During 2005 the three largest secondary equity investors in UK PPP projects have consolidated their position by tapping additional sources of funding. Following a wave of further fundraising, Infrastructure Investments (I2), Henderson and Secondary Market Infrastructure Fund (SMIF) now have a combined investment potential of about £1.2 billion. Considering that the UK secondary market in total has just over £750 million assets under management – it is clear that these three funds will dominate the UK market for the coming years and are likely to lead a charge into Europe.

SMIF has probably been the most innovative of the three in raising new funds. In June 2005 it secured a £250 million leveraging against its portfolio assets lead arranged by BES, HVB and WestLB. This debt is secured at a junior level to the senior individual project debt. This was followed by the joining of a new equity partner, Bank of Scotland, which invested £68.7 million into the fund.

Henderson's PFI secondary fund announced its final close on 10 October, heavily oversubscribed. Following its first close in December 2004, third and final investor commitments were scaled back at £330 million – the fund's original target was £200 million. Still, at £330 million Henderson infrastructure is the smallest of the big three.

Highlighting the increasingly broad appeal of PPP assets to global institutional investors, investors in Henderson's fund include pension funds, insurance companies and family offices from the US, UK and mainland Europe. Investors include AP3, The State Pension Fund (VER), Merseyside Pension Fund, Storebrand.

Tapping a wider market

The wider institutional investor market has seemingly been the last to get on the PPP-band wagon. Now that the PPP procurement model, constructors, lenders and primary investors have pushed PPP around the globe, there is a need for secondary players to provide liquidity to operators and constructors so that they are able to recycle their equity and bid for more projects.

While the PPP story has been spread by the marketers of the funds looking for backing by pension funds in the US, Canada and Europe – there are signs that PPP equity could be on the verge of spreading its appeal to an even wider group of investors when the promoters of these funds begin to look for an exit, with IPOs seemingly the most likely route.

Eyes on an exit become more focused with the introduction of private equity into the secondary market. This happened when the UK's largest private equity house, 3i, invested £150 million in the I2 fund in June, making I2 the largest PPP secondary equity fund at £450 million. I2 is a joint venture fund initially established by Barclays Private Equity and SG Corporate & Investment Banking.

There is, in fact, already a secondary investment vehicle floated on the London exchange – PFI Infrastructure. But at only £50 million in size, unless it goes for a rights issue, it is unlikely to trouble the big three, especially given Treasury PFI guidance stipulates that projects under £25 million are unsuitable for PPP: A properly diversified PPP portfolio needs to be in excess of at least £200 million.

PPP equity investments have generally been seen as a high-yielding low volatility income streams benefit from long term government backing. This kind of asset is in competition to fixed income investments and commercial property. However, the introduction of private equity would suggest there is some fast money still to be made in the relative short term (under 6 years).

This was certainly the case with the changing of hands of a 50% stake in the M40 concession in the middle of 2004. Laing purchased a 50% stake in Carillion for £19.65 million in June and within four months sold it on to SMIF for £26.2 million.

Refinancing uncertainty

That is not to say large returns are only possible with asset disposals – much more common is the secondary funds' ability to squeeze out value through skilful management and the extraction of upside by running the projects more efficiently – and refinancing for cheaper debt. However, refinancing has got more complex, with a fog of interpretation shrouding relations between sponsors, authorities and the Treasury with regard to termination liabilities.

There is uncertainty in the market following the publication by the Treasury of refinancing guidelines, in particular surrounding termination liabilities for sponsors. The guidelines state that "there should be no increase in compensation payable by an authority to a defaulting contractor as a result of a refinancing, unless there is a clear value for money case to the contrary." This would appear to favour disposals in the secondary market, as primaries could do without the complication of releasing upside through negotiating a refinancing with the authority and Treasury and instead opt for a sale. Still the equity purchaser will still have to grapple with these uncertainties to unlock efficiencies by refinancing (see adjoining box and search 'Behind the headlines' on our website).

Beyond the UK

As the opportunities in the UK plateau the funds are beginning to look overseas. Returns are tightening principally due to competition between the secondary funds and operators capable of purchasing assets, and also because of the incremental advance of risk transfer and profit limiting at the concession award stage. The most recent example of this was the award of the Docklands Light Rail Woolwich extension, where the concession awarder – DLR and Transport for London – asked for bidders to include three fixed price call options at specified points along the concession.

While the three large UK funds have stolen a march on global competitors – as the UK is the most mature PPP market and (perhaps along with Australia) the first breeding ground for secondary equity investors – they are likely to face further competition in Europe and beyond – CIT, for instance, recently established the Canadian Infrastructure Fund and the Santander Infrastructuras was launched in Spain (search 'Shopping funds' at www.projectfinancemagazine.com).

Questions and Answers with Barry Williams,
director at SMIF

PF: What have been the most significant changes in the past 12 months?

Williams: The last twelve months have seen the consolidation of the secondary market with a further £350 million of equity acquired. Whilst there has not been a major step change in the level of activity, we expected the market to bed down to £300 million-£400 million per annum and this has occurred.

At the same time the competition has remained fierce with some new entrants to the secondary arena, albeit on a relatively modest scale. The need to adjust to the changing market and the need to manage actively the portfolios of assets acquired has seen SMIF and I2 establish (or align themselves) to asset management businesses.

Finally, the market has seen the secondary funds grow so that they are now among the largest investors in the PPP sector with, combined, over £750 million of assets under management, representing c. 10% of the market.

