Prepared by:  Patrick Boocock

 

 

 

Merits of Infrastructure Investment

 

Infrastructure assets can be broadly defined as any assets that generate reliable and predictable cash flows and are necessary to maintain basic human needs.  Such assets can include:

 

• Roads
• Railways/High Speed Transit
• Airports
• Ports
• Powerplants/Windfarms
• Hospitals
• Schools
• Government buildings such as office buildings, courthouses, police stations, etc.

 

With the continued growth in China’s population, all levels of Government will continue to require the development of new infrastructure well beyond the current economic crisis.  One of the benefits of private sector development and financing of infrastructure is that it allows the construction of infrastructure today with the repayment of such infrastructure occurring over time which provides two key benefits: (i) helps Government’s better manage current budgetary constraints (i.e., they don’t have to pay for it “today”) and (ii) better matches the use of the infrastructure over time with the repayment of such infrastructure (i.e., future users of the infrastructure will be the ones who pay for it).

 

Infrastructure is quickly being recognized as a distinct asset class by sophisticated investors across the globe for its impressive investment characteristics which include:

 

·        Large, long-term assets providing essential services

·        Limited or no competition and high barriers to entry

·        High operating margins and low maintenance capital expenditure

·        Predictable and steady cash flows with a strong yield component

·        Inflation correlated revenues

·        Low volatility and correlation to other asset classes

 

 

Procurement Options

 

The two primary types of transactions involving infrastructure around the world include either:

1. Sale of an existing asset by Government – this is often done by local Government’s who need to raise money to fund other services.  Asset sales can include things such as toll roads, parking lots, parking meters, power stations, etc.
2. Construction of a new asset by the Private Sector but mandated by Government – this is where Government has decided that a new asset (e.g., toll road) is necessary in its community to maintain proper traffic flows etc and is looking to the private sector to deliver the project.  There are a number of procurement options available to deliver such assets under this approach all of which have different degrees of risk transfer between the Government and private sector.

 

Although we are open to discussing any possible procurement structure depending on Government’s preferences, the remainder of this paper will discuss the Design-Build-Finance-Operate (“DBFO”) model as it is the procurement model that transfers the most risk to the private sector and is the one that is considered to provide the best value-for-money solution in markets such as Canada, Australia, UK, USA, etc.

 

The following are the key commercial points of a DBFO project:

 

1. Government determines key parameters of the “Asset” that needs to be developed and prepares preliminary specifications which will be provided to the private sector (e.g., the location and technical specifications of a toll road, hospital, etc.)
2. Government procures the project either under an open tender call (should be limited to no more than three shortlisted teams) or negotiates directly with a preferred team.  There are strengths and weaknesses of both approaches but the quickest solution is to negotiate directly with a preferred team.  Transparent pricing can still be obtained under this approach even without competitive tension
3. Government and private sector negotiate concession agreement terms.  Given the number of precedent transactions completed globally, the key terms and risk transfer concepts have been tested and can be easily adapted to the Chinese market
4. Private sector prepares initial design and engineering plans in conjunction with Government approval
5. Private sector team determines fixed price for the initial construction cost and future operating costs and can therefore determine the necessary toll rates, transmission rates, or annual payment required from Government (depends on type of asset class)
6. Private sector team arranges the necessary financing to fully fund the project at financial close.  The ability to raise the financing at an attractive rate is directly dependent on the credit strength of the project.

The summary risk transfer profile of a DBFO project is as follows: 

 

 

 

Commercial Structure

 

The commercial structure of a DBFO project generally takes the following form:

 

 

 

 

 

 

 

 

Key points of this structure are as follows:

 

