SPOTLIGHT Debt Finance

Project finance and the bond markets Bonds are increasingly becoming a source of project funding. Steve Baseby, a treasury projects adviser, looks at the pros and cons of this trend.

ecently it has become viable to Project-specific objectives may worldwide network of skills that have seek project funding from fund depend on the state of the project and enabled deals to be executed in western Rmanagers who have previously can include: as well as emerging economies. This bought unsecured corporate debt, or does not mean that the market provides debt secured by debenture on property. ● proving financial capacity during a all the solutions. Indeed, its major diffi- Bond investors have shown willing to negotiation phase; culty has been a constraint on the term spread their risk to receivables securiti- ● borrowing efficiently during a con- of the funding, which can ebb and flow sation, and now to the project finance struction phase; as the bank markets suffer periodic liq- risk of one asset special-purpose vehi- ● selling the use of novel technology to uidity constraints. cles (SPVs). This trend towards adopting the finance market; The dash for gas generation invest- risks previously taken by commercial ● reducing the equity in a completed ment of the early 1990s was able to banks has been driven by the funds’ project; secure 18-year bank funding, which need to enhance yield on the ever- ● otherwise refinancing such a project; included a three-year construction peri- growing volume of money they receive ● maintaining flexibility in order to od. At that time several major banks in this pension-conscious world, while reorganise the project’s contractual could not commit to these long terms maintaining the relative certainty of arrangements; and even though the useful lives of the assets cash flows which bonds provide. ● maintaining flexibility to develop the were 30–35 years, and the concept of a Any discussion about how to fund a project further. stranded asset had yet to become project first requires an understanding known outside the US. Shorter facility of the objectives of the given project. This list is unlikely to be exhaustive but lives have become more the norm, This is important because the new trend it highlights the factors a corporate may which means that the project promoters in bond financing projects can offer a have to consider when judging the value are committed to refinancing to achieve different funding structure to that of the of differing finance sources. The deci- the same overall financial structure of traditional bank facility market. It can sion process will become more compli- the earlier deals. become too easy to chase these differ- cated when a project brings together The major attraction of facility ences as benefits in themselves while two or more joint venture (JV) partners, remains its apparent flexibility. A small losing track of the investor’s overall each of whom may have objectives that group of banks can be brought in as commercial purpose. differ or change over time. underwriters during the closing of the project’s contractual stage. The bankers Objectives Bank facility financing are used to finalising the deal within Corporate objectives can include: For years, this route has offered a work- pre-approved parameters from credit able means of getting projects under- committees which are themselves nowa- ● ring-fencing the financial risk in a way. The bank market has developed a days often contactable around the non-recourse vehicle; clock. The promoters can obtain varying ● minimising the equity input; degrees of assurance of funding from ● minimising the debt cost; the banks to close contracts with third ● targeting an EPS flow; parties, such as fuel suppliers or cus- ● targeting a cash payback period; tomers. Problems in construction or ● targeting a rate of return; operation can be managed by calling a ● targeting certain fix : floating interest meeting through the agent bank. The rate ratios over the debt life; and promoters can explain their problems to ● diversifying sources of funding. a generally expert audience. Any subsequent physical or commer- The first may be stating the obvious cial redevelopment of the project can be but it is important to understand the accommodated in a facility agreement degree to which project promoters are by waiver or modification. However, willing to provide explicit or implicit inventive investment bankers are likely guarantees, the latter by perhaps off- to be able to replicate all these factors take agreements. Steve Baseby within a bond structure. The degree to

