‘Use it or lose it’

There is much tension on the eve of the pilot phase launch for the European Investment Bank’s (EIB) project bond initiative. In many ways, this is not unexpected. After all, it’s perfectly normal to experience anxiety as a major event looms. Dread, however, is a slightly more worrying emotion.

But there was definitely a hint of dread among the senior EIB executives Infrastructure Investor spoke with prior to the pilot phase getting underway. Specifically, executives expressed real concern that the initiative might fail to officially launch in 2014 if its test phase proves unsuccessful.

Before going any further, it’s worth remembering what the project bond initiative is all about. After the financial crisis blew up and banks started to deleverage, bank debt for European public-private partnerships (PPPs) declined substantially. 

Into this void stepped the EIB, helping to keep the market alive throughout the difficult years of 2009 and 2010. The latter ended up being a record year for the bank, with the EIB lending close to €3.5 billion to European PPPs.

But as former EIB president Philippe Maystadt told this magazine in the summer of 2011: “What I always explain to governments is that you cannot expect that the EIB will continue to lend more and more and act as a substitute for commercial banks”.

To make sure this wouldn’t happen, the bank embarked on a bold experiment to resurrect capital market investment in infrastructure PPPs, hoping to recapture what was once a thriving, €100 billion market that collapsed unceremoniously in 2008, when most monoline insurers lost their investment grade rating.

So the EIB devised a credit enhancement mechanism – known as the project bond initiative – which will see the bank provide either a fully funded subordinated debt tranche or an unfunded subordinated debt guarantee, which can cover a project’s full life-cycle. The credit enhancement mechanism will target project bonds issued by sponsors to help mitigate construction, operations, performance, and/or traffic risks.

Successful credit enhancement should propel these bonds to A-rated status from the usual, below-investment-grade BBB of your average PPP project. In theory, this will make these bonds considerably more attractive to a plethora of institutional investors across the continent and in the process create a new source of liquidity for European infrastructure.

Momentum: unsteady

Sounds like a great solution – so what’s the problem, I hear you ask? In a nutshell, the project bond initiative has about 18 months to prove itself worthy of more European Union (EU) money, or it will probably not be rolled out in 2014, as originally planned.

“Our nightmare scenario is that public authorities and sponsors don’t do what’s needed [to use the project bond initiative]. If we don’t use it we will lose it and it [the project bond initiative] might not launch in 2014 if the pilot phase doesn’t succeed,” one of the EIB senior sources confided.

The pilot phase, launched in early November, will see the European Commission (EC) reroute €230 million of grant money previously allocated to trans-European transport, energy and broadband projects to be used as “capital at risk” for the project bond initiative. In the EIB’s estimate, the €230 million can help catalyse up to €4.4 billion of deals – a multiplier effect of 19 times.

But EIB executives are right to be worried about whether the pilot phase will make enough of a splash to convince the EC to further open up its purse strings. One reason for that is that the project bond initiative has already lost quite a bit of momentum.

According to EIB vice president Dario Scannapieco, a work group on project bonds was set up as early as 2009. In September 2010, EC President Jose Manuel Barroso dropped the first hints that the Commission and the bank would be looking at officially unveiling the initiative, which eventually transpired in late February 2011. But the much-hoped for announcement immediately deflated expectations with its 2014 official launch date.

No doubt sensing this, former EIB president Maystadt was pushing to test the initiative sooner rather than later. He told Infrastructure Investor:  “Personally, I think that it would be a mistake to wait until 2014 to launch the first [project bond] initiatives. But this is my personal view – I can’t speak for the EC.”

The EC certainly heard him. Still, it’s hard not to interpret the concerns expressed earlier in this piece by the senior EIB executives as evidence that sponsors and procuring authorities might not have the project bond initiative sufficiently in mind to adopt it with any sense of urgency.  

That’s partly because both parties will have to implement changes before the project bond initiative can be used.

Procuring authorities, for example, will have to alter how they structure tenders to accommodate capital market financing, as well as other changes, such as allowing non-committed financing at the best and final offer stage.

Sponsors, for their part, will have to engage a bond arranger in a timely fashion, involve the EIB early in the process, and use credit rating agencies to rate the bonds. They will also have to be involved in the actual marketing of the bonds. 

Also, all of this will have to be done rapidly, as there will be a first evaluation of the project bond pilot phase early next year. As the EIB sources neatly put it: “If there are no projects done till the middle of the next year, then it’s highly likely the project bond initiative will launch in 2014.”

Timing: the best and worst of times

It’s hard not to think about Charles Dickens’ immortal “It was the best of times, it was the worst of times,” from a Tale of Two Cities, when thinking about the timing of the pilot phase. 

Launching in early November 2012, the project bond testing period manages to simultaneously fall in the middle of record institutional investor appetite for infrastructure debt (good timing) and possibly the worst period in recent memory for European PPP deal flow (bad timing). Considering its greenfield bias and focus on trans-European projects, the latter might carry more weight than desired.

According to data from the European PPP Expertise Centre, European PPPs sank to a 10-year low during the first half of 2012, with only €6 billion worth of new-build PPPs reaching financial close. To make matters worse, the two countries that accounted for 76 percent of the market during H1 2012 – France and the UK – are showing an unsteady commitment to the PPP framework.

In the UK, the problem is not recent, with the Coalition government heavily criticising the Private Finance Initiative (PFI), the country’s standardised procurement process for PPPs, and currently working on reforming it. Needless to say, the surrounding uncertainty has significantly impacted the country’s PFI pipeline.

France, which has just concluded a multi-billion euro PPP high-speed rail programme, has also changed government recently. And, as happened in the UK, the new French government is expressing displeasure with former President Nicolas Sarkozy’s procurement method of choice. In a recent report, the government attacked the use of PPPs to refurbish French universities via the ‘Operation Campus’ initiative, vowing to look at other alternatives for these projects.

For the project bond initiative, lauded at a recent Freshfields roundtable as crucial to the future of European greenfield PPPs, the data is not very encouraging. 

The absence of a pipeline is not the initiative’s only obstacle, though: it’s also facing stiff competition from other alternative sources of debt – everything from debt funds to direct lending by institutional investors – that are arguably more nimble than the project bond initiative.

The appeal of the project bond initiative has always been its scale, its “big bazooka” potential. But that scale needs a matching pipeline. And while no one seems to doubt procurement will eventually have to ramp up to meet the approximately €1 trillion of infrastructure the EU requires through 2020, no one quite knows when that will happen.

Tussle in Brussels

But even assuming the pilot phase is a success, the project bond initiative is still facing a considerable hurdle: it has to fight for its corner in the upcoming 2014 to 2020 EU budget. That’s not an easy job, considering how fraught discussions are expected to be for the upcoming budget, with the UK calling for a freeze or cuts to the amount of funding Brussels will receive.

This is a problem because money for the subordinated debt pieces and/or guarantees that will be at the heart of the project bonds initiative will have to flow from the EC to the EIB. According to the senior EIB sources, the money is projected to come from the so-called ‘Connecting Europe Facility’.

The latter was first called for by the EC in October 2011 with the aim of channelling an extra €50 billion to help fund cross-border infrastructure across the EU’s 27 member states. Worryingly, the EIB sources were not able to provide an estimate of how much the project bond initiative will receive from the facility because, well, no one really knows how much money will be set aside for the next EU budget.

All of which leads to an inescapable conclusion: the project bond initiative runs a real chance of arriving stillborn. 

That would be a shame, given its potential. But it would be remiss to ignore how easily it might be felled by a combination of EU bureaucracy, a lack of greenfield pipeline, competition from more agile debt sources, and just sheer bad luck.