Why Eastern Europe Needs Private Capital to Bridge Infrastructure Gap

Emerging Markets, May 2015

If the Central and Eastern European countries’ vast infrastructure gap is ever to be bridged, then private capital will need to be part of the solution. The picture today is one of scattered progress and broader inertia.

The European Investment Bank has put the infrastructure gap for the CEE region at almost Eu500 billion, a figure that obviously cannot be met purely through public spending, particularly with many nations still attempting fiscal consolidation. “There definitely continues to be a need for infrastructure spending, and if we look down the line five years from now, that need is just going to be increasing,” says Claire Coustar, who runs a team arranging financing for infrastructure in CEE at Deutsche Bank.

Any hope of a vibrant institutional market for project financing in the region is distant, though, with a few exceptions. “It’s overwhelmingly still a bank market, particularly in the Balkans and Turkey,” says Coustar. “In some Eastern European countries, like Slovakia, the Czech Republic and Poland, you are seeing more institutional money coming in as people become more comfortable with sovereign risk in those countries.”

Whenever bank liquidity is high, it tends to impede the development of capital market involvement. “There is a large amount of liquidity around from banks who are very interested in financing long-term infrastructure,” says Markus Kriegler, head of corporate finance at Erste Group Bank in Vienna. “At the moment banks are both active and aggressive, although the picture can change quite considerably.”

There are positive examples of using the capital markets. The R1 Expressway refinancing in Slovakia is an example: a Eu1.242 billion bond issue of 25.8 year bonds, with an average bond life of approximately 15.5 years. This deal, completed at the end of 2013 and the biggest project bond placement in the region that year, was the first PPP refinancing in Slovakia and followed lengthy negotiations between the public and private sectors over allocation of risk and remuneration. The bond took out Eu1 billion of loans that had been signed in August 2009 among a club of 13 banks, including the EBRD and KfW, and in doing so significantly reduced the debt costs.

“Slovakian Expressway showed that, for the right structure that ticks all the right boxes – strong investment grade, funded, bond format, fixed rate and long-dated – these transactions attract institutional money,” says Coustar. Institutional capital tends not to want floating rate debt or long availability loans in transactions like these, preferring liquid bond instruments with a fixed rate that they can trade in and out of.

“Institutional money tends to be more interested once you’ve finished the construction phase of a project,” she adds. “Naturally institutional money tends to want to be funded on day one: it doesn’t like long availability periods, as it’s not very capital efficient. So once you get past the construction phase on some projects, you will probably start seeing refinancings with institutional money.”

Alina Woloszyn, partner at KPMG in Warsaw, agrees. “With project bonds, the question is about taking construction risk,” she says. “Investors are not used to taking this risk: bonds like this are very limited, and are usually private placements.”

Indeed, the problem is, that Slovakia deal is still very much an outlier. “Other than the example you mention, there has been no major project bond used for financing infrastructure in the region,” says Kriegler, whose Erste Group was an investor in the bond.

Still, it’s a useful template at least. “I would expect that for other projects, bonds will now be seriously considered as one element of the financing.” Indeed, the next one might be another Slovakian deal, the D4-R7 ring road around Bratislava, another PPP with PricewaterhouseCoopers as an advisor. “That will be a major project with a volume way above a billion euros,” Kriegler says.

Two things in particular can help bring about deals like this: government policy making it attractive for international institutional investment to come in, and the availability of deep local currency pools of capital.

“Historically, the biggest hold-up in terms of going ahead with infrastructure is getting governments to put the programmes in place,” says Coustar. She does she positive examples – notably Turkey, introducing things such as assumption agreements and quasi-governments support for privately funded infrastructure projects, but says there needs to be more. “I would like to see more proactivity on the past of some emerging market governments in terms of their willingness to do more infrastructure through the private sector,” she says. “A lot of the time there is still a preference to use quasi-sovereign entities to lead the fund raising. If you want the development of private sector funds, you need the first step, which is the government being willing to award concessions to the private sector and to support transactions” through availability payment, debt assumption or similar instruments.

If things aren’t being put in place in individual nations, then clearly multilaterals may have to play a role. The European Investment Bank in particular has sought to develop enhancements to help deals get along, as part of the broader Juncker Plan, the Eu315 billion initiative unveiled by European Commission president Jean-Claude Juncker last year, which aims to use Eu21 billion of EU funds (Eu 5 billion of it through the EIB) to raise private cash in the capital markets in order to get unfunded infrastructure projects moving. “Everyone is now looking closely at the instruments we might get under the Juncker initiative, which would be very helpful,” says Kriegler. “I think the sort of leverage they want to achieve can only be done if there is an instrument that is subordinated and takes the first loss in a project structure,” he adds. “That will enable bonds to achieve a better rating, which would make it effective for long-term investing. If IFIs want to have a bigger role here, it needs to be in terms of creating these subordinated instruments to put a lawyer between equity and senior debt.”

If not the ECB, then the role of other multilaterals, export credit agencies and so forth is essential, particularly on greenfield projects where there’s no government or quasi-government support such as availability payments or debt assumption agreements.

On the second point – local institutional capital – the picture is mixed. “In a country like Poland, local funding could play a role,” says Kriegler. “There is a deep market there, with institutional investors like insurance companies who have become quite active in the credit market. There have been examples – not in infrastructure, but in buyouts – where you can finance amounts equivalent to billions of euros in zlotys.” He says the same could be true of the Czech Republic, were the country to push more for the development of PPPs. Beyond that, if Israel is considered part of the region, then that’s certainly an example; “we even structured one deal there [the Ashalim project in the Negev desert] partly in local currency even though the revenues were in dollars, specifically to tap into local currency demand from local Israeli funds,” says Coustar. But that’s about it. “Those deals work in local currency markets where interest rates are not too high. So in Turkey it would be very difficult unless you had a matching profile of local currency revenues and debt, which is rarely the case with these transactions.”

There is another method of using the capital markets to fund infrastructure, but it is indirect, using city or municipal bonds to fund a budget which can then be used for infrastructure.  “City bonds usually fund various infrastructure purposes and they are not usually dedicated to specific capex,” says Alina Woloszyn at KPMG in Warsaw.

This tends to be the norm in her home market. “Poland has the most mature and liquid capital markets in the region, but despite that, infrastructure financing here is mainly done through EU funds and public budgets.”

What can be done to change that? “The key  to success would be promotion of these structures among public sector decision-makers, a public procurement process, and simplifying the PPP regulatory framework,” she says.

“But I see strong interest in it: people are always coming back and asking about infrastructure. The question is always about who is taking the market risk. There is never any shortage of projects, but the question is the number of projects that are bankable, and at a stage where they can be financed.”

Kriegler makes a similar point. “There is a need to build track records in these kinds of projects, so investors can see that there have been successful projects in the past,” he says. “The more that have been successful, the easier it will be to raise funds.”

As for the type of deal that works, roads are the natural fit: stable, predictable long-term cashflows, and a clear point when construction risk disappears and it becomes easier for investors to assess risk and reward. Others say airports and health – Croatia, for example, has tendered hospital development on a PPP basis – although energy is an increasingly complex area for investors, particularly given uncertainties around oil and other commodity prices and their impact on the economic viability of projects. Kriegler also points to renewable energy projects, which he thinks are well suited to private investment, and indeed has so far been almost entirely financed on that basis to date.

But if deals do come along successfully, there is a hope that the demonstration effect can build a practical, vibrant market. “With those steps in place, you can get enough investors looking at transactions to move to stage two, which is more traditional non-recourse infrastructure financing, like in western Europe and the US,” says Coustar. “That’s the long term goal.”