Sunday, 17 February 2019

The lenders' views

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There have been grumbles from Asia’s project finance lenders’ community that even though regional liquidity, both offshore and onshore remains strong, there has been a low volume of live deals from the region over the past 18 months or so. By Jonathan Rogers.

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Nevertheless, the fact remains that Asia is now the pre-eminent source of PF transactions globally, having risen to around 50% of volume from about 20% 15 years ago. Still, there remain perennial complaints about a frequently telling lack of best practice limiting the Asian PF pipeline and prolonging deal timelines. 

Europe is probably the benchmark for best practice in the PF universe in terms of transparency, structuring and the legal and regulatory framework. Asia is nowhere near as homogeneous and the region’s project finance sector is best seen as a spectrum. Australia and Singapore sit at one end, approaching the European benchmark standard, and the likes of Laos and Vietnam at the other, where there have been concerns about the behaviour of government with regard to off-takes and commitment to sponsors and development and export credit agencies. 

Looking at the spectrum in the rear view mirror as it were, the perspective of a potential project lender or investor will be to envisage the worst-case scenario from a best practice perspective: the debt restructuring and all the twists and turns it involves, where a terming out and substantial haircut will be the final outcome and there will be shouts, literal or otherwise of “what on earth were we thinking?”

“Many projects have problems and obstacles to be addressed. Most frequently, it’s about obtaining government approval and the issue of land acquisition. And there are difficulties with securing government commitment to a project, particularly in the power sector where off-take agreements are involved,” said F Machida, of JBIC in Singapore. 

“It generally involves intense discussion with the sponsors and governments to address these issues, but as JBIC found out in emerging Asia, governments tend to stick to a textbook style PPP model, where senior bankers usually suffer from inappropriate risk-sharing, although they need more involvement by host county governments.” 

Land acquisition has become the major bugbear of project finance in Asia and perhaps the most egregious example is the World Bank-funded Khimti-Dhalkebar Transmission Line project in Nepal, which has been stalled for 10 years thanks to exorbitant price demands from Sindhuli locals for the 3.6 hectares of land earmarked for the project. Unrealistic price demands from a wide range of local households are more frequent when external funding is involved and finding the right compensation level, and whether it should come from sponsors, ECAs or development agencies, is an issue to be resolved in many Asian countries.

By contrast, in China, the power of eminent domain has been invoked to requisition land for projects, and that has smoothed the timeline for both externally and locally funded schemes.

The process of project procurement involves the interplay of government expectations, which are by their very nature politically loaded and wrapped in the national interest, and the risk and return hurdles of the private sector, whether this is the sponsor, a commercial bank or a debt investor. And bilateral or multilateral agencies will also have a variety of vested interests that comprise a mix of fundamental mission statement (for example, poverty reduction in the case of the Asian Development Bank) and internal rates of return for any given project.    

While Asia is a granular proposition as far as project finance is concerned and countries differ in the “available” best practice according to the legal framework and the government procurement modus operandi, there is also a spectrum of best practice through different sectors in the same country. The availability of sound projects in power, water, roads, ports and airports is not a unipolar proposition from a single country perspective.

For example, in Thailand the power sector is regarded as transparent – and something of a regional model in that regard – and has been the source of innovative long-tenor project financing. On the other hand, the toll road sector in the country is seen as problematic and complaints about overestimating traffic on greenfield toll projects (which beset the toll road sector throughout Asia) are an industry commonplace.

“The toll road sector is difficult from a best practice point of view in that estimating traffic is hardly a science. Thailand’s experience is not unique in what remains a fundamentally problematic asset class. By contrast, in the power sector, the success of deals has been underpinned by the country’s power development plan, which is set out every year. And EGAT is one of Asia’s most respected off-takers, with a solid track record and the EGAT Act effectively tying in Thai power risk to the sovereign risk level,” said Colin Chen, head of project finance at MUFG in Singapore.

