Author: DLorimer

Derivatives are used to hedge against uncertainty in macroeconomic factors influencing project cash flows, in particular interest rates, exchange rates, and to a lesser extent CPI and sometimes fuel prices.

Projects make use of such hedges to immunise their cash flows against adverse changes in the underlying factor, thereby  decreasing the volatility of cash flows available for debt service and allowing the project to leverage higher than they would otherwise be able to.

Corporates and Parastatals engaged in infrastructure projects also make use of hedges if they have significant borrowing programs, and more commonly, to lock in exchange rates when they purchase significant capex in a foreign currency.

Hedges, however, come at a cost, with the result that the banks offering them to the projects earn a considerable return. In particular, with the implementation of Basel III, and the Credit Risk Transfer (“CRT”) requirement, also called Counterparty Valuation Adjustment (“CVA”), spreads have widened considerably.

As an indication of how profitable a hedge may be to the investor, banks recognising PnL from derivatives in their trading books up front may earn as much as 2.0% – 3.5% of the notional debt amount on day 1 of the trade. (This is because profit and loss on the trading book is measured as the change in the mark-to-market, or NPV, of each derivative in the book.

Spreads on commodities (fuel) and on CPI are significantly wider than on interest rate swaps and fx swaps, with CPI swaps in particular being of interest because of the investor demand for CPI-linked debt.

Hedging instruments incur both market risk and credit risk. Market risk can be hedged by the investor in turn by entering into an equal and opposite position with its own trading counterparties. However, credit risk is a function of the unknown, but statistically predictable, future fluctuations in the underlying macroeconomic factor(s). Unlike the derivative trading activities which an institution typically enters into with banks, derivatives with a project will not be governed by a collateral agreement or CSA, with the result that the credit exposure can spike. Helpfully, hedges typically rank similarly to the tranche of debt which they are hedging, and are therefore typically senior in both the pre- and post enforcement payment waterfalls. This results in a probability of default (“PD”) and a loss given default (“LGD”) very (very) similar to that of the senior debt. However, the exposure at default changes in accordance with a probability distribution function, as touched on above.

Hedging derivatives can create a significant return kicker for traditional debt instruments, and may constitute an opportunity for a debt investor in that:

• The work to determine the project’s credit quality may already have been done to evaluate more traditional investments; and
• The credit exposure can become negative if the underlying moves in the “right” direction, leading to an implied funding benefit.

The investment banks typically reserve credit lines to cover credit risk associated with a hedging instrument provided to a project in the amount of the potential future exposure which will not be exceeded with a  98% probability, sometimes referred to as the swap’s PFE. This is calculated quantitatively by running, for example, 10 000 monte carlo simulations on the underlying asset, for example the interest rate curve. For each simulation, the hedge is revalued at each duration. The exposures at each duration are then sorted in, say, descending order and the 200th largest exposure at each duration is plotted to form the PFE curve. Similarly, expected exposure can be modelled by using the 5000th (or median) exposure at each duration. This process is relatively straight-forward to carry out for interest rate swaps using every-day tools, provided that the original market data is available and the investor is comfortable to rely upon simulated spot rates and forward curves. The same exercises for fx swaps would be more challenging because of the need to maintain a realistic arbitrage-free forward exchange rate curve in simulations.

Using market data available at the time of writing, the PFE for a 12-year vanilla amortising interest rate swap was approximately 15% of the original notional loan amount and decayed rapidly towards zero at later durations as the number of remaining payments contributing towards the NPV reduced.

More details on project finance hedging to follow in later posts…

Full recourse or corporate debt differs from non-recourse debt in that it is the sponsor that borrows the funds, rather than an insolvency-remote SPV. While funds borrowed may be for the purposes of conducting a project to build a specific infrastructure item, recourse is to the full balance sheet of the borrower. Consequently if the project fails, the borrower must still repay.

Borrowers are typically large corporates or parastatal entities. Evaluation of the debt opportunity presented by these entities is no different to that traditionally used to evaluate corporate or full recourse debt.

Similarly, corporates and parastatals frequently issue bonds. The spreads available on these bonds are readily available on Reuters, INet Bridge or similar.

