Infrastructure assets have enjoyed increasingly positive press on either side of the credit crunch because of their presumed immunity to the economic cycle and the hope for a wave of government spending in coming years. However, the sector shares in many of the crunch's effects, in stresses such as an increased cost of debt, sponsor and lender illiquidity, deleveraging, and a more conservative approach to deal-making. After the first round of the crisis, in the last quarter of 2007, the sector looked vulnerable to a number of concerns; notably widening margins, the possible weakness in the construction sector, and a reduced availability of long-term debt. The 2008 crisis has brought a larger number of more specific risks and weaknesses to the fore.

Maura Goldstein, a partner in Baker Botts' global projects group, says that "The immediate reluctance on the part of debt providers to do deals is driven by fear over the lack of liquidity in bank funding markets. In this climate, it will be difficult to get even good deals done. Once this crisis settles down, then participants will still have the recession to contend with." Infrastructure lenders in the US, and to a lesser extent in Canada, have effectively shut up shop until at least the first quarter of 2009, and one banker familiar with the sector believes that even that timeframe is ambitious; "We need to keep a hand in the market, but we aren't looking to close any deals for at least a few more months, maybe the second quarter of '09. And we're not the only ones taking that view, nobody wants to lend in these conditions." Those that are lending are doing so, often because they had committed to a financing before the worst of the crunch. They are proceeding with caution, lending at an increasing premium, and with flex provisions written into every contract.

Hedges flattened

Volatility in funding markets has not just hampered banks' ability to extend credit, it has also strained the economics of deals with floating rate exposures, including some bond financings. This is certainly the case on the recent Capital Beltway deal, as the project's bond debt pays a floating rate that tracks the movements of the SIFMA index, and the project swaps this obligation to a fixed rate with Goldman Sachs, Depfa, Scotia, NAB and BES. The SIFMA index had traditionally set at around 70% of Libor, but during late September it jumped to around the 8% mark, and diverged from Libor. The banks felt the brunt of the higher variable rate costs, but the sponsor was also slightly exposed, since the debt was not entirely hedged.

Another major lender concern for sponsors is counterparty risk; exposure to what once may have been robust financial institutions, both banks and monoline insurers, but whose downgraded ratings, and in the worst cases, insolvency, leads to a reassessment of the project's rating. Another of Depfa's financings, along with Dexia, for Bilfinger Berger's Golden Ears Bridge concession, also came under pressure, when both the ratings of both the bank and monoline wrap providers Ambac and XL were downgraded. Moody's put the project's Baa2 underlying rating on review for downgrade in late September, noting not only that the two bond insurers had been downgraded, but that Depfa, as one of the interest rate hedge providers and the sole inflation swap provider, had also been downgraded.

The move highlighted the exposure of several projects to the credit quality of swap providers and, as bail-outs in Europe continued apace, has led to sponsor nervousness. While the government bailout of Hypo Real Estate, which owns Depfa, has staved off some of this concern, none of the projects are entirely out of the woods. A source familiar with Depfa's balance sheet says that the bank's problems are due to short-term illiquidity problems, rather than a more profound problem with its balance sheet. He continues, "Its liabilities do not outweigh its assets and, if it manages to weather the storm, could survive in the longer term. The storm is, however, rather brutal."

Many of the enhancements that were significant, and increasingly popular, elements of infrastructure finance have also been stripped away. The monoline insurers are severely depleted in numbers, and their wraps often do not provide a sufficient pricing benefit to justify the bond insurers' premiums. Project bond issuers often used guaranteed investment contracts or total return swaps to blunt the effect of negative carry, where debt repayment obligations eat into bond proceeds before they can be put to work earning revenue. AIG was an enthusiastic provider of total return swaps, as well as, alongside the bond insurers, of guaranteed investment contracts. Both products look shaky, as does the use of credit default swaps to hedge out bondholders' exposure to projects. Accreting swaps vanished quickly.

