Crunch time for PPPs?
By Paul Gosling
All the financial markets are feeling the squeeze, as the credit crunch bites hard. But the multi-billion dollar question is whether PPPs will suffer along with everyone else, or whether buoyant global market demand will see the sector through.
David Cooper, head of private finance initiatives and structured project finance at Barclays Commercial Bank, says that international interest has yet to translate into the business volumes that characterise the UK market. “Look at the UK compared to any other market in the world, then the UK is still bigger than any other market out there,” he points out. And that remains true, even though demand in the UK has fallen.
There is particular disappointment amongst those who got used to a strong and regular demand for PFI deals for NHS bodies, says Cooper. The big acute hospital new-builds have been signed-off, with more of a focus on small polyclinics. But Cooper suggests UK demand will resurface, even in the NHS, with much of the health infrastructure needing renewal. There is also growing demand for waste and social housing.
Cooper says that while progress on PFI regeneration schemes has been slow, he hopes this will develop. “It takes a lot longer and it needs to be more joined-up,” he says. “There is a lot of talk and very little action.” Cooper believes that the UK Government needs to become clearer about what is sees as the private sector role in regeneration projects and provide clearer leadership for schemes. “It’s frustrating, because things should happen more quickly,” he says.
Anne Baldock, partner and global head of the projects, energy and infrastructure group at legal practice Allen & Overy, shares the view that demand in the UK has dropped. “The big flurry of the big hospitals is finished,” she says. “Schools deals are still coming and there is the M25, of course. But it’s quieter. The prison sector has now gone on a different route. The credit crunch is having a bit of an influence: people are reluctant to launch new projects when they are unsure about funding. But lead time is such that this has yet to have much of an impact.”
Baldock points out that it is now the global market that is growing substantially. “Internationally it is very buoyant,” she says. “The US and Canada are very active. Abu Dhabi and Dubai are very busy. Europe is more active than the UK – particularly France, Portugal and Belgium.” The majority of European schemes are in transport, as are almost all in the US – road, rail and airports. “Canada is interested in health PPP projects and the States is talking about it,” she adds.
Nick Prior, senior partner at Deloitte’s PPP practice, takes a similar view of demand. “Clearly it’s strong,” he says. Prior adds that different countries still use PPP for different types of infrastructure and approach things in different ways. “But it’s a strong market out there. Transport is where most countries are going for it. It is seen as an alternative model for all major procurement on the infrastructure side.”
Prior reports a big interest in the Gulf States in the use of PPPs for infrastructure development, for example in Abu Dhabi to catch up with Dubai and in Dubai to keep ahead of the other Gulf States. But Prior predicts this market will evaporate as the Gulf States become frustrated by the delays associated with PPP procurement, when they actually have the funds to finance the infrastructure improvements themselves.
Demand, at least on a global level, remains high. What is more, points out Bank of Scotland, the pipeline for deals is so long, that the deals coming to market now represent commitments made by banks prior to the onset of the sub-prime lending crisis. BoS refers to its involvement in the financing of the £260m Tyne Tunnel 2, signed-off in November, to prove its continued commitment to the market.
But circumstances have undoubtedly changed in recent weeks – and that change can be illustrated by one word, monolines. Bond insurers – called monolines, because bond insurance is their only line of business – have hit big trouble, after they branched out of their core operations of guaranteeing US municipal bonds to guarantee bonds backing sub-prime mortgages in the US. Many of those guarantees now look set to be called in.
As a result, the credit ratings of the monolines are being reviewed by Standard’s & Poors, Fitch and Moody’s. Fitch has cut Ambac from AAA to AA, leaving Ambac to raise fresh capital, while MBIA has also announced that it is seeking an extra $1bn capital to protect its investment grade.
These pressures on the monolines are of enormous importance to the PPP sector, because for the last decade or so they have been heavily involved in guaranteeing PPP bonds. Ambac guaranteed £500m on the Barts and Royal London hospitals PFI project; £730m on the Allenby & Connaught Ministry of Defence accommodation scheme; £580m on Colchester Barracks; £356m for a new hospital campus in Manchester; and $27m for Fordham University in New York.
MBIA has played a similar role, guaranteeing £600m for the National Air Traffic Services PPP, and also backing bonds on the Allenby & Connaught project. It is very active in emerging PPP markets, including Australia, Chile and Mexico, and has a total exposure to $158bn of PPP-type infrastructure projects.
