There is possibly no topic more often discussed in project financing than the development of a liquid project bond market. Within Europe, the need has arguably never been greater. The fallout from the global crisis has placed greater strain on government balance sheets, which means that European governments are likely to become more reliant on the private sector to deliver major projects. But the twin effects of Basell III and the eurozone crisis have meant that banks have long tired of providing long-dated funding.

Market participants hope that institutional investors can help plug the gap left by banks in the market for senior debt. “In terms of potential financial investors coming in and being prepared to provide the debt instead of banks, there are signs that a number of pension funds are becoming more active at doing that,” says Alex Carver, partner at Freshfields Bruckaus Deringer. “These ought to be a sensible area for them because it’s long-dated cash flows for economically significant, quasi-monopolistic assets.”

But, one of the difficulties for this new class of lenders is that project finance debt is predominantly not investment grade and institutional investors are often reluctant to dedicate the resources to the credit process for a bespoke project financing. The European Commission has sought to address this through its 2020 Project Bond Initiative. Several other structures, especially those involving ECAs, have also helped in the development of new instruments or concession structures.

The EU steps up

The purpose of the 2020 Project Bond Initiative is to reopen the capital markets as a meaningful source of financing for infrastructure projects. In particular, the initiative is designed to fill the void left by the collapse of the monoline bond insurers. But in another sense, the 2020 Initiative is different to the monoline model, since it is only meant to enhance bonds to the AA or AA- level and the support from the European Investment Bank, the vehicle for the initiative, is capped at a lower proportion of project exposure than the monolines offered.

For project companies that are seeking to raise senior debt by issuing project bonds, the EIB would provide a credit enhancement for up to 20% of the senior debt. This would make the credit rating of infrastructure projects high enough for pension funds to participate at sponsor-friendly yields. The credit enhancement is likely to take the form of either a first loss piece or a contingent credit line.

Following a public consultation in the spring of 2011, the EIB has proposed a pilot phase that would take place before the end of the current multi-year framework in 2013. The European Commission has pledged Eu230 million in funding towards this phase. Out of the total, the commission has earmarked Eu200 million for transport projects, while Eu20 million and Eu10 million will go towards energy and communications projects, respectively.

The EIB is in the process of identifying projects for the initiative and is looking closely at those that are situated in the more mature European markets. One deal likely to serve as a pilot is the A7 in Germany, for which Bilfinger Berger (advised by UniCredit) BAM/Vinci (advised by Deutsche), Hochtief (advised by SG), Meridiam and Strabag (advised by PwC), are understood to be bidding. DEGES, the granting authority, has delayed issuing an invitation to negotiate to bidders as it works out alterations to the concession structure to accommodate the bond enhancement. Other projects mentioned include the A11 in Belgium and the A1/A6 in the Netherlands.

Ready for take off?

But there are some concerns about the feasibility of the initiative. Several of the projects earmarked for the pilot phase are already at an advanced stage and in several EU member states, particularly the Netherlands, the procurement process does not allow for a funding competition after the naming of a preferred bidder, so altering the concession structure will be tricky

Sponsors, grantors and the EIB will also need to settle questions about assigning controlling creditor and surveillance functions. The EIB suggested in its consultation paper that it would act as the controlling creditor, but to fulfil the monitoring function would be more tricky. “The EIB obviously have a huge number of loans in this market, but they have tended to have been through a global agent or alongside another creditor representative” says Carver. “While they certainly have the expertise, taking on primary responsibility is a significant commitment.”

The most likely outcome is a structure that borrows heavily from a template that UK-based advisory firm Hadrian’s Wall Capital has developed. In this instance, the EIB would act as controlling creditor and senior bondholders would retain control rights that vary according to the issue under consideration. Serious issues would require greater bondholder consultation, while the controlling creditor alone could decide more minor questions. Given that the first pilot projects are expected to involve a combination of bank and bond debt, the logical option would be for the banks to take on the surveillance role.

While the various governmental and private players have yet to settle these questions, market consensus is that once these details are clear, the initiative should just about work. “The appetite is there from institutional investors and that appetite will also develop the pricing eventually” says Thanos Babanikas, managing director and head of infrastructure finance advisory at UniCredit. “But, they need to be persuaded to invest in these transactions, so we will need to wait a few months for the first tangible examples to see if this takes off and how.”

