Bridging the gap – opportunities and constraints to mobilising the capital markets for infrastructure finance

July 2023 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

July 2023 Issue

Infrastructure lies at the intersection of several themes that are increasingly top-of-mind in the world’s most developed economies, including energy security, the energy transition and climate change adaptation, digitalisation and addressing an aging society. Many big-ticket assets will need to be constructed, refurbished or replaced in the next five to 10 years and beyond, including new liquified natural gas regassification plants in Europe, gigabatteries and offshore wind farms, to name a few.

According to one estimate, just for the energy transition alone, $44 trillion is required in cumulative investments by 2030 to effectively transition away from fossil fuels while maintaining power generation. To accomplish the energy transition, to say nothing of the other equally pressing goals – a staggering amount of capital will need to be gathered and deployed.

Historically, bank lending and equity have been the traditional mechanisms to finance infrastructure. This is largely because banks possess deep experience in different infrastructure asset classes, are able to match drawdowns and amortisation requirements with project construction, and generally can accommodate longer maturities.

Against the current backdrop and a number of recent developments, this bias toward the syndicated bank market for infrastructure finance is becoming less pronounced – principally through regulatory reforms, such as the Basel III framework which requires all internationally active banks to implement more vigorous prudential and regulatory capital treatment of long-term loans traditionally used to finance infrastructure, and, to a lesser extent, fiscal and volume constraints regarding government and development bank support for infrastructure (though the US Inflation Reduction Act and European Green Deal are notable exceptions to this trend).

Capital markets have a role to play in satisfying the demand for infrastructure. Capital markets can offer diversification of funding sources, support multiple currencies and maturities, foster transparent pricing and free transferability among more passive classes of investors, and contribute to better information about infrastructure through issuance disclosure and ongoing reporting. On the buy-side, institutional investors that subscribe to infrastructure capital markets products are typically attracted to the stable returns and steady cash flow that many infrastructure investments generate, the availability of investment grade debt ratings under one or more rating agency methodologies applicable to the financing of infrastructure assets, the ability to source and match assets to their liabilities, and the potential to participate in financing green assets, which can be further facilitated through sustainable finance labels such as green, sustainable and sustainability-linked bonds.

This article will discuss the main opportunities and constraints of each new principal capital markets product being used, and can be further used, for infrastructure finance. It will conclude with a few recommendations to develop a fit-for-purpose infrastructure finance ecosystem.

Capital markets products for infrastructure finance

Capital markets present a menu with a variety of instruments, each of which can contribute to infrastructure finance.

Corporate bonds represent the largest and most liquid product that the capital markets can offer, outside of government bonds. They are the most traditional debt capital markets product of general application, though they are not specifically tailored to infrastructure finance. Corporate bonds typically have medium- to long-term maturities, a low risk profile as they are often investment grade rated, senior ranking, and are freely transferable, often publicly listed or quoted, with bullet maturity and few covenants, other than a negative pledge.

As these bonds are usually raised at the parent level, corporate bonds have historically been used to refinance project debt after construction is complete and the project is generating cash, and can be used to finance equity injections for new projects. The main investor base comprises institutional investors, and corporate bonds are distributed through both public offers (Securities and Exchange Commission (SEC)-registered and European Union (EU)-regulated market listings) and private placements.

Corporate bonds have a role to play in most sophisticated capital structures, though their use as a vehicle for infrastructure finance is limited because they do not typically accommodate the complexity of a greenfield project, including features such as delayed draw, incurrence and maintenance covenants, and amortisation. They are designed to be easily understood and tradeable across sectors, offering a high degree of disclosure and pricing transparency. Using corporate bonds for infrastructure finance poses a challenge insofar as they are most appropriate in low leverage situations, which is not the case for many projects that require significant debt financing. However, for issuers operating in certain regulated industries, corporate bonds (vanilla or more structured) may still be a viable funding option where the regulation allows for the corporate to charge and collect revenues for new projects during the course of construction.

After corporate bonds, high yield (HY) bonds represent the next largest segment of the debt capital markets. HY bonds typically have maturities ranging from five to seven years, a higher risk profile as they are sub-investment grade rated, senior or senior subordinated ranking, and are freely transferable, often publicly listed or quoted, with bullet maturity and a suite of incurrence covenants that govern, among other things, indebtedness, liens, dividends and sale of assets. HY bonds are usually secured in Europe and usually unsecured in the US. They are usually issued in private placements and reserved for institutional and qualified investors. While HY bonds are not often used for infrastructure finance, a number of infrastructure-like HY bonds have been issued for leveraged buyouts or refinancings of infrastructure assets.

