Leveraging Insurance & Capital Markets solutions to credit enhance project finance and infrastructure transactions – Q1/22
Corporate finance is the primary source of financing for private infrastructure. For example, private investment in regulated enterprises such as utilities has a lengthy track record, often manifesting itself on these corporations’ financial sheets.
The same holds true for developers in other areas, including ports, oil & gas, waste and, historically, the Energy sector. Publicly traded companies hold a significant portion of infrastructure assets, offer infrastructure services, and invest in infrastructure initiatives. They vary from small organisations to multinationals.
Recently, because of tightening fiscal restrictions, infrastructure funding has increasingly taken the form of project finance. This method has now evolved into the financial solution for infrastructure that involves public bodies acting as regulators or counterparty. Project financing has been an increasingly common method of attracting private money, particularly investment in projects with a high degree of specialisation, a low re-deployable value, and high capital intensity.
Market developments have resulted in the establishment of co-investment platforms with the purpose of leveraging institutional investors’ funds in project financing. The primary motivation for developing these mechanisms was the recognition that while not all investors possess the resources and expertise necessary to make direct infrastructure investments, some have developed significant scale and market presence, as well as the necessary expertise to conduct due diligence on infrastructure assets.
These co-investment platforms aggregate investor cash for direct participation in infrastructure projects, obviating the need for middlemen such as investment managers or banks. This trend is bolstered by huge funds seeking to lower the cost of infrastructure investment and to better connect their internal governance and portfolio management frameworks with direct infrastructure investments.
Non-payment insurance plans (NPI) supplied by diversified, multi-line insurance firms give project finance lenders a credible source of investment-grade, unfunded risk capacity and protection. Credit insurers are designed to safeguard banks by insuring against payment failures on short, medium, and long-term trade and non-trade related loans to developed and developing market borrowers. Marsh for example, estimates that credit insurers paid around USD2 billion in claims to banks in the aftermath of the financial crisis in connection with insured borrower defaults between 2008 and 2010, and many hundreds of millions in the ensuing years.
Infrastructure financing gaps
Recent capital market crises have prompted banks to rethink their resource allocation strategies. Not least, banks understand that financing long-term debt, such as that associated with infrastructure projects, is more challenging than financing short-term debt. While capital has received much attention in recent years, liquidity is even more critical — as shown by the fact that Lehman Brothers’ 11% capital-to-asset ratio was inadequate to prevent the business from failing in September 2008. The investment banking strategy of ‘taking short-term debt, repackaging it as long-term debt, and selling it on’ has also been highlighted as a defective model that fails to function in an illiquid market.
While banks continue to invest, some projects seem to be less appealing than in the past. As a consequence, a possible financing vacuum may develop as new infrastructure projects materialise, but existing bank investors are unwilling – or unable – to finance them to the same level. This may not be true for all projects across all institutions, but new initiatives are being scrutinised more closely — all the more so in light of the rising cost of financing. ‘Focusing on the cost of debt does not suggest that there is a gap; rather, it indicates that it may be less economically viable to finance projects at that cost, but funding may still be accessible,’ a senior industry figure explains. So, is there a finance gap in actuality, and if so, how may it be closed?
A significant cause for the sluggish adoption of infrastructure project bonds is a lack of understanding (among governments and project sponsors) about the viability of bond financing in comparison to the “tried and true” path of bank debt, multilateral financing, and capital contributions. Infrastructure bonds have significant potential to spread outside the countries in which they are now utilised, although each kind of financing is still relatively new and is highly dependent on market conditions in particular markets.
Another long-standing hurdle, TBE construction risk is increasingly being managed by targeted credit upgrades or (in certain situations) by smart investors who believe the additional return is a reasonable value in comparison to the risk assumed. This is especially true for private placements, although public bond investors are increasingly ready to assume construction risk. Investors would be wise to carefully assess the risk-reward profile in light of real recovery rates and available credit mitigation. Additionally, construction risk may not be entirely novel for investors who are already indirectly exposed to it through the corporate bonds of (say) corporations undertaking large capital projects.
There is no one-size-fits-all formula for project bonds, and local circumstances will always differ. Numerous financing alternatives vie for investor and procurer attention, each with unique perks and drawbacks. While the precise transaction structure for each market is likely to evolve, there is a case to be argued that infrastructure financing will gradually shift away from bank debt and toward institutional investors. While this shift occurs, both governments and project sponsors would benefit from a better understanding of the conditions necessary for the establishment of such a market.
