We speak with Duncan Caird, Head of Infrastructure & Real Estate Group, Americas at HSBC Global Banking and Markets about the sectors likely to see significant activity in 2019, the evolution of PPPs, and how borrowers can mitigate rising US interest rate risk.
Bonds & Loans: If you look at some of the larger regions or countries in the Americas – Mexico, Brazil, Argentina and the Andean powerhouses like Colombia or Peru – where do you see the biggest opportunity for new infrastructure development from a sectoral perspective?
Duncan Caird: There are many opportunities in the region, but some will inevitably be filtered through the array of elections we’ve seen come to pass as well as those on the horizon. Continued certainty and sound economic policies are central to a region not unfamiliar with political volatility. In Mexico, for instance, we’ve seen a great deal of uncertainty removed across the board by the renegotiation of NAFTA – and the creation of the USMCA, but a number of policies being discussed or rumoured to be in the works could weigh on some large-scale developments, like the New Mexico City Airport, or key infrastructure upgrades within the oil and gas sector.
We continue to see significant opportunities in Mexico related to the country’s diversification efforts, primarily in the energy sector. We see rising activity in the renewable energy space, and we are likely to see greater movement in the country’s gas sector as it looks to open up different supply markets and diversify supply away from Texas, where it currently secures the bulk of its imported gas. This will require greater investment in transmission infrastructure, both greenfield and some degree of refurbishment. The development of the country’s refinery segment is also becoming increasingly important as Mexico looks to develop its value-adding capabilities domestically, which will require additional capital.
Toll roads have also occupied a growing share of the infrastructure pipeline in Mexico in recent years, and if the government continues to invest in moving these projects forward we could also see significant private investment opportunities appear alongside that.
We are keen to continue supporting existing clients coming into the country, and are seeing a range of reserve-based lending opportunities in Mexico, and the capital markets as an attractive option for financing key strategic assets there.
Brazil continues to yield a range of opportunities. One of the more positive shifts over the last couple of years is the U-turn seen at Petrobras – more stringent governance practices, more robust procurement practices, and a steep reduction in leverage – which positions it well in moving forward with infrastructure upgrades. Broadly speaking, until we know the outcome of the elections it is hard to determine the full extent of the opportunities before the development and funding community. But the infrastructure need is there, regardless of the administration that assumes power. What we do know is the oil and gas sector will continue to be important, and expanding pre-salt production will be key to yielding new opportunities across the upstream, midstream and downstream sectors.
Argentina has accelerated fiscal reform and sought to increase productivity, but borrowed at a staggering rate in a bid to help finance the elimination of unaffordable subsidies. Combined, these factors are partly responsible for the current economic environment. Demand for new projects is there, including appetite for new power stations and transmission infrastructure, waste to energy, toll roads, and the Vaca Muerta shale deposits. But there are big question marks around the currency and the country’s ability to meet its dollar obligations, resulting in its deepening partnership with the IMF. The extent to which the current economic situation is resolved will likely determine the scale of the opportunities that manifest on the ground.
Colombia continues to yield a range of high-quality opportunities. The bulk of infrastructure demand is focused on midstream assets such as new pipelines and LNG infrastructure that would help ease industrial logistics traffic away from the heavily congested motorways in parts of the country. Key sectors like agriculture and airports will also generate new opportunities as the economic environment turns more favourable, particularly as the price of oil continues to rise. The toll road programme has been quite successful there, owed in part to the structural robustness of the PPP programme in place, which will likely generate new opportunities as well.
Peru will also see opportunities in logistics infrastructure and new airports in particular, including an expansion of Lima’s international airport. Oil and gas is also quite active, with PetroPeru working diligently on a number of refurbishments to its refinery.
Bonds & Loans: Latin America’s need for new high-quality infrastructure is well known, but will the region’s governments – many of which are transitioning, or likely to transition to new administrations – struggle to push new infrastructure initiatives forward given the rising cost of borrowing in US dollars? How can governments mitigate that risk?
Duncan Caird: One of the consequences of financing projects in jurisdictions vulnerable to high inflation was the creation of Real Internal Rate of Return (IRR) provisions within project finance structures. These structures ensure that if a developer has a concession for 10, 20 or 30 years, there are mechanisms for mitigating the impact of legislation that demonstrably reduces net equity return, such as inflationary policies. One of the things developers could consider is an IRR concession extension, which could actually address multiple situations, whether there has been a force majeure, an administrative error, or increase in taxes. It tends to be a good behavioural mechanism as well.
