Overview and Background
UK Guarantees has three distinct elements – a guarantee scheme, a co-lending scheme and an export guarantee scheme.
Under the export guarantee scheme up to £5bn in loan guarantees will be provided to overseas buyers of UK exports. The scheme does not appear to be aimed specifically at the infrastructure market and is not considered further here.
The co-lending scheme and the guarantee scheme are targeted specifically at the UK infrastructure market. They are best understood, in KPMG’s view, as a response by Treasury to three related issues:
- recent evidence of the falling away of appetite in the commercial bank market to lend long-term to infrastructure projects. Treasury is also aware of a widespread view in the market that the residual appetite to lend long-term will be further depleted once banks adjust their lending policies in response to Basel 3.
- lack of certainty as to the ability of infrastructure projects to access capital markets finance. A number of structures and products are currently being proposed in the market, to fill the void left by the collapse of the monoline insurance market in 2007, but most of these are either untested and/or likely to require novel elements of public sector support to make them viable.
- continuing fragility in the economy and the construction sector specifically and therefore a real desire to ensure that investment in infrastructure is delivered at the pace required to support economic growth.
The Co-Lending Scheme
The co-lending scheme (badged by Treasury as the “temporary lending programme”) provides for Government finance to be invested alongside private finance where there is insufficient commercial lending appetite. This is a re-launch of the Treasury Infrastructure Finance Unit (TIFU) whose brief existence prior to the last election allowed the Greater Manchester Waste deal to be financed. TIFU was subsequently shut down because it appeared that there was no further need for it. The loss of bank market appetite in recent months has caused that conclusion to be revisited.
The co-lending is primarily aimed at the smaller and less complex “PFI” social infrastructure and transport deals. This is driven by a recognition that the main risk to these deals being financed is simply the lack of appetite amongst commercial banks to lend long term, rather than project risks or their allocation. Also where deal sizes are small they would be less attractive to the bond markets even if credit-enhanced by a guarantee. The Treasury have indicated that up to £6bn of deals could be eligible. The £6bn clearly relates to the overall value of the deals and the scale of co-lending necessary to unlock this may be expected to be some order of magnitudes lower.
Loans will be on commercial terms (to satisfy State Aid concerns), and will only be available for less than 50% of the debt requirement. As was the case for TIFU the scheme is open on a temporary basis for 12 months.
The interesting issue will be how proactive is the use of the co-lending product. TIFU was purely a liquidity intervention seeking to fill any capacity gap that emerged but only once the private sector market had failed. There was also no intervention on pricing grounds even if the last bank into a deal forced up the pricing. There is an opportunity this time for the product to be used more aggressively making an earlier intervention into deals, helping to accelerate the pace of deal closure, and pushing back on out-of-market pricing.
It is however unclear how frequently it will be needed. Whilst there are a number of deals in the market where sponsors are struggling to secure sufficient liquidity at bid stage, there are no deals in the market which have yet actually failed to proceed for lack of financing. In particular there is plenty of bank appetite for short-term lending, but the Treasury is understood to much prefer long term financing solutions to anything that forces re-financing risk into deals. It remains of course an option for equity to cover that re-financing risk but experience in Australia, where margins are today much higher than expected five years ago and the equity in some deals is exposed, suggests it would be unwise to rush in that direction.
The Guarantee Scheme
The guarantee scheme has much wider application and covers projects sponsored by both the public and private sectors. It allows project promoters struggling to finance their projects to apply to Treasury for bespoke guarantees, in return for which (and to satisfy State Aid rules) the Treasury will levy a guarantee fee. The Treasury press notice suggests that a guarantee would cover one or more specific scheme risks, such as construction risk or revenue risk, but KPMG understands in most cases this is likely to be simplified to a straightforward financial guarantee of all the obligations of the debt. In KPMG’s view this has the clear potential to open the door to pension and bond market finance for infrastructure projects. Treasury has indicated that projects worth in aggregate around £40bn could be eligible.
There are five criteria for application:
- Nationally significant, as identified in the Government’s National Infrastructure Plan 2011. The Government will also consider other exceptional projects of national or economic significance on a case-by-case basis, such as university accommodation / infrastructure. Whilst this criteria appears to focus the guarantee scheme on the economic infrastructure schemes in the National Infrastructure Plan, further clarification from Treasury has made clear that all PFI/PPP schemes are considered within the ambit of the Guarantee Scheme. It is clearly Treasury’s intention that UK Guarantees support should be available to as many schemes as possible.
- Ready to start construction within 12 months from a guarantee being given and having obtained (or about to obtain) necessary planning and other required consents. It is not clear from the Press Notice, but we understand that Treasury intends the guarantee scheme to be available for at least 2 years, which would imply that any project expected to be ready to start construction within 3 years of today, ie before July 2015, could expect to be eligible.
- Financially credible, with equity finance committed and project sponsors willing to accept appropriate restructuring of the project to limit any risk to the taxpayer. Although Treasury has not ruled out providing support to the equity in a project, the main focus of the guarantee scheme is to credit-enhance the debt, and Treasury will wish to ensure that the risk of any guarantee it provides being called is limited by sufficient exposure of private equity ahead of it. We understand Treasury will require a counter-indemnity from the project vehicle, broadly similar to the terms which a commercial creditor would require.
- Dependent on a guarantee to proceed and not otherwise financeable within a reasonable timeframe. This is an important test which could be applied more or less strictly by the Treasury to manage the flow of applications. It is particularly important for those involved in projects currently in procurement, as it implies that good effort must first be made to try to finance the projects without recourse to UK Guarantees.
