The growth of the PPP concept across Europe has long been touted as a source of innovative new project financing techniques. Industry pundits have predicted a surge in use of project bonds and equity instruments to counter the traditional dominance of bank financing in the region. All that was needed ? they said ? was one high-profile eurobond deal which would act as a benchmark for the flood of issuance that was to follow.

That requirement was met in July with the launch of a Eu126.5 million bond refinancing for the SCUT do Algarve shadow toll road in Portugal. The deal met all the criteria ? it was large, euro-denominated, long-term and infrastructure-backed ? and set the stage for similar financing structures across Europe.

But as 2001 draws to a close there is little sign of a follow-up issue any time soon. Why? ?In many ways 2001 has been a strange year in the UK and Europe,? muses Chris Wrenn, director at monoline insurer Financial Security Assurance (FSA) in London. ?A lot of projects are moving forward but few have actually closed. The pipeline is, however, starting to fill up.? He is confident that 2002 will see further use of bond issues to back long-term PPP deals in the region. And he is not alone.

One of the overriding rationales for the increased use of bonds is the growth of the pensions market in Europe. ?The appetite for European paper is definitely increasing,? says Robert Rees, director in the securitisation department at ABN Amro in London. ?There has been historic underfunding of pensions in Europe and the investor base is now being forced to take longer-term assets.? A recent survey by William M Mercer showed that private sector pension assets in 15 European countries represented 40% of total GDP in 2000 compared with 32% in 1996. The survey, published in May this year, drew on data supplied by 172 fund managers in 17 European countries. It showed that the largest growth in pension fund assets had been in the Netherlands (up from 121% to 162% of GDP), Sweden (up from 77% to 112%) and Denmark (up from 76% to 100%).

The survey also reveals the increasing movement away from domestic investment to pan-European investment ? all good news for large-scale infrastructure projects. The move to Eurozone equities is particularly pronounced in Ireland, Spain and Portugal. The percentage of Irish pension assets invested domestically has dropped from 34% to 19% in two years ? and 15% of pension assets are now invested in Eurozone equities. In Spain the proportion is 15% and Portugal 17%.

While statistics like these are enough to whet the appetite of any project sponsor, there are still clearly pros and cons to the use of bond versus bank finance.

Bond versus bank

The traditional logic behind the use of bonds is that they can ?plug the tenor gap? left by bank finance and achieve much longer maturities than are possible from the bank market. But this distinction no longer seems to be true. ?Banks do longer term deals now and will compete on a level footing with the bond market,? says Jonathan Scott, senior director at KPMG in London. ?I have seen banks go to 30 years in the last couple of years,? he adds.

This change is largely the result of increasing competition in the bank market and the entry of the UK building societies ? with long-dated mortgage liabilities ? into the sector. Such facilities almost always involve some form of refinancing option after the initial construction phase, however, and are rarely if ever expected to run their course. ?Banks will lend extremely long-term but I will leave it up to other people to say whether or not they should do,? notes one industry expert.

And bonds may also become a viable alternative for shorter maturities. ?Shorter maturities are possible as well in the capital market but pricing differences to the loan solution are probably smaller,? says Werner Von Baum at Corporate Bond Origination, Hypovereinsbank in Munich, which was joint bookrunner on the Algarve bond along with BSCH. ?The advantage of a bond solution comes largely from the fact that many investors work in a different regulatory framework. As such, cost of funding and return requirements are very different.? But are bonds cheaper? Not necessarily. While pricing over gilts is probably cheaper than pricing over Libor there are local anomalies ? and the cost of the wrap ? to be considered.

The consensus is, therefore, that funding for European projects can be available on almost equal terms from either the bank or bond market. Indeed, one adviser to a series of upcoming European PPP deals notes that he has received a series of proposals across the spectrum of financing options. ?Our exploratory investigations suggest that there is a very wide range of finance available ? a lot of institutions are hungry for these types of assets,? he says. But there is no doubt that non-bank finance in Europe still has a number of hurdles to cross before euro-denominated project bonds become commonplace.

There is clearly strong demand in Europe for long-dated assets ? but how suited are projects to these types of investments? Despite the visibility of deals such as SCUT do Algarve, project bonds might still be a bit of a risky call for these types of investors. They will initially prefer long-term government stocks or high-grade corporates to the more complex types of paper that projects inevitably entail. ?The capital markets are generally better suited to refinancings,? explains Scott at KPMG. ?It is difficult to put together a bond issue against a project plan that you know from experience will never happen. You need more flexibility.?

The Algarve deal was a refinancing of 24-year debt of the concessionaire Cintra. As with most long-term project debt, this loan was always intended to be taken out with a refinancing relatively quickly. ?Bond financing is always less flexible than bank financing,? says Scott. ?Once the project has passed the construction phase the risks are far lower and there is therefore less flexibility required. This is what bond financing is best suited to.?

