Encouraging Private-Sector Capital To Engage More Broadly And Widely

Private-sector capital waiting to be deployed into infrastructure investments is at a record high (see chart 1). Institutional and private investors see investing in infrastructure as offering a number of advantages, such as generally higher recovery rates in the event of default than for corporate bonds and more attractive yields than for government bonds and similarly rated corporate bonds. That's because of infrastructure projects' illiquidity premium and long-dated maturities that match pension fund long-term liabilities. (See “Rated Global Infrastructure Displays Strong Credit Quality And Low Risk,” published on April 17, 2018.)

Chart 1

Although there is significant capital interested in infrastructure, the credit risk profile of existing global opportunities may not be attractive for institutional investors (see table 1). To date, they are mainly investing in developed countries. Approximately 97% of total private capital investments mobilized by multilateral lending institutions (MLIs) occurred in high- and middle-income countries, according to the MLI community's joint 2017 report "Mobilization of Private Finance." The much smaller share of private-sector investing where MLIs are involved in low-income and emerging markets is, in our view, due to their higher underlying investment risks. Such elevated risks include political and regulatory uncertainty, embedded risks in government concessions, currency exchange rate risk, and policies that are often less developed and somewhat unpredictable. (See "It's Time For A Change: MLIs And Mobilization Of The Private Sector," published on Sept. 21, 2018).

In this context, creating an environment and financing structure that encourages private investors to engage in a wider spectrum of risks and a wider number of geographies is critical and all the more necessary given constraints on sovereign fiscal resources.

Table 1

Credit Enhancements As Catalysts Of Private Capital Deployment

Many risks holding back private investors could be effectively transferred to a third party. Credit enhancement aims to mitigate specific risks of a project that may weigh on its overall credit profile and therefore make that project less appealing to private-sector participants. To be effective, we believe credit enhancements must offer a menu of risk/return options that are both suitable and useful to various types of investors and investments. We believe that MLIs will increase engagement with the private sector via credit enhancements to facilities private capital deployment. Plus, commercial insurers will likely continue to innovate to effectively deploy their capital across different projects and expanded geographies, and look at the whole capital structure beyond senior debt.

Our analysis of the impact of a credit enhancement instrument on project creditworthiness reflects default risk and relative seniority in the event of default, but not ultimate recovery, according to our rating methodology. However, we do factor in postdefault enhancements when analyzing bundled structures, such as project finance collateralized loan obligations (CLOs), where ratings not only reflect the likelihood of default but also payment priority, recovery prospects, and credit stability (see "S&P Global Ratings' CLO Primer," Sept. 21, 2018). Our methodology focuses on default risk rather than recovery because we perceive timeliness of payment as the crucial for private-sector project finance investors, who prioritize long term-cash flow prospects over recovery potential.

Credit Enhancements As A Cash-Flow Stabilizer

Credit enhancements that effectively mitigate or delay default risk are likely to result in the project debt being rated higher than it would have been absent the enhancement. Under our project finance methodology, the benefits of additional liquidity facilities tend to be reflected in our downside scenario analysis, where cash buffers allow for projects to survive longer or with more cushion during a limited period of stress, thereby reducing the probability of default. In certain projects, this type of credit enhancement is funded at financial close, immediately creating a buffer for senior lenders instead of kicking in only if needed (see table 2).

Table 2

Enhancing Recovery: Partial Guarantees And Political Risk Insurance

Credit enhancement instruments that aim to increase recovery for lenders, such as partial guarantees, have been widely used in emerging markets, particularly in Latin America, and have not worked (see table 3). The use of these instruments is not limited to infrastructure investment but also largely deployed to enhance sovereign debt. In our opinion, these instruments do not generally raise the creditworthiness of a project finance rating despite enhancing ultimate recovery.

Political risk insurance (PRI) tends to cover risks related to currency transfer and convertibility (T&C) risk, expropriation, breach of contract, war and civil disturbance. T&C risk insurance has long been used by banks and other foreign investors in emerging-market countries to protect against the possibility that a government would impose currency controls on domestic entities' ability to remit abroad hard currency funds owed to foreign creditors. This type of insurance, however, becomes effective only after an event of default on the outstanding debt. Plus, the payout is subject to defined waiting periods as well as potential arbitration whereby, only after arbitral award, the lenders can make claim under the insurance. Due to lack of timeliness of payment, we do not expect this type of instrument to result in rating uplift, even though it may provide some comfort to investors regarding a minimum level of recovery.

A minimum guaranteed recovery will enhance our recovery rating but will not influence our debt rating. Our recovery rating estimates the range of principal that lenders can expect to receive following a default of the project. We define the likely default scenario and then assess recovery using one of two techniques, such as discounted cash flow analysis or liquidation analysis. We also examine the terms and conditions of project assets, such as contracts and concession agreements, for example, to estimate the expected recovery.

