Bank lenders and institutional investors have traded favourable debt terms against the management of credit risk during the infrastructure finance boom of the past 18 months. Now, with the cycle turning in the global credit markets, loosely structured and highly leveraged acquisition loans are looking far less attractive. As a result, it is estimated that up to $34 billion of leveraged infrastructure loans may be left paralyzed under current market conditions.

Cheap debt with relatively generous terms has been the order of the day among infrastructure sponsors. To meet market demand, banks have combined project finance structuring techniques with covenants prevalent in leveraged finance facilities – allowing sponsors to acquire infrastructure assets at record-breaking debt multiples.

Despite the advantages for borrowers, Standard & Poor's Ratings Services believes that this new form of acquisition hybrid poses a significant credit risk to the infrastructure sector. Many assets recently purchased for eye-watering acquisition multiples have failed to boast the operating and cash flow strengths assumed typical of infrastructure assets. Such risks are likely to be exacerbated as credit markets become increasingly volatile and investor confidence fragile.

With $332 billion in leveraged loans currently sitting on banks' balance sheets globally, bankers are unlikely to be keen to lend to infrastructure assets in the current climate without comfort that credit risks are well mitigated.

Investors and lenders alike therefore need to examine the risks associated with each individual transaction, and if necessary seek more credit protection than is currently being provided within the hybrid structure to ensure that the level of debt can be supported by the underlying asset. This is particularly pertinent as new assets are brought under the infrastructure umbrella – with car parks, motorway service stations, and motor vehicle certificates now claiming to be strong infrastructure assets.

Hunger for infrastructure drives development

Over the past few years the boundaries of infrastructure finance have been increasingly pushed, with investors hungry for new types of assets and financing techniques. Consequently, the lines between project finance and leveraged finance have become evermore blurred, with investors marrying together structuring techniques from both financing classes to acquire infrastructure assets. Crucially, the high debt multiples usually associated with project finance transactions have been adopted in conjunction with the relatively flexible controls, and weak security packages more common in LBOs. As a result, increased debt multiples are often coming at the expense of necessary risk mitigants.

Since 2006 a phenomenal appetite for infrastructure assets has spread worldwide (see "The Amazing Growth of Global Infrastructure Funds: Too Good to be True?" published on Nov. 30, 2006, on RatingsDirect). This, in turn, has fuelled a surge in the number of acquisitions within the sector, making it a significant area of growth for the syndicated loan market. Landmark deals include the purchase of UK-based airport operator BAA Ltd. (BBB+/Watch Neg/NR) by a consortium led by Grupo Ferrovial S.A. in February 2006 for $30.2 billion, the acquisition of the Indiana Toll Road for $3.8 billion by Macquarie Infrastructure Group and Cintra Concesiones de Infraestructuras de Transporte, and Goldman Sachs' Admiral Acquisitions consortium's £2.8 billion acquisition of Associated British Ports (ABP).

Fusion of project finance and leveraged finance

As for the financing of "greenfield" infrastructure assets, investors have turned toward project finance to raise funds when acquiring mature infrastructure assets – securing high leverage multiples due to the stable cash flows and monopolistic environment. They have then incorporated leveraged finance structuring techniques instead of carrying out an LBO of the asset as would traditionally have been the case for the acquisition of mature infrastructure assets (see table for the various structuring techniques typically associated with leveraged finance transactions and project finance transactions, respectively).

Of key concern for Standard & Poor's is that, in combining techniques, investors have been trading favorable debt terms against the management of risk. Often we are seeing new infrastructure acquisition financing structures employing structural features, such as short shareholder lock-in periods, that are weaker than those of traditional transactions, coupled with a very aggressive financial structure.

Therefore, investors need to have fully analysed the risks associated to such an infrastructure acquisition as the increasing use of hybrid structuring techniques is increasingly undermining infrastructure's reputation for strong, stable credit quality and assets must no longer be assumed to be of investment grade.

Leveraged finance and project finance structuring techniques

Leveraged finance                                                              Project finance
Corporate entity in competitive environment                          Asset with stable cash flows over the long-term, monopolistic environment
Debt capacity dictated by market-driven multiples                 Debt capacity dictated by discounted cash flows
Medium-term maturity, lower leverage, bullet repayment        Long-term maturity, higher leverage, amortizing repayment, lower margins
Standardized due diligence                                                    Detailed due diligence
Key ratio: debt to EBITDA                                                   Key ratio: loan to project life coverage
Flexible financial undertakings                                                Fixed financing structure, monitored/updated
Capital expenditure lines accounted for, but not                      Future expenditure (i.e., restoration of assets)
mandatory future capital expenditure                                       accounted for
Standardized security interest charges                                     Ring-fencing security and "cash waterfall" controls

Infrastructure – an ever expanding asset class?

For the past 18 months, sponsors have also been using the hybrid structure to acquire assets not traditionally considered as infrastructure. These assets do not benefit from the significant track record of other sectors such as ports and airports and therefore may not be suitable to support high debt multiples, perhaps lacking the necessary long-term stable cash flows or a strong monopoly position in the market.

The acquisition of 50% of Tank & Rast, a German motorway service area operator, by RREEF – the infrastructure division of Deutsche Bank – is a clear example of the market opening up to new assets and financing acquisitions that would not previously have been recognised as infrastructure-style deals. Interestingly, Tank & Rast was initially purchased by the private equity investor, Terra Firma, in November 2004 for Eu1.1 billion, employing a leverage finance structure. This acquisition was financed using an all senior debt facility, with a debt multiple of six times debt-to-ebitda. Now, as little as three years later, RREEF is buying just 50% of Tank & Rast for Eu2.27 billion, with a leverage multiple of 11 times ebitda.

