In Project Finance Magazine's 2007 market survey Babcock & Brown (B&B) topped the poll for most popular dinner date. Bankers' enthusiasm for a meeting reflects B&B's healthy appetite for new deals, its business model is holding up, and that it usually has a conservative approach to structuring debt financings.

On 30 June 2007, B&B had assets of over A$52 billion ($47.2 billion) under management across its four divisions, including A$19.1 billion in infrastructure alone.
"I'm always surprised by these guys," says Vishal Agarwal, partner at PricewaterhouseCoopers and head of infrastructure finance for Sub-Saharan Africa. "Look at their history: they began as a boutique adviser based on the West coast in California and made their mark in structuring leases – and then shifted to making principal investments."

Agarwal worked with Babcock & Brown in the Rift Valley Rail project in Uganda and Kenya, which reached financial close in December 2006. He adds: "They are able to do deals of size and magnitude and in such numbers because they are able to move quickly. We got them to close their equity participation in the rail concession in less than 40 days – despite not having any investment exposure to Africa. Unlike some of their peers, they are not completely return-focused, but they are driven by what value they can bring to improve operations."

The B&B interim results, due as Project Finance Magazine went to press, will probably show a considerable increase in assets under management following the Alinta and Natural Gas Pipeline of America (NGPL) acquisitions, as well as a number of other smaller deals.

B&B has 450 people dedicated to infrastructure globally working on deal origination, asset management and support. "2007 was a robust year both in terms of economic activity and transaction-wise," says Peter Hofbauer, global head of infrastructure.

The standout deals

Babcock & Brown's standout deals for the year include: Trans Bay Cable project in California, the Babcock & Brown Wind Partners global refinancing, the Reliance Rail deal in New South Wales, the Natural Gas Pipeline of America acquisition, the Diabolo rail link, and the Alinta purchase.

The Alinta deal garnered outsize attention, since Alinta has an enterprise value of A$14.5 billion, King, and involved a tussle with reigning infrastructure manager Macquarie. Alinta's shareholders approved the A$7.7 billion ($6.4 billion) Babcock & Brown-led takeover bid, which involved a number of its managed funds, as well as Singapore Power (SP), ahead of a rival bid from Macquarie Bank. Macquarie claimed it offered A$0.44 more per share in a mix of three options – including all-cash. Investors fretted that Macquarie could not follow through on its bid, and many felt that B&B and SP could offer a better long-term home for the assets.

But the Alinta acquisition, as well as the equally large purchase of Natural Gas Pipeline of America from Kinder Morgan (now Knight), obscures the project development and financing activity that makes up the rest of the list of standouts. The Trans Bay Cable financing, for instance, involved a multi-year permitting process, with B&B acting as developer and equity provider. The developer closed the $515 million financing package for Trans Bay in September 2007.

The deal is notable as the for using an ownership structure that leaves the asset in the hands of a local municipality for regulatory purposes, but leaves the developer with full rights to use the cable, and to its transmission scheduling rights. "Trans Bay Cable was a classic Babcock & Brown transaction," says Hofbauer. "It was a unique deal that no-one had seen before and we developed a solution to a problem which attracted public and financial support."

The Trans Bay debt financing split into a $267 million senior loan wrapped by Ambac and a subordinated loan of $188 million, both from BayernLB. The debt is priced at around 50bp for the senior tranche and 100bp for the junior tranche, despite closing as the credit crunch had surfaced. The senior debt was, at 33 years, the longest-dated bank loan ever in the US power sector.

The credit crunch has affected both general lender risk pricing perceptions and, more particularly, perceptions of the financial health of monoline insurers. BayernLB, which launched syndication in January, faces some scepticism from potential participants that it can close at present pricing levels. So B&B gained an underwritten deal at attractive pricing for an asset whose revenue is heavily regulated.

But it will need to look at where credit and equity market sentiment leave its funding options on upcoming deals. "The immediate impact of the credit crunch is deleveraging, with short term funding, such as margin loans, being the first area to have reduced liquidity, which has resulted in some forced selling in the listed equity markets," says Hofbauer. "Potential sponsors could find difficulty in future transactions where there is a mismatch between short term funding and long term assets," but he adds: "Typically we look to match assets and liabilities."

Babcock & Brown can now group similar assets together, and finance them on a portfolio basis, but still match debt tenors and terms to the right assets, rather than finance each separately. For example, listed fund Babcock & Brown Infrastructure (BBI) has a majority stake in Benelux Port Holdings, which recently reached financial close on a three-year bullet acquisition facility for the purchase of operators Manuport and Westerlund. The lead arrangers on Eu280 million of senior debt, which priced at around 130bp over Euribor, are Dexia, Dresdner and LloydsTSB.

Babcock & Brown has been quick to take advantage of this portfolio effect through leveraging and lowering the cost of capital for its funds. For instance, BBI is rated Baa3/BBB-/ BBB (Moody's/S&P/Fitch) and raises debt at a corporate level. Babcock & Brown Wind Partners (BBW) completed the first global wind portfolio refinancing in May 2007.