Table 3

Combining Credit Enhancement Instruments Could Be More Credit-Friendly

One of the most innovative structures recently implemented in an emerging market combined two traditional credit enhancement instruments, a liquidity facility and a PRI, to mitigate exposure to the revenue counterparty.

ELZ Finance S.A. (not rated by S&P Global Ratings) issued €288 million of privately placed, euro-denominated senior secured bonds and on-lent the proceeds to its sister company, Turkey's ELZ Saglik Yatirim A.S., which was awarded the 28-year concession by the Turkish Ministry of Health to design, build, finance, equip, and maintain an integrated hospital campus in Elazig with 1,038 beds. The project revenues are not subject to price or volume risk but are based on making the hospital available to the ministry and subject to customary deductions for unavailability or poor performance.

The senior bonds were structured with a new credit enhancement scheme including:

• PRI provided by the Multilateral Investment Guarantee Agency (MIGA, part of World Bank Group), designed to cover currency inconvertibility and nontransferability, expropriation, and breach of contract; and
• Two liquidity facilities provided by the European Bank for Reconstruction and Development (EBRD; AAA/Stable/A-1+) during construction and operations.

Based on public available information, we understand the credit enhancements served two purposes:

• To mitigate the risks associated with the construction contractor during the construction phase. EBRD provided the "construction support" facility in the form of an irrevocable, on-demand letter of credit that may be drawn if the construction contractor fails to pay amounts due.
• To enhance the credit profile of the sole revenue provider, the Turkish Ministry of Health, by combining a liquidity facility and a PRI. As briefly explained above, the PRI is subject to arbitration. To mitigate the risk of a protracted arbitration process, the structure benefits from a "revenue support" facility that the EBRD also provides. The facility provides liquidity that kicks in once the debt service reserve account is fully depleted and aims to keep the issuer current on interest and principal repayments while the claim process under the MIGA insurance policy is worked through.

We believe this proposed structure could effectively address the non-immediate payment from the PRI, effectively delaying a potential default. While the PRI's enforcement and arbitration continues, EBRD liquidity ensures the payment on the debt remains current. In our opinion, this credit enhancement structure could effectively mitigate the exposure to a weaker counterparty.

Asset bundling to mobilize private investments

In another example of financial innovation and mobilization of private investment in emerging markets, Allianz Group entered into a partnership under the IFC's Managed Co-Lending Portfolio Program. Under the agreement, Allianz intends to make an investment of $500 million, which will be co-invested alongside IFC debt financing for infrastructure projects in emerging markets worldwide. We understand that Allianz will co-invest in a portfolio of loans that the IFC has granted to infrastructure projects in emerging economies and that fulfill a defined set of eligibility criteria. The IFC will provide a first-loss protection to reflect the risk/reward profile of an institutional investor. Under this structure, Allianz's insurance entities can now access emerging-markets infrastructure loans, which have historically been funded only by international development institutions, local banks, and some international banks. The portfolio approach enables private investors to invest in the emerging market, limiting the exposure to single asset and single country risk.

This type of innovation complements more traditional project finance or large corporate portfolio CLOs (see table 4).

Table 4

Credit Substitution Covers It All

The most well-known and widely used instrument for credit enhancement in developed countries, before the financial crisis, was a full guarantee issued by a highly creditworthy party put in place to cover timely payment of interest and principal to investors in case the underlying project failed. A guarantee, or credit substitution, is the purest form of credit enhancement whereby the evaluation of the creditworthiness of the primary obligor is shifted to that of the guarantor and the terms of the guarantee. S&P Global Ratings' guarantee criteria identify the circumstances under which a guarantor could be excused from making a payment necessary for servicing the obligations of the guaranteed securities and take those circumstances into account in the rating. Timeliness of payment is a key component of the guarantee criteria.

When a full guarantee is provided, investors buy and price the risk of the guarantor rather than that of the underlying asset, in particular if provided by an MLI or a sovereign. Full guarantees, however, may not foster investors' understanding or appreciation of the underlying asset and therefore may not support the development of an effective long-term financing market for infrastructure in a specific country.

Table 5

The "Halo Effect"

Whether a credit enhancement by third party aims to delay a potential event of default on the debt or enhance the recovery prospects to investors with potentially different impact on a rated security, the role of the credit enhancement provider, in our opinion, remains a key consideration for investors.

