CONFIDENTIAL FOR RESTRICTED USE ONLY (NOT FOR USE BY THIRD PARTIES) FINANCIAL SECTOR ASSESSMENT PROGRAM MEXICO TECHNICAL NOTE INFRASTRUCTURE FINANCE AND CAPITAL MARKETS: ACHIEVEMENTS AND CHALLENGES JULY 2016 This Technical Note was prepared in the context of a joint World Bank-IMF Financial Sector Assessment Program mission in Mexico during June, 2016 led by Alfonso Garcia Mora, World Bank and Ghiath Shabisigh, IMF, and overseen by Finance & Markets Global Practice, World Bank and the Monetary and Capital Markets Department, IMF. The note contains technical analysis and detailed information underpinning the FSAP assessment’s findings and recommendations. Further information on the FSAP program can be found at www.worldbank.org/fsap. THE WORLD BANK GROUP FINANCE & MARKETS GLOBAL PRACTICE LATIN AMERICA AND THE CARIBBEAN VICE PRESIDENCY CONTENTS Page A. Introduction ................................................................................................................ 1 B. Capital markets development in Mexico ................................................................... 2 Instruments ................................................................................................................. 2 Investors ..................................................................................................................... 4 C. Infrastructure financing: developing a financing ecosystem...................................... 5 PPP framework .......................................................................................................... 5 Infrastructure financing instruments .......................................................................... 6 D. The role of development institutions........................................................................ 12 E. Conclusions and recommendations .......................................................................... 14 i GLOSSARY ADR American Depositary Receipt AE Advanced Economy AUM Assets Under Management CDPQ Caisse de Dépôt et Placement du Québec CKD Certificado de Capital de Desarrollo (publicly listed private equity fund specific to Mexico) CerPI Certificados de Proyectos de Inversión (publicly listed private equity fund specific to Mexico) CIEN Certificado de Infraestructura en Escolar Nacional CNBV Comisión Nacional Bancaria y de Valores—Banks and Securities Supervisor CONSAR Comisión Nacional del Sistema de Ahorro para el Retiro EME Emerging Market Economy EPC Engineering, Procurement, Construction Fibra E (Fideicomiso de Bienes Raices para el Sector Energetico (publicly listed REIT type fund for equity investments in mature infrastructure assets specific to Mexico) FONADIN Fondo Nacional de Infraestructura GDP Gross Domestic Product GP General Partner IPO Initial Public Offering LAC Latin America and the Caribbean LP Limited Partner MILA Mercado Integrado Latinoamericano NYSE New York Stock Exchange PE Private Equity PNI Programa Nacional de Infraestructura 2014-2018 PPP Public Private Partnership NAFIN Nacional Financiera SNC, Institución de Banca de Desarrollo. (Development Bank) SHCP Secretaria de Hacienda y Credito Público—Ministry of Finance SME Small and Medium Size Enterprise UDI Unidades De Inversión UK United Kingdom ii A. Introduction 1 1. Mexico’s challenges in infrastructure finance can be framed along similar lines as other Advanced Economies (AEs) and large Emerging Market Economies (EMEs). It is broadly acknowledged that traditional financing sources from governments and banks will not suffice to cover the infrastructure financing gap. This is the result of a combination of factors. The size of infrastructure needs already exceeded funds available before the 2008 financial crisis. But this was worsened by post-crisis fiscal constraints, and higher risk aversion and regulatory constraints faced by banks. In order to fill in this financing gap, governments are targeting long-term investors such as pension funds, insurance companies and sovereign wealth funds, as part of the solution. 2. Capital markets could play an important role in mobilizing institutional investors to finance infrastructure in the most advanced EMEs, including Mexico. However, they cannot be thought as the silver bullet for infrastructure finance, but a very important complement to government and bank financing. Capital markets can play a role in financing infrastructure by providing additional funds in long tenors and lowering costs of financing through increased competition. In this regard, number of challenges are still being addressed by both AEs and EMEs starting from developing an acceptable risk allocation model for institutional investors, to making available the right investment vehicles and instruments. 3. A number of capital markets financing solutions are being tested in AEs and EMEs with some trends taking more relevance that apply to Mexico. Instruments being developed globally with greater success are showing three common elements that will be assessed for Mexico in this Technical Note: i) Liquidity is not a major concern for long term institutional investors, such as pension funds, while higher yields are. The consequence is that there is greater appetite for instruments with lower transaction costs where there are less degrees of separation from the real assets, such as infrastructure funds or unlisted products. As long as asset allocation to infrastructure is relatively small, as it is expected to remain in most countries, it does not impact liquidity needs of institutional investors. ii) Financing structures are increasingly following hybrid models where banks and institutional investors participate jointly in the debt tranche of projects with several types of listed and unlisted instruments. So capital markets solutions need to be designed in coordination with bank financing. iii) Listed instruments, including project bonds, are facing a number of practical difficulties (e.g. standardization, disclosure regimes) preventing them from becoming the dominant instrument. Project bonds are increasingly seen as one 1 This Technical Note was prepared by Catiana Garcia-Kilroy, World Bank, with invaluable research assistance support from Gonzalo Martinez Torres, World Bank. 1 more financing instrument among others, and mostly suitable for brownfield projects. 