How the Global Credit Crisis is Affecting Project Finance in the Gulf Arab States
By Richard Keenan
How different the project finance landscape looks now in the six Arab states that make up the Gulf Cooperation Council — Kuwait, Qatar, Bahrain, Oman, the United Arab Emirates and Saudi Arabia.
Only eighteen months ago, the project finance market was awash with liquidity. There seemed to be no end to the appetite among commercial banks to lend money to large power and water and oil and gas projects in the Middle East.
Lenders were happy to reach financial close with very significant commitments on their books, comfortable in the knowledge that there would be very strong interest from banks wanting to take on syndicated loans. Many large projects were oversubscribed in the syndication market by more than half the required commitment. Law firms were being invited to pitch for sponsor legal roles on the understanding they would prepare “covenant light” packages that had become the buzz words in the project finance market.
Today, the markets are still reeling from the events of the last few months and no one really knows what the long term implications of the current credit crisis will be. However, one thing is clear: the project finance markets are unlikely to return to the heady days of 2005 to 2007 any time soon.
What makes the implications of the global financial crisis so interesting from a Middle Eastern perspective is the massive amount of infrastructure, particularly in the power and water sector, that needs to be developed over the next 10 years. It is estimated that the power and water sector in the six GCC states will require about $50 billion of investment in new power generation capacity and $20 billion of investment in water desalination by 2015.
It is possible that some of this demand may subside with the current economic downturn and, in particular, the fall in the price of oil. However, so far the governments of the GCC have given every indication that their plans for urban and industrial development will go ahead despite the economic gloom. Some of the more ambitious projects such as the King Abdullah Economic City and the other proposed economic cities in the Kingdom of Saudi Arabia may not proceed at the pace originally planned. In any event, according to recent reports published in industry journals, much of this increased demand for energy and infrastructure capacity is required to service development that is currently under way.
This article explores some of the likely implications of the global financial crisis for the project finance market in the GCC and how GCC projects are likely to be funded over the next few years.
Enhanced Government Participation
One of the consequences of the current state of the credit markets is likely to be an enhancement of the role played by governments in the development and financing of projects throughout the GCC.
Thanks to the recently ended commodities boom, most of the GCC governments and ruling families are in an enviable position in comparison to the governments of western economies in terms of available cash reserves to draw on if need be to fund the development of domestic energy and infrastructure projects.
It is likely that we will see governments take on a greater level of participation in projects than has typically been the case in the past, either through larger equity participations or through increased government funding. Debt-to-equity ratios in the independent power and water sector in the GCC have been typically 80:20 and an average of 70:30 in the refining, LNG and petrochemical sectors. Some commentators expect that debt-to-equity ratios in the power sector will fall to 70:30 and as low as 50:50 in other sectors such as LNG, refining and petrochemicals. Given the significantly reduced capacity of international commercial banks to participate in these projects, governments and sponsors may have to increase their equity stakes. Most of the equity slack may have to be taken up by governments.
Government participation in projects may also come through equity investments by sovereign wealth funds. The Abu Dhabi government’s investment arm, Mubadala Development Company, recently announced that it has formed a joint venture with France’s Veolia Water that will focus on investments in water and wastewater, power transmission and distribution, and district cooling infrastructure.
In the Kingdom of Saudi Arabia, it is anticipated that the Public Investment Fund and the Saudi Industrial Development Fund will provide greater levels of funding than they have in past projects. Both of these funds are affiliated with the Ministry of Finance, and their functions include the provision of finance to projects in the Kingdom, provided that certain criteria are met.
The Abu Dhabi government is currently proceeding with two projects, the Shuweihat independent water and power project and the second Abu Dhabi wastewater treatment project, with the intention of financing development of these projects in the short term through a bridge loan and securing long term finance sometime in 2009 when hopefully market conditions will have improved. If a long term financing commitment cannot be secured by an agreed date, then the Abu Dhabi government will have the option of buying out the sponsors’ interest in the projects and proceeding without foreign sponsor and lender participation.
Unless there is a dramatic improvement in the project finance market in the short term, it is possible that this model will be adopted by some of the other GCC tendering authorities. This approach gives governments flexibility in a very challenging market. It allows them to proceed with development of projects, harness whatever appetite there is in the private sector to participate and, as a last resort, draw on government cash reserves if need be to complete infrastructure critical to meeting rapidly escalating demand for power, water and wastewater infrastructure. Governments, sponsors and lenders in the GCC region will be closely following the outcome of negotiations currently taking place in relation to these projects.
