More banks are expected to securitise their Private Finance Initiative loan books, following the groundbreaking deal for Depfa Bank which closed in November lead managed by Merrill Lynch International.

Depfa, the Dublin based specialised public finance bank, completed a synthetic securitisation backed by 24 loans to PFI projects across a number of sectors, including schools, hospitals, roads, police stations, court buildings and other public offices.

The deal, which was launched under the name Essential Public Infrastructure Capital (EPIC), transferred risk to third parties mainly via credit default swaps (CDS), and was motivated by regulatory capital adequacy objectives rather than funding requirements.

But in the future there are also likely to be cash as opposed to synthetic deals from other banks with sizeable infrastructure loan books - in fact Depfa's next deal, planned for 2005 and expected to be much bigger, will likely feature some cash sales.

It is not only bank lenders that are looking to make more use of the capital markets. Corporates are also searching for more efficient sources of financing, and in October a group of contractors in Portugal issued Eu257 million of bonds backed by construction work payments relating to four SCUT shadow tolls that they are building.

A synthetic EPIC
Depfa did its deal with the help of Kreditansalt für Wiederaufbau (KfW), the German development bank. Last year KfW Bankengruppe divided its activities into a number of separate units, including KfW IPEX Bank for project and export finance, and KfW Förderbank, which in this case acted as swap intermediary.

KfW interposes itself in these financing structures by setting up a credit default swap with the originating bank. KfW then itself purchases credit protection by entering into credit default swaps with institutional investors. The advantage is that KfW is Triple-A rated, and can get the best CDS execution prices because of its strength as a swap counterparty. The loans remain on the balance sheet of the originating bank, and because KfW has a zero risk weighting as swap counterparty the bank does not need to set aside regulatory capital to cover counterparty risk.

The £355.7 million unfunded super senior tranche, sold as a CDS, was rated Triple-A by Standard & Poors (S&P) and Moody's. In this deal the entire super senior tranche was bought by a single investor - the monoline insurer Ambac.

The supporting subordinated tranches, totalling £32.05 million and rated from Triple-A to Double-B, were cash tranches sold to investors as floating rate Credit Linked Notes (CLNs).

The various tranches were issued through the EPIC special purpose company registered in Ireland. Depfa was advised by Clifford Chance in London and AL Goodbody in Ireland.

"Doing a true sale transaction backed by PFI loans would be very complicated, since there are often restrictions on the transfer of the loans, and the security is difficult to transfer," explains Andrew Bride, managing director at Depfa Bank. "The advantage of a synthetic deal is that the loans stay where they are on our balance sheet, and we have tried to create a model that we could use for a global deal in the future, since we have loans in a number of jurisdictions."

"The main aim of doing the transaction for Depfa was regulatory capital relief, so it was is important to have a zero risk weighted institution like KfW in the structure, since with a 20% risk weighted institution we would have still been required to set aside regulatory capital to cover the swap counterparty risk," Bride explains.

"The Depfa deal is a synthetic collateralised loan obligation (CLO), not untypical in its structure, and somewhat similar to the Promise and Provide deals which have also featured KfW in the structure as a Triple-A rated swap counterparty with a zero risk weighting," explains Peter Voisey, partner at Clifford Chance in London.

"The monoline insurers have an appetite to take positions on the super senior swap, and in this deal Ambac was an investor rather than wrapping the deal," Voisey explains. "German law is the principal law in the transaction, because KfW were involved and prefer to use German law, but future deals backed by UK PFI loans could be done equally well under English law," he adds.

A new asset class

In 2003 KfW did around Eu22 billion of synthetic securitisations via its Promise platform (for mortgages) and Provide platform (for small and medium sized enterprises), so its role as swap intermediary is tried and tested in the market. The main users are German banks, but KfW is keen to extend its business outside of Germany, and has done offerings for Portuguese and Dutch banks, helping them securitise their mortgage portfolios. With the Depfa deal KfW has established a new asset class by backing a transaction involving PFI loans.

Depfa will itself retain the first loss piece on the EPIC deal, which will absorb any initial losses in the PFI loan portfolio. Given the synthetic nature of the deal, the loans will remain on Depfa's balance sheet and it will continue to administer and service them. Only the risk has been synthetically transferred to the institutional investors who have bought the super senior CDS (in this case Ambac), and the cash investors who bought the CLNs.

