Todai Finance Innovation Program Lecture 4 Report

The venue for the 4th Lecture of the Todai Finance Innovation Program shifted to theKojima Conference Room of the Economics Research Annex at the University of Tokyo Hongocampus. The trio of lecturers Atsuo Akai, Tomohiko Taniyama and Takayuki Fukuda spoke on thetopic of “Securitization and Project Finance”, with Mr Fukuda (Special Advisor to the Chief Cabinet
Secretary) providing participants with valuable insight into government related project finance andthe recently introduced concession framework.

What is Securitization? –Atsuo AkaiAssets can be a source of return but can also be a cluster of risk at the same time.
Securitization breaks down such risk into its component parts (such as credit risk, interest risk), andreorganizes the risk so that it may be handed over to the risk taker through the financial / capital
market. The process of securitization is comparable to the process of turning dirty water (risks
investors unwilling to take) to clean drinkable water (risks investors willing to take) through various
processes such as filtration (credit enhancement), chemical treatment (diversification) andsedimentation (tranching). In the financial market it is relatively easy to deal with credit and market
risk, therefore risk is rebundled into securities with such factors in mind.

One of the driving factors behind securitization is the potential to generate funds fromareas traditional corporate finance cannot cover. Using asset finance it is possible to cut away assets
from the corporate and these assets are able to stand on their own. This means that for example, even
if the credit rating for a company were low, the assets it owns (e.g. cash) would still have a very highrating. Generally speaking for TV companies asset quality is low, but if you cut away thebroadcasting rights they are actually very high quality (if viewing is guaranteed). Further dividing
such assets into its component risks such as market risk and credit risk, allows for the coverage ofareas that corporate finance cannot cover. It has provided benefits for both investors and thoseissuing the securities. For investors, securitization has created new financial products that can beinvested in, and has proved especially beneficial for life insurance or pension companies. For theissuer of such securities, it provides new funds that can be allocated towards other activities /investments. Recently in Japan, securitization is playing an increasingly important role ininfrastructure projects.

When dealing with securities, it is necessary to perform prepayment projections, i.e.
making predictions of the fair market price. In order to make such predictions, it is necessary toresearch what percentage of people would take what kind of action in a particular situation. For
example, in the case of housing loans, if interest was to go down it is logically expected that people
would refinance, leading the peak of the triangle in the figure below to move further left and higher(area remains the same). This can be explained by the fact that as interest goes down, profits
decrease leading to an increase in payment amount. The part A in the figure below does not move so
we can take this portion out with fixed interest (tranche A: can be sold to life insurance companies
and pension funds) and we are left with the variable portions B. From this it is clear to see that there
exist parts that have all the volatility of people’s actions and parts that are independent of them.
Furthermore, if you split the sections in three vertically, you are able to obtain sections that can pay
off in the short, medium and long term.

In recent years, new technology such as big data has begun to play an increasingly
important role in analyzing people’s behavior, replacing traditional prepayment models. It involves
estimating what kind of financial situation people are in and how interest rates should move inaccordance to that. However, it is important to note that not all people will take logical measures as
there may be some who do not read the newspaper, or there may be people who relocate or returnthe loan ahead of schedule due to the good economic conditions.

Significance of Securitization according to Financial Theory –Tomohiko Taniyama
According to the Modigliani-Miller theorem, the market value of a company is
independent of the capital structure used to finance investments under assumptions of no income taxand distress costs. Therefore, this implies that securitization does not provide any added value to acompany and just involves extra costs for investment banks. Recapping how market value of acompany is calculated, before the emergence of the Modigliani-Miller theorem, company value wascalculated from debt + equity, whereas now it is calculated in terms of discount cash flow plus therisk of underlying assets.

Although the Modigliani-Miller theorem implies that securitization does not provide
added value, in reality studies have provided various economic benefits of securitization. Theseinclude enabling financing for assets that have been hard to finance through the traditional system,or the small lots facilitating pairing of the right asset with the right investor. Securitization has
created market access for things that were difficult to invest in before and has lead to funds dealing
with unique items (e.g. vintage wines). These funds are structured so that fund managers who
manage these new assets must increase the return of investors and general partners in order toincrease their own returns. The unbundling also has many applications in projects, which like assets
can be seen as both a source of returns as well as a cluster of risk. Projects are usually associatedwith added risks such as climate and operational risk. Currently, the infrastructure funds market(especially in Asia) is experiencing steady growth, following a similar trend to the real estate funds
market but with a 10-year lag.

What are the characteristics of the infrastructure business? There exists regionalmonopoly with few competitors, and there will always be users of the infrastructure. Furthermore,
there is room for improvements in profitability with an increase in know-how of private firms.
Currently Japan is facing the problem of ageing infrastructure, and the major solution has been
identified as the incorporation of private sector funds, as opposed to other alternatives such asincreasing taxes or decreasing levels of service. This is where securitization plays a pivotal role as avehicle to bring in private sector funds, supported by regulations such as PPP (Public PrivatePartnership) and PFI (Private Finance Initiative).

Trends in Japan (PPP/PFI, Concession) –Takayuki Fukuda
Japan is currently facing twomajor issues in relation to infrastructure: 1)
Infrastructure is getting old and needs
repair/replacement 2) Rapidly augmenting
number of foreign visitors to Japan is placing
increasing strain on infrastructure such as
airports and ferry terminals, calling for theneed to increase capacity. On the other hand,thesuchamount set aside by the government for

infrastructure projects has remained roughly constant in recent years. Hence, new methods offinancing (especially those that involve the use of private money) have had to be developed to steer
away from the traditional methods such as issuing bonds.

Implications of Category, Scheme and Phase on Risk-ReturnInfrastructure can largely be divided into the two categories of economic infrastructureand social infrastructure. Economic infrastructure includes transport, energy / utilities and otherssuch as satellites and parking spaces (users usually pay). On the other hand, social infrastructurerefers to facilities such as educational facilities, hospitals and prisons (users may pay for the service
provided but not for the hard infrastructure itself).

However, in addition to the category of the project, scheme variation can lead tosignificant variations in risk-return. There are three schemes: income from public, income from user,
and income from public and user. With the income from public scheme, the provider of the service
receives payments from the government, meaning that as long as the agreed level of service ismaintained payment will be received, hence there is relatively low risk associated. At the opposite
end of the spectrum there is the income from user scheme where the service provider obtains revenue

from the users of the service. This has a comparatively higher level of risk associated, as it cannot beknown whether users will be willing to pay for the service until operations actually begin. Finally
there is the income from public and user scheme, which is a hybrid of the two, where the service
provider obtains revenue from both sources. One example is the sewerage system, which iscomposed of the wastewater system (can trace the source and charge accordingly) and rainwatersystem (can’t charge anyone so income obtained from public).

Finally, in order to properly evaluate risk-return it is necessary to look at the phase of aproject. A project in the greenfield stage is a project that is still in the planning phase, which has therisk of not knowing the amount of expected usage until the operation actually begins. On thecontrary, a project in the brownfield phase is already up and running so it is possible to examine
previous records to see the approximate levels of usage expected. In this way it can be seen how
projects in the same category may have different levels of associated risk according to the schemeand phase of the project.

Regulation Reforms
PFI was introduced to Japan in 1999 with the aim of increasing the contribution ofprivate capital in infrastructure projects. At the time, there existed a large imbalance in the type ofscheme under which infrastructure projects were operated, with approximately 70% operated underincome from public schemes and a mere 5% under income from user schemes. However, thisimbalance continued even after PFI 1999 and this was partially attributed to articles in the law thatremained which specifically stated that responsibility of maintenance and operation of certain
facilities such as sewerage systems and airports lay with local or national governments. The 2011
PFI reform introduced the concession framework to overcome such an issue, allowing operationrights to be granted to private companies while the ownership of such infrastructure remained withgovernments. In return for these operation rights, the private company would be required to pay thegovernment a certain fee. This fee, usually being relatively large, means that the private operator
needs to finance it in some way, usually in the form of a loan from a financial institution.
Securitization plays an important role here as it allows for the operation rights to be separated andheld as a right of pledge in order for the private company to obtain the loan.

