Long Division

1 March 2012 Credit rating agencies are already sharpening their pencils for institutional investors in the UK market. Can the industry get its sums done in time to measure up? Colin Leopold finds out
As scapegoats for the financial crisis go, the credit ratings agencies have had a pretty easy ride compared to former RBS banker Fred Goodwin (knighthood stripped), or his replacement, Stephen Hester (harangued into rejecting his bonus).

Nonetheless, the agencies’ misreading of subprime mortgages in the US and what many perceive as a North American bias for infrastructure has done little for their image in European markets. That may be all about to change.

As the UK government continues to woo institutional investors, attention is turning to the role of Moody’s, Standard & Poor’s (S&P) and Fitch as gatekeepers to over £20bn in potential project funding to which the UK government claims can be teased out of pension funds.

Ratings are a sticking point for these investors and crucial to their way of thinking about capital funding models. With no monoline insurance industry offering the comfort of wraps on bonds in the UK, how the ratings agencies view both the British government and the individual projects will be significant.

As rules on liquidity constraints roll down the tracks for insurance firms and pension funds, a higher credit rating is all that will work for many potential investors.

“A lot of investors we’re dealing with, such as the insurance companies, are regulated under Solvency II and that is highly ratings driven,” says a source at one of the largest monoline insurers. “AA is very important to them and BBB is pretty painful.”

Like Basel III in the bank sector, Europe’s Solvency II regulations will restrict the amount of cash insurance firms can invest, because it will have to be backed up by its reserves. There are rumblings that similar rules could be brought in to cover pension funds, too.

The influence ratings have on institutional investors is hard to overstate. With most projects over £75m eligible for a rating, most of the government’s pipeline could potentially be put under the microscope.

So how do the agencies themselves view the sector, and could their involvement rock an already unsteady relationship between contractors and funders?

Rocking the boat
“There is clearly a very significant degree of reliance which institutional investors place on the ratings process,” says Andrew Davison, a senior vice president in Moody’s Infrastructure Finance Group, “we are very conscious of our role.”

“We are not saying risk is bad, but we are highlighting that risk appetite and return requirements are different between banks and institutional investors.”

Both Moody’s and S&P have undertaken a number of studies over the past year on the impact of banking regulations on infrastructure funding. Perhaps unsurprisingly, the results point to a clear shift in the funding landscape from banks and debt, towards more rated-driven low-risk funding.

“It will likely mean a switch of the financing market more towards the US situation where infrastructure is primarily funded by capital markets,” says Jon Manley at S&P, “a situation which just doesn’t exist here.”

Few will argue against evolution in the funding markets given the current uncertainty, but it’s also a process that takes time and, more often than not, some teething and tantrums along the way, considering where we are at the moment.

“The ratings environment is not working properly in the UK yet,” says the monoline source. “We hear a lot about projects needing to get to a single-A rating for investors. Certainly in the UK it’s very difficult to achieve that, especially with Moody’s but also with S&P for greenfield projects with construction. You can’t really get to that A grade until you’re in operation phase.”

The Canadian market has attracted comparisons over the past few months following the moves to bring in pension funds.

But many in the funding community are quick to point out that UK projects are a long way from Canada’s consistently high A-ratings and developed bond market.

“It is important that the credit quality of UK transactions is sufficiently robust,” says Silja Turville, managing director of Eagle Oak Capital. “At least mid-BBB credit quality will be required, although the effect of Solvency II on insurers is likely to push the credit quality required to the A-range.”

The monoline insurer puts it in plainer terms: “Institutional investors are not going to come into projects with construction risk anytime soon. The government is very supportive of the plans but then it says it wants margins at 3% – you need an additional third party coming in to bridge that gap.”

Indeed, one source at a leading infrastructure debt fund told this magazine that rather than it being an issue of risk, the returns are simply not enough to attract institutional investors into the market in the first place, regardless of rating.

Problem or solution
Can the ratings agencies really make sense of these issues in a way that appeals to investors keen on safe, low-risk, long-term returns?

“If one of the concerns is the potential for incremental risk during construction phase, then the logical solution is to mitigate that risk and there are a number of different mechanics in which to do that,” says Davison. “If one of the concerns is incremental risk during construction then the logical solution is to mitigate that risk. There are a number of different ways to achieve this.”

He talks about a number of structural features which could help get a project to an acceptable investment grade, including additional cash-funded equity support, lower gearing, contingent equity such as a guarantee from a corporate sponsor, enhanced collateral posted in the form of bank letters of credit or performance-based supports, or even government grants.

Of course it’s unlikely the government would stand behind construction risk on its pipeline of projects – as this would go on balance sheet. So how might a contractor feel about providing additional credit support to enhance a project’s rating?

“Contractors here are just not prepared to put in that level of support because they just haven’t had to and it’s very expensive to do that,” says the insurer. “The cost is often greater than it’s worth getting up to single A.”

Stephen Beechey, at contractor Wates, agrees. “If requirements are too draconian, we won’t be able to get projects away.” However, other countries do put such burdens on their contractors, so it can be done. In particular, it demands a heavily capitalised balance sheet at the construction company. Such a situation could also give large global contractors with financially strong parents greater power in the UK market.

“With large-scale infrastructure, energy and power projects for example, the numbers are so significant one of the big issues will be which contractors are available that have the balance sheets to do that,” says Beechey. “You’ll end up with only the big international players.”

There is already a shift in this direction in waste, where companies such as Viridor –
backed by international firm Pennon Group – are increasingly looking to fund deals without any debt.

Beechey says the answer, for UK names at least, lies in finding the right mix between bank and bond financing. “One of the things that could work better is if we use a more traditional structure with debt to get us through the first three to five years and then convert it to an institutional investor.”

With banks avoiding long-dated returns, there is a lot of interest in finding ways in which banks can do what they do best. “That’s the structuring and the early stage transaction management,” says the insurer.

Indeed, if credit ratings can achieve one thing, it’s putting each party’s role into perspective. If institutional investors can carry the rating of the operation stage of a project, the only significant issue identified by the agencies is the refinancing risk – a responsibility which could be filled by government.

The upcoming PFI review may offer it the perfect opportunity. “I would expect the UK government to consider using the reform of PFI call for evidence to create a pipeline of transactions of the right credit quality to enable bank and institutional lenders to fully participate in the market,” says Turville.

With rated-projects competing not just internationally with markets such as Canada, but also with the wider corporate market, the
government would have an even greater responsibility to provide a consistent dealflow.

“In a sense the long lead-in time, in terms of procurement and bringing projects to the financing market, needs to be a more efficient and responsive process,” says Manley. “Investors value a clear deal pipeline and predictable timing rather than delays.”

Once the participation of pension and insurance funds has been secured, it’s clear that the rating agencies could play a defining role in the market but, following the downgrading of France and Spain, there are still some who feel it should be a limited one.

“They certainly have a role to perform,” says Gershon Cohen, chief executive of Infrastructure Funds at Lloyds, “but at the same time there is no substitute for carrying out your own independent due diligence to ascertain whether you are comfortable with the risks and associated rewards. They provide an additional source of guidance and verification but I don’t think they should be the absolute.”

Indeed, ratings may be a mechanism that institutional investors already feel comfortable with but there is also the rest of the industry to consider – right down to the man on the street.

“We need to raise the level of knowledge so that there is a fuller appreciation and understanding of the value expressed by the rating,” he adds, “broadly pension and insurance funds which are the conduits and aggregators for the man on the Clapham Omnibus who ultimately suffers if they get it wrong.”

This page was last updated on:
9 May 2012.


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