Historic infrastructure performance suggests now is the time for increased infrastructure secondaries opportunities in Canada, writes Nigel Brindley, co-founder of investment advisory firm Stratus Infrastructure.
The Canadian public-private partnership (PPP) market is considered to be one of the largest and most mature in the world. The market took off in the mid-2000s and experience from the UK would suggest that the time is ripe for an emerging secondary market in Canada. So where is it?
What is a PPP?
Source: Stratus Infrastructure
The standard public-private partnership model is for contractor-sponsors to bid for, then build and operate greenfield public infrastructure projects. Projects range from road and rail schemes to health, education and housing. These are delivered through special purpose companies (SPCs). The SPCs raise their own finance to fund projects mainly from a combination of debt and equity. To minimise funding costs, the structure is highly geared, typically circa 90 percent and the debt secured on future project cashflows. The contractor-sponsor generally takes no more than 50 percent of the equity tranche to avoid debt being consolidated on its balance sheet (less on larger projects to limit its cash exposure). The remainder of the equity is provided by third party financial investors. The SPC structure ensures that the debt is ‘non-recourse’ and the project risks ring-fenced within the project.
What is the attraction of a secondary PPP market?
Investors are attracted to PPP infrastructure assets by the quality of the public sector client covenant (effectively sovereign obligations), high predictability of future cash flows, low risk of termination and opportunities to enhance value. Critical mass is important to driving scale economies and portfolio efficiencies that extend to management, supply chain, insurance and lifecycle costs, advisory and audit fees and so on, as well as diversifying project risk.
Secondary PPP buyers are specialist infrastructure funds or institutional investors such as pension funds (or amalgamators) and insurance companies who are attracted by the long-term, counter-cyclical, inflation-linked yields characterizsd by PPP assets (part of the attraction being the ability to match liabilities over time).
The history of the secondary PPP market in the UK
Source: Stratus Infrastructure
The procurement of primary/greenfield PPPs took-off in the UK in 1996. Sponsors incur considerable costs in bidding and developing these projects (typically up to 10 percent of a scheme’s capital value) and therefore are keen to recycle equity investments into new projects at an early stage. However, as a general rule, they are prevented contractually from selling equity until project construction is complete and operations have started.
By the operational stage, the construction risks have been overcome and project revenues from the public sector have begun to flow. Consequently, a lower risk premium is required by financial investors creating significant potential profit on sale for sponsors.
Source: HM Treasury project database and ESSU PPP equity database
By the end of 2003 in the UK, some seven years after the emergence of the primary market, 360 deals with a capital cost of £21 billion ($34 billion; €29 billion) had been closed. Typical project gearing is 90 percent resulting in an equity tranche of circa £2.1 billion of which contractor-sponsors typically held up to half.
The potential tradable secondary market size in 2003 was therefore around £1 billion. The number of deals done since 2003 has more than doubled the size of this market despite a marked turndown in primary activity since 2010.
The year 2003 is significant as this was when a number of specialist secondary funds were set up, providing liquidity to sponsor groups seeking to sell equity stakes in operational projects. Up to this time, secondary transactions had been mostly single asset deals and these new funds refocused the market onto portfolio transactions, marking the emergence of a volume secondary market.
The following year, 33 transactions involving 95 projects were completed, the same number as over the previous six years combined. Transaction values continued to accelerate as portfolio sizes increased.
The development of the Canadian PPP/P3 Market
The greenfield PPP (or “P3”) market started in Canada in the mid-1990s but only 15 deals were completed by 2000. Central procurement agencies were formed at both state and federal levels between 1999 and 2006 after which the market accelerated. In 2007, 5 times the number of greenfield P3s were closed than in the previous year. Since 2007, despite the global financial crisis, Canada has consistently closed between 10 and 20 deals per year. The total number of deals to date is about 220 with a capital cost of circa $70bn.
Typically, 20 percent of the capital cost is funded by the government, de-risking private sector debt and thereby reducing lending margins. Generally, private sector equity accounts for 10 percent to 15 percent of the remaining funding.
Due to project size (average capital cost of $300 million as compared to $100 million in early stage deals in UK), contractor-sponsors commonly joint venture to share costs and risks. Typically, their combined share of total equity is limited to 25 percent to reduce cash demands. Financial investors take the rest. Consequently, the tradable equity held by contractor-sponsors in Canada will be around $1.4 billion.
