Project Bonds and Mini-Perms: A New Era in the Middle East
By Richard Keenan
Two developments in Abu Dhabi may together prove to be a watershed in the Middle East project finance market.
The Abu Dhabi Water and Electricity Authority last month released a request for proposals in connection with the Mirfa independent water and power project that allows bidders to propose a mini-perm funding structure.
Separately, the sponsors of the Shuweihat 2 independent power and water project are in the process of refinancing the project through a project bond.
Projects have been financed before with mini-perm structures and project bonds, but use of these structures is recent and still uncommon.
The Al Dur independent power and water project in Bahrain that achieved financial close in 2009 used a mini perm. The project finance market in the Middle East in 2009 was still reeling from the effects of the global financial crisis, and the Al Dur IWPP may not have been financed had it not been for use of a mini-perm structure not previously adopted in the Middle East.
The $2.3 billion project bond offering by Ras Laffan Liquefied Natural Gas Company in 2006, followed by the $1.25 billion project bond offering by Dolphin Energy in 2009, were the first two projects to tap into the project bond market in the Middle East. However, a power and water project has not been financed or refinanced yet in the Middle East through a project bond. Shuweihat 2 will be the first.
The release of the Mirfa RFP allowing for the implementation of a mini-perm structure and the refinancing of Shuweihat 2 through a project bond are indicative of two things: recognition of the ongoing capacity constraints affecting the commercial bank market and a growing consensus that the power and water sector in the Middle East is now mature enough to look to the project bond market as an alternative and viable source of liquidity.
The closing on the financing for the Al Dur project in July 2009 was followed by a recovery in the long-term debt project finance market in the Middle East. Power and water projects such as Shuweihat 2 and Shuweihat 3 in Abu Dhabi, the Barka 3 and Sohar 2 IPPs in Oman and the PP 11 and Qurayyah IPPs in Saudi Arabia were all financed with long-term tenors of 15 years or more.
Weak Bank Market
However, three years after the closing on Al Dur, the commercial bank market in the Middle East is still recovering from the global financial crisis. The political unrest caused by the Arab Spring, the implementation of Basel III and the eurozone banking crisis have prolonged the recovery.
The appetite within the commercial bank market for long-term tenors of 15 years or more remains subdued. The number of international commercial banks in the market for long-term debt, particularly the European banks, has steadily shrunk over the last four years. Saudi and other regional banks have stepped in to provide liquidity, but this has not been enough to fill the gap left by reduced international bank participation.
Commercial banks remain concerned about liquidity or their ability to access the inter-bank market at rates that match their costs of funding.
With fewer banks in the market to provide long-term commitments, margins for tenors beyond eight to 10 years have remained elevated compared to pre-financial crisis pricing.
The shrinking pool of banks has made it difficult for some bidders to secure the required funding to support bids on power and water projects. The response by a number of
procuring authorities in the region has been to relax tender requirements in terms of the amount of committed finance bidders are required to secure. While this approach may allow more developers to bid for projects, they are still left with the problem of inadequate resources in the bank long-term debt market.
The permission to use mini-perm financings to support bids is the first real step to address this problem.
A mini-perm structure is basically shorter-term borrowing from a bank. Mini-perm financings typically involve a tenor of eight to 10 years covering both the construction phase of a project and a four- or five-year period post completion. From a bank standpoint, such a structure allows for an early exit and avoids the banks having to commit to a long-term tenor without at least having the benefit of a significant improvement in the financing terms.
Hard Versus Soft
There are two types of mini-perm structures: a soft mini-perm and a hard mini-perm structure.
Hard mini-perm structures typically require the sponsors to refinance the loan prior to maturity. Failure to refinance is an event of default. Hard mini perms have been less popular because of the tendency for sponsors and lenders to try to push the refinancing risk on to the procuring authorities. Lenders typically insist that a failure by the borrower to refinance should lead to a default under the concession agreement and payment of termination compensation by the authority to cover the outstanding debt. In Australia, for example, where mini-perm structures have been widely used, the procuring government authority in many cases assumes the refinancing risk. This obviously leaves the government with significant exposure.
