panel discussion australia’s DOMEstiC Infrastructure ... · 10|kanganews supplement october 2012 panel discussion 1 australia’s DOMEstiC Infrastructure InVestMent OPtiONs panellists

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panel discussion 1

australia’s DOMEstiC Infrastructure InVestMent OPtiONs

panellistsn Simon La Greca Principal Infrastructure Debt AMP CAPItAl n Craig Lee Managing Director, Head of Asia Pacific AssureD GuArAnty n Kevin Lewis Investment Director, Debt Investments IFM n Ross Pritchard Director, Infrastructure Debt HAstInGs FunDs MAnAGeMent n Bob Sahota Head of Fixed Interest CHAllenGer n Mark Upfold Partner KInG & WooD MAllesons

Moderatorn Mark Goddard executive Director, Head of Debt securities and syndicate WestPAC InstItutIonAl BAnK

ACCessInG DeBt

Goddard are investors satisfied with the quantity and range of issuance from infrastructure borrowers being offered in the domestic bond market?n la Greca There are pros and cons to all markets, and each has its attractive characteristics. If you think about the reasons why investors choose to allocate to international infrastructure, they relate to diversification and deal flow. It is quite normal for investors to look for diversification both in their home market and internationally.

In infrastructure this is especially true because the UK and parts of Europe have some of the most mature and established infrastructure sectors in the world, dating back to the 1970s in terms of early public-private partnership (PPP) projects and

straight privatisation. As a result, investors are comfortable with those markets and happy to invest there for diversification.

In terms of pure return metrics – as a spread to base rates – generally the returns internationally have been higher than Australian equivalents for similar instruments. There are a number of reasons for this, not least of which is the high base rate environment here in Australia that adds to the overall cost of funding. A declining base rate in Australia might help. n lewis In the domestic market we are certainly seeing a lowering in the base rate and a holding up or raising of margins. This can provide local-market opportunities for investors. We have even seen some deals coming in at around 400 basis points over swap for five-year tenor and an investment-grade credit, which is surprising. We are certainly interested in the sector at the point when margins reach 300-plus basis points over swap.

ustralia’s need for new and improved infrastructure – both in

the resources sector and across the country, including urban

infrastructure – is predicted to entail a funding task of many hundreds

of billions of dollars. Much of that will be debt financing, and local investors say

they are prepared to work in tandem with banks to access the pipeline.

a

“Many domestic issuers rightly see the local investor base as favouring single-A or better credits, so for the triple-B issuers – which is the bulk of the infrastructure space – there are some real challenges to accessing the domestic market.”c r a i G l e e A s s u r e d G u A r A n t y

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n sahota I find infrastructure to be a very rational sector. There are instances where we have witnessed successful infrastructure transactions in the Australian corporate bond market. Issuers have been able to get 10-year paper away at what we consider to be attractive levels. Infrastructure debt providers need to be mindful of the global opportunity set – taking into account factors such as the base rate and the basis swap cost of bringing funding back to Aussie dollars.

Everything we do for our stakeholders and our funds is driven by relative value. We have to look at investments and assess whether we are better off investing in AUD for particular tenor or whether we should look at the same borrower issuing into the UK or the US market at a different level.

Goddard craig lee, what we can do to attract more borrowers to come to the domestic

market instead of going offshore for their debt funding?n lee Part of the concern for issuers is execution risk. Many domestic issuers rightly see the local investor base as favouring single-A or better credits, so for the triple-B issuers – which is the bulk of the infrastructure space – there are some real challenges to accessing the domestic market without paying margins that are too wide.

Goddard How challenging is it for an investment firm to manage allocations to infrastructure borrowers across the capital structure? For instance, if a firm is already an equity holder in a project to what extent, if at all, is its capacity to invest in the same project’s debt reduced?