The development of the Canadian market varied considerably from that in the UK in the following ways:
- The UK volume market took off in 1996, 10 years earlier than in Canada
- UK deal volume trended at four times the Canadian rate in its formative years (1999 to 2006)
- Canadian PPP average deal size is 3x that of early stage UK deals
- Contactor-sponsor equity is more fragmented and generally for a smaller percentage share than in UK
So where is the Canadian Secondary PPP/P3 Market?
Source: CCPPP database and InfraDeal transaction database (brownfield)
The UK market suggests that the critical mass of PPP primary deals closed before a secondary market develops at scale is around 300 or £20 billion to £25 billion capital cost.
On this basis, the Canadian primary market, although structured differently is at or about this threshold. So is a secondary market about to break here too?
In order to answer this question, the following factors need to be considered:
Equity share structure
In order to control project risk exposure and exploit value enhancement opportunities, investors prefer controlling interests. However, this is constrained by the fragmented shareholdings and minority interests held by contractor-sponsors. Minority stakes are generally insufficient to exert the changes necessary to realise portfolio benefits. This is different to the UK, where due to smaller deal sizes, typical sponsor equity shares were 50 percent.
Also, within Canadian projects, equity holders tend to be constrained by contractual ‘lock-in’ provisions that prevent potential sale for a period of five years. This will extend the lag between the primary and secondary markets.
In the PPP market in particular, pre-emption clauses typically give existing shareholders the ability to acquire any disposal stake at either “market value” or, preferably for the seller, at the price offered by a third party purchaser.
As existing financial investors in Canadian P3s generally hold majority or controlling stakes, it will be in their interests to exercise this right. Consequently, potential third party acquirers are deterred by the prospect of incurring bid costs for which there may be little prospect of success.
Financial investor stakes
In the mid 1990s, PPP/P3 was an unproven asset class with untested risks. In the UK, financial equity in primary deals was generally held by closed-end specialist funds (typically with 10-year terms). This drove portfolio sales in the second half of the life of these funds creating a further source of secondary market activity.
Globally, the market has evolved as financial investors have become familiar with the risks. Equity stakes are now more commonly held by open-ended or listed funds with no compulsion to sell. This is the case in Canada.
Project bonds v commercial debt funding
Traditional sources of PPP financing collapsed in the global financial crisis. Commercial lending banks withdrew from the market and bond financing stalled when the ‘monoline’ insurers that guaranteed them failed. Consequently, ‘unwrapped’ publicly traded bond financing emerged in Canada in 2010 to fill the funding gap. By 2011, more than half the primary deals closed were majority funded by publicly traded bonds, a trend which has continued since.
The problem with traded bonds is that they impede changes in equity ownership. Unlike commercial debt which is provided by (or in the case of club deals led by) a single bank, bonds are held by many owners and managed remotely by trustees. The trustees may have little discretion or appetite to grant the necessary consents or waivers to changes of ownership and rating agencies are required to confirm that the bond rating and thereby valuation will not be affected.
Furthermore, project bonds do not lend themselves to refinancings in the same way as commercial debt thereby removing one source of financial up-side for an acquiring financial investor.
Financial investor appetite
Most financial investors tend to have a limited interest in small individual assets or portfolios. Transaction and management costs associated with smaller deals are disproportionately greater. Consequently, larger infrastructure funds are not attracted by PPP assets and the mid-market/smaller specialist secondary funds tend to be motivated by portfolio transactions or larger asset sales. Due to slower primary dealflow and larger average deal size, the secondary market in Canada will take longer to develop.
So what is the case for a secondary market in Canada?
Recycling of contractor-sponsor equity is necessary to keep the primary market active and, due to pre-emption rights, most sales are likely to be to existing co-investors. However, there is a commercial incentive for selling sponsors to attract external bidders to introduce competition and drive value.
As the scale of the secondary market in Canada is not yet sufficient to attract new entrants, it is characterised by the opportunistic stance adopted by existing investors. However, activity in the Canadian primary market continues to trend at 15 to 20 deals annually so scale continues to build keeping alive the prospect of a more active secondary market emerging in the next few years.
Although the development of a secondary market in Canadian P3 equities has been impeded by the factors discussed above, due to the prominence of tradable bond financing, there is already an active secondary market in P3 debt!
Due to the different characteristics within the P3 market in Canada compared to the UK, the Canadian market has yet to achieve the critical mass required to trigger an active secondary market. However, there are commercial drivers that will attract new entrants to this market and there are niche opportunities for small specialist funds or direct investors with an appetite for long-term, low risk, counter-cyclical investments.
Nigel Brindley co-founded Stratus Infrastructure with Bob Shekleton. The firm provides investment advisory services to infrastructure investors, sponsors and lenders.