New Structures: “Whole Business” Securitizations Of Project Cash Flows
Capital markets financing is less expensive and more flexible than bank finance. Banks, after all, charge margins on their cost of funds that need to cover capital adequacy costs, return on shareholders’ equity, funding costs and profit margins. Banks also need to charge for credit risk and, in the context of project finance, project risk.
If banks, their overheads and costing structures are “disintermediated” and finance is sourced directly from deep and liquid capital markets, competitive funding advantages arise for borrowers able to tap into such markets.
This funding advantage, in part, explains the popularity of securitization as a financing technique.
Securitization is a capital markets tool that enables cash flows to be isolated from the credit risk of the originator. Once isolated from the originator’s credit risk, such cash flows can be used to back securities issued in the capital markets — called “asset-backed securities” or “ABS” — having a higher rating than securities issued by the originator! A security with a higher rating than another security will attract relatively lower financing costs.
Borrowers have not been slow to appreciate the competitive funding benefits of securitization. In 1999, global ABS issuance reached $198.8 billion (despite concerns about Y2K and interest rate hikes). Most of the growth in ABS issuance is now taking place outside the United States where ABS issuance increased by 71.2% in 1999 over 1998 levels to $47.3 billion.
With this growth has also come another feature: innovative securitization structures have been developed outside the United States, based on local legal concepts, that enable whole businesses rather than isolated receivables to be securitized. These “whole business” securitization structures have particular relevance to international project finance transactions and demonstrate that, increasingly, the demarcation between securitization and project finance is being blurred.
As a result, in Europe, major infrastructure financings are now using securitization, in conjunction with project finance techniques, to enable projects to be financed. An important example of this was the October 1999 issue by London City Airport of £100 million 7.886% senior secured notes due 2021 in order to finance its activities. This transaction was the first time that a “whole business” securitization was used in the context of financing a project in the United Kingdom and provided the issuer with fixed-rate finance for 21 years — terms that the bank debt market simply could not match. (The bank debt market would only look at 3–5 years floating rate finance.)
Given the importance of whole business securitization techniques for project finance, this article examines the background to such transactions generally and the London City Airport transaction in particular.
Securitization is a process by which illiquid assets, in the nature of cash flows and connected contract rights, are pooled and repackaged into marketable securities representing claims against the illiquid pool. The marketable securities are then sold to third-party investors.
In order to undertake a securitization, it is usually important that the asset pool generates a stable and predictable cash flow because it is that cash flow that will service principal and interest payment obligations under the marketable securities. The illiquid asset pool will also usually provide security for the debt service obligations of the marketable securities. Thus, the pooled assets must be low risk and the loss experience understood.
As with other securities issues, asset-backed securities may take the form of an individual offering where all investors own, pro rata, incoming revenues from the securitized assets or a multi-tranche offering in which different classes or tranches of securities are issued carrying different rights to the asset pool.
Benefits of Securitization
Securitization provides a number of potential benefits over conventional bank finance.
First, it can be a cheaper and more flexible source of long-term financing, particularly for companies below investment grade. This was a major reason driving the London City Airport transaction where the term of the notes issued was far longer than that available in the bank debt market. Also in the case of whole business securitizations, interest coverage ratios, debt-service-coverage ratios, debt-to-equity ratios and debt-to-earnings ratios are perceived to be more generous than in the case of bank-financed deals. Moreover, other perceived benefits arise over bank finance for issuers. In a default scenario, troublesome bank group dissenters are less likely to be prevalent as they will have been replaced by bondholders. Bond trustees are also less influenced by relationship factors than an agent bank on a bank deal.
Second, securitization can provide balance-sheet relief through the removal of securitized assets and corresponding funding liabilities from the balance sheet of the originator (thereby improving capital adequacy ratios in particular for financial institutions and reporting ratios, such as debt-to-equity ratios and return-on-assets ratios).
Third, it is a method for widening a company’s sources of finance thus enhancing liquidity.
Fourth, it enables assets to be matched with liabilities. A 20-year income stream may be financed by bonds having a 20-year term thereby avoiding risks of funding mismatches.