The incentive for Depfa is to reduce the amount of regulatory capital that it needs to set aside against its loan book, so allowing it to improve the return on equity of its infrastructure financing. Depfa sees itself as a repeat issuer, and says that the know-how gained in this transaction will smooth the way for the channelling of more infrastructure assets in the secondary market.

The deal creates an additional way for other institutional investors and banks to gain exposure to the UK infrastructure market and it is likely that other major PFI lenders will follow Depfa's lead in due course. Depfa itself is planning a much bigger deal next time round in a repeat of the KfW structure next year or early 2006.

Other banks may do the same, or could theoretically do true sale deals that actually remove the assets from the balance sheet. However PFI loans often have onerous restrictions on transfer, since project like to keep a tight group of lenders rather than having loans sold on and traded, which could complicate matters in case of problems with the project and the need to negotiate with creditors. So synthetic securitisations are viewed as an ideal solution for PFI loan books.

"Right across the infrastructure market I think that we will see banks trying to recycle their loans and freeing up capital for more deals," comments one banker.

Eiffel innovation

Another innovative capital markets deal for infrastructure contracts was closed in October, when Deutsche Bank led the Eiffel 1 FTC transaction out of Portugal, backed by future flows of cash payments due to the various construction companies that are building four SCUT shadow tolls.

The construction companies are members of various Agrupamentos Complementares de Empresas (ACEs), which are joint ventures set up by groups of contractors to build the toll roads. There are 10 contractors in total, but the key members are Mota-Engil, Bento Pedroso Construcoes (BPC), and Obras Publicas e Cimento Armado (OPCA).

This same group of ACEs are building the four motorway concessions that are included in the deal. The concessions companies involved are Norace (Auto Estrada do Norte), Vianor (Costa da Prata), Lusitania (Beira Litotal e Alta), and Portuscale (Grande Porto).

The bond offering is a way of channelling cheap funding to the contractors during the construction phase of the SCUTs, which is often long at around five years. The bonds have a tenor of three years, and were sold in a single Eu256.6 million tranche. They were rated BBB- by S&P and Baa3 by Moody's.

Each individual toll road is subject to a concession agreement with the Portuguese government, and the financing is already in place for the concessionaires under project finance arrangements. Thus each of the four concessions has a bank syndicate attached to it, which is dependent upon the road being built to eventually get repaid. The banks have already put in place the loans for the construction period, and have assessed what work needs to be done, so the cash is already in place for payments to be made to the contractors.

"The contractors are working on the construction of the roads, and as work is being done they submit invoices which have to be approved by the bank lenders' technical advisers," explains Mike Redican, Managing Director in Debt Capital Markets at Deutsche Bank in London. "Once that approval has been given, the concession company is able to present that invoice to the agent bank for the concession, and the loan facility already in place can be drawn down to pay the contractor."

"The Eiffel 1 structure does not cut across any of the bank loans, and we have done nothing to disturb any of their agreements, but are simply buying a future flow of payments for construction work," Redican explains. "Under the deal structure the concession company will now pay the money owed to contractors directly to the Eiffel 1 account bank, so all we have done is redirect that flow to the bondholders."

Making investment grade

The deal was done under Portuguese law using a Fundo Titularizacao de Creditos (FTC), or funded participation units. The companies in the ACEs are not rated by S&P, but the structure and high level of overcollateralisation helped the deal make investment grade. If the overcollateralisation of Eiffel 1 drops below 3x, from 4.85x times when the deal was launched, cash will be trapped until a nine month reserve account is built up.

Deutsche Bank initially took the whole Eiffel deal on its own books, before privately placing some of the bonds, and has not released pricing details.

The pricing is likely to be significantly within what the construction companies would pay for bank debt, in particular for the smaller members of the ACEs joint ventures. In fact as more capital markets transactions are closed, bankers expect the bond markets to increasingly drive pricing, forcing bank lenders to lower the cost of their loans.

Redican expects to see more ABS offerings out of Portugal. "In Portugal to date all the infrastructure deals have been done in the bank market, but there is now great interest in taking these deals out and refinancing them in the capital markets," he says.

With regard to the securitisation of project loan books, synthetic deals may represent the way forward. There have been a number of transactions in the United States, dating back to the first Project Funding Corporation deal from Credit Suisse First Boston back in 1998.

CSFB later followed this up with a second transaction, and since 2001 there have also been offerings from Citibank and TCW. But in the UK and European PFI market, restrictions on sale and assignment of secured loans will make outright portfolio sales difficult, and bankers expect to see more deals where the loans are kept on balance sheet, but the risk is synthetically transferred.