At a time when banks are looking to de-leverage their balance sheets, the traditional avenues open for them to shed project finance debt – during syndications and through collateralised debt obligations – are closed. True, some syndication has taken place but only on a limited basis and with the arranging banks comfortable at their initial commitments before any sell-down. In the run-up into Basel 3, which will force banks to better match their funding with their assets, 20 and 30-year project debt does not sit easily against traditional bank funding maturities of 3 months to 1 year.

The great hope for infrastructure finance is that institutional investors will supplement bank liquidity and offer an exit for banks laden with project debt. The cleanest and simplest way for institutional investors to get involved by buying project bonds. However, bonds have been unable to get a foothold in the market because of the competitiveness and flexibility of banks, and when liquidity is tight for banks the capital markets have generally been equally as inhospitable.

The other increasingly popular alternative is to launch an infrastructure debt fund whereby a manager or bank raises commitments from institutional investors and either acts as a bank in the primary market or buys loans in the secondary market. In this regard, infrastructure debt funds have the benefit of bringing in extra liquidity from institutional investors without the downside inflexibility of project bonds.

In July this year Barclays launched a £500 million ($816 million) infrastructure debt fund – Barclays Senior Debt Infrastructure Fund I – the first bank-led debt fund of its kind in the UK. The fund will have access to any projects arranged by Barclays and will be seeded with £200 million of assets to provide a return from day one. Barclays will retain a 20% interest in each asset, alongside the fund. The fund is only open to institutional invest­ors and is primarily aimed at bringing pension funds into the long-term project debt market and funding the UK’s ambitious five-year £200 billion National Infrastructure Plan.

Outside of banks, AMP Capital and Sequoia Investment are each attempting to raise Eu1 billion for their respective infrastructure debt funds. They will need to establish a new asset class in a market that has been dominated by banks, and to educate investors without the need for rating agencies. Fortunately, under Solvency 2 debt products have broadly better treatment for life and insurance funds than equity investments.

“Two issues with infrastructure debt funds are the returns for investors and the fees charged by the manager,” says one project finance banker. And that is the nub for legacy loans. While infrastructure debt funds will likely carry a fee-light structure similar to fixed income funds and can source primary project loans today at around 250bp, the widening spreads post-credit crunch makes it impossible for banks to attract investors to a fund stocked with pre-2008 loans at par. “Legacy assets are yielding far less than today’s assets, from 100bp-120bp pre-credit crunch to around 300bp-320bp for some asset classes today,” says Steve Cook, director and the head of structuring at Sequoia Investment Management Company. “To make up for that 150bp-200bp differential, legacy assets will need to be fed into a fund or sold at the mid to low 80’s [80p in the £1 discount].”

So debt funds, unless banks are willing to take a profit and loss hit, are unlikely to offer a de-leveraging that is any more effective than an outright sale of their loan book. Despite the pressure on bank balance sheets, particularly on European banks, it is perhaps telling that only the most capital-starved banks have attempt­ed to shift their loan books. The first was Royal Bank of Scotland’s disposal of its project finance loan book, with a par value of £3.9 billion but sold for £3.3 billion, in November 2010, suggesting a discount of 84.6p to the £1. Next, Banco Espirito Santo managed to sell over half its Eu2.6 billion ($3.67 billion) portfolio of underwater syndicated project and corporate loans in an ad hoc process. BES also seeded the Sequoia Fund with Eu100 million-worth of project loans chosen by Sequoia.

Bank of Ireland is in the process of selling its Eu3.28 billion non-Irish project loan book. Bank of Ireland is following the path RBS laid down with its project loan book sale to BTMU, and rejecting the process used on the Banco Espirito Santo sale earlier this year by selling the portfolio in chunks rather than allow buyers to pick off the best assets. In mid-October, Bank of Ireland sold $1 billion of its energy project finance of its energy project finance loans to GE Energy Financial Services at around an 8% discount to par. The energy loans tend to yield a little more than infrastructure debt, and even during the heights of the credit bubble had average margins of closer to 200bp than 100bp. Many of the infrastructure loans are now priced below most banks’ cost of funding.

“If banks carry loans yielding less than their cost of funding, it costs banks each day they hold those loans. Neither does it make sense for banks to carry loans just over their cost of funding because they are not properly rewarded for the risk and the opportunity costs are high,” says one banker. But achieving a clearing price that is agreeable to both seller and buyer is difficult except in the most pressing situations, such as those faced by RBS, Bank of Ireland and next, probably, Dexia. Under generally accepted accounting principles project finance loans are not deemed to be tradable instruments and therefore are not marked to market.

“It’s difficult for banks to take a hit on their P&L by selling below par because these are mostly performing assets,” adds Cook. “Banks may logically take the view that although the cost of funding is high and it costs the bank to hold pre-credit crunch loans, those funding costs may fall again.”

Between 2000 and 2007 around Eu100 billion project finance loans a year were placed with banks. Banks with Eu10 billion-plus project loan books that are caught in the midst of the Eurozone debt crisis and will be looking to de-leverage are likely to include Dexia, Credit Agricole, Societe Generale, BBVA, Santander and UniCredit. The traditional avenues of syndication and CDOs are probably unviable for pre-2008 deals – which Lloyds can half attest to in light of its pulled Gable Funding cash CLO.

Dark pools of liquidity remain open to project banks via bilateral agreements with institutional investors. Project loans can be posted as covered collateral for a full recourse loan with an institutional investor for shorter tenors – say five years – which will provide funding but no regulatory capital relief. Whether banks are pushed to relinquish their loan books or go through an orderly run off, only the market can decide. The worst case scenario will be several banks in the market at once looking to dispose of similar assets. It could be a wise but brave move for a bank to willingly enter the market early.