The poor showing by the Portuguese socialist party (PS) in the European Parliament elections in June has had an immediate effect on the PPP market, with a number of projects informally put on hold.

With national elections due in September the centre right PSD, which did well in the European elections, is casting an anxious eye over future budget deficits and public spending plans, and has pressed for road and rail projects to be delayed until after the election.

On hold are the Eu1.45 billion ($2.06 billion) high speed rail project running between Poceirao and Caia, and the remaining projects from a programme of seven toll roads, launched in 2007 by the current socialist government led by Prime Minister Jose Socrates. The roads include the Eu1.34 billion AE Centro highway, where a consortium led by Mota-Engil was judged to be running ahead of a rival bid from Dragados/Edifer.

According to local lenders the opposition party is suspicious about the need for some of the roads projects, particularly those with low traffic projections. However, the PSD is not opposed in principle to PPP and there is consensus that schools and hospitals may fare better politically.

The slowdown has put a dampener on bank appetite for a market that had returned to life despite the credit crunch. Portuguese, French and Spanish banks have taken a number of toll roads to financial close in the past months. But even if the market picks up again, as in other PPP sectors around the world, one of the key challenges is how to estimate the cost of long debt financing in an unstable lending market, and the thorny subject of refinancing risk.

To mini-perm or not?

Hard mini-perms are out of favour, since both sponsors and bankers are strongly focused on refinancing risk. A set date for refinancing at prevailing market conditions at year seven or eight gives rise to a risk of a project going into default, a risk that lenders, the government and sponsors would all prefer to avoid.

Soft mini-perms remain the structure of choice, with strong incentives for the sponsor to refinance because of cash sweeps and punitive margin step-ups. According to a survey published early in 2009 by PricewaterhouseCoopers (PwC), a majority of more than 20 banks polled found hard mini-perms to be unacceptable. But the way cash sweeps are used in soft mini-perms deeply divides the market. Those that encourage sweeping are keen to create the strongest incentive on equity to refinance, and would be happy to see a material fall in returns to equity if a refinancing does not occur.

Others are very concerned about the reduced incentives sweeps give equity to properly manage projects. If dividends are to be deferred for a material period, they ask, how is performance properly incentivised and rewarded?

PwC suggests that to maximise lender appetite, a middle road is needed, with enough sweeping to attract lenders requiring refinancing incentives, but enough surplus cashflow left to preserve performance incentives.

During the first half a number of road deals reached financial close in Portugal, and the signs are that the more aggressive use of cash sweeps came out on top of this debate. "We are still seeing tenors of 25 years and sometimes more, but at year even or eight there is a full cash sweep mechanism, and a significant step up in margins," says a banker. "The road projects are relying mainly on Portuguese and Spanish banks, though French banks like Societe Generale have a strong presence in PPP lending as well," he adds.

Road and rail

ACS is in expansionary mode in the infrastructure sector and has been winning sizeable PPP contracts in Portugal. Last December Iridium, the ACS concessions subsidiary, won the contract to build and operate the Baixo Alentejo highway, which will run between the towns of Sines and Beja in central Portugal.

Iridium is at the head of a consortium that includes Edifer, Tecnovia and Conduril. Dragados, the ACS construction subsidiary, is leading the work's execution. This will involve 84km of new highway, work on 43km of existing road, and road improvements on another 220km, and will total Eu410 million.

The support of the European Investment Bank was crucial, contributing Eu210 million, and the rest of the external financing was already guaranteed by a group of commercial banks, led by Societe Generale, at the time Iridium won the concession in December 2008.

Iridium is also a bidder for the construction of the first high-speed rail (HSR) section, in a consortium with Brisa, advised by CaixaBI and Millennium BCP. The HSR section will connect Caia and Poceira and will require a total investment of Eu1.4 billion. The other bidding group on the 40-year concession is led by Mota Engil, advised by BPI and BES.

Although project has fallen foul of the concerns of the Social Democrats on grounds of cost, it is still likely to go ahead after the election. The EIB is expected to lend heavily into the project, with loans and guarantees of up to Eu600 million, but that still leaves a sizeable portion of commercial bank debt to raise. Most of the revenue will come from availability payments, though around 25% will come from state rail company REFER for maintenance.

