Bonds – Giving more encouragement
This article probes the reasons behind the seeming unwillingness of the market in Asia to adopt the project bond funding solution and outlines some possible steps to enable this source of financing to become a part of the mainstream. By Audra Low, head of originations and structuring, and Marat Zapparov, director of infrastructure, Clifford Capital.
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Much has been said and written about the disintermediation of banks in infrastructure financing, with institutional investors, such as infrastructure debt funds backed by institutional capital, pension funds and insurance companies, keenly looking at this asset class as a source of attractive, stable, long-term yields with cash inflows that match their long-term liabilities.
In Asia, however, there has been little evidence of institutional capital becoming a serious alternative to the funding that is currently available from commercial banks. ECAs, Exim banks and multilateral development agencies and sponsors in the region continue to rely on these traditional sources of financing for greenfield and brownfield projects alike. This article probes the reasons behind the seeming unwillingness of the market in Asia to adopt the project bond funding solution and outlines some possible steps to enable this source of financing to become a more prevalent option.
The market in Asia that has had meaningful and sustained success in developing a project bond market, including for greenfield assets, is Malaysia. Since the first long-term ringgit-denominated project bond was issued in 1993 for YTL’s greenfield gas-fired Paka and Pasir Gudang IPPs, numerous other similar project bonds have been issued for various infrastructure projects across the country, ranging from power plants, terminals to toll roads. These project bonds have largely been subscribed to by the Employee Provident Fund or EPF, and other pension and insurance funds in the Malaysia. Today, EPF remains the largest investor in ringgit project bond issuances in Malaysia.
A key factor that has ensured successful development of the market in Malaysia has been the existence of one or more specialist investors that understand the sectors and the structures, have the capability and institutional expertise to analyse the transactions and can anchor not only specific issuances, but the development of the project bond market as a whole. In Malaysia, this role has been largely undertaken by EPF, with support from the local rating agencies.
Finding local institutional investors similar to EPF with sufficient size, depth and knowledge of project financing in some countries within Asia can prove to be challenging, particularly in those with the greatest need for new infrastructure. Therefore, such countries will need to continue to rely on cross-border US dollar-denominated financing at least in the near term – whether this comes from banks, multilaterals, ECAs or international institutional investors.
However, as far as institutional capital is concerned, an entity has yet to emerge that has the ability and financial strength to develop and anchor the market across Asia, similar to the role EPF played for the Malaysian market, although on a deal-by-deal basis, we are beginning to see some institutions looking to play this role. As an example, for the US$450m bond issuance for Mersin International Port in Turkey in 2013, Clifford Capital, alongside the EBRD and IFC acted as anchor investors, providing comfort on execution of the deal to the issuer, as well as a “halo effect” for co-investors, some of which may perhaps lack the specialist project finance lender expertise necessary to diligence such transactions.
One key reason for the rather slow start to project bond activity in Asia arises from the current environment in the region (perhaps with the exception of Australia, which has an active PPP market), where ample bank liquidity is pursuing a limited pipeline of bankable projects. To see meaningful participation from institutional investors in this part of the world, first there needs to be a larger pool of well-structured projects brought to market on a regular basis.
As it is, there is a significant disparity in the economic and sovereign risk profiles of the many countries that comprise the project finance markets in Asia. Only with a steady pipeline of bankable projects would bond investors commit the time and resources required to build up the knowledge and capacity to evaluate and monitor transactions in each of these markets. This is, of course, a well-known conundrum with few easy solutions.
The stand-alone credit risk profile of projects in Asia also poses a challenge for investment managers with a mandate to invest pension fund or insurance fund capital. Many sovereign credits in Asia are still sub-investment grade, with counterparties to key offtake contracts often being entities with a social and/or public role (for example single buyers of electricity), hence relying on central government budgetary transfers to subsidise the low tariffs for end-users for the public goods they provide.
This means that without political risk cover and/or credit enhancement of some form, project ratings will be capped by the sovereign rating at best, or otherwise, will simply not be bankable. Whilst risk insurance is generally available from private insurers, many projects will need the support of multilaterals and ECAs given the size of the overall infrastructure investment that is needed in this part of the world.
At this stage, there is no obvious PRI product that responds to the needs of bond investors, although entities such as the World Bank and ADB have been working on credit-enhancement products for this investor base. Novel approaches to credit-enhance key counterparties in the region will be necessary, as well as a concerted effort from interested stakeholders to articulate the credit-enhancing features of new products to the institutional investor base.
There is also a question as to whether project bonds are necessarily the most effective funding solution during construction. In addition to negative carry, projects during construction require significant monitoring and active involvement by lenders to ensure construction budgets are met and projects milestones achieved in a timely manner. This is something that banks, or specialist financiers such as Clifford Capital, have the skills and resources to undertake, however it remains challenging with a large and group of bond investors.
As the lender consenting process for bond investors can be cumbersome, whether through a voting mechanism or bondholder meetings, bonds are typically “covenant-lite” compared with bank loan structures. Bondholder consents are typically reserved for fundamental credit issues, such as payment defaults, acceleration or security enforcement. For project owners, the less intrusive nature of bond financing may be an attractive feature, however, should there be any unanticipated changes in the projects that necessitate some changes to the financing terms, they could find it difficult to obtain approval from reluctant bond trustees and passive, possibly even disinterested bondholders. For tendering authorities, the checks and balance that come with the level of scrutiny that comes with traditional project finance is partially lost.
