High Yield Debt

High-Yield Debt: Broadening the Scope of Project Finance
PAUL G. MCKEON
The Journal of Structured Finance 1999.5.3:62-69. Downloaded from www.iijournals.com by Long Form on 01/14/14. It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
PAUL G. MCKEON
is a managing director at Deutsche Banc Alex. Brown in New York.
he structuring of project financings has developed significantly over the past several years as sponsors, bankers, and investors have become more sophisticated in their allocation and understanding of project risk. This article examines the evolution of financing structures, the catalysts for change, and the resulting enhancements. Based on these trends, it is anticipated that a growing number of project financings will involve innovative structures with below-investment-grade credit profiles sourcing capital from an increasingly sophisticated investor base.
GLOBAL INFRASTRUCTURE REQUIREMENTS AND THE RISE OF PROJECT FINANCE
Since the mid-1980s, many developing country economies have implemented free market policies concurrent with the World Banks structural reform programs. As a result, ideologies of these countries have begun to shift away from economic nationalism, and the developing world particularly in Asia and in Latin America has experienced a period of unprecedented economic growth. As these economies grow, so does the requirement for economic infrastructure to sustain the growth. A 1994 World Bank report1 documented the direct correlation between an increase in a nations GDP and an increase in its infrastructure. As such, infras62
HIGH-YIELD DEBT: BROADENING
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tructure development has proven to be crucial for economic growth. Conversely, countries will not sustain growth if infrastructure is not adequately developed and maintained. In addition to the market policy reforms that have facilitated infrastructure investment, there have been fiscal imperatives. Governments simply cannot afford to keep pace with the funding requirements associated with rapidly growing infrastructure demand. As pressure for anti-inflationary policies and fiscal conservatism has continued to mount from the International Monetary Fund, private investment in developing countries increasingly supplants the role of public sector financed infrastructure development. In the late 1980s, initiatives such as the build-operate-transfer (BOT) law in the Philippines, Mexicos private toll roads program, and Chiles and Argentinas move toward a competitive electricity market attracted high levels of private sector financing activity. Private sector participation in emerging market infrastructure projects has taken the forms of both privatization and greenfield development and investment. The financing of greenfield projects has been primarily on a project finance or a limited recourse basis. This method has proven particularly effective in developing countries because financing is provided based on the strengths and commercial logic of a particular project. This has enabled the mobilization of significantly greater flows of investment capFALL 1999
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PROJECT FINANCE
ital, both debt and equity, while preserving the borrowing capacity of the sovereigns. For the sponsors of these projects, project financing is particularly attractive because it enables them to raise debt on a limited recourse basis. It shields the sponsors from certain project and country risks while allowing debt to be raised at the project level, often removed from sponsors' balance sheets. Lenders generally benefit from recourse to the equity contributed the assets of the project and the contracts that bind the parties to the project. As a result, compensation for lenders and equity investors is commensurate with the risk they are willing to accept in the project structure.
MARKET-BASED STRUCTURES AND CHANGING RISK PROFILES: A LOOK AT THE U.S. POWER SECTOR
The U.S. power industry illustrates the evolution of project finance as project structures have been adapted to rely on market-based cash flows rather than the pure investment-grade counterparty commitments and contract-based cash flows. Traditional power project financing structures have been based on long-term contractual arrangements with investment-grade counterparty risk. Now, market-driven transactions, including merchant power projects, are growing in importance. This fundamental change in the world of project finance is brought about by the investors increasing willingness to commit the resources to understand project structures and story credits with strong commercial rationale.
