In today’s turbulent financial and political times, securing finance for construction projects is harder than ever. Even government entities are being asked to pay more for debt than they feel is appropriate.

Dollar-denominated finance from international banks is particularly expensive. Those that do lend are asking for margins much higher than their local counterparts are prepared to offer for local currency loans. As a result, financings in local currencies, such as riyals or Egyptian pounds, increased in 2010 and in Saudi Arabia this is expected to continue to rise in 2011.

Contractors say borrowing from banks to pay projects bonds or make equity investments, for example, in public-private partnership (PPP) special project vehicles, is a struggle for some.

“It is a lot more difficult to borrow now and there is a lot of scrutiny on all aspects of the business,” says the managing director of a UAE-based contractor. “So far, we have not struggled [to borrow], but that is because we don’t carry much debt and we have good cash flow.”

Financing pressure in Saudi Arabia

A scheme that demonstrates the pressure project parties are under when it comes to financing is Saudi Arabia’s massive $5bn mixed-use Jabal Omar real-estate project in Mecca.

The client, Jabal Omar Development Company, is renegotiating a construction contract with developer Saudi Binladin Group, after local lenders for the SR1.35bn ($360m) bridge loan used to start construction were dissatisfied with the uncertainties involved in the use of a cost-reimbursable form of contract.

It is a lot more difficult to borrow now, and … a lot of scrutiny on all aspects of the business

This led to the contractor being asked to rebid the scheme on a lump-sum basis. Sources say the banks were then dissatisfied with the resulting fee proposal and the client began talks with other contractors. Until contracts are signed Jabal Omar Development Company will not be able to draw down on the remaining SR750m.

This situation, where the banks involved (Al-Rajhi, Saudi Hollandi, Sabb, National Commercial Bank and Bank al-Jazeera), are dictating contract terms to clients, shows the importance of cost certainty to all involved. It was the banks that asked for a project management firm to be appointed to control the megaproject.

The $18.6m project management contract was given to the US’ Hill International in September 2010. Contractor Saudi Oger was awarded the first $1.49bn contract for the northern section of the scheme in December 2007, comprising 15 tower blocks, supporting roads and infrastructure. The local Nesma and Partners Construction was awarded a $907m, 24-month contract in December 2010.

Alternative funding mechanism

The disagreement over construction costs is delaying the raising of the main financial package, with debt finance funding most of the development costs. However, Jabal Omar is also planning a rights issue and a project sukuk.

Turning to the capital markets in this way is a step more developers are considering as an alternative funding mechanism. Investors, however, will not want to take on construction risk, meaning short-term debt or other equity investment will be needed during the construction phase. Sukuk and project bonds are more likely to be used as a refinancing tool once the project risk profile improves. Bankers in March said they expected to see six or seven project bonds issued in 2011 across sectors from energy and power to transport and real estate.

As Jabal Omar shows, structuring projects to give cost certainty is all-important in today’s market and is another reason PPPs are gaining popularity. Clients can reduce their borrowing requirements and pass risk on to the private sector in return for fixed payments and a guaranteed quality of asset and level of service.

Abu Dhabi and Egypt have been leading the region on the use of PPPs with several projects in the UAE having got under way. Egypt through its PPP Central Unit, has made great progress in securing private interest. The market is waiting to see how the political situation affects the programme in the long term. Delays are inevitable.

Meanwhile, the region’s first road PPP – a 327-kilometre-long highway from Mafraq to Ghweifat on the Saudi Arabian border is still under negotiation between the Abu Dhabi Department of Transport and preferred contract consortium led by Austria’s Strabag.

A review of the budget by the Department of Finance at the end of 2010 is understood to have led to a request for Strabag to reduce its bid.

Looking ahead, Saudi Arabia’s General Authority for Civil Aviation is set to award the Gulf’s first PPP airport in 2011 for the $2.4bn expansion of Medina’s Prince Mohammed bin Abdulazziz International airport. Kuwait is looking at PPP structures for $28bn of projects and Bahrain signed an estimated $325m wastewater PPP at Muharraq with low bidder South Korea’s Samsung, the UK’s United Utilities and Abu Dhabi’s AD Invest in February 2011.

Financial close was expected to be reached shortly after contract signing. Parties involved in the project declined to comment on how the current volatile political situation in Bahrain will affect the scheme. About $300m of debt is expected to be raised between France’s Credit Agricole, Natixis, Japan’s Sumitomo Mitsui and the Export-Import Bank of Korea. The project consortium will also make equity investments.

Slowing project finance market

International banks at the MEED Project Finance Conference 2011 in early March, said they expected the region’s project finance market would slow as a result of the political instability. They attributed this, in part, to caution among credit committees in Paris and London.

A dearth of international finance will mean the region’s construction projects will be seeking more local involvement in 2011, through debt, bonds, sukuk and, in a few cases, rights issues. This will work well in markets, such as Saudi Arabia, where local liquidity remains high, but other states, such as the UAE and Bahrain, will likely find there is less investment available.