Who is afraid of construction risk?

Frédéric Blanc-Brude, Omneia R. H. Ismail: This paper is the first one of a series examining the opportunity for institutional investors to become involved in infrastructure debt, as part of the NATIXIS Research Chair on infrastructure debt instruments and governance.

Author(s):

Frederic Blanc-Brude

Research Director at EDHEC Risk Institute–Asia

Omneia R. H. Ismail

Senior Research Engineer with EDHEC Risk Institute-Asia

In "Who is afraid of construction risk?", the authors focus on the question of credit risk in infrastructure investment but also address a public policy question that has come to the fore since the financial crisis of 2007-9: should pension funds and insurance companies invest significantly in new infrastructure projects? The notion of a potential convergence between macroeconomic policies aimed at supporting long-term growth and the need to invest in long-term, stable fixed income products for institutional investors is attractive. However, few practical solutions have emerged and, while investors have expressed interest in the kind of long term debt that is commonly found in infrastructure project finance, they have also shied away from financing new projects for fear that their construction period represents to great and too unnecessary a risk for them to take. Hence an apparent disconnect between public policies highlighting the need to invest in new infrastructure to support growth and investors' demand for existing or more 'mature' infrastructure debt. This paper makes valuable contributions to this debate and to our understanding of the management of infrastructure debt credit risk. Infrastructure project finance debt has different characteristics from regular corporate debt. It has longer maturities and lower spreads and is the product of specific corporate governance setup: the single-project firm also known as a single purpose entity (SPE). SPEs only invest once at the beginning of a multi-decade project and spend most of their active life de-leveraging. Moreover, lenders are in a position to structure most aspects of the credit risk of SPEs. The endogenous nature of credit risk in project finance thus allows the selection of higher quality projects that can tolerate high levels of initial leverage. The combination of high initial leverage and continuous de-leveraging creates a dynamic credit risk profile, where the positive effect of de-leveraging on credit risk tends to more than offset that of increasing uncertainty. This effect of the passage of time in project finance is reflected in the spread changes and the credit risk migrations that the authors document in this paper for individual project loans: as infrastructure projects live their lifecycle, they become lower risk and this is reflected in credit spreads as well. Hence the infrastructure project lifecycle offers diversification potential that should not be ignored. The authors suggest that this effect is not negligible. It follows that investors should embrace construction risk in properly structured infrastructure debt portfolios.

Type: EDHEC Publication
Date: le 21/03/2013
Research Cluster : Finance

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