Policymakers face a major challenge following the global financial crisis in funding the massive global demand for new energy sources and infrastructure. The Asian Development Bank has estimated that in Asia alone, the requirements for infrastructure investment will total $8 trillion over the coming decade. (See report here)
Governments are constrained in public sector expenditure and the overall appetite of the commercial banking sector to take and hold large project loan assets is much reduced, due to liquidity constraints and post-financial crisis regulation. Despite industry lobbying efforts, Basel III is likely to affect further the cost to and willingness of many banks to allocate capital for project finance by applying a high risk weighting to long term loans (however well structured). In order to stay in the business of project financing, banks must look at novel ways to access institutional money for their project lending activities without using up balance sheet capacity.
Specialist energy and infrastructure funds, private equity firms and institutional investors are increasingly active as alternative providers of private sector capital but the amounts involved have not made a significant impact on the funding deficit. Policy banks, multi-lateral government agencies (MLAs) and export credit agencies (ECAs), primarily from North Asia, have stepped up to meet this challenge with increased levels of direct lending and are pushing out the boundaries of their traditional roles and products.
This cannot, however, provide an inexhaustible supply of funding for new projects or meet the growing refinancing requirements of existing projects.
The solution — project bonds
The international capital markets present a largely untapped pool of capital to boost the debt capacity available for project financing. Project bonds are not, of course, a new phenomenon and have been deployed extensively in infrastructure developments in Europe and the US pre-global financial crisis, albeit commonly with the wrap of monoline insurers which have largely exited the market post-2008. They have also been successfully used at investment grade pricing in the construction, refinancing or expansion financing of large LNG, pipeline and petrochemical projects. There is however a real sense that the time has come for a vastly increased use of project bonds, both for construction financing and as a method of refinancing short term bridge financing by bank lenders. This view is reinforced by a number of specific governmental initiatives (further discussed below) to stimulate the project bond market.
Capital markets funding of energy and infrastructure projects ticks a number of important boxes:
a deep investor base which provides long maturity, fixed rate funding without the regulatory constraints imposed on banks;
a diverse market (including an established regime to access Islamic investors) which funds into both investment grade and high yield products;
value recognition through the rating process of project structuring and risk mitigation so that investment grade can be achieved notwithstanding construction risk or even a lower sovereign rating for the host country;
generally a more flexible covenant package than traditional project finance debt (resulting in less intrusive oversight of project-level decision making); and
typically documented and syndicated in a shorter timeframe than traditional project finance debt (subsequent to finalising project structuring and documentation).
Key issues with project bonds
There are a number of well documented drawbacks with bond funding. These notably include exposure to timing and pricing uncertainty on launch due to capital markets volatility, public disclosure requirements in the offer documents, cost-of-carry on bond proceeds, lack of flexibility and active participation of bondholders in decision making and the investment philosophy of trading out if a project runs into difficulties.
The key to raising funds from the capital markets is of course to secure a credit rating at or above investment grade from one of the internationally recognised rating agencies. These agencies will undertake an in-depth review of the project and allocate a credit rating based on an evaluation of the project’s capacity to meet its existing and planned financial commitments — investment grade being the key benchmark below which many institutions will not invest. Pricing and availability of funds from the capital markets therefore depend on the existence of a rating and that rating being investment grade or above.
It is often commented that the capital markets are unlikely to be available to support purely greenfield projects with no track record. It is true that historically project bonds have been focused on the refinancing of existing indebtedness once a project is up and running (and thus generating reliable revenues) rather than financing prior to project completion. However institutional investors are actually able to take construction risk on properly structured greenfield projects — the key is meeting the requirements laid out by the rating agencies in their ratings criteria.
In emerging markets projects, it is also worth keeping in mind that the sovereign rating of the host country does not necessarily operate as a ceiling and it has been possible to obtain a credit rating for a project which is higher than that assigned to the country in which the project is located. In addition to the requirement that the project be generally well structured, the key to ‘breaching the rating ceiling’ in this way is the inclusion of credit enhancements satisfactory to the rating agencies, such as the elimination of foreign exchange risk through offshore dollar payments and control of these payments through secured offshore bank accounts.
Issues in multi-sourced projects
Particular challenges arise when incorporating project bonds into multi-sourced financing structures (an increasingly common occurrence particularly for the “mega-financings” of large scale energy projects in recent years where the sources of funds are likely to be drawn from commercial bank debt, ECAs, MLAs, the capital markets and possibly other sources as well). Whilst each intercreditor arrangement needs to be carefully tailored to meet the specific project and its own capital structure, there are some key principles of how to fit project bonds into multi-sourced intercreditor structures. These include:
Capital structure and intercreditor decision-making
A key issue in evaluating whether to include a capital markets tranche in a project financing is a consideration of the different dynamics in decision-making between the commercial banks and ECA / MLAs on the one hand and the bondholders on the other. For example, commercial banks, ECAs and MLAs are used to monitoring (and expect to monitor) operational and credit issues on a real time basis — particularly through construction. Bond investors generally do not and will expect only to be notified of fundamental credit issues such as non-payment of interest (coupon) payments under the bonds.
