Financing issues

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Financing issues

• Raymond Bourdeaux
• The World Bank
• St. Petersburg May 23, 2008

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Specifics of project finance debt
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Why investors want to raise debt?

• Cost of equity vs. cost of debt
• Cost of equity 18
• Cost of debt 12
• Where to mobilize financing? / non recourse
  financing
• Increasing borrowing allows to reduce the cost of
  a project to the Government

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Debt characteristics the basics

• Maturity
• Grace Period
• Funding rate
• Margin
• Conditions Precedents
• Covenants and debt service cover ratio
• Event of Default
• Consequence of Event of Default
• Security

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What is a bankable deal?

• A project that Banks consider sufficiently
• attractive to mobilize long term limited / non
  recourse financing
• Different financing institutions have different
  requirements who is going to finance the
  project?
• What amounts are required to finance the deal?
• To which extent does this tally current financial
  modeling results?
• But there is no upside to debt the only concern
  for a lender is to minimize risks

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Debt characteristics the basics

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Debt characteristics the basics
Additional Money Requested by Lenders to Service
Debt due to traffic uncertainty

time
Lower than expected revenues
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Structure of Availability Payment (AP)

• Availability Payment (AP) starts on the first
  year of operation
• A portion of the AP will be indexed to reflect
  OM cost inflation
• It is proposed that AP will follow 2 rules, to
  reduce the incidence of high starting level due
  to shorter maturity in ruble
• On a nominal basis, AP can only reduce year on
  year
• Such reduction cannot happen in the first 5
  years of operation, to ensure that Investors can
  design a project with the lower acceptable level
  of equity IRR

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Ways of decreasing debt funding requirements
(apart from additional Government support)

• Increase tariffs / revenues ( feasibility) ?
• Upfront Government contribution ?
• Decrease operation and maintenance costs
• Allow variability of design to reduce
  construction costs ?
• Defer some of the construction until later ?
• Increase equity ?
• Increase maturity and / or grace period ?
• Ensure lower cost financing ?
• Split the project into phases / reduce the
  project scope?
• Making sure that the project is competitively bid
  to maximize competitive tensions between bidders
  ?

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Challenges for finance raising

• Finance raising is investors responsibility, why
  does it matter?
• Deals are challenging, investors will expect
  Government to understand the challenge and to
  show has addressed it in its approach
• Investors will expect that Government know the
  deal is bankable, because the relevant detailed
  financial studies have been done
• Specifics of the deal
• Size of project versus typical projects in this
  category
• Untested market, both legally and finance raising
  wise
• Finance raising work will take a long time once a
  bidder is selected
• Multi Laterals Agencies cannot support
  exclusively at bidding stage
• Is the amount of financing required prevent
  proper competition between commercial banks
  (exclusivity vs. size)?

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Overall risk allocation
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Impact of setting the risk allocation at a
suboptimal level and having a too short timetable

• Timetable. Size and risk allocation influence
  bidders willingness to participate
• The less the competition, the more demanding
  investors will be
• The best moment to ensure reasonable risk
  allocation is early on. After bid award, the
  pressure is to close the transaction, not improve
  the risk allocation

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PPP risk allocation principle

• PPP risks need to be allocated to the party best
  able to manage it
• This is very different from allocating all risks
  to the private sector
• Inadequate risk allocation leads to
• Failure of project to reach financial close (eg
  all risks revert back to Government)
• Failure during construction (half constructed
  motorway and liabilities attached to it))
• Failure during operation (costs of re- tendering
  and liabilities reverting back to Government)
• Risks magnitude vary depending on project phases
  some risks can be allocated early on in the
  bidding process and some continue to exist until
  the end of the project life. This impact the
  optimum risk allocation, typically there are
  four distinct period for projects
• Before bid submission
• Between bid submission and financial close
• During construction
• During operation

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Typical risk allocation
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Bank margin
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Risk of change in bank margin and maturity the
issue

• Margin and maturity are finalized only when the
  loan is ready to be signed
• Lenders margin are a function of demand and
  supply, market appetite and due diligence.
  Typically it is linked to
• Transaction size
• How many transactions are in the market at the
  same time
• The amount of due diligence done upfront
• The amount of lending competition
• Any financial disruption
• In theory and assuming competition for funding
  exists, once a preferred bidder is selected it
  will have a better ability to negotiate down
  banks margin or extend maturities.
• So bidders cannot fully control banks margin at
  the point of bid submission.
• Who should take the risk of change in bank
  margins and maturities between bid submission and
  financial close?

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Risk of change in bank margin and maturities
Typical risk allocation

• Risk exists in any countries and is a typical
  risk associated with bidding for project
  financings.
• only in the period between bid submission and
  financial close, margins are fixed at financial
  close (subject only to refinancing).
• Risk normally borne by bidder
• Might be different if narrow or volatile or
  difficult market.

