Italy Looks To Institutional Investors To Support Its Infrastructure Financing

Primary Credit Analyst: Manuel Dusina, London (44) 20-7176-5530; manuel.dusina@standardandpoors.com Secondary Contact: Michela Bariletti, London (44) 20-7176-3804; michela.bariletti@standardandpoors.com

Table Of Contents
The Government Moves To Promote Private Investment Greater Transparency Is Key Tapping Into Investors' Appetite For Italian Securities Project Size Will Determine The Nature Of Funding Used Related Criteria And Research Appendix: How Standard & Poor's Rating Methodology Might Apply To Italian Project Bonds

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Italy Looks To Institutional Investors To Support Its Infrastructure Financing

Italy, like the rest of Europe, is looking to infrastructure investment as a means of restoring growth to its economy. According to state bank Cassa Depositi e Prestiti (CDP), the country's infrastructure needs to 2020 total about 340 billion, spread across transportation (approximately 50 billion), energy (approximately 180 billion), broadband internet access, and social infrastructure (health care and education, for example). National infrastructure funding in Italy historically relies on bank loans and international financing institutions, which currently account for approximately 80% of total project finance funding in the country. Acknowledging that economic constraints and increasing bank regulation render this financing model all but obsolete, the Italian government last year introduced new laws to promote the development of an Italian public-private partnership (PPP) program and ready access to the capital markets. In Standard & Poor's Ratings Services' view, these laws should also help encourage institutional investors to participate in the Italian project finance market. Overview Italy estimates its infrastructure needs between now and 2020 at about 340 billion. Recognizing that it can no longer rely on state and/or bank financing, the government introduced new laws in 2012 to stimulate investor appetite for infrastructure assets. These laws should help to bring the pricing of bonds nearer to that of bank loans and should, in our view, encourage issuers to raise or refinance their debt through the capital markets.

The Government Moves To Promote Private Investment

The infrastructure financing environment is changing. Traditional bank lending--although still accounting for approximately two-thirds of global project finance lending--has come under pressure as new regulations, including Basel III, require banks to hold more capital on their balance sheets. Such changes could cut the bank loans available to finance infrastructure projects. They could also lead to higher financing costs for borrowers because lenders will look to lend over the short term, which requires less capital than long-term lending. In 2012, the Italian government introduced three laws that update the process through which strategic infrastructure in Italy can be procured and financed. The first of these, the Liberalisations Decree (Decreto legge 24 gennaio 2012, n. 1), introduces, among other things, a streamlined procurement process including an ad hoc contract to procure infrastructure assets ("Contratto di disponibilita"); a new form of public-private partnership (PPP); as well as the ability for project companies to issue bonds to finance infrastructure projects. The second law, the First Growth and Development Decree (Decreto Legge 22 giugno 2012, n. 83), inter alia, opens up the possibility of special-purpose vehicles (SPVs) engaged in infrastructure funding programs to acquire private resources through the issue of securities with a tax regime similar to those for government bonds for a period of three years after the law has been approved.