Recognising the fundamentally different drivers of bondholders and other senior creditors, the starting point for developing appropriate intercreditor mechanics for multi-sourced deals is to establish the makeup and quantum of each debt source relative to the others and to then ensure that any entrenchment of minority rights does not lead to a ‘tail wagging the dog’ situation. Where bondholders are in the minority, our experience is that they are on the whole willing to allow majority creditors (project finance banks, MLAs and/or ECAs) to decide waivers and consents. However, they will require comfort that ultimately they are not left in a payment default scenario for an extended period of time. In this regard, the project sponsors’ concern to ensure quick and commercial decision-making should also be kept in mind.
Separate or common terms?
We have seen the market move to a common terms approach in recent years. This provides the project sponsors with the benefit of a single covenant package with the main terms of the financing documented in a common terms agreement and each individual debt tranche being documented in a separate creditor-specific facility agreement. While individual creditor-specific facility agreements may have unique covenants within them, any breach of such covenants will typically require an affirmative vote across all relevant creditors to take enforcement action. Arguably this approach gives the bondholders better terms than they might otherwise expect in typical bond documentation however for simplicity and consistency of approach, sponsors accept this.
Ranking of debt sources
Project bonds will typically be treated as senior creditors on a pari passu basis to other senior lenders. Whilst some specialist debt funds have examined the use of mezzanine project bonds (including structures which involve subordinated bonds designed to provide a “first loss” debt tranche for the project, thereby enhancing the credit of the senior bonds), this is not yet a market which has taken off in earnest.
The introduction of a capital markets tranche of senior debt can of course occur at various stages in the lifecycle of a project financing. It could, for example, come in at the construction stage as a means of refinancing commercial debt or perhaps to fund an expansion post-project completion. To the extent not introduced from the outset, sponsors will wish to embed the flexibility to introduce project bond issuances in the initial loan terms (as has been the case on recent large scale ECA-led financings in the LNG and petrochemicals sectors). Lenders will want to ensure that this source of non-bank funding does not disrupt the overall lender group’s effectiveness. In particular, this will involve the customisation of intercreditor terms (particularly as regards loan administration and enforcement procedures as mentioned above), development of acceptable new/replacement debt criteria and lender approval of the specific bond structure (possibly through the incorporation of a detailed bond structure memorandum.
Project bonds: where to from here?
The fundamentals of supply and demand lead us to believe that project bonds will become an increasingly important part of the funding equation for energy and infrastructure development over the coming years. Indeed, we are already seeing a high degree of innovation and new thinking to unlock the potential in this market and foresee the continuation of this trend.
Some of the more notable trends we are seeing (and that we expect to develop further together with other innovations in this area) include:
ECAs as the new monolines
As mentioned above, monoline-wrapped capital markets issuances, which have historically been an important feature of infrastructure financing (particularly in Europe and the US), have largely dried up with the decline of the monoline insurers following the global financial crisis. To many, the substitution of ECAs for the monolines to provide credit enhancement for project bonds is an attractive proposition. Indeed, we are already seeing ECAs assume this role, such as in the recent SACE-wrapped bond of the Andromeda solar power project in Italy.
Government initiatives to support the development of project bond markets
We are also beginning to see a variety of government credit support programmes which seek to stimulate the project bond market and establish it as an additional source of financing for energy and infrastructure projects. Such programmes notably include the EU’s Europe 2020 Project Bond initiative, the pilot phase of which was established by the European Commission in July this year, which aims to stimulate private-sector investment in key EU infrastructure projects in the transport, energy and broadband sectors. EU funds will be contributed to the European Investment Bank (EIB) which in turn will provide credit enhancement of senior secured project bonds for eligible projects.
Similar programmes are being proposed or introduced elsewhere, including the recently announced UK Guarantees scheme, although we have not yet seen these types of programmes introduced or proposed in Asia.
The potential role of offshore renminbi bonds
Another potentially game changing development in recent years is the development and expansion of the renminbi bond markets. This is a market which has shown exponential growth since the launch of the first renminbi Eurobond in 2010. Although the predominant funding currencies in the global energy and infrastructure markets continue to be the US dollar and the euro, given the general importance of China in world trade and contracting and its emergence as a very significant participant in the global energy and infrastructure markets, we should expect use of renminbi bonds in finance plans of major projects in the not too distant future.
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