Written By: William M. Fitzgerald
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Written: January 2013
Promoters of infrastructure funds argue that investments in infrastructure projects offer less risk to investors because they provide necessary services to local and national economies. Consistent demand to make use of infrastructure projects makes for stable cash flows during long investment horizons, a quality that is unique to the set of opportunities that investors consider when seeking returns on their capital. To support this assumption, promoters often point to the experience of the municipal bond market in the United States, which is the broadest and deepest capital market that supports infrastructure financing. Over the course of decades, the default rates of U.S. municipal bonds has been extraordinarily low, giving investors a sense of comfort that their capital is not be heavily exposed to credit risk.
My experience in the municipal bond market has led me to conclude that the above argument is a fair one if placed in the appropriate context. Defaults or restructurings of infrastructure projects are more prevalent than investors realize but they receive less attention by those who track and report on the progress of investor capital. During a time like the present in which interest rates are low and credit spreads narrow, investors gravitate toward higher yielding investment opportunities and they struggle to detect when a yield level signifies an elevated danger of loss of capital. In the infrastructure debt market, such projects have several characteristics that I will highlight.
While at Nuveen Investments, I directed a study of the bond defaults and restructurings that we experienced in the bond funds that we managed. Our study reviewed our investment experience between 2001 and 2003, a period during which companies like Enron, WorldCom and United Airlines entered bankruptcy and Arthur Anderson dissolved. Preceding this period was a six year span in which interest rates declined, the equity market appreciated significantly, investors were stretching for yield and borrowers were levering balance sheets. A credit crisis commenced when the stock market crashed and corporate bond default rates eventually rose to a peaked of 15% in 2002. With approximately $35 billion in infrastructure debt in its various funds, Nuveen had a unique population of infrastructure projects that we could examine to understand why some infrastructure projects failed to cover the costs of financing. At that time, we had invested in over 2000 infrastructure project bonds that were rated BBB or lower and 200 that were not rated by either Moody’s or Standard & Poor’s. The results of the study yielded the below conclusions.
Infrastructure projects that fail to meet their financing obligations fit into six categories:
- Scale. Infrastructure projects that are sized to meet the demand that one can forecast in the near future are usually able to support the debt that the sponsors use to finance them. Projects that are sized for demand that the sponsors expect to develop during a longer time horizon are more likely to default. The culprit is often the “demand study” that forecasts the demand for the project well into the future. The variables that determine usage of infrastructure are usually highly uncertain and the forecasts notoriously inaccurate beyond five years.
- Technology. Infrastructure projects that incorporate “state-of-the-art” technologies involve higher risks than those that use proven technologies. Technology risk applies as well to technologies that are proven at a small scale and are then incorporated at larger scale. Applying technology to increasing scale can exponentially increase the number of things that can go wrong in an implementation phase. For example, when the City of Denver planned the Denver International Airport to replace Stapleton Airport, it planned to install an automated baggage handling system to increase efficiency. The baggage system had been successfully tested at a smaller scale but when the airport commenced operation, the large number of bags and the increased number of on-ramp and off-ramp points caused congestion similar to what one experiences at highway interchanges during rush hour. The City decided to scrap the automated system to ensure a successful opening.
- Economic Development. At the top of the policy agenda for any leader of government is a program to grow the economy and create new employment opportunities. Often such programs seek to create an environment that new employers will find attractive, which includes new infrastructure such as business parks, water systems, sewer systems, roads, convention centers and local airports. These projects are planned not to meet any currently existing demand but to meet demand that the government hopes to attract after such projects are installed. When financed with debt, such projects involve a significant transfer of risk from the sponsor of the economic development agenda to the investor.
- Commercial Risk. When infrastructure projects are planned by local governments, it is common to find that the users are heavily concentrated in a single industry or a small number of companies. When financed with debt, the investors assume undiversified credit risk that may not be apparent at first glance. While infrastructure projects appear static and have very long lives, the companies that use them can experience dramatic change in their industry structures, capital structures and organizational leadership within the time frame of just s few years. In many cases, local governments choose not to expose taxpayers to the risk that a corporation will fail to comply with contractual payments and they will require that the user provide guarantees directly with the creditor. For example, many of the airport terminals in the United States that serve a single airline are financed by bonds that are secured by leases to these airlines. In terms of contract law, this means that a specific airline and not the local government is responsible for making payments on the debt and that the investor is actually taking corporate credit risk in the airline.
- Real Estate Risk. Real estate developers are good at many things. One involves using other people’s money for their own purposes. Another is to transfer risk from themselves to other parties, particularly those who provide them with capital. Those who develop real estate projects are keen on infrastructure because it enhances the potential value of a real estate project and allows the developer to create a narrative of the future of the development that can become very compelling to investors. However, the infrastructure project only produces cash flow if the real estate project proves successful. Therefore, the fortunes of the infrastructure project take on the risk dimensions of the real estate project.
- Excess Leverage. Like real estate developers, investment bankers are good at many things, chief among them is using other people’s money. To an investment banker, a stable stream of cash flows from an infrastructure project represents an opportunity to engineer a financing transaction that takes capital from one party and transfers it to another party. Rather than solve for the amount of debt that represents a responsible capital structure, the investment banker solves for the size of debt for which the interest payments fit under the expected revenues. This equation leads to high debt on infrastructure projects. Examples include countless toll roads in Australia, Europe and the United States where a modest decline in user demand causes payment defaults on debt.
Two Final Notes
First, the default studies that Moody’s, Standard and Poor’s and Fitch publish focus on categories of bonds based on their rating and sector definitions. These categories fail to adequately describe the real source of risk to investors in infrastructure. It is important to peer through these categories and identify the actual risks that investors take in committing capital to projects. While generally true that default rates rise as credit ratings decline and that they are higher in certain sectors than others, it is important to understand that these rating and sector categories may describe how bonds fit into the market but they do not describe the risk factors that investors assume when committing capital.
Second, defaults and restructurings in infrastructure projects generally occur during one of two critical time periods during the life-cycle of a project. The first critical period is within two years of the financing. During this initial phase, the sponsor completes construction and commences operation. At this point, all parties will see if the project is appropriately scaled for demand and whether all components of the project operate as expected. The second critical period is typically five to seven years after the project commences. Up to that point, projects typically experience unforeseen challenges and the operator either proves its ability to manage them successfully or seeks to revise the capital structures of the projects to fit the cash flows that the projects generate.