Monday, December 10, 2012

Project Bonds – Definition, purpose, concerns, and remedies

1. What are project bonds?

Project bonds are private debt issued by a project company to finance a specific off-balance-sheet project. Because the project company’s only purpose is the project, project bonds are an asset-based form of financing. Project bonds can be placed publicly or, most oftentimes, privately.

Today’s project bond market is concentrated in the US and Canada; issues in Europe and emerging markets are still seldom.

2. Who needs project bonds?

Project bonds are necessary from both the borrower’s and the investor’s point of view:

First, bank lending capacity has and will become ever more limited, due to increasing capital requirements and liquidity constraints for commercial banks as well as tight public budgets. This is especially true for long-term financing, which is, nevertheless, fundamental for an economy’s competitiveness, productivity, and long-term growth.

Second, from an institutional investor's (pension fund, insurance company, etc.) perspective, there is a strong demand for long-term investment opportunities. However, bond markets for very long maturities are oftentimes underdeveloped.



Project Desertec


3. Project bond concerns

Riskiness of project bonds

Project finance is characterized by the following factors:

  • off-balance-sheet financing (e.g. usually non-recourse vis-à-vis the sponsor);
  • longer maturity, compared to corporate loans;
  • higher leverage, compared to traditional corporate finance.

All of the above make the investment more risky for an institutional investor because they typically invest exclusively in high-quality assets.

Debt origination

A general remark is that bank loans are faster and cheaper to deliver than bonds. Indeed, bonds require a rating and the respect of a specific issuing procedure (namely marketing documentation), which increases time and transaction costs. The result is that project bond financing is often inefficient for small transactions.

Another challenge related to bond debt origination is the fact that deliverability and pricing of project bonds are unknown until actual issuance of the bond, As a matter of fact, this might counter the typical public bidding process (“Certain Funds Period”). In addition, public authorities can lack necessary project bond know-how which will enhance this issue even further.

Finally, bonds are settled upon issuance. This can contradict the financing needs of the project company that will usually need funding spread over the whole construction phase and, as a consequence, will cause cost of carry of early provided funds.

Loan vs. bond administration

Compared to traditional bank financing, bonds carry a certain number of disadvantages:

  • The confidentiality of bank loans is higher: For one, possible restructuring negotiations are lead out only among a limited number of banks. In addition, bond markets need, even in the normal course of business, higher disclosure requirements to bridge the information asymmetry between investors and issuer and to compensate for the close monitoring that is common place in case of bank financing and lacks in case of bond financing.
  • Bond financing terms are usually less flexible than bank loan terms and conditions. Moreover, the administration (prepayments, waiver proceedings, etc.) of bonds is normally less flexible than the administration of bank loans. For example, in case of bank financing, an agent will coordinate voting processes within the banking pool. This function is usually missing in case of bond issues.

Liquidity of project bond markets

Oftentimes, project bond markets lack infrastructure and liquidity. This can lead not only to bond pricing dilemmas but also to a more difficult refinancing of bonds.


Dhukwan Project


4. Solution proposals

Riskiness of project bonds

The riskiness of project bonds can be moderated by two basic means, e.g. by modifying the structure of the debt itself or by providing credit enhancement.

The first method refers to debt tranching, thus cutting the overall debt burden of the project company into different pieces and conceiving a priority order of repayment. This solution, however, will necessarily make the financing structure more complex and, as a consequence, potentially shy away investors.

The idea of providing credit enhancement tries to alleviate the off-balance-sheet character of project bond financing. De facto, credit enhancement gives investors indirectly access to the balance sheet of third parties such as project sponsors, commercial banks, state-owned or supranational development banks, and debt service reserve funds. In legal terms, third-party support can be arranged particularly as a letter of credit, guarantee, stand-alone facility, or sub-participation. The EU/EIB 2020 project bond initiative might serve as an example here. The downside of this second solution is that is operates in the shadow banking area: Because credit enhancement usually constitutes, from a bank's perspective, an off-balance-sheet item, it runs against current attempts to reform the stability of financial system.

Debt origination

The administrative origination process can only be shortened through standardization. As far as possible, such standardization should apply to any stakeholder in the origination process. Examples include rating methodologies for project bonds and a legal framework for SPV issuers.

To promote project bonds, it will be necessary to amend public tender regulation. By way of explanation, it is essential that the bidding process specifically closes out the uncertainty linked to size and pricing of bond issues. What's more, firm underwriting by investment banks can also ensure a certain funds period for the project.

Excess funding at the outset of the project can potentially be avoided by deploying MTN programs. Obviously, the high costs for preparing a MTN program imply that this solution can only apply to large-size projects.

Loan vs. bond administration

If not already provided for in mandatory bond regulation, a legal structure for efficient bond administration should be put in place by way of contract. Standard forms for loan agreements should serve as a template here.

Creating conclusive incentives for investors may also help to enhance the administration of bonds. As a matter of fact, if investors can benefit from straightforward bond execution, they will also enhance their efforts to ensure efficient administration. Incentives could include

  • Link credit enhancement and the assigned rating to bond administration processes (Example: Reduction of credit enhancement in case a waiver is not treated during a specific time period.)
  • Link coupon rates to the efficiency of the bond administration
  • Extend simple majority decisions as much as possible

Liquidity of project bond markets

Liquidity of project bond markets can be built up by taking the following initiatives:

  • Create a capital market infrastructure for project bonds, allowing a more efficient placement, listing, trading, and settlement
  • Encourage private investment in project bonds by providing a supportive investor regulation
  • Attract foreign investors to domestic project bonds by setting tax incentives such as lower interest rates on interest income and by canceling withholding tax requirements on interest payments
  • Favor market making activities for project bond markets


Resources:

  • Scannella – Project Finance in the Energy Industry: New Debt-based Financing Models, International Business Research 2012, pages 83 et seq.
  • S&P Rating Direct – How Europe’s New Credit Enhancements for Project Finance Bonds could affect Ratings, November 13, 2012
  • Sawant – Emerging Market Infrastructure Project Bonds: Their Risks and Returns, Journal of Structured Finance 2010, pages 75 et seq.
  • European PPP Expertise Centre – Financing PPPs with Project Bonds, October 2012
  • Lam, Chiang, Chan – Critical Success Factors for Bond Financing of Construction Projects in Asia, Journal of Management in Engineering 2011, pages 190 et seq.
  • European Commission – A Pilot for the Europe 2020 Project Bond Initiative, October 19, 2011
  • European Commission – Regulation Proposal Europe 2020 Project Bond Initiative, October 19, 2011