One of the key risk areas considered by the banks when lending to an infrastructure project is country risk. This has a number of different sub categories, including:
- Political violence, such as revolution, insurrection, civil unrest, terrorism or war;
- Governmental expropriation or confiscation of assets;
- Governmental frustration or repudiation of contracts;
- Wrongful calling of letters of credit or similar on-demand guarantees;
- Inconvertibility of foreign currency or the inability to repatriate funds.
Of these risks, currency convertibility and repatriation is perhaps the most prevalent, as most infrastructure capex is paid for in hard currency, while the revenue stream of the project, or if not the project, at least the offtaker, is usually local currency. Consequently care needs to be taken to ensure that the project or offtaker is able to source the currency which the loan is denominated in. Unfortunately fx swaps are typically inadequate to the task of immunising a project against currency convertibility and repatriation risks for a number of reasons, being:
- Often local currency rate curves, and therefore forward fx curves, do not usually go out to the durations of the debt. If they do, they may be illiquid and expensive;
- Fx swaps can result in very significant credit exposure, which may nullify the benefit of having done the swap in the first place; and
- It may be the state which prevents repatriation.
There are a number of different ways to mitigate this risk, some of which may be available only during the structuring stage of the transaction, and some of which can be bolted on afterwards.
Political Risk Insurance
It is possible to purchase Political Risk Insurance (“PRI”) to cover one or more of the heads of cover indicated in the list above. Premiums can be paid either up front or periodically (usually annually in advance) and may be payable by the project or the investor. Premiums range in size as well as value for money, as different providers will have different mandates to provide such cover.
Commercial PRI
Commercial PRI is available from any number of large commercial insurers and reinsurers, such as Lloyds.
Pricing for commercial PRI is volatile, depending upon current perceptions of the liklihood of the risk being insured against that actually occurring in the specific jurisdiction, as well as market appetite for such risk.
MIGA
The Multilateral Investment Guarantee Agency (“MIGA”) is an international financial institution which offers political risk insurance guarantees to help investors protect foreign direct investments made in developing countries against political risk. MIGA is a member of the World Bank Group and is headquartered in Washington, D.C. It was established in 1988 to serve as an investment insurance facility of the World Bank to help investors overcome political and other non-commercial risks and invest confidently in developing countries. Since its inception, MIGA has provided more than USD24 billion in cover for 700 projects in over 100 developing countries. MIGA currently has an outstanding guarantees portfolio of USD 9.2 billion (2012).
MIGA offers partial credit guarantees (“PCGs”) to cover the credit risk of a sovereign government or parastatal entity, and partial risk guarantees (“PRGs”) to private projects to cover a government’s failure to meet its contractual obligations. Heads of terms covered are:
- Civil unrest, terrorism or war;
- Governmental expropriation or confiscation of assets;
- Inconvertibility of foreign currency or the inability to repatriate funds;
- Non-honouring of sovereign financial obligations;
- Breach of contract
The final head of cover above covers situations where the government or parastatal entity breaches its contractual obligations, rather than the Project breaching its obligations. Consequently if it is to be used, care needs to be taken during the structuring phase to ensure that the risks being guarded against are included in the contractual arrangements with the government or parastatal (and not only the project).
Interestingly, MIGA appears in the past to have priced its cover as a function of the heads of cover utilised, rather than risk of the cover actually being called. Consequently including an obligation from the sovereign to compensate the project in the event of the other political risks occurring or to not perpetrate them means that the project can purchase the breach of contract cover alone, with significantly lower premiums than if it had purchased the full PRI suite.
Export Credit Agencies
Export Credit Agencies (“ECAs”) are quasi-governmental institutions mandated to support and encourage the export of their domicile countries’ goods and services. This support can take the form of credits (financial support) or credit insurance and guarantees (pure cover) or both, depending on the mandate the ECA has been given by its government. ECAs can also offer credit or cover on their own account, similar to normal banking activities. Some agencies are government-sponsored, others private, and others a bit of both.
ECAs currently finance or underwrite about USD 400 billion of business activity abroad – about USD 55 billion of which goes towards project finance in developing countries – and provide USD 14 billion of insurance for new foreign direct investment, dwarfing all other official sources combined (such as the World Bank and Regional Development Banks, bilateral and multilateral aid, etc.). As a result of the claims against developing countries that have resulted from ECA transactions, ECAs hold over 25% of these developing countries’ USD 2.2 trillion debt. (Numbers courtesy of wikipedia – suffice it to say, ECAs are a significant contributor to infrastructure finance.)
ECAs provide both commercial cover, which covers against all risks, and PRI, provided that a qualifying percentage of the goods and services employed in the project (usually the construction) are sourced from the ECA’s home country (“Local Content”). In the case of loans covered by ECAs, 85% of debt is typically the maximum commercial cover provided, although PRI is usually available for the remainder. ECAs prefer investors to be aligned in terms of commercial risks.
ECAs charge a premium for cover, which may be up front or recurring. However, unlike commercial PRI, their mandate is not to maximise profits, but rather exports. Consequently using ECA cover may decrease the aggregate cost of debt, inclusive of the premium. Correspondingly, margins for ECA-covered debt are usually very low, as a (good) ECA will typically have a similar credit rating or quality to its home country. This reduction in margin is not effected through a reduction in the probability of default, but rather a reduction in loss given default of the loan.
Investment treaties
Infrastructure transactions often have geographically-dispersed equity holding structures in order to take advantage of tax- and investment treaties between the host country and the countries in which the holding companies are domiciled in. Mauritius is a good example of this, having a large number of tax treaties with various African countries. Similarly, Kenyan projects are often held out of the United Kingdom, which has the lowest withholding tax on dividends of all its investment treaty partners.
An added benefit for investors is that investment treaties provide foreign investors with potential relief when they have experienced business difficulties in a host country arising from the acts or omissions of an arm of the host state such as the executive, the courts, the legislature, or administrative or regulatory officials. An award under such arbitration can be enforced by attaching the non strategic assets of the host country in the investor country.