But with most of the monolines most heavily involved in PPP bonds hit by the sub-prime fall-out, the use of wrapped bonds is at an end, at least for the moment. This is admitted even by the bond insurers themselves.
Louise Minford, managing director and head of infrastructure finance UK and Ireland for Ambac, says it is “difficult” to estimate how long before it will again be active in the PFI and PPP market, but that it is fully committed to the sector. “Nobody knows – it could be quick, or it could be a few months,” she says. “There are so many different things going on at the moment. There is general market turmoil which creates uncertainty among investors. A lot depends on their confidence in the rating agencies and the timing of monoline capital raising plans. There is a commitment to maintaining our Triple A rating.”
The immediate challenge is to finance one of the largest PFI/PPP projects ever to come to market, the UK Ministry of Defence’s £13bn Future Strategic Tanker Aircraft (FSTA) contract, to replace the RAF’s fleet of VC10 and TriStar aircraft. Ambac had been expected to guarantee at least £2.5bn worth of bonds. Now, with the loss of the monolines, the use of bonds for PPPs is pretty well at an end and it is down to bank loans, at the cost of a price increase.
Deloitte’s Prior says: “The monoline issue has meant that you can’t use the capital markets for PPP and they are looking at all-banking solutions. That is a real runner. Pricing has certainly gone up, but six to nine months ago we were in an unprecedented strong market. Pricing has certainly increased. But liquidity is more of an issue. Banks will probably put pricing up where not already committed. That will have affordability implications and that will take longer to sort out. The market is still there.”
Barclays’ Cooper takes a similar perspective. “The crunch is a liquidity crunch, not a credit crunch,” he argues. That liquidity shortage is felt particularly by some of the medium sized banks, such as those that specialise in infrastructure loans, creating additional pressure on syndications. “That’s taken a lot of liquidity out of the market,” he says. “And it’s difficult to read what is going to happen in the bond market.” The result is that there are now “less cut-throat margins” on PPP lending.
The structure of PPP deals is changing, not just in terms of giving up on bond financing, but also in the way in which banks will lend. Where previously clients had to deal with one or two banks, now they will typically have to involve five or six. The norm had been that after deal completion, the lead banks would syndicate loans to reduce their capital commitment. But with the drying-up of the inter-bank lending market, banks have got very nervous about syndication.
As a result the syndication, in effect, takes place up-front, instead of after deal completion. Cooper says that public sector clients have to get used to negotiating with more banks. “It’s not a difficult issue to confront, it’s just one that they are not used to,” he says.
Paul Davies, a PricewaterhouseCoopers’ partner, suggests the significance of the loss of the monolines should not be overstated. “For most PPPs there was a choice between banks or bonds anyway,” he says. “We run funding competitions to see which is most competitive and they were mostly pretty close.” The other change in PPP funding now is the increased use of market flex, says Davies – giving funders the opportunity to marginally increases rates if they are unable subsequently to syndicate loans on existing rates.
There is a consensus that there is a tightening of capital availability from banks. But with newspaper reports constantly stressing the size of the sovereign wealth funds, particularly those of China and the Gulf States, is there a prospect of them stepping in to take over? In practice, their involvement may be limited, suggests Emma Ormond, analyst at Oriel Securities.
Ormond agrees that sovereign wealth funds are showing increased interest in PPP schemes and by propping up some of the largest banks – such as CitiGroup, which is heavily invested in PPPs – they are already heavily committed to them, indirectly. Ormond predicts that the funds will increasingly involve themselves in PPPs in emerging markets, with the Gulf States’ sovereign wealth used within the Gulf region and Egypt, and China’s funds going into Africa, for instance.
Mark Burke, a partner with Grant Thornton’s government and insfrastructure advisory team, is confident that world demand will help the PPP sector to withstand the short-term troubles. “Global PPP is learning fast from the lessons in the UK,” he says. He points to the fact that his team is working on health and medical devices projects in both Canada and Greece. “These are examples of people replicating across the globe what we have been doing in the UK, which PUK has been exporting.”
But, he warns, the continuation of demand in the PPP emerging markets may ultimately depend on the development of local support and finance infrastructures and PPPs not being fully serviced from external sources. “Governments will want to find opportunities where the local economies take the benefit,” says Burke. “They won’t want the benefits to go outside the country – that they take the downsides, while all the upsides go elsewhere.”