Modern infrastructure deals and related financing structures

August 2023 | EXPERT BRIEFING | FINANCE & INVESTMENT

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Investing in energy and infrastructure is not a new phenomenon, but what remains remarkable is the pace at which new funds have been raised (both equity and debt-focused), new market participants have entered the sector and new issuances of all shapes and sizes have hit the tape.

Coupled with an increased focus from many investors on reaching environmental, social and governance (ESG)-related goals and a shift in the regulatory landscape, it is perhaps no surprise that many of the new deals getting done today are in the infrastructure or ‘infrastructure-adjacent’ category, and that the definition thereof continues to expand.

Since the late 1980s, the funding of infrastructure deals has largely been achieved through the limited or non-recourse financing structures we have come to know as ‘project finance’. Such arrangements are often negotiated between the project sponsor and one or more commercial banks in the sector that have traditionally been very comfortable with the assessment of potential project risks and are well-versed in the universe of project documents, such that they can get themselves comfortable with the lack of recourse beyond the project being financed.

And while traditional project finance remains a significant part of the infrastructure ecosystem (and deserves an article of its own), the expansion of equity participants and capital providers has had an enormous impact both on what constitutes infrastructure and how deals are financed today. Notably, fundraising for infrastructure-focused funds has increased dramatically both in absolute terms and relative to other private markets fundraising, at a time when both venture capital and private equity have faced headwinds, and this has attracted a number of big names from ‘traditional’ private equity markets into the infrastructure sector.

Adding to the changing face of infrastructure is the inverse phenomenon: traditional ‘core’ infrastructure funds are beginning to seek out both growth equity investments and full-scale platform acquisitions to achieve higher absolute returns – structures which do not naturally lend themselves to the traditional project finance model. And expansion has come as a result of the sheer volume of such fundraising efforts: with such a significant amount of capital available to deploy, there is an increasing need to do so at a larger scale than was the case with the traditional single-asset models, leading to more investment in development platforms, joint ventures and joint development arrangements.

We now have an increasingly wide net being cast when investors are seeking out infrastructure investments and investors taking an increasingly broad view of what assets or investment comprise ‘infrastructure’ when compared to the traditional energy and power thinking of the past. As a direct consequence, financing structures more familiar to participants in venture capital and private equity transactions are becoming more commonplace throughout the industry.

As equity providers have expanded what has traditionally been thought of as infrastructure and the project finance model has faced increasing competition as a result, it stands to reason that the group of lenders in this space has grown beyond those commercial banks with traditional expertise. You now see a broader range of lenders, including private credit providers, financing deals in the energy and infrastructure sector, and this has been particularly noticeable as the definition of ‘infrastructure’ broadens to capture energy transition, clean energy and infrastructure-adjacent projects.

This has contributed to the long-term observable trend of convergence between the project finance world and the leveraged finance world when considering viable financing structures and related documentation. Coupled with the growing number of highly sophisticated and well-capitalised financial sponsors looking to participate in infrastructure investments and an increasing presence of strategic investors in the market, this has pulled traditional project finance increasingly toward leveraged finance models, with covenants becoming somewhat less restrictive and documentation allowing for greater operational flexibility – paving the way for the development of financing products which seek to take features of asset-level project financing and combine them with the traditional flexibility afforded borrowers and sponsors in the leveraged finance space. The resulting product is evolving but will offer an interesting path forward for future infrastructure investments.

It is worth mentioning at this point the impact the current inflationary environment has had on these developments. Although traditional energy and infrastructure investment has often been viewed by many as an inflationary hedge, the expansion of what constitutes ‘infrastructure’ has resulted in some uncertainty around that idea. As these concerns are more likely to impact assets that lend themselves to leveraged finance models, we have observed some recent bias toward more traditional infrastructure investments, and therefore a boost in the popularity of project finance structures. Although the long-term effects of this development remain to be seen, given the various factors discussed herein we would expect this will ultimately be a short-term change in focus as part of the continued longer-term popularity of non-traditional infrastructure assets and related financing structures.

Market participants have also been extremely focused on the effects the Inflation Reduction Act is likely to have on future investment activity and related financing efforts. While the legislation is still new, many regulations still need to be written and additional clarity is needed around some key aspects of the incentives, we have already seen a great deal of enthusiasm in the industry and the beginnings of significant investment as a result.

It seems clear that the new credits and revised transferability regime will create an environment with more certainty around returns (which will likely be less dependent on a historically limited number of big tax equity investors) and ultimately lead to even greater investment in the future. It will be critical for both equity and debt investors, particularly those that have historically not been as familiar with tax credits, and their respective advisers to understand the intricacies of this shifting regulatory landscape in order to take full advantage of what is on offer and accurately assess project risk and projected returns.

Investment in the energy and infrastructure sector is at an inflection point. As equity investors have raced to deploy capital in the sector, the traditional understanding of what constitutes an infrastructure investment has expanded and, as a direct result, so have the ways in which those structures are financed. As the energy transition continues to capture the attention of an increasing number of market participants, and additional regulatory guidance is provided around tax credits and other available investment incentives, it will be critical for financing sources and their advisers to understand the underlying asset class while being creative in their ability to provide flexible financing solutions.

Christopher Nairn-Kim is a partner at Davis Polk. He can be contacted on +1 (212) 450 3203 or by email: christopher.nairn@davispolk.com.

Christopher Nairn-Kim

Davis Polk