1 July 2003
Recession, terrorism, war and epidemic have converged to produce what many call the “perfect storm” currently deluging the global airline industry. Major carriers struggle to survive, old assumptions are questioned, new business models are emerging, financing is scarce. Airports cannot help but suffer as passenger traffic falls off a cliff and costs rise due to the new security and health measures required to lure travelers back to the air.
For governments in developing markets eager to attract private capital and expertise to upgrade and expand their crucial gateways to the global economy, the timing of these events could not be worse. The challenges inherent in designing a concession regime that balances international investors’ interests with the public interest in the safe, reliable and economic construction and operation of airport facilities are already difficult enough. Nevertheless, we must hope governments, developers and financiers continue to overcome all these concurrent challenges and complete, perfect and (where necessary) restructure these critical privatizations.
This article will examine some of the structures that have been developed in these transactions, certain issues, resolved and unresolved, they present and the impact on these structures of recent adverse developments. The transactions vary in form, from operating arrangements through concessions to trade sales (and combinations of the foregoing), and in the extent of new construction involved. We will focus here on concessions involving new construction, understanding many issues are common to all forms of airport privatizations.
The key risk common to international financing of infrastructure in emerging markets is country or political risk. This risk is particularly acute in the case of airport concessions because of (1) the sheer physical and, increasingly, security hazards inherent in air transport, (2) the direct use of the facilities by the public, (3) the retention by the government of critical traffic control, security and even military functions and (4) the reliance of investors on the government not to interfere with the concessionaire’s activities, management and financial arrangements, to permit agreed tariff adjustments and commercial development and, in the event of termination, to make a payment sufficient to repay the related financing. On the other hand, one advantage of international airports over other infrastructure facilities (subject to recent developments described below) is the generation of substantial amounts of foreign-currency revenues.
This risk can be mitigated in several ways, including of course by recourse to creditworthy foreign sponsors, but also for example by insurance covering currency restrictions (exchange rates themselves will be a concern only where a significant portion of revenues is in inconvertible currencies) as well as nonpayment on termination, or indirectly by the participation in the financing of official lending agencies. Without delving in detail into the peculiarities of traditional political risk insurance policy forms, particular issues can arise in trying to marry such coverage with other forms of credit support, such as financial guarantees.
In order to attract a financial guarantor, the debt obligations to be incurred must enjoy an investment-grade rating prior to being “wrapped” by the guarantor. This means (1) they must be structured on a sound basis in terms of risk allocation, security etc. and (2) they cannot be constrained by a “sovereign ceiling” (the rating of the host country’s external debt obligations) below investment grade (as they were not, for instance, in the case of the Santiago, Chile airport privatization). In the case of below-investment-grade sovereigns, however, “piercing” the ceiling means offering political risk insurance.
A financial guarantor, typically a monoline insurer, is unconditionally obligated to make timely debt service payments. Where political risk insurance is required, the financial guarantor will thus want to ensure it controls the exercise of remedies etc. on the assumption the political risk insurer will want to avoid triggering liability on the part of the government and thus exposure under the political risk policy. By the same token, the political risk insurer will want to give the government all reasonable leeway before the covered termination obligation is triggered. Both will want to control the actions of the concessionaire in handling disputes with the government, sometimes down to attending every meeting and approving not only decisions made but even retention of counsel.
In addition, official political risk insurers will want to condition their obligations on compliance by the project with environmental and social policies they are charged with promoting. This in turn creates a potential gap in coverage from the financial guarantor’s perspective, because the political risk coverage can fall away due to events beyond the control of the guarantor or even the concessionaire. In fact, the host government could very well be preventing environmental compliance at the very moment it is also reneging on its termination payment obligation.
These inter-guarantor conflicts can even extend to favoring different groups of sponsors: the financial guarantor will want the reassurance of an international operator ensuring compliance with ICAO standards, while the political risk insurer will be concerned that a local partner with sufficient clout have a significant interest in the project.
The guarantors will be tempted to try to resolve these issues “on the back of” the concessionaire, e.g., by imposing “hair trigger” events of default to reduce the possibility of a lapse in political risk coverage and/or by freezing the owners out of discussions with the government. Naturally the concessionaire will resist such an outcome. Moreover, while it may well welcome assistance from financing parties in dealing with its government client, the concessionaire naturally wants to manage that relationship with a minimum of interference and prevent the owners’ interest from being “squeezed out” by agreement of the other parties.
The foregoing discussion has focused on support for an airport concession’s foreign debt obligations. Additional complications, including new intercreditor issues and conflicts, can arise where foreign equity investors also seek to procure political risk coverage. Other aspects of country risk, such as legal risk (in particular land title issues but also regulatory predictability and contract enforcement), are less easily managed.
Other issues are particular to airports in developing countries. Most such countries (though not all) have a flag carrier that (together, perhaps, with those of neighboring countries) accounts for a large share of airport revenues and often relies on government financial support. In the case of such weak credits investors will want to receive some security for the airline’s obligations to pay airport fees. Indeed, in the current environment, investors will be looking closely at all relevant airline credits, subject to the mitigant that local demand may be strong enough to be taken up relatively quickly by competitors in the event a particular international carrier has to reduce its presence in a given market.
A recent report1 examined the incremental impact of the SARS epidemic on airports and related flag carriers, particularly in Southeast Asia. It observed that, while paradoxically Asian carriers might increase their market share due to the crisis, it might lead to a permanent reduction in traffic levels, putting pressure on fees and, together with additional health-oriented remedial costs, resulting valuations.
One impact of the recent severe financial stress on the airline industry is the trend toward low-cost airlines, which are demanding fee concessions from airports, and the use of smaller regional jets on shorter and intermediate routes. These trends cannot but have an effect on airport planning and economics as they rearrange the traditional hub-and-spoke, large-aircraft industry model and increase competition among carriers and manufacturers. Among other things, finding ways to increase the contribution of commercial revenues assumes greater importance in this environment.
Airport concessionaires and prospective concessionaires affected by these developments may need to rethink financing structures. Reduced hard-currency airside fees may be replaced by more volatile local-currency lease revenues. Financiers may require more control of Centre for Asia Pacific Aviation, “Aviation Analyst Asia Pacific,” Issue 47, March-April 2003