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Financing issues
Raymond Bourdeaux
The World Bank
St. Petersburg – May 23, 2008
Specifics of project finance debt
Why investors want to raise debt?
• Cost of equity vs. cost of debt:– Cost of equity: 18%– Cost of debt: 12%
• Where to mobilize financing? / non recourse financing
• Increasing borrowing allows to reduce the cost of a project to the Government
cost of capitaldebt 60% 50% 40%equity 40% 50% 60%
14% 15% 16%
Debt characteristics: the basics
• Maturity
• Grace Period
• Funding rate
• Margin
• Conditions Precedents
• Covenants and debt service cover ratio
• Event of Default
• Consequence of Event of Default
• Security
What is a bankable deal?
“A project that Banks consider sufficientlyattractive to mobilize long term limited / non recourse
financing”:
• Different financing institutions have different requirements: who is going to finance the project?
• What amounts are required to finance the deal?• To which extent does this tally current financial modeling
results?• But there is no upside to debt: the only concern for a
lender is to minimize risks
Debt characteristics: the basics
•
time
Debt repayments (principal + interest)
Additional Debt Service Coverage
Additional Money Requested by Lenders to Service Debt“Cash flow Gap”
Grace Period
Note that the shorter the maturity of the debt , the larger the early support required from the Grantor
Debt characteristics: the basics
•
time
Lower than expected revenues
Additional Money Requested by Lenders to Service Debt due to traffic uncertainty
Structure of Availability Payment (AP)
• Availability Payment (AP) starts on the first year of operation
• A portion of the AP will be indexed to reflect O&M cost inflation
• It is proposed that AP will follow 2 rules, to reduce the incidence of high starting level due to shorter maturity in ruble:
– On a nominal basis, AP can only reduce year on year– Such reduction cannot happen in the first [5] years of operation, to
ensure that Investors can design a project with the lower acceptable level of equity IRR
Uses of Availability Payments, Periodic basis (in Million Rubles)
-
500
1,000
1,500
2,000
2,500
3,000
Op Yr6
Op Yr7
Op Yr8
Op Yr9
Op Yr1
0
Op Yr1
1
Op Yr1
2
Op Yr1
3
Op Yr1
4
Op Yr1
5
Op Yr1
6
Op Yr1
7
Op Yr1
8
Op Yr1
9
Op Yr2
0
Op Yr2
1
Op Yr2
2
Op Yr2
3
Op Yr2
4
Op Yr2
5
Op Yr2
6
Op Yr2
7
Op Yr2
8
Op Yr2
9
Op Yr3
0
Principal Repayment Interest Repayment Operating costTaxes (including VAT) Availability Payment
Uses of Availability Payments, Periodic basis (in Million Rubles)
-
500
1,000
1,500
2,000
2,500
3,000
Op Yr6
Op Yr7
Op Yr8
Op Yr9
Op Yr1
0
Op Yr1
1
Op Yr1
2
Op Yr1
3
Op Yr1
4
Op Yr1
5
Op Yr1
6
Op Yr1
7
Op Yr1
8
Op Yr1
9
Op Yr2
0
Op Yr2
1
Op Yr2
2
Op Yr2
3
Op Yr2
4
Op Yr2
5
Op Yr2
6
Op Yr2
7
Op Yr2
8
Op Yr2
9
Op Yr3
0
Principal Repayment Interest Repayment Operating costTaxes (including VAT) Availability Payment
Ways of decreasing debt funding requirements (apart from additional Government support)
• Increase tariffs / revenues ( feasibility) ?• Upfront Government contribution ?• Decrease operation and maintenance costs • Allow variability of design to reduce construction costs ?• Defer some of the construction until later ?• Increase equity ?• Increase maturity and / or grace period ?• Ensure lower cost financing ?• Split the project into phases / reduce the project scope?• Making sure that the project is competitively bid to maximize
competitive tensions between bidders ?
