This article identifies the general trends arising out of the credit crisis that have affected project finance lenders, and outlines their impact under existing facilities and on the process of raising finance. It also explains how those trends are starting to influence the structure and terms of project financings.
The broad underlying trends affecting the market are:
- lack of liquidity – banks are reluctant to lend to each other, due to fears about counterparty risk;
- reduced lending capacity – this is partly a function of illiquidity; also, as banks’ capital has been eroded by losses, the amount of debt that they can support has shrunk;
- increased pricing – driven by uncertainty about what the future will bring;
- risk aversion – driven by the economic downturn generally and fears of recession;
- de-leveraging – banks need to liquidate assets to generate capital to maintain their capital ratios. This tendency is to some extent counteracted by market conditions;
- shorter tenors – in general, shorter tenors are perceived to be lower risk and are more available; and
- state investment and nationalisation of banks – this is bringing pressure on commercial lenders to maintain lending to domestic consumers and small business loans at the expense of international or project lending.
Various forms of Government intervention have been taken or are due to be implemented, and it remains to be seen how effective they will be in reversing these trends.
The effects of the trends identified above on existing facilities include:
1. Market disruption clauses
These are standard provisions which require the borrower to indemnify the lender if the lender’s cost of funding is higher than the interbank reference rate (e.g. LIBOR) which is normally taken to represent that cost. Last September/October there were reports that the LIBOR market had ceased to function; the screen rates were no longer regarded as an accurate measure of what banks had to pay to raise funds in the interbank market. This led to some cases of market disruption clauses being invoked. There were concerns that many others would follow.
To date however these concerns appear to have been relatively shortlived, if only due to the huge amount of liquidity that central banks have been pumping into the system to stimulate the market and its effect on the cost of funding. In addition, there are a number of factors which may have deterred potential claims, including:
- to trigger the clause, a significant proportion of lenders must be affected (usually 30 per cent or 50 per cent of total commitments);
- lenders belonging to the panel which provides the data used for setting the reference rate risk potential criticism if they invoke the clause;
- the technical and administrative difficulties likely to arise in formulating and agreeing a replacement rate, particularly where a large syndicate is involved; and
- possible adverse commercial implications if a lender admits its cost of funding is higher than the reference rate.
Borrowers should note that any hedging agreements which they may have will assume that the reference rate applies and therefore will not respond where market disruption is invoked.
2. Increased costs
As lenders have had to re-evaluate the level of risk associated with their assets, it seems inevitable that risk weightings will increase for the purposes of capital adequacy requirements, requiring additional capital to be set aside, and reducing the lender’s rate of return from a given facility.
Facility agreements generally entitle lenders to pass increased costs of this kind through to the borrower only to the extent that they are attributable to a change in law or regulation (rather than in the application of an existing law or regulation).
However, this position described is not universal. In some facilities the allocation of the risk of increased costs under existing law/regulation may be more complex – for example, the lender may have reserved the right to pass through increased costs associated with a deterioration in the borrower’s credit standing. In these cases borrowers are likely to face a claim for increased costs.
3. Lender discretions
The credit crisis places stress on all entities in the value chain, and creates a risk of default by various counterparties of the project company (including financial counterparties such as guaranteed investment contract (GIC) providers and credit support providers as well as the project company’s supply chain and customers). Where these occur, a default under the facility agreement will arise, making an array of rights and sanctions available to the lenders, including in relation to the future of the facility.
However, although no specific default may have come to light, borrowers will find lenders applying particular scrutiny in reviewing periodic financial statements and in reviewing and approving periodic cashflow projections used to calculate cover ratios. Assumptions used for these projections will inevitably be more cautious than those previously applied. The facility agreement may also entitle the lenders to demand an interim forecast or a review of reserving requirements or to make requests for information. Cover ratio calculations based on periodic or interim forecasts may, even if falling short of an outright event of default, give the lender the right to step up reporting and monitoring requirements, to require production of a remedial plan, or to block distributions and in some cases to step up the margin or to require surplus cash to be swept and applied in prepayment.