Although the EIB is rumoured to be looking at gas storage projects in Spain and Italy, the main focus of the initiative is on the transport sector, since the EIB has a particular focus on projects that are part of the Trans-European Networks (TENS) scheme. The credit enhancement is in some respects an extension of another EIB product, the loan guarantee for TENS transport projects, which offers a contingent, and eventually subordinate buffer to senior lenders against traffic risk.

National enhancements – and sovereign worries

Renewables is expected to be a growth area for project financing in Europe, and while the EIB has been a major player in this sector, export credit agency (ECA) participation is likely to be an alternative catalyst for a project bond market for renewables developers. EKF’s extension of a guarantee to pension fund debt provider PensionDanmark shows how ECAs might overcome bond investors’ difficulties with the risk profile of renewables assets. The EKF/PensionDanmark product emerged from the financing of the Jadraas deal in Sweden, and could involve up to DKr10 billion ($1.7 billion) in export finance debt.

The 203MW Jadraas onshore project was the first time that PensionDanmark had taken a principal position in a senior project financing, thanks to full cover from EKF. Since then PensionDanmark has followed this up with the Northwind offshore deal in Belgium and is in early talks with Arise Windpower and Platina about using the same product for the 160-250MW Lingbo wind farm in Sweden.

But, according to Salvatore Santoro, senior vice-president at DNB, the real test is without any ECA cover: “I think the next step is to bring more pension funds to the table, but it’s mainly to bring them on the risk side. What they have been doing so far is to provide liquidity against the ECA guarantee, I think the very interesting transition will be when and if they will be ready to take on project risk.”

There are limits to ECA liquidity, especially since ECAs are vulnerable to sovereign downgrades. In 2010, Italian ECA Sace provided a guarantee for the Andromeda PV transaction, the first ever project bond in Italy, and the first ever publicly rated and listed solar bond in the world, but Sace has not since followed this up with any similar deals. US Ex-Im had been working on an enhanced bond financing for a portfolio of solar projects in Ontario that First Solar was developing, and RBC had been in line to run the bonds. But First Solar has since sold parts of that portfolio to buyers with little interest in the product.

To expect ECAs to fill the gap entirely left behind by the monolines is unlikely. “In continental Europe, the only precedent really is the Andromeda financing for a PV plant, which by its nature involves risks that cannot be regarded as similar to those of an infrastructure project”, says Enrico Lucciola at Sace. He adds: “The structuring of a project bond when you have no visibility on the exact duration of the construction period is a hard task.”

The private model

One private sector initiative which might help fill the void is the Hadrian’s Wall template. Aviva, which has a history of lending directly to UK PFI projects, agreed with Hadrian’s Wall to launch a £1 billion ($1.6 billion) debt infrastructure fund, which, once it is up-and-running, will be making subordinated debt commitments to infrastructure projects.

Since the debt would be in a first-loss position, the buffer would help improve the credit rating of any senior debt that sponsors layer on top of it, and would facilitate a project bond issue in a similar fashion to the EC’s project bond initiative. The intercreditor arrangements are structured so that Hadrian’s Wall would provide monitoring services and senior bond creditors would step in if the performance of their investment deteriorates.

Hadrian’s Wall provides a model for how the EC’s initiative should function, but also offers an all-private sector solution to the project bond conundrum. Almost incidentally, it creates an alternative asset class to low-yielding senior debt investments for investors, with a return that is more favourable than those on bank-managed funds. Bank-managed funds may struggle to offer attractive yields to investors because many of them have conceived of their funds as ways of offloading pre-2008 loans onto third parties, because their portfolios have struggled to cope with the impact of higher funding costs since 2008.

But these widening spreads created the appetite amongst institutional investors for senior infrastructure debt, which looks especially favourable today because of the fall in yields on safer sovereign bonds. But sponsors, government and underwriters still need to assuage investors’ long-standing and persistent concerns about construction risk, counterparty risk and long-term performance risk. This would improve the rating of assets and reduce the time and expense that bondholders have to devote to credit due diligence and portfolio management.

Investor education will help. Rene Kassis, who is overseeing a new infrastructure and real estate senior debt fund at La Banque Postale Asset Management, says: Expertise has a lot to do with it. You need to go beyond the general considerations and concepts if things are to move forward. While many investors are ready to accept that these are investment grade-type assets, they still need to understand in detail the underlying dynamics of these transactions.”

Market participants believe that once institutional investors digest a few pioneer financings, a liquid project bond market could emerge. Whether the best examples come from the EIB, ECA-wrapped issues or other private sector initiatives will depend on the dynamics of each structure and the sponsors and governments concerned. But these participants have moved beyond hoping for new instruments to emerge, to working on their mechanics.