Recent Trends in Project Finance

01 February 2007

As the geographical and industry sector range of projects has spread, so too have the techniques and structures involved in developing and funding them. Developers and financial advisers considering the array of products available to them to take their project through to financial completion most effectively need access to projects lawyers who can advise across the full range of issues involved, rather than those who feel constrained to operate more narrowly as specialists in, for example, bank lending. Indeed, in many ways it is inappropriate to describe project finance as a specialist area of law. The legal practitioner who is most able to assist his or her clients draws on a range of skills extending to mergers and acquisitions; private equity; acquisition finance; construction and commercial contracts; environmental and social issues; capital markets; derivatives; and bank, export credit agency (ECA) and multilateral agency (MLA) lending. Clients increasingly seem to prefer working throughout the life of a project finance transaction with a small core team of lawyers that can cover these fields without the constant need to bring in other teams from specialist departments (although specialists will, of course, occasionally have an important role to play). Beyond the usual demands for cost-efficiency this is driven by a recognition that the best advice is obtained from lawyers who see the whole picture rather than a single piece of the jigsaw puzzle. 

To illustrate the range of issues the legal practitioner faces, it is worth focusing on a few current trends in the global projects market. 

Infrastructure Funds

Increasingly, and particularly in the US and Western Europe, pension funds and private equity firms are acquiring infrastructure assets. They are attracted by the steady cash flow and income stability generated by secure assets with utility characteristics: ports, toll-roads, water companies, regasification plant and similar. Reportedly over the last 24 months more than US$500 billion in leveraged infrastructure funding has been raised in the United States alone. TheUK and other European markets are following a similar trend. Funds such as those run by pioneering infrastructure fund manager Macquarie and by Goldman Sachs, Deutsche Asset Management, Merrill Lynch and others – often working closely with pension funds – are pursuing airport authorities, ports, water companies, toll roads and similar infrastructure businesses. Elsewhere in the world, similar moves are under way with Gulf-based institutions forming Gulf Cooperation Council-based infrastructure funds such as the ENOC/GIB/Standard Bank GCC Energy Fund, as well as shariacompliant Islamic funds including the Infrastructure Growth Capital Fund (IGCF). 

The financing techniques can look like textbook leveraged finance, the skills in handling a competitive bid for a public company are pure M&A, but the assets are infrastructure and the risk analysis ultimately depends on skills based in the world of utility projects. For projects lawyers (in the widest sense) these deals represent an interesting convergence of M&A with legal and transactional project finance skills. 

Recent landmark infrastructure deals include work for the Canadian Pension Plan Investment Board (CPPIB) in its successful consortium bid for AWG (Anglian Water) in the UK and its acquisition of electricity transmission company HEI Transelec Chile, from Hydro Québec and the International Finance Corporation. 

PPPs 

Public-private partnerships appeal to governments as a method of investing in infrastructure without affecting their credit ratings. Proponents also cite the economic efficiencies achieved through involvement of the private sector in public projects. TheUK has the most established programme, but other leaders in the world markets include Australia, Spain and Canada, with Germany tipped as a major market looking ahead. There are also several large-scale initiatives under way in the United States. 

The cash-flow profile of PPPs makes them ideal vehicles for securitisation, with the economic risk being passed from the original lenders to institutional investors via collateralised loan obligations (CLOs), which pool together the repayment obligations of several project loans. At the more refined level, CLOs provide a means of layering different levels of project risk, from super senior sold to a monoline or other insurer, to higher risk mezzanine and first-loss paper, the latter of which may be held by original lenders. Although European PPP collateralisation is still comparatively rare, the techniques of the international capital markets are generally very much in use in the world of international projects. 

Headline PPP transactions in 2006 include the US$4.8 billion Indiana Toll Road project in the United States and the more than £1.5 billion Allenby Connaught Barracks project in the UK. 

The Project Bond

Talked up for years as the way ahead for cross-border funding of oil and gas and other ‘hard currency’ projects, the strong bank and ECA market, and residual political risk concerns remaining as the legacy of the currency crises of the late 1990s, meant that the political risk absorbing bank, ECA and MLA lending markets have tended to dominate emerging market projects in recent years. In addition, leveraged finance and buyout appetite for emerging markets has opened up other new sources for project and utility acquisitions. Nevertheless, successes, such as 2004’s US$1.1 billion Tengizchevroil project bond issued by a Kazakh oil company (owned by Chevron, ExxonMobil Corporation, KazMunayGas and LUKARCO) and financings for Qatari projects, such as the recent US$1.5 billion RasGas offering, highlight a growing interest among developers in tapping the demand for privately placed rule 144a/regulation S bonds to fund project development. This approach focuses less on the strict operational covenants and expansive monitoring rights commonly requested by banks and ECAs, and more on a real-world analysis by the ratings’ agencies of the project’s risks and benefits, and the security of cash flow from sales of oil and gas to offshore buyers. Projects globally, including in West Africa and the Middle East, are now looking seriously at project bond financing. 