4. Mexico is particularly well placed to make capital markets a reliable financing source complementing bank financing. Its capital markets are relatively mature, there is sufficient critical mass of long-term domestic institutional investors, and there is a relevant track record of innovative solutions for infrastructure financing from which to build. Section B of this Technical Note will assess the degree of maturity of the Mexican capital markets in those aspects that are most relevant for infrastructure financing. Section C will discuss the different elements of the infrastructure financing ecosystem taking stock of the PPP framework and financial innovations that have been developed, with emphasis on impact, expected developments and potential improvements. Section D, will discuss the role of development financial institutions in mobilizing private sector financing with emphasis on Banobras and Fonadin. Finally, section E will conclude and provide a set of recommendations. B. Capital markets development in Mexico Instruments 5. Government bond markets in Mexico are competitive, present a diversified range of instruments and maturities, are well regulated and innovative. Government bonds are the main market with an outstanding size of 23 percent of GDP as of end-2016. Government bonds are well-structured both in the primary and secondary market. The latter includes efficient market making arrangements providing liquidity across the yield curve. Issued maturities go up to 30 years in fixed coupon. Most instruments are issued at fixed rates while about 25 percent of the outstanding stock are indexed-linked bond which use the UDI as a reference tracking inflation. Foreigners hold around 36 percent of outstanding debt and have been instrumental in lengthening the yield curve and increasing secondary market liquidity. All these instruments provide a reliable long-term risk-free yield curve to be used as price reference by other financial assets in the economy, including infrastructure assets. 6. Non-government bond markets are not a substantial source of long term financing representing only 9 percent of GDP as of December 2015. Non-financial sector issues dominate with 65 percent of outstanding bonds, if commercial paper is not included (see Figure 1). The market is only accessible and efficient to issuers with AA domestic rating or above. This is partly due to some restrictions affecting operation of lower rated bonds, such as restrictions for banks and broker dealers to enter into repos with counterparties other than banks and broker dealers as well as to previous restrictions affecting pension funds to invest below AA although these no longer apply. In bank centric markets, such as Mexico, raising capital is proportionately more costly for lower rated issues that tend to be smaller and bear the same reporting and legal costs as the larger ones. Hybrid issuance regimes 2 with lower financial reporting costs, as recently 2 Hybrid issuance regimes refer to issuance modalities between a public offering and a private placement. They generally imply lower cost of issuance and shorter time-to-market as their reporting and disclosure requirements are lighter than those of public offerings. These regimes target only institutional investors 2 adopted in Mexico, may be part of the solution. Secondary market liquidity is scarce, so the role of specialized price vendors providing “third party” valuations is critical. These are based in extrapolating prices from the sporadic secondary market trading of bonds and/or estimated spreads over the government yield curve. Other advanced EMEs face a similar situation in all these aspects. 7. However, Mexico is showing recent and important developments in infrastructure project bonds as a sub-segment of non-government bonds. Growth in infrastructure related bonds for mature projects has accelerated since their launch in 2009 representing, as of end-2015, 10 percent of outstanding non-government bonds or 1 percent of GDP (see Figure 1 and section 3 below). Underlying assets are relatively low risk in projects in their operational phase and with stable revenues. These project bonds are filling a financing gap where banks would not be a financing alternative, given the large size, lower returns and longer tenors typical of mature infrastructure assets. Figure 1. Outstanding stock of non-government fixed income securities Source: Staff elaboration with data from Secretaria de Hacienda y Credito Publico de Mexico (SHCP) 8. Equity markets are relatively small at 38 percent of GDP as of end 2015. They are smaller than peer countries with only 141 companies compared to 311 in Chile and 359 in Brazil. Companies have few incentives to raise capital in the stock market as relatively cheap financing is available from other sources, including banks and international and domestic bond markets, given the low interest rate scenario, as well as suppliers offering discounts and short term financing for their inputs. The lack of dynamism is also in part related to the existence of large public sector conglomerates that are not listed, along with family-owned corporations reluctant to transparency requiring a lower level of protection than retail investors. They are equivalent to the 144 A issuance regime in the USA. 3 requirements of being listed. Other factors include the lack of a developed securities lending market and regulatory restrictions on operations with shares of medium and small companies. Though the latter is being addressed as part of the changes to the equity market structure. Relevant efforts have been made in terms on international connectivity through ADRs in the NYSE and the incorporation in the Regional initiative Mercado Integrado Latinoamericano (MILA) agreement with Colombia, Peru and Chile. However, these efforts have so far had a small impact on attracting new listings. 