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The third law, known as the Second Growth and Development Decree (Decreto Legge 18 ottobre 2012, n. 179), promotes the development of an entrepreneurial culture that is appealing for foreign investment. We believe these laws introduce a more innovative and benign legal and fiscal regulatory regime, one that could support the development of a project bond market. This should enable Italy to tap into the increasing demand, confidence, and appetite among European and worldwide institutional investors for infrastructure assets that we've observed in other European markets. In a recent survey by Preqin, an infrastructure data and research firm, 58% of investors questioned said they were planning to increase their allocation to the asset class over the longer term. Project bonds could in our view constitute an ideal match for these investors' investment strategies, at the same time lifting the burden of infrastructure funding from government and providing an alternative source of financing from the banking sector. The new legal regime should also help to reduce some of the costs previously associated with infrastructure investments. For example, prior to the approval of the First Growth and Development Decree on Aug. 8, 2012, unlisted issuers, such as project finance SPVs, issuing bonds in excess of a 2 to 1 debt-to-equity ratio were charged a withholding tax on interest payable. This prevented the deduction of interest payable and made access to the capital markets onerous. And although issuers could have pursued securitization, this would have resulted in significant additional costs compared with bank financing. In addition, the First Growth and Development Decree allows guarantees--which must be explicit, irrevocable, unconditional, and in a written form--to be provided to project bonds. The Decree also identifies international and national financial institutions that can provide such guarantees, including CDP and Servizi Assicurativi del Commercio Estero (SACE; the Italian export credit agency), along with foundations and private funds. We understand that the guarantee is only available for a specific period, likely during a project's construction phase or until such time as the project is picked up by the concession holder. This should in our view further support infrastructure investments funded through the capital markets because it addresses investors' reluctance to invest directly in projects that are pre-completion, commonly known as greenfield projects. However, we believe any shift to bond financing from bank loans is likely to be gradual, for two reasons: First, investors have up to now been reluctant to invest in infrastructure projects due the lack of data and their inexperience of this asset class (see "How To Unlock Long-Term Investment In EMEA Infrastructure," published Oct. 4, 2013). What's more, the Italian project bond market remains untested and market participants will, in our view, take some time to get acquainted with the new legislation. (We outline the factors that we might consider when rating Italian project transactions in the Appendix.) The second reason is that Italy has always used banks to finance infrastructure programs. The BreBeMi motorway in Italy, for instance, was the largest European PPP transaction completed in the market in the first half of 2013 (2.3 billion). The project involves the construction a 62-kilometer motorway between Brescia and Milan, under a 20-year real toll concession. Although this transaction provides clear evidence that the revised PPP framework has had a positive impact, allowing the country's first large greenfield PPP transaction to achieve financial close on a project finance basis, it is financed entirely by bank loans. And we understand that the Tangenziale Est Milano road concession (2.2 billion), on target to reach financial close by the end of this year, will also rely on bank funding.

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Italy Looks To Institutional Investors To Support Its Infrastructure Financing

Greater Transparency Is Key

We contend that there are several factors and transaction characteristics crucial to securing investor interest in infrastructure assets. One of the most pressing is greater transparency of project contracts and performance. Italy does not have a significant track record of PPP transactions, even though such transactions represent an important share of financing infrastructure in Europe. According to the European Public Private Partnership Expertise Centre, Italy accounted for about 2% of total European PPP volumes and less than 300 million in 2012 (see charts 1 and 2), with a prevalence of small to midsize projects (that is, less than 300 million). This, in our view, is because private capital has historically been discouraged from investing in public infrastructure projects due to the lack of transparency in planning, procurement, and authorization of public infrastructure projects, and to uncertainties surrounding the timely disbursement of public funds. Indeed, the previous PPP regulatory framework led to a high project mortality rate during the procurement phase, largely because the guidelines lacked clarity. We believe that transparent, widely shared information is important during the procurement phase of a project because it can improve governance. Specifically, disclosing information on government contributions and risk-bearing under PPP transactions can aid cost management. And the widespread disclosure of contract details may well produce more sustainable contracts and benefit equity sponsors by reducing the risks of renegotiation. Furthermore, the lack of transparency and disclosure of risk heightens investor uncertainty and creates market unease. In our view, the financial reporting of European projects is on occasion incomplete, inconsistent, and unclear. Of particular concern is the general lack of information regarding operations, financial statement line items, and the nature and effect of other events and conditions such as the consequences of adverse weather on a project's operations or disputes over the terms of the contract that are relevant to the analysis of project finance transactions. Finally, we are of the view that all stakeholders should receive information at the same time and with the same frequency. Most companies typically provide quarterly financial reports to their relationship banks. While some of this information may be confidential and commercially sensitive, we believe that sufficient data should be provided publicly to investors holding project finance securities to enable them to make informed investment choices. This minimizes the risk of creating a two-tier market where bond investors are materially disadvantaged relative to private loan investors.