In a liquid market, the Mandated Lead Arranger (MLA) role will be given to a small number of banks (typically one or two), who will undertake to underwrite the whole facility, and are likely to complete a large proportion of the syndication after financial close. The MLA role will typically be competed.
In a less liquid market, syndication is more difficult, and banks feel less comfortable about large underwriting commitments. Instead they will either seek to share the MLA role amongst a larger group, each having a smaller share to distribute, or (where feasible) qualify their underwriting commitments by reference to reasonable endeavours. Banks honouring historic underwriting commitments are likely to accumulate unsold debt on their balance sheets.
In an illiquid market, as currently prevails, the norm is the club deal. In a club deal each of a number of banks agrees to take and hold a specified portion of the facility amount, without syndication (whether before or after signing) being assumed. The more illiquid the market, (i) the lower the amount each club member is prepared to take and hold, and the larger the number of banks required, and (ii) the less willing any bank will be to commit to take and hold a specific amount prior to financial close. In some cases the sponsors may have to take on a book building role. Where this happens tensions can arise in their relationship with the MLAs.
For sponsors, the club structure introduces additional complexities. These include (i) the challenge of concluding a financing with a large group of funders and (ii) the potential erosion of value through the application of the lowest common denominator to finance terms - this can give rise to new dynamics, such as the situation in which the sponsors are effectively obliged to accept the position of a bank that holds out for unfavourable terms but whose requirements cannot be rejected as there is no oversubscription in the funding group.
Particularly for larger projects, the challenge for sponsors at the early stages of the process will be to identify experienced and committed funders who, whilst not agreeing to underwrite debt, will work as the consortium’s advisers to develop a financeable and deliverable solution.
Funders acting in this capacity may expect to be rewarded for their early commitment, both financially and in terms of a right to match the ultimatelychosen funding terms, and possibly a favourable share of the swaps for the project, other ancillary banking business (through appointment as account bank) or additional fees (through appointment as documentation bank, insurance bank, and so forth). At the same time, the sponsors’ funder selection process will need to retain a level of transparency and certainty of commitment, due diligence and pricing that enables any procuring entity, as well as the sponsors, to be satisfied as to its value for money, affordability and deliverability.
In syndicated facilities, the concepts of pricing and structural market flex allow changes to pricing and terms after a commitment letter has been signed to the extent necessitated by the process of syndication. In club deals a comparable dynamic, which can be described as “extended market flex” provisions, in which pricing and terms may be revised due to prevailing market conditions or a club member’s response to the credit crisis. Where this occurs in a context where the consortium has been selected on a competitive basis, this can cause issues because, in particular:
- the project company’s financial model/structure may be unable to withstand a significant increase in the cost of senior debt; and/or
- significant late lender-driven changes to the terms of the project company’s bid may disturb the basis of evaluation and in so doing affect the selection process.
“Another very powerful market change over the last six months has been a significant reduction in lender risk appetite ...”
Similar issues arise in relation to the terms of any bid bond which a consortium bidding for a project has to provide as a condition of its appointment as preferred bidder. At a minimum, the sponsors need to ensure that the bid bond cannot be called if they are unable to deliver the pricing in their bid due to an increase in the pricing of their funding.
Evolution in financing terms
The principal changes we are seeing are:
1. Shorter tenors
Tenors for project finance deals of 25-27 years - typical up to the first half of 2008 - are now generally viewed as being much less available. There is evidence that, in addition to the general contraction in project finance debt capacity in the last six months, there are numerous project finance lenders who now prefer, or are strongly advocating, a move towards much shorter tenors (such as 7-12 years). In our view, the project finance market is currently in a state of flux in relation to this particular issue.
Shorter tenor facilities use a “miniperm” structure, which will, broadly speaking, amortise at the same rate as a longterm facility, leaving a bullet repayment at final maturity which the borrower must refinance. These facilities are likely to contain various features designed to mitigate the risk of the borrower being unable to refinance by the final maturity date, such as:
- a period of accelerated amortisation leading up to a target refinancing date set a year (for example) before the final maturity date. This creates an additional comfort zone in the borrower’s performance against cover ratios, which will help in obtaining financing. It also helps to ensure that the borrower will be able to refinance within the same cover ratio and gearing parameters as the original facility even if the cost of financing has risen;
- a reporting and monitoring regime in relation to the steps taken to refinance.
