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Credit Attributes of Project Finance



CHRIS BEALE n initial study conducted by Stan- mined that project finance should have a higher
is global head of project
finance at Citigroup in
New York, NY.

A dard & Poor’s Risk Solutions indi-
cated that project finance loans at
ABN AMRO, Citibank, Deutsche
Bank, and Société Générale perform better in
a default situation than corporate loans. This
capital weighting than unsecured corporate loans,
due to its unique risk characteristics. Indeed, the
MTF hypothesized, in the absence of rigorous
data, that project finance exposures are inher-
ently riskier than unsecured corporate loans:
is head of project finance in article examines the results of this study, pro-
the Americas at Société poses qualitative explanations for the conclu- The MTF has reviewed some initial
Générale in New York, NY.
sions, and proposes next steps for the industry. evidence on realised losses for each
product line [including project finance].
NATHAN FOX STUDY BACKGROUND For the [project finance] portfolios, our
is assistant vice president, initial evidence suggests that realised
project finance at Citigroup While anecdotal evidence exists that losses during difficult periods may
in New York, NY.
project finance loans perform better than exceed those of senior, unsecured cor-
unsecured corporate loans, there never has porate exposures…[however] the MTF
SANDRA BELL is a senior been a rigorous analysis of project finance notes that data limitations in this area
managing director and loan performance. A study of project finance are particularly severe, and welcomes
JAMES BERNER is an credit statistics would be useful for refining the industry comment and evidence on the
associate in project and rating agency process, educating credit com- loss data for each of these product lines.1
structured finance at
Deutsche Bank Securities,
mittees on the risks of project lending, and
Inc. in New York, NY. ensuring that project finance loans are prop- The MTF erred on the side of being
sandra.bell@db.com erly managed and provisioned. However, conservative in the absence of data and subse-
banks had been reluctant to share data col- quently proposed a punitive risk-weighting
ROBERT PREMINGER lectively until 2002, when the Basel Com- table for project finance loans.2
is head of the project finance
mittee on Banking Regulation put forth new Unless banks could present sufficient data
portfolio management group
in the Americas at Société regulatory proposals that would penalize proj- to refute Basel’s hypothesis, the proposed reg-
Générale in New York, NY. ect finance based on the hypothesis that this ulations could result in adverse effects on the
robert.preminger@us.socgen.com class of loans was riskier than corporate loans. syndicated project finance loan market. The
The Basel Committee on Banking Reg- increased capital requirements at most banks
JAN PRINS ulation charged its Models Task Force (“MTF”) would reduce the economic returns of project
is head of structured
products of ABN
with the role of analyzing the unique credit con- finance lending, possibly resulting in higher
AMRO in Amsterdam, siderations of structured credit products loan pricing or diminished appetite for new
The Netherlands. (including project finance) that merited special transactions. While larger banks in the project
jan.prins@nl.abnamro.com attention. In its initial hypothesis, MTF deter- finance industry might be able to adopt the