Challenges for finance raising
• Finance raising is investors responsibility, why does it matter?– Deals are challenging, investors will expect Government to
understand the challenge and to show has addressed it in its approach
– Investors will expect that Government know the deal is bankable, because the relevant detailed financial studies have been done
• Specifics of the deal:– Size of project versus typical projects in this category– Untested market, both legally and finance raising wise– Finance raising work will take a long time once a bidder is selected– Multi Laterals Agencies cannot support exclusively at bidding stage– Is the amount of financing required prevent proper competition
between commercial banks (exclusivity vs. size)?
Overall risk allocation
Impact of setting the risk allocation at a suboptimal level and having a too short timetable
• Timetable. Size and risk allocation influence bidders willingness to participate
• The less the competition, the more demanding investors will be
• The best moment to ensure reasonable risk allocation is early on. After bid award, the pressure is to close the transaction, not improve the risk allocation
PPP risk allocation principle
• PPP risks need to be allocated to the party best able to manage it:– This is very different from allocating all risks to the private sector
• Inadequate risk allocation leads to :– Failure of project to reach financial close (eg all risks revert back to
Government)– Failure during construction (half constructed motorway and liabilities
attached to it))– Failure during operation (costs of re- tendering and liabilities reverting
back to Government)
• Risks magnitude vary depending on project phases: some risks can be allocated early on in the bidding process and some continue to exist until the end of the project life. This impact the optimum risk allocation, typically there are four distinct period for projects :
– Before bid submission– Between bid submission and financial close– During construction– During operation
Typical risk allocation
Risk Government position
Bid position International practice
AT financial
close
Interest rate movement between bid submission and financial close
Interest rate movement post financial close
Margin movement between bid submission and financial close
Margin movement after financial close
Inflation on capital grant
Inflation of revenue guarantee / av payment
Bank margin
Risk of change in bank margin and maturity: the issue
• Margin and maturity are finalized only when the loan is ready to be signed
• Lenders margin are a function of demand and supply, market appetite and due diligence. Typically it is linked to:
– Transaction size– How many transactions are in the market at the same time – The amount of due diligence done upfront – The amount of lending competition– Any financial disruption
• In theory and assuming competition for funding exists, once a preferred bidder is selected it will have a better ability to negotiate down banks margin or extend maturities.
• So bidders cannot fully control banks margin at the point of bid submission.
• Who should take the risk of change in bank margins and maturities between bid submission and financial close?
Risk of change in bank margin and maturities: Typical risk allocation
– Risk exists in any countries and is a typical risk associated with bidding for project financings.
– only in the period between bid submission and financial close, margins are fixed at financial close (subject only to refinancing).
– Risk normally borne by bidder
– Might be different if narrow or volatile or difficult market.
Risk of change in bank margin
• TYPICALLY, THE RISK IS ALLOCATED TO THE PREFERRED CONCESSIONAIRE, SINCE:
• The bidders have much deeper experience in estimating bank margins than the grantor.
• Subject to major due diligence findings post bid submission, margins might be reduced post bid submission
• Difficult for Grantor to control the risk and no interest for bidder to mitigate it if it does not take the risk
Note that:• in theory, savings on lowering margin changing maturities could be
shared with grantor, but it is unlikely that bidders would accept upside sharing without downside sharing
Interest rate
Risk of change in interest rate: the basics
• Loans are quoted in relation to floating rate
• It is often better to ensure the interest rate of the loan is fixed for an infrastructure project
• An interest rate swap allow a borrower to exchange a loan with a floating interest rate with a fixed interest rate
10 year interest rate swap, rubleevolution over the last year
Change in swap rate over last year has been in the region of 135-155bp points (6.4% to 7.5-8.0%
between sept 06 and nov 07
5 years IRS ruble swap rates
6.00
6.20
6.40
6.60
6.80
7.00
7.20
7.40
7.60
7.80
8.00
1/1
1/2
00
7
1/2
1/2
00
7
1/3
1/2
00
7
2/1
0/2
00
7
2/2
0/2
00
7
3/2
/20
07
3/1
2/2
00
7
3/2
2/2
00
7
4/1
/20
07
4/1
1/2
00
7
4/2
1/2
00
7
5/1
/20
07
5/1
1/2
00
7
5/2
1/2
00
7
5/3
1/2
00
7
6/1
0/2
00
7
6/2
0/2
00
7
6/3
0/2
00
7
7/1
0/2
00
7
7/2
0/2
00
7
7/3
0/2
00
7
8/9
/20
07
8/1
9/2
00
7
8/2
9/2
00
7
9/8
/20
07
9/1
8/2
00
7
9/2
8/2
00
7
10
/8/2
00
7
10
/18
/20
07
10
/28
/20
07
11
/7/2
00
7
11
/17
/20
07
11
/27
/20
07
Risk of change in interest rate: the issue
• Floating interest rate (Libor, Russian base rate etc..) changes with time and is not something the Bidder can control.
• Usually, Governments are not prepared to compensate Concessionaire for change in interest rate during construction or operation.).
• Entering into an interest rate swap implies a contractual commitment( the interest rate swap). Usually such contract is entered at the time of financial close. This is common practice.
• When the bidder submits its bid, it has to use an assumption about the swap rate applicable for its Interest rate swap. The bidder cannot control the swap rate.
• Who should take the risk related to movement in interest rate swap ?
Risk of change in interest rate: Typical risk allocation
– This issues is true in any country and is a typical risk associated with bidding of project financing.
– The issue arises purely between bid submission and financial close, assuming interest swap rate markets exist for maturities similar to the one considered for the project loans.
– The standard treatment (UK, South Africa etc..) is that,the Government takes the risk of change in swap rates between bid submission and financial close.
Risk of change in interest rate: example of risk allocation
– Government provides reference source for swap rate before bid submission for reference for bidders
– Such quote is used to calculate capital grant and revenue guarantee / availability payment requirement in the bid.
– Around the time of financial close, the swap rate is quoted by banks and entered into by the Concessionaire. Such rate becomes the reference rate to re-compute( based on the financial model) the level of capital grant and availability payment that will keep the Concessionaire financially whole (no gain / no loss) compared to its bid case at bid submission.
– Period of uncertainty for the Government is purely during the period from bid submission to financial close.
Risk of change in interest rate
• Entering into a large swap might change the quotation for this swap Possible solutions to this:
– A swap for the full amount is entered into at financial close. Obtaining independent quote for such a large swap might be difficult.
– The swap is broken down into a set of swaps entered into during construction, for a number of drawdown
– Contractual provision preventing market collusion can be introduced to ensure the quote is procured in a manner satisfactory to grantor .
Inflation
Risk of change in inflation: the issue
– Inflation impacts project during bidding, construction and operation since construction and operating costs increase with time
– The cumulative impact of inflation might be significant over the life of the project (bidding, construction, operation).
– Forcing investors to take inflation risk can result either in (i) no bid or (ii) bids that include very high forecast for inflation since bidders have limited protection against this risk.
– Governments typically allow for some form of protection against inflation in typical procurement contract. The key issue is to make sure that this is properly adapted to the specifics of a PPP transaction.
Example of partial inflation to revenue guarantee
– If there is no mechanism for inflation, the bidder, has no choice but to assume a high inflation) assumption throughout the life of the concession resulting in a high estimate of operation and maintenance costs (pink line)
– If the inflation is limited throughout the operation period, indexation represent a significant limitation of liability to the Government (blue versus pink line)
– Even assuming a scenario with high inflation for a limited period of time (7 years – yellow line) indexation to inflation might result in a reduction of liability to the concessionaire
– Note that operation would start only in 2012
Inflation risk, typical risk allocation
– Government support ( capital grant and /or availability payment or revenue guarantee) is at least partially indexed to an inflation factor.
– Such inflation factor is calculated from the date of bid submission so it covers the period of bid submission, construction and operation
– The inflation factor seeks to mirror as closely as possible reality. The inflation applies to part of costs related to inflation only
Forex
The project is potentially exposed to foreign exchange rate movement in the following ways:
– Construction and other construction related costs might not be fully denominated in ruble if imports are considered.
– Revenues are most likely denominated in ruble
– Debt Financing might be sourced in other currencies to ensure long maturities and / or deeper pool of financing
– Some of the operating costs might be denominated in a currency other than the ruble.
– Foreign equity holders might require returns calculated in a home currency.