“As we see existing projects refinancing and new projects coming on stream, there are opportunities over and above just true greenfield projects in which to invest.”r o s s p r i t c h a r d H A s t i n G s F u n d s M A n A G e M e n t


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n Upfold One of the interesting things I’m starting to see that I’ve not seen before, particularly in the context of the recycling of infrastructure assets and asset sales by governments, is the setting up of legal documents to facilitate an exit into the capital market – whether here, which was common, or offshore, which was not. Five years ago this wasn’t being done, but in today’s world the markets are anticipating that the Australian banks are acting as a bridge into a possible offshore capital-market takeout.

I see the role of the domestic banks, particularly in the large-scale infrastructure recycling transactions, as effectively bridging into a capital markets refinancing because of the tenor. n sahota One thing you have to learn as an institution is that you don’t want to go toe-to-toe with the banks in what they do well. Infrastructure loan transactions with tenors of up to five years with good sponsors are keenly sought – they have a very big stake to take those on in terms of their balance sheets. What we have to do as institutions is work out how we can be complementary to what the banks are putting together.

If you look from a sponsor or borrower point of view, they might be happy with the bulk of their financing going out to five years, but then structuring another tranche for investors, like us, who might go for longer tenor might be attractive. Even if issuers have to pay a bit more than what they are getting from the bank side, on a blended basis it is not that expensive when you look at the total debt package.

So fund managers have an opportunity to work in a very complementary way with the banks in terms of providing the significant amount of debt capital that needs to come into the infrastructure sector. n pritchard It’s probably worth putting this all into context as well. By our calculations, private infrastructure is worth in excess of A$3 trillion (US$3.2 trillion) equivalent internationally. Probably two-thirds of that is debt and an excess of 85 per cent of that debt is currently provided by banks.

We all know the US has a much more developed and deep capital market than Europe, the UK and Australia, so it’s not surprising that quite a lot of infrastructure projects are financed out of the US. I agree with Bob Sahota that investors are not competing with banks to finance infrastructure – especially in Australia where the provision of institutional money into infrastructure is relatively in its infancy.n lee Also, as Basel III and the regulatory capital rules for banks start to kick in it will become increasingly expensive

n pritchard Like other investors, Hastings Funds Management manages both equity and debt funds, so this is certainly an issue we have come across. It presents a number of problems, even though the infrastructure class is usually quite stable – because if things go wrong you have a fundamental, and quite a large, conflict of interest. The issue in this event for a firm that invests in both equity and debt is working out which interests are going to prevail, and how to manage this. We have learned from our mistakes in the past in this regard and in future we will be trying to avoid investing in both equity and debt from the same company. n lewis IFM is renowned for its investments in infrastructure equity and we have been doing this type of investment for a long time. I agree that debt and equity infrastructure investments can be mutually exclusive at times because equity investors want cheaper debt, whereas debt investors seek wider margins – driven by the hurdle rates in mandates – which perhaps are not appealing to equity participants.

On the other side, there’s not a lot of equity available in projects like PPPs – 12-15 per cent of the capital structure as equity is not a lot of dollars invested. When you’re a significant equity investor the effort it takes to get invested doesn’t really stack up so you tend to go elsewhere – leaving these deals open to us as debt investors. n la Greca At AMP Capital there is a clear Chinese wall between the debt and equity teams: you might find that our equity team bids on a particular project and we may be backing a competing consortium on the debt side. We focus on keeping the teams separate, due to the conflicts identified by Ross Pritchard. n sahota It’s vital to keep the debt and equity teams very separate. One thing learned from the financial crisis is that you find it very hard to stand up, as an organisation, and say our debt guys are going to enforce against our equity guys. We’ve seen that from afar.

loAn FunDInG

Goddard Has there been any sign of significant quantity of debt previously provided to existing infrastructure sector borrowers by the banks being spun off into capital markets – either domestic or offshore? do investors compete with banks for infrastructure financing?

