The Canadian provincial PPP pipeline is gushing with new deals, and the federal government is also beginning to initiate its own programme. However, debt pricing has increased significantly over the last year, and there are more projects than there are builders. Both spell challenging times for provinces, though less so their grateful bankers
Following the continued activity in the British Columbia and Ontario markets, other provinces are following suit, rolling out PPP and infrastructure programmes, and issuing requests for qualifications for a broader range of projects than has previously been seen in the country.

Ontario starts the hard stuff

Ontatrio is coming to the end of the build-finance section of its current programme, which has predominantly involved hospital contracts. The next phase includes more build, finance and maintain (BFM) models, some of which would also allow sponsors to shoulder more, or all, of the design risk in certain of the projects.

To date, there have been two BFM projects in the programme, the Sault Area hospital, awarded to a consortium of Carillion, EllisDon, and a subsidiary of Labourers' Pension Fund of Central and Eastern Canada; and the North Bay hospital, awarded to a consortium of the Plenary Group (equity), with PCL and Johnson Controls, with financing from Deutsche Bank. Both are 30-year concessions.

The province has only seen one design-build-finance-maintain (DBFM) project in the past year, for the Durham Consolidated Courthouse, which was awarded to a Babcock & Brown-led consortium, also under a 30-year concession. TD Securities was the bookrunner on that deal, with RBC and Scotia as co-managers

When the Durham courthouse deal closed in March 2007, its C$213.7 million ($218 million at current rates) of senior secured amortising bonds. The maturity of the bonds is 32 years, and they have a coupon of 5.051%. The bonds were priced at C$102.78 with a yield of 4.827%. The bonds have an average life of 21.5 years, and were priced at 72bp above the comparable government of Canada long bond.

The C$374 million of North Bay hospital bonds, underwritten by Deutsche, priced within days of the Durham bonds. They had a 33-year term, and an average life of 22 years. The sponsor achieved similarly keen pricing, with sources close to the deal suggesting that the spread was just a little higher, in the mid-70s.

The total funding for North Bay is C$420 million, of which senior debt is C$374 million, and C$46 million is in the form of equity and subordinated debt. The weighted average cost of capital is particularly low on this deal, in single figures, a feature believed to be due to the risk transfer to the subcontractors, PCL and Johnson Controls, and therefore a decreased credit risk left in the vehicle.

The first full DBFM hospital, the Niagara hospital in St Catharine's, is currently up for bid, with three shortlisted proponents; consortiums led by Plenary, Carillion with EllisDon, and Bilfinger Berger with John Laing.

However, since the first BFM projects were awarded, the aftermath of the credit crunch has adversely affected the sponsors' ability to raise cheap debt, which in turn affects the value-for-money reports that the provincial authorities rely upon to make their case for private participation in infrastructure delivery.

Since the third quarter of 2007, margins have widened by between 15bp and 30bp on Canadian infrastructure and PPP deals, and both banks and sponsors have begun to put protective mechanisms, including flex provisions, into place. The provinces, and their respective awarding bodies and agencies, will have to weigh up and accommodate the increased cost of capital for their projects.

Despite a general recognition that the PPP market could be facing challenging times, the provincial governments remain optimistic that private involvement in infrastructure development remains the cheaper alternative.

At Project Finance Magazine's recent infrastructure finance forum in Toronto, David Livingston, president and chief executive of Infrastructure Ontario, said, "We don't see the availability of debt and equity as a problem, and we have been successful so far in attracting both."

Flex provisions and managing spreads

Despite such enthusiasm, however, the agency is assessing the possibilities of implementing changes in its concession and contract awarding policies to reduce the impact of market fluctuations on its deals.

At the same forum, Duncan McCallum, managing director and head of infrastructure in Canada for RBC Capital Markets, suggested that an effective way to minimise this risk was for the provinces "to shorten the time from bid to close from 120 days down to, say, one month." He also pointed out that the premium for a bank holding a spread could be as much as 25bp, or a 5% capital cost increase, over a six-month period.

Such precautionary measures may indeed be necessary: A number of recently closed Canadian deals, including at least one wind power deal, involved implementation of a flex provision due to the market upheavals late in 2007.
One banker, involved in a number of active bidding processes, and therefore preferring to remain anonymous, elaborates; "The Canadian market is at a point now where banks are cautious about underwriting deals, and every project in the market now will have a flex provision included in it."

Frank Sacr, managing director at Société Générale, notes that volatility in the Canadian benchmarks for bank market pricing has begun to have an impact on bank debt spreads. He explains that, "CDOR [for Canadian and large foreign banks' funding costs], against Canadian Libor [for smaller foreign bank funding costs] have had a close correlation over the last several years. However, since last summer, we have seen substantial volatility between these benchmarks, thus affecting some lenders'net returns on infrastructure loans."

Deals with market risk will have an even tougher time. The A25 financing, for Quebec's first PPP, and a mixture of toll and availability revenue, closed and syndicated successfully in a trying market, but it did not set a precedent for upcoming deals. Bankers will watch the upcoming Port Mann (British Columbia) and A30 (Quebec) financings for an idea of where spreads have come in, though the traffic risk is less on the A30 than on the A25. As these deals have not yet closed, the anonymous banker believes that the ultimate financings will both feature flex provisions.

Robust market?

On the hospitals and similar deals, even if the spreads have increased by 30bp, when coupled with the fact that the Ontario BFM projects closed with such low pricing last year, the stretched margins only reach the 100bp mark. As one sponsor active in the Canadian market notes, "these spreads are similar to those on the early Canadian hospital deals, such as the William Osler [Ontario] and Abbotsford [British Columbia] hospitals, which closed in 2004."