40 The Treasurer – July/August 1999 SPOTLIGHT Debt Finance

which this may or may not However, any sustained be possible for any partic- period of price difference ular deal today will rely is bound to be arbitraged more on a bank’s histori- out unless one of the cal presence in this mar- markets is pressed to ket relative to a fund man- withdraw for regulatory ager’s rather than the reasons. technicalities of the deal A more intrinsic reason itself. It is simple fact that for a cost difference is banks are likely to employ likely to be the lender’s project-specific experts, comprehension of the such as engineers and risk. As I noted earlier, the credit analysts, while fund fund managers may have managers may lack the neither the technical nor resources to carry out the credit analysis even the credit analysis as resources to be in a posi- the flow of bonds increas- tion to understand fully es. The kickback is that if the credit risk of a partic- something goes wrong it ularly complex engineer- could result in a syndicate ing project, or the portfo- of 20-plus bank experts to Preparing to float: load your project with the best financing opportunities lio of projects in which manage! they would hope eventu- debt rate as they follow the trend for ally to invest. Their normal course of Bond market financing gearing up; at the extreme ends of the action would be to look to the credit rat- The bond market can offer longer-term scale, playing with the timing of cash ing agencies to provide the analysis and maturities. A low interest environment flows becomes an irrelevance. monitor the credit value over the debt means that the slower repayment can The major perceived drawback of life. However, project finance by its accelerate the cash available within a bond financing remains the difficulty of nature is likely to be over one asset on a project for distribution, and this may seeking approval for post-issue changes non-recourse basis, and this is unlikely appeal to an NPV, IRR analysis or cash to the project structure. Typically one will to achieve ratings above the bare mini- payback analysis-driven organisation. deal with a bond trustee who will have mum investment grade without some Alternatively, it will increase year-on- limited capacity to negotiate on behalf form of guarantee. year interest costs within the project. of the bondholders. Beyond that the Guarantees may be available in the This may not appeal to an EPS-driven trustee must attempt to raise a quorum form of high-quality customers tied to organisation, depending, of course, on of bondholders to get a decision. offtake agreements, or high-quality how it does its books. (Against this the cosy meeting with 20 suppliers and operators, but the non- Bond markets have also shown an readily available bankers begins to look recourse nature of a project financing is appetite for heavily leveraged deals with attractive.) Bond documentation can be likely to bias the risk towards the project debt equity ratios better than the 85 : 15 fairly specific on what to do in such an finance SPV. In any case, the trend is to 90 : 10 typical for bank financed pro- event, but the more one swings the deci- towards projects with increasing ject financings a few years ago. This sion towards the trustee the less mar- degrees of market exposure. Explicit may suit new promoters, or those look- ketable a bond may become. guarantees can be available in the form ing to re-finance extant projects, of insurance wraps, but these cost although banks are reactive and are Which is cheaper? money and insurers have indicated a likely to match any trend in this regard. Of course, cheap debt may be the sole preference for multi-asset projects while Gearing up with a bond re-financing objective. However, in the normal run of project financing is often over one asset. may make cash available at bond issue events the costs are likely to be similar. which otherwise may not have emerged Both markets require upfront fees. Both The main objectives for years. Similarly, extending the matu- will base the interest rate on an under- I hope the above has clarified some of rity with a bond issue may provide inter- lying factor, be it government bond or the arguments for and against the esting NPV advantages. However, care LIBOR, and today’s swap market developing use of bonds for project needs to be taken to ensure these are appears willing to convert the basis for finance. The main message is to define not illusory. Increasing debt in one part almost any reasonable maturity. Both the promoters’ objectives and then look of a business will reduce it in another. will apply a similar risk margin. for the source of finance, and not to be Was that the objective? Creating a cash Any substantive difference is likely to driven by the first marketing man pile in a project-finance SPV may not be due to the state of the differing funds through the door. ■ mean it is readily accessible outside the providers, but both markets remained SPV if that was the objective. reasonably synchronised through the Steve Baseby has worked for British NPV analysis assumes the discount Asian/Russian crisis of late 1998, Telecom and Southern Electric during rate is known and is reliable as a for- although the banks lost liquidity through and following their privatisations. His ward-looking measure. The discount bad debt provisions while fund man- work includes corporate treasury in its rate for corporates moves closer to their agers continued to receive liquidity. broadest sense, taxation and insurance.

42 The Treasurer – July/August 1999