Financial models in infrastructure investments - what can we miss?

Typical infrastructure investments are made for the long term. While some investments in this asset class may be similar to private equity investments in terms of duration, many core infrastructure investments have an expected lifetime of 15 years or more. In such a long lifespan, it is difficult to accurately forecast all the factors that will impact the returns and flows from the target/project company all the way until the investment fund.  

The technique of financial modeling allows us to have an overview of the key flows, costs and expected returns during the lifetime of the investment on the basis of the information known as of today as well as laws and regulations currently in force. A few best practices, however, need to be followed to make it a reliable model that can serve different purposes, typically in the context of an acquisition or for financial reporting. It is not unusual that a model is built for the purpose of the acquisition only, and that another model is developed for financial reporting purposes.  

Even if the picture is not perfect, a good financial model makes it possible to identify debt capacity and tax costs, and also sets the premise for the return on investment. It also gives a view on when to expect cash traps or the impact of taxes. 

Focusing on a clear, non-aggregated view and choosing the appropriate level of equity  

If the investment is performed through a chain of holding companies (as is usually the case), these are seldom reflected in the financial model; or the total investment that goes through these companies is aggregated so that there is no clear view per company. The focus is usually put on the target/project entity, third-party lenders and the overall shareholders’ return (which combine the equity portion and the shareholder debt portion).  

By providing an aggregate view only, the financial model may miss potential repatriation issues or costs within the chain of holding companies. For instance, if the model assumes quarterly dividend distributions up the chain, it needs to be confirmed whether this would be legally possible. In many European countries, interim dividends are not permitted or are 

restricted to certain types of entities only. If this is the case for the jurisdiction of the target or the holding companies, additional repatriation methods should be considered, such as capital reductions (which have limitations as well) and a higher level of debt.  

The advantage of equity is that dividend income often benefits from an income tax exemption (or partial exemption) at the level of the recipient. At the level of the paying company, the dividend may be subject to withholding taxes unless EU directives or treaty exemptions apply. The application of the exemption under these directives or treaty benefits have been 

challenged over the past years by tax authorities and courts on the basis of the substance of the holding companies. A proposed directive (Unshell Directive or ATAD 3) even seeks to establish minimum standards for the application of the tax benefits under EU directives or treaties but by no means will it prevent member states from imposing stricter requirements.  

When funding the structure with third-party and shareholder debt, the interest limitation rules kick in very quickly. The total debt in such a case is not aimed at maximizing interest deductions but to ensure that the profits of the project can be repatriated to the shareholders without corporate restrictions – as there are for dividends (approved annual accounts or interim accounts, corporate resolutions, etc.) and in a speedy way. It also helps that some countries do not have withholding tax on interest but would otherwise apply it to dividends. Other countries which apply interest withholding tax may grant an exemption on the basis of directives or tax treaties – but lenders are then subject to the same scrutiny on the substance as mentioned above for the dividend withholding tax exemption.  

One important point regarding debt is that when there is an interest expense on one side, there is interest income on the other side. If this is intra-group debt and the borrower does not get a deduction of the interest expense due to the interest limitation rules, the lender in the group will still be paying tax on the interest income unless itself has interest expenses to pay to another lender. The issue is shifted to the next level and the tax impact will depend on the tax attributes of the ultimate lenders (e.g., fully taxable, preferential regime, tax exempt status, etc.).  

At inception, the financial model needs to capture the impact of equity and debt and support in reaching the appropriate levels for both. 

Regular adjustments for environmental effects are key 

In addition, future events that may affect the operation of the project (for instance, new environmental or tax laws, regulatory restrictions, changes of norms, unexpected costs and others) are not reflected in the financial model and may substantially impact its output. 

Whenever there are relevant events that affect the premises of the financial model, it is critical to review it to assess whether the assumptions remain valid and correct.  

A refinancing or unforeseen circumstances not yet reflected in the model, such as a debt repayment, a capital reduction, additional capex to conform the operations to new rules, could impact the planned returns and the repatriation flows. 

In particular, new laws creating or increasing tax rates, eliminating exemptions or creating additional rules to be followed to ensure access to such exemptions, could trigger a tax burden which was not originally planned when the investment was made. The rapidly changing tax environment requires a constant assessment of infrastructure investment structures and a tax review of the financial model.  

Is a restructuring required? 

Depending on the changes and their impact on the financial model, a restructuring of the investment structure may be required. If the restructuring is needed due to a resulting onerous tax (among other reasons), careful attention should be paid to the potential application of the general anti-abuse rules (GAAR). The GAAR may apply if the transaction (or restructuring) is mainly or solely motivated by tax reasons. If so, the restructuring steps would be disregarded, and taxation would apply as if no restructuring had taken place. 

In sum, changes to the investment structure are possible but need to align to business objectives. If a structure had numerous entities because of banking reasons, co-investors’ or legal requirements, it should be possible to rationalize it when those entities are no longer needed and would only represent unnecessary administrative costs and cause delays in the repatriation route. 

Given the long-term nature of many infrastructure investments, a periodic independent review of the financial and tax model is extremely useful but may also be required to comply with governance requirements or regulations such as the Alternative Investment Fund Managers Directive (AIFMD).  

An inappropriately built model can lead to material errors, which may go undetected for many years if not independently reviewed. Such review may thus entail costs with the review itself, but it can be a powerful tool to detect issues that otherwise would only be found out later once there would be a cash trap, additional taxes or valuation errors. How often should this review happen and how detailed should it be? Considering the current markets and the global economic situation, possibly every year. Otherwise as often as needed, keeping in mind that a full review may not be necessary depending on the type of event impacting the financial model.  

This article was published in AGEFI Luxembourg.