The need for new power capacity worldwide continues to grow, and developers have created many versions of the independent power producer (IPP) structure. Until recently, most private IPPs have featured long-term power purchase agreements (PPAs) for capacity or energy. Such long-term PPAs made project financing of single power assets attractive to investment grade investors, especially when an investment grade utility has been the counterparty in the PPA. Once in place, the long-term PPAs have effectively insulated the IPP debt and equity from power price risk. Now, IPPs are progressively more exposed to market conditions, including power price risk. In the U.S., for instance, restructuring of both the natural gas and electricity businesses has driven the changes in the power sector. The PPA-based structure is compared to the market-based structure in Exhibit 1. The major factor differentiating a market-based IPP (merchant plant) from a traditional IPP is that a merchant plant generally does not have a PPA for a portion, or possibly for any, of its capacity or energy output. Hence, power generators that formerly relied on contractually determined cash flows will now rely to some degree on more volatile, market-driven revenue streams. The success of merchant power plants will depend on their ability to produce power consistently below the markets forward curve for electricity (implicit or explicit as the case may be) and risk mitigation. Therefore, lowcost plants selling into well-developed electricity wholesale markets will be preferred from a financing and credit risk perspective. Higher-quality cash flows combined with
EXHIBIT 1
Evolution to Market-Based Structures
Equity
Sponsors Sponsors
Sponsors Sponsors
Equity
Constructor Constructor
Construction Agreement
IPP IPP
PPA
Utility Utility
Constructor Constructor
Construction Agreement
Merchant Merchant Power Power Plant Plant
Spot Market
Market Market
Fuel FuelSupplier Supplier
Long-term Fuel Supply Contract
Operator Operator
O&M Agreement
Other OtherProject Project Parties Parties
Supporting Agreement
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greater business transparency will favor such projects. The appropriate type and level of capitalization for these merchant plants will, in part, depend on the targeted credit profile for the project but almost exclusively will be a function of the quality of the cash flows and the lenders tolerance for accepting merchant risk. Market-based projects generally will follow this merchant plant model. Exhibit 2 summarizes degrees of contractual conditionality and the corresponding impact on project leverage.
DEVELOPMENTS IN THE PROJECT FINANCING MARKETS: VARIATIONS OF FUNDING SOURCES
willingness of investors to commit increasing resources to more in-depth credit analysis for yield pick-up. Since 1990, the fixed-income capital markets, including higher-yielding instruments, have been tapped with increasing frequency for limited-recourse project financing. Exhibit 3 highlights the sources of project finance for both debt and equity in both public and private markets. As the project finance investor base has expanded and become increasingly sophisticated, variations of the traditional financing sources have emerged: 144A public bonds/high-yield bonds. Traditional Rule 144A bonds are often considered a halfway house between private placements and publicly registered bonds. Disclosure requirements are not as pressing as for publicly registered bonds and qualified institutional buyers may trade between themselves without having a requirement to hold the bonds for two years before trading them (a requirement in Rule 144A of the Securities Act of 1933). High-yield project bonds, bonds rated below investment-grade, have comprised a growing proportion of 144A project issuances. High-yield paper is desirable from an issuers standpoint as it can provide enhanced equity returns based on extended tenors and greater covenant flexibility relative to alternative debt financing sources. The high-yield investor base has begun to grasp the peculiarities of project financings and is getting
Over the last decade, we have seen investors accepting new project risks such as market and construction risks. As market-based project structures have been used in an increasing number of industry sectors with varying risk profiles, capital market project investors have grown in both number and type. Issuers continue to benefit from wider and deeper distribution channels and an increasing number of private and public investors purchasing project bonds. The investor universe has expanded to include money managers and high-yield investors in addition to the traditional insurance and pension investors. Such a diversification of the investor base can be attributed to a broader trend of globalization and sophistication in the financial services industry and the
EXHIBIT 2
Market Risk versus Leverage
Risk Management Naked Merchant Plant 100% Power Purchase Agreement
Supply Hedging
Power Mkt Hedging
Tolling Arrangement
Less Leverage
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More Leverage
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EXHIBIT 3
Sources of Project Financing
Public Public Equity Equity Private Private
SEC SEC Registered Registered Project Project Financing Financing Public Public Rule Rule 144A 144A
Traditional Traditional Private Private Placement Placement Debt Debt Private Private Commercial Commercial Banks Banks
Export ExportCredit Credit Agency Agency Government Government Bilateral/Multilateral Bilateral/Multilateral Development Development Agencies Agencies