“One of the interesting things i’m starting to see, particularly on the recycling of infrastructure assets and asset sales by governments, is the setting up of legal documents to facilitate an exit into the capital market.”M a r k U p f o l d K i n G & W O O d M A l l e s O n s

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for banks to provide debt to lower-rated infrastructure assets, particularly in longer tenors. So the natural home will start to shift toward the capital markets. n la Greca One of the things we’ve tried to focus on is creating subordinated debt tranches. This means the banks can take care of senior debt, with additional layers of leverage created for projects that can support this with the right kinds of uptake or concession contracts. This is one area where institutional investors can get expose to infrastructure.

In general, the subordinated tranches are longer-dated than the senior because the senior lenders are not going to want the junior refinance event before the senior debt matures. This means you’re typically looking at tenors of seven or eight years. For institutional investors the advantage is being able to attract a pricing premium as the tranche is both longer in duration and more subordinated in the capital structure. Also, generally it’s privately-held paper so it doesn’t trade.

Goddard there has been a lot of talk about investors picking up secondary market loan exposure to infrastructure projects. is this your experience?n lewis There are some opportunities in this sphere. Some of it is driven by parties that are holding the debt and looking to exit, but that is not reflective of a problem with the asset. There is some opportunism in the market – you can take those positions, given the discounts on offer, quite comfortably.

In terms of projects that are on the way, we’ve certainly participated. For example, the desalination plant in Victoria. That project that has been beaten up in the media on a regular basis since its inception but, although the contractors have had a tough time with it, from a debt investor’s perspective it has been a very good investment. We have picked up additional exposure to that project in recent times. This shows that there are willing investors for this type of investment – even for projects that are being criticised by the court of public opinion.

Goddard does there come a point of conflict between whether you get involved in bond or loan financing? is there a need to encourage more capital markets activity, to attract a wider range of investors?n lewis We’re quite open to buying bank loans where we think they present the appropriate relative value.

n sahota Exactly right: you need to have the flexibility to invest either way. In many cases, the loan format – particularly for longer tenor – is actually more attractive than the bond. You get more information, you generally get a better covenant package, and you get to know how the business is tracking over time as well as early enforcement triggers. This is much more than bondholders receive. n lewis It gets back to the discussion about banks being facilitators to bring more debt investors into the market along the way. Intermediaries are doing some underwriting and they have great reach in terms of relationship with alternative investors. This again shows we are not competing with banks, we are working with them.

Goddard are there many investors in the wider australian market who have the ability to participate in infrastructure in either bond or loan format? n la Greca It probably comes down to individual mandates. You can have funds or separate accounts, and funds normally have a broader mandate. In terms of our own fund, we’re very much only focused on the loan market because we like to have more control. This is feasible through the loan market as there are fewer participants and generally speaking we would have been involved in originating the transaction in the first place.

As a result, we are able to structure the terms that suit the particular needs of our fund, and to manage that asset over its life. So if situations crop up along the way that mean something needs to change, we can facilitate that because we have a relationship with the equity holder and we’ve been involved in the loan from day one. That’s where many of our clients have been focused. Bonds have their own attractive characteristics as well – our focus is simply elsewhere.n lee We’ve had some discussions with large investors who have run the slide rule over exiting banks and their portfolios and approached us to add some value to their credit rating and due diligence processes. So there’s certainly appetite out there for real loans, not just bonds.n sahota There were large books available for loans early on. European banks exiting the market were selling which led to some really attractive deals. Since then, Europe’s long-term refinancing operation has given the banks much more time to work out their problem issues and build up their risk-weighted assets rather than being forced to sell loans.

“in many cases, the loan format – particularly for longer tenor – is actually more attractive than the bond. you get more information, you generally get a better covenant package, and you get to know how the business is tracking over time.”B o B s a h o t a C H A l l e n G e r


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Goddard mark upfold, in your experience are some borrowers resistant to putting investors into loan product because of the implications of the terms and conditions?n Upfold When it comes to greenfield-style PPP projects there are not enough of them in the market, even though we have heard confirmation during the conference today that the pipeline is growing. Over the last year or so, we have noticed that when we are invited to advise on this type of project, sponsors want us to put a team forward that can structure a bond or a bank loan outcome. After the financial crisis the idea of having investors involved in loans disappeared as a concept and the banks ruled the roost. However, these days sponsors like the idea of having more flexibility in terms of having the option of bond or loan financing available.

