Evaluating European Infrastructure Bonds
By Partha Pal
Infrastructure bonds are expected to be a growth market in 2014.
This past year was a significant year for the emerging European market in such bonds. Further developments are expected, given both the need for new sources of funding for infrastructure and, from the perspective of institutional investors, the need for investment products that allow them to meet their investment requirements.
European infrastructure bonds have traditionally been a monoline-wrapped product, with investors able to draw comfort from the claims payment ability of the monoline and the contractual validity of its wrap, while leaving the heavy lifting of assessing the transaction to the monoline. In the absence of monoline involvement and, unless using the services of an intermediary investment manager, institutional investors need to apply an analytical process that covers legal and structural risks, as well as commercial ones.
This article is an overview of some of the legal and structural matters that warrant consideration by institutional investors.
Infrastructure bonds are capital market debt instruments issued by special-purpose entities where interest is paid, and principal repaid, using the cash flow generated by one or more pieces of physical infrastructure owned by the issuer or by another entity to which the issuer makes a loan.
They are asset-backed bonds, as opposed to corporate or sovereign bonds, that rely on the ability of the issuer to pay interest and repay principal using all cash flow available to it, rather than any dedicated cash flow. As such, they are susceptible to focused analysis in terms of the robustness of the cash flow and its sufficiency for debt service purposes. The cash flow can be enhanced through various credit, liquidity, risk-management and operation-management features designed to ensure debt service is paid.
It is helpful when analyzing infrastructure bonds to look at two key elements: the “asset side,” meaning the infrastructure that generates the cash flow used to service the bond, and the “funding side,” meaning the structural features that are used to enhance the cash flow from a credit, liquidity, risk-management and operation-management perspective.
Starting with the assets, the infrastructure has two manifestations.
The first is the physical. Infrastructure assets are of various types and no categorization is fully comprehensive or satisfactory. However, a useful categorization is based on usage: utilities (such as electricity, gas, telecommunications and water), transport (such as roads, railways, airports, seaports and railway stations) and social (such as schools and universities, social housing, health care, recreational facilities and penal or correctional facilities). Clearly, without a physical asset there is no infrastructure and no cash flow. Creating and maintaining the physical assets is a necessary part of any transaction.
The second is non-physical. Infrastructure assets generate cash flow either pursuant to a regulatory framework (for example, the generation of electricity from renewable sources that is sold to a distributor at a price predetermined by a regulatory framework as opposed to through market forces or subject to a contract-for-differences framework) or pursuant to a contractual framework (for example, the payment of contractually-determined availability payments by a public authority in consideration for the provision of a road or a health care facility). In many cases, there will be both a regulatory aspect and a contractual aspect to how the cash flow arises.
Investors need an understanding of both the physical and the non-physical aspects. The non-physical aspect is self-evidently legal in nature because it is based on rules.
Diligence relating to the rules revolves around three key questions. How does the infrastructure generate cash flow? How might the cash flow be reduced? How might the cash flow be stopped?
While framing the questions in this way is straightforward, responding to them in a comprehensible manner requires sophisticated legal analysis, taking account of both regulatory and contractual matters, and an understanding of both the technology behind the infrastructure as well as the motivations of those who actually make payments, thus enabling the cash flow to be generated.
The physical aspect is less self-evidently legal in nature, because on its face, it is concerned with technical matters of complex engineering. However, both construction and maintenance of the physical assets will have contractual underpinnings. For example, if the physical assets are not constructed or operated to satisfactory standards, this may affect their ability to generate enough cash flow to service the debt, thus giving rise to the need to remedy the failure and to recover both the costs of remediation and other losses that flow from the failure of the responsible transaction participants.
Unlike other asset classes that back structured bonds such as residential mortgages, consumer loans or trade receivables, infrastructure assets are heterogeneous and require case-by-case assessment, both from the physical and non-physical perspective. This is certainly possible, but in order to be undertaken efficiently requires a systematic framework. It also requires a structured-finance mindset, meaning testing structural robustness by considering how the structure would respond after an insolvency event affecting each transaction participant.
While the asset side of an infrastructure bond is concerned with physical engineering, the funding side is where financial engineering becomes prominent. The funding side features of infrastructure bonds are similar to those that are found in conventional project financing.
Reserves are used either for specific asset-related purposes where there will be a need for expenditure or, more generally, to ensure debt service payments are made in a timely fashion. Hedging may be used to mitigate the possibility of variation in interest rates, currency exchange rates or possibly commodity prices that, if not mitigated, could have an impact on the cash flows available for debt service. Cash-flow control may be used to ensure that cash flow is collected and applied in a disciplined manner so that debt service payments are made. There may also be subordinated debt, in which case there is a need to ensure that the sponsors have enough economic interest in the continued functioning of the project and the continued generation of infrastructure cash flow.
Again, adopting a structured finance mindset is necessary, so that the implications of insolvency of the transaction participants can be assessed and provided for.
Where infrastructure bonds differ markedly from conventional project financing is the way in which the issuer, as the debtor, and the bondholders, as creditors, interact and how creditor rights are enforced in the event of financial distress.
In conventional project financing transactions where the creditors are banks, these functions will typically be undertaken through a facility agent. The agent will be able to interact as it considers appropriate, with mechanisms existing within the finance documents to allow lenders to exercise democratic rights. This approach works because, in the bank market, the identity of all lenders will at all times be known to the agent, allowing the necessary interaction to take place. In the context of capital markets, such a level of interaction is not so easy to facilitate because bondholder identity is both transitory and opaque (with bonds being held through clearing systems and custodian accounts).
There are basically three approaches to structuring interaction between the issuer and bondholders in infrastructure bond deals.
One is not to have any particular structural features. This is not as radical as it might first sound. Corporate and sovereign bonds do not have any such features. If there is distress, bondholders convene ad-hoc committees and deal with the situations that have arisen, with bondholders themselves determining the framework and decision-making lines. However, this approach is not consistent with the world of structured finance, nor with infrastructure as an asset class, where there is a greater need for interaction given the complex physical nature of the assets during both the construction and operating phases.
Another approach is to have a third party who acts for the benefit of all investors. This is the office holder described as a “servicer” or “special servicer” in the context of other asset classes. In theory, this is a good idea in that the issuer has a single point of contact and the bondholders have a single point of contact. In practice, this has proven harder to operate efficiently as servicers in other asset classes have faced various comments from investors about the discharge of their functions. Servicers have in any event been careful about owing duties directly to bondholders for fear of liability and conflicts of interest.
The third approach is to have an individual or collection of bondholders that takes the lead in interacting with the issuer. In theory, this could be an anchor investor or a collection of anchor investors, who constitute a creditor committee from the outset with stewardship responsibilities. However there can be no assurance that the anchor investor’s interests will necessarily be the same as that of other investors. Nor can there be any assurance that the anchor investor will retain its holding during the entire term of the transaction.
Each approach has its advantages and disadvantages and it may take some time before any form of standardized approach emerges ― the approach may vary to reflect how the asset side functions in connection with different types of infrastructure. However, a governance framework made up of all three elements, in different variants, could also be plausible with, for example, an office holder dealing with uncontroversial matters but relying on bondholder participation where greater complexity is involved and having a deciding voice if consensus cannot be reached.
Infrastructure bonds are complex and a proper review requires a thorough approach. For example, insurance requirements apply to the asset side of a transaction. A security package must be structured at the level of the issuer. The rating process is important, and institutional investors draw comfort from ratings. However, as the rating agencies have been at pains to point out following the onset of the financial crisis, a rating is only a statement of opinion and not a guarantee of performance; hence the importance of a rigorous, structured approach to diligence and assessment.