increasingly comfortable with such risk profiles. Given the enormous capacity of the high-yield market, amounting to approximately $118 billion in 1998, these investors will be crucial to providing depth in financing sources for projects over the coming years. Commercial banks/LIBOR funds. Bank loans, the largest source of traditional project financing, typically provide floating-rate debt with shorter-term maturities and higher costs (certainly for below investment grade credits and emerging markes borrowers) than the fixed-rate alternative provided by bonds. However, in situations where unfavorable market conditions exist for bond investors and issuers, such as rising interest rates or a glut of issuances, bank loans may provide a more effective means of financial execution. In addition, traditional bank loans offer projects a flexible drawdown schedule during the construction phase. As a result, sponsors do not face negative cost of carry interest payments on the amount of bond proceeds beginning at the time of financial closing, before the bond proceeds have been spent on construction costs.
The floating rate institutional loan market, the primary driver behind the explosive growth in the U.S. leveraged loan market, has provided an important alternative to project financing in the commercial bank market. Participants in the floating rate institutional loan market including prime rate mutual funds, collateralized debt obligations (CDOs), and hedge funds typically look to invest in the senior secured segment of the capital structure and tend to be yield-driven. While project finance paper often meets the structural and security requirements of this investor class, issuers may need to consider the costs and benefits of certain investor objectives such as front-end funding and yield requirements. Nonetheless, this investor class has provided and will continue to provide an important source of liquidity for projects. The ongoing consolidation in the financial services industry especially the trend toward high profile mega-mergers has shrunk the traditional bank loan syndication market and reduced capacity for substantial hold amounts. As a result, successful retail syndication for bank financings is becoming critical for
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banks to commit large underwriting amounts while reducing their exposure to acceptable levels. Access to new investors, such as floating-rate LIBOR funds, will be instrumental to the achievement of this goal. Private equity/mezzanine finance. Mezzanine finance, which includes subordinated debt, convertible securities, and preferred stock, is a variation of private equity and falls between debt and equity in a projects capital structure. Private mezzanine transactions are highly negotiated to meet the specific needs of projects while providing investors with fundamental investment protection and attractive upside potential. Mezzanine participants include a number of different investor types: dedicated mezzanine and equity funds, insurance companies, traditional highyield investors, collateralized bond obligations (discussed later), and hedge funds.
Increasing Acceptance of Emerging Market and Below-Investment-Grade Credits
overall increase in non-investment grade project financings. The growth of both emerging market and noninvestment-grade project bonds signifies broadening investor acceptance of credit profiles with more complex stories. As investors look to put money to work, they find the yield on project finance bonds to be attractive relative to comparable corporate credits. Additionally, with a scarcity of oil/gas, power, metals and mining corporate bonds, project bonds provide a vehicle to participate in these industries. This growth represents a dramatic increase from 1992 to 1998 as seen in the graph in Exhibit 4.
Cadereyta Project Financing
While investors have become increasingly comfortable with the assumption of new project risks in the power and other sectors, they also have demonstrated willingness to accept emerging market credits in the capital markets, particularly those that are belowinvestment-grade. Since the early 1990s, project bond investors have shown increasing willingness to invest in the emerging markets. The increase in the number of emerging markets project financings has been an important driver of the
The Cadereyta project financing, which closed in June 1998, illustrates the combination of innovative structures and accessing multiple debt markets for a below investment grade credit. Deutsche Banc Alex. Brown acted as exclusive advisor and arranger for this $1.52 billion project financing, rated Ba2/BB by Moodys and Standard & Poors, respectively, for the refurbishment and expansion of a Pemex refinery in Mexico. The Cadereyta Sponsors SK Engineering and Construction of Korea, Siemens AG of Germany, and Tribasa of Mexico needed to maximize available capacity in a turbulent market where capital was scarce. They approached the leveraged bank market for an unprecedented $805 million, ten-year commercial bank loan; the high-yield and emerging capital markets for a $370 million 144A twelve-year bond offering; and the German development bank, Kreditanstalt fr Wiederaufbau, for a $345 million twelve-year loan. The struc-
EXHIBIT 4
Emerging Market and Non-Investment-Grade Project Bonds
14
(Total No. of EM Project Bonds)
12 10 8 6 4 2 0 1992 1993 1994 1995 1996 1997 1998