– Currency swaps can protect against movements in foreign exchange but such swaps are entered into at financial close.
– Price to end users cannot always be significantly indexed to a foreign exchange rate (elasticity of price of toll tariffs vs demand).
Should any of the construction cost be sourced in currency other than the rubles?
– There appears to be significant bottleneck in terms of key supplies on the Russian market. This has lead to significant increase in prices of cement and steel.
– Some of the construction related costs (engineering design, management staff etc.) will not be denominated in rubles.
– Part of the rationale for the PPP strategy is to encourage sourcing of material in currencies other than ruble.
– the currency risk (for construction) is limited to the period between bid submission and financial close : at financial close, the Government liability is fixed.
– Nothing prevents the Government limiting its exposure to this risk (maximum amount of cost denominated in Foreign Currency, or dead band for swap rate movement).
Possible mitigation mechanisms
– Bidder is encouraged to finance using ruble financing:
• Government help to mobilize local banks?• Bidding criteria to reward local currency financing?
– Tariff formula takes into account impact of foreign exchange:
– Bidder bid fixed amount allowed to fluctuate against forex:• If required, maximum amount can be set as a ceiling to cap grantor risk.• Bidder takes risk on make up of financing plan• Risk for Government:
– Sudden devaluation of the ruble (if amounts is not capped)– If Ruble appreciate, not a risk, reward to grantor– Size of potential liability will be linked to debt amounts in foreign currency which
will not be finalized at bid submission date.
– Bidder compensated in direct relation to a proportion of the actual foreign denominated debt repayment schedule:
• If required, maximum amount can be set as a ceiling to cap grantor risk • Bidder not exposed to make up of financing plan• Difficult to evaluate bidders proposals
Risk associated with foreign exchange: Proposed mechanism for capital cost
• Government allows for a certain portion of the capital cost to be denominated in foreign currency and protected for exchange rate risk via swaps
• At bid submission, Government provide reference for currency swap rates for the construction period
• At financial close, the swaps rate are quoted by the concessionaire banks and the difference leads to an increase (or decrease) in the capital grant.
Risk of change in foreign exchange rate examplefor capital costs
Impact of local sourcing (with price increase pass through) versus importing and Government absorbing fx risk
Should any of the debt be denominated in currencies other than ruble?
– Can the project raise debt financing without foreign denominated debt?
• How much will Veshneconombank commit?• How much is available in the commercial debt market?• How much will IFI prepare to commit?
– If the project has some construction costs not denominated in ruble, does it make sense to borrow only in rubles?
– If such amounts are available, what is the maturity that will be attached to it?
• Will all the debt have a maturity longer than 17years?• Is it likely that for these amounts, the debt tranches will have
several maturities, including “shorter” maturities of say 12 years• Is constraining maturities increasing revenue guarantee to a
higher level than otherwise required with foreign debt denomination
• Impact on margin? • How will a bidder benefit from competition between banks (and
margin reduction) if no competition is possible
Euro denominated debt
• Euro denominated debt is different from rubles denominated debt:– Longer maturity available (20 years and above)– Long term swap exists and are liquid for the
long maturities– Long term swapped rate is lower than the ruble
swap available (4.7% for 20 year versus 8% for 10-12 years)
– Depth of the euro market for Project finance loans
Risk associated with foreign exchange: Example of mechanism for debt denominated in euros
• Before bid submission, Government defines the maximum amount of debt that can be denominated in Euro and benefit for fx protection (eg concessionaire can source additional debt denominated in Euro but without forex compensation mechanism from the grantor).
• The Government reserves its right to reject any repayment profile / maturities that it does not consider appropriate for foreign denominated debt at financial close.
• The Government introduces in the CA a maximum amount of ruble exposure it is prepared to take in relation to this foreign denominated debt
• During the life of the loan, credit / debt are registered and payment made / received by grantor in relation to the debt
Conclusions
• Debt raising is a key element of structuring a project financing
• Project finance lenders have specific requirements that need to be taken into account
• Some of the financing risks tend to be dealt with in a similar fashion, and the proposed risk allocation ought to reflect international standards to ensure the right competition