Outside of oil and gas and the emerging markets, but of real interest to observers of project finance, is the recently closed approximately US$2 billion Fortescue bond financing for an iron ore project in Western Australia, which involves development of mining, rail transportation and processing facilities in the Pilbora region of Western Australia. Blending the techniques and covenants package of a high-yield bond with more traditional project finance covenants and structures, this bond financing was particularly interesting for the way it addressed project completion risk. 

Reflecting the challenges encountered when ‘junior’ mining companies have sought to raise finance without a strong balance sheet to support the project through to ‘financial completion’ (construction complete, project operational, marketing tests met and certain legal and financial tests complied with), the Fortescue project had neither a particularly strong sponsor balance sheet nor a lump-sum EPC contract passing a substantial portion of completion risk to a contractor. The answer was a series of structural solutions, including various layers of cash reserve, a focus on an incentive driven construction contracting strategy and an overall emphasis on building risk contingency into the project budget. A parent company equity injection, the return on which is tied to project production, was also interesting. Although some of these techniques have been looked to for mining projects funded in the bank, ECA and MLA markets, such as the Moma titanium project in Mozambique, their adaptation for a project bond broke a mould that had suggested the product is more suited to either ‘brownfield’ expansion or recapitalisation of projects with existing cash flow, or to projects where an investment grade credit assumes the completion risk. The ability of the ratings agencies to look beyond completion risk and determine that the project is fundamentally robust, based on a range of factors, reflects the more holistic and less prescriptive approach of those agencies and the capital markets. 

A Refocus on Political Risk

Recent state moves for a higher degree of control of oil and gas assets in venezuela, Russia and elsewhere, together with investors’ readiness to accept risk for higher returns, draw attention yet again to the role of political risk and its mitigation in project financing. Many buyers who recall clearly the problems of the 1990s, such as those involving Indonesian IPPs and the Dabhol project in India, will be getting a clear sense of déjà vu! A complete understanding of what amounts to expropriatory events for the purposes of political risk insurance contracts, and related carve-outs from completion guarantees, has long been a key weapon in the armoury of skills required of lawyers working on emerging markets projects. It is also important for projects lawyers to understand the range of products available in the market and to work with project developers and other advisers to align these with the likelihood of events arising. 

Political risk insurance contracts – for example those of the Overseas Private Investment Corporation and Multilateral Investment Guarantee Agency – do not simply specify that any governmental failure to perform should be treated as expropriation. For example, policy changes in venezuela could result in reduction of debt coverage for project financings in the oil and gas industry, but fall short of expropriation for political risk insurance purposes. 

With increasing interest from developers and lenders in projects in a diverse range of emerging market economies, including a flurry of activity of sub-Saharan states new to the world of project finance, such as Madagascar (where the Ambatovy Nickel project looks to set a new benchmark for large-scale mine project financing in Africa), the Democratic Republic of Congo and Mozambique, as well as continued activity in Russia and Latin America, projects lawyers with a full understanding of techniques to mitigate and lay-off political risks will be in demand. 

Regional Leaders

A recent report by the bank HSBC suggests that one in every three project finance dollars in the world is now raised in the Middle East. The same report indicates that US$33 billion was raised in the first half of 2006, and this seems set to rise substantially by the end of the year. The demand is such that constraints on bank debt capital and Islamic finance sources will see the region increasingly looking to the international capital markets and other new sources of funding. 

A market once dominated by oil and gas export projects, such as the sequence of LNG projects so successfully developed by Qatar Petroleum and its partners, will increasingly seek to develop more power, desalination and downstream and industrial projects, for example, in the petrochemical and aluminium sectors (including the Emirates Aluminium project in Abu Dhabi, which is predicted to be the world’s largest greenfield aluminium smelter project), as well as infrastructure projects and non-power utilities.

In the meantime, the gargantuan potential of China in the sector seems about to realise itself. A recent announcement by China’s government stated it would invest an estimated US$59.5 billion in Olympic Games-related infrastructure between 2006 and 2010, Guangdong province has indicated it plans to spend US$35 billion in road and rail infrastructure and US$125 billion has been identified as the required sum for Chinese water infrastructure over the next five years. 

The well-publicised problems of the Dabhol project in the 1990s have made most international project banks wary of Indian projects for a number of years. But, there are signs of interest in a number of new projects such as Reliance Industry’s US$6 billion integrated refinery project. With China reportedly outspending India in infrastructure by seven to one in absolute terms there is, however, clearly some catching up to do. India’s industrial giants such as Reliance and Tata will have a key role to play. 

Africa too looks set to be an active market for project finance over the next years, particularly with development of natural resources projects in sub-Saharan Africa. 

Finally, in terms of regional focus, with the successful commissioning of the BTC pipeline in 2006, the precedent has been set for successful large-scale cross-border projects in the Caspian region. 2007 could see a number of large-scale regional pipeline and upstream oil and gas projects tapping the project finance market. 

These are exciting and challenging times for project finance lawyers. Those who are adaptable, and ready to travel internationally at short notice, will no doubt be kept busy over the next few years.

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