Since its President Luiz Inácio Lula da Silva passed a federal PPP bill in 2004, Brazil's infrastructure market has witnessed a number of changes, particularly during the last year. This is the first major wave of roads and infrastructure projects in the country for around 15 years. Under the umbrella of the federal bill, a number of states have also initiated their own PPP and concessions programmes, with toll roads and mass transit projects at the forefront.

Following the legislation, the PPP projects were determined by the Brazilian government's ministry of planning, budgets and management. However, the responsibility was transferred to the government's investment bank, Banco Nacional de Desenvolvimento Econômico e Social (BNDES) in 2007, in a move to make the processes more efficient. Luiz Borges, legal counsel at BNDES, explains that the in Brazil, PPP refers to availability-payment or subsidy based projects, and concessions, are self-sustaining from direct revenues such as tolls.

In May 2008, both Fitch and Standard & Poor's increased the country's sovereign rating to investment grade, and Moody's is widely expected to follow suit in the coming months. The impact of the improved rating, combined with a slew of long-term projects, and an established history of lending from BNDES and multilateral agencies, could finally justify sustained interest in the sector from international lenders. However, despite certain favourable conditions, there are also some distinct challenges in funding the country's infrastructure.

The federal prize

In October 2007, the federal government held an auction for seven brownfield toll-road concessions on inter-state national highways. The bidding process was based on operators offering the lowest toll rate, and the winning bidder would also commit to a required capital expenditure set by the federal government. Spain's OHL won five of the seven lots, with the other two going to consortiums led by Acciona and BRVias. The concessions run for 25 years, after a 5-year construction period.

But sponsors must cope with the fact that the credit markets have not, to date, offered bank debt with maturities of more than nine or ten years, or bonds longer than 12 to 15 years. BNDES is an exception, offering loans of up to 12 years. "We don't have an efficient bond market in Brazil," says Alessandro Levy, investor relations manager at OHL in Brazil, "The government is issuing 30-year concessions, but bond maturities here are only seven to twelve years at most."

However, this set of projects is well suited to BNDES debt, as the bank can lend up to 70% of a project's capital expenditure. Levy explains that the capex for the company's five roads is expected to be R$4.2 billion ($2.6 billion) over a five-year period.

OHL funded the initial months of the concession with equity and an 18-month, $100 million bridge loan, arranged by Deutsche Bank, which the company has already prepaid. Levy says that the company has maintained a conservative base case scenario in its plans to fund the project in the longer term.

To finance the projects, Levy believes that the company will take out long-term bank loans when the assets are fully operational, but in the shorter term, bridge loans are obtainable more quickly, and give the sponsor more flexibility. "There is a lot of money internationally, and a lot of projects in Brazil, but we have to go internationally to fund them, because there is no long-term money in Brazil."

Still waiting for a bond market

Fabio Russo, project finance manager at CCR, Brazil's largest toll-road operator, agrees with Levy, and also believes that it will take a few years for the benefits of investment grade to change the credit profile in the country, but thinks that longer debt and more favourable rates will be a natural result of the improved rating, based on other Latin American precedents; "The tenors are not adequate for an investment grade country, it will take a little time."

For OHL's projects, Levy says; "Bridge loans are preferable as we want to wait and see, firstly, if the market improves in the next couple of years; secondly, if the cost of debt and the possibility of long-term debt changes; and it gives us time to calibrate how much BNDES will input to a project." There is of course significant risk of not being able to arrange back-to-back bridge financings though, in this case, Levy believes that the risks of the longer-term alternatives are greater.

He explains the funding strategy; "Though BNDES can fund 70% of the construction, OHL is calculating the contribution at 50%. We estimate that in years one to five of the concessions, during construction, revenues will be between 44% and 51% of their potential, and the projects will generate around R$1 billion of cash."

It will fund the rest of the project during the construction phase through R1.5 billion from its other Brazilian concessions (it has four already in operation). These operations had revenues of R$400 million in 2007, and OHL will raise debt against this sum at 3x Ebitda, to account for a further R1.5 billion. Levy also notes that other infrastructure projects in the country are as highly levered as OHL's.

OHL has mandated Santander to arrange its next short-term loan, again secured against its existing assets, and the bank is now working with Banco do Brasil and Bradesco to syndicate the approximately R$1.5 billion total. The margin on the debt is relatively slim, at 103.7bp over CDI (the Brazilian inter-bank rate). But CDI is, relative to other base rates such as Libor, exceptionally high, currently at around 12.5%. Levy notes that, "The original margin was going to be 80bp, but we are paying more because of the credit crisis."

BNDES debt is priced over TJLP, the Brazilian long-term interest rate, and the rate at which BNDES borrows from government. TJLP is set at 6.25% until September 2008, and has not fluctuated since July 2007. Even with a very wide margin, a BNDES loan is undoubtedly much cheaper than commercial domestic debt.