However, the government is still in the process of passing more reforms in order toresolve issues that exist in the implementation of the concession framework. One area that wasaddressed in 2015 was the transfer of personnel between the public and private sector. For example,
not many people from private companies have experience leading passengers on the tarmac atairports. The PFI 2015 reform allows such personnel currently employed in the public sector to shift
temporarily to the private sector and return after the set period has passed. Such transfer of know
how is essential in the shift from public to private operation.

How is concession different to subcontracting and privatization?
There are two major differences between concession and subcontracting. The first is that
subcontracting is often done for a period of 3-5 years, and remains on the balance sheet of thegovernment. For the operator, the short time span means that it is only really possible to operate
under conditions given by the government and there is no real room to make proposals. The timescale for concession is much longer, ranging from 10-30 years, which allows room for the operatingcompany to make proposals to the government in order to make operations more efficient andmaximize profits.

The second major difference is that with concession the operation rights fee emerges atthe very start. This means that the private company pays the fee before the project begins and takessome risk. In order to recoup their initial investment, they must generate profit from the operation
during the period of the concession. Hence there is pressure to optimize operations under the given
conditions of the concession (for example can’t easily raise price, certain level of service must bemaintained). It also promotes the lending financial institution to check whether the operator iscapable of managing such operations and repaying the loan, so there is a double check system for theoperator in place (first by the local/national authority, second by the lending financial institution).

There are various merits to concession over privatization. Concession gives the operationrights of a particular public facility to a private company on the basis that the facility will continue tobe public. This is not necessarily the case if the facility is privatized. In addition, the fixed period of
the license means that there is the opportunity for new companies to put their name forward, thus
working to prevent monopoly by a particular company. It also allows the government to return theoperation of the facility back to the public sector if needed, whereas with privatization this may bevery costly. Finally, one of the major merits to concession is that it addresses the issue of risk
allocation. In most cases, private companies are unable to cover all of the risks associated with aproject, which became evident in the Tohoku Earthquake of 2011. The case of Sendai Airport isdiscussed in further detail below.

In 2011, the government spent approximately 10 billion yen to restore Sendai airport, asum too great for almost all private companies especially considering the yearly cash flow of theairport amounts to only a few hundred million yen. In the concession deal done after the disaster of2011, private companies were made to join an insurance scheme that would cover for up to 1 billion

yen in damages. If any damage sustained is within 1 billion yen the private company is responsiblefor restoration but if damages are beyond this amount the Ministry of Land, Infrastructure andTransport will cover the excess. If the ownership of the airport were private, taxpayers would
question why taxpayer money was being used for restoration, however, under the concession
framework the ownership of the airport still remains with the government so it makes sense for themto pay to have it restored. In this way, as ownership remains with the government there can berealistic risk allocation achieved.

Role of concession going forward
In Europe many large construction companies are taking part in concession deals.
Concession deals are currently on company balance sheets, limiting the number that may be held at
one time. Although the concession framework has started to be implemented in Japan, unfortunately
funds have yet to enter into such deals. This is understandable as it can be seen as a high hurdle forfunds with little knowledge in these fields to enter such deals. At present it is rather companies thathave accumulated knowledge in related fields such as railroads and utilities that are playing leadroles in concession deals. However, going into the future it is hoped that the involvement of funds
may help to get these deals off the balance sheet, and people that have acquired knowledge fromthese deals will be able to spin out and become fund managers.

Even still, the concession scheme has had various benefits especially for the government.
For example, KIX needed a 10 billion yen subsidy per year in order to be able to pay the interest, butsince the concession deal the need for the subsidy has gone. It is important to note though that theconcession framework is not only about cost reduction, but also promotes new innovative solutions(e.g. pier boarding bridge at Sendai airport to increase capacity). With traditional public works evenif asset value went down the lending institution did not need to worry, as the government would
cover the debt that remained. However, now if asset value decreases there is the risk of defaulting,so there is a large need to protect capital. It will also become necessary to be able to choose how tofund depending on the situation, and there will surely be high demand for skilled fund managers andgatekeepers. With such developments, the infrastructure market will no doubt become a highlysophisticated one in the coming future.