Indeed, the presence of EGAT was instrumental in the innovative Nam Thuen 2 hydroelectric power project (NTPC) from almost a decade ago, which involved a complex exercise in dual-country political risk mitigation, a sober take on foreign exchange levels and a robust environmental and social safeguards plan. The presence of the World Bank and Asian Development Bank in structuring the project was essential to its success, with the agencies working with government to overcome numerous obstacles. 

The patchiness of the Lao legal framework was seen as a major hurdle to overcome in getting the project off the ground and in the event, the government of Laos implemented new laws and agreed to address any further legal issues with legislation as and when required at the Lao National Assembly level.

This must be regarded as a model of PF best practice in Asian jurisdictions, where project financing comes up against a poorly developed legal framework; one thinks of Cambodia, Myanmar and Vietnam in this regard.

The story is different in India, where there is colossal demand for power but a wide range of off-takers, and to put it bluntly, none of which is notably creditworthy. Indeed, the credit backdrop in the India power sector has deteriorated in recent years, something that has contributed to a woefully thin roster of completed PF power deals from the country. When the Indian government had its counter-guarantee programme in place, power projects were able to be fast-tracked. But the insalubrious experience of the Enron-constructed Dabhol power plant arguably set back the Indian project finance market by years in relation to the demand that is there in the country. 

And as well as the deteriorating economic environment, which last year saw the rupee come under intense pressure, significantly increasing the debt service cost of existing projects and eroding the appeal of greenfield projects, the regulatory environment in India is seen as a major impediment to the growth of its PF market. Bilateral treaty claim have been made around five times over the past few years by foreign investors, principally in the telecoms sector, and all this together with the capriciousness of the Indian tax authorities combines to create a grim landscape for Indian PF.

The irony is that India is regarded as having excellent onshore EPC and project finance skills, but the problem has been one of implementation in most cases. Many Indian financiers have suggested that the government set up a ministry of infrastructure to try to address all the above issues.

Numerous Asia-based project finance bankers were critical of the approach of regional government in the PPP sphere, suggesting that they tend to skimp on budget and prioritise the less interesting projects rather than those that would pique the interest of commercial lenders and might therefore contain a more structured element.

“Governments in the region must choose the most interesting and viable projects for private sector participation and then the longer tenor and more structured deals are likely to emerge. There should be a sense of the need to create excitement among lenders and investors. This extends from the central to the municipal government level,” said Michael Barrow, deputy director general of the private sector operations department of the Asian Development Bank in Manila. 

“Pricing can’t substitute for risk and even though there are projects that may exceed a bank’s or export credit agency’s return hurdle, residual risk will generally be prioritised, and if the risk is unmanageable or poorly allocated, the deals will not happen. The money is certainly out there, with the banks and in the vast savings pools in the region. But there are too many inadequately prepared deals that lack the appropriate structuring and risk balance,” said the ADB’s Barrow.

Indeed, the mantra most recited on the topic of best practice in Asian PF from industry practitioners was the need for intense liaison on deal structure between government, banks and agencies. 

A classic example of best practice along these lines, is – perhaps unsurprisingly given the country’s noted capital markets transparency and prudence – the Ichythys LNG project in Northern Australia, at US$34bn representing the world’s largest project financing. The sponsors, led by Japan’s Inpex and France’s Total SA, managed to secure US$20bn of limited-recourse financing, an achievement that spoke of the strong reputations of the sponsors and the stringency of the project’s structure.

In a timeline of little under a year, the sponsors, advised by Allen & Overy as legal advisers to the sponsors and Credit Agricole and Mizuho as financial advisers, conducted intense negotiations with ECAs and after a term sheet was produced, financing was secured six months later. The project ownership was split between an upstream and downstream structure, with the former owned in an unincorporated joint venture (UJV) structure allowing the ownership interests of the JV partners to be aligned. Such a structure could clearly be adopted on much smaller projects in other countries in Asia.

There has been talk in the European capital markets of the “great disintermediation” as loan volumes have plummeted over the past 18 months while bond issuance has hit record levels. The same is true in the US, where the quest for yield has prompted a bonanza at lower reaches of the debt credit curve. Project finance might be an area that is crying out for such disintermediation and that it would be easy to argue sits bang in the middle of the debate about best practice.