We believe investors may ultimately decide to participate in the long-term financing of infrastructure alongside MLIs to benefit from their role and influence at the negotiation table when things go wrong. From a project finance perspective, it is challenging to quantify the impact of the "halo effect" on the creditworthiness of the assets and the ability of noteholders to be paid on time. However the involvement of an MLI may have a positive impact on the design of the relevant public-private partnership (PPP) scheme, the quality of project selection, and project preparation or the governance of the relationship between the project and the local authority, somewhat reducing the operational risk of doing business in emerging economies.

Furthermore, these institutions may also help fight corruption and bribery in the tender process for the construction of new infrastructure assets. The MLIs' work collaborating with local authorities and government, thanks to their extensive experience in lending to sovereigns in emerging economies, can certainly provide further support in mobilizing private investments.

Credit Enhancement Initiatives Will Not Succeed On Their Own

In our opinion, credit enhancement, in and of itself, will not transform nonbankable projects into bankable projects. While credit enhancement of a project's financial structure may enhance the credit quality of senior debt, it cannot ensure the bankability of a poorly planned or prepared project. If an infrastructure project has a weak business profile, is exposed to a weak irreplaceable counterparty, and/or has a transaction structure that does not sufficiently protect project creditors, the presence of credit enhancement facilities would at best only delay the project's eventual demise.

As discussed, institutional investors are becoming increasingly attracted to infrastructure due to their need to match long-term assets and liabilities--while at the same time picking up higher yields than from traditional investments in investment-grade sovereign and corporate debt. Still, many nontraditional investors remain wary of such assets. The key to increasing their participation, perhaps, is to promote a better understanding of the risks associated with this type of lending, develop a pipeline of projects with uniform structures with clarity about risk allocation, and support the procurement phase.

We believe MLIs are also important in driving systemic change to increase the ability of emerging markets to attract private financing. The World Bank Group and the EBRD, through their project preparation facilities, have been working with governments in emerging markets to enhance the local contractual framework. For example, the EBRD in recent years has helped Egypt with the design of a new feed-in tariff program for renewable projects. The revised framework to the initial 2014 program now allows for disputes to be put to arbitration outside of the country. This triggered the EBRD in June 2017 to launch its US$500 million framework to finance renewable energy in the country and that since has provided finance for 16 projects (as of Aug. 31, 2018). This is a good example of how policy work can improve the investment climate.

Appendix Overview Of Our Project Finance Methodology

S&P Global Ratings' rating methodology for project finance structures the analytical process according to a common framework and divides the analysis into several components so that we may consider all salient factors.

These components include:

• Counterparty risk criteria. How we factor in the credit quality of a project's key counterparties, be they the buyers of the project's output or a provider of services and materials to the project.
• Construction phase criteria: How we assess a project's construction phase risk.
• Operations phase criteria: How we assess a project's operations phase risk.
• Transaction structure criteria: How we assess the constraints, legal framework, and protections around a project.

The framework methodology is the overarching architecture that brings together the above four components of criteria. When reviewing our new project finance criteria, we recommend starting with the framework methodology, where we describe the process for assigning a credit rating, break down the aforementioned components into a series of steps, and address how we rate other debt in a project financing.

To start, a transaction must meet our definition of a project financing for us to apply the relevant criteria. Assuming it does, projects have two distinct periods: construction and operations. When rating a project that is under construction, we assess the construction stand-alone credit profile (SACP), then we move on to operational risks and develop an operations SACP. The weaker of the two determines our project SACP. For example, if we conclude that a project's construction SACP is 'bbb-' and the operations SACP is 'bbb,' the project SACP would be 'bbb-'.

The project SACP becomes the project finance issue credit rating unless there are modifiers applied. For example, we assess as part of transaction structure a project's link to its parent and its structural protections. Weaknesses could result in a lower rating. Modifiers that could result in a higher rating include whether the project is a government-related entity, is subject to sovereign rating limits, or benefits from a full credit guarantee.

While senior secured debt is always present in a project finance structure, we may also rate, for example, subordinated debt or holding company debt. We also assess the recovery prospects for a project's debt.

Related Research

• It's Time For A Change: MLIs And Mobilization Of The Private Sector, Sept. 21, 2018
• S&P Global Ratings' CLO Primer, Sept. 21, 2018
• Rated Global Infrastructure Displays Strong Credit Quality And Low Risk, April 17, 2018
• General Criteria: Guarantee Criteria, Oct. 21, 2016
• Project Finance Framework Methodology, Sept. 16, 2014
• Project Finance Operations Methodology, Sept. 16, 2014
• Project Finance Transaction Structure Methodology, Sept. 16, 2014
• Ratings Above The Sovereign--Corporate And Government Ratings: Methodology And Assumptions, Nov. 19, 2013
• Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
• Project Finance Construction Methodology, Nov. 15, 2013
• Project Finance Construction And Operations Counterparty Methodology, Dec. 20, 2011