Osler and its companion project the Royal Ottawa hospital were the only two deals that went forward under the previous administration's PPP programme. The Liberal party, which returned to power in part based on criticism of the outgoing Tories' approach to PPP, explicitly rejected the programme that led to the two hospitals, though they reached financial close after the Liberals took power.

Even with the increased pricing, sponsors believe that they can provide better value for money for the provinces; and it seems that the governments concur. To put the increase cost of capital on project finance deals in a wider market context, as Glen Carter, a managing director at RBC Capital Markets, points out, leveraged buy outs are seeing much more significant rises in spreads from deals one year ago.

But, he continues, "the pressure on margins on project finance deals may still increase, because where capital is limited, banks will want to see a return of percentages in the teens, otherwise they can get more by investing elsewhere. Because there are so few indigenous Canadian banks, the pressure could be greater here. There is a bias towards stronger pricing from the lender, to enhance the return on scarce capital"

Monoline-wrapped bond deals had also been popular on Canadian deals, notably on the Golden Ears bridge project in 2006, and the Calgary ring road deal in 2007. There was also some deal of speculation on whether Deutsche Bank wrapped the North Bay bonds after financial close. However, as one banker comments, "there is a now a reticence about using monolines, none of the banks wants to do it, though the benefits had been there."

Despite these concerns, banks are fond of the Canadian infrastructure deals, particularly the availability payment deals. As Michael Uhouse, a managing director in DEPFA Bank's infrastructure group, explained, "the quality of the public sector counterparties on Canadian availability-based PPP projects provides a good risk/return balance within a global portfolio."

The nationwide pipeline

But the allure of new projects is still clear to provinces, which like trumpeting the arrival of new hospital, even if they are wary of explaining the financial engineering that goes into them. The developments in the last years have made some impact in addressing the country's infrastructure needs: A recent study on the state of the country's infrastructure conducted by Statistics Canada indicated that overall, its average age has fallen from 17.5 years to 16.3 years since 2001, rated in terms of investments made in infrastructure assets.

Following in the footsteps of BC and Ontario, as well as some isolated deals from Alberta, the other provinces, including Quebec, Nova Scotia and the Maritime provinces, have initiated PPP programmes.

Booming and oil-rich Alberta has a the most impressive stream of projects out for bid, or imminent, including municipal deals, two schools packages, a fire stations project, a wastewater deal, and a large police headquarter concession valued at around C$500 million. Notably, however, this province does not have an awarding agency, in the Partnerships BC or Infrastructure Ontario image, and a number of participants in the Alberta bidding processes have commented that this may be the next logical step.

BC and Ontario have both maintained their respective deal pipelines, with Ontario adding jails, more courthouses, a service station concession and a forensics laboratory to its alternative financing and procurement programme, while Partnerships BC is advising the Canadian federal government on its first PPP, a concession for the new headquarters of the Royal Canadian Mounted Police which, although in BC, will be under federal authority.

New Brunswick issued a request for expressions of interest for a courthouse project early in 2007, as part of a proposed infrastructure programme, but despite responses from experienced equity providers, including Plenary and Babcock & Brown, the province opted for local construction companies instead.

Who is going to build it?

Although the wider margins on infrastructure debt may be not be as problematic as increased cost of capital in other sectors, there is another difficulty facing the Canadian PPP deals. According to Mike Marasco, a senior vice-president at the Plenary Group, "construction capacity is our biggest concern."

Alberta and British Columbia are the most badly affected of the regions where there are a number of projects in construction simultaneously. The upcoming C$700 million Grand Prairie hospital project in Alberta, for example, is located in an area where there is very little residential development, and so interested bidders are building the expense of setting up a camp for contractors into their financing proposals.

The nature of the project also affects the amount of pressure on the sponsor to deliver adequate construction personnel. The oil sands projects, for example, require many hands on deck, and roads projects that involve bridges or tunnelling require even scarcer skilled labourers. The build-finance hospitals, on the other hand, are relatively straightforward to erect, and in Ontario the labour shortage is less of a problem.

Simon Chapman, senior vice president of infrastructure development at Carillion, agrees that finding enough manpower to address all of the country's construction needs is a concern but, he says, "the governments recognise that they have to phase the projects for that reason." He also notes that as "an integrated developer, bringing investment, construction and services to the table, the biggest constraint is in the construction box."

For a sponsor such as Carillion, which is bidding on many of the PPP projects, it is fundamental to have a structure in place to ensure it has the construction resources available. In some cases, the concessionaires will bring in construction staff from overseas, but at a cost to the project, and with the related immigration issues. Chapman explains that where these concerns affect its projects, "Carillion either teams with local constructors, or uses its own in-house construction capability."

Other Canadian sectors have developed different mechanisms to ensure they can meet their labour requirements. On the Invenergy's St Clair 584MW gas-fired power plant in Ontario the contractor, Fluor, made sure it had a conditional agreement ensuring that skilled workers could be brought in cross-border.

Can they keep smiling?

Despite the increased and variable margins on debt for Canadian PPP deals, the country's need for additional infrastructure development, the impact of recent projects, and provincial governments' lust for photo-opportunities, will ensure that the provincial and federal authorities will keep bringing deals to market. Indeed, in Ontario, the shift from build-finance to DBFM models suggests an increased comfort with the private sector on the government's part.
For sponsors, the long-term nature of the assets paired with the perceived low-risk on the availability deals especially, will keep developers and equity investors alike keen to maintain involvement with a safe market. Even if they are paying more for their debt, they stress, it is still relatively cheap.

Ironing out the kinks from the award processes, and making bids run quickly and more smoothly is viewed by both sides as the next step in what is still quite a young programme.