It's the economy

The crunch has also forced lenders and sponsors to revisit the economic and demographic assumptions underlying their financings. For instance, ports deals in North America were once considered the powerhouse of the North American infrastructure sector, but are now struggling. There were five major ports acquisitions in the region in 2007, and also a number of smaller transactions related to ports and ports services. The depressed international markets have resulted in a decrease in freight trade (see chart below) and, as one former banker, who underwrote one of the ports acquisitions, put it, "the port of New York and New Jersey is a ghost town".

Another factor is that, although container carriers are arriving with imported freight, it makes little sense to send them back empty, but the US exports market is also considerably slowed. The ports deals were structured on revenues from a mixture of shipping and container volumes. The debt facilities were aggressively structured, with pricing tied to leverage, which was in turn relatively high, starting at around 14x on most of the deals. The projections had factored in the extreme fluctuations familiar to shipping markets but, according to the source, "even under the worst base case, no one could have predicted this".

While ports sponsors are so far standing by their assets, they are having to increase their equity contributions to do so. AIG Highstar and RREEF (a Deutsche Bank fund) are both said to have injected extra equity into their POPNA and Maher terminals, respectively. The deals were all very similarly structured, and Ontario Teachers' Pension Plan (for its OOIL assets), Goldman (for its stake in Carrix), and Highstar (for its other ports assets, including MTC) will have to monitor the effect of the worsening US economy on their holdings.

Ports do not act as a perfect guide to the performance of other infrastructure deals, however. Shipping is a volatile market at the best of times, and some troughs are expected. Furthermore, the appeal of the assets, as core infrastructure, with little possibility of competition, and long operating histories, still stands; the extra equity investment may be a short-term inconvenience, but the fundamentals of the deals are still structurally sound, say bankers familiar with the assets. Most importantly, most of these deals are backed by private equity funds and pension plans, which are among the few financial institutions that can still bail out their holdings in the short term.

Loaded Inbound and Outbound containers - Los Angeles and Long Beach ports

These same institutions may also benefit from the credit crunch; and in some cases it is more cost effective for them to bid for projects without any debt. Citi Infrastructure Investors (CII) is unlikely to raise debt immediately for its Chicago Midway airport concession, and has the relative luxury of waiting to refinance the deal when credit markets are more appealing. Despite the credit crisis, private equity is still liquid, and investors are looking for bargains. One M&A lawyer familiar with the infrastructure market says she has never been so busy, though "when we're representing the sellers, we're accepting terms that would never have flown in a happier market". Indeed, there may even be further possibilities for bargain-hunting equity, with assets and projects coming to market not because the projects themselves are troubled, but because of the pressures on existing sponsors.

Toll roads have a slightly smaller amount of private equity involvement, and traffic has not seen quite as dramatic a decline as port use. But petrol sales have declined, consumers are driving less, and paying tolls, at least on less essential routes, is another luxury expenditure that could suffer in a recession. With the exceptions of the Indiana toll road, the Chicago Skyway, the SR-125 in California and the Sea-to-Sky highway in BC, all the other toll roads concessions in the US are in construction.

In August 2008, Macquarie Infrastructure Group wrote down a number of its international toll road assets, decreasing the portfolio's net asset value from A$9.78 billion ($6.48 billion) in June 2007 to A$9.23 billion in June 2008. This included write-downs on its interests in the Chicago Skyway, the South Bay Expressway and the Dulles Greenway. In September it also reported an 8.3% decrease in traffic volumes on the Indiana Toll Road. According to analysts familiar with the traffic forecasting, such pessimistic numbers would be included in the models used by banks, and the falls do not place toll concessions in imminent danger, unless traffic never recovers. For now, sponsors' results have felt most of the pain of high petrol prices.

Canada's PPProblems

Availability-based public private partnerships face different pressures, since their revenues usually benefit from government guarantees. For operational deals, or at least those without distressed monolines or banks as swap providers or guarantors, the crunch's effect is minimal. However, the crunch looks set to alter profoundly the way future projects are procured and financed. Such deals are currently most common in Canada, under a number of the provinces' social infrastructure PPP programmes.