9. A number of innovative equity instruments for infrastructure financing have been developed since 2009. These include listed infrastructure equity funds (CKDs) 3 showing promising results. Additionally, the Government is creating new products after structural changes improving the enabling environment for infrastructure finance from the private sector, such as the Energy Reform in 2014 and the PPP Law in 2012. New financial products include mostly listed equity funds with different formats to the CKD such as the CerPI and the FIBRAs. Section 2 will discuss in more detail these products. Investors 10. There is a diverse investor base comprising mutual funds, insurance companies, pension funds and non-residents. Mutual funds are large at 11 percent of GDP as of end-2015, but operate mostly as money market funds investing only in medium and short tenors. Insurance companies are small at 6 percent of GDP and have very conservative investment rules with 47 percent of their portfolio in government bonds. Pension funds represent 14 percent of GDP and are the main source of long-term financing in Mexico. Foreign investors are a very relevant source of long-term finance, but so far only in government bonds holding 30 percent of total debt and 60 percent of fixed coupon bonds. However, they could have a potential catalytic role in long term finance for infrastructure (see below). 11. Mutual funds invest short-term but have the potential of becoming a source of longer term finance after recent Government reforms. So far, mutual funds have been promoted and distributed by banking conglomerates as a flexible substitute for high yielding savings accounts to their existing clients, and avoiding reserve requirements. This structure does not promote the existence of mutual funds with different business models and investment objectives. The financial reform approved in January 2014 allows for “open architecture” mutual funds separating fund management from distribution. The new model is being implemented and is expected to help develop independent mutual funds with broader investment profiles. This is expected to drive mutual funds to operate not only as money market funds but also to develop business models targeting more sophisticated and long- term investments. 12. Pension funds dominate long-term finance generally, including infrastructure with both positive and negative consequences. They are the main investors in infrastructure, though limited by regulations to listed instruments, including 3 CKDs are not limited to infrastructure. There are several CKDs dedicated to real estate, private equity and financing. 4 project bonds and listed private equity funds (CKDs). The industry is very concentrated which makes them very influential in any pricing process in the long tenors and limits market liquidity, given their buy-and-hold investment profile. Regulations allow for a relatively large bucket for infrastructure exposure, in average around 18 percent of AUM, depending on the type of fund. However, they have only invested around 4.5 percent of AUM in infrastructure. This is the result of three factors: lack of investable assets; restrictions to invest in unlisted instruments; the small size of investment teams that cannot cope with the increasing pipeline of CKDs and similar instruments, and limited skills to invest in riskier and more complex assets. The challenge is to create a larger pipeline of investable projects, stronger and larger investment teams within institutional investors, as well as the conditions for a greater variety of long term investors, including foreigners, in the infrastructure finance market, for which there is growing appetite. The latter is already taking place in the Mexican REITs (Fibras) where foreigners are very active. C. Infrastructure financing: developing a financing ecosystem 13. The sheer size and scope of commitments under the National Infrastructure Program (PNI) for 2014-2018 is a clear indicator of the pressing need for long-term private capital. The program aims at USD 596 billion of investments of which 37 percent would come from the private sector. The recent breakthrough sectorial legal reforms would support a stronger engagement of the private sector including: the Energy Sector Reforms and Financial Sector Reform, both enacted in 2014, as well the new PPP Law enacted in 2012. These legal reforms would need to be accompanied by a comprehensive ecosystem of innovative set of policies, regulations and instruments supporting long-term finance for infrastructure. The government has already taken important steps in the implementation of the PPP law and by developing several new financing instruments (see below). PPP framework 14. Mexico is one of the most mature PPP markets in LAC. PPPs have been implemented in Mexico since the 90s under different legal formats under the public works concession law. A major step was the enactment of a comprehensive PPP Law in 2012, which was amended in 2015 and 2016 to address some shortcomings that showed as it was implemented. This Law applies to all PPP projects carried out by agencies and entities of the Federal Public Administration (Art.4 fraction IV of the PPP Law). However, the agency or entity that seeks to participate with federal public resources in PPP projects must meet the requirements of the Second Chapter of the PPP Law. In the case of sub-national government, the PPP Law is optional to develop PPP projects and it´s mandotory for local projects when the financial scheme comes mostly from federal resourcesonly 11 projects have been approved under the new PPP law, until last year, in the health, communications and roads sectors. . 