There are also likely to be sanctions if the loan has not been repaid by the target refinancing date, such as a full cash sweep to pay down the loan and an increase in the margin, to incentivise punctual refinancing and to de-leverage so far as project earnings allow.
One variant is the “soft miniperm”, which incentivises early refinancing without an express abandonment of longer-term tenors.
Miniperm structures present equity with very significant issues in terms of IRR expectations, which may have a significant impact on the sources of funding for equity that are available, on the cost of equity and on the overall cost of the project. The sponsors’ intention will be to extend the term, or to refinance on a longer-term basis once market conditions allow.
Where the project is being procured on a PPP basis with a state sector offtaker, the project company may seek to transfer some or all of the refinancing risk on to the procurer/offtaker. This could take the form of an uplift in periodic payments if the new cost of funding exceeds a certain level; alternatively, an assumed uplift in the margin following the target refinancing date could be priced into the periodic payments at the outset.
Wherever a third party agrees to assume or share the burden of increased financing costs on a refinancing, it is likely that a collection of other issues will arise, such as:
- whether any refinancing gain has to be shared and, if so, to what extent;
- whether payments made by the third party to mitigate refinancing risk can be clawed back;
- control over the decision to refinance and its terms and conditions;
- how to provide the third party with comfort that the cost to it is being kept to a minimum; and
- whether the third party should have an option to require the retendering of other elements of the project at the time of any prospective refinancing, either to make the project more bankable or in seeking cost savings.
2. Increased pricing
Margins have increased dramatically, although this has been particularly offset at least for the time being by reduced interbank rates.
3. Change in lender risk appetite
Another very palpable market change over the last six months has been a significant reduction in lender risk appetite, compared to the typical position pre-summer 2008. This is manifesting itself in a number of ways:
- first, in our experience lenders are requiring greater levels of completed due diligence in order to issue letters of support of the type often sought by procuring entities;
- secondly, lenders’ attitudes to unfunded risk being retained in the project company seem to be hardening; this is resulting not just in greater focus on financial reserving (such as major maintenance/ lifecycle and pass-down issues (including subcontract cap levels and guarantees)), but also in greater analysis of risk allocation at supply/offtake agreement level (this last point meaning that, in the context of a competitive procedure, it is arguably now even more important to establish lender issues at an earlier stage of the process than was previously thought necessary); and
- thirdly, additional focus on risk is inevitably adding greater pessimism to downside sensitivity testing, with the result that additional headroom is being added to cover ratio requirements, demanding lower gearing and again reducing the return to equity. Against this, it remains to be seen whether the apparent move towards shorter tenors means lenders will take a less rigorous approach to longer-term project risks; our view is that even short-term lenders will remain interested in allocation and mitigation of longer-term risks, given that addressing these issues in a way that makes the project more robust from the outset is likely to be critical in mitigating refinancing risk.
4. Equity bridge loans
There is evidence that lenders’ appetite for equity bridge loan structures is reducing. Again, this is directly relevant to equity returns, and if it proves to be the case that equity bridge loans are not available, or are unattractively priced, careful thought will be needed as to how best to structure (and remunerate) equity contributions being made earlier than might previously have been contemplated when the project was originally being planned.
Sources of funding
As the factors affecting the availability and pricing of conventional project finance bank lending are likely to continue for some time, it is certain that there will be changes in the funding sources for projects. Some of the developments which have been anticipated are:
- increased involvement of multilateral agencies, export credit agencies and development finance institutions;
- increased use of Islamic financing;
- new models for institutional investors to invest in projects;
- as a number of specialist private equity funds have been downgraded and forced to sell assets, new private equity funds entering the sector;
- less participation from monolines;
- fewer capital market based structures and, in the absence of Government credit support, securitisation of project debt portfolios; and
- oil majors and commodity traders helping to finance their counterparties.
It is difficult to predict accurately at this point how things will unfold. However it is clear that most of these developments would have significant implications for the process of raising and structuring finance for projects, and on its terms.