In the roads sector, most of the projects involve building stretches of road that are partly tolled and partly free to use. From the point of view of the sponsor, the deals are mostly based on availability payments made by public sector entity Estradas de Portugal, though there is an element of traffic risk.

In April the Algarve Litoral project reached financial close, sponsored by Dragados and Edifer, the same group which won the Baixo Alentejo concession. Algarve Litoral featured Soc Gen as adviser, and Santander also committed to the deal.

"This deal closed at a time when the credit market in Europe continued to be challenging," says a lawyer who worked on the transaction. "We negotiated and agreed finance documents in just over four weeks."

Other transactions that reached financial close in the first half were the Eu600 million Litoral Oeste concession, featuring Brisa with CaixaBI as adviser, and the Baixo Tejo toll road, also featuring Brisa. Caixa and BPI committed to that deal.

Meanwhile bankers say that the Pinhal Interior PPP is being held up until after the elections, again on the grounds of cost. Four bids were submitted in the last round, from Mota Grouip, Dragados/Edifer, Soares de Costa and Brisa/ Teixeira Duarte.

Bankers say that the deal is down to a shootout between Dragados/Edifer and Mota, with net present value (NPV) bids in the region of Eu1.2 billion. As with AE Centro the original plan was that there would be some explicit state guarantees, with additional EIB involvement.

Local lending

One of the effects of the financial crisis around the world has been to make projects more reliant upon domestic or regional banking groups, as the conservative lending environment makes banks focus more on local risk, that they feel comfortable with, and local sponsors with whom they have longstanding relationships.

Thus banking groups tend to have a regional flavour, and  Portuguese and Spanish banks have been more dominant than ever in Portugal.
Spanish banks have many problem loans connected to the construction industry and residential and commercial property, but neither Spanish nor Portuguese banks were very heavily involved in US subprime via the ABS market, and funding conditions have improved in recent months.

One positive sign for Portuguese and Spanish banks is the re-opening of the European covered bond market, which has been buoyant since early May, when the European Central Bank announced a Eu60 billion buying programme. Around Eu40 billion of issuance took place between mid May and mid June, allowing banks to refinance mortgages and public sector loans at tight spreads, in the mid-swaps plus 100bp area for Spanish and Portuguese issuers (and half that for German issuers).

In mid-July Caixa Geral de Depositos (CGD), which Fitch rates AA–, was in the market with its first ever offering of public sector covered bonds, which Fitch rated AAA. The deal is the first in a Eu5 billion programme.

The ECB has viewed breaking the logjam in the capital markets as crucial to getting lending volumes up again, so the renewed access to funding for banks using both mortgage and pubic sector loans as collateral is a very positive sign for lending activity across the entire spectrum of banks activities, project finance included.

But even though Portuguese and Spanish banks do have an appetite for infrastructure lending, the size of upcoming projects makes some bankers slightly wary. "The Portuguese banks have provided most of the commercial bank debt on toll roads, with the Spanish taking most of the rest, while the French banks are in, but not very heavily," says a banker in Madrid. "Enough capacity was there for the ones signed over the past year, but I'm not so sure abut the future ones because they are very big."

He suggests that additional banks from France, Germany and perhaps Japan will be needed, and mentions KfW and Mizuho as possible sources of liquidity.

Outside of the road sector, there are a number of hospital deals in the pipeline, but these have suffered from the complexity of the PPP structures being used. The main challenge is that the PPP contract involves both infrastructure and clinical services.

However the Cascais and Braga hospitals did reach financial close, in early 2008 and early 2009 respectively, both solely underwritten by CaixaBI, showing that the various risks could be apportioned between sponsors and lender.

The next round features hospitals in Todos o Santos and Algarve, but they have run into difficulties because the NPV bids anticipated by the Ministry of Health could not be met by sponsors because of higher debt costs. These two projects are likely to be re-tendered.

"There are delays, and everything is very slow," comments a local banker. "We have been involved in hospital deals for several years now and it has been a very frustrating experience."