When the 10 new member states joined the EU earlier this year, the expectation was that they could combine their earmarked structural and cohesion funds with PPP transactions. In so doing they can avoid raising the 15% to 25% co-financing requirement from their own balance sheets. This is particularly pertinent given their budgetary predicament, that many operate near the threshold of the fiscal stability pact and that all suffer from a need to raise co-financing to EU access grants for badly-needed infrastructure investment.

On paper, co-financing using a PPP structure is allowed. Yet in reality it is now highly doubtful that there will be a single hybrid transaction in the region over the next two years. "The nail in the coffin of the hybrid theorising is that the lead times on a typical DBFO road concession are about 18 months but the EU funds are reabsorbed in 2006," says one financier active in Eastern Europe. "Better to follow the example of Ireland, Spain and Portugal, and burn as much of the grant funding using traditional procurement methods while they can, whilst running a PPP programme in parallel."

Pure PPP
Blazing the trail for PPP in the region is Hungary. The M5 concession has now changed completely from a real toll road to an availability-based regime. The Eu750 million refinancing incorporated the construction of the 48km phase 2 of the project, and the anticipated Eu150 million phase 3 is expected in the market at the beginning of 2005. Meanwhile the Eu500 million M6 deal is closing in double-quick time. The tender was launched in January, a preferred bidder named in August and financial close is due before year end.

The Hungarian PPP taskforce has effectively put the entire domestic road network into a vignette system. Following a similar concession model, phase 2 of the M6, the M7 and M43 should be out to tender in 2005 going into 2006.

However the speed with which M6 has closed has raised some eyebrows among bankers not involved in the deal. Says one banker, "M6 was set on an extraordinarily fast track. And one may well ask whether best value has been achieved. One school of thought says that a take-it-or-leave-it tendering process avoids corruption and ensures pure competition, but the other school says that an optimum, cost-effective solution is unlikely to be found."

Others quibble the pricing is too cheap. The debt on M5 is priced at 130bp over Euribor during construction, 120bp for the first five years of operation, 130bp for the next five, 140bp for the next five and 160bp for the remaining 3.5 years. The debt in its early years is only 20bp-30bp higher than a comparative road deal in the UK and Hungary is rated A- without significant deal precedence.

The list of banks participating in the M5 project - the largest transport deal in the region to close in 2004 - gives a good indication of participants in future projects. Noticeable by its absence is RZB. Marc Faller, head of project finance at RZB, says of the M5, "Of course we look at such transactions, but we have to look closely at the margin of what is effectively sovereign risk and compare it to other sovereign-rated debt. And we believe there are higher margins to be had elsewhere."

RZB's strategy in Central and Eastern Europe (CEE) has been to largely concentrate on industrial-sector project financings and M&A deals, often working in close partnership with the EBRD and the IFC to mitigate the political risks.

Barriers to cross border deals
Political will continues to be both the most significant barrier and driver to infrastructure projects in the CEE. Despite the disparate and often PPP-hostile legal environments, if the government throws its weight behind a project it invariably gets done. "There is a general political will for new forms of financing," says Christopher Blin, vice-president Infrastructure and Energy, Citigroup. "It is typical that a project will need the consent of various ministries, which is time consuming. But with strong political will we do not see domestic legal frameworks as significant barriers to infrastructure projects."

Citigroup is currently advising the Gdansk Transport Company (GTC) - the winning consortium on Poland's prospective A1 motorway running between Gdansk and Torun. The 35-year, Eu700 million concession has had a long and arduous labour, and is typical of the sort of protraction future projects will hope to avoid.

The tender for the concession as a toll road was announced in December 1995, but stalled in 2000 over doubts about its financial viability. A preliminary agreement was signed in 2002, with revenue based on a vignette system allowing road usage for a set period of time for a one off payment. This summer a sizeable legal hurdle was surmounted when the government passed legislation to allow service payments to be paid under a concession agreement. Financial close is now expected at the beginning of 2005. Sign that the concession should be a success was given recently when the operator John Laing took a stake in the project consortium, its first investment in Eastern Europe.

One of the most challenging features of the A1 and other road concessions in countries with relatively little experience of PPP concessions is the public sector wariness of changes to the project company in the lifetime of a concession, either due to default or as an exit to an equity position. Robert Phillips, partner at CMS Cameron McKenna says, "There is still a certain amount of lack of comprehension on the public side regarding PPP, which they had not originally contemplated. Negotiating an agreement between state and lenders is often difficult as there is a reluctance to accept that lenders should have step-in rights if a project company is in default. Also, the public side finds it difficult to comprehend a change in equity participants in the lifetime of the concession - and this can present difficulties."

