Deal Flow Picks Up in a Market Well on the Road to Recovery
Global Finance Award Winners Forecast a Continued Upturn in 2004
The global project finance market has sprung to life this year, following two years that many institutional and bank lenders would just as soon forget. Will 2004 be the year that the market shifts into high gear? Perhaps.
Global Finance asked winners of its Best Banks in Project Finance awards to provide their views on where the market is headed in the next 12 months. Without exception, bankers say the deal flow is increasing and the outlook is positive.
Global project finance volume rose 21% in the first nine months of 2003, to $64.9 billion from $53.6 billion in the same period of 2002, according to London-based Dealogic ProjectWare. The number of transactions rose by 34%, to 191 from 143.
While there are unmistakable signs of a rebound in activity that is expected to continue in 2004, many markets will remain challenging, says William Chew, project finance credit analyst at Standard & Poors in New York. It is more important than ever, he says, that projects be carefully structured to avoid potential credit problems.
In Europe, which has been the center of the recent stirring in project finance activity, governments are turning to major infrastructure projects to stimulate stagnant economies. Export credit agencies and the European Bank for Reconstruction and Development are enticing bankers to join a rising tide of projects in Central and Eastern Europe.
Meanwhile, high oil and gas prices are generating increased investment in the energy sector. Alternative sources of power, such as windmills and waste-to-energy projects, are gaining in popularity.
While bankers are excited about the prospects for the year ahead, they remain wary of possible pitfalls. Here, in their own words, is what to look for in 2004.
Infrastructure Projects on Track
By Jeff Thornton, head of infrastructure finance, Royal Bank of Scotland
The outlook is for continued growth in global infrastructure project financing in 2004, with transportation, health care and alternative energy projects leading the way. Much of the growth will be in Europe, where governments are turning to infrastructure development to stimulate sluggish economies.
The London Undergrounds public-private partnership, or PPP, program to upgrade and maintain the London subway system was a major factor in the sharp growth in infrastructure project financing in 2003. The Metronet consortium alone raised $4.87 billion to rehabilitate two of three groups of lines on the Underground. While there is no sign of diminution in the UK transportation industrys demand for funding in the year ahead, much of the new project activity in 2004 will come from outside of the UK, particularly in France, Italy, Spain, Greece, the Netherlands and the Republic of Ireland.
Ambitious schemes to bring European countries closer together and to make cross-border trading more efficient will require the construction of new highways, railroads and bridges. There will be significant lending by the European Investment Bank for projects in southern Europe as part of the Trans-European Networks, or TENs, project to enable the physical movement of goods and people to promote economic cohesion. Meanwhile, the prospect of EU enlargement to include the countries of Central and Eastern Europe will give additional impetus to infrastructure projects that will provide enhancements to existing facilities.
Since public funds are insufficient to cover the planned spending, the EU is trying to involve the private sector more in financing infrastructure projects through PPPs. There is unlikely to be a shortage of funding, although the mix of funding products and providers is changing. In the future, there will be fewer index-linked capital markets products and an increase in the use of credit guarantees through plain, monoline ‘wrapped’ bonds. A handful of primarily US-based insurance providers, or monolines, specializes in the business of insuring debt securities. The triple-A-rated insurer wraps the bonds and takes the credit risk on a project in return for a premium. The insurance, in effect, raises the rