Credit enhancement: a boost to private capital in infrastructure?

A strange irony persists in today’s infrastructure investment market: private capital waiting to be deployed into the sector is at an all-time high, yet investors seem reluctant to commit. Even in developed countries, few investors are willing to partake in transactions with merchant or construction risks without taking a higher risk premium.

This can make the financing of infrastructure projects more costly—a challenge particularly acute in emerging markets where further investment risks abound.

But many such risks could be transferred to a third party. Indeed, the use of the balance sheets of financial institutions, sovereigns, and multilateral lending institutions could be improved by providing credit enhancement and risk mitigation instruments on top or alongside the traditional lending instruments.  Risk mitigation instruments encourage the private sector to deploy capital into much-needed infrastructure projects—and across a broader spectrum of project types and, crucially, geographies.

The appeal to investors

But it’s a long road ahead. Though infrastructure remains a favorable asset class for institutional investors, more than the lion’s share of capital is channeled to the developed world. By some estimates, approximately 97 percent of total private capital investments mobilized by multilateral lending institutions occurred in high- and middle-income countries. Heightened investment risk compounds the problem. Elevated risks in developing markets include political and regulatory uncertainty, embedded risks in government concessions, exchange rate risk, as well as underdeveloped and unpredictable policy frameworks.

With these drawbacks in mind, creating an investment environment that mitigates these risks—and encourages investment for the most needy projects—is high on the priority list. Credit enhancements could serve this purpose. In short, credit enhancements aim to mitigate the specific risks of a project that either weigh on its overall credit profile or decrease its appeal to the private sector.  Their effective use can lead to project debts receiving a higher rating compared to a scenario where enhancements are absent.

Credit enhancements can take various forms: cash flow stabilization, for instance, can prevent or delay potential distress and default; recovery enhancement can reduce losses in the event of default. Also in use are combined instruments that provide both of these enhancements. We also see the use of credit substitution: a guarantee that serves to fully transfer the risk of timely debt repayments from the project finance issuer to a guarantee provider.

Partial guarantees for recovery can be an attractive feature for investors as they give enhanced visibility on recovery, while the experience and influence of a multilateral lending institution can be another significant draw—known as “the halo effect.” Though it’s difficult to quantify its impact on an asset’s creditworthiness, their involvement may have a positive impact in numerous areas including the design of the relevant public-private partnership (PPP) scheme, the quality of project selection and preparation, and the governance of the relationship between the project and the municipal actor.

This can go far to reduce the operational risk of doing business in emerging economies. For instance, the World Bank recently provided a $500 million partial guarantee to Argentina’s RenovAr program to develop the country’s renewables sector. Though not a full guarantee, such an instrument can help a project rating withstand sovereign stress.

Far from the silver bullet

It’s crucial to remember that the involvement of multilateral lending institutions, though influential, is not enough to solve financing gaps alone. Their mere presence cannot make a non-bankable project bankable, nor can it transform the prospects for poorly planned projects. Then there’s the sheer scale of infrastructure financing gaps: meeting the UN’s Sustainable Development Goals (SDGs), which aim to improve the social and economic well-being of every citizen worldwide, will require annual investment between $5 trillion to $­7 trillion until 2030.

Nonetheless, the role of the multilateral lending institution as a credit enhancement provider could become an important factor for institutional investors deciding whether or not to deploy capital—most notably in emerging markets. And, in this light, sovereign owners have called on them to ramp up their assistance for resource mobilization on a far broader scale across the private sector.

Among other advantages, their involvement serves to match investors to projects better suited to their risk-return profiles, while keeping investors interested in infrastructure—which typically enjoys higher yields compared to investment-grade sovereign and corporate debt.

Against this backdrop, multilateral lending institutions could become an increasingly important fixture in financing global infrastructure.

Disclaimer: The content of this blog does not necessarily reflect the views of the World Bank Group, its Board of Executive Directors, staff or the governments it represents. The World Bank Group does not guarantee the accuracy of the data, findings, or analysis in this post.