So it is tempting to call for the full-scale introduction of a project bond market, where there would be the natural introduction of longer tenors than is typically the case in Asian PF financings, where the consequent creation of a liquid secondary PF credit curve would bring down term financing costs for issuers. As would increasing the universe of liquidity providers from a limited pool of commercial banks to a wide pool of bond investors. Surely, everybody would win.

But MUFG’s Chen is sceptical that this would provide a universal panacea for Asia’s PF market, saying:”Bond markets are not always ideal for project finance transactions. Versus typical bank financing for projects where payments are tailored to construction milestones, capex needs and where there can be complex amortisation schedules, a bond facility comes at a predetermined drawdown. often in one large lump payment. And sponsors will probably face negative carry issues.” 

Malaysia has the region’s broadest project finance bond market, focused on the power sector, with Sharia-compliant structures lending themselves naturally to the project finance proposition. The country’s sovereign wealth fund Khazanah and other pension funds provide a natural pool of liquidity for the Islamic product and power supplier Tenaga is along with EGAT regarded as one of Asia’s most creditworthy power off-takers.

The need to make projects attractive from a sponsor’s point of view is perhaps the salient issue over the medium term, as Basel III capital requirements will reduce the amount of liquidity available to fund Asian projects from the bank sector, with the “slack” required to be taken up by a bigger portion of sponsor’s equity. In order to retain banks’ bottom lines in the face of reduced volume, it might be necessary for them to accept looser security packages at the sponsorship level, such as a reduction in the amount kept in escrow cash sweep accounts.

This is perhaps inevitable as the PF playing field becomes increasingly fluid and the traditional roles less defined. So ECAs can be cast in the role of competitor to the banks rather than as facilitator, with banks such as Kexim having set up advisory departments over the past few years in competition with banks and legal firms. Their ability to extend long tenor at compressed pricing has put commercial lenders’ margins under pressure and ECAs have increasingly been used as a lever by sponsors in dealing with commercial banks in the region, in a push to achieve lower funding levels. 

Ironically, the rise in bank funding costs seen as the result of Basel III – which for some lenders is in the triple digits over Libor at medium tenors – means this dynamic only adds to impasse, and explains the dwindling deal volume.

Still, there are pockets of optimism among PF bankers. BNP Paribas’ Bruce Weller said that although it is difficult to generalize on weaker structures “people have, with the passage of time, generally ygotten more comfortable with country risk and in assessing the true risk on projects.”

“Ten to 15 years ago there was a scant project operating track record. But now a number of projects have an established operating history and banks are increasingly comfortable with refinancing these projects, and that has become an essential part of the PF equation in Asia Pacific.”

If coming through a refinancing or two provides overall comfort to the PF proposition in Asia, so too does the presence of what are perceived as key relationship banks on project deals. And while volume has diminished over the past year and a half, and deals have tended to be closed on a club basis, there have also been cases of deals getting underwritten and apparent aggression in this regard seen with some of the Japanese mega banks. 

MUFG’s Chen offered the IFC’s A and B loan structure as a models of solid practice in the Asian project finance market, under which participants in the B loan component of a project – the IFC retains the A portion, with funds lent 50/50 in the A and B tranches – enjoy transfer and risk convertibility mitigation under the IFC’s preferred creditor status. In addition, loan participants enjoy the IFC’s structuring skills and experience in addressing environmental and social issues as well as the institution’s global government contacts rolodex. 

The A/B loan structure is exempt from withholding tax, generally enables longer-tenor borrowing and from the borrower’s perspective can facilitate introduction to a broad universe of commercial banks.

“The A loan and B loan structure has advantages to certain participating banks in that the IFC is a lender of record and therefore documentation and administration is potentially simplified. In terms of risk mitigation, it is an incentive for banks since the IFC cannot be paid in full on the A portion of the loan until all the lenders on the B portion have been paid,” said MUFG’s Chen.

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