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Risk of change in bank margin

• TYPICALLY, THE RISK IS ALLOCATED TO THE PREFERRED
  CONCESSIONAIRE, SINCE
• The bidders have much deeper experience in
  estimating bank margins than the grantor.
• Subject to major due diligence findings post bid
  submission, margins might be reduced post bid
  submission
• Difficult for Grantor to control the risk and no
  interest for bidder to mitigate it if it does not
  take the risk
• Note that
• in theory, savings on lowering margin changing
  maturities could be shared with grantor, but it
  is unlikely that bidders would accept upside
  sharing without downside sharing

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Interest rate
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Risk of change in interest rate the basics

• Loans are quoted in relation to floating rate
• It is often better to ensure the interest rate of
  the loan is fixed for an infrastructure project
• An interest rate swap allow a borrower to
  exchange a loan with a floating interest rate
  with a fixed interest rate

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10 year interest rate swap, rubleevolution over
the last year
Change in swap rate over last year has been in
the region of 135-155bp points (6.4 to 7.5-8.0
between sept 06 and nov 07
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5 years IRS ruble swap rates
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Risk of change in interest rate the issue

• Floating interest rate (Libor, Russian base rate
  etc..) changes with time and is not something the
  Bidder can control.
• Usually, Governments are not prepared to
  compensate Concessionaire for change in interest
  rate during construction or operation.).
• Entering into an interest rate swap implies a
  contractual commitment( the interest rate swap).
  Usually such contract is entered at the time of
  financial close. This is common practice.
• When the bidder submits its bid, it has to use an
  assumption about the swap rate applicable for its
  Interest rate swap. The bidder cannot control the
  swap rate.
• Who should take the risk related to movement in
  interest rate swap ?

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Risk of change in interest rate Typical risk
allocation

• This issues is true in any country and is a
  typical risk associated with bidding of project
  financing.
• The issue arises purely between bid submission
  and financial close, assuming interest swap rate
  markets exist for maturities similar to the one
  considered for the project loans.
• The standard treatment (UK, South Africa etc..)
  is that,the Government takes the risk of change
  in swap rates between bid submission and
  financial close.

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Risk of change in interest rate example of risk
allocation

• Government provides reference source for swap
  rate before bid submission for reference for
  bidders
• Such quote is used to calculate capital grant and
  revenue guarantee / availability payment
  requirement in the bid.
• Around the time of financial close, the swap rate
  is quoted by banks and entered into by the
  Concessionaire. Such rate becomes the reference
  rate to re-compute( based on the financial model)
  the level of capital grant and availability
  payment that will keep the Concessionaire
  financially whole (no gain / no loss) compared to
  its bid case at bid submission.
• Period of uncertainty for the Government is
  purely during the period from bid submission to
  financial close.

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Risk of change in interest rate

• Entering into a large swap might change the
  quotation for this swap Possible solutions to
  this
• A swap for the full amount is entered into at
  financial close. Obtaining independent quote for
  such a large swap might be difficult.
• The swap is broken down into a set of swaps
  entered into during construction, for a number of
  drawdown
• Contractual provision preventing market collusion
  can be introduced to ensure the quote is procured
  in a manner satisfactory to grantor .

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Inflation
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Risk of change in inflation the issue

• Inflation impacts project during bidding,
  construction and operation since construction and
  operating costs increase with time
• The cumulative impact of inflation might be
  significant over the life of the project
  (bidding, construction, operation).
• Forcing investors to take inflation risk can
  result either in (i) no bid or (ii) bids that
  include very high forecast for inflation since
  bidders have limited protection against this
  risk.
• Governments typically allow for some form of
  protection against inflation in typical
  procurement contract. The key issue is to make
  sure that this is properly adapted to the
  specifics of a PPP transaction.

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Example of partial inflation to revenue guarantee

• If there is no mechanism for inflation, the
  bidder, has no choice but to assume a high
  inflation) assumption throughout the life of the
  concession resulting in a high estimate of
  operation and maintenance costs (pink line)
• If the inflation is limited throughout the
  operation period, indexation represent a
  significant limitation of liability to the
  Government (blue versus pink line)
• Even assuming a scenario with high inflation for
  a limited period of time (7 years yellow line)
  indexation to inflation might result in a
  reduction of liability to the concessionaire

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Inflation risk, typical risk allocation

• Government support ( capital grant and /or
  availability payment or revenue guarantee) is at
  least partially indexed to an inflation factor.
• Such inflation factor is calculated from the date
  of bid submission so it covers the period of bid
  submission, construction and operation
• The inflation factor seeks to mirror as closely
  as possible reality. The inflation applies to
  part of costs related to inflation only

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Forex
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The project is potentially exposed to foreign
exchange rate movement in the following ways

• Construction and other construction related
  costs might not be fully denominated in ruble if
  imports are considered.
• Revenues are most likely denominated in ruble
• Debt Financing might be sourced in other
  currencies to ensure long maturities and / or
  deeper pool of financing
• Some of the operating costs might be denominated
  in a currency other than the ruble.
• Foreign equity holders might require returns
  calculated in a home currency.
• Currency swaps can protect against movements in
  foreign exchange but such swaps are entered into
  at financial close.
• Price to end users cannot always be significantly
  indexed to a foreign exchange rate (elasticity of
  price of toll tariffs vs demand).