- Good value to the taxpayer, assessed by HM Treasury to have acceptable credit quality, not present unacceptable fiscal or economic risks and to make a positive impact on economic growth. A catch-all for knocking out schemes that may meet all the other criteria but do not appear to Treasury to represent best use of the Government’s support.
The use of guarantees is, in our view, a logical approach for a fiscally-constrained Government. It should be possible to structure the guarantees so they do not score on the Government’s balance sheet, and hence the approach makes good use of the Government’s AAA rating to credit-enhance infrastructure projects to a level that makes them attractive to the capital markets.
We would expect the types of deals for which a guarantee would be particularly helpful to include:
- Deals larger than say, £200m, where bank market capacity will be a constraint
- Deals where the construction risk is too big or difficult to be wrapped by contractors
- Deals with other particular risks that will scare capital markets, eg revenue risk
The guarantee scheme should also enhance the role of the Green Investment Bank (GIB). Although there will be questions about how UK Guarantees and the GIB work alongside each other, the guarantee scheme should increase the ability of the GIB to make sizeable and meaningful interventions.
It is KPMG’s view that the guarantee scheme potentially dovetails well with the promised creation of the £2bn Pension Infrastructure Platform (PIP) next January. One possible scenario, not yet proposed by Treasury but which appears to KPMG now to be feasible, would be projects financed by the PIP from financial close but with the construction risk covered by the guarantee scheme. Construction risk-bearing equity would still be required, perhaps from contractors or infrastructure funds, to manage the construction stage risks and mitigate the Treasury’s exposure. The PIP would then essentially be putting debt rather than equity into the project during construction, and would be a passive investor until the guarantee fell away after completion, at which point its “debt” could convert to “equity” at par, and it could take control of the project asset. Construction stage equity would achieve its required IRR at construction completion, with an equity kicker pre-arranged with the PIP and Treasury at financial close.
The mismatch between the indicated 1 year life of the co-lending scheme and the 2 year life of the guarantee scheme may reflect a belief in Government that within the next year the availability of capital markets products for infrastructure will have matured and been proven to a degree sufficient to be able to be able to rely on a combination of these and the guarantee scheme alone. It is believed the Government also hopes that after a number of years structures may evolve so that the need for the Government guarantee element falls away and capital markets may be tapped directly without any support, as they are currently for example by the regulated utilities.
We believe the Treasury to be looking closely at the funding competition currently being run for Alder Hey Hospital for an indication as to the extent to which certain financing products being proposed are deliverable in the market with and without Government support. We anticipate that over the next year Treasury will draw on experience from supporting a number of schemes to narrow down its views as to what types of support offer the minimum necessary intervention and hence best value to the taxpayer. At this stage it is deliberately keeping its options open as there is no precedent from which to propose a “one size fits all” solution.
What does this mean for Project Promoters?
The main objective of the UK Guarantees initiative is keep the infrastructure investment programme on track by getting deals closed and giving promoters confidence to develop new projects.
The criteria suggest that the guarantee scheme and the co-lending scheme form a last resort safety-net for projects, only to be employed where securing sufficient private finance proves an insurmountable hurdle. It may be speculated however that Treasury intend a more interventionist approach, especially where it appears schemes may be being delayed for lack of sufficient interest and hence competition amongst private finance providers.
Promoters must therefore strike a balance between proceeding on a ‘business as usual’ basis and making every effort to hold bidders’ feet to the fire, and at the same time being careful to leave open a channel for bidders to bring forward variant proposals where they can clearly evidence material savings to the public sector by tapping into innovative public sector support mechanisms.
Where it does become necessary to apply for one or both of the support mechanisms, it would be prudent for promoters to assume a degree of delay in getting the arrangements agreed. The Treasury will need to undertake due diligence on a scheme to the same rigour as a commercial lender, and will need to reach agreement with the equity as to what happens in various downside scenarios, albeit Treasury intends that these terms should mirror the standard terms required by creditors. The good news is that Treasury itself is keen to be seen to be getting deals unblocked and striking deals quickly, as it did with Greater Manchester Waste.
Applications to Treasury for any of the schemes can be made from now, though we understand legislation will be necessary for their implementation. The Treasury has said that it hopes to award the first support packages in the autumn, which would seem to KPMG to imply a need for specific legislation to be introduced immediately after the recess. If there is no existing Bill onto which this can be bolted we would speculate it may need to be introduced as stand-alone legislation.
It is understood that Treasury will be looking to staff up the Infrastructure Financing Unit Ltd in order to undertake due diligence on and process applications on both the Co-Lending and the Guarantee schemes.
What does this mean for Project Bidders?
Bidders in the process of a competitive tender would be well advised to explore all possible means of securing the necessary private finance on an unsupported basis as at least in the short term promoters remain under an incentive to prefer such offers to ones which would require them to approach Treasury. At the same time it would be remiss of any bidder not to be considering the extent to which UK Guarantees creates a “game-changer” in infrastructure financing, enabling financing solutions so much cheaper than the current bank market product that they are too attractive for any promoter to ignore.
Where a bidder has a financing proposal which would require a degree of support from UK Guarantees, we would recommend this is discussed as early as possible with the project promoter so that they are well-informed as to what is being proposed and are in a position to discuss that informally with Treasury. If any UK Guarantees support is offered into a bid process, competitive advantage will be gained by the relative ability of a bidder to make use of that support mechanism to drive down pricing within their financing solution.