The SCUT do Algarve bond was wrapped by XL Capital Assurance and has a tenor of 26 years (weighted average life of around 20 years).It was priced at 55bp over 20 year euribor mid-swaps. The monoline wrap covered both the bond issue and a Eu130 million EIB loan. In many ways it is surprising that the first euro-denominated infrastructure bond should come from Portugal as it has one of the toughest securities law environments in Europe for this type of deal. Problems were overcome by the bonds being issued through special purpose vehicle Algarve International BV, domiciled in the Netherlands.

?There was extremely strong appetite for the bonds and the deal could have been sold well beyond the size of the transaction,? notes Alberto Ramos, head of project finance in Europe for XL Capital Assurance in Madrid. ?The Algarve deal will be replicated over and over again,? he predicts. But it is important to remember that a considerable part of the deal's attraction was that it was both a refinancing and a shadow toll road: revenues from a shadow toll road are very predictable and far less susceptible to change than many other project structures. The high quality of the deal is reflected in the fact that even without a wrap it would still have been investment grade ? triple B.

The issue of rating raises the thorny question of whether or not project bonds will be achievable in Europe in the near future without a monoline wrap. Not surprisingly, the jury is still out on this one. Werner von Baum at Hypovereinsbank believes that they will. ?It is possible to do a small project bond without a monoline wrap as long as the risk-return profile is attractive for bondholders. Transactions are getting done but the size has to fit the story and the investor has to be able to identify relative value,? he says.

In the UK, unenhanced bond issues for infrastructure projects have been done since the mid-1990s ? the first being the £165 million bond issue for the Docklands Light Railways extension at Lewisham in 1996. That deal marked the first time that a PFI project had involved both bond and bank finance ? as the deal also comprised £30 million bank funding from Midland Bank. The bond issue was lead managed by BZW and placed with UK pension and insurance companies. The deal was rated single-A by Duff and Phelps but BZW decided not to get a wrap as it was confident that it could sell the bonds unenhanced.

But the excitement surrounding the early stages of PFI projects in the UK at that time has since been tempered by experience and whether or not such an issue could be sold unwrapped in today's market is unclear. ?As long as there is a wide spread between triple-A and triple-B you will get monolines taking advantage of the situation,? notes Scott at KPMG. ?But it [an unwrapped bond] can be done.? Rees at ABN Amro reckons, however, that it will be some time before unwrapped bonds are seen for the large infrastructure projects now planned in continental Europe. ?It doesn't make sense to try and do an unwrapped bond as the cost [compared to the cost of getting a wrap] simply doesn't add up,? he notes. ?As a result we don't really know if it is doable as it doesn't make sense to try.? Not surprisingly, the monolines feel that a wrap is essential for some time to come. ?In some of the early transactions that were not wrapped there was a lot of economic value left on the table,? claims Wrenn at FSA.

Given that there is substantial demand from both the bank and bond markets for European project assets, it cannot be too long before the next eurobond issue hits the market. The smart money is on the A28 project in France, which has been in the pipeline for a long time. The project covers construction of a 125km stretch of the A28 toll road between Rouen and Alencon and is being constructed by a joint venture between Bouygues and Caisse des Depots. Financing is being arranged by CDC, which declined to speak to Project Finance for this article. A source close to the deal explains that it is likely to take the form of an index-linked bond but that there are certain regulatory hurdles that still have to be crossed. ?There are problems in France but I am not hearing anyone say that they are insurmountable,? he says.

Another project that is extremely likely to involve capital markets funding is Portugal's latest toll motorway project, the 113km SCUT do Norte Litoral road that will link Oporto and Caminha to the north of the country.This is a 30 year concession and has been awarded to Ferrovial, manager of the SCUT do Algarve. The deal will involve the construction of 41km of new road and the maintenance of 72km and will cost around Eu330 million. Now that SCUT do Algarve has paved the way, there is a strong likelihood that this deal will involve a mix of bank and bond funding. Ireland has a raft of PPP deals coming to the boil ? among which is a £97 million six-project schools programme. In Italy two PPP projects are underway ? a $15 million hospital project and a large $160 million healthcare project in Milan. There is also the $5.6 billion high-speed rail link between Belgium and Amsterdam which has been financed but could be a fertile source of refinancing mandates in the future. Greece is also hotly tipped as a source of new deals.

Despite the progress that has been made, significant hurdles to non-bank funding of projects in Europe still remain. Security laws can present real problems ? but can be got around, as was the case in Portugal. Several countries still have very strict rules on gearing (in some cases no more than 1:1 debt to equity) which preclude highly-geared project companies. But as more and more deals get done these hurdles will gradually be removed. ?We have a happy confluence of interest [between the sponsor's needs and the demand for long-dated paper] in Europe,? says Scott at KPMG. ?The structure of project bonds is not ideal as they do not have annuity repayment profiles but are usually 25 year bullets, but people will increasingly consider them as the demand is there.?

The suitability of such instruments to the construction phase of a project is clearly questionable ? and it seems that refinancing is where the capital markets have the clearest role to play ? at least in this early stage of European PPP. And the pace of change cannot be forced. Rees at ABN Amro points out that the first public project bond deal in the UK ? the Severn River Crossing ? was done in 1989 but the market did not really get going until 1997. ?There is a lot of education still to be done,? he says.