However, Levy says paying such a premium for the short-term commercial financing is a fair deal, because it provides the sponsor with a measure of flexibility while it waits for more favourable long-term options; "There is no way to bring down the cost of capital in the current market, but we need long-term financing, and so we don't mind paying more for upfront capital in the short term."

RodoAnel hits the headwind

Among the sub-sovereign awarding authorities, the state of São Paulo has been particularly active in issuing PPP projects and concessions. The state recently awarded a concession for the western section of the ring road around the city of São Paulo to CCR. The concession is known as RodoAnel Oeste, for which CCR hopes to reach financial close in the fourth quarter of 2008.

CCR, through its special purpose vehicle ViaQuatro, was also successful in bidding for the $515 million, 30-year São Paulo metro line 4 project, a new line from the city of São Paulo, from the Centro Histórico to the Avenida Paulista, and into the suburbs. Financial close is expected in the last week or July or first week of August 2008.

The financings for CCR's two active projects have differed significantly from the OHL federal roads model. Russo explains that, though the two projects are dissimilar, neither was eligible for BNDES funding.

"For the RodoAnel ring road project, there is very little capex required, other than to construct the toll plazas and to resurface parts of the road. We may also do some expansion work, but not until three or four years into the concession." The upfront payment to the government, of R$2 billion over a 24-month period, is where much of its capital is required.

BNDES however cannot fund this investment, as it only funds construction costs. Russo, rather wryly, notes that the state government is using the upfront payment directly to fund the construction costs of the southern section of the ring road.

Line 4 goes offshore

"For the metro line 4 project, we bought the trains from Korea, Germany and France, so we did not qualify for BNDES funding, as it requires the contracting to be within Brazil." The Inter-American Development Bank (IDB) is arranging all of the debt financing for ViaQuattro, in two tranches. It is providing a 15-year A loan of around $70 million, and six to eight banks, led by ABN Amro, are to provide a 12-year B loan of roughly $240 million.

The A loan has been reduced from around $90 million, and the B loan increased from $213 million, as the B loan was oversubscribed. The pricing on the debt is still to be confirmed, but it will be calculated on an escalating scale, starting at approximately 200bp over Libor, and rising to 220bp over the life of the debt.

While recognising the benefits of this type of financing during construction, Russo, like Levy, regards the financing options available to Brazilian projects during construction as severely limited by the country's credit market; "Multilateral and BNDES debt is preferable while the road is still a project, but when it becomes a company, it needs appropriate longer-term financing. Brazilian bonds are inflation-indexed in these cases, which makes them good for infrastructure projects, but only after completion."

Indeed, CCR has funded three of its existing Brazilian transportation concessions in the domestic capital markets (AutoBAn, NovaDutra and ViaOeste), but only issuing debentures to refinance the projects five or six years after completion. Russo expects that CCR will refinance RodoAnel in the same way.

In the immediate term, though, to cover the concessions costs during construction, Russo remains pragmatic; "Multilateral debt has an advantage over bond financing, even given currency risk, as the bank market is comparatively more stable for deals in Brazil. The IFC and IADB hold a significant portion of the infrastructure debt which mitigates a lot of the risk in syndication, allocation and underwriting."

The equity is willing, the debt, less so

São Paulo is now set to issue five new roads lots in an auction expected in August or September, involving three major interstate-connector roads, and two smaller lots. These roads will be in the RodoAnel model of a large upfront payment to the state. Ten bidders are expected to participate in the auction, and in this case there is just an 18-month period for the upfront payment, which could be as high as R$3.8 billion. As with RodoAnel, BNDES loans can only be used for capital expenditure, and so cannot be considered for the upfront payment, under this model.

The pressing question regarding this concession is whether the Brazilian debt market can sustain another large, short-term financing for a long-term concession. Both CCR and OHL are looking at the project. Russo notes that, though the credit crisis did not have much impact on the ViaQuatro metro deal, as it benefits from government availability payments, "the Rodoanel has been more challenging; raising debt in this market has been difficult everywhere."

Says Levy, "Sponsors have to go outside the country for dollar financings, but as the revenues are in Reais, we would prefer to finance as much as possible domestically. There are better maturities on international debt, which are much better suited to our projects, but it is riskier because of currency hedges and swaps and suchlike."

Though the terms of BNDES loans are more palatable to investors in the short term, the development bank, whatever its political heft, is too restrictive to support a modern infrastructure finance market. In the mean time, sponsors have little alternative but to choose the two lesser evils of long-term dollar debt and short-term Reais funding, in the hope that a modern project bond market will materialise.

Brazil has spent the last several decades being fruitlessly touted as the country of tomorrow. Sponsors hope that its project bond market is not similarly elusive.