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Should any of the construction cost be sourced in
currency other than the rubles?

• There appears to be significant bottleneck in
  terms of key supplies on the Russian market. This
  has lead to significant increase in prices of
  cement and steel.
• Some of the construction related costs
  (engineering design, management staff etc.) will
  not be denominated in rubles.
• Part of the rationale for the PPP strategy is to
  encourage sourcing of material in currencies
  other than ruble.
• the currency risk (for construction) is limited
  to the period between bid submission and
  financial close at financial close, the
  Government liability is fixed.
• Nothing prevents the Government limiting its
  exposure to this risk (maximum amount of cost
  denominated in Foreign Currency, or dead band for
  swap rate movement).

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Possible mitigation mechanisms

• Bidder is encouraged to finance using ruble
  financing
• Government help to mobilize local banks?
• Bidding criteria to reward local currency
  financing?
• Tariff formula takes into account impact of
  foreign exchange
• Bidder bid fixed amount allowed to fluctuate
  against forex
• If required, maximum amount can be set as a
  ceiling to cap grantor risk.
• Bidder takes risk on make up of financing plan
• Risk for Government
• Sudden devaluation of the ruble (if amounts is
  not capped)
• If Ruble appreciate, not a risk, reward to
  grantor
• Size of potential liability will be linked to
  debt amounts in foreign currency which will not
  be finalized at bid submission date.
• Bidder compensated in direct relation to a
  proportion of the actual foreign denominated
  debt repayment schedule
• If required, maximum amount can be set as a
  ceiling to cap grantor risk
• Bidder not exposed to make up of financing plan
• Difficult to evaluate bidders proposals

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Risk associated with foreign exchange Proposed
mechanism for capital cost

• Government allows for a certain portion of the
  capital cost to be denominated in foreign
  currency and protected for exchange rate risk via
  swaps
• At bid submission, Government provide reference
  for currency swap rates for the construction
  period
• At financial close, the swaps rate are quoted by
  the concessionaire banks and the difference leads
  to an increase (or decrease) in the capital
  grant.

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Risk of change in foreign exchange rate
examplefor capital costs

• Impact of local sourcing (with price increase
  pass through) versus importing and Government
  absorbing fx risk

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Should any of the debt be denominated in
currencies other than ruble?

• Can the project raise debt financing without
  foreign denominated debt?
• How much will Veshneconombank commit?
• How much is available in the commercial debt
  market?
• How much will IFI prepare to commit?
• If the project has some construction costs not
  denominated in ruble, does it make sense to
  borrow only in rubles?
• If such amounts are available, what is the
  maturity that will be attached to it?
• Will all the debt have a maturity longer than
  17years?
• Is it likely that for these amounts, the debt
  tranches will have several maturities, including
  shorter maturities of say 12 years
• Is constraining maturities increasing revenue
  guarantee to a higher level than otherwise
  required with foreign debt denomination
• Impact on margin?
• How will a bidder benefit from competition
  between banks (and margin reduction) if no
  competition is possible

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Euro denominated debt

• Euro denominated debt is different from rubles
  denominated debt
• Longer maturity available (20 years and above)
• Long term swap exists and are liquid for the long
  maturities
• Long term swapped rate is lower than the ruble
  swap available (4.7 for 20 year versus 8 for
  10-12 years)
• Depth of the euro market for Project finance loans

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Risk associated with foreign exchange Example of
mechanism for debt denominated in euros

• Before bid submission, Government defines the
  maximum amount of debt that can be denominated
  in Euro and benefit for fx protection (eg
  concessionaire can source additional debt
  denominated in Euro but without forex
  compensation mechanism from the grantor).
• The Government reserves its right to reject any
  repayment profile / maturities that it does not
  consider appropriate for foreign denominated debt
  at financial close.
• The Government introduces in the CA a maximum
  amount of ruble exposure it is prepared to take
  in relation to this foreign denominated debt
• During the life of the loan, credit / debt are
  registered and payment made / received by grantor
  in relation to the debt

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Conclusions

• Debt raising is a key element of structuring a
  project financing
• Project finance lenders have specific
  requirements that need to be taken into account
• Some of the financing risks tend to be dealt with
  in a similar fashion, and the proposed risk
  allocation ought to reflect international
  standards to ensure the right competition

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Financing Issues
THANK YOU !!! Raymond Bourdeaux The World
Bank Rbourdeaux_at_worldbank.org