Traditionally, one way to address the issues surrounding negative carry and the cumbersome waiver and consenting process is to have the banks fund the projects fully during construction and then be partially or wholly taken out by bond investors once construction is completed and the project has some operational track record. This is workable since the need for waivers and consents also lightens significantly once the project successfully achieves commercial operation and is running smoothly.
A bond take-out is then favoured by banks, as it allows them to recycle their capital, reduce the need for costly long-term funding (particularly when Basel III is fully rolled out), and earn additional fee income with arranging the bond issuance. Banks continue to be well-equipped to originate, structure and execute complex project financings and to accept and manage construction risks inherent in greenfield projects.
However, does this mean project bonds are ruled out entirely for greenfield projects? We think not. For larger projects, bond investors can take some comfort from bank-cum-bond financing structures by relying largely on banks to undertake the close project monitoring and even delegating some of the lender consents to banks, provided inter-creditor matters are appropriately structured. Another potential solution is to have a specialist anchor institution “front” other institutional investors with specific authority to make certain decisions in such waiver and consent processes.
This is something that is recognised by the Monetary Authority of Singapore (MAS), which has been keen to develop a market for Asian project bonds as part of the several initiatives that the Singapore Government has undertaken to promote Singapore as a regional infrastructure financing hub. MAS has been engaging with industry players such as Clifford Capital to identify ways to allow institutional investors to provide committed financing to greenfield projects, even if the take out only takes place after project completion.
In May 2013, during the keynote address at the Silver Jubilee Celebrations of the SEBI, Singapore’s Deputy Prime Minister and Minister of Finance Tharman Shanmugaratnam set out a few strategic priorities that would assist the development of the institutional market for infrastructure debt, including the development of new intermediaries, harnessing pools of domestic savings in emerging markets, credit enhancement solutions and addressing policy and regulatory risk.
Given the potential depth of institutional funding, governments that are serious about attracting sizeable private sector infrastructure investments into the country should not disregard institutional debt investors. Often, the benefit that institutional investors brings is access to long-term local currency capital, which may not be available from international or local banks. This is of particular significance for emerging jurisdictions that rely on US dollar-denominated financing for their large domestic investment requirements and where, rightly, macroeconomic prudence makes governments reluctant to take on large long-term foreign-currency liabilities. As such, the most fundamental and pressing issue today is no doubt the need for Asian governments to find ways to improve the bankability of projects, bring more deals to market quickly and ensure robust tender processes.
Multilaterals such as the World Bank and ADB have started to look into ways to support the greater use of project bonds in infrastructure financing. Possible solutions that have been successfully utilised in Europe include comprehensive credit wraps similar to the monoline insurer model of old, and the introduction of a first loss debt tranche as a form of credit enhancement for the bond tranche. It should just be a matter of time before similar products find their way into Asian projects. Asian governments could potentially accelerate the adoption of such practices by working with the multilateral agencies and ECAs on possible solutions.
Tendering authorities also need to pay attention to their tender processes and project documents as there are specific issues that arise from the use of bond financing. These include:
* Execution risk – Debt capital markets are inherently volatile and since bond arrangers rarely give firm commitments in terms of amount, financing terms or pricing, projects could be subject to substantial execution risk. Even if tendering authorities are prepared to take on interest rate risks right up to financial close, they should consider if fall-back financing should be a requirement in tendering for projects in case the bond issuance window closes, to ensure projects are able to achieve financial close in a timely and orderly manner.
* Refinancing risk – To what extent should tendering authorities bear refinancing risks and conversely share in refinancing gains for projects that contemplate a bond take-out? Traditionally, governments have sought a 50-50 sharing of refinancing gains with project owners. This has been generally accepted as long as projects have fully amortising financing structures in place from day one, with any refinancing undertaken only if it results in further gains for project owners.
However, if long-term bank financing becomes constrained in the future, take-out financing will become a necessity. To encourage sponsors to accept some refinancing risk, governments may need to consider ways to mitigate this risk. This can take the form of a full or partial payment adjustment that allows sponsors to maintain their projected equity returns. Also, if interest rates have been locked in at financial close through swaps, these may need to be unwound when floating-rate loans are replaced by fixed-rate bonds. Tendering authorities will therefore need to consider if they are willing to bear such breakage costs.
* Early termination payments – Unlike commercial banks, bond investors loathe prepayments. As such, bonds are often structured with non-call and make-whole provisions. With interest rate swaps, pre-mature termination may entail a gain or a loss depending where interest rates are vis-à-vis the fixed rate. With bond financing, tendering authorities will invariably bear additional termination costs from make-whole provisions and project agreements will need to reflect this.
* Bid evaluation – Tendering authorities can proactively promote the use of alternative funding sources by structuring RFPs to include refinancing provisions. By the same measure, allowing bidders full flexibility in determining the optimal funding mix for a given project may make it difficult for tendering authorities to evaluate bids on an equal footing. RFPs will need to provide clear guidelines to bidders to explore all funding sources while ensuring that bids can be evaluated fairly on both pricing and risk factors.
Finally, governments may also consider developing the local institutional funding market, as this will form an important source of competitive local currency denominated funding for infrastructure projects. In Asia, high levels of household savings have so far found their way primarily into infrastructure financing through banks. As markets mature and the regulatory environment affecting banks and institutional investors evolves, inevitably the interest in infrastructure debt as an asset class from institutional capital will grow, as investors seek risk-adjusted, stable long-term yields.