Total Number of EM Project Bonds Number of Below-Investment Grade EM Project Bonds
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EXHIBIT 5
Cadereyta Structure
Bank BankLenders Lenders Bondholders Bondholders KfW KfW
Collateral Assignment
$804.8MM Bank $370.3MM Bonds $346MM KfW
SKEC SKEC Conproca, Conproca, Project Company S.A. de C.V.
Siemens Siemens
Construction Contracts
Assignment of Payments
Pemex Pemex Refinacin Refinacin
PEMEX PEMEX
Tribasa Tribasa
Pemex Contract/Pemex Notes
ture, shown in Exhibit 5, also included a $2 billion interest rate swap to mitigate all of the floating interest rate exposure. Deutsche Banc Alex. Brown closed the oversubscribed bond financing simultaneously with the bank financing.
ADDRESSING INTERCREDITOR ISSUES AND FINANCING POOLED ASSETS
As a result of the widening and deepening of the project debt markets, the below-investment-grade market continues to expand to provide liquidity for issuers. As such, issuers can better arbitrage debt markets to optimize capital structures and achieve other financing objectives.
Subordinated Debt Financing
Until recently, little subordinated debt had been invested in project companies. This trend is now being reversed, with subordinated debt increasingly being utilized. This increased activity is the direct result of two important current developments: 1) the increasing sophistication and development of the U.S. and European highyield markets, and 2) the pressure on project sponsors to achieve the lowest possible cost of financing. One of the difficulties with structuring a subordinated debt investment in a project is the relationship
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between the subordinated debtholders and the senior lenders. In default situations, subordinated debtholders rights and remedies are very limited and intercreditor issues, such as shared security, prove difficult to resolve. Bankers have found construction risk to be especially challenging with regard to subordinated debt because of senior lenders priority position in the capital structure and the fact that senior lenders generally refuse to give subordinated lenders access to any payment of liquidated damages from construction contractors. In spite of these difficulties, a layer of subordinated debt in the capital structure of a project makes eminent sense as project equity, especially post construction, tends to have certain debt-like qualities. Consequently, it is usually possible to strip out the top layer of equity cash flow and create a security whose cash flow profile meets most debt criteria. Several sponsors have been able to get around intercreditor issues with senior lenders by inserting the subordinated debt above the project company at the holding company level, as illustrated in Exhibit 6. Such a structure solves a number of problems associated with subordinated debt. It is also possible to structure a transaction where a pool of subordinated debt money is raised for several projects at one time. This pooled structure has the advantage of both economies of scale and credit diversification, but it requires substantially more work than a single project offering.
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EXHIBIT 6
Structural Mitigation of Inter-Creditor Issues
Sponsors Sponsors Lenders Lenders Subordinated Debt Hold Hold Co. Co. Senior Senior Lenders Lenders Senior Debt
Equity
Equity
Project Project Company Company
With regard to pricing, subordinated debt obviously sells at a higher coupon than senior debt at the project company level. The subordinated debt premium increases as the debt is distanced from the project company. Despite this fact, robust projects still can achieve attractive subordinated debt pricing, even at the holding company level. In addition, sponsors can lower the yield premium by including several diverse projects in the holding company as investors will accept a lower coupon in return for risk diversification.
Project-Backed CLOs/CBOs