Corporates with significant infrastructure assets may also issue bonds. However, the funds from such bonds may not in all instances be used to create infrastructure assets, but rather for general corporate purposes.

Infrastructure funders may issue bonds or seek to obtain loans, the proceeds of which are earmarked for infrastructure investments.

 

This is debt advanced on traditional Project Finance principles:

• Lent against projected cash flows;
• Either pre-contracted offtake arrangements with credit-worthy offtaker or statistically predictable or provable retail offtake (e.g. toll road traffic, supported by traffic studies);
• Risk allocation to project parties, such as Engineering, Procurement and Construction contractor, Operator, etc; but…
• Usually no risk allocated to sponsor: Debt is non-recourse;
• Comprehensive due diligence process including technical, legal, insurance, tax and model audit;
• Complex legal documentation suite with back-to-back agreements.

Non-recourse debt is predicated upon the predictability and stability of the future cash flow stream, with the consequence that much time and effort goes into contracting away risk which may lead to the cessation of or volatility in such payment stream. This results in risk being allocated to as many third parties as possible outside of lenders and equity. A particular characteristic of such risk transfer is back-to-back provisions in the project contracts. For example, an event which gives rise to the offtaker gaining the right to terminate the offtake contract will usually be mirrored in the EPC and Operations and Maintenance (“O&M”) contracts, conferring the right to terminate such contracts upon the Project. Usually, and ideally, the threshold for obtaining such rights will be lower in the EPC and O&M contracts than the offtake contract.

Maximum liability for equity investors in a non-recourse financing is limited to their investment, while there may be carve outs to such limitation of liability in a limited-recourse financing.

A typical project structure is as below. Blocks represent parties, while arrows represent contracts and therefore contractual relationships.

Non- and limited-recourse debt is typically documentation-intensive, and the project documents and finance agreements are often voluminous.

Project finance debt providers will seldom allow the project to be funded by debt. Consequently the project will almost always require at least some equity investment. Equity investors can be categorised into strategic or financial investors. Strategic investors include the project developer, construction counterparty, operator or supplier.

Financial investors will have no interest in the project other than their investment. Private equity infrastructure funds invest in industries such as electricity, gas, water, telecoms, roads and airports, to acquire a steady return over a long period of time. Infrastructure funds aim to maximise gearing to increase equity returns, possible because of the typically stable cash flows on infrastructure transactions.

The private equity sector is dominated by a number of large firms, mainly based in the USA, but operating internationally. Compared with top US buyout groups, European private equity firms tend to be small and confined to national markets.

The expected returns required for investment at each stage of the project lifecycle vary, as does the risk of such investment. The cost of investment is typically measured on a discounted cash flow basis, possibly with probability-weighted elements or simple scenarios. (Anecdotally, I have heard of stochastic project models, but never seen one, and am a little dubious as to the additional value that they might add to an investment decision.) The price of equity is then typically determined by back-solving for a required return (which will be, mathematically, the risk discount rate).

Generalising grossly, equity returns might look something like the following:

Lifecycle stage	Return
Development	Very high. Returns for developers may be extremely high because the development fee is often used as a free carry in the project. Relatively little cost  compared to the capex is expended in the development stage, but can all be lost if the project does not go ahead.
Pre construction	Medium-high
Post construction / operating phase	Low-medium

There are four main asset classes commonly used within the Infrastructure Asset Class, not accounting for hybridisation, being:

• Equity
• Non-recourse or limited recourse debt
• Full recourse or corporate debt, including bonds
• Derivative instruments, particularly used for hedging.

In addition, there are a number of risk overlay products which transfer various portions of the risk of investment into infrastructure transactions to third parties. Setting aside the obvious example of physical damage and business interruption insurances, these are, in particular, Export Credit Agency products and political risk insurance.

