According to unlisted fund data provider Prequin, there are now around 54 unlisted infrastructure debt funds, and of those, 39% offer debt or mezzanine investments as their only investment strategy. In addition, six funds are raising a combined $7.1 billion in capital commitments.

Banks, far from viewing funds as competitors, are promoting project loan funds as a solution to the market’s liquidity woes. Barclays launched its £500 million ($744.5 million) Infrastructure 1 fund in 2011. La Banque Postale Asset Management closed its first Eu500 million ($650 million) infrastructure debt fund this month. Macquarie recently established Macquarie Infrastructure Debt Investment Solutions (MIDIS). Natixis has a Eu2 billion joint venture with Ageas under which the insurer will buy large chunks of the project loans that the bank originates. JP Morgan Asset Management is managing a portfolio of project loans that PensionDanmark acquired from Bank of Ireland.

The arguments for non-bank lenders taking a piece of the project finance debt market have never been stronger. Bank liquidity is shrinking – caused in part by Basel III's capital adequacy and net stable funding requirements, and in part by the fallout from the pre-2008 bank race for market share which spawned sub-100bp debt pricing. This pricing would have been untenably low over the long-term, even without the crash, and has bedevilled banks’ efforts to make secondary sales at acceptable prices.

A number of traditional project lenders have either folded (such as WestLB’s metamorphosis into Portigon) or, like Bank of Ireland, Banco Espirito Santo (BES) and RBS, pulled back from the market and sold its non-performing project loan portfolios at a discount, in some instances to non-bank newcomers.

Bank project debt pricing is also expected to increase as Basel III bites over the next four years, although that result is by no means certain, putting the project finance pricing norm more in line with the higher yields institutional funds have traditionally looked for, and enabling those new non-bank lenders to more effectively compete with banks as debt providers.

Government and multilateral initiatives–notably the European Commission’s 2020 Bond Initiative – are also emerging to help sponsors access debt from institutional investors with credit-enhanced offerings and free up stretched multilateral and export credit agency lending budgets.

A new market dynamic

The new market dynamic is long overdue. There have always been sound arguments for non-bank infrastructure debt – long-term assets with stable returns and good recovery rates. The ultimate recovery rate on defaulted project loans averaged 80% between 1983-2011, according to a recent Moody’s study. The product should find appetite in any institution looking for a mix of short-term and long-term investments.

And long-term project debt funds could provide a solution to a problem that has dogged project finance lending since its inception – the mismatch between long-term lending and short-term bank borrowing to fund that lending.

But if the development of a non-bank project debt market has always made sense, why is it happening today rather than 10 years ago, when pension funds first came into the market as equity investors? The reasons for the slow market development include a historical lack of adequate yield in the project market, lack of expertise in the non-bank sector and a gulf between what borrowers and non-bank lenders are looking for from the project debt market.

Project borrowers have long been able to make early debt repayments without penalties, something non-bank investors with long-term liabilities will struggle to accommodate, although the actual cost to them is likely to be small and early repayments fairly rare, given the economic outlook.

Project borrowers are also used to grace periods and risk sharing with the banks during project construction periods, a flexible arrangement that requires expert asset and market knowledge. In addition, working out and restructuring defaulted loans has, in the past, been easier for borrowers with bank loans, rather than bonds, because of the knowledge base within the bank market. Sponsors will apply the same thinking when talking to new debt funds.

Many of the new funds are staffing up to acquire that base of project knowledge. For example, BlackRock, with its hires of FSA veterans Philippe Benaroya, Chris Wrenn and Gilles Lengaigne from Blackstone’s GSO, and AllianzGI, with its hires from MBIA, have both poached teams from the project sector. But it will take some time and demonstrable successes to lure strong credits away from the banks, particularly if there is no significant saving in the cost of debt.

Fixed, floating rate and long-tenor debt

Where debt funds could have an advantage for sponsors is on tenor and the certain financing costs that their fixed-rate products offer. Since the crash of 2008, bank appetite for lending longer than 6-8 years has shrunk for all but the strongest credits. To get long-tenor deals in place, at least on paper, banks have been offering floating rate mini-perms where debt service obligations increase rapidly after year six, forcing borrowers to carry out a refinancing.

For projects that were originally closed with very conservative future cash-flow predictions, the structure has generally worked. For others, particularly a number of deals in the Mediterranean markets, the model has proved onerous, with sponsors unable to refinance at viable pricing and either having to inject considerable sums of equity or letting the projects default. As one project banker concedes, “Fixed-rate debt offerings over long tenors would give sponsors more certainty of funding, and sponsors may be willing to pay a premium for removing refinancing risk.”