In place of lender step-in rights, banks are asking for state-backed guarantees for either 100% of the debt or a significant proportion. Although a direct guarantee is likely to fall foul of Eurostat guidelines (specifically liabilities under the framework of the European system of accounts, ESA-95) and the project payments considered on-balance sheet, this may be relatively painlessly overcome with some clever structuring. In the TAV Italian high-speed rail project bond issue, for example, on-balance sheet status was avoided by putting in place a contingent guarantee - where the government becomes liable to service debt coverage after a specified period of time - rather than a direct guarantee.

Credit upgrade expectations driving deals
The failings of the A1, M1-M15, the D47 - which one banker involved on the deal called an "unmitigated disaster" - and to a lesser extent the M5, could make some investors and banks sceptical as to the palpability of future deal flow.
But this is more than outweighed by the benefits of accession. The accession countries and next-wave accession countries are likely to benefit from a surfeit of bank appetite because of the higher margins and expected credit upgrades that convergence will bring - in effect there is usually a lag between the credit agencies rating and banks perception of sovereign risk.

The recent sovereign upgrade for Romania bodes well for the future. Already there are a number of deals in the pipeline in Romania, including the Eu480 million Cormanic-Predeal motorway, the Eu180 million Predeal-Brasov motorway, and the Eu320 million Danube suspension bridge, among others. Following the D47 episode, the Czech Republic now has a well-regarded PPP task force in place, and is re-launching its PPP effort with the Prague ring road project first to go.

Slovakia is also on the cusp of tendering three of four road projects after a consortium of advisers concluded that PPP would be the best option to meet the need for more road infrastructure. The state was advised by Deloitte, Dewey Ballantine, Dedak & Partners and Mott Macdonald.

If the scheme goes ahead in its entirety it will comprise three highways at a cost of some Eu5.2 billion. The projects are a Eu2.5 billion, 250km project linking Zilina to Presov; a Eu1.5 billion, 220km, Zvolen-Kosice motorway; and a Eu1.2 billion project linking the two motorways. A tender for sponsors on the first phase could be issued as early as Spring 2005.

If the region is to take off in a big way bankers would dearly love Poland - by some margin the largest of the recently acceded economies - to roll out an extensive PPP programme. Following A2 and A4 there is little on the horizon, though there have been murmurings of a Warsaw Metro concession, there have also been rumours that Poland may drop PPP altogether in the conventional sense and outsource construction to the private sector on a one to five year pre-financed basis similar to the general contractor scheme in Italy.

Types of roads, types of financing, and beyond
The majority of roads being considered are within national boundaries linking cities and ports. The projects tend to have a strong identity with the ruling government - they are vote winners. The larger projects, the cross border deals, could be wholly more difficult to procure as the stagnant TENs programme has shown. The last major cross border deal in the region was the M1-M15 motorway linking Vienna to Budapest, whose toll regime failed because of poor road usage.

Bankers will keep a close eye on how the Eu4.3 billion Brenner rail tunnel in Austria will proceed because there is little visible upside to Austria in providing a link along this Munich-Verona axis, other than moving traffic from its transport system. Being merely bypassed by a European transport corridor is a major political barrier to TENs, particularly to the landlocked countries of the CEE.

There is a swing toward availability-based revenue streams emerging in the financing of the deals being done. Both Poland and Croatia have tended toward placing traffic risk with the private sector in the past. The Zageb-Macelj toll road in Croatia reached close on Eu312 million of debt facilities in late August. However, little risk was taken by the banks with Hermes providing 95% commercial and political risk cover on a Eu100 million tranche and GKA covering 95% of the Croatian government's obligations. (Search Zagreb-Macelj for the deal analysis).

Now Poland will go for an availability-based regime on the A1 motorway, after dropping the idea of real tolls due to the inadequacy of base case traffic forecasting. Hungary has also adopted a nationwide vignette system.

It has been mooted in Austria that the EUROPPASS real toll network could be extended outside Austria in Slovakia and beyond given the success of the automatic microwave system. Although the EU prefers satellite technology, its plan for widespread adoption of a Eurovignette - where revenue from road systems can subsidise the construction and operation of others - has faltered on the dubious reliability of the satellite positioning system.

Beyond road, rail projects are on the distant horizon, the Brenner tunnel is in the fist category of high priority in the TENs scheme. A high speed rail link is also rumoured from Germany through Austria, Slovenia and through to Greece, but this is at an embryonic stage. More likely are short links between large conurbations such as Vienna and Bratislava.

In the near future banks are looking to roads. And whatever guise future developments take, the upside to convergence with more prosperous western Europe should keep attracting both banks and investors alike. The Zagreb-Macelj toll project financing in Croatia has shown that conventional PPP is not the sole preserve of the London debt market. With the successful completion of three of four deals through Hungary, Croatia, Romania and Poland among others, the region should tempt more foreign investors such as Laing, and banks out of London, Germany and beyond. If, on the other hand, protraction and reversals continue to characterise project development in the CEE, competing for funding with western European projects will come at a higher price.