Conversely, for government infrastructure projects I have been involved in, one advantage to having a bank group as opposed to a bond solution in the greenfield construction risk phase is that there is a lot of value attributed to the rigour of the bank credit processes – their oversight and due diligence.

One of the features we had in the original bond funding, pre-financial crisis, was that it tended to be a one-bank only piece of work. Now governments looking at bids would like to see bank rigour so more banks are involved.

I think the opportunity for bonds is in the refinancing phase, post construction. If you look back at the deals done just pre-financial crisis and during the crisis years, the engineering of the financial sponsors was designed to create multiple re-fi points in their transactions because they were anticipating earning an upside at every re-fi point. All those old deals are coming to a point where there will be a refinancing need. The question will be whether the banks who typically play in this space want to use their capital on those re-fi transactions or whether they want the higher risk-returns on the new projects, or whether they can do all of them. This is where some opportunity for bonds will emerge. n lee The other challenge with greenfield deals is in the upfront credit work, the amount of due diligence and effort required to scour the documents. For the broader capital market that’s a challenge. The other challenge is that the capital markets will need the capacity to underwrite debt well in advance of the bid – that’s part of the way the bidding process is set up for governments. That could be a challenge for Infrastructure Australia and other advisers to think about when they’re talking with the states: how do you manage that risk? A lot of the

money managers are looking after superannuation and you can’t really risk a future commitment without also having an identified return.

neW ProJeCts

Goddard so far the domestic bond market hasn’t been particularly successful in terms of funding new projects in the infrastructure space. are there any particular areas of the sector that would lend themselves to easier investor access?n sahota There are many positive aspects of infrastructure as an asset class: the defensive nature of the cash flow and the stable nature of the asset class are very attractive. However, the biggest hinderance to the asset class was the absolute level of leverage applied to infrastructure transactions. In the pre-financial crisis world, these deals were highly levered because they could sustain the leverage and because the market was so hot – there was so much liquidity – it was provided at very low margins.

As these deals come up for refinancing, there has to be some give – either some equity must come in to deleverage the projects in terms of the refinancing or there must be an increase in margin. One solution could be what Simon La Greca has already mentioned – adding a subordinated tranche.

These are all opportunities we are looking out for in terms of the refinancing task and new projects. We will probably get a new model in terms of financial leverage to make it attractive for investors like us to allocate capital to the sector.n lewis A part of the analysis, particularly if you’re looking at subordinated debt issues – and we participate in some of these for export terminals – is to look at the whole supply chain. In other words, where the equity is invested and what the commitment is in the supply chain, particularly in privately-funded export terminals. That’s what gets us comfortable.

It varies with any new projects: you have to look at the life of the project. It starts off as potentially more risky, but this depends on how the construction risk is mitigated for debt investors. What we expect to see for some of the riskier construction-type projects – and perhaps this goes back to the complementary nature of banks versus institutional markets-type solutions – is for the banks to fund them initially, with the long-term money from the capital markets coming in as the initial risks are mitigated or removed.

“What we expect to see for some of the riskier construction-type projects is for the banks to fund them initially, with the long-term money from the capital markets coming in as the initial risks are mitigated or removed.”k e v i n l e w i s i F M

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n lee The investors on this panel are better equipped than most to deal with the project finance-type construction risk and complexity, as well as sub debt. But many institutional investors don’t necessarily have the breadth of credit skills and the human capital to manage the risks. So they might look to the banks and firms like Assured Guaranty to manage that, or get involved once the project has been de-risked.