What are prices doing? What factors could cause an inflection point and how likely is this?

Common perception is that prices have become more competitive this year. However, this is in part a reflection of the nature of the assets which have come to the market (which have generally been of high quality) and in part a reflection of the maturation of the secondary funds value enhancement strategies (which are now more certain than twelve months ago). Pricing continues to be driven by the premium over the risk free rate which investors demand from this asset class which has remained broadly unchanged over the year. It is unlikely that pricing will become markedly more aggressive in the forthcoming 6-12 months and it may well reverse trend as certain of the secondary funds reach a level of asset diversity which means that further acquisitions are desirable but unnecessary.

What moves are funds taking as competition becomes stronger and the opportunities for arbitrage (as primaries need to recycle their debt) diminish? Is Europe or the rest of the world currently a viable market?

The business strategy of the secondary funds differs markedly. Two principal factors are influencing strategy – investor demands and management team approach. SMIF continues to seek to expand into areas where returns are attractively risk weighted. As our investors and thus our capital structure are flexible this has meant a greater focus on quasi-primary activity and European activity. Other funds are more constrained and continue to focus purely on secondary activity. Europe is now proving to be a viable market but we do not anticipate much secondary activity until late 2006 to early 2007.

What moves are primaries making, if any, to take advantage of the competition among secondary funds? (i.e. packaging a portfolio of assets, retaining assets, etc.)

I think it is fair to say that 'primaries' are looking to compete with secondaries in the majority of cases to benefit from the current competition for assets. However, it remains the case that approximately 30-50% of business is through negotiated sale. This is partially because of the time (and cost) consuming nature of the competitive processes for vendors and bidders alike and partially because of the relationships that are developing which often resemble a 'feeder' primary to 'captive' secondary partnership.

On the face of it, the Treasury's guidance on termination liabilities would appear to benefit the liquidity of the secondary market by making refinancings a less attractive proposition – is this your view?

It is fair to say that the lack of senior debt refinancing activity does create some increase in demand from primaries for secondary fund exits. It should also be remembered that such refinancings are often an important part of the secondary funds' value enhancement strategy. However, it is undoubtedly fair to say that for those corporates attempting to return capital the lack of refinancing activity has removed one route to this goal, leaving disposal as an even more attractive alternative.

If you could hand the Treasury a wish list, what would be on it?

This is a difficult question as the Treasury is primarily developing and implementing policy and, as such, has only limited impact on the secondary market. I suppose the top of the wish list would be for all arms of Government to stop tinkering with PPP and let the market mature. Second, would be to implement the stated policy of encouraging liquidity rather than stifling it – at present there is inconsistency between the macro position to encourage liquidity and the micro position of tinkering with new primary transactions in a manner which will reduce their liquidity in the future.

Are you concerned that the increasing sophistication of concession awarders could stifle the secondary market by limiting returns? (For example, Transport for London recently asked for fixed-priced call options at three specified dates during the concession from bidders on the DLR Woolwich Extension).

We are naturally sympathetic to the Government acting commercially and improving value for money for the tax payer. However, current thinking on PPP concessions is driven by the backdrop of political uncertainty which continues to dog the PPP concept.

On the one hand there are those that believe that PPP represents value for money to the taxpayer over the concession life and will result in assets which are built to last and will be well maintained. This camp believes that value for money is driven out of the competitive process of procurement and, in this context, capping returns simply disincentivises the private sector from performing over 25-30 years.

Others believe that it is politically unacceptable to see the private sector materially profiting from social infrastructure concessions however well it performs and that, in the social infrastructure context, private sector incentivisation will not lead to materially improved asset performance.

When considered against this backdrop it is not surprising that various legs of Government will seek to 'hedge their bets' and this is especially the case in transportation infrastructure where the future is, by definition, more susceptible to demand driven changes. However, if it were to go too far we would of course be concerned that these actions will stifle the liquidity and active management secondary funds bring.

Do equity transfers in the strategic partnership projects present new challenges over transfer of stakes on traditional PPP projects?

I think the challenges are very similar save that certain secondary funds will not be set up to play a proactive role in managing the strategic aspects of such PPPs in partnership with the public sector and others will not have the funding capacity to undertake incremental initiatives over time due to their closed end nature. SMIF does not suffer from these constraints and is actively involving itself in the BSF and LIFT initiatives.

With private equity entering the market, are exits for funds likely soon? Is the wider market ready to accept IPOs? What about securitisations?

SMIF is always looking to benefit from cheaper sources of capital. However, SMIF is established to hold and manage assets over the long term and is unlikely to be attracted by an exit at this stage.

What is the optimum size for a fund? Is it getting ever-bigger?

It is fair to say that we originally thought £500 million would be the optimal size. However, whilst this level does provide the asset diversity benefits and economies of scale we were originally looking for, we now feel that there is no sensible upper limit on size and envisage growing well beyond the £500 million level.

Where will the market be in 12 months time?

We feel that the secondary market will continue to mature. Transaction levels will stay in the £350 million to £500 million range per annum in the UK with increasing demand from Europe. Secondary funds will continue to develop into long term and proactive asset managers and some of these skills will be transferred into primary transactions. It is likely that a merging of the primary and secondary equity markets will occur with both new entrants such as 3i and existing players such as SMIF starting to blur the lines still further between primaries and secondaries.