Summer 2014

PROJECT BONDS: Is it time to bet on infrastructure debt?

FactoryWill Middle East infrastructure debt finally come of age as an asset class? Progress won’t be fast, but it is coming. George Mitton reports. There was much excitement about the successful issuance last year of $825 million of project bonds relating to the Shuweihat 2 project in Abu Dhabi, a power and desalination plant owned by Ruwais Power. After a brief flurry of Middle East project bond issues in 2006-07, from the likes of RasGas and the Dolphin pipeline, the market had gone cold.  Yet here was a new issuance of exactly the kind of bonds investors want – long maturity, with stable and fairly predictable returns, of a project that is backed by the Abu Dhabi government. There was so much optimism around the deal that Stephen Kersley, chief financial officer of Taqa, the largest shareholder in the project, declared the scheme was “the first step in building an active and liquid project bond market in the region”. Is Shuweihat 2 an inflection point, to be followed by a rush of new project bonds issuances? Experts on the region say, yes, more is coming, but it is wise to be cautious. GROWTH MARKET
On the positive side, market conditions have never been more supportive of infrastructure debt. Commercial banks, which provide most of the financing for Middle East infrastructure, are less keen to lend than in the past, due partly to bank solvency rules, such as Basel III, which require them to keep more of their assets on their balance sheets.  The example from other regions is encouraging. In Europe, Allianz Global Investors said in March that its infrastructure debt investments now exceed €2 billion ($2.7 billion).  These investments are ideal for institutional investors with long-duration liabilities, it says, and are an appropriate way to gain higher returns than low-yielding government bonds will allow. The Middle East certainly has plenty of large infrastructure projects to choose from. The Sadara petrochemicals complex being built in Jubail in Saudi Arabia by Saudi Aramco and Dow Chemical, has been valued at $20 billion. Dubai is expected to spend at least $7 billion on build-out in advance of the Expo 2020. Meanwhile, Qatar continues to invest huge sums in stadiums and a metro system prior to the 2022 World Cup. RECYCLING
For project owners, project bonds have a number of advantages. The bonds are typically fixed rate, not floating like most bank loans.  They are a good way to get support from stable, long-term investors; in the Shuweihat 2 issuance, 56% of buyers were insurance companies, according to the law firm Latham & Watkins, which advised on the deal Perhaps most appealingly, project bonds offer the opportunity for developers to free up capital that is tied up in existing projects so that they could invest in new developments. This last quality is what Gravis Capital Partners, a London-based asset manager, hopes to capitalise on with its new GCP Sovereign Infrastructure Debt fund, which invests in subordinated debt issued by multinational power companies building infrastructure projects in the GCC. By buying bespoke subordinated bonds relating to power projects, the fund allows power companies the opportunity to free up capital for further investment, while giving investors in the UK-listed fund – both institutional and retail – a stable income stream which the firm hopes will return at least 7% a year. “You’ve got this enormous pipeline but each project requires the power companies to invest a hefty amount of equity,” comments Rollo Wright, partner, Gravis Capital Partners. “They don’t have a bottomless well of equity to invest, so recycling some of the money will allow them to build and develop,” Wright adds. Will the GCP fund be part of a new wave of infrastructure debt funds focused on the Middle East? The signs are good, though there are a still a number of reasons to be cautious. OBSTACLES
Firstly, there are regulatory barriers. Saudi Arabia, the largest market in the GCC by far, offers an example. In Saudi Arabia, there is a desire to structure much project debt financing as Islamic bonds, or sukuk.  Yet, the Saudi regulator, the Capital Market Authority (CMA), does not allow investment funds to invest in sukuk unless they obtain a specific waiver. This restriction explains why investment funds have accounted for relatively little investment in sukuk, which has mainly gone to banks and government agencies. “At the moment there is not enough coming through in terms of funds because of these restrictions,” says Harj Rai, partner at Latham & Watkins in Dubai. “To develop the market in Saudi, that’s something that needs to change in future.” Rai says progress on the regulatory side may be slow, however. A pipeline of large initial public offerings in Saudi Arabia means the CMA’s attention may be focused on equity and capital markets regulation for much of this year.  That said, there are larger trends that could hasten change. One is the aforementioned effect of Basel requirements on bank solvency, the other is a potential fall in the oil price, which would see government agencies less flush with liquidity and less willing to invest in sukuk.  These two trends could create a gap in demand for sukuk, and perhaps nudge the CMA into loosening the restrictions that prevent investment funds from filling that gap. BE CAUTIOUS
Another drag on the growth of an infrastructure debt market in the Middle East is a shortage of project bonds to invest in.  Mark Wells, who works in the specialised product group, fixed income, for BNP Paribas Corporate and Investment Banking, has examined many potential project bond issuances and says that, although Shuweihat 2 is not a one-off, he doesn’t expect a glut of issuances in the near future.  Instead, he predicts one or two project bond issues in the next 12 to 18 months. The reason is that the projects in the region that could potentially issue bonds are complex. Who are the existing financiers and what consents do they need to give before a bond is issued? Is it possible to issue bonds at a competitive rate, given that many projects have bank financing that was arranged prior to 2007 at attractive rates? Another issue concerns swaps. Because banks lend floating, but projects want fixed-rate money, project companies have swaps in place. To issue fixed-rate bonds could leave them over-hedged. “These factors mean that when you look into the details, you get a slower pipeline of projects bonds than you’d expect,” says Wells. “Does it mean there aren’t opportunities? No. But you need to be more cautious.” Beyond these concerns is a question about what kind of bonds investors want to buy. Some of the largest projects, such as the Qatar World Cup build-out and the Dubai Expo preparations, may not appeal to institutional investors, which often prefer to stay out of what they consider to be risky real estate plays. It may transpire that infrastructure investors are quite picky about which sectors they want exposure to. These complications explain why there hasn’t been as much issuance of infrastructure debt as might be expected in a region that is building so much. They also help to explain why funds that invest in infrastructure equity have been relatively few in number. MENA Infrastructure, a Dubai-based asset manager that oversees $300 million of infrastructure assets, is the exception and not the rule. Clearly there are obstacles to be overcome before infrastructure debt becomes a deep and feasible investment theme in the Middle East, yet it seems gradual progress is being made. ©2014 funds global mena

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