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Chart 1

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Italy Looks To Institutional Investors To Support Its Infrastructure Financing

Chart 2

Tapping Into Investors' Appetite For Italian Securities

Investors are showing an increasing appetite for Italian corporate securities (see "Italian Companies Are Turning To The Capital Markets Amid Weak Credit Conditions," published June 5, 2013). Historically low interest rates on European sovereign bonds with high ratings have prompted investors in infrastructure debt to accept narrower spreads. If the decline in Italian sovereign spreads were to continue, we believe we may see further sustained domestic and international investor demand for Italian infrastructure securities at attractive yields and long tenors. At the same time, thanks to the aforementioned legal reforms, the cost of issuing bonds rather than loans is narrowing, in particular for large projects. We are starting to see margin step-ups in bank loans, providing encouragement for issuers to refinance their debt through alternative funding sources. As a result, in net present value terms, there is no longer a significant gap between the interest rate an Italian issuer would pay for a bond issue and the cost that banks apply for a loan. Recent conditions have been favorable, and companies have taken advantage of increased investor appetite and issued debt at increasingly lower yields. For example, in March 2013, Italian car maker company Fiat SpA issued a

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euro-denominated bond via its vehicle Fiat Finance and Trade with a coupon of 6.625%, which we rated 'BB-'. This compares with the same issuer 7% coupon euro-denominated bond in March 2012, which we rated 'BB'. Therefore, we believe that Italy now has a framework in place to fund its infrastructure investments through a combination of bank and bond finance. However, over the next 18 to 24 months, we anticipate that projects with construction risk will still be financed mainly through banks loans, and possibly refinanced via the capital markets once the assets are in operation. We believe this will be the case unless the construction risk is satisfactorily mitigated--by recourse to guarantees or adequately structured credit enhancements such as the European Investment Bank's (EIB's) Project Bond Credit Enhancement (PBCE) initiative, currently in its pilot phase. (For more details on the PCBE program, see "How Europe's New Credit Enhancements For Project Finance Bonds Could Affect Ratings," published Nov. 13, 2012.)

Project Size Will Determine The Nature Of Funding Used

In essence, we believe that funding for Italian infrastructure projects may vary depending on their size: Small projects (less than 100 million) will be mainly financed through loans provided by banks or placed privately with institutional investors, as we observe in the U.K. (For more details, see "Inside Credit: Shadow Banking Looks Set To Capture A Larger Share Of Project Financing In 2013," published April 16, 2013.) Midsize projects (100 million-300 million) will be financed through a combination of funding sources. While commercial banks will retain a significant market share, we believe long-dated debt to be deployed in these projects will more likely funded from alternative or non-bank sources, including project bonds. Large projects could offer the most likely opportunities for financing through project bonds. This is because large-scale transactions typically need a larger group of investors than small or midsize projects, and because the revised tax relief, particularly in connection with the cost of registering the security package (previously as high as 2% for bond issuance), is more materially attractive. However, the successful funding of Italian infrastructure projects will depend on the appetite of institutional investors toward a new product, actual transaction costs, and the country risk that investors may still perceive as the biggest hurdle.

Related Criteria And Research

The articles listed below are available on RatingsDirect. How To Unlock Long-Term Investment In EMEA Infrastructure, Oct. 4, 2013 Italian Companies Are Turning To The Capital Markets Amid Weak Credit Conditions, June 5, 2013 How Europe's New Credit Enhancements For Project Finance Bonds Could Affect Ratings, Nov. 13, 2012 Project Finance Construction And Operations Counterparty Methodology, Dec. 20, 2011 Nonsovereign Ratings That Exceed EMU Sovereign Ratings: Methodology And Assumptions, June 14, 2011 Updated Project Finance Summary Debt Rating Criteria, Sept. 18, 2007