15. The PPP institutional framework can still be reinforced to increase the Government’s effectiveness in program implementation and would provide certainty to financiers. Two important issues remain to be addressed. First, the PPP law 5 does not cover all projects, as some projects that contractually and financially operate as PPPs can still be structured under the sectorial concession laws. This reduces the degree of standardization PPPs should have (e.g. degree of project preparation, contractual arrangements, risk allocation matrix, tendering, etc.). Second, there is not a formal PPP unit in charge of overseeing, providing guidance and standards in the project preparation cycle that would develop a structured and sizeable PPP program. This is a critical function that generally resides in the Ministry of Finance. The Investment Unit at SHCP has a PPP area which is currently partially conducting the role of PPP unit but it does not cover the whole spectrum of PPPs and its resources are limited. An option is to strengthen it so it becomes a full-fledged PPP unit. The existence of a structured and sizeable PPP program has proved to be critical in mobilizing private capital efficiently in AEs, with the UK and Canada being the most representative examples. Infrastructure financing instruments 16. Mexico’s financial sector has strong potential for increased private sector financing of infrastructure, with the support of capital markets. There is ample liquidity in the domestic bank and non-bank financial sector, as well as strong appetite from foreign banks and institutional investors. While very positive progress has been made in developing equity and debt instruments for infrastructure finance, further efforts are needed for a broader long term investor base; refined infrastructure financing instruments articulating bank and capital markets financing; and improved infrastructure financing ecosystem through a stronger APP framework and a greater catalytic role of development banks shifting from direct lending into induced credit. Equity instruments for infrastructure 17. The innovative strategy to develop hybrid capital markets instruments, between private and public offerings regimes – CKDs - has produced promising results. Listed private equity funds (CKDs) had a slow start when launched in 2009. They were designed as a solution to address the prohibition of pensions fund to invest into typical unlisted products (real estate, PE, infrastructure). After several regulatory and governance adjustments they doubled their size since 2011 and reached around US$ 6.2 billion as of end-2015 (see figure 2). Around 30 percent of listed CKDs are related to infrastructure funds investing in both greenfield and brownfield projects. CKDs are having two important positive results: (1) they have opened up the opportunity for pension funds to invest in infrastructure equity assets with higher yields than project bonds, and(2) they are increasing the leverage capacity of project developers allowing them to invest in a greater number of projects. The SHCP and CNBV have been flexible and creative in refining governance, reporting and concentration limits in CKDs. 6 Figure 2. CKDs: Total issued amount Figure 3. CKD Issuances by sector (mill. of Pesos) (units) 90,000 20 80,000 Infrastructure Energy Rest 70,000 15 60,000 50,000 10 40,000 30,000 20,000 5 10,000 0 0 2009 2010 2011 2012 2013 2014 2015 2009 2010 2011 2012 2013 2014 2015 Source: SHCP 18. CKDs have the flexibility to operate under several types of models depending on the investors and partners involved. The most relevant models include: (1) a traditional PE model with a General Partner (GP) and pension funds as Limited Partners (LPs), though with direct participation in the investment committee, provided that a 10% holding is kept; (2) a co-investment with a project developer such as a construction company that may take part or all of the construction risk of the project through an EPC contract; (3) a co-investment with an unlisted SPV in a joint venture scheme with the CKD. Under the latter the unlisted SPV can be owned by a foreign or a local investor that is generally more experienced than pension funds in the CKD. 19. There are several regulatory and governance issues being raised in the CKDs that are important to address. • Listed versus unlisted. As mentioned above, CKDs are very specific to the Mexican context, as they were created to overcome the fact that pension funds by law cannot invest in unlisted products. Two potential obstacles for future growth of the the CKDs are: (1) the higher transactional cost of listed instruments; (2) the disclosure regime of CKDs’ investments typical of public offerings. The latter may keep them outside certain important infrastructure investments that sponsors consider have commercially sensitive information. Internationally, pension funds can invest at least a small part of their portfolio in unlisted products, as long as there are objective valuation methodologies established. Therefore, consideration should be given to opening up the option of pension funds investing a small part of their investment portfolio in private placement vehicles with operational costs and disclosure regimes aligned with infrastructure projects. If such a regime was implemented CONSAR should develop a framework to ensure prudency in investment decisions and minimum qualifications of investment teams within pension funds. • Potential misalignment of interests under the PE model. The traditional PE model has raised issues among pension funds on potential lack of alignment between the GP and the LPs (pension funds) on the tenor of investments and on administration fees. This conflict has also been raised in other jurisdictions in AEs 7 and EMEs. PE’s average life of 10 years is too short for most infrastructure projects and for pension funds investment needs. Additionally, the typical PE remuneration model of 2 percent of assets and 20 percent of profits can be too onerous in certain infrastructure investments with relatively low but stable cash flows, unlike the higher yields of riskier traditional PE investments. Similar concerns have been raised by pension funds in AEs leading