The the rapidly increasing need for immediate investment in energy transition and growing the digital economy has created a funding gap to meet capital needs. Over just a few years, infrastructure and the project finance markets that fund their development are facing a transformative juncture.

The project finance market has long been supported primarily by the bank loan and bond markets. Project finance is typically used to fund the construction and operation of capital-intensive assets--spanning wind farms to stadiums and beyond--with debt serviced from cash flows generated from the completed projects and secured by collateral including project assets, with debt instruments that feature strong covenant packages and guarantees. Private markets are also currently contributing to the supply of capital funding powering the projects of the future (including energy transition and the data centers that enable artificial intelligence and cloud computing services) by providing new sources of long-term financing for industrial and infrastructure projects through corporate, structured, and project-level debt raisings. But for these new financings and new projects, the private market's appetite for risk and uncertainty may be larger than that of the public market, and with less transparency.

We expect the customization of project finance transactions to become both more common and complex as demand for new infrastructure project financing grows. With an expansive amount of capital available and significant competition at play in funding these essential assets, issuers are likely to ultimately use multiple layers of financing across both public and private markets. The resulting dynamic capital funding will mark a significant evolution from today's bank-dominated finance--propelled by the support of private markets.

Growing in size and scale in the last decade, alternative asset managers have developed lending platforms to offer a direct channel for borrowers encompassing origination to distribution and placement of the loan with various investors. The rapid growth in demand for infrastructure and the diverse and complex nature of projects have catalyzed funds dedicated to infrastructure, where the flexibility of direct origination is applied to arranging new project financings.

Project Finance Currently Features A Mix Of Funding Sources, Anchored By Banks

Since 2018, commercial banks have been providing about 80% of global project finance, followed by bonds (accounting for most of the balance). Traditionally, commercial banks have been the primary source of funding for project finance due to both their legacy sector expertise, flexibility in lending during construction, and at times, offering more attractive pricing than capital markets (see chart 1).

But while banks and capital markets have supported global project finance needs historically, their capacity to meet future needs is far more questionable. Global project finance's annual issuance volume has been steadily rising for several years--more than doubling from $200 billion in 2012 to $440 billion in 2023.

Nonetheless, the prospects for future project finance funding are substantially greater. This growth is likely to be fueled by the combination of issuers' strong need to refinance the existing infrastructure bank loan funding, demand for funding new core power and transport infrastructure projects in developed and emerging economies, and the frenzy of financing unfurling in the wild west of energy transition and digital infrastructure projects.

Chart 1

The commercial bank loan market may not have the willingness or capacity to meet such a massive need. The refinancing of data center bank loans is estimated between $20 billion and $30 billion, and originators are also supplementing the public markets with private placement offerings and other funding sources for this longer-term financing.

The additional investment required for actualizing new infrastructure projects--including more than $900 billion needed for global data center investment through 2029, and more than $4 trillion needed for energy transition projects--compounds those numbers (see charts 2 and 3). At the same time, shifting regulations and increased capital requirements under Basel III may over time prompt banks to derisk. Although commercial banks' expertise and pricing advantage will likely continue to provide an edge for bank loan financing over other sources of project finance funding, private credit's role is likely to increase.

Chart 2

Chart 3

Funding Needed To Fuel Capital-Intensive Growth

Because infrastructure is capital intensive, the funding gap to meet growing needs may be constantly widening.

Globally, at least $2.5 trillion is invested annually into core infrastructure projects such as transport and power, but this amount will rise by 30% to $3.3 trillion per year to meet infrastructure needs through 2030, according to McKinsey. Investment in energy transition and digital infrastructure is likely to exponentially expand demand for this type of funding. S&P Global Ratings expects U.S. data centers will require 150-250 terawatt hours of incremental power per year by 2030, with the existing power grid likely the biggest hurdle to meeting that demand.

Compared with a typical corporate borrower, a project finance borrower is generally more complex due to its long-dated nature, as well as the risk differential that may materialize during the construction and start-up phases. As a result, the documentation governing the transactions is more complicated and extensive to explicitly consider the elements of each phase and how those risks can be mitigated. The risk tolerance for these phases can vary. Traditionally, banks have had a greater appetite for construction risk because they tend to be more active project finance lenders. This is particularly evident in their involvement in club deals because they are more involved in real time. While banks can more quickly respond to waiver requests during the construction process, institutional lending groups may take longer to marshal votes from a wider bondholder group. Bank debt is also better suited for the construction phase because it only incurs interest when drawn down. Consequently, the borrower avoids carrying costs and the bank mitigates its exposure risk.

Dynamics are changing rapidly. With new technologies and uses imagined and implemented every day, market participants are facing a new world of project financing needs. The nature of the infrastructure projects themselves (with a broadening in attention from hospitals and toll roads to energy transition, data centers, and digital infrastructure) are changing the risk profiles and opening opportunities to private credit. The substantial resources needed for such innovative and transformational projects is also bringing new investors, including those that may have a higher tolerance for risk.

In addition to construction and technology risks, new projects bring new complexities, such as the substantial power and water needs for new data centers. And these complexities are exacerbated by those of the transactions.

