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Wednesday, 13 December 2017

A life in project finance – Peter Barlow

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Peter Barlow gives a historic and personal overview of the progress that has taken place in the world of project finance.

To view the digital edition of this report please click here.

The origins of project finance can be disputed but the modern discipline can be traced back to the 1970s. It was used at that time primarily for joint-venture situations in the resource sectors. It essentially involved the use of special purpose vehicles to allow investors to spread debt loads, using associated cashflows for the repayment of debt. Its use was partially dictated by the reluctance of joint venture partners to take individual responsibility for the entire debt. Various structures therefore evolved, including the use of both incorporated and unincorporated JVs where risk and reward (often with a view to tax liabilities) were allocated. 

It was around this time Project Finance by Peter Nevitt was published. An interesting aspect of those first editions was that it mentioned various asset financing techniques such as leasing. It was relatively sanguine about trying to cover the entire spectrum of asset financing, which would be considered ambitious in a modern approach. Conceptually, this was entirely correct, as “project finance”, a name that goes in and out of fashion, is fundamentally cashflow lending and is thus entirely analogous to structured finance, leveraged finance and other financing techniques  (the eighth edition of that book was published last year and it is slightly disconcerting that this edition includes a number of deals with which I was intimately associated, including Paiton and Dahbol).

In the 1980s, the technique was given added stimulus by several factors, such as banks’ willingness to lend long-term. Previously, this has been limited to real estate. The transfer of what was seen as assets that were traditionally controlled and owned by the state to private-sector concessionaires was viewed as innovative (strictly speaking this was not the case; one example is the early railways in South America being financed by British capital).

Banks were then encouraged to lend long-term to these new concessions, which ultimately led to, for example, the Eurotunnel financing – a financing that Japanese banks assumed was disguised sovereign risk and where UK and French banks were unofficially pressured to lend by their governments. Many other banks followed their lead.

Bank of America, as a major project lender, was unusual in that it refused to participate on the basis of the risk of unknown ground conditions being allocated to the lenders. This later proved to be the risk that caused substantial cost overruns and delays. BofA subsequently took over Security Pacific, which had taken a participation, so BofA didn’t avoid exposure in the end. Despite the Eurotunnel experience, banks had now developed a thirst for financing long-term infrastructure – the door was open to create immense opportunities in the 1990s.

The project finance “experiment” continued in the UK but over the next 15 years it metamorphosed as large concessions-regulated utilities started to be financed as investment-grade corporates (with various subsequent aggressive releveragings causing several hiccups along the way). Smaller PFI deals were increasingly structured by accounting firms as these deals became commoditised and too small for the banks to make money, given their higher cost bases.

The government did err in some cases, for example the failure to capture refinancing gains – best exemplified by the Macquarie Birmingham Toll Road deal. However, there was some more equitable sharing of risk in later deals.

Of more interest to me personally was the export of project finance to other countries, particularly Asia. Although deregulation in the UK and US power markets was not to happen until the mid/late 1990s, the independent power project (IPP) model was taken up first by Malaysia in 1991; and Thailand and Indonesia continued with the process.

I moved to Hong Kong when working at Bank of America, and we advised and lent on the first Malaysian IPPs (now being brought back under Malaysian quasi-state ownership). The major deal in the mid-1990s was the Paiton power station in east Java by Edison Mission Energy and the size (over US$1bn) was too large for commercial bank markets.

Thus a structure, involving US OPIC, US Ex-Im, JBIC and commercial lenders, evolved. The use of export credit agencies (ECAs) in the early days is significant as they provided political risk cover in many countries that were unacceptable risks for commercial banks and they provided long-term finance. They also provided subsidised interest rates that could be restructured/swapped. JBIC also had the advantage of very low yen rates. ECAs have enjoyed a revival as a result of the 2008 financial crisis and it will be interesting to see if the introduction of Basel III will give them further momentum.

The concession-based financing technique continued to be adopted in Asia throughout the 1990s. Bank of America either advised or lent on: two telecoms concessions signed in Thailand; an aborted attempt to build a Mass Transit in Bangkok in 1992; the first Dabhol deal – which was the Enron deal that had a Government of India guarantee of the off-taker – fatally weakened by the second Dahbol deal, an aviation fuel pipeline deal in Hong Kong; several geothermal deals in the Philippines; and a number of others. We deliberately avoided China projects, which proved to be a wise decision.

In 1998, I returned to the UK to join International Power. That proved interesting since not only was it an opportunity to sit opposite my former colleagues and competitors, but it was one of the few major corporates that relied almost exclusively on project finance. The company was one of the largest users of project finance in the world and used primarily commercial bank finance and export credit to finance its assets in the 24 countries in which it operated. International Power tripled its size during 2000–2011. More than 20 major project financings were completed in that period, exceeding US$1bn individually in many cases.

A few highlights were: completing the ANP US$1.2bn financing in the US in 2001 – about a month before the business model of banks financing mini-perms with bond take-outs in the US power markets collapsed – a financing that if it had not occurred would have caused significant financial strain on International Power; launching the US$1.6bn Shuweihat syndication the day after 9/11 and still executing it successfully; completing the takeover of Edison Mission Energy and financing this though a commercial bank syndicate – the first time a portfolio financing with underlying project debt of anything like that size had been attempted; and the Paiton extension financing, a complicated deal as the company could not disturb the original financing on which it had worked 15 years previously.

In terms of lessons learnt and observed, the world of project finance, like many things, runs in cycles. Themes, such as the use of ECAs, continue to ebb and flow, but always with a slightly different angle. Basel III will have a major impact – eventually even Japanese banks’ behaviour will be influenced by Basel III. It is also clear that the importance of local bank financing, both in local and foreign currencies, will increase. Chinese banks are only now starting to exert their influence on project finance and this will expand beyond natural resource projects into infrastructure as they try to increase the yield on their significant quantity of assets.

It is likely that we will see some further withdrawal of long-term project lending by major foreign commercial banks and there will be dedicated funds set up (an example is Clifford Capital in Singapore) that will be unconstrained by Basel III and thus able to buy debt participations in the manner executed, not entirely successfully, by banks’ syndication teams. Project finance personnel will migrate to these funds and provide their valuable expertise to them.

There are, of course, some things that do not change – deals still take a long time, which causes some frustration with bank management and means that it takes a long time to gather the experience that is gained by actually executing several deals in various sectors. The project finance community is fairly incestuous and many of us have known each other for a long time. I have been very fortunate to work with some excellent teams during my banking career and at International Power and that cannot be emphasised enough as an ingredient for success.

Finally, given that this is its 500th issue, a note on Project Finance International magazine: There is no question that PFI is by far the most informative and reputable magazine for the project finance community. It enabled numerous bankers who used to call on me to appear very informed and is definitely required reading for the syndications groups – with interpretation from the project financiers.

While the choice of PFI Deal of the Year is alongside the mysteries of the Oracle of Delphi – examples such as the award to a €20m toll road in the same year as International Power completed the US$1.8bn Umm Al Narr project, and the award another year to a wind farm that had not closed, I am sure that with further experience, these mysteries will be revealed to me. Nevertheless, I think we all appreciate the excellent information and comment that the magazine provides.

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