Goddard How important is the creation of a robust pipeline of infrastructure projects, so the sector becomes more predictable in terms of supply?n pritchard We’re in a slightly different realm here in that there is a wealth of opportunities, particularly in light of the regulatory capital imposts Basel III will bring for banks. As we see existing projects refinancing and new projects coming on stream, there are opportunities over and above just true

greenfield projects in which to invest. This means there’s a reasonable quantity of projects over and above the traditional infrastructure pipeline, which should encourage investors to participate. n la Greca Sitting behind the money we have to invest are institutional pension funds, superannuation funds, and life insurance businesses. For these firms to agree to allocate to infrastructure, they need to know it is worth their time and effort to learn and research this sector and obtain approval to invest in it. Our clients really quiz us on the deal pipeline and the opportunity set going forward. They want to know they will be able to get diversification.

Certainly, it’s very important to know what the pipeline is. But I think a mix of greenfield and brownfield projects is also important for our clients to see, as well as making sure the returns they’re getting in the infrastructure asset class stack up relative to other asset classes.


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There’s no doubt that clients are attracted to infrastructure because of the long-term contracted cash flows they can get from the space and the relatively low volatility. But they are always measuring this against what they can achieve in other asset classes. n lee The other important thing with a regular pipeline of infrastructure deals is that it tends to legitimise the asset class rather than it being seen as an alternative or an opportunistic move. This helps to educate asset consultants and fund managers, who can then develop teams to manage the risks in a much more cohesive way.n sahota One thing mandates have to cater for is that infrastructure investments are quite illiquid, and that is quite a new concept here in Australia. In order to be able to provide seven- or eight-year funding in Australia you need to have a core view of infrastructure as an investment that sits in the income-producing part of asset allocation.

Following on from this, we have been able to make a number of inroads towards unlocking the A$1.3 trillion of superannuation money that is accumulating in order to provide funds to sectors like infrastructure.n lewis In terms of looking for diversity in the pipeline and for multiple projects coming on stream, this is more important if you are investing through a fund and you need to have a well-diversified portfolio. At IFM we have a lot of individual mandates. Therefore, the pipeline itself is not a big factor because it is accepted that there can be some concentration in those particular mandates that might only have, for example, six to 10 assets. Infrastructure debt funds would need to have a much broader range.

enCourAGInG GroWtH

Goddard if there was one thing that could facilitate greater funding for infrastructure debt from the bond market, what would it be?n sahota The most encouraging thing from our perspective is that the Queensland government has intimated that it will seek active involvement and feedback from the private sector in order to get infrastructure financing in place. If that is the case, we are happy to provide feedback on what works for us in terms of relative value. If that process is replicated in other states and other projects, this is very encouraging for real-money investors.n la Greca That’s exactly right. I take toll roads as an example

“in terms of pure return metrics, generally the returns internationally have been higher than Australian equivalents for similar instruments. there are a number of reasons for this, not least of which is the high base rate environment here in Australia.”s i M o n l a G r e c a A M P C A P i t A l

– having more availability-based charges or removing the patronage, volume-based risk for investors and putting that risk where it most naturally sits is an encouraging sign. If people continue to think along these lines there should be a good pipeline of deals that we can do here in Australia. n Upfold One of the good developments going on at the moment is that Infrastructure Australia, Infrastructure NSW, Projects Queensland and others have all announced formally that they are looking at different ways of funding. I think they use references to funding in two ways here: one in the sense of funding though a user-pay system for the long-term use of the asset, and the other is in referring to external capital financing. There is an engagement to work out whether there are better ways of funding greenfields projects, using the strength of government balance sheets to facilitate an efficient capital market. n pritchard There are ways other than PPP for alternative funding structures. I would like to see more of the vanilla PPPs that are easier and more attractive to institutional and bond investors. n lee I think the market is moving in the right direction. I still think at the political level there’s often a very simplistic view of the big pipeline of projects they want to get under way on one side, while on the other they see superannuation as a honeypot of cash. There’s a view that they can simply put the two together, without recognising the challenges involved in doing so.

However, we are certainly encouraged by the feedback from investors. We will continue to work with investors to encourage them back to the infrastructure asset class – from which many have been absent for some time. n lewis We’re encouraged by people reviewing the PPP model, though we think they still need some work. They are far too expensive to bid into for equity participants, they’re too long in gestation even for the debt group – you have to dedicate 12 months and sometimes more to the negotiation phase of those documents.

