The prevailing capital market conditions are expected to have the following effects on PPP bid markets:
1. Risk is in the process of being repriced but has not yet stabilised. This will place sustained short-term pressure on the pricing of debt capital for PPP projects.
2. A reduction in the availability of debt capital in the short to medium term.
3. Tighter credit standards including lower debt to equity ratios (leverage), higher debt service coverage ratios (interest cover) and wider use of capital reserves and sinking funds to manage revenue volatility risk.
4. Limited availability and increased cost of credit enhancement services and tougher credit rating standards.
A further effect will be the disappearance of the IPO capital-raising model for transportation projects in the short to medium term (1-5 years). The Australian equity market has demonstrated a long-standing appetite for infrastructure securities. The many innovations include the single asset investment vehicle, sector-specific investment vehicles and innovations such as the stapled security. Nevertheless, present uncertainty suggests that the IPO method of raising capital is not feasible in present market conditions and unlikely to make a re-appearance in the new future. There are three factors at play here:
First, the market is wary of high debt levels and distress premiums are greater now than at any time in the past 15 years.
Second, the market has demonstrated a reluctance to carry delivery risk. Promoters may need to revert to quarantining the delivery risks for future large-scale construction projects. The investment grade credit rating given to the Lane Cove Tunnel project by Standard and Poor's in 2006 was influenced by the underlying credit rating of the constructor, Leighton Group and a qualitative assessment of that company's capabilities and track record.
Third, new IPOs will need to address the question of optimism bias in forecasting and the perception of systemic forecasting error.
The survey of PPP financial advisers and lenders suggests that PPP transactions will be harder to do in present market conditions but not impossible. The degree of difficulty increases with projects that carry patronage risk and those that require investors to absorb high levels of delivery and operational risk. The degree of difficulty in raising capital for future PPP projects can only be determined on a case by case basis. The factors that will mitigate finance risk for PPP projects in present market conditions include:
• conservative leverage
• high debt service coverage ratios
• adequate reserves
• source and stability of the payment stream
• underlying credit rating
• benign abatement regimes
• availability of appropriate credit insurance
• capabilities and track record of consortium members, and
• state risk allocation.
Refinancing risk is also a potential difficulty for existing projects although mature projects with strong revenue streams, staged maturities and availability-based payment arrangements mitigate this risk. For projects not featuring these covenants, refinancing risk presents a more serious problem.
The survey of finance executives suggests that the cumulative effect of recent events in capital markets can be expected to have the following long-term impacts on the PPP bid market.
1. Equity will be difficult to source. The demise of the IPO equity raising option will also mean the end of other equity-raising techniques employed with this model such as the dividend reinvestment plan and deferred equity subscription arrangements. Firms will find it increasingly difficult to meet new minimum equity capital standards and the short-term outlook is for higher cost of equity pricing.
2. It may be increasingly difficult for small firms and non-credit rated market participants to find a place in consortium line-ups. In tighter capital market conditions, this is expected to result in a reduced number of players in the bid market.
3. The construction industry will be reluctant to provide long-term equity capital for PPPs when the alternative is relationship contracting and lower project risk absorption.
A contraction of the PPP bid market has important implications for the future provision of infrastructure in Queensland and the rest of Australia. These include:
1. A decline in the number of PPPs with the loss of benefits available from this procurement method
2. A slowing of the roll-out of the South East Queensland Infrastructure Plan and Program with consequential effects on both transitional and long-term economic development in Queensland (Regan, 2007a)
3. A greater emphasis on State provision of infrastructure financed through state debt or taxation with associated "deadweight" costs.
Financiers and advisers responding to the survey agreed that new PPP transactions over the next 12 to 18 months will attract higher spreads or risk premiums. As previously identified, this is especially the case with greenfield projects that carry market or patronage risk. Projects where the revenue is by way of state availability payments such as projects in health, justice and education and the refinancing of mature market risk projects should be easier to finance although risk pricing, leverage and debt servicing criteria are expected to be tougher throughout 2009.
A further factor influencing the financing of PPP transactions is the relative maturity of the industry and the allocation of risk. Research by the Australian Centre for Public Infrastructure in 2006 suggests that some infrastructure industries attract lower lending risk premiums than others. Mature tollway projects, energy generation and transport hubs (airports and ports) and social infrastructure generally attract lower debt funding margins, on average, than projects in higher risk categories such as in the water and urban transport industries. This research was based on capital market indicators for the period 1995 to 2005 and a return beta proxy for systematic risk (Regan 2004, 2006).