There is a current trend towards development of smaller projects in the GCC without project finance using design, build and operate structures or to use common industry speak, “DBO” structures. Under a DBO structure, the responsibility for providing finance lies with the public authority, as does ownership of the facility. There is likely to be an increase in the procurement of smaller infrastructure projects using the DBO model, particularly in certain sectors such as the water desalination and wastewater sector. However, it remains to be seen whether governments in the GCC will be prepared to procure larger projects, such as independent water and power projects, using DBO structures and thereby tie up sovereign funds that could be invested more profitably elsewhere.
Both the Shuweihat model and the DBO approach allow cash-rich governments the flexibility of building now and privatizing later at a time when there is more liquidity in the private sector.
Given the dependence of the GCC over the last 10 years on the expertise of foreign developers and international bank debt to fund projects, it is unlikely that we are going to see GCC governments fund large infrastructure and energy projects entirely on their own, notwithstanding the severity of the current global downturn. However, it is highly likely that the present economic conditions will necessitate a much greater level of investment from governments if they are to realize their ambitious development plans within the time frames they have proposed.
Increased ECA Participation
There is little doubt that one of the ramifications of the current credit crisis will be a greater participation of export credit agencies in the financing of projects throughout the GCC. ECA presence in the GCC has steadily grown over the last 10 years. ECAs are playing an increasingly significant role in the funding of projects that has included the provision of loan guarantees to international banks, direct loans and advisory services to project sponsors.
The ECAs are not exposed to the problems that currently plague international banks, and many of them have no shortage of liquidity.
The Japanese Bank for International Cooperation has the largest capacity among ECAs for direct lending. JBIC has played a key role in financing a number of major projects in the region, including a $2.5 billion loan in connection with the Rabigh petrochemicals project in the Kingdom of Saudi Arabia and a $1.3 billion loan to the sponsors of the Fujairah F2 independent water and power project. Other ECAs that are playing an increasing role in financing projects in the GCC through direct loans are the Export-Import Bank of Korea and Export Development Canada.
As well as providing an alternative source of funding, ECAs also offer more stable pricing for long-term finance. Although the formulations used by ECAs for setting interest rates and risk premiums vary depending on the relevant ECA’s policy and the type of product, many of the ECAs, including JBIC, set their interest rates and risk premiums by reference to OECD guidelines.
The provision of insurance covered by ECAs is also likely to increase significantly. Those commercial banks that are still in the market for underwriting deals are going to become very selective in terms of the transactions they underwrite. Any transaction that can over offer ECA covered tranches is always likely to be more attractive to commercial banks in jurisdictions or regions where political risk is a material issue.
The implementation of the Basel II rules on banking, which determine capital adequacy requirements for bank exposure to various types of transactions, including project finance, could also result in an increased demand for ECA cover in projects. The inclusion of an ECA-covered tranche in a project finance transaction will reduce the covered commercial banks’ obligations to put aside capital to satisfy the more stringent capital adequacy requirements of Basel II and other capital adequacy requirements recently implemented by central banks throughout the world in response to the global financial meltdown.
Continuing Role for Commercial Banks
Foreign commercial banks will continue to play an integral role in the financing of projects in the GCC. However, the commercial banks with liquidity available to lend to projects in the short term are likely to be fewer in number and the size of commitments these banks will be willing to take on will be significantly reduced. The syndication market is closed, and the view of most bankers is that any project financings that do go ahead in 2009 will be done as club deals. Commercial banks are now certain to take a far more cautious approach to underwriting transactions. Projects structured on the Abu Dhabi, Omani, Qatari and Saudi models are likely to be favored by commercial banks.
The cost of borrowing is clearly a significant issue at present and most commentators appear to share the view that, notwithstanding the recent drastic measures taken by central banks to cut interest rates, the cost of inter-bank borrowing will remain elevated at least in the short term. Pricing for long-term project finance debt is likely to be more than double the margins seen in 2007. High borrowing costs could lead sponsors and governments to look for alternative sources of funding.
