8.22 PF2 projects are therefore expected to source debt finance from sources other than bank debt. The tender process will require bidders to develop a long term financing solution where bank debt does not provide the majority of financing requirement. Therefore it is expected that institutional investors will become an important source of finance for PF2.
8.23 Institutional investors face a number of issues in taking up the financing challenge including:
• resourcing and expertise - historically institutional investors have provided very little debt for PFI projects that was not guaranteed by monolines, leading to a shortage of skills required to assess project risks;
• construction risk - some investors have steered clear of greenfield construction risk. However, low project default rates and the attraction of optimising yields means investors are now changing their views where suitable construction support packages can be arranged to mitigate risks; and
• Solvency II - in much the same way that Basel III will require the banking industry to hold more capital against risk-weighted assets, the insurance industry is faced with a similar challenge with the future implementation of the European Commission's Solvency II Directive. Long duration loans of lower credit quality will attract higher capital requirements. To reduce the capital required and avoid unaffordably high interest rates being charged to the borrower, projects will need to achieve a higher credit quality than that which PFI projects have achieved in the past.
8.24 In order to stimulate demand for infrastructure related capital markets issuance amongst institutional investors, projects are likely to need to achieve a credit rating in the A- to BBB+ range for the reasons set out above. Credit enhancements will be needed to achieve this rating requirement. These credit enhancements include inter alia changes to the capital structure, increased contractor support or changes to the typical risk allocation of projects. Additionally mezzanine debt and guarantees can also provide credit enhancements to facilitate the raising of long term senior debt. Government is aware of a number of private sector initiatives and supports their continued development.
8.25 Government has engaged with the finance community, including rating agencies, institutional investors and banks, to understand key drivers to project ratings. It recognises that different investors and rating agencies have different views including whether the largest risks occur during construction or in operations. Consequently, to solve both construction and operational risk concerns, projects are likely to be structured with additional risk capital to absorb project risks and fluctuations in project cashflows. In the Government's view PF2 projects are likely to require approximately 20-25 per cent of risk capital for standard accommodation type projects; however, this could be higher for other sectors or projects which are perceived to contain additional risks. This risk capital could be provided as a combination of equity and subordinated debt or other forms of financing instrument providing protection to the senior lenders.
8.26 Government expects the cost of debt to further reduce as the PF2 market matures and more investors become attracted to the asset class through the delivery of robust contract structures and demonstrated project successes.