Securitization is considered to be “good for business” by compelling an issuer to be more disciplined in how it operates its businesses thereby improving systems, documentation and the issuer’s understanding of the real cost of its portfolio. It is also becoming more familiar to regulators outside the United States. The introduction of securitization-friendly laws in markets such as Italy and France has caused corporates and regulators to embrace securitization to such an extent that it is no longer viewed in such markets with suspicion but rather as an important and necessary finance technique.
“True Sale” Securitizations
The most common type of securitizations are receivables sales or “true sale” securitizations.
These involve the transfer of assets by the originator to a bankruptcy-remote special-purpose vehicle that issues debt to fund the purchase. The receivables invariably continue to be administered or collected by the originator with little real disturbance to existing collection procedures.
A “true sale” structure does not easily accommodate originators with contracts that are difficult to transfer, businesses that have numerous bespoke contracts generating receivables, businesses that generate cash revenues or businesses that require much time and management to generate revenues. For such originators — and London City Airport was one of them — the use of “whole business” securitizations is more appropriate.
Whatever structure is adopted for a particular securitization transaction, a range of issues must be considered in nearly all cases.
One issue is the benefits sought to be achieved by the originator of the asset pool and how to structure the deal to achieve them.
Another issue is the nature of the asset pool to be securitized. In this regard, the term and regularity of payment of the asset pool will be a deal driver as will the credit quality of the pool. Almost all securitizations require credit “enhancement” to cover the risk of underlying obligors in the pool defaulting. Typical credit enhancement alternatives include injecting “extra” financial assets into the securitization — such as additional receivables — and using reserve accounts and credit wraps (such as insurance and letters of credit from third parties). Administration and collection of the pool must also be considered, in particular, to minimize the risk of co-mingling of assets of the administrator and the pool.
Another issue is asset isolation. The structure selected must be able to withstand the bankruptcy of the originator. In the United States, too much recourse back to the seller and too little default risk being transferred to the buyer may undermine the assets being considered as transferred to the buyer with there being no resulting “true sale.” Under English law, legal form is more generally respected.
In addition, observance of all legal formalities associated with any transfer of underlying assets must take place; otherwise, the assets may not vest in the purchaser. In English “true sale” securitizations, for example, equitable assignments of assets are common under which written offers and oral acceptances typically effect a transfer so as to avoid local stamp duty. This type of transfer has other legal consequences — for example, by virtue of s.136 Law of Property Act 1925, the purchasers under such an assignment cannot enforce the assigned debt directly against the debtor in legal proceedings without first joining the seller. (This would not be the case if notice of the assignment were given to the debtor by the seller — a perfected “legal” assignment.) Other methods of asset transfer used in the UK in the context of securitizations include using participations and, increasingly, declarations of trust. Compliance with applicable accounting rules is necessary if off-balance sheet treatment is required.
Another issue is how best to effect credit and liquidity enhancement. “Credit enhancement” addresses the risk of nonpayment by obligors while “liquidity enhancement” addresses risk of payment at the wrong time.
Credit enhancement is usually provided by the seller, rather than a third party, and usually through reserves of assets rather than direct recourse. As the pool liquidates and pays out the lenders, the remaining reserves vest in the seller. Another popular technique is for the seller to buy a junior tranche of marketable securities subordinate to the securities issued to the purchaser.
Direct or third-party liquidity enhancement is common in the form of loans, the structure of which will be settled having regard to capital adequacy considerations of the lender.
Tax issues are major concerns. There may be stamp duty, value-added tax, and withholding tax to pay, especially after transfer of assets to the purchaser and on any marketable securities issued under the securitization.
Finally, there will probably be regulation specific to the industry of the originator that will have an effect on the transaction structure.
Public or Private Offering?
If the marketable securities are to be offered to the public, then terms and conventions commonly used in the market must apply, including the need for the securities to be rated. Private offerings, on the other hand, may contain customized or unusual terms. Where securities are to be rated, they are unlikely to be rated higher than the seller’s rating in the absence of substantial elimination of seller credit risk. Legal issues to be considered include compliance with securities laws and laws governing conduct of investment activities.
