A global shortfall in infrastructure investment has been identified in the post-financial crisis environment, including by the likes of the European Investment Bank (“EIB”) and the World Economic Forum. This has resulted in the introduction of various initiatives to encourage capital market investment and lending, including EIB’s Europe 2020 Project Bond Initiative and the HM Treasury’s UK Guarantee Scheme.
Traditionally, bank debt has been the “go-to” source of project finance. In contrast, the popularity of project bonds has fluctuated over the past decade, reflecting the changing environment in which project bonds have been issued.
Prior to 2008, project bonds were commonly insured and “wrapped” by monoline insurance companies. This means that those insurance companies would insure, and act as financial guarantor for, the bond issuance. Project bonds benefitting from such credit enhancement would accordingly appear more attractive to institutional investors. In 2008 however, those monoline insurance companies started to experience rating downgrades, which contributed to their demise. Project bonds decreased in popularity immediately following this time. As monoline insurance companies controlled most aspects of construction, their demise also created a void as to how projects were controlled.
The post-financial crisis environment has been characterised by heightened capital regulatory requirements, notably those introduced under the “Basel III” framework. As a result, banks have developed stricter lending requirements and a more selective approach to lending and how they deploy their balance sheet. The constriction of available bank funds, together with the shortfall in infrastructure investments, has led a resurgence in the popularity of project bonds.
PwC reported that in 2013 there were landmark projects with capital markets involvements in Brazil, Spain, Holland, the UK and France. In 2014, the first project bond in Italy was issued by a solar company. In 2015 DLA Piper advised, and continues to advise, on a number of project bond issuances and/or projects with capital markets involvement. We have seen that project bonds are more commonly issued alongside and pari passu to senior bank debt, rather than being the sole source of funding for a project.
WHY PROJECT BONDS?
From the sponsor’s perspective, incentives to obtain funding by way of project bonds may include the lower cost of debt, availability of longer tenure, the ability to directly access capital markets and the ability to gain wider access to funds.
From an investor’s perspective, the potential returns of the project bonds (which are usually issued at senior secured level) may outweigh the perceived risk. Historically, institutional investors have been perceived to be more passive than bank lenders in the funding process, and have experienced difficulties in obtaining the resources required to undertake the necessary due diligence for project bonds. Post-2008, we have seen parties such as asset managers and fund managers step in to facilitate the negotiation and due diligence aspects for one or more institutional investors.
Finance structures involving project bonds, particularly those issued alongside bank debt, can be complex. For the purposes of this piece we will highlight two key areas to which particular consideration should be given.
From the outset it should be noted that bonds typically operate differently to bank facilities with respect to what is traditionally known in bank lending terms as “drawdown”. Whilst parties can agree for bank facilities to be drawn upon a borrower’s request, bonds are typically issued in full and in one issuance on the issue date for the purposes of pricing certainty. The bullet issuance may result in what is commonly referred to as “negative carry” from the issue date. At the time of issue, the bonds will start incurring interest. “Negative carry” refers to the interest that an issuing project company (“ProjectCo”) would incur on funds that are not required at that point in time.
There have been a few methods employed to address the issue of negative carry. One such approach has been to enter into an arrangement whereby immediately following the issuances of the bonds by ProjectCo to investors, the bonds are bought back by ProjectCo and held in custody until they are re-purchased over a period of time by the investors.
This requires ProjectCo and the investors to commit to purchasing the bonds at specified points in time. Another approach is for the bonds, following issuance, to remain uncommitted until they are sold to investors at the prevailing market price.
Other structural considerations that should be given to project bonds are those which should be given to any bond issuance – including: (i) in what circumstances should mandatory or optional redemption be allowed?; (ii) in what circumstances should make-whole apply?; and (iii) will the bonds be cleared via a clearing system? From a commercial perspective, the answers to the above may result in cost implications. From a legal perspective, those answers would impact the suite of legal documents required to be put in place.
Special consideration should be given to intercreditor arrangements, especially where there is more than one source of funding.
In the pre-financial crisis environment monoline insurance companies, in addition to providing credit enhancement, generally also held all the voting rights in intercreditor arrangements. As a result, the challenges that are currently faced with respect to the administration of project bonds were less prevalent at that time.
In the current environment, considerations relating to administration of the voting relating to amendments, waivers and consents should include: (i) how the votes will be weighted; (ii) what the voting procedure will be for each creditor group (institutional investors for example are perceived to be more passive than bank lenders); and (iii) how each creditor group will be represented. Administration of intercreditor arrangements may be challenging particularly where there are a large number of bondholders, particularly if held through a clearing system.
Tailored approaches can be used to address the intercreditor requirements of the funding group, including where there are a large number of bondholders. Tailoring may include:
- appointing a different agent for each creditor group, with those agents feeding through to a common agent;
- establishing entrenched rights for certain creditor groups which are exercisable without the consent of the common agent;
- dividing matters requiring voting into: (i) minor matters that the common agent may make a decision in respect of without creditor vote (with notification of the decision being sufficient); (ii) matters that require majority resolution; and (iii) matters that require unanimous resolution;
- designating a “controlling creditor” (with reference to priority of each finance party); and
- deferring certain decisions to the advice of independent experts.
With the continued shortfall in infrastructure investment and regulatory constraints faced by bank lenders, we expect to see a continued increase in market activity with respect to project bond issuances. If a sponsor or ProjectCo chooses to proceed with a project bond issuance, particular consideration needs to be given to matters such as, without limitation, the structure of the bond and interaction of bondholder’s rights with other creditors.