In Canada, construction concerns are more prevalent than in the US, since the country's various labour markets have been tight in the face of demand from commodities projects such as oil sands developments. But the more pressing challenge in Canada is that, given the increased cost of debt, on top of construction and bidding costs, the PPP model will be come a harder sell to the public. While governments can borrow at a more attractive rate than private sector developers, the private sector's promise of construction and operational risk transfer has countered the lower cost of state debt. As margins continue to increase, flex provisions are enforced, and the relationship between Libor and CDOR remains unpredictable, the question of value-for-money may begin to have a greater impact on PPP programmes' viability.

The Canadian deal pipeline is backed up, and while the financial markets in the region have so far met the demands of PPP sponsors, they are showing signs of being unable to keep up. Margins on debt for hospital deals have effectively doubled in the course of a year, and while sponsors aim to remain competitive in the procurement process, the increased cost is transferred to the bid. Many banks and bond underwriters are struggling to commit.

The Plenary Group, which has been particularly active in the region and the sector, has more or less terminated its long-time relationship with Deutsche Bank for some of these reasons. TD Bank has stepped up to back the St Catharine's hospital project in Niagara, replacing Deutsche in arranging the financing. The deal is set to close with a combination of bond and bank debt, before the end of November 2008. Institutional debt providers, such as SunLife and CanadaLife, are coming into their own in backing projects, meaning that banks that place such tranches, including CIT and TD, as well as Canadian banks that have been frozen out of PPP to date, are gaining in prominence.

Babcock & Brown's recent Alberta Schools project reached financial close under trying conditions. Its C$465 million ($375 million) multiple-tranched financing combined bond and bank debt, which, according to one of the lenders, was the only way to get the deal closed. Duncan Ball at B&B says that he expects this kind of hybrid financing to be replicated in other Canadian PPP deals; a prediction already being played out in Niagara. But one of the problems with Canadian social PPPs is that many sponsors require exclusivity from their banks, and there is not enough liquidity in the market for three or four or more fully committed financings in any procurement process.

Some of the provinces also award projects without the financing entirely committed, and in some cases in Alberta and in a few instances in BC, the bidders have had to provide a letter of credit, usually of C$10 million, to hold their bids. The combination of factors has meant that some of these LCs have come close to being drawn, and a draw has been averted only by delaying deadlines or renegotiating terms. The consensus for both borrower and sponsor is that exclusivity cannot continue in this market, and that a conservative approach to bidding on upcoming projects considers the real danger of commitment risk.

Possible solutions

Infrastructure, and particularly core infrastructure, is set to receive priority attention from the US government. In the US, both the incumbent President George Bush and President-elect Barack Obama are in favour of a new $100 billion economic stimulus package, one of several that have been put forward to ameliorate a severe recession. Around a quarter of this sum will be used to finance infrastructure upgrades, the necessity of which has widespread acceptance. Infrastructure development, improvement and maintenance all create employment opportunities, and parallels with the post-Great Depression spending boom in the US point to a renewed public works programme in the US. Indeed, Obama has also mooted a federal infrastructure bank to oversee the implementation of the programme. A recent study from the Collaboratory for Research on Global Projects at Stanford University identified between $15 billion and $20 billion highway projects in the US which could be implemented in between 30 and 90 days, given the appropriate federal funding support.

Whether a massive state-directed public works programme presents opportunities for commercial banks is harder to discern, and the bank market is not moving quickly to demonstrate its utility. Bankers feel that coping with fear in the markets can only be addressed with caution. The effective freeze in lending until 2009 is a result of a fear of the unknown, of which institutions are wounded and how badly.

Project financiers are also learning to concentrate on new risks, work more collaboratively, and to turn to government institutions with the strength to tempt in lenders. Federal support programmes such as TIFIA and private activity bonds, the PILOT system, and various other forms of tax-exemption are all aids to future projects, but commercial lenders must also find their new place in the market. For those sponsors in the fortunate position of being able to inject equity as a stop-gap, or those that have been steadily deleveraging, the fear may not be so consuming. For the rest, the waiting game continues.