In the wake of the global financial crisis, traditional lenders under attack from enhanced regulatory requirements and higher lending costs significantly reduced their exposure to the long-term project finance market. To enable project sponsors to access international capital markets and alternative institutional investors, a new type of product was needed. This was a job for bond, project bond.
However, even capital markets have risk tolerances and potential buyers have struggled to understand and overcome some project risks. Whilst accessing capital markets to fund project development is not new in relatively developed markets, such as the US or Western Europe, the risks found in other markets or in particular industries have proven to be more of a challenge. Recent innovations have shaken existing project bond structures and stirred the appetite of capital markets investors by demonstrating how new products and techniques can address these risks.
The challenges of project bond
Traditional project bonds (if there can be such a thing, given the relatively short history of project bonds) need stable governments, assured project cash flows, well-tested asset security and no construction risk. Project bonds generally cannot achieve a satisfactory credit rating unless the construction phase has been completed or investors are protected against construction and other risks in some way. Prior to the onset of the global financial crisis, monoline insurance companies addressed the inability of projects to achieve a sufficiently high credit rating on their own by providing financial guarantees to investors. Monoline insurers also acted as the controlling creditor and took many decisions on behalf of the bondholders, thus enabling effective and timely decision-making, which had been a problem affecting senior financing groups dominated by bondholders. The demise of most monoline insurers in the global financial crisis brought these credit enhancement and control issues back to the fore in designing project bond structures.
Credit enhanced bond
The lack of monoline insurance for construction risks impacts not just the credit rating of projects and therefore the marketability of project bonds and coupon rates, but also causes deal uncertainty and affects deal economics. To counteract that, a number of international agencies (including the European Investment Bank and the International Finance Corporation) have started offering credit enhancement products to improve the credit rating of project bonds and, in many cases, to alleviate construction risk and support the initial phase of a project. In three of the first five EIB projects to have used these new credit enhancement instruments (the Castor gas storage project in Spain, the A11 road project in Belgium and the A7 road project in Germany) the construction phase of the project was covered for amounts up to €200m.
Credit enhancement products can either be a funded commitment (such as a subordinated loan) or an unfunded contingent commitment (such as a letter of credit or guarantee), although the market has indicated a strong preference for the unfunded, contingent form of credit enhancement. The EIB unfunded letter of credit can typically be drawn where there are cost overruns, for debt service, to satisfy financial covenants, or when having to make an accelerated repayment. To date, the unfunded letters of credit which have been implemented have been issued for up to 20 per cent of costs during the construction phase of a project and have enhanced credit ratings by up to 2.5 notches, making the project bonds considerably more attractive to investors.
Informed bond
A large number of bondholders, as opposed to the typically smaller bank lending syndicate, can raise ongoing governance issues. Dealing with a large number of investors with differing interests (including new bondholders who have acquired bonds in the secondary market) can be much more time consuming for sponsors, especially without a monoline insurer acting as the controlling creditor. Although the bond trustee will act as an intermediary and there will be a threshold for majority bondholder approval (commonly 75 per cent), bondholders are likely to have less institutional knowledge of the technical and operational issues affecting infrastructure and power projects than traditional bank lenders. Their decision-making will therefore be slower than lenders who have been involved with multiple projects and are familiar with different project structures and risks associated with project work.
Accordingly, as part of the decision making and control process, technical advisers or monitoring advisers are frequently appointed to advise and consult with the bondholders. In a Scottish road financing project last year (which was funded 50 per cent by project bonds and 50 per cent by bank debt), a technical adviser was appointed to hold meetings with the sponsor to discuss the financial and operational performance of the project. The adviser also made regular site visits to inspect the progress of the project and reviewed all budgets and reports to the bondholders so as to provide recommendations to the bondholders on matters relating to the project. In the case of some project bond structures, the technical adviser’s or monitoring adviser’s recommendation on a majority of matters is binding, unless a certain proportion of bondholders disagree with such recommendation. If this is set at a reasonable level (frequently 25 per cent) the decision-making process can be accelerated and improved.
Forward purchase bond
One of the key disadvantages of typical project bonds, when compared to a revolving credit facility, is that the bond proceeds are paid to the sponsor on one occasion, in a lump sum, at financial close. This means that interest immediately starts to accrue without any corresponding immediate need for a large proportion of those funds to implement the project. Whilst a sponsor can invest the unused funds, the negative carry which results from the gap between interest paid and interest earned will hurt a project’s economics and make project bonds less attractive.
One structural solution is to set aside a portion of the bonds as ‘forward purchase bonds’ which the bondholders are committed to purchase in the future. Investors would be obliged to acquire the forward purchase bonds as and when required by the sponsor, but at a price that was determined upon financial close at the outset of the project. Since this price may not represent the market price of the forward purchase bonds at the time of their purchase, investors receive a commitment fee as consideration for agreeing to acquire the forward purchase bonds.
This structure was used in the Scottish road financing project. However, there was only one principal bondholder that anchored the investment in that transaction, as opposed to multiple investors each being committed to buy forward purchase bonds. Similar structures that involve a payment schedule where bondholders invest their funds over time in accordance with the agreed timeline have also been adopted in recent project bond transactions in Belgium (the A11 road project), Germany (the A7 road project) and elsewhere in the UK (for example, the North Tyneside Council’s social housing project).
Conclusion
Given the scale of investment in infrastructure that is necessary across Europe, the Middle East and Africa and the constraints imposed on commercial lenders following the global financial crisis, project bonds and capital markets funding for large-scale projects is here to stay as the world of public resources is insufficient to meet the investment needs required.
Whilst there are some concerns about funding long-term projects through capital markets products, it is clear that international financial institutions support project bond structures and are working creatively to come up with structures to mitigate those concerns and minimise any risks that capital markets investors associate with project financing. We do not expect project bonds to completely overtake traditional project financing methods. However, particularly given the spectre of the new regulatory environment, which has imposed significant additional constraints on the ability of commercial banks to finance long-term projects, it will be for bonds, project bonds, to secure the participation of capital markets in the future of infrastructure and power projects.
Kevin Atkins and Nikolai Mikhailov are partners at Chadbourne & Parke (London) LLP. Mr Atkins can be contacted on +44 (0)20 7337 8173 or by email: katkins@chadbourne.com. Mr Mikhailov can be contacted on +44 (0)20 7337 8018 or by email nmikhailov@chadbourne.com.
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Kevin Atkins and Nikolai Mikhailov
Chadbourne & Parke (London) LLP