ABS investors are usually institutional investors, such as pension funds, who lack the resources to evaluate ABS risks. Such investors rely on rating agencies to do this for them. The rating agencies do so after focusing on the quality of the pooled assets and key factors such as asset isolation and credit and liquidity enhancement before ascribing a rating to a deal.
In order to rate a whole business securitization, rating agencies have adopted an approach that combines elements of a structured or securitization transaction and a corporate transaction. For example, Standard & Poor’s focuses on four key concerns.
- Status of originator. If it is sought to rate an issue above the originator’s rating, then the key operating company should ideally be a single-business and single-activity company so that the scope of the commercial risks associated with the business can be determined. This part of the rating agency analysis derives from a corporate bond issue ratings approach. The concentration is on future revenues and understanding the cash-generating attributes of the relevant business. There is no fixed portfolio of assets being securitized (as would be the case in a true sale securitization) and, consequently, the rating agencies must obtain an understanding of business operating risks, competitive risks and costs and revenues.
- Enforceability. The transaction must be enforceable and not subject to legal challenge. While general law grounds — like ultra vires and capacity — for a challenge must be considered, insolvency law impact is the key concern as it would be on a conventional structured deal or receivables financing.
- “True” control. The issuer must have total control over the underlying security package and revenues. The security package should confer priority over all other creditors and, once realized, the proceeds of the security package should repay all indebtedness under the notes.
In terms of the “control” issue, under English law, a first ranking fixed charge will largely be unaffected by liquidation. Administration is another issue. This is a procedure under which a creditor or director can petition the courts to appoint a licensed insolvency practitioner as “administrator” of a company if to do so would achieve a better realization of the transferor’s assets than would be achieved on a liquidation or the survival of the company as a going concern.
An automatic stay on security enforcement can apply on the appointment of an administrator, and the administrator can dispose of assets charged to other creditors whether under fixed or floating charges. Standard & Poor’s says:
“The balance of control in administration is weighted against the secured creditor. If the originator is in administration, there can be no true control.”
A secured creditor can appoint an administrative receiver and block the appointment of an administrator provided that the security package contains a floating charge over the whole or substantially the whole of the property, assets and undertaking, present and future of the applicable company.
At a minimum, rating agencies require floating charges to be included in the security package for a “whole business” securitization. In addition, first priority security interests must be granted over the assets of the operating company which should secure, in full, the principal and interest on the ABS. Certainly floating charge assets should not primarily be relied upon to generate funds to pay investors.
- Liquidity support and other structural considerations. As with a conventional true sale securitization, liquidity support via cash reserves and liquidity facilities is typically considered at a level that mitigates liquidity risk. In addition, structural requirements (such as credit enhancement and measures to reduce the risk of challenges to security arrangements and potential insolvency filings against key companies) are also focused upon. The importance of credit enhancement cannot be underestimated. Many whole business deals are real-estate based with overcollateralization provided through the excess of the value of real estate over the secured indebtedness.
“Whole business” securitizations offer a potential solution to the difficulty of structuring around underlying revenue streams arising from contracts that are not assignable or capable of being subject to fixed security and complex businesses that require active management and that generate revenues otherwise than from short-term receivables. Such transactions will increasingly be a feature of international securitizations, particularly in markets where creditor-friendly bankruptcy laws allow creditors, effectively via receivers, to assume control of underlying revenues on an on-going basis and manage the revenue pool of a business in order to extinguish capital markets indebtedness.
To date, the whole business securitization technique has been mainly used as an important refinancing tool — primarily for acquisition financings.
However, such a structure may be used to finance the construction or development phase of a project if a third-party credit wrap from an insurer or other rated entity is obtained or if one has “free” unencumbered assets from existing projects for use as over-collateralization.
Whole business securitization can also be adapted to accommodate international companies with assets in various countries some of which do not permit direct security. In a recent transaction, key operating companies of the Tussaud Group granted mortgages over the shares of companies located in markets where direct security was not possible together with covenants to ensure that such “downstream” companies did not incur debts or grant security over or dispose of their assets. A satisfactory rating was nevertheless forthcoming.
More adaptations of the whole business securitization structure will certainly follow as the pace of international securitization increases and as originators in securitizable industries or sectors come to recognize the need to finance their businesses through the capital markets to ensure they are not at a competitive disadvantage.