Mind the tenor gap in infrastructure financing
Infrastructure projects are built for the long term. For example, most types of power plants have a lifespan of between 20 to 30 years and hydropower plants can run up to 100 years. In addition, capital costs for many infrastructure projects are significant and likely require debt financing.
As such, there is a necessity and an opportunity to spread repayments of project funding over a longer term, thereby easing pressure on the project’s ability to repay. However, in many lower income countries across Africa and Asia where the need for infrastructure is the greatest, there is a significant gap between the long lifespan of infrastructure projects and the tenor of funding available for such projects, especially in local currency.
Let’s take the Kekeli Efficient Power (Kekeli) project as an example. This 65 megawatts (MW) natural gas-fired power plant in Togo was looking for local currency debt facilities for up to 14 years. However, local banks only offered loans up to 7 years. If Kekeli took on the 7-year debt, the repayment pressure would roughly be doubled as the time window to repay halved. Even if this would be affordable, there would be little buffer for potential construction delays, working capital increases, costs or expenses overrun, etc, before the project got tipped over into major distress.
Currently, most of the tenor gap is filled by development finance institutions (DFIs). However, many DFIs only provide funding in hard currency. In solving the tenor mismatch, a currency mismatch is introduced. Therefore, to nurture infrastructure development in lower-income countries, understanding why local funders such as banks, and capital market investors such as insurance companies and pension funds shy away from providing long term financing is key.
What is holding them back?
Firstly, infrastructure projects are complex. Many parties are involved, including sponsor, developer, contractor, off-taker, regulator and many more. Careful coordination is required to successfully construct and operate a project. It is also complex from a legal and technical perspective and requires ample expertise to thoroughly evaluate the risks on a case by case basis. If funders are not yet deterred, they will still be reluctant to have their capital locked in for a long period of time and will charge a significant risk premium.
Secondly, many of the banks in lower income countries rely heavily on short term wholesale funding instead of retail funding as the saving rate is low. Wholesale funding is less “sticky” and might dry up overnight when the market goes through episodes of instability. As such, to either manage their assets and liabilities mismatches internally or to comply with regulatory requirements (via liquidity ratios etc.), banks can only lend for the relatively short term.
To resolve these issues, the first and critical step would be a continuous effort in building the capacity of local bankers and capital market investors such as insurance fund managers, pension fund trustees, as well as local regulators. DFIs, with their extensive project experience and various technical assistance programmes, are best placed to undertake this role. For example, with support from the Private Infrastructure Development Group Technical Assistance, GuarantCo has organised various capability workshops across Africa and Asia attended by delegates from local banks and financial institutions to learn about the variety of approaches to project financing transactions in various infrastructure sectors, the use of the credit enhancement instruments to mitigate project risk and local currency financing credit solutions. In addition, GuarantCo conducted a bond market study in Bangladesh which was launched at a local capital market infrastructure finance conference to promote the bond market in Bangladesh.
Another form of capacity building is “learning by doing”. Instead of replacing local funders, DFIs can hold the hands of local banks, insurance companies and pension funds and guide them into infrastructure projects in a risk-controlled way. DFIs can act as an arranger or advisor to demonstrate proper risk assessment and structuring of an infrastructure transaction so that funders are more comfortable with providing longer tenor capital. Alternatively, DFIs can provide guarantees such as those offered by GuarantCo to take some risks off banks that are new to infrastructure or investors with an investment grade mandate, unlocking a new pool of long-term capital.
As for the local banks’ asset-liability management challenge, the most fundamental solution lies in the increase of their retail banking capacity as well as the strengthening banks’ balance sheets which impacts on their credit ratings and thus their ability to access longer-term funding themselves. However, it is recognised that this might not be achievable overnight. Ahead of that, an alternative solution could involve using a liquidity extension guarantee, as in the previously mentioned Kékéli transaction. GuarantCo provide a guarantee to local commercial banks, which essentially extended the tenor of the loan by seven years after the original seven-year term. With this guarantee, the banks were able to manage their liquidity whilst providing a facility with a total tenor of fourteen years to Kekeli which made the project financially more robust.
Having a guarantee “added” to the financing structure may not necessarily mean a higher borrowing cost for the project. Without a credit or liquidity guarantee, some lenders and investors simply will not participate, limiting the sponsor’s ability to “shop around”. Most of the remaining funders likely ask for a significant risk premium to compensate for the perceived high risks due to the lack of infrastructure expertise in navigating and structuring for the project’s complexity. A guarantee from a guarantor that understands infrastructure projects, undertakes thorough due diligence and proper structuring, and has a strong credit rating, such as GuarantCo (Fitch AA-, Moody’s A1), will send a strong positive signal about the project, potentially achieving a lower all-in cost.