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Appendix: How Standard & Poor's Rating Methodology Might Apply To Italian Project Bonds
We rate project bonds according to our project finance criteria (see "Updated Project Finance Summary Debt Rating Criteria," published Sept. 18, 2007). Unlike our approach for rating corporate issuers, we do not assign an issuer credit rating (ICR) to a project finance transaction. This is because an ICR reflects the terms and features of the various debt tranches issued by the project obligor, which may result in different default expectations. Rather, the issue rating on a project focuses on the risks of construction and operation, the project's long-term competitive position, its legal characteristics, and its financial performance. Our project finance ratings address default risk and do not include any material consideration of the potential recoveries following a payment default on the rated issue. The new Italian legal framework introduces the possible use of debt guarantors and identifies permitted applications under which their guarantee could apply. Under our criteria, issued debt can benefit from an unconditional and irrevocable payment guarantee of timely interest and principal provided by an entity, such as a monoline insurer. When such a guarantee exists for the life of the transaction, the long-term rating on the guaranteed debt issue will reflect the higher of the rating on the guarantor and the Standard & Poor's underlying rating (SPUR). However, if a guarantee is offered only for a limited period of time during the life of the project (as we understand will be the case under the new Italian legislation), the issue rating on the project may be constrained by the project's credit quality. This is because the project rating reflects the probability of default of the project during its entire life. If, during the period where the guarantee is not available, the project's credit quality is weaker than the issue rating during the guaranteed period, then the project issue rating will reflect the weaker period.

Europe's Project Bond Initiative offers alternative credit support

The recent changes introduced by the Italian government are in our view compatible with the European Investment Bank's Project Bond Credit Enhancement program. As the PBCE is only available to infrastructure projects financed by project bonds, we believe the recent changes introduced in Italy to support capital market funding should enable bond-financed Italian infrastructure projects to be eligible for such enhancement. The EIB's credit support lies at the subordinated level of the capital structure so as to enhance the credit quality of a project's senior debt--a function also promoted by the guarantee announced in the revised Italian framework. However, we anticipate that a project structure would include either the PBCE or a guarantee, but not both. This is because to maximize value for project sponsors, the public sector, and lenders, these credit enhancements come at a cost--not only in financial terms, but potentially also in terms of control and governance. Although credit enhancement or a partial guarantee can enhance the senior debt, it may be insufficient to enhance the overall credit quality of a weak project. In our opinion, if an infrastructure project has a weak business risk profile, is exposed to a weak irreplaceable counterparty, and/or has a transaction structure that doesn't sufficiently protect project creditors, then the presence of credit enhancement facilities would at best only delay the project's eventual demise. Such facilities would not structurally enhance a project's long-term capacity to service senior debt in full and

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on time.

How country risk can influence project bond ratings

In our opinion, project finance is highly sensitive to country risk because we consider infrastructure projects to be highly exposed to regulatory, fiscal and political, and economic risks. Therefore our project ratings generally restrict the maximum rating differential above the related sovereign to no more than two notches. An example of a project transaction rated higher than its related sovereign is Luxembourg-based SPV Watercraft Capital (Project Castor; see Postsale Report: Watercraft Capital S.A., published Aug. 9, 2013), which also happens to be the first project benefitting from EIB PBCE support within its structure. To establish the maximum rating differential, we determine the degree to which the project is exposed to country risk. We base our assessment on a combination of what we see as the project's concentration of revenues in its country of domicile and the project's degree of sensitivity to country risk. In specific circumstances, our criteria allow the use of alternative measures besides revenues to assess an entity's concentration of activity in its home market--capital employed, for instance. We then combine our assessment of a transaction's country risk exposure with the rating on the related sovereign to determine a maximum rating differential. There may be cases where the sovereign, or a counterparty that would benefit from extraordinary support by the sovereign, is the direct or indirect offtaker to the project contract (so that project revenues are directly dependent on the sovereign's or counterparty's ability to honor the contract). In these instances, the sovereign rating would act as a formal cap on the debt rating of the project. (For details of our counterparty dependency assessment, see "Project Finance Construction And Operations Counterparty Methodology," published Dec. 20, 2011.)
Additional Contact: Infrastructure Finance Ratings Europe; InfrastructureEurope@standardandpoors.com

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