Equity markets
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McCann: secondary
equity providers to
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A secondary equity market is growing up in UK private finance initiative (PFI) and public-private partnership (PPP) projects that could offer investors high returns and boost liquidity.
At least half-a-dozen secondary funds are investing or seeking assets. Making the running are such investors as Secondary Market Infrastructure Fund (SMIF), a five-partner team bought out from Abbey National and Babcock & Brown last year; Innisfree; and Barclays Private Equity.
When Star Capital Partners bought SMIF in December, it had acquired a portfolio of 23 project assets with an underlying gross asset value of £2 billion. These included Carillion's 30% share in the Dartford and Gravesham Hospital PFI and HSBC Infrastructure's interest of over 85% in the Falkirk Schools PFI. Barclays has set up Infrastructure Investors (I2) with Société Générale to invest in projects as they become operational. Each bank has committed £150 million ($269 million) to I2, which has a target of £450 million.
Innisfree manages three primary funds and a £150 million secondary fund via a joint venture with M&G Investment Management. The fund is open for investment.
Henderson Private Capital, Noble Fund Managers, and Edinburgh-based boutique Quayle Munro also run funds that are buying into established projects. Henderson's £200 million secondary PFI fund targets an annual cash yield of 10% to 12% and a gross internal rate of return (IRR) of 15% to 18%.
“A secondary market enables primary investors to recycle their capital and gives them an understanding of what exit rates are,” says Innisfree director Matthew Weber.
Now that public- and private-sector sponsors have worked out how to put together the basic construction and management agreements on simpler PFI/PPP deals, they can start working out the best capital structure.
“The secondary market will be finance driven, not construction driven,” says Martin McCann, a partner at Norton Rose who is currently advising on the acquisition of a portfolio of 32 projects. “This is all about equity liquidity.”
PFI/PPP needs equity liquidity because debt liquidity has shrunk as banks have pulled out of project finance. Secondary equity providers have a lower cost of debt and should drive project costs down throughout the PFI/PPP programme.
“They put together packages that make their equity the cheapest too,” says McCann. “That means no more shadow passengers as part of consortia who provide, say, £3 million of equity and sell out a couple of years later for £5 million. The primary providers will have to understand what the secondary providers can offer.”
Early PFI/PPP contracts sometimes specified that primary investors couldn't exit before construction was complete.
According to consultants Ernst & Young, primary funds look at a five-year to seven-year return horizon and will then sell to secondary funds. Secondary funds want a discount of between 9% and 11% pre-refinancing, and of 12% or 13% post-refinancing.
Flexible and stable
PFI/PPP projects look like a good investment. Cashflow returns are measurable and stable, portfolio management diversifies risk and there are several ways to make money – refinancing debt after the risky construction phase of a project, securitizing project revenues or even equity dividend streams, or ultimately selling to a tertiary investor that wants to hold long-dated assets. The prospect of making 15% or more IRR over 25 or 30 years is bound to attract big buy-and-hold investors, such as pension funds.
The public sector should be pleased that PFI/PPP equity will be a cheaper and more liquid asset. When the UK government asked Pricewaterhouse Coopers to study IRR in PFI/PPP projects, PwC said that equity returns were around 2% higher than a weighted average cost-of-capital benchmark. “More equity competition should help bring rates down to 10% from around 15%, depending on what can be got out of the pension funds,” says Allen & Overy partner David Lee.
The secondary market hasn't quite taken off. Trade investors in successful early PFI/PPP projects have enjoyed high returns. “A lot of contractors are not so desperate to sell, because these projects have decent yields,” says Weber. “There's quite a lot of supply, and quite a few players, but it's not a mature market yet.”
It should grow quickly, though. “This is the most aggressive part of PFI/PPP,” says McCann. “A handful of secondary funds have suddenly emerged and are taking people out at financial close. In six months, everybody will be doing it.”