Basel “advanced” approach (with a degree of self-regula- definition of default would be narrow enough to incorpo-
tion based on their own historical project finance loan loss rate the unique experiences of project finance, yet broad
experience), such an approach might not be feasible for enough to be used in comparisons with corporate finance.
smaller banks. Indeed, even if a few smaller banks were to This study settled ultimately on a definition of default sim-
exit the sector due to increased capital charges, overall ilar to that used by Standard & Poor’s and Moody’s Investors
liquidity would be reduced, further impacting the project Service for corporate lending (see Exhibit 2). It incorporates
finance loan sector and shrinking this important source of situations where banks restructure loans in anticipation of the
capital to several industries. borrower missing a payment, but does not consider simply
In response, early in 2002, ABN AMRO, Citibank, a technical covenant violation as a default. Finally, this def-
Deutsche Bank, and Société Générale—the “Four Lead inition is intentionally broad and conservative, leaving open
Banks”—formed a small group to analyze the credit statis- the possibility of conducting statistical analysis on the database
tics of their combined project finance loan portfolios to using a narrower definition of default, if requested.
create the first industry database—with a primary goal to
respond to the regulator’s requests for more data. This STUDY RESULTS
project finance loan database would contain the combined
results of all four banks’ portfolios, representing approxi- The initial results of the Risk Solutions study of the
mately 24% of the global project finance loan market over Four Lead Banks’ portfolios confirm the anecdotal expe-
the past five years for all industry sectors, according to the rience that the LGD of project finance loans is quite low.
Project Finance International/Thomson Financial Securities Data The LGD of the Four Lead Banks’ combined project
League Tables.3 Although 24% of the market is a statistically finance portfolios was approximately 25%. In addition,
relevant sample, the Four Lead Banks realized early on that the majority of the defaulted project finance loans in this
a second phase of the study would be required, whereby study resulted in a restructuring with 100% of loan value
additional banks would join the study and contribute enough maintained. Each of the Four Lead Banks had an individual
data to enhance its validity and integrity. A broader study average recovery rate significantly above 50%.4
would eliminate any question of statistical adequacy and
merit greater attention from regulators, investors, and the
rating agencies. The loss given default of the Four Lead
Banks’ combined project finance
STUDY METHODOLOGY portfolios was approximately 25%.
The four banks provided their loan data to Standard In addition, the majority of the
& Poor’s Risk Solutions (“Risk Solutions”—the con-
defaulted project finance loans in this
sulting division within the rating agency with significant
experience in developing and analyzing credit statistics study resulted in a restructuring with
for corporate loans). The Four Lead Banks worked 100% of loan value maintained.
together with Risk Solutions to develop a standard
methodology for the analysis of three key credit statistics:
Risk Solutions concluded that the average recovery
• the probability of default of a project finance loan rate of project finance loans in the Lead Banks’ portfo-
(“PD”); lios was at or above all other asset classes in the Standard
• the portion of the loan principal lost in the event & Poor’s PMD Loss/Recovery database (including lever-
of a borrower default (“Loss Given Default,” or aged loans, unsecured bank loans, and bonds). The global
“LGD”); and project finance loans in this study displayed recovery rates
• the expected loss (“EL”) for project finance loans, similar to North American leveraged loans and the
essentially the product of the first two concepts. project finance loans had better LGD rates than secured
(Refer to Exhibit 1 for an overview of these terms.) debt, senior debt, and senior unsecured debt.
Regarding probability of default, Risk Solutions
A pivotal component of this analysis is the use of a determined that the historical default rates of project
uniform, appropriate definition of “default.” An appropriate finance loans are comparable to “BBB+”-rated corporate


Credit Statistic Terminology

Term Explanation

Probability of Default (PD) A borrower’s PD is the statistical probability that a borrower will default within one year.
PD is a number (such as 1.0%) equal to a credit rating (such as “BB”—the rating assigned to
borrowers with a 1.0% PD). Borrowers with a lower annual PD receive a higher credit rating.
Loss Given Default (LGD) LGD is the financial loss a bank incurs on a facility when the borrower defaults. It repre-
sents the value of the loan in a default, through the subtraction of one minus the recovery
rate (represented as a percentage of the facility amount). For example, a loan that experi-
enced a 67% recovery of principal would have a 33% LGD.
Expected Loss (EL) EL is the mathematical product of PD and LGD. For example, a “BB”-rated portfolio with
a 33% LGD and a 1.0% PD would have a 0.33% expected loss rate (33%  1.0% = 0.33%).
Loss Rate The actual loss rate of a portfolio is the mathematical division of the total loan amounts
outstanding by the real credit losses experienced in a single year. For example, a $25
million annual loss on a $500 million portfolio has a 0.5% loss rate. Credit analysts try
to predict the actual loss rate by estimating the EL of a portfolio.

