A necessary ingredient
This blog, the third in our direct procurement series, focuses on another fundamentally important aspect of the success (or otherwise) of the direct procurement model – the appetite of debt providers to participate in the new regime. Debt forms an integral part of the capital structure and without it there is no value gain for equity in most investment propositions. Direct procurement may never get off the ground if equity and debt considerations cannot be reconciled.
Why it’s attractive
It is self-evident that regulators such as Ofgem or Ofwat would want direct procurement to succeed (and are keen for participants in their regulated industries to adopt it) in view of the potential cost savings and the kick-starting of innovation that can be achieved.
It’s also not difficult to see why equity investors are interested.
On a macro level, infrastructure has seen a surge of interest in the last ten years, particularly as the long-term (and often revenue stable) nature of infrastructure investments differentiates it from more volatile options.
There is also potential for operators to “cherry-pick” overall structures (such as the OFTO “late” model where investment was made after the design and construction phase) and flexibility around potential corporate structures (either directly licensed or via contractual arrangements).
Question: what’s in it for me?
The key question is what will the banks, debt and pension funds, insurance companies and other financial institutions think about direct procurement (and their appetite and ability to finance projects under its umbrella)?
In the main, debt providers do not create their products in a vacuum and tend to work to fill a hole that equity approaches them to fill. They do not tend to be pioneers themselves, but are generally very forthcoming and keen to work with equity to build something that works for everyone once there is something on the table that they can take to credit or investment committees.
One of the key challenges that equity investors will face in putting structures together will be convincing debt providers that directly procured projects are a better option in which to put their funds to work as compared to other current, more established routes.
Answer: quite a lot, actually
It may be trite to say it, but it’s true: the same thing that attracts equity providers to a directly procured project should also attract debt providers.
Some of the factors that may make direct procurement an attractive proposition for debt providers include:
- Potentially less risk as compared to other products they could finance. An increase in potential debt providers and the resulting increased competition is likely to benefit equity, the operator and, ultimately, the customer. This will likely be most keenly felt in the pricing of debt offered but also in terms.
- The innovation itself. It is no secret that the current funding balance in the debt markets is significantly tilted towards supply rather than demand, and the most pioneering and forward thinking debt providers are always on the lookout for new products to lead on and to create greater value and profit for their shareholders. There are benefits, both in terms of price and reputation, in being the first into a new product.
- The shape and scope of debt providers involved with today’s infrastructure market, which has changed significantly since the days of PPP/PFI. Potential debt investors range widely from private equity to sovereign wealth, pension funds, insurance companies and property funds, alternative capital providers and the stalwarts of project financing in times past, the banks.
- The potential ability to tap into the UK Guarantees Scheme. This scheme, established in 2012 to provide government support for key UK infrastructure projects, is designed to unblock certain projects that might otherwise struggle to procure solid debt financing. It can provide the necessary credit enhancement boost to ensure that certain projects (similar to the Thames Tideway Tunnel, although it was not itself backed by the Scheme) reach that all important investment grade rating, allowing best access to capital markets funding. If equity investors are able to creatively combine direct procurement approaches with UK Guarantees Scheme access, debt investors overall are much more likely to be comfortable about the product. It’s certainly another quiver in an equity investor’s bow.
Future model for direct procurement
The Thames Tideway Tunnel may be a unique project (both in scope and investment size), but also in terms of the different participants in the consortium providing different skills. It is entirely possible that significant elements of its structure may form the foundation of potential models for direct procurement in the future, even if not replicated exactly in other projects.
It would not be surprising for a directly procured project to see a debt capital structure containing a combination of the following, all working in partnership together:
- Shorter-term private equity focused debt investors covering the design and build phase (taking a greater return because of the higher-risk).
- Longer-term debt investors providing support to the operations phase.
- Perhaps yet other providers (such as banks) covering ongoing capital requirements or more operational matters.
But there will still be headwinds
Nonetheless, equity investors will face a number of challenges in bringing debt providers into the fold for directly procured projects, in particular:
- Simpler and more tried and tested alternatives that debt investors feel more comfortable with, even with the chance of less attractive returns.
- Concerns about how involved (or otherwise) the relevant regulators are in terms of pushing direct procurement as a model; at the moment, they range from very involved (Ofgem re the OFTOs) to merely guiding (Ofwat or Network Rail). Without direction and consistency from the regulators confidence in the product may be limited.
- Concerns about less successful attempts at direct procurement approaches so far (such as the stalled CATO model for onshore electricity generation).
- The political impact of its adoption given that government wants to foster innovation and lock-in cost savings, but with the inherent danger that market participants may feel dictated to and forced into direct procurement without sufficient flexibility when it comes to implementation.
When equity investors are creative and convinced that something is worthwhile investing in, debt providers will surely follow. If enough equity providers get excited about opportunities (in an otherwise staid market for innovation in infrastructure arrangements) then creativity should follow; and debt providers will help to realise that creativity.
That being said, there is still a long way to go before direct procurement reaches any sort of critical mass. To achieve that, debt providers will have to see more of the positives than be concerned about the negatives.
A version of this expert insight first appeared on the Practical Law Construction blog on March 14, 2018.