The Al Dur IWPP in Bahrain was financed in 2009 using an 8-year hard mini-perm structure. This was first time this structure had been used in the power and water sector in the Middle East and was chosen in response to the very challenging market conditions at the time. The sponsors and lenders took the refinancing risk. According to Project Finance magazine (Al Dur: Enter the mini-perm), the sponsors in Al Dur have to refinance by year 5 or the sponsors will be liable for a margin increase of 50 basis points and a 100% cash sweep for the remaining term. Before application of the cash sweep, the deal amortizes in line with a 20-year amortizing loan. Under the base case model, an 80% balloon payment is left for repayment at the end of the 8-year term. Of the remaining 20% of the loan, 10% is repaid in accordance with the repayment schedule and the other 10% is repaid by base case cash sweeps. There is an automatic event of default if the project is not refinanced before the end of the 8-year term.
The financing of the Al Dur IWPP was the first use of a mini-perm structure in the Middle East project finance market. However, it is fairly aggressive from the standpoint of the sponsors and lenders and has probably been viewed by the market as a deal structured to accommodate exceptional circumstances rather than a precedent to be followed.
A soft mini-perm structure typically involves a long tenor (say 21 years for a 25-year concession). However the sponsors have an incentive to refinance the loan by an earlier date. Unlike under a hard mini-perm structure where refinancing the loan is compulsory, under a soft mini-perm structure, a failure by the sponsors to refinance is not an event of default. If the loan is not refinanced, then the margins increase, making the cost of borrowing more expensive, and the lenders are entitled to a cash sweep under which most, if not all, of the project’s available cash flow must be applied to repay the loans, thereby eliminating the prospect of any dividend payments to the
Sponsors using soft mini perms benefit from a long tail: the concession period will have 10 or 15 years left to run beyond the term of the debt. Accordingly, if the refinancing does not take place before the soft mini-perm debt reaches maturity, then the lenders are more or less in the same position they would be under a long-term loan facility.
However, the sponsors take the refinancing risk and use of a soft mini-perm structure will always come down to whether the sponsors think the gamble is worthwhile. The potential gain from a refinancing on better terms is the key driver from a sponsor standpoint. There is recent precedent in the Middle East for incorporation of a mechanism allowing procuring authorities to share any financial upside that may result from refinancing the project. The financing of the Barka 3 and Sohar 2 IPPs in Oman in 2010 is a recent example.
If the procuring authorities in the Middle East want to encourage wider adoption of soft mini-perm structures in order to create more liquidity in the local project finance market, then they should consider whether it is reasonable to expect project sponsors to share the refinancing gains while keeping all the downside risk.
The mini-perm structure contemplated by the Abu Dhabi Water and Electricity Authority in connection with the Mirfa IWPP is expected to be a soft mini-perm. ADWEA will look to the sponsors to assume refinancing risk associated with any mini-perm structure a bidder may propose.
There are a number of drivers behind the choice of a mini-perm structure. Sponsors may choose such a structure in the belief that finance terms will improve and a refinancing of the project will enable both the sponsors and the procuring authority to benefit from an expected improvement in the debt markets. This was the case with respect to the Al Dur IWPP in 2009. Some mini-perm financing structures incorporate back-ended repayments or require a sizable balloon payment at maturity. These structures allow sponsors to bid lower tariffs and, for this reason, may be allowed by procuring authorities.
ADWEA’s rationale for allowing bidders to propose a mini-perm structure in connection with the Mirfa IWPP is probably twofold. It opens up liquidity for bidders and makes the bidding process more competitive by allowing more developers to bid on the project. It appears ADWEA also wants to encourage bidders to consider refinancing the project after construction in the project bond market.
Each year the many project finance conferences that take place throughout the region include on their agendas a panel discussion about why so few projects in the Middle East are financed in the bond market. The two projects widely regarded as
pioneering the use of project bonds in the Middle East are the $2.3 billion project bond offering by Ras Laffan Liquefied Natural Gas Company in 2006 and the $1.25 billion project bond offering by Dolphin Energy in 2009 as part of a $4.2 billion refinancing of the Dolphin energy project that supplies Qatari natural gas to the United Arab Emirates and Oman.
The project bond market in the Middle East has been slow to develop. Abundant cheap long-term bank debt, previously available in the Middle East, stifled its growth. The commercial banks used aggressive pricing before the global financial crisis in 2008 to hold market share. The project bond market initially offered sponsors longer-term financing than banks could offer, but by the late 1990s and for much of the last decade, banks were able to compete with bond investors and commit to tenors of 20 years or more.