Different Definitions of Default

Source of Definition Definition

Project Finance Recovery Study Borrower was unable to make a contractually scheduled payment of principal and/or
interest. This would include bankruptcies that disrupt payments, including default and
cure within the grace period, consensual restructuring, amendment of the credit
facility’s repayment terms, and/or refinancing of the facility with the original lenders in
order to give the borrower more time to repay the loan.a
Standard & Poor’s A default is recorded upon the first occurrence of a payment default on any financial obli-
gation, rated or unrated, other than a financial obligation subject to a bona fide commercial
dispute; an exception occurs when an interest payment missed on the due date is made
within the grace period. Distressed exchanges, on the other hand, are considered defaults
whenever the debtholders are coerced into accepting substitute instruments with lower
coupons, longer maturities, or any other diminished financial terms.b
Moody’s Investors Service Includes three types of default events:
• There is a missed or delayed disbursement of interest and/or principal, including
delayed payments made within a grace period;
• An issuer files for bankruptcy (Chapter 11, or less frequently Chapter 7, in the
U.S.) or legal receivership occurs; or
• A distressed exchange occurs where: 1) the issuer offers bondholders a new
security or package of securities that amount to a diminished financial obligation
(such as preferred or common stock, or debt with a lower coupon or par
amount), or 2) the exchange had the apparent purpose of helping the borrower
avoid default.c
Standard & Poor’s Risk Solutions, Project Finance Recovery Study: An Analysis of Aggregate Data from ABN AMRO, Citigroup, Deutsche Banc Alex.
Brown, and Société Générale (unpublished; New York, March 18, 2002), p. 4.
Brooks Brady and Roger J. Bos, Record Defaults in 2001 the Result of Poor Credit Quality and a Weak Economy, Standard & Poor’s, February 2002, p. 11.
David Hamilton, et al., Default & Recovery Rates of Corporate Bond Issuers (Special Comment), Moody’s Investors Service, February 2002, p. 23.


Typical Project Finance Loan Characteristics

1. Perfected first priority liens on and pledges of the project’s 8. Prohibition on additional indebtedness, which, when com-
assets (including shares, physical assets, and material contracts bined with the typically steady or increasing cash flows of
and funds on account) that preserve exclusive project finance projects, increases debt service coverages over time.
lenders’ access to repayments from a liquidation of the pro- 9. Transparency of the project’s performance due to its single-
ject or for negotiating purposes with sponsors and other asset nature. This contrasts with corporate borrowers that fre-
lenders. quently have diverse streams of revenues, complicated
2. Involvement of “deep-pocket partners” with stakes in the subsidiary structures and accounting treatments, and cash flow
projects, including central governments, sponsors, contrac- streams that are difficult to analyze.
tors, insurers, suppliers, off-takers, etc. These parties often 10. The essential commercial value of projects allows them to sur-
have key stakes in the success of the project. While not obli- vive the bankruptcy or credit deterioration of a sponsor, sup-
gated contractually to support the project, these groups may plier, contractor, etc. Indeed, a handful of projects with sponsor
have vested interests in the project’s success and frequently bankruptcies have demonstrated that projects often maintain
are willing to protect their interest in a troubled project bor- their ability to service their loans, despite the bankruptcy of
rower by injecting equity into the project to preserve the the sponsor or off-taker. This ability is due to the inherent
value of their investment or strategic relationship. independent viability of the project’s value and cash flow.
3. Step-in rights (which allow the lender to “step in” to the bor- 11. The syndication of project financing loans encourages con-
rower’s shoes and take over a contract) and covenant servative structures that appeal to a broad retail market, limits
triggers that serve as “early warnings” to banks to renegotiate the possibility of unsophisticated banks being able to offer
a structure before the borrower’s credit quality deteriorates aggressive bilateral loans, and ensures that all lenders benefit
beyond a curable point. While corporate loans also have these from a controlled recovery process in a default situation irre-
features, project finance loans are structured deliberately with spective of the size or importance of their respective partici-
tighter covenants to trigger a renegotiation of loan terms pations. Project financings generally are so large that the
before any significant credit deterioration. demands of syndication preclude any market participant being
4. Sponsors often act as counterparties in the projects, giving able to set imprudent terms successfully. The syndication pro-
them vested interests in the success of the project. cess creates a de facto “checks and balances” relationship
5. Restrictions on facility drawdowns, use of proceeds, and among the participants so no single lender or small group of
mandatory prepayments in favor of the lenders. lenders (depending, of course on the terms of the credit doc-
6. Contractual obligations, penalties, and remedies to influence uments) can commit the entire syndicate to unfavorable
the activities of the sponsors in favor of the lenders. workout terms. In addition, the pari passu nature of syndica-
7. Offshore and debt service accounts to mitigate cash flow tion ensures that smaller lenders will have the same recovery
volatility, where appropriate. expectations as larger, more sophisticated lenders.

