SMIF: A higher gear

The UK's secondary equity PPP market had a busy year in 2005. The big three secondary funds, Hendersons, Infrastructure Investments (I2) and SMIF each raised new capital, while the Treasury continued to tweak the UK PPP model to claw back upside to the private sector. In terms of raising finance, SMIF was the most inventive of the three funds. At the beginning of 2005, SMIF closed a £250 million leveraging innovatively secured against its portfolio of UK PPP/PFI equity.

The debt was structured as a six-year bullet with the margin paying 150bp over libor to year five and 200bp to year six with banks offered £27.5 million tickets. The pricing is higher than an ordinary vanilla PFI deal because banks are lending against equity, but lender risk is mitigated by the cross collateralisation effect of a portfolio. Detailed lending studies were undertaken which showed that a significant number of projects would have to fail to threaten debt service. The lead arrangers will also take comfort from a set of covenants that limits SMIF's equity exposure to any one project, and to operators and to sectors.

The mandated lead arrangers on the deal — BES, HVB and WestLB — successfully syndicated the loan, with four banks coming in at lead arranger level: AIB, ING, Islandibanki and Nationwide.

The debt syndication was complex, but appetite picked up once prospective takers ran through longer than usual credit checks, with some establishing a new category of asset class in which to book the deal. Leveraging against a portfolio of assets on a junior level is fairly common in other infrastructure areas, for instance the wind farm sector, but it is believed to be the first time that the public syndicated loan market has been used on a portfolio of secondary PPP equity stakes. SMIF now has investments in 58 infrastructure projects and its fund size is just under £400 million.

Though leveraging increases risk, the cost of debt is much cheaper than equity – as a rough guide, debt costs around 6%, and equity returns would be expected to reach double figures. Using debt the existing shareholders are more highly geared to any upside and do not suffer from dilution.

Though the leveraging was originally conceived as of long term strategic importance, such is the growth of the fund that SMIF is likely to revisit the structure again. Now that the precedent has been set, it will be easier for SMIF to tap the banks in the future. A SMIF partner says, "SMIF is engaged in a continuous process of raising capital, blending new equity and debt, to make the fund as open-ended as possible. The fund has continued to grow through our intermediate targets and we now believe there is no upper limit on either the life or the size of the fund"

Later in 2005, SMIF also attracted new equity backers, Bank of Scotland and AMP Capital. The investors join SMIF's principal backer, Star Capital Partners – Star capitalised the fund in August 2003 after an MBO earlier in the year from Abbey National and Babcock and Brown by Espirito Santo Investment. While Star is the majority shareholder in SMIF, the management team are also owners of the business. The Bank of Scotland will lend the expertise of its infrastructure personnel, most notably, Gershon Cohen.

The participation of new investors highlights both the regard in which SMIF is held and the vogue for infrastructure investments. A good deal of SMIF's success, besides the expertise of its managers, arises from the fund's flexible capital structure. Unlike other funds such as Hendersons that has a closed structure (whereby a target is set for the fund raising and once met the fund does not accept new money until there is sufficient demand to open another fund) SMIF is open-ended in nature.

This has important implications because the optimal size of a secondary fund with a diversified number of assets was thought to be around £300 million but by common consent this has since increased — particularly given guidance by the Treasury that stated PFI/PPPs would not be considered on projects below £25 million. The flexibility of SMIF's investors and thus its capital structure has also meant that it is able to have a greater focus on quasi-primary activity and European activity, whereas some rivals have a purely secondary remit.

During 2005 the secondary funds witnessed a surge in growth that has required a completely new approach to project management as PFI projects mature. The operational management required for a PFI project after the end of construction is markedly different from that needed prior to building completion, and the skill set therefore changes. SMIF has led the way in building a large (over 50 employees) asset management team, both to oversee defensive strategy on asset value and to create new profit opportunities.For funds with the longevity predicted for this business, this role is central, and SMIF believes that it defines the main difference between the pure financial funds and the long term PFI owning companies.

Also, during 2005 the Treasury continued to tinker with the model with clarification on refinancing guideline that did little to clarify. Continued efforts on the part of the Treasury and concession awarders to pare down the profits accruing to the private sector would stymie the secondary market and slow the overall progress of PPP. Secondary equity players thrive on the upside to PPP and play an important role by allowing constructors and operators to recycle their equity and bid on new projects at lower rates. At present the market is witnessing an inconsistency between the government's macro position to encourage liquidity and the micro position of tinkering with new primary transactions by authorities in a manner which will reduce liquidity in the future. Investors will hope the model is left alone and the market is allowed to mature by its own devices.

The next frontier for the UK-based secondary equity funds is Europe. As more and more investors move into the infrastructure space, and PPP equity in particular, as a viable alternative to other high yielding, low volatility assets such as commercial property, competitive advantage will be key. With the expertise of its managers, its hands-on approach to asset management and its flexible capital structure, SMIF is likely to lead the charge.

SMIF Portfolio Leveraging
Status: Closed 8 March 2005, syndicated early summer
Description: £250 million leveraging of PPP equity portfolio
Sponsor: SMIF
Mandated lead arrangers: BES, HVB, WestLB
Lead arrangers: AIB, ING, Islandibanki and Nationwide
SMIF's counsel: Lovells
Lender counsel: Freshfields