The HY bond market has recorded significant growth in recent years, and investors have gained familiarity with and more appetite for exposure to various infrastructure-like sectors, particularly utilities, telecommunications and transportation. The HY bond market has a track record of documentary innovation, and in some instances has accommodated delayed draw, amortisation and covenants (including maintenance covenants) customary for infrastructure finance, making it uniquely positioned to cater to infrastructure finance, particularly buyouts of infrastructure assets, and refinancings of project debt, where leverage remains relatively high.

However, securities laws concerns typically do not permit forward-looking projections to be provided to investors, limiting the application to greenfield projects. Additionally, obtaining consents that may be necessary in the life of a project could prove more difficult due to free transferability and lack of look-through to beneficial ownership via the clearing systems.

Another capital markets product that has become more and more adapted to infrastructure is the US private placement (USPP). USPPs are typically placed with US-based insurance companies and can accommodate long maturities that are unavailable in the public bond markets for corporate issuers and at fixed rates in swapped or unswapped currencies. In recent years, USPP investors have become more active in infrastructure finance, mainly by accepting more ‘bank-like’ terms.

As USPPs are unquoted and unlisted, they tend to have a higher risk profile, though some will have an NAIC rating equivalent to an investment grade rating; otherwise they can be tailored to a particular infrastructure asset, with either senior or subordinated ranking, guarantees and security over all of the project assets and receivables, delayed draw, amortisation and incurrence, and maintenance covenants that replicate a project finance arrangement, though typically with more flexibility. USPP investors are particularly experienced in transportation and energy-related assets in the US, UK and Australia.

The main advantage of USPPs is that the documentation is relatively standardised (other than the financial and covenant terms that are particular to the project), and this makes it a cost-effective route to market. Bespoke terms can accommodate both greenfield and brownfield projects. USPP investors prefer to be pari passu with project finance banks, rather than replace them. In recent years, concerted effort has created a similar private placement product to be subscribed by European investors, called European private placements (EuroPP), which could fill a similar role in the market.

Of all of the capital markets products available, project bonds have the most promise. These are debt securities issued by a special purpose vehicle or project company with sole recourse to the project assets and associated cash flow and are uniquely tailored to infrastructure finance. Project bonds can have medium- to long-term maturities, generally carry a higher risk profile as they are complex and require analysis of the project fundamentals as well as those of the security, senior ranking, guarantees and security over all of the project assets and receivables, delayed draw, amortisation and incurrence and maintenance covenants that replicates a project finance arrangement, though typically with more flexibility.

Historically, project bonds have been used for brownfield projects and to refinance bank debt.

Market participants have been predicting a boom in project bonds for some years, though it has been slow to develop. There have been a series of successful deals, and there is growing investor interest developing in the US, Europe, the Middle East, Latin America and elsewhere. However, their bespoke nature can make them harder to market, and the investor base is narrower than for other capital markets products which may appeal to a broader spectrum of investors, of which infrastructure is a component.

Conclusions and recommendations

The capital markets must be mobilised to play a significant role in infrastructure finance, though absent a significant change in the debt markets, any single capital markets product will likely not become dominant. In addition, unlike other specialised types of capital markets debt, such as covered bonds, no legislative framework currently exists in the US, UK or EU that is specifically tailored to infrastructure debt, as project bonds are structured as a bundle of contracts and covenants, rather than under a legislative framework that promotes standardisation.

Project sponsors should therefore consider a diversified base of funding, depending on the stage of construction and operation, the sector and jurisdiction in question. As the number of projects seeking finance is expected to increase, infrastructure finance will require tapping multiple sources, and more work will need to be done on facilitating the cooperation between various classes of debt providers, namely across bank and bond, including potentially classes of bond investors.

The goal should be to foster an ecosystem approach in which various types of infrastructure debt can coexist, including voting in a coordinated manner in project-related consents. Onramps and offramps need to be built so that debt maturities can be extended using one product or another. The objective should therefore be to free up capital to be redeployed to other projects. Supercharging the capital markets for infrastructure finance may require building a platform for debt providers that is product agnostic in order to reduce distribution costs and time-to-market, encouraging greater standardisation of documentation terms (other than those that must necessarily differ from project to project) and developing common disclosure standards and transparent pricing, which are aims that market participants can contribute to achieving through collective action and dialogue.

Roberto L. Reyes Gaskin is a partner at Latham & Watkins LLP. He can be contacted on +33 (1) 4062 2129 or by email: roberto.reyesgaskin@lw.com.

Roberto L. Reyes Gaskin

Latham & Watkins LLP