Returns Draw Private Funding

As traditional private credit markets become increasingly crowded and the reopening of public markets compresses spreads, alternative asset managers searching for new sources of alpha are honing in on project finance. Private players are raising substantial sums in new funds with an energy and infrastructure mandate--prominently evidenced by Blackstone and Brookfield alone having raised $13 billion in the second half of 2023, based upon the largest energy transition private credit fund ever raised (the $7.1 billion Blackstone Green Private Credit Fund III, in combination with the $6.0 billion Brookfield Infrastructure Debt Fund III). Similarly, private debt allocations are also bringing strong growth to funds with a mezzanine debt strategy. In our view, this is a funding mechanism that could potentially fit within project financing structures.

Alternative asset managers may see richer returns for a given level of risk in project finance. The infrastructure projects themselves generally may have higher returns because they are more highly levered than corporates at the same rating level--but, are generally protected by more extensive covenants that restrict the nature of the enterprise, limit additional debt, and govern strictly cash flows. Project finance documentation isn't generally subject to the so-called loopholes and trapdoors that permeate the broadly syndicated corporate market. Additionally, the diversity of infrastructure projects allows managers to align investments with their strategies and bring subject matter expertise into their investment management process.

Alongside the appealing prospect of alpha, alternative asset managers are flocking to project finance for the investment horizon. The life insurers (particularly annuity providers) that play an increasingly central role as investors in several of alternative asset managers' lending platforms have long-term liabilities and asset-liabilities-matching policies. These require investment in long-duration assets that are inflation-resistant and mitigate credit erosion over time. Infrastructure assets that are project financed typically feature these characteristics. Notably, roads, hospitals, energy transition, and even data centers may have value for decades. And either through contractual mechanisms or the ability to raise prices, they tend to be inflation-resistant. (See "Inflation And High Yields: N.A. Transport Infra: Essentiality Outweighs Affordability As Counterparty Risks Loom", Nov. 29, 2022).

For the borrower, private funding is more easily fungible for commercial bank funding than bond markets. In our reviews of both public and private project finance transactions, we have observed faster private placement issuances among the rated infrastructure entities than among public bond transactions. Because fewer parties are involved, private funding also offers more certainty of execution, speed, flexibility, pricing, and terms than the bond market. These hallmarks of direct origination through private funding benefit project finance borrowers. At the same time, direct origination through private credit can provide tailored maturities, covenants, and terms to a specific situation. This is critical, considering how infrastructure projects can have widely varying needs over their useful economic life.

Prospect Of Resilience And Diversification Provides A Further Draw

Project finance also offers the prospect of credit resilience and diversification versus the highly leveraged small-to mid-market corporate borrowers that traditionally comprise the corporate direct lending market. This credit resilience in the project finance sector is reflected in the performance of our current ratings and default and performance studies.

Nearly 74% of the project finance entities we rate are investment grade ('BBB-' or higher), and more than three quarters of these ratings have stable outlooks. This reflects stricter structural covenant and security packages, along with a concentration in the largely resilient essential infrastructure space.

Additionally, our default and ratings performance studies reflect show this reliance lasts through credit cycles. Infrastructure has maintained a two-year average cumulative default rate of 0.88% between 1981 and 2023--demonstrably lower than the global nonfinancial corporates rate of 3.78%. As part of the infrastructure asset class, project finance has a corresponding default rate of 1.31%. Further analysis of historical default cycles shows that infrastructure may offer some diversification from nonfinancial corporate credit. For instance, the infrastructure sector was relatively unscathed during the 2008-2009 global financial crisis--during which its peak default rate remained under 1%, compared with 6% for nonfinancial corporates. Notable similarities of aligned periods of credit stress between infrastructure and nonfinancial corporates were prevalent in the 2001 recession, while differences can be seen in other periods, including the 2005 power market crisis in the U.S. (see "2023 Annual Infrastructure Default And Rating Transition Study", published Sept. 11, 2024).

Chart 4

However, this resilience in project finance and infrastructure debt is based on our historical observations of the rated debt instruments, and the project finance entities that we currently rate are largely investment grade. Over time, new financings may be structured more aggressively and with higher leverage. New types of funding in the market may bring new deal structures with weaker guarantees, covenants, or collateral than those in the past. Some new private market investors may be willing to accept higher levels of these risks, and this could mark a shift from traditional public market investors in this asset class that typically look for predictable cash flows and relative credit quality.

A Changing Market, Not Without Risks

The prescient challenge remains tied to the rapidity with which the landscape of project finance is changing. As demand for infrastructure funding appears promised and poised to increase, private markets appear at the ready to take on the complexity of these assets—where new and innovative approaches can introduce new considerations for the risk metrics of a deal.

The expansion of alternative asset managers into the project finance funding market may offer a unique source of funding and provide opportunities for new participants to develop specific expertise for their areas of interest. This carries potential benefits for both lenders and borrowers. But investors' alpha may vary with the asymmetry between the systemic and situational transparency available in project finance.

Because an investor with specific knowledge of the nuances of a project can more efficiently and flexibly provide credit to the borrower, private markets' transparency is situational--where access to nuanced knowledge of deal flow, terms, and performance is unlike the systemic transparency of public markets' clear and concise benchmarks that can alleviate risk. The convergence of public and private funding sources for infrastructure projects will be key to watch as capital availability and significant competition for funding essential assets increases.

While private credit project finance offers the potential to offer more capital, better matched to borrowers' evolving needs. But this offer may not be without risks.