Perhaps there is no debate more perennial in project financing than whether the capital markets can and will supplant bank debt as a source of project funding. Institutional investors have the right time horizon to hold long-dated infrastructure debt. But in many markets banks have offered competitive tenors, and have been able to point to negative carry, construction risk and the intrusions of the ratings process as significant drawbacks.

Capital markets protagonists argue that this time is different, because of the capital constraints that Basel III could cause for banks. The new capital adequacy rules make holding long-term debt more costly. The European Union’s members’ fiscal constraints should spur them to park more assets on the balance sheets of the private sector. If the EU is to meet its infrastructure investment targets by 2020, private capital needs help to plug a funding gap. On cue, up comes the EU and European Investment Bank’s European 2020 project bond initiative.

The EU steps up

At a conference on the European 2020 project bond initiative in Brussels in April, Olli Rehn, the European commissioner for economic and monetary affairs said: “Partly due to the fall in investment during the crisis, estimates on investment volumes considered necessary in Europe’s transport, energy and communication networks until 2020 point to total amounts between Eu1.5 and Eu2 trillion. However, currently our public budgets are struggling with the necessary fiscal consolidation. That’s why we need to find smart ways and means to fund projects of major public interest.”

From now until 2020, the EU estimates that Eu500 billion ($700 billion) will be needed for the implementation of the Trans-European Transport Network (TEN-T) programme. In the energy sector, public and private entities in the EU member states will need to spend around Eu400 billion on distribution networks and smart grids, another Eu200 billion on transmission networks and storage as well as Eu500 billion to upgrade and build new generation capacity between now and 2020. And up to Eu268 billion in capital investments are required to achieve the Commission’s broadband targets.

As Basel III bites – the first wave of bank compliance is set for 2015, with full-compliance due in 2018 – the cost of long-term bank debt should make bond solutions comparatively affordable. As the EIB has pointed out, however, bond financings for PPP projects and other project financings for infrastructure in Europe effectively ended with the demise of several monolines in the early stages of the credit crunch.

The European bond initiative is designed to facilitate institutional investor appetite for projects by offering credit enhancement from the EIB, and with the EIB acting as controlling creditor. The initiative proposes two forms of credit enhancement: a fully-funded subordinate tranche equal to up to 20% of the senior debt and a guarantee of senior debt of up to 20%. While the products are designed to fill the void left by the disappearance of the monoclines, they would not involve wrapping the entire debt amount to AAA. Their aim is to lift the credit rating of a project to the A or AA rating needed to attract large numbers of institutional investors.

In a special comment on the initiative, ratings agency Moody’s says that both forms of credit enhancement are capable of lifting “senior secured project bonds issued by PFI/PPP projects from low investment-grade to single-A ratings.”

Picking products

There is a broad consensus in the market that the most efficient and effective use of EIB funds would be to use the unfunded guarantee facility, since cash is not required upfront, and the capital required to service a portfolio of unfunded guarantees should be much lower than the funded equivalent, depending on the EIB’s internal ratings procedures.

The precise mechanism through which a 20% unfunded guarantee would work is still unclear. However, one proposal that Deutsche Bank contributed to the consultation process would require using two separate guarantees rather than one to maximise the effectiveness of the EIB’s presence and align creditor interests. The proposal suggests the EIB puts up guarantee facilities worth 25% of senior debt split between two facilities. The first would be a guarantee facility equivalent to 10% of total senior debt that would provide support to the project’s debt service burden during construction and into operations. The facility would work in much the same way as the EIB’s existing loan guarantee instrument for TENs transport projects (LGTT), by refinancing senior commercial debt with EIB subordinated debt if the project struggles to stay above a defined debt service coverage ratio. The LGTT, as its name suggests, is currently only available on TENs projects.

The second element of the Deutsche proposal is 15% guarantee that would be deployed in the event of a default to minimise creditors’ loss given default (LGD) to close to 0. The principal benefit of this proposal over a straight guarantee of loss on termination is that creditors will not be tempted to accelerate towards default knowing that they can recover all of their principal from the project plus guarantee and instead will be motivated to work out the situation. Any unused liquidity guarantee cannot be added on to the LGD guarantee. The size of the proposed guarantee reflects the work that banks have done – partly for the lobbying effort on Basel II – in studying default and loss given default rates on their project finance debt portfolios.

Whatever the mechanism for the EIB support, it is a certainty that the EIB will act as a controlling creditor. Given EIB’s pedigree and track record this will provide comfort to the European bond-buying community. As EIB President Philippe Maystadt said in the consultation: “The project bond model is intended to step into the void left by the disappearance of the monoline-wrapped infrastructure bond market.” However, one banker says, “it is a mistake to think the EIB will act as a monoline in its function as a controlling creditor. It will probably act in the same way as monitor and agent until something goes wrong with the project, because investors had their fingers burnt with the monolines and will want a greater say in and around defaults.”

Ready for take off?

The 2020 European bond initiative is due to become fully operational in 2014 – though a pilot project in the PPP sector is possible in 2013 – and the scheme will initially enhance between Eu1 billion to Eu5 billion in the early years before ramping up to between Eu10 billion to Eu20 billion by 2020.

According to Maystadt: “The aim would be to make the maximum number of projects bankable. The intention is to focus on TEN-T, TEN-E and certain ICT-related projects. However, in the initial phases of the initiative a compromise might need to be found between supporting large EU priority projects and currently available projects that would help build a large, well-granulated and diversified portfolio.”

Will the European bond initiative take off? One obstacle is that the procurement processes in many member states do not allow a funding competition after the award of preferred bidder. This should be overcome with relatively simple legislative changes. A bigger challenge is that the raison d’etre for the initiative is to plug a funding gap but it is difficult to argue that a funding gap currently exists, and there is uncertainty as to whether the gap will emerge. A funding gap will be a function of governments tendering projects and the supply of bank debt – supply and demand.

The deal pipeline for infrastructure projects in Europe is not that large, and the large projects that have been tendered have been reasonably comfortably placed with project banks. Local solutions also seem to dominate. In France, in particular, sovereign guarantees and the Dailly tranches have boosted liquidity for its high-speed rail PPP and government accommodation projects and the UK’s RBS and Lloyds have been active in the infrastructure space, if only to appease the UK government, their largest shareholder.

More importantly, there is room for scepticism about whether this additional financial engineering is needed to raise project ratings to investor comfort levels. France’s Dailly tranche is effectively a triple-A obligation, and many of the existing concession-level tweaks that emerged in the aftermath of the crisis, including refinancing guarantees, would help project ratings reach the required levels.

In Canada, for instance, an unenhanced single-A PPP market already exists, and has long been the sweet spot for project bond investors. By coincidence, the start of 2011 saw the country’s first attempt at a widely-distributed triple-B PPP financing, for the CHUM hospital in Quebec, which featured an eight-year construction period. Banks have complained bitterly that ratings agencies gave single-A ratings to deals that would be rated triple-B in the UK or Australia. Agencies responded that more straightforward concession structures and sturdier attempts to mitigate construction risk justify the higher notching. These measures are all available to grantors in the EU.

On the bank debt supply side, if Basel 3 really does bite banks, or they are constrained by a spiralling Euro-zone sovereign debt crises, the capital markets will be the only place (save from heavy direct EU and member state lending) to affordably fund large infrastructure projects using long-term debt. However, the wholesale use of bond debt has long been discussed and has disappointed before. Political will, both to regulate banks balance sheets and procure projects, will ultimately determine the success of the 2020 European Bond initiative.