Many sponsors are also considering the viability of pre-committed project investment funds as a way to secure greater certainty of long-term financing for their projects. These funds, known as collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs), represent an efficient way to diversify the risks inherent in individual project loan or bond investments. Beyond lowering financing costs, the main advantage of a CLO/CBO fund, once in place, is the avoidance of long lead times to negotiate terms with lenders and rating agencies. A dedicated project CLO/CBO fund can provide the sponsor with access to a large capital pool, creating the opportunity to finance projects that by themselves may be too small to access the capital markets. Key investor considerations in project-backed CLOs are the credit quality of the underlying projects, the corresponding risk profiles, and the resulting collective portfolios of risk. Although loss recovery data for pro68
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ject loans is limited, recovery rates on project loans may be higher than those on comparable corporate loans, particularly where project loans are appropriately secured and economic incentives strongly support project debt. Some key issues that should be considered in the establishment of a project fund include: 1) the ability to secure a diversified portfolio of project loans, geographically or by project type, 2) determination of the minimum eligibility criteria for individual projects, 3) the need for mechanisms to adequately assess the creditworthiness of each project financed by the fund, 4) forms of additional credit enhancement, and 5) mitigation of liquidity risks. While the possibility of timing and prepayment mismatches may leave the CBO/CLO with liquidity shortfalls, liquidity can be increased through a number of structural techniques. In addition, the CLO/CBO generally incorporates interest coverage covenants. Common project CLO/CBO structural enhancements include: 1) employment of a multiple-tranche debt structure where the subordinate tranche(s) provide enhancement to the senior tranches, 2) sponsor credit enhancement, 3) a cash collateral/reserve account, and 4) excess spread/interest retention.
CONCLUSIONS
External considerations driving demand for infrastructure, the growing role of the private sector in infrastructure development, and an expanding investor base have been important factors behind the changing shape of project finance.
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In conjunction with the aforementioned changes in developing economies and in the capital markets, capital structures for projects have increasingly reflected enhancements that allow sponsors to reduce financing costs and maximize returns. By using innovative structures and combining different financing sources, sponsors can achieve the optimal financing with respect to overall tenors, pricing, and terms. In order to address the increasing needs of sponsors and investors alike, a project finance house needs to provide the full spectrum of financial services, including strategic structuring advice, balance sheet support, and strong distribution capabilities. This includes the ability to underwrite transactions, mobilize investors, and distribute below-investment-grade paper. Successful project financings have begun to access an increasingly sophisticated investor base that is becoming accustomed to analyzing complex project transactions and receiving an acceptable return for accepting project risks; this trend will continue with the high-yield debt market playing an increasingly important role in financing projects globally.
ENDNOTES
This article was written in collaboration with Paul A. Brown, Vice President, and Kerry McKeon, Associate, of Deutsche Banc Alex. Brown. The article uses extensive data and research from Deutsche Banc Alex. Brown project finance capital markets. 1Source: Infrastructure for Development, World Development Report 1994. World Bank, Washington D.C., 1994.
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High Yield Debt

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High-Yield Debt: Broadening the Scope of Project Finance

GLOBAL INFRASTRUCTURE REQUIREMENTS AND THE RISE OF PROJECT FINANCE

Merchant Merchant Power Power Plant Plant

Fuel FuelSupplier Supplier

Long-term Fuel Supply Contract

Other OtherProject Project Parties Parties

Power Mkt Hedging

12 10 8 6 4 2 0 1992 1993 1994 1995 1996 1997 1998

HIGH-YIELD DEBT: BROADENING

$804.8MM Bank $370.3MM Bonds $346MM KfW

SKEC SKEC Conproca, Conproca, Project Company S.A. de C.V.

Pemex Pemex Refinacin Refinacin

Project Project Company Company

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