I agree with Craig Lee that it’s not a simple matter of bringing together the infrastructure pipeline and the superannuation pool of funds. There are structural reasons why this is more difficult in Australia than in some other jurisdictions, like Canada. For example, the term appetite of defined benefit pension funds in Canada is liekly to be much longer than that of the defined contribution pension funds that are predominant in Australia. •

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infrastructure Australia, based in Sydney, was established by the Commonwealth government in 2008 as an independent statutory organisation to advise government and the private sector

on national infrastructure priorities. Paul Roe, director of policy, says although the body’s role is an advisory one, with the federal government having the final say on funding, so far the government has contributed funding to all projects identified by Infrastructure Australia as “ready to proceed” on its first infrastructure priority list released in May 2009.

A key goal of Infrastructure Australia is to increase the pool of funding available for infrastructure investment and to facilitate the broader application of more efficient financing mechanisms. Roe says this is vital as Australia has an infrastructure deficit, and he adds that there is likely to be an increase in demand for infrastructure due to population growth and ageing projections. “Moving forward, there is likely to be less rather than more fiscal space to fund infrastructure,” he says.

Roe explains that with the Australian government pushing to return to surplus and state governments focusing on maintaining or regaining triple-A credit ratings, governments at both Commonwealth and state level are under considerable budget pressure. This underpins the drive towards looking for non-traditional funding sources for infrastructure finance.

Given the funding and financing challenges, the Australian government established a working group to report to Infrastructure Australia on options to inform infrastructure financing and advise on the use of private financing, user charges, and alternative finance models. “In particular, there is significant scope

for increases in user charging and that has a nice segue into facilitating private sector participation in infrastructure – it is underused as a funding source,” Roe says.

The finance working group called for a three-pronged approach: a major reform of infrastructure funding, improved infrastructure planning to provide a deep pipeline of projects, and steps to encourage more flexible and efficient markets that attract private investment.

In terms of capital market financing, Roe says Infrastructure Australia is looking to further understand the forces at play, including investigating why Australian sponsors have tended to favour offshore capital markets and domestic bank funding over the local bond market.

“We are taking a systematic look at supply and demand factors, including the demands of the superannuation industry. In particular, we want to understand if there are any policy constraints on the efficient functioning of domestic capital markets,” concludes Roe.

Queensland’s infrastructure needsAt the state level, Queensland has significant infrastructure requirements to cater for future growth. With a new state government in March 2012 has come a change in philosophy around infrastructure funding. In February 2009 Queensland lost its triple-A credit rating from Standard & Poor’s. A key reason for the downgrade was the state’s commitment to continue with infrastructure spending plans despite projections of reduced revenue. The new government remains committed to

building infrastructure, but it is also keen to regain a top credit rating.

One of its initiatives is Projects Queensland, tasked with improving the way projects are structured, financed and delivered. Dave Stewart, acting executive director at Projects Queensland, explains the new approach: “Queensland is well and truly open for business, with an extensive pipeline of infrastructure projects. However, whereas the previous prevailing attitude was to use private financing as a last resort, the new government policy is actively seeking private financing opportunities to deliver its infrastructure programme.”

The desire of the investor community to be part of the new market also applies at state level, Stewart adds. “There is now real appetite for private involvement in the delivery of infrastructure projects.” •

financing federal and state infrastructureAs federal and state governments aim to consolidate their balance sheets, finding alternative infrastructure finance – including capital market options – is firmly on the agenda.

“We Want to understand if there are any policy constraints on the efficient functioning of domestic capital markets.”paUl roe inFrastructure australia

keynoteaddress

“the neW government policy is actively seeking private financing opportunities to deliver its infrastructure programme.”dave stewart projects Queensland

panel discussion australia’s DOMEstiC Infrastructure ... · 10|kanganews supplement october 2012 panel discussion 1 australia’s DOMEstiC Infrastructure InVestMent OPtiONs panellists

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