The Changing Landscape of Project Finance

01 February 2007

Glenn S Gerstell, Milbank Tweed Hadley & McCloy LLP

The past year was an eventful one, with many industrial sectors and geographic regions experiencing tremendous growth in both number and value of projects closed. The Indian market, as just one example, has seen nearly a 600 per cent increase in activity (measured by value) over 2005. In total, global project finance has continued its strong, six-year upward trend with projects in 2006 valued at approximately US$150 billion, an increase of more than US$30 billion on 2005. Still, this must be evaluated in light of the global economic unevenness of the past few years, precipitated in part by the Asian financial crisis of the late 1990s and the dot-com implosion a few years later, which rippled through the project finance market with a somewhat delayed but deeply depressive effect. 

Now, as it appears that the overall project finance market is clearly (albeit perhaps unsteadily) rebounding, some of the same economic complications still exist, but there are other, and in some cases newer forces coming into play that generate conflicting trends and make predictions difficult. 

There is, however, at least one undeniable trend: project finance is being applied more broadly, both in terms of geography and the industrial sector. For a variety of reasons relating to the countries’ common legal systems and approaches to the market, the US, the UK and Australia are still generating the most project financings, with Saudi Arabia nearly edging out the US in value of projects closed. Indeed, Saudi Arabia’s surge is of little surprise, as Middle East project financings have largely outperformed other regions, with four of the largest six projects of the year generated by the region. Asia, especially Japan, has also seen significant transactions in the past year. Some of the biggest economies of the developing world – China, India and Brazil – appear to be embracing project financing to a greater extent. In Brazil, the federal government’s 2004 legislation to promote public-private partnerships with guarantee funds available to support commercially riskier projects has finally yielded its first contractual arrangement – in the form of a 30-year concession contract to run Line 4 of Sao Paulo’s subway. 

The ever increasing geographic reach of project finance is apparent when financings are being proposed and undertaken in some of the poorest countries of the developing world, which invariably present the highest political risk. Naturally flowing from this true globalisation of project finance is the rise in the expertise of counsel in so many countries – as is evident from the many excellent lawyers listed in the following pages. Although the largest and most visible transactions still tend to be awarded to the globally recognised law firms in the field, it is also true that many lawyers in cities around the world are entirely capable of serving the needs of increasingly sophisticated local markets. 

Perhaps most representative of the changing nature of project finance is the infrastructure sector – which constituted only a small fraction of deals as recently as few years ago. Last year, by some accounts, the infrastructure sector was the leading one, with 130 deals worth approximately US$45 billion and accounting for over 30 per cent of total dollar volume of project financings. In the US, a growing demand for stable and long-term investments has drawn both pension funds and private equity firms to the infrastructure market, bestowing billions of dollars on the market and enabling many new projects. 

Commercial banks have long dominated the market, in part because they had the right product mix and because they had the large staffs needed to analyse complex projects. Increasing sophistication on the part of institutional investors, however, has enabled them to play greater roles in the origination of projects. This influx of new participants the market has given rise, in turn, to changes in the structure and pricing of infrastructure projects in the US. 

Symbolic of this changing structure and pricing is the US$3.8 billion Indiana Toll Road transaction that came to fruition in January 2006, with Cintra and Macquarie winning the 75-year concession. In the transaction, lead arrangers BBvA, BNP Paribas, Caja Madrid, DEPFA, Dexia Credit Local, Royal Bank of Scotland and Banco Santander included a series of accreting swaps in the financing that deferred interest payments and allowed the buyers to raise higher levels of debt, and thus offer a higher price. With the successes of the Indiana Toll Road and its immediate predecessor in a neighbouring state, the Chicago Skyway, a number of states are now setting up programmes to take advantage of the availability of equity funding and privatised assets. As just a few examples, Miami is seeking bids to build a tunnel; California has passed legislation pushing infrastructure deals; there are discussions regarding the New Jersey turnpike; and Chicago’s Midway Airport may be privatised. All this enthusiasm – largely a product of government officials envisioning new ways to close budget gaps – will probably abate somewhat when participants realise the true difficulty of privatising existing public infrastructure. 

The resurgence in infrastructure attention is not, however, confined solely to the US. Canada, India, Indonesia and Latin America are all being closely watched. In 2007, one focal point will be on Brazil, where federal and state governments are eager to push transportation infrastructure, along with water, ports and other facilities. Mexico, greatly in need of more and modern roads, is another candidate for significant infrastructure project finance. 

The telecom and satellite sector has seen relatively few limited recourse financings over the course of the last year, notwithstanding a significant amount of capital expenditures being generated in the sector. With the wave of consolidations that has swept through the industry, there are few small players and startups left in the sector (with the exception, perhaps, on the African continent). This consolidation has left the remaining players larger, more mature, and most importantly cash-rich, enabling them to borrow on the strength of corporate credit rather than project finance. 

Yet project finance opportunities still remain in the telecom sector, with sponsors and investors confident that the worst days of the over-expansion are behind them. One reason for such opportunities is the incessant development of technology – especially in the areas of wireless and broadband applications – forcing constant capital expenditures in efforts to remain competitive. The US$1.98 billion project financing by the usually conservative Japanese banking community to fund the construction of eMobile’s 3G network is a notable and recent example.