This is particularly important in the context of the rising cost of borrowing in US dollars, which leads to an important question for the region’s governments: how can they limit the amount of foreign borrowing against their country’s balance sheet? There is a fairly clear distinction between assets that tend to be heavily dollarized, such as airports or oil and gas refining, and those that aren’t, such as toll roads or midstream pipelines. Those with dollar revenues are naturally easier to finance externally than those generating incomes in local currency. To an extent, the ease of funding projects at a time of rising US dollar costs comes down to what currency the government wishes to encourage infrastructure to be financed in, and what kind of hedge it can put in place to mitigate the risks.
Bonds & Loans: Many governments in the Americas, keen to attract funding into large-scale infrastructure projects, have responded constructively to the region’s infrastructure deficit, launching a range of frameworks and public-private partnership schemes designed to enable these governments to take on additional risk that would have otherwise been shouldered by the private sector in developing and financing these projects. But looking at the frameworks rolled out in countries like Chile, Peru or Argentina, do you get the sense we could see them being tweaked to more evenly spread risk between the private and public sector?
Duncan Caird: I’d like to answer that by looking more closely at some of those structures. Let’s look at the RPICAO structure in Peru. This was originally developed at a time when the country was struggling to shore up international capital to finance the North-South toll road. In a bid to remove as much risk as possible, these construction milestone-based payment certificates were made irrevocable, and became a very reliable commitment for the government of Peru at the time. In a sense, you could argue that because the country was not very well known to global infrastructure investors, the government needed to overcompensate in a bid to make the opportunity more attractive and inspire confidence among potential participants.
In Argentina’s PPP programme, the TPI structure is an irrevocable certificate based on construction milestones – and they’ve replicated this key aspect because they need to inspire confidence among the international investment community.
Contrast this with the case in Colombia, which didn’t lean on the same mechanisms through its landmark toll road PPP programme, but which required four rounds of project bidding and tendering before investor confidence in the structure was sufficient.
In all of these cases, the issue is not necessarily one of risk transfer, but one of generating confidence. That said, I support the continued tweaking of these programmes. But I also recognise that to make these opportunities attractive to vast pools of investors and to realise them in an expedient fashion, governments must overcompensate in some ways, and part of that is to shoulder more risk.
Bonds & Loans: The soft mini-perm is a stalwart structure for many infrastructure projects and help open the capital markets for infrastructure developers. But capital markets refinancing can be daunting during periods of high volatility – which tend to weigh on capital market access more than loan access. Are there any structural innovations that can help give borrowers a bit more certainty and help reduce refinancing risk?
Duncan Caird: There is no such thing as a free lunch. Interest rate hedging – whether done off Treasuries or an alternative benchmark like LIBOR or its eventual replacement – is one option. One could acquire a 20-year interest rate hedge with a break option at the end of a mini-perm, for instance.
Where we see some borrowers struggling is where the quality of the credit spread has deteriorated, which is usually more a function of the underlying sponsors’ credit quality. The obvious trade-off you tend to find with hedging and not hedging is a short-term reduction in dividends versus eliminating the likelihood of a capital crisis at the mini-perm break, so we think it’s worthwhile from a long-term risk perspective.
The other thing borrowers can do is to proactively engage directly with large institutional investors throughout the project, helping to reaffirm the quality of the credit and shore up demand ahead of a capital market transaction. This doesn’t mean a borrower is hedging all of their risk, but it will go a long way towards ensuring demand is there when a borrower chooses to launch a transaction – and it can help reduce duration risk.
Bonds & Loans: HSBC has worked on some of the most notable infrastructure transactions in the Americas to date. Are there any particular case studies that you and the team would say exemplify a novel or innovative structure that could be replicated in other jurisdictions across the Americas?
Duncan Caird: The Grupo Aeropuertario de la Ciudad de México (GACM) funding programme was excellent to work on and one of the highlights of my career. We advised on the UDS2bn 10-year and 30-year tranches in 2016 and the USD4bn dual-tranche offering in 2017, and acted as a champion for the external green bond certification the company received – which lent itself to the success of both transactions and the funding programme as a whole.