to the development of collective investment platforms where pension funds have more flexibility on the tenors, and the remuneration of the internal technical team. Co-investment models with developers and foreign investors in Mexico seem to lead in this direction (see Box 1 on Infrastructure Mexico). This is a desired development not only in joint ventures with foreign investors but also among domestic pension funds only. However, policy support may be needed in this process so that overtime the adequate technical expertise is developed among pension funds and project fund managers to manage such vehicles. Box 1. CKD Infrastructure Mexico: a partnership with a long-term foreign institutional investor in local currency CKD Infraestructura México, SA de CV is a recent and innovative example of how CKDs can be used for investing in infrastructure. This investment platform was launched in late 2015. Caisse de Dépôt et Placement du Québec (CDPQ), and a consortium of five Mexican investors including FONADIN, Pensionisste and the three largest Afores are investing in the platform. CDPQ holds a 51% interest in the co-investment vehicle and is the controlling manager. CKD IM, whose certificates are listed on the Mexican Stock Exchange, holds the remaining 49%. CDPQ is a Canadian long-term asset manager for Canadian pension funds and insurance companies with around CAD 250 billion AUM invested globally. A specific investment team has been appointed to manage the Mexican investment platform but it will also, draw form the expertise of infrastructure investment teams from CDPQ. This platform will allow the Mexican investors to benefit and learn from CDPQ's infrastructure investing expertise. It will give CDPQ local intelligence and deal access and probably some political risk protection. The platform plans to invest up to MXN 35.1 billion (USD 2 billion) in Mexican energy, telecommunications and transportation projects and has an investment horizon of 50 years. Planned investments will be in equity in brownfield projects with stable cash flows in local currency. This reflects CDPQ’s willingness to assume exchange rate risks and manage these on a portfolio basis, which is facilitated by three factors: i) the indexation to inflation of the projects revenues; ii) the long term horizon of investments; iii) the diversification of the portfolio at a global level. Investments are planned as joint ventures with an infrastructure operator that has “skin-in-the- game” and is responsible for managing the infrastructure assets. The first investment has already taken place in an SPV managing four mature toll roads, in partnership with the Mexican construction company ICA (see diagram below). While this is a single operation at an initial stage, it shows a possible option to address several obstacles long-term institutional investors in Mexico are facing: i) knowledge transfer from highly specialized international assets manager; and ii) a vehicle with a partner with aligned interests regarding fees and investment horizon. 8 • Pension funds in CKDs’ investment committee. A distinct feature of CKDs in Mexico, in relation to PE funds, is the direct responsibility of pension funds on every investment through voting rights in the investment committee, provided that a 10% holding is kept, along with the PE General Partner. This may create two types of problems: on the one hand pension funds may not have the required expertise to take technical decisions on every investment; on the other hand, it reduces the monitoring role of investors on the performance of the General Partner (GP) as is the case in traditional PEs. The SHCP and the CNBV have recently created a new type of listed PE fund, the CerPi addressing these issues (see below). However, some interviewed pension funds have expressed their preference to participating in investment committees to reduce potential principal agent problems. The co-investment models mentioned in the above paragraph could be part of the solution. Source: Staff elaboration with inputs from press releases and interviews with representatives from CDPQ, SURA, Banorte, Banamex and Fonadin 20. Two new equity investment vehicles were created in 2015 that are expected to attract a greater range of investors: CerPI and FIBRA E. The CerPI is an evolution of the CKD, closer to PE Funds that, when a pension fund participates, requires another entity (different from Mexican pension funds) to co-invest a minimum of 30 percent. This rule seeks to attract sophisticated foreign and domestic investors along pension funds participating in CerPI’s. It is also expected to be a more agile vehicle as pension funds may not be required to participate in the investment committee, however this committee will no longer be involved in day to day investment decisions, and will instead 9 oversee managers performance and approve investments with related parties and counterparts in conflict of interest. CerPI is to be a friendly vehicle in attracting foreign investors into co-investment arrangements. The FIBRA E is a fiscally favorable equity like vehicle targeting mature projects, specifically in the energy and infrastructure sectors, producing stable cash flows and targeting retail investors. It can provide an exit strategy for projects initially financed through CKDs or CerPI’s during the construction and rump up phases. Both products are very specific to the Mexican regulatory context. Considering the success of precursor products, FIBRA for real estate and CKDs, there are high expectations on the capital that they can mobilize. Debt instruments for infrastructure 21. While domestic project bonds for infrastructure are still small - one percent of GDP- they are the largest among EMEs and are an ideal alternative for large mature infrastructure projects. Main holders are pension funds with around 63 percent of outstanding volume, and insurance companies holding around 7 percent. Project bonds present the same features as ordinary corporate bonds with ratings above AA