Bank loans were also easier to close compared to project bonds. It is time consuming and expensive to issue project bonds. Project bonds are securities, and there are various securities laws and exchange listing rules and regulations to navigate. The documentation required to issue project bonds varies depending on governing law and market practice. Project bonds issued to US investors under Rule 144A require underwriters to obtain 10b-5 disclosure opinions. Both sponsors’ and underwriters’ counsel have to carry out extensive due diligence in relation to the project. The sponsors and their advisors have to prepare an offering memorandum or circular. The offering circular has to describe the project in considerable detail, including each of the project and finance documents, risks associated with the project together with a summary of the bond terms, a description of project modeling, information about the sponsors and various other disclosures.
With the exception of private placements involving a limited number of investors, the issuer of a project bond must also have the bonds rated. The typical rating process involves a number of steps. The sponsors are usually required to prepare a written presentation to the rating agency in advance of a management presentation. The ratings process also often requires a site visit by the rating agency.
The rating agency usually issues a pre-rating after the meetings with the sponsors and extensive due diligence on the project, and a final rating is issued upon financial close. The process of obtaining a pre-rating can only commence once the project structure is known, and a final rating cannot be issued until the project documentation is close to final form. It is possible for project sponsors to obtain a pre-rating from only one rating agency. However, the sponsors will need ratings from two rating agencies before a project can receive a final rating.
It is also more difficult to amend project bond documents or obtain waivers from project bond investors compared to banks.
However, if the appetite of banks for long-term debt remains subdued and the pricing of bank debt remains elevated, then more attention will shift to the project bond market. Banks and their credit committees are scrutinizing project structures and credit risk far more than they did before the financial crisis. The days of named lending by the banks are long gone.
Large project financings in the Middle East can only be financed with support from export credit and multilateral lending agencies in the form of direct loans and guarantees. The lending requirements and credit approval conditions of these institutions are onerous and can lead to delays in the execution of transactions. Many project financings are taking longer to execute than they did before the financial crisis.
Accordingly, any competitive edge that banks enjoyed over project bond investors because of their ability to execute rapidly has dissipated. A project bond will still take longer to close than a straightforward bank loan even if the bank loan involves a club of banks. However, it would be interesting to compare some recent project financings involving multiple banks with export credit or multilateral lending agency backing with the delivery of project bonds in terms of time to execution.
Further development of the project bond market in the Middle East power and water sector will require educating credit rating agencies and institutional investors.
Projects in the Middle East are procured on the back of strong sovereign balance sheets, and risk allocation embodied in Middle Eastern projects, particularly in the power and water sector, compares favorably to other regions. The power purchase agreements are essentially energy conversion or tolling agreements, and the project company does not assume any fuel supply or quality risk. If completion or operation of plants is affected by political force majeure or breach by the procuring authority, then the sponsors and project financiers are kept whole. Most importantly, defaults by project sponsors in the region are rare.
Convincing rating agencies, underwriters and project bond investors that power and water projects in the Middle East are sound investments should not be difficult. The greater challenge is aligning the expectations of bond investors with the terms and conditions that have been accepted by the banking sector and have become market practice in the Middle East.
The Middle East project market over the last 10 or 15 years has been a sponsor-driven market. Leading developers in the region have forged finance templates that have become well entrenched as market practice. Significantly, since the financial crisis, there has been only limited enhancement of bank covenants; finance templates developed prior to the financial crisis have not changed significantly.
If project bond investors are going to compete with the banks, they must be willing to accept the standard list of covenants and other terms with which the banks have been comfortable. However, it will be up to sponsors to educate them.
Consider, for example, the debt service coverage ratios that are typically applied in bank loan agreements in the local power and water project finance market. It is market practice for the conditions precedent to the initial draw down on a bank loan to include a condition that the financial model and base case show a minimum or average projected debt service coverage ratio of at least 1.20:1 and for the conditions a borrower must satisfy before making distributions to equity investors to include maintaining a debt service coverage ratio of between 1.10:1 and 1.20:1. For project bond investors familiar with project models and financings in other regions, use of these ratios as a test of the base case and as a distribution test may initially seem favorable to the sponsors. However, due diligence on the project risk allocation and the credit quality of the government counterparty should demonstrate to bond investors that use of such low ratios for these purposes is justified.
Industry leaders and commentators are bullish on the potential for growth in the project bond market in the Middle East. The project that will hopefully be a catalyst for this growth is the refinancing of the Shuweihat 2 independent power and water project in Abu Dhabi. The project reached financial close in October 2009 with $2.2 billion committed in the form of long-term bank debt, and the plant commenced commercial operations in 2011. The project sponsors are in the process of refinancing the project partly through a project bond offering of about $800 million.