Importantly, the deal is being marketed as infrastructure play, and indeed, the asset does have a 90% market share and a proven cash flow. However, this has only been the case during a benign market environment in Germany. Furthermore, motorway service operators' revenues tend to rely upon retail and catering revenues to a great extent, which arguably cannot provide such operational and revenue flow stability as mature infrastructure assets – such as toll roads.

Indeed, the experience of UK motor way service operator, Welcome Break, demonstrates the pitfalls of assuming that this asset class can support significant levels of debt – with the refinancing of the Welcome Break in 1997 proving inappropriate and leverage in the securitization structure ultimately too high to remain sustainable.

Clearly, however, if such assets as Tank & Rast have employed the appropriate security measures and controls, and lenders and investors alike have performed the necessary amount of due diligence, then of course credit risks may well be suitably mitigated. If this is perhaps the case, then the relatively low margins of Tank & Rast's senior debt – ranging from 175 basis points (bp) to 195bp – could be justified. Yet, Standard & Poor's believes that applying infrastructure-style financing techniques to less mature asset types could serve to undermine the sector's reputation for strong, long-term revenue flows if appropriate risk mitigants are not employed.

Origins of the acquisition hybrid

Hybrid acquisition financing structures are fairly new to the infrastructure sector, with the South East Water deal in 2003 heralding the first transaction of this kind on a large scale. It was the subsequent flurry of French toll road deals in 2005 and 2006 that brought infrastructure acquisition transactions into the mainstream – with Eiffarie's purchase of Autoroutes Paris-Rhin-Rhone (APRR) providing a template for future transactions.

Techniques from both leveraged finance and project finance were evident in the APRR transaction. The Eu1.8 billion revolving credit facility, for example, has a medium-term maturity and a weak structural package with respect to shareholder lock-in periods. Such terms are typically associated with leveraged finance transactions. The aggressive financial structure of the APRR acquisition – due to high consolidated leverage and low debt service coverage ratios – is, however, more akin to those seen within the realm of project finance. Similarly, the facility's cash sweep, as well as the inclusion of future capital expenditure requirements, are also project finance techniques.

Notably, the revolving credit facility carries an investment-grade rating, as does the recently rated Eu500 million term loan facility, reflecting the asset's strong, recurring cash flow generation capability. This and other credit strengths served to offset the transaction's aggressive financial structure, significant refinancing risk, and weak structural package.

More protection needed to mitigate risk and offset poor performance

The lack of security measures among hybrid structures and the diminishing level of controls, if left to persist, could negatively affect credit quality in the sector.

Certainly, not all infrastructure assets have performed so robustly as APRR. Significantly, several key assets in the sector have recently demonstrated the need for strong security covenants for investors. Notably, Eurotunnel S.A.'s historic underperformance prompted the third restructuring of its debt, with a long and bitter battle between shareholders and several classes of creditors. This eventual restructuring allowed Eurotunnel's senior debt, Tier 1A, Tier 1, and Tier 2 be fully repaid in cash at 100% par including accrued interest, with shareholders receiving 13% of the new company's equity. The lower ranking creditors were not compensated nearly as well, however, with some Tier 3 creditors threatening lawsuits.

Poor performance at Eurotunnel, as well as at UK-based underground rail infrastructure financing companies Metronet Rail BCV Finance PLC and Metronet Rail SSL Finance PLC, has served to highlight that there are some important exceptions to the rule that infrastructure represents a stable asset class.

Nevertheless, for well-structured and more conservatively leveraged transactions, such as the refinancing notes issued in August 2007 by Channel Link Enterprises Finance PLC as part of the £2.8 billion securitization of Eurotunnel, it is still possible to achieve investment-grade underlying ratings. Prior to the latest restructuring and securitization, the company had an unwieldy and complex debt burden of more than £6.2 billion.

Another example of how leveraged acquisition hybrids are now tapping the capital markets, despite current turbulent conditions, is the recent £4.1 billion refinancing of UK-based Thames Water Utilities Ltd. (BBB+/Watch Neg/–), which also launched and closed in August. Similarly, the recently launched Eu1.52 billion acquisition debt package for Budapest Airport into the loan syndication market is also likely to find demand from investors due to the asset's strong infrastructure characteristics.

Credit deterioration heightens infrastructure risk

Deteriorating credit quality has not been constrained to certain segments of the infrastructure sector alone, with credit quality declining most notably across leveraged loan markets in general. A rise in M&A activity and leverage multiples has been evident across the European loan market in the benign credit environment of the past few years (see chart). Contractual terms have also been weakening elsewhere in the loan markets, with the introduction of "covenant-lite" LBOs further reducing lenders' control over borrowers' performance.

European Senior Loan Volume 1999-2007*

Furthermore, Standard & Poor's has recorded that the level of senior debt amortizing within European LBOs has dropped steeply, to 15% at the beginning of 2007 from 50% in 2001. With risk mitigants deteriorating in this fashion across the loan market in general, Standard & Poor's does not believe that the infrastructure asset class can maintain a strong credit quality. Hybrid acquisitions must therefore be restricted to infrastructure assets operating within monopolistic environments with stable cash flows over the long term. Moreover, high leverage should be accompanied by the necessary structural package and creditor protections.

Primary Credit Analyst: Michael Wilkins, London
(44) 20-7176-3528; mike_wilkins@standardandpoors.com
Leveraged Finance & Recovery: Taron Wade, London
(44) 20-7176-3661; taron_wade@standardandpoors.com