17
may
2014
infrastructure
investor
because the contractor fails, not because
it is impossible to complete the asset.”
Andwhile investors say history counts
few examples of failing contractors, some
think the risk has grown stronger over
recent years. “Contractors have suffered
a blow after 2008, when construction
activity slumped. Some of them are now
in weaker positions,” says Jos Heemelaar,
international asset director at JohnLaing.
FOUNDATION COURSE
For investors, however, construction risk
seems to have become a less scary beast
than it was.
For one, says Cohen, yield-hungry
investors understand they can get a sig-
nificant premium for taking on construc-
tion risk. Most practitioners agree that
an additional return of 300 to 400 basis
points is often warranted when backing
a project in its greenfield years.
Investors have also come to under-
stand that, in a world where everyone is
hunting for operational assets, being able
to buy assets early in the process provides a
sizeable competitive advantage. “Investors
taking greenfield risk in a long-term infra-
structure fundwill gain access to the long-
term brownfield cash flows,” says Cohen.
Several studies have helped buttress
confidence. Empirical research by the
EDHECRisk Institute, which hosts a chair
on infrastructure investment backed by
Meridiam Infrastructure and placement
agent Campbell Lutyens, recently showed
that construction risk in project finance
is overall well managed – and that only
in exceptional cases should cost overruns
be expected.
AMarch report byMoody’s also found
that the 10-year cumulative default rate for
the infrastructure sector was 6.6 percent
in the decade to 2013 – far less than levels
displayed by similarly-rated corporates.
Yet where investors have really pro-
gressed, observers say, is in their under-
standing of how construction risk can be
efficiently managed.
Private investors generally see risk
mitigation as a two-step process: the tight
framing of a developer’s obligations and
commitments in a fixed price, day-certain
contract, followed by the deft monitor-
ing of these arrangements throughout
construction.
Michael Dinham, head of infrastruc-
ture at ING, concurs that construction
risk is mostly about pinning down what
he calls the “pinhole risk” – the developers’
ability to identify and exploit any contract
loopholewhenever something goes wrong.
THE RIGHT TOOLKIT
Yet Woodhams underlines the need to
strike a fine balance between being well
protected and remaining competitive
during auctions – which implies avoiding
overburdening partner contractors with
covenants and specifications.
One key aspect investors have learnt
to focus on, he says, is whether the
money drawn down from the funder is
being deployed directly in the project –
or diverted elsewhere in the corporate
structure. He also sees provisions that
enable sponsors to swiftly replace a fail-
ing contractor as particularly crucial.
Potential for external shocks remains.
Macro risks, such as inflation or commod-
ity risks, can impact construction costs sub-
stantially – for example if labour or raw
material costs rapidly inflate. Pinpoint-
ing and structuring them correctly at the
outset, Dinham says, helps avoid nasty
surprises further down the line.
Yet perhaps thegreatest challenge is to
harnesswhat hecalls “commissioning risks”.
“Getting an infrastructure asset built is
rarely a problem. But getting it to work
to required specifications is a different
matter.” Often this involves dealing with
sophisticated technology – but not always.
Dinham says wastewater treatment plants,
for example, have often been a source of
unforeseen problems.
Complicating these matters, argues
Heemelaar, is a recent yet sustained lower-
ing of liability caps. “There is a commer-
cial limit to what you can push down,” he
reckons, which now stands at between 20
percent and 30 percent of capex.
According to Phil Adam, head of
EMEA project bonds at HSBC, capital
markets are responding to such concerns
through innovation. “Over the last 12 to
18 months, we’ve seen Infrastructure UK
prepared to wrap risk, Assured Guaranty
back smaller deals, the European Invest-
ment Bank offer its credit enhancement
product and banks willing to provide
liquidity to boost project credit during
construction phase.”
The rebuilding of London Heath-
row’s Terminal 2, Conduit points out, is
being almost entirely funded via capital
market debt.
Meanwhile equity providers try to
mitigate residual risks through portfolio
diversification, tightened relationships
withdevelopers and guarantees fromtheir
parent companies. Massimo Fiorentino, a
senior investment director at Meridiam,
explains that active engagement with
local communities and authorities helps
assuage conflicts when things turn sour.
Like in most experiments, however,
having the right tools is only one condition
of success. “Perceptions of construction
risks are changing because the means to
managing it are better understood,” says
Cohen. “[But] this understanding is highly
dependent onwhether the initial analysis
is robust and if those performing it have
demonstrable track records.”
n
RISK
