Financing of Infrastructure Projects
The issue of infrastructure improvement has long been one of the most pressing ones in Ukraine. Certain signs of improvement have been seen lately, but in general the issue still remains unresolved, especially given the challenges faced by the Ukrainian economy in recent years.
Infrastructure projects are highly complex, expensive and lengthy in terms of realization. Needless to say, they require significant funds which, in most cases, cannot be allocated by sponsors without attracting financing from third parties. A specific feature of large infrastructure projects is the long payback period of projects and the increased risks associated with it. Due to this and a number of other reasons, the financing of infrastructure projects is very specific. This is an issue not only for emerging markets but also for countries with developed economies where the authorities offer solutions aimed at support and promoting the development of infrastructure. For example, the European Union Commission and the European Investment Bank have jointly established the European Fund for Strategic Investments to support projects in the private sector.
Large infrastructure projects can be financed in various ways, including via bank loans, private and public placement of project bonds. Each of these ways has its pros and cons, which will be discussed below. To determine the best financing scheme for a particular project, it is necessary to take into account not only the specifics of the project itself and of the country it is implemented in, but also all the nuances of financing schemes. This includes the following factors:
— ability to respond to changes in circumstances along the life of a project,
— acceptability of financing conditions with a view to the terms of a project and generated cash flow,
— the nature and level of transactional risks,
— confidentiality issues,
— the total cost of financing and its value-for-money efficiency.
When deciding on a specific type of financing, one should consider the amount of funds required, the complexity and type of transaction, conditions on the bank lending market and capital market in a particular jurisdiction, transaction support price, the need for special conditions and non-standard covenants, the time required for preparation to financing, strategic issues, such as the need to diversify the pool of creditors, the publicity of the transaction, etc.
For example, a loan from a small group of banks or private placement of bonds to a small group of investors may give flexibility regarding the drawdown schedule, confidentiality, amendments and waivers. Private or public placement of bonds can provide financing for a longer period than a bank loan, and, therefore, a lower risk associated with the need for refinancing, which can favorably affect the entire project economy. Attracting finance through the public offering of bonds to a wide group of institutional investors can provide for lower costs of financing compared to other methods. However, this method does not ensure flexibility when amendments are necessary.
In practice we see quite a controversial situation. On the one hand, there is significant demand for infrastructure projects and financing, especially in private sector. On the other hand, recent changes in banking regulations implemented after the global financial crisis have made long-term lending, which is normally required for infrastructure projects, less attractive to many banks.
Talking of financing infrastructure projects, the very first choice would be between corporate finance and project finance scheme. The choice depends on many factors, with the main being the size of the project, the total debt burden of the company, the profitability of the company, the owners’ willingness to accept the project risk for the whole business, or vice versa the need for this, given the specifics of the project. Depending on the value and liquidity of a company’s assets and its performance, the corporate lending option can both attract lenders and scare them away.
In contrast to corporate financing, lenders in project financing normally have no recourse to the sponsor’s entire business and proceed in their assessments solely from the specifics of the project itself and revenues it can generate.
To date the main sources of project finance have been long-term amortizing bank loans and project bonds. Both loans and bonds are usually secured by the project company’s assets and its rights under project agreements. In most cases, sponsors prefer a non-recourse project financing structure, as they are reluctant to transpose the risks of a specific project to their entire business. This is also true for projects with several sponsors (consortium members).
At the same time, although lenders have no recourse to sponsors in project financing, their role and expertise often play a key role in a project’s successful implementation. Their participation in the project is also among the significant factors underlying a positive decision by creditors on project financing. Therefore, despite the fact that sponsors may be bound by obligations under project agreements, loan documentation will contain provisions preventing them from selling their shares in the project (change of control clause), at least until the project is successfully launched. In most cases, violation of this condition leads to default and the right of lenders to demand immediate loan repayment.
The share of project bonds in the total financing volume of infrastructure projects is gradually increasing. According to Thomson Reuters, the share of financing projects in Europe through the issuance of bonds increased from 3% to 23% in 2008 — 2014. Project bonds were mostly used to finance projects in the fields of oil and gas, railways, ports, and telecommunications.
Many infrastructure projects are implemented through concession. However, banks usually provide loans for a shorter term than the concession period. For example, for 10 years with a concession period of 20 years. This creates additional refinancing risk for the sponsors and the project company. And in most cases, banks provide loans for a much shorter term of 3, 5 or 7 years.
While banks are becoming more and more limited by regulators in their ability to issue long-term loans, investors from the non-banking sector are more flexible in providing long-term financing. Project bonds for the life of a project ensure financial stability of the project and eliminate the refinancing risk, giving the opportunity to stream the surplus funds for payments to the project company’s sponsors/shareholders.
An important issue in the implementation of greenfield projects is the drawdown schedule. The project company does not usually need all the funds at once, using them gradually in the course of the project construction. If the entire amount of financing is received immediately, the project company faces the problem of servicing a larger amount of debt than it actually needs in a certain period of time. And taking into account the fact that the interest on bank account balances will be clearly lower than the interest for use of loan funds, this has a negative effect on the project’s financial conditions.
In this light, the advantage of bank loans is that they may offer a drawdown schedule synchronized with a project’s funding needs. At the same time, the bank’s commitment fee is significantly lower than the interest for loans. In the case of bonds, the entire amount is disbursed immediately. This reduces the attractiveness of this method of financing, since the return on equity is reduced, though this negative factor is balanced by the longer term of available financing.
Taking into account the above specifics of various forms of financing, it is reasonable for certain large projects to use a combined financing structure, which includes bank lending for a term significantly shorter than the project life, subject to refinancing by the issuance of project bonds after the project is commissioned. At the same time, the issue of project bonds can be both public and private, either listed on a stock exchange or not. In turn, listing bonds can attract a larger pool of creditors and provide better financial conditions. They do, however, impose a compliance burden on issuers (reporting, etc.).
While banks are still the main creditors of infrastructure projects, investors from the capital market have become increasingly interested in this area, since the money of pension funds and insurance companies need long-term investments ensured by stable cash flows. This trend will only intensify over time, providing sponsors with broader options of financing sources.
As we can see, companies encounter problems in financing infrastructure projects even in developed European countries. In Ukraine, where the credit risk is much higher than in EU countries, this problem is obviously much more severe. If we look at the projects implemented in recent years, the vast majority of them have gone through only with the support of IFIs (EBRD, IFC, EIB, NEFCO).
This is partly due to instability in the country and the high risk associated with lending to projects in Ukraine, and partly due to the fact that public-private partnership mechanisms do not work in Ukraine. Moreover, infrastructure financing through the issue of project bonds (either private or public) is still not available in Ukraine and for Ukrainian projects in the broader sense.
Thus, it is very important to create state support programs for infrastructure development by the private sector and implement statutory rules and procedures which will ensure access to such programs for eligible companies as well as smooth and predictable implementation of infrastructure projects in Ukraine.
Oleksander Plotnikov is a partner at Arzinger