1. A special purpose project company “Project Company” would be owned by the private sector team which maybe owned entirely by a private Equity Investor or it can be a partnership between a private Equity Investor and a Government entity (depends on the preference of Government)
2. Project Company would be a “non-recourse” entity meaning that it would be fully insulated from the financial performance of the private Equity Investor (i.e., bankruptcy remote) which provides added protection to the Government and Lenders that the Project itself could not be adversely impacted by poor financial performance of the private Equity Investor’s other projects
3. The Government and Project Company would enter into the Concession Agreement which would provide Project Company with the rights to develop and operate the Project for a specified number of years (e.g., the right to build and operate a toll road for 50 years) and would detail the obligations and penalties of Project Company if it did not perform to prescribed performance criteria.  The Concession Agreement would also detail things such as allowable toll increases and reversion of the asset back to the Government at the end of the concession term
4. Project Company would enter into a fixed price Design-Build Contract with a construction contractor.  The construction contractor would be required to provide specified levels of security to support its performance.
5. Project Company would enter into a fixed price Operating Contract with an operating contractor.  The operating contractor would be required to provide specified levels of security to support its performance.
6. The private Equity Investor (and Government JV if applicable) would capitalize Project Company at financial close with the necessary amount of equity based upon the final financial structure
7. Lenders would lend money to Project Company in an amount fixed at financial close.

 

Credit Characteristics

 

Both from a debt and equity perspective, the underlying cash flows and contractual strength of the concession agreement with Government on infrastructure projects results in a very strong credit profile which is why the infrastructure sector has traditionally been very attractive to long term investors such as pension funds and life insurance companies.

 

The financial structure on an infrastructure project is ultimately determined by the level of risk being assumed by Project Company.  For example, if Project Company assumes certain construction risks that have not been subcontracted to a Design Build Contractor, then it will likely mean that additional equity will be required to absorb these risks before Senior Debt is impacted.  From a gearing perspective, lower risk infrastructure projects where the revenue stream is guaranteed by Government (subject to meeting performance specifications) is typically in the 90% Debt/10% Equity range with higher risk projects such as toll roads being in the 75% Debt/25% Equity range.

 

The following is a brief summary of the key credit characteristics typically seen in infrastructure projects as it relates to the Senior Debt:

 

1.      The key risks during construction being cost and schedule overruns are mitigated through fixed price/time contracts with the Design Build Contractor which is supported by various levels of security such as performance bonds and/or cash and the obligation to pay liquidated damages

2.      The key risks during operations being maintenance and repair cost overruns are mitigated through fixed price/time contracts with the Operating Contractor which is supported by various levels of security such as performance bonds and/or cash

3.      Any remaining risk at the Project Company level would be identified and priced into the transaction appropriately (e.g., contingency reserves, etc)

4.      Significant scenario testing will confirm that the debt service coverage ratios are robust and will provide sufficient buffer for performance failures or profit declines long before Senior Debt is impacted

5.      The strength of the Concession Agreement with Government will minimize the political risk of the Government not following through on its obligations

6.      Senior Lenders will have senior ranking security over Project Company and have the ability to step-in and replace management and the Design Build or Operating Contractor for performance failure before the Government can terminate the Concession Agreement

 

Based on the above strengths, Senior Debt (whether bank debt or capital market bonds) has typically received high investment grade ratings from agencies such as Standard and Poor’s and Moody’s.  This means that depending on the final risk profile of the Project, that the Senior Debt would typically be rated in the BBB to A+ range.  This obviously would need to be considered in light of the unique political environment in China.

 

Infrastructure Capital Advisors Approach

 

Infrastructure Capital Advisor’s (“ICA”), approach to the development and financing of infrastructure projects is simple.  We will source, originate, structure and package targeted infrastructure projects to a point where they are ready for a domestic Chinese Bank to lend money as Senior Lender and if interested even as Equity Investor.  In the event that the Bank is not interested in the equity component, we would source a third party equity partner. 

 

Although the approach is simple, the work required to get there is significant and takes considerable time to develop.  The following provides a sample timeline of required steps to get a hypothetical toll road transaction to reach financial close:

 

 

 

 

Note, the above timelines assumes that there has not yet been any detailed design/engineering work conducted by Government.  In many instances, Government will have already completed this work and in fact is ready to commence construction.  In such a scenario, ICA will still work to “package” the project together and get it ready for the Bank for final credit approval.