unsecured loans in the long term, but “BB+”-rated loans tures. Indeed, project finance loans include a number of credit
in the short term. Based on the aggregate experience of enhancements that mitigate risk, such as first-priority liens,
the Four Lead Banks, static pools of project finance loans cashflow sweeps, covenant triggers, limitations on indebted-
from the 1998 to 2001 period would have a 10-year cumu- ness, etc. (Refer to Exhibit 3 for more detail.) Since bank loans
lative average probability of default of approximately are the primary source of non-recourse capital available to
7.5%—comparable to a “BBB+” corporate rating—and new projects, banks use their favorable negotiating position
a one-year average probability of default of approximately with the project sponsors to implement favorable structural
1.5%—comparable to a “BB+” corporate rating.5 This enhancements specific to project and leveraged finance. Estab-
discrepancy between the short-term and long-term rat- lished corporate borrowers, on the other hand, have access
ings confirms the project finance sector’s experience that to a number of different sources of capital, including the
project finance loans become less risky as they mature. bond and equity market, securitizations of receivables, etc.
These various capital providers (bank loans, bonds, equity)
EXPLANATION OF THE RESULTS compete with each other on cost and deal terms. Since pro-
ject finance loans have less direct competition from other
Project finance loans have a better LGD than senior forms of non-recourse capital, banks can use their advantage
unsecured corporate loans due to their unique structural fea- to negotiate terms in their favor. These include construction
features, cash traps, dividend restrictions, etc. generally representative of the broader bank market (since
Although project finance loan agreements generally nearly all the loans studied were widely syndicated), a
do not contain all of these structural enhancements, banks larger study would serve to validate the results and be of
do use a number of these features as “early warning” mech- value to the existing and additional participants. In addi-
anisms to notify them when projects are having difficulties, tion, there are a number of analytical possibilities with a
thereby providing an opportunity for the parties to restruc- larger sample size: the study could incorporate statistically
ture the transaction or otherwise develop an acceptable relevant analysis of project finance credit statistics based
solution to avoid a default. As a result, project finance loans on region/country of borrower (jurisdiction), industry
experience lower LGD rates than comparably rated cor- sector, leverage, quality of collateral, and correlation, if
porate loans that do not incorporate these features. any, between PD and LGD.
Second, project finance banks should continue the
efforts initiated in this expanded phase of the study to
Since the loss-given-default and create in the future an ongoing industry-wide database
expected-loss results for project useful for credit analysis, bank regulation, and credit rating
agency analysis. This database should incorporate input
finance loans are lower than corporate from Basel, national supervisors, banks, and rating agen-
finance loans of an equivalent rating, cies. The database could serve as a useful tool for future
credit analysis and evaluation of project finance regulations.
less capital is required to reserve
against their expected losses. ENDNOTES

The information in this article is accurate as of August

2002. Basel’s regulatory process and the S&P study results are
IMPLICATIONS OF PROJECT FINANCE subject to modification from time to time.
Working Paper on the Internal Ratings-Based Approach to
Specialised Lending Exposures, p. 12.
Since the LGD and EL results for project finance 2
Models Task Force on Specialized Lending, Revised Out-
loans are lower than corporate finance loans of an equiv- line Proposals for Specialized Lending Exposures (unpublished
alent rating, less capital is required to reserve against their memo, January 2002), p. 1.
expected losses. This is especially true as projects mature. 3
Project Finance International, January 23, 2002, Issue 233,
Indeed, based on the results of this study, project finance p. 56.
loans should require roughly one-half the capital of cor- Standard & Poor’s Risk Solutions, Project Finance Recovery
porate loans of a comparable rating. Since project finance Study: An Analysis of Aggregate Data from ABN AMRO, Citi-
loans in this study have default rates very similar to corporate group, Deutsche Banc Alex. Brown, and Société Générale (unpub-
default rates, with more favorable LGD figures, they should lished; New York, March 18, 2002).
Standard & Poor’s Risk Solutions, Project Finance Default
require less capital reserves than corporate loans.
Study: An Analysis of Aggregate Data from ABN AMRO, Citi-
group, Deutsche Banc Alex. Brown, and Société Générale (unpub-
INDUSTRY’S NEXT STEPS lished; New York, July 18, 2002), p. 6.

The project finance industry should pursue two key

next steps: To order reprints of this article please contact Ajani Malik at
First, the industry should expand the study to include amalik@iijournals.com or 212-224-3205.
more participants. While the initial four-bank sample is

Reprinted with permission from the Fall 2002 issue of The Journal of Structured and Project Finance.
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