

The Centre Hospitalier de l’Université de Montréal project, which reached financial close in 2011, was the largest P3 bond issue in Canadian history and one of the first to use bonds to finance the short-term phase.

Bond financing takes one of two forms: private placements with the LifeCos – the major life insurance companies – or broadly sold bond issues.

The Canadian bond market has a healthy appetite for issues of P3 bonds: the Oakville Hospital’s $592-million issue in 2011 was oversubscribed by 300 per cent. Once issued, there are no restrictions on the bonds’ re-sale. It’s a highly evolved and active market.

Meanwhile, some of the European banks that have restored their balance sheets are showing renewed interest in Canada’s P3 primary debt market. “In fact, we’re seeing some of them trying to introduce innovative products they’ve used in the European P3 market,” says Plotkin.

A Canadian institution, too, is offering creative debt solutions. ATB Financial, the Alberta crown corporation, is providing fixed-rate loans for short-term financing — in contrast to the variable-rate loans otherwise available.

 “There’s a question of liquidity,” says Borduas. “It depends on whom you wish to approach and the size of the project. For the sponsors of the project, it is somewhat easier to negotiate only with the bond underwriter.”

Sheldon Gordon is a freelance business and legal affairs writer in Toronto.