Collaborating with the Insurance Markets
Along with offering impartial advice and assistance on the complete spectrum of traditional project and operational insurances, Matrix provides access to a variety of specialised, tailored solutions that add value to financings and investments. Two of these bespoke products are Non-Payment Insurance (NPI) and Residual Value Insurance (RVI).
Conversely, there are organisations such as insurance companies and pension funds that are interested in making long-term investments. In an ideal world, insurance companies and pension funds would provide the majority of infrastructure finance, since their demands match those of the infrastructure companies. Insurers and pension funds, on the other hand, are often unable to engage directly in infrastructure projects. This is because such investments are potentially high risk, and since these institutions manage a large amount of public money, they are compelled by law to exercise caution when making investments.
Due to the insurance market’s independence from the business cycle of project finance lenders, it provides a mechanism for banks to manage long-term project financing risks, including pre-completion construction risk. Additionally, by assisting the insured lender in increasing the amount of its ticket, non-payment insurance might generate upfront fee revenue.
Owing to the fact that the insurance functions in the background (due to the policy’s secrecy provisions), the presence of such coverage is often unknown to borrowers, sponsors, and other parties.
Depending on the form of the insurance and the extent of defaults covered, NPI may offer coverage for a single obligation or, similar to synthetic securitisations, for a portfolio of obligations.
While NPI has been used to mitigate credit risk on project finance transactions for some time, it was initially created in the context of trade finance to enhance international commerce by providing protection against trade receivables default and political risk insurance. While trade credit insurance is a sizable and vibrant business, the range of products falling under the NPI umbrella has expanded significantly, with more specialised and industry-specific kinds of protection being offered.
One such example is Residual Value Insurance where Matrix is at the forefront of leading the sector toward a much broader and deeper functionality. By using the underlying concept of RVI and applying it to a range of different asset types and coverage structures, we can assist companies in raising capital more efficiently and managing their asset value risks in new ways. RVI can also offer benefits related to accounting treatment, capital optimisation and cashflow improvement.
When used creatively, RVI can ‘harden’ asset values to make them suitable for use as collateral on debt or highly-structured financings when lenders may otherwise be unwilling to loan at a reasonable Loan-to-value ratio against those assets. It can also higher support LTV levels than uninsured assets, closing the gap in leveraged capital stacks.
A traditional example of RVI can be found in Shipping, RVI protects the owner of a vessel from the downside. At the policy’s expiration, if the market value of the ship’s selling price is less than the insured sum, the insurer will make up the difference or acquire the ship for the insured amount. The primary advantage of obtaining RVI is that the shipowner’s risk of vessel value loss may be passed to the insurer. This effectively sets a ceiling on the ship’s future worth.
Typically, the owner and insurance company agree that the vessel must be structurally sound and in excellent condition as RVI does not cover costs incurred as a result of vessel damage, only appropriate wear and tear is permitted.
Matrix: Solving the Financing Dilemma
Our highly skilled, specialised international development and construction team arranges and coordinates large-scale building and operation programmes across the world. Our team of experts represent all key stakeholders, including project owners and sponsors, contractors, special purpose companies, banks, engineers, governments, and public authorities, by developing risk allocation and marketing strategies, liaising with project lenders, designing policy wordings, placing the agreed programme, and managing ongoing servicing through development and operation.
We provide tailored insurance coverage for contractors and owner-controlled projects in a variety of sectors, including mining, energy, ports & terminals, electricity, renewable energy, and transportation infrastructure.
Clients benefit from a completely integrated and effective risk mitigation plan coordinated with local brokers and insurers as well as worldwide insurance markets.
There are several policies available, including those covering environmental risks, start-up delays, pre-handover coverage (seamless transition from construction to operation), output performance coverage, and terrorism/political risk.
” Our leading team represent all key stakeholders, including project owners and sponsors, contractors, special purpose companies, banks, engineers, governments, and public authorities, by creating risk allocation and marketing strategies, liaising with project lenders, designing policy wordings, placing the agreed programme, and managing ongoing servicing through development and operation. “
Contact Brad McGill, Managing Director Capital Markets
T: +44 (0)203 457 0916
M: +44 (1)205 835 2875