 

Benefits of Using ICA

 

The approach of having ICA act as a Bank’s “Infrastructure Development Division” is common in other countries where Government’s have a strong mandate to deliver infrastructure as quickly as possible.  In such markets, the delivery model has evolved over time to a point where Government and Banks no longer wanted Banks to be the “last stop” before financial close as Banks were the ones who ultimately decided on the final risk profile and found that being engaged at the last minute often resulted in significant risks not having been identified or priced resulting in changes and delays to a project.  As such, Banks realized that the best way to minimize its risk and maximize its profits was if the Bank itself controlled the development and progress of getting these projects to financial close.

 

The key benefits of having ICA act as a Bank’s “Infrastructure Development Division” are as follows:

• Exclusive Project Pipeline - ICA has established relationships with Government officials, realestate developers and construction contractors and can therefore identify and secure preferred positions on infrastructure projects meaning our partner Bank will also enjoy the benefits of having an exclusive project pipeline (i.e., no competitive tendering of banking products)
• Experience and Technical Skills - ICA has significant experience and the technical competencies in leading multi-disciplinary teams to package such complicated projects to a point where it would be ready for a Banks final credit approval.  As it is such a new market, such experience and skills under “one roof” are extremely hard to find as they include a number of skillsets including finance, legal, design, construction, real estate development, etc.  The ability for ICA to oversee and control all components of a project will increase the probability that a project will achieve financial close in the shortest period of time
• Improved Risk Management - Given ICA’s experience, it will be able to identify and evaluate all project risks that would be relevant to lenders and equity investors providing significant risk management benefits to a Bank.  As this risk review will happen from the beginning of a project, it will eliminate last minute changes to project scope and price
• Bank Profitability – At the core of ICA’s experience is its ability to develop unique financial structures that maximize returns for both lenders and equity investors.  As ICA would attempt to secure preferred positions on projects, this will translate directly into better earnings potential for our partner Bank

 

ICA Proposal

 

As ICA’s business crosses a number of disciplines, it is not something that a Bank would have the internal resources to do and therefore it is our belief that ICA should remain as an independent advisory firm that provides all of the services to a Bank as described above based upon the following broad terms (which obviously need to be discussed further):

 

1. ICA acts as a Bank’s exclusive strategic advisor to source, originate, structure and package infrastructure projects across China by providing the following services:

·        Identification of target projects and establish relationship with Government

·        Secure partners for the project (construction, operations, etc)

·        Engage and manage architects, engineers, technical advisors, etc (unless completed by Government or third party Equity Investor)

·        Engage lawyers to draft all related project documents and negotiate these documents with Government and partners

·        Prepare financial model, credit papers, risk summaries, and all other financial analysis

·        Manage and obtain external credit rating if applicable (from Moody’s or S&P)

·        Source and negotiate with an external Equity Investor if the Bank does not want the equity component itself

·        Manage Government relationships and expectations

·        Prepare any proposal documents required by Government

2. In return for the services provided above, the Bank would pay ICA the following:

·        A fixed monthly fee to ensure ICA can cover its cost base (budget to be provided)

·        Out of pocket pursuit costs based upon an agreed budget (note that unless a third party equity investor is involved, the pursuit costs can be significant primarily in the areas of legal and design/engineering fees).  Such costs would be recovered from the project once financial close was achieved

·        A completion fee equal to a specified percentage of the deal size upon achievement of financial close (this would represent ICA’s risk adjusted profit)

3.  Other considerations to be discussed include:

·        Share ownership in ICA by the partner Bank

·        ICA could also act as Equity Investor in the projects with such equity being funded by the partner Bank (with potential for future IPO or spin-off into an Infrastructure Fund)

·        ICA could be branded with the partner Bank’s brand for better brand recognition

 

Next Steps

 

ICA is currently in negotiations with a number of Banks and other financial institutions regarding this business model some of which have expressed a keen interest to further discuss and refine the relationship.  If this business model is something that you believe your organization would be interested in pursuing, we should establish a series of meetings where we can discuss business terms in more detail and once agreed in principle, we can start drafting a detailed partnership agreement that outlines the roles and responsibilities of both parties.

 

Given the urgent demand for infrastructure across China large projects are already being announced as ready for construction and therefore it would be beneficial to roll this business model out as soon as possible in order to secure projects and develop brand recognition early in China’s infrastructure boom.