During the last few years, tenors in some energy projects were pushed out to 15 years, and it was quite common for tenors in the power sector to extend beyond 20 years. The tenor of equity bridge loans extended to seven years on some transactions, three to four years beyond the scheduled date of project completion and often on margins no higher than 30 to 40 basis points. The low cost of borrowing over these extended equity bridge tenors enabled sponsors to maximize their internal rates of return. It remains to be seen whether such lengthy tenors will be obtainable in the near future. The consensus among most banks at present appears to be that maximum tenors for long-term project finance are likely to be 10 to 12 years. Sponsors may find it difficult to negotiate tenors for equity bridge loans that extend beyond project completion dates at margins anywhere near the sort of margins lenders were signing up to in the recent past.
We may also see the re-introduction of cash sweeps to encourage sponsors to refinance deals after a six- to seven-year period.
The last three or four years in the project finance market have been characterized as a sponsor-driven market where financing terms were dictated by sponsors and reluctantly accepted by lenders eager to participate in a highly competitive lending environment. The distinctions between the project finance and the corporate finance models were starting to blur. It really did seem for a while as though some fundamental principles of the traditional project finance model may have changed for good.
The tables have now of course turned. We are now likely to see a return to lending in accordance with tried and tested principles of project finance that have evolved over the last 30 or so years.
Lender protections such as long life cover ratios, repeating representations on interest payment dates, look forward events of default, and other lender covenants that were once standard market practice, but that have been eroded in recent years, will make a swift comeback. The inclusion of market flex clauses in bank underwriting commitments is now non-negotiable, and banks are paying particular attention to material adverse change provisions and insisting on more subjective and discretionary tests for determining the occurrence of any such event. Commercial banks are also now likely to insist on the provision of completion support by sponsors in any project where there are deficiencies in commercial and project contractual arrangements that have the potential to undermine the banks’ interests.
This is not to say, however, that lenders are necessarily likely to have it all their own way now. If GCC governments do end up taking larger equity stakes in projects and retain the option of buying out foreign sponsor interests in projects, lenders may find that, although the shoe is on the other foot, it ends up on the governments’ foot. Some of the government tendering authorities in the wealthier members of the GCC may adopt a take-it-or-leave-it approach with lenders. However, whether or not governments will have the luxury of adopting such a negotiating position will depend entirely on the reliance by each country on external debt to fund its projects.
Increased Participation of Islamic Banks
So far Islamic financial institutions have been relatively unscathed by the global financial crisis. It would probably be unrealistic to think that this will remain the case. Islamic banks are heavily exposed to real estate and private equity throughout the Middle East and with heavy selling of stocks, commodities and oil in the last few months, these investments are bound to be affected. Many of the Islamic banks have exposure to the property market in the GCC and some of these markets, particularly Dubai, are starting to show signs of being affected by the global economic downturn.
However, the long-term outlook for Islamic finance institutions remains quite positive. Most industry commentators believe that the Islamic banks should survive the economic downturn in considerably better shape than the conventional banks. The intrinsic characteristics of Islamic finance have helped to insulate it from the effects of excess leverage and speculative financial activities. Islamic law prohibits the payment of interest and requires transactions to be linked to tangible assets, which has deterred investment in complex and intangible financial derivatives that have caused such havoc for conventional banks around the world.
Over the last few years in the GCC, we have seen a steady increase in the participation of Islamic banks in project financings. The Islamic tranche for the Shuaibah independent water and power project in the Kingdom of Saudi Arabia that closed in 2005 was $200 million, and the Islamic tranche for the Marafiq independent water and power project, also located in the Kingdom and that closed in 2007, was $600 million. These and other transactions, like the Rabigh petrochemical project, have demonstrated to the market how Islamic finance techniques can be successfully utilized in the context of multi-sourced financings, while remaining consistent with the principles of Islamic law.
This trend is likely to continue with sponsors now looking to the Islamic banks for financing more than ever.
Reduced Size of Projects
One other consequence of the global credit crisis may be a reduction in the size of projects. Over the last 10 years, we have witnessed the evolution of the “mega project,” particularly in the power, water, refining and petrochemical sectors. The size and complexity of these projects have meant construction contractors have had to take on enormous project completion risk that they factor into their contract prices. There are also only about five or six construction contractors in the world with balance sheets and resources large enough to undertake these projects. This has meant reduced competition amongst contractors that has contributed, in turn, to the high cost of contracting.
We may now see the cost of construction contracting fall in light of the global economic downturn. However, the extent to which these costs fall in the GCC remains to be seen.
A combination of high construction costs and a significant reduction in the availability of liquidity in the international banking market may lead to a decision by governments to scale back the size of some of these projects.