and very low liquidity (see table 1). But in this case, competition from banks as alternative financing does not apply. Contrary to the case of corporate bonds, banks cannot afford the large size, lower returns and longer tenors typical of mature infrastructure assets under project bonds. All these are features acceptable to pension funds investment profile, including their low liquidity, given their buy-and- hold investor profile. A relevant aspect is that they generally trade at a spread over corporate bonds of equivalent ratings. This may be a sign of greater risk aversion to the fiduciary structures they are based on, or the higher perceived risk of the underlying asset. Around 26 percent of these bonds have partial credit guarantees provided by either Banobras or FONADIN. Further analysis on how to align the spread with bonds with similar ratings and tenor is recommended. Table 1. Infrastructure project bonds, by type 4 (2009-2015) Type of rate Quantity Nominal 45 Indexed 24 Credit rank Quantity Senior 63 Subordinated 6 Credit rating Quantity AA 28 AA/AAA 7 AAA 34 Credit enhancement Quantity Surety 7 On-time payment guarantee 11 Pledge on securities 2 Source: SHCP 4 Credit rating refers to the national scale. 10 22. Existing debt instruments could be broadened to include infrastructure debt funds to appeal to a broader range of private sector investors. Commercial banks are rarely able to provide loans on a recurrent basis beyond 10-12 years. The long tenor gap is generally provided by Banobras at 20 years and beyond in syndicated loans with other banks. A possible solution is to explore developing Debt Infrastructure Funds (maybe under private placements, CKDs or CerPIs format) through which pension funds and other institutional investors could provide long-term loans along banks providing shorter tenors, as is already happening in other markets. If necessary, Banobras could credit- enhance loans offered by the Debt Infrastructure Funds through partial credit risk guarantees (e.g. for construction, liquidity and political risk). This would enable Banobras to be more efficient from a balance sheet perspective instead of providing direct long tenor loans. It will also offer pension funds and other investors a new instrument with a risk-return profile between an equity CKD and a project bond. Box 23. securitization A Bonds: 2. Project challenges was recently created to finance education instrument trends and infrastructure (CIEN). The bond is backed by the securitization of future flows to be new generation The transferred by of theproject bonds, federal after the demise government of monolines to sub-national in 2008, iswith authorities still in the process of being infrastructure developed both in AEs and EMEs, though with promising results. Project bonds projects in education. So from the investor perspective the bonds are exposed only as a to the of total proportion infrastructure lending is still small at around 9 percent of global project finance debt as of end 2015. But their risk ofsuch transfers. While these instruments differ from project bonds, they can still be growth has been steady for the past four years. relevant instruments to mobilize private financingHowever, potential fiscal impact on After the 2008 future crisis, initiatives committed to develop funds would new need to betypes of project bonds have taken place mostly in the United monitored. States and the European Union. In both cases, they rely on risk sharing arrangements where the Government or a specialized agency (e.g. TFIA in the case of the USA for transport and the Project Bond Credit Enhancement Initiative in the EU) Latin America is the region, among EMEs, with the largest volume of project bonds. Prior to the crisis, during the late 1990s and early 2000s, Chile successfully used project bonds to finance roads. The bonds were issued in the domestic markets; they were indexed and had the full wrap guarantee of monolines. Post crisis the most important experiences include Brazil, Mexico and Peru. With the exception of Mexico, in all these cases, issuances have been placed in the offshore markets and mainly in hard currency. These experiences tend to show three important characteristics in project bonds: • They are more suitable for brownfield projects, though greenfield projects may be also be viable, provided a bank is co-investing. • They require relatively large size thresholds. • They, generally, require some type of credit enhancement to align the appetite of institutional investors, even in brownfield projects. Additionally, project bonds, when listed, present three important challenges that are not yet fully solved: • The disclosure regime of listed bonds may be misaligned with commercially sensitive information the sponsor may not want to disclose. • Complexity of obtaining approval of multiple bond-holders when requiring amendnments or changes in covenants. This was a very important role monolines took on behalf of bondholders, known as “controlling creditor”. • The cost of carry in greenfield projects when all funds are disbursed at the beginning of the construction phase. Some solutions have been developed to address these challenges, however, optimum solutions have not been developed yet. 11 Box 3. Infrastructure debt funds Infrastructure debt funds are increasingly becoming more popular internationally as a result of the low yield environment. A quantitative shift took place in 2015 with USD 11.5 billion raised compared to USD 4.5 billion raised in 2014 (Prequin). Institutional investors are shifting from investing only in equity funds into adding debt funds to their portfolios, mostly in mezzanine debt with higher returns. Two factors are playing for a greater use of debt funds by institutional investors. On the borrowers side, developers are prepared to accept the more restrictive covenants that institutional investors require, in relation to bank debt (e.g. make whole payments), as they can lock in historically low rates in very long tenors. On the