"By not addressing the global water crises, none of the UN Sustainable Development Goals will be achievable. Clean Water & Sanitation [SDG 6] is interconnected to all SDGs"
The water crisis is a tragedy of epic proportions. A large part of humanity - more than 2 billion people - do not have access to safe drinking water. An equal number of people do not have access to safe sanitation as well.
This post is part 5 of a series of 8 posts by TIGRIS co-founder, Saud Siddique, detailing thoughts on the current global water crisis, and recommendations on how it can be effectively addressed.
5. Capital Recycling
The multiplier effect of capital recycling can be a powerful mechanism to meeting the huge financing needs for Water PPPs.
As constructed PPP projects enter the operational phase, there will be opportunities to recycle the original capital employed.
For example, the refinancing of post-construction PPP projects can be accomplished with capital from a newer group of private investors at a lower cost (since the risk for investors is reduced in the operational phase of PPP projects).
Let’s examine a BOT project cycle as the project moves from conceptualization, through development and construction, and into operation. As shown in Diagram 4 below, there is a progressive de-risking exercise, at the end of which can emerge an attractive cash-flow generating asset with the potential to produce predictable and consistent revenue for decades.
Diagram 4 - Risk and Expected Return Profile over Project Life Cycle
The de-risked cashflows are attractive for yield-seeking institutional investors and traditional infrastructure funds. The process from project conception to operations is one in which value is added at the successful completion of each key development stage, and the sponsor investing earlier in the process expects to generate higher returns when the asset or portfolio is sold.
As shown in Diagram 4 above, it is possible to refinance and make the capital structure of a water PPP more efficient along different stages of the project lifecycle.
Also, as shown in Diagram 5, there can be a number of options in terms of the types of capital that can be accessed. The predictability of future cash flows will allow for various options to tailor the financial structure to that which best matches the cash flow profile of projects and minimize the cost of capital. Minimizing the cost of capital will also allow for lower water tariffs to the public.
Diagram 5 - Spectrum of Financing Options
At the initial pre-construction/development phase, access to pools of capital is typically limited. This is because of the high-risk nature of the project, and the fact that no cashflow is yet generated. Once construction is completed, i.e., the Project has achieved Post Construction Operation Date (PCOD), the return profile of the asset then becomes very attractive, as it is effectively a yield-producing, long-term asset. Access to broad pools of capital is significantly enhanced, across different segments of the capital markets. When project risks are substantially lower, and particularly when project cashflows are more predictable, it is possible to secure opportunities to refinance debt on better commercial terms.
Since lenders will take comfort from the predictable cashflow backed by long-term contractual arrangements, it may be possible to refinance the debt structure with yield funds, which could provide 25–30 year capital. The stream of predictable cashflow will be attractive to yield investors who want to be able to hold such assets for 15, 20 or 25 years, i.e., “buy and hold” water investments with fixed-income characteristics.
YieldCo or Securitization Vehicles
In terms of capital recycling, once the Project is in the operational phase and generating predictable cashflow with growth upside (e.g.,through tariff increases), the existing Sponsor or Investor may be able to sell their equity stake in the Project to yield investors, or through a YieldCo or some other form of such vehicles, by essentially securitizing the cash flows of the Project.
Ultimately, opportunities to invest in a Water PPP exist along a continuum, with risk and return characteristics being a function of not only the relative maturity of the asset(s) in question, but also other return-enhancing strategies undertaken by fund managers, such as asset aggregation (see Diagram 6).
Diagram 6 - Capital Recycling for Asset Developer - YieldCo
The YieldCo platform is a proven vehicle for allowing Sponsors/Investors to not only to recycle its capital, but also to realize attractive investment returns from investing in a project at the early stage of the project lifecycle. There are numerous examples of how a properly structured Yield Co can provide a strong exit, large capital gain, and capital recycling, option for the Sponsor.
This was the premise behind the establishment of Hyflux Water Trust (HWT) in 2008, the first global capital recycling YieldCo vehicle ever done for Water BOT projects. Hyflux, the developer of the long-term water infrastructure assets, with a cashflow profile generally similar to IPPs, generated approximately 50% returns by divesting its stake in several assets to yield investors. The listing of HWT on the Mainboard Singapore Stock Exchange allowed for a highly diversified group of investors.
YieldCos offer investors direct exposure to pooled cash-generating water assets, which have relatively low operating risk, and which provide predictable cash flows and stable growth (as capacity utilization of the underlying projects increases as water demand increases).
The potential pipeline of BOT projects in developing countries can be in the hundreds of billions of dollars. A global YieldCo which is pooling a project from various developers can be a very powerful vehicle for attracting a wide range of institutional investors seeking predictable cash flows (see Diagram 7).
Diagram 7 - Global YieldCo Overview
The salient features of a Global YieldCo are as follows:
projects can be pooled as into one or several Annuity Generation Platform (s) covering different geographic regions, types of assets (eg.water treatment plants, waste-water treatment plants, waste-water recycling plants, etc).
investing in such Yieldcos can be attractive to yield investors (pension funds and insurance companies), given annuity type returns from owning long-term operating projects.
As indicated in Table 1 below, the capital gains to project developers from divesting projects can be highly attractive depending on different yield scenarios (return requirement of investors). For both public sector, and private sector, the profits will allow redeployment of capital to develop more projects and continuously recycle capital.
Table 1 - Attractive Capital Gains from Divesting Projects
Part 6: "Splitting" Water PPPs into Discrete Project Components and Companies