Another manifestation of ever changing sector preference is the resurgence of interest in submarine communications cables. For the past several years, the prevailing view was that global overbuilding had created such an excess of ‘unlit’ fibre optic cables that it would be a long time before new cable would be laid on ocean floors. Capacity take-up rates – fuelled by the explosive growth of internet usage – have far exceeded projections, however, so suddenly there is much talk of new investment and significant expansions. The FLAG and vSNL sub-sea cable systems (both owned by Indian groups) have announced major expansions and the long-brewing Project EASSy initiative in Eastern Africa may finally now be poised for financing by a group of development banks. There is probably no better example of the speed of change in the project finance world than that of submarine cables – going from almost inconceivable to worth exploring within a couple of years. 

Like other targets of project finance such as power plants where the easiest projects have already been completed, ‘greenfield’ or new telecoms installation projects have already been undertaken around the world. The more developed countries have long since issued multiple cellular and fixed line licences, so few opportunities exist for project financing of major new ‘build-outs’. The risks associated with financing a third or fourth entrant into a wireless market are too great to support most project financings. Nonetheless, opportunities remain in the telecoms sector. 

Africa is the big exception to the statement that major telecoms build-outs have already been completed. Elsewhere, refinancing opportunities in Europe and Latin America will be prevalent, perhaps in ‘project-style’ loans with less stringent terms than traditional limited recourse project financings. 

The fresh water and wastewater sector has not seen many financings, for a variety of reasons. Until recently, the sector was characterised by small (typically municipal) facilities, with a level of investment that did not lend itself to large-scale financing. There is an increasing appreciation, however, of the incontrovertible and extraordinary need for water infrastructure around the globe. This, coupled with changes in both public attitudes and government regulation, promises substantial expenditures in the sector. The potential in this area has not escaped the attention of financial investors or industrial sponsors. In the US and Europe, the story regards the replacement of ageing infrastructure and upgrading to comply with more stringent environmental standards. In the developing world, the story is simply the need for clean drinking water, sanitary facilities and rivers free of sewage. Just recently, China announced that it plans to invest approximately US$1.59 billion between 2006 and 2010 in the sector, constructing 35 new wastewater treatment plants by 2008. Spain has proposed a US$3.56 billion desalination scheme to irrigate regions near the country’s southeast coast. In the Middle East, additional desalination projects combined with power plants are on the drawing boards. 

Although these are potentially significant prospects, the reality is that very few water sector projects have been completed through project financing. Many governments view water as a public resource and are thus hesitant to yield control or involvement in the sector. Moreover, as noted, the projects that are completed tend to be smaller and more local in nature, thus receiving less attention than the multibillion-dollar projects prevalent in other sectors. Yet the sector does possess several characteristics that should make it attractive: the technology behind the industry is generally well-established, which in turn translates into low risk; the usual small size of these projects enables deals to close relatively quickly; and the rate-payer and rate schemes in such transactions tend to remain stable. 

Turning to the sector that has historically been most closely associated with project financing – energy – the driving factor recently has obviously been the continued increase in oil prices. TheLNG industry continues to demonstrate significant strength, with major projects in development throughout the world and substantial investments being made almost daily. This has a multiplier effect, as new LNG refinery projects inevitably require expansive infrastructure undertakings such as new pipelines, ports, loading terminals and specialised ships. The high price of oil has also translated into greater interest in alternative energy projects, such as wind farms, that may not have been competitive at lower fossil fuel prices. The wind financing area has been one of the most active in the past year. 

Project financing has been utilised bit by bit in non-traditional sectors, such as toll roads, prisons, government housing, convention centres, arenas, sports stadiums and hospitals. Although many obstacles remain, it is likely that this trend will continue. With possible plans by the Louisiana state government to privatise its hospital infrastructure in the aftermath of Hurricane Katrina last year, and the US government’s announcement to privatise military housing (one such project being the proposed relocation of US troops from Okinawa to Guam), many non-traditional sectors appear poised to lend themselves to project financing transactions. Most of the project financings of non-traditional assets, however, are predicated on public-private partnerships, which are often fraught with difficulty. Governments are often eager for the cash generated through privatisation, and at the same time reluctant to cede control over assets traditionally in the public sphere. This inevitably presents additional requirements and complications, together with the introduction of a government participant to the negotiating table in project financings. If the right balance is struck however – and typically with the aid of skilled attorneys such as those on the following pages – such partnerships can succeed and be lucrative for all parties. 

The application of project finance techniques to novel industrial sectors and to more difficult countries, the ever increasing size of transactions (billion-dollar commercial bank loans are no longer a rarity), and the continued development of government regulation all spell greater risk. Greater risk in projects typically requires more participants to absorb that risk – thus generating more complexity, as a large number of debt providers, sponsors, insurers and other participants are now involved in ever expanding markets. The sheer number of participants has led to a necessity to differentiate and stand out in a sea of competitors. As such, the industry has seen a surge of sophisticated hedging and riskshifting mechanisms now being provided by the larger investment banks and institutions, which inevitably leads yet again to more participants and complexity. Advising those participants on how to deal with that complexity to achieve a successful project financing is surely one of the key roles of counsel.

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