While the new debt funds have an opportunity to distinguish themselves from bank lenders with longer tenors and fixed rate debt, it is unclear what the general mix between senior debt and higher risk/reward mezzanine offerings from the funds will be. Some non-bank investors have bought into the senior project loan market – PensionDanmark bought Bank of Ireland’s portfolio and as part of the sale of BES’ loans, the bank seeded the Sequoia Fund with Eu100 million of project loans chosen by Sequoia – but only at a discount.

And to date, pension fund senior lending to projects has been very rare, with the most high-profile examples being PensionDanmark’s loans to the Jadraas and Northwind wind projects, both of which were guaranteed by Danish export credit agency (ECA) EKF.

Of those funds that have raised capital – AMP Capital for example – the focus has been on subordinated debt where the yield is high enough to whet investor appetite for illiquid assets. Additional sources of sub-debt also benefit project sponsors, not least because a layer of first loss debt improves the credit rating of any senior debt that sponsors add on top.

But mezzanine debt is expensive and sponsors tap it sparingly. And given that the gap in project bank debt availability is mostly at the senior lending level – which is lower risk but also lower return – it is not certain that non-bank lenders will bridge that gap.

The biggest question mark over the role new debt funds will play is the types of credit they will be willing to lend to. Low risk project financings, such PPP/PFI and ECA-backed deals, are still well served, and although ECA-guaranteed financings still have a little adverse treatment under the Basel III capital adequacy regime, banks are unlikely to provide much of an opening for newcomers. Similarly, the yield on such deals is generally low and appetite from the new funds is likely to be limited.

Non-investment grade projects offer significantly better yields, but they are costly and complicated to structure and require high levels of staffing, while sponsors and offtakers, even when state-owned, are rarely solid credits. In addition, the projects are almost always greenfield with few or no past benchmarks on which to base future cashflow predictions. The cost of staffing up for these deals, which in emerging markets take years to structure, is unlikely to be economically viable for new entrants unless a quick succession of repeat deals is a certainty.

Major liquidity providers or niche lenders?

So while an influx of alternative debt providers is good news for project sponsors, it is unlikely to be a solution to a liquidity crunch. Past alternative project debt solutions were usually bond or capital markets-driven, but have not delivered major volumes of project debt. Bonds, for instance, still only account for around 5% of project debt, and debt funds in turn will likely have a role, but a niche one.

There is also little certainty that the new market dynamic will be permanent. Low fixed-income yields, low interest rates and unpredictable equity markets are forcing fund managers to look at alternatives. So while the fit with infrastructure lending appears a good one, it is a reactive rather than proactive trend and one that could reverse as quickly as it started, if fixed-income yields, for example, picked up again.

The trend is similarly reactive in the banking sector. While the banks are promoting alternative sources of debt as a way of coping with the fallout from Basel III, most bankers’ conception of the way the market should develop is in line with the trend among some project lenders since 2008. They want to offer advisory services without lending, to book fees and pass on most of a project’s risk to non-bank lenders under a joint venture arrangement.

Recycling bank debt is important in this climate, particularly since governments everywhere view infrastructure development as part of the cure to recession. But there will need to be an alignment of interest between funds, banks and government, and the new funds are not going to be passive receptacles for bank paper.

Basel III is also not going to push banks out of a market they have dominated since its inception and banks may be able to cherry-pick the most lucrative mandates, effectively blocking any real growth in non-bank lending development.

What goes around comes around

Ultimately, future development of this new market dynamic will be played out on the yield curve. But should the new dynamic take hold in a big way, and that looks unlikely, there will be some major ironies to consider.

First, government debt has long been a staple of pension funds, and, in a way, the market is coming full circle. PFI/PPP initiatives brought in private equity and put infrastructure debt off the government books. But in many instances, despite net present value benefits and some risk transfer, this debt has proved expensive over the long term. Tapping pension funds for a combination of debt as well as equity in the privatisation of state assets may have provided an acceptable yield for the funds and cheap debt for government, had government decided to actively promote the development of the two markets in tandem.

Second, the development of infrastructure debt funds is in part due to tighter bank regulation. But the majority of the new funds are unlisted and not subject to the same regulation as the banking sector. Consequently, there is a possibility, however remote, of a return to the dangerous overleveraging of projects, if the funds were to take a major slice of the project lending market. Lack of transparency could lead to unrealistic levels of borrowing at unrealistic pricing and ultimately another round of defaults and restructuring in the global infrastructure sector. If the market is to develop, both banks and funds will need to be policed.