lenders side, institutional investors are receiving higher yields, comparable to what banks can obtain, and benefit from outsourcing risk management to a knwolegeable third party. Infrastructure debt funds are generally part of hybrid finacing structures that include shorter-term bank loans. While project bonds can still be an important instrument to mobilize institutional investors, infrastructure debt funds are more flexible instruments, are easier to engage in greenfield projects, bear lower transactions costs and offer higher yields. In LAC, Colombia and Peru have launched several infrastructure debt funds with promising results though they are still in their initial stages. In both countries infrastructure debt funds target to provide long term debt to greenfield projects complementing bank financing in shorter tenors. They are considered by pension funds as a instrument that allows them to bridge their infrastructure skill gap while obtaining higher yields than in project bonds. D. The role of development institutions 24. Several development entities support infrastructure finance in Mexico from different angles and segments. The most important ones are FONADIN, a fund created by a Presidential Decree in 2008 allocated within Banobras, the largest development bank. Two other development banks, NAFIN and Bancomext, provide financing and guarantees to projects in renewable energy, though their core focus is SMEs and the export sector respectively. The division of labor between the three institutions and the fund is not formally defined or coordinated, which may lead to potential overlaps and unnecessary competition. Recently the SHCP took the initiative to address these potential issues by creating a working group to define the division of labor between the different development institutions and to coordinate their engagements in systematic way so as to maximize impact. 25. FONADIN is a fund created by a Presidential Decree in 2008 as a vehicle to address market gaps in the highest risk segments of socially relevant projects. Part of its assets include 4,031 kilometers of revenue generating toll roads that were restructured after being liquidated by the Government in the late 90s. FONADIN is a very flexible vehicle offering non-reimbursable and reimbursable products across the whole project cycle in economic infrastructure and through a broad range of products. Non- reimbursable products include grants, viability gap funds and financing feasibility studies 12 to government authorities. Reimbursable products aim mostly at reducing credit risk in financially viable projects through subordinated debt, partial credit and performance guarantees. It also seeks to support medium size Mexican concessionaires in the energy and construction sector through equity investments in projects so they can compete with international or larger sponsors. Additionally, it supports mobilization of capital from institutional investors by participating in the capital of CKDs. As of end-2016, FONADIN had supported on a cumulative basis 117 projects with almost USD 8 billion5 of which 44 percent was non-refundable, mobilizing a total of USD 25 billion mostly in highways (51 percent). 26. Banobras is a dominant player in infrastructure finance providing 47 percent of total bank credit as of end-2016. It is specialized in infrastructure finance directed to only financially viable projects. Most of its portfolio includes projects supported by sub-national governments (54 percent) or self-sustained projects (33 percent). It provides two types of products: direct long-term loans and instruments for “induced lending” 6 . The latter include second tier long-term loans to banks participating in infrastructure projects, partial guarantees for bank loans and capital markets instruments. The share of direct lending is in the process of shifting into induced lending from 16 percent as of end-2012 to 26 percent as of end-2016. Banobras has played an important role in lengthening financing tenors in infrastructure by participating in bank syndicates or co-financing along domestic and foreign banks. Under these arrangements Banobras, offers loans at around 20-25 year tenors while banks lend at around 10-12 years. Two other products that are being offered include staple loans in health projects at very low interest rates and local currency funding to foreign banks. 27. The challenge for Banobras is to reduce its share in infrastructure financing and crowd in financing from commercial banks and institutional investors. These are already stated objectives for Banobras (see table 2). However, this strategy would need to be carefully planned and implemented with sufficient resources to ensure its success for two reasons. First, the already stated objective of increasing Banobras’ direct credit may be potentially in conflict with crowding in private sector investments when faced with a choice in particular projects. Second, the organizational structure and skill set required to provide guarantees for “induced credit” are very different to that required for direct credits. In this case, Banobras would need to make an additional effort to face the institutional inertia from previous practices and build a different set of skills among its staff. It is important to note that the institutional investor mobilization target is not very ambitious in absolute numbers targeting only 20,000 million pesos in 2018. While this may be explained by the low base, scenario and challenges faced by project bonds (see above), it may be worthwhile to assess new types of products to mobilize debt financing such as the proposed infrastructure debt funds. 5 Exchange rate used: 18 MXP/USD. 6 “Induced lending” is the term used in Mexico for additional lending triggered by products offered by development institutions. 