 

Supply contracts will typically contain provisions relating to the following:

• Price and price escalation
• Take-or-pay provisions. I.e. how much the project must pay to the supplier irrespective of whether it is able to receive the supplied goods
• Quality specifications for the supplied goods (e.g. calorific value of coal, sulphur content, ash content, etc for a coal power plant)
• Details on any performance tests including what tests must be undertaken, when, what constitutes a pass, and whether they may be repeated
• Pass through provisions for events outside of the project’s control, such as force majeure and change in law. In particular, these will be based on the offtake contracts
• Consequences of failing to meet obligations for each counterparty, and the rights which will arise therefrom. In particular, termination rights and consequences of termination
• Guarantees (delivery date and performance levels), including limitations of liability for the supplier, rates of accrual of liquidated damages and performance security (liquid bank bond, vs parent company guarantees)

Similarly to under the EPC and O&M arrangements, the Project will attempt to pass as much risk through to the Operator as possible.

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This is achieved through the following:

• Fixing prices in advance, or, if not feasible, indexing them in the same manner as the fuel-pass-through revenue component of the offtake price (or water, etc, as applicable)
• Any compensation for risks outside of the control of the supplier which the supplier may enjoy will typically be limited to the compensation which the project enjoys from the offtaker. This is typical for, amongst other provisions, force majeure and change in law
• Any provisions which may lead to termination of the offtake contract, or any of the project’s other contracts, will, to the extent applicable, be mirrored in the supply contract, often with a slightly more onerous threshold, so that the project can terminate the supplier before the other contract is terminated and attempt to fix the situation.
• The supplier will pay liquidated damages at a pre-defined rate per day of plant unavailability resulting from failure to supply, or, if applicable, upon failure to meet the guaranteed quality specifications of the goods supplied (e.g. calorific value of coal supplied to a coal power plant). These liquidated damages are typically capped, and usually guaranteed by either a liquid, on-demand bank performance bond or a parent company guarantee.

Projects will often, but not always, have one or more supply contracts. Supply contracts are those for major items which are required to run the plant. Examples include:

• Fuel supply agreements
• Water supply agreements
• Electricity supply agreements
• Reagent supply agreements

Projects such as this include conventional thermal power plants (fuel supply and transport, sometimes water and reagants) and desalination plants (electricity supply).

Some projects will not have any supply agreements. Most renewable energy projects fall into this category, since sun and wind are free to the project.

O&M contracts will typically contain provisions relating to the following:

• Price and price escalation
• Scope of work, detailing the Operator’s responsibilities and who will pay for the work (is it a pass through cost?)
• Mobilisation provisions (when the Operator must ready itself to start performing its obligations)
• Details on any performance tests including what tests must be undertaken, when, what constitutes a pass, and whether they may be repeated
• Pass through provisions for events outside of the project’s control, such as force majeure and change in law. In particular, these will be based on the offtake contracts
• Consequences of failing to meet obligations for each counterparty, and the rights which will arise therefrom. In particular, termination rights and consequences of termination
• Guarantees (delivery date and performance levels), including limitations of liability for the Operator, rates of accrual of liquidated damages and performance security (liquid bank bond, vs parent company guarantees)
• Variation procedures

Similarly to under the EPC arrangements, the Project will attempt to pass as much risk through to the Operator as possible.

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This is achieved through the following:

• Incorporating as much of the annual price into the fixed and variable components, rather than pass through. If undertaken successfully, the risk of overruns on price are then for the Operator’s account. This is not always successful. However, the O&M fees may be relatively small compared with revenues, such that some uncertainty may be relatively easy for the project to bear
• Any compensation for risks outside of the control of the Operator which the Operator may enjoy will typically be limited to the compensation which the project enjoys from the offtaker. This is typical for, amongst other provisions, force majeure and change in law
• Any provisions which may lead to termination of the offtake contract, or any of the project’s other contracts, will, to the extent applicable, be mirrored in the O&M contract, often with a slightly more onerous threshold, so that the project can terminate the Operator before the other contract is terminated and attempt to fix the situation.
• The Operator will pay liquidated damages at a pre-defined rate per day of plant unavailability, or, if applicable, per percentage point downside performance, upon failure to meet the guaranteed performance levels of the plant. These liquidated damages are typically capped, and usually guaranteed by either a liquid, on-demand bank performance bond or a parent company guarantee

The Operator may be incentivised to perform by passing some of the financial reward of outperformance through to him.