That Eu1.03 billion refinancing and releveraging replaces the project debt at each wind farm and provides funds for the portfolio's expansion. The deal's lead arrangers are Banco Espirito Santo, Millennium BCP, Bank of Scotland and Dexia Credit Local.

Impact of the credit crunch

The credit crunch has affected the pricing of risk, and this has led to an increase in the weighted cost of capital for sponsors, since margins have increased and leverage on assets has fallen. But Hofbauer is optimistic about infrastructure: "Infrastructure is a defensive asset which generates real cash flows, so it will not be as impacted as other sectors: it provides real rates of return that are protected from inflation and backed by an asset.

"The overall nominal cost of borrowing is in any case likely to be largely unchanged, since an easing monetary policy and falling base rates will offset increases in debt margins. In the US, real interest rates may move to below zero, as interest rates fall to a lower level than inflation.

"Larger transactions for portfolio holding companies will be more challenging, because there is likely to be a shallower pool of funding available for structurally subordinated debt. Lenders are also going to be more selective about the sponsors that they will support."

The biggest casualties in the infrastructure market have been acquisition financings for assets that meet only the broadest definition of infrastructure and sport high leverage. Banks have suffered, particularly when they provided underwriting commitments in the months leading up to the crunch and then faced limited appetite in syndication.

"The key is to be realistic about the capital structure," says Hofbauer. "The deal needs to make sense to all players by providing an appropriate return for risk, and banks are key partners in a long-life asset. We look at the total return irrespective of capital structure first, and see if the unlevered return on the asset matches the risk. A capital structure can make a good deal better, but you cannot make a bad deal good," says Hofbauer.

B&B, as a leasing boutique, had a reputation for aggressive structuring, and the creation of new products for its clients. Some of this ethos survives, in that B&B pioneered the widespread use of third party tax equity for US wind financings. In the last five years, the use of tax equity has allowed wind farm developers to retain control of their projects, rather than sell them to a larger company that had the capacity to benefit from the tax incentives available to wind power producers.

"Babcock & Brown was instrumental in bringing institutional investors back to the US wind market around 2002/2003," says Richard Homich, principal at Advantage for Analysts, a financial structuring and analysis software firm spun out of Babcock & Brown. "The Sweetwater wind project was a watershed in the market, with the PAP structure – the pre-tax after-tax preferred partnership flip – enabling third party investors to take advantage of production tax credits. Variants of this structure are now found in about 75-80% of the US wind market financings."

Still, while B&B does rely on complex ownership structures, particularly where the vagaries of tax systems are concerned, its debt structures tend to be cleaner than many rivals, Macquarie chief among them. For instance, the accreting swap structure has a list of followers that includes Cintra, Macquarie and Morgan Stanley's Infrastructure Fund.

But B&B has eschewed the product. "We have never undertaken an accreting swap, because it goes back to my point that we do not look to push the envelope on capital structure," adds Hofbauer.

The strategy

Babcock & Brown, together with Macquarie, has established a specialist funds and asset management business model that most major investors of infrastructure now hope to emulate. Investors as diverse as UK manager and PFI specialist Land Securities Trillium and Australian toll road operator Transurban now manage funds featuring third-party capital.

The benefit of the fund management model is that the parent company can apply its balance sheet to higher-risk development projects, which potentially offer large capital gains, and then funnel the lower-risk completed assets into its funds. The funds also provide a stable residual income in fund management fees to the parent company.

"Our strategy is to focus on the established markets of Europe, North America and Australia and originate deals off-market by being the developer, or secure assets where there is no competition through bilateral negotiations, or where there is limited competition," says Hofbauer. For instance, in North America B&B's bidding for greenfield projects has seen successes, it has not enjoyed great success in the bidding for operational toll roads at auction.

But both in deal origination and fund management B&B is geared for growth. Anecdotal evidence suggests that in deal origination it looks for a mid-20s% return from a standing start.

The specialist funds, such as wind, power, and PPP have first refusal on development and acquired assets, while the generalist wholesale funds such as Babcock & Brown European Infrastructure Fund (BBEIF) have the right of second refusal. BBI, which is busy integrating the large Alinta and NGPL acquisitions, is holding back from any major purchases for 12 months.

But according to Hofbauer conditions are still looking good for Babcock & Brown "I am bullish about the prospects of the infrastructure market and the continued support of the debt market. Moreover it is a great time to be long equity; we have raised over A$4 billion of equity in the last six months."

Babcock & Brown is looking to diversify into markets where infrastructure funds have been less active. It has five employees based in Dubai and is currently exploring options to expand its business in the region beyond aircraft leasing. The Middle East offers some intriguing opportunities to a fund manager, since its economies have vast development ambitions and substantial pools of available equity capital.

But its sponsors also enjoy a low cost of capital and strong relationships with banks. Babcock & Brown, tested in mature infrastructure markets, will need caution in expanding into new markets, while making sure its existing commitments stay clear of the crunch's fall-out.