13 Table 2. Banobras strategic targets in infrastructure finance Objectives March 2016 Target 2018 Change in percentage 1. Increase direct and “induced” credit 438,925 mill. 583,400 mill. 47 % MXP MXP 2. Promote commercial banks financing for 63 % 60 % 8% infrastructure as percentage of total infrastructure credit 3. Mobilize institutional investors into 10,500 mill. 20,000 mill. 90 % infrastructure MXP MxP Source: staff elaboration with inputs from Banobras. 28. Banobras and FONADIN have played an important role to mobilize private financing into infrastructure though their role should be refocused to avoid market distortions. This would be particularly important for mobilizing long-term financing through capital markets instruments. New initiatives and products to be encouraged, some of which are being planned include: a more systematic use of guarantees, adding to the current menu political risk guarantees for sub-national governments risk; guarantees and/or co-investments to support the launch of new products such as the proposed infrastructure debt funds (see Box 3). Regarding FONADIN, its flexibility could support a greater role in promoting capital markets solutions to mobilize long-term institutional investors. For example, it could play an important role in creating confidence for the proposed infrastructure debt funds. Along these lines, consideration could be given to off- loading through project bonds mature and profitable projects currently on the balance sheet of development banks or FONADIN. A greater critical mass of capital markets instruments financing infrastructure would create a strong precedent for new projects, as well as opportunities to test new instruments and develop standards for capital markets instruments as it is already taking place in AEs (e.g. legal documentation, disclosure regimes, pricing). This direction is already being followed in part by the GoM through the creation of new instruments (e.g. CerPI, FIBRA E) but could be reinforced by a more proactive role of FONADIN and Banobras. E. Conclusions and recommendations 29. Mexico is very well placed to develop efficient capital markets solutions to complement bank financing for infrastructure, though a number of important adjustments are needed. The SHCP and the CNBV have been very dynamic and successful when compared to peer countries in developing new financing instruments. However, there is wide gap between the capacity and readiness of the financial sector to channel domestic and foreing savings to infrastructure, and the lack of bankable projects. The latter is in part due to the need to reinforce the implementation of the PPP law and establish a stronger institutionality to implement it. This aspect is critical to develop a bankable pipeline of projects. The second aspect is a more focused and coordinated approach from development banks and FONADIN to crowd in private sector investment, gradually reducing direct lending. The third aspect is to continue following the flexible 14 and dynamic approach to develop financial innovations for infrastructure finance. Ideally, this should consider overtime a greater role for unlisted financial products. Finally, the greater participation of other investors beyond pension funds, as well as larger and more sophisticated investment teams within institutional investors would be important. A recap of the main recommendations in this note follows. 30. Create a PPP unit in the SHCP that would allow the systematic implementation of the PPP law and the development of a standardized PPP program Good practices and standards created by this PPP unit would overtime, facilitate establishing a single and compulsory PPP legal and practical framework applying to all PPP projects. This would be critical to develop a credible pipeline of bankable projects and, as experienced in other countries, can significantly lower the cost of financing and improve the pipeline of PPP projects and contracting conditions for the Mexican Goverment. Similar PPP units could also be created in the larger subnational governments. 31. Develop a systematic and coordinated financial guarantee program for Banobras, Nafin, Bancomext and FONADIN. These guarantees would bridge the risk gap in capital markets instruments including: infrastructure debt funds in the construction phase providing long term debt along with banks shorter maturities; project bonds to reduce undue spread. FONADIN, could additionally support the reinforced PPP unit in project preparation in a more systematic way (see below). 32. Develop debt infrastructure funds preferably under unlisted funds, with potential guarantees from FONADIN or Banobras. As a second option they could be under the regimes of CKDs or CERPIs. The objective would be to complement bank loans with longer tenors, more efficiently than having Banobras providing long term loans, while developing a new investment option for pension funds. 33. Continue with the flexible process of adjusting hybrid listed private instruments so they are better aligned with more traditional private placement vehicles. Given the market acceptance of the existing instruments and the complexity of changing the pension fund law, it seems that listing instruments, with flexible arrangements, would still be able to mobilize a significant share of long term finance. However, internationally, these instruments are generally unlisted. Consideration should be given to allowing pension funds invest, even if a small part of their investment portfolio in private placement vehicles. If such a regime would need to be accompanied by a frameworks ensuring prudency in investment decisions and minimum qualifications of investment teams within pension funds. 34. Promote collective investment platforms to break away from PE misaligned incentives for long term finance in infrastructure. Support to the Infrastructure Mexico CKD is a step in the right direction as well as the recently created CERPIs and FIBRA E regulations. Further analysis is recommended to create incentives for joint structures with project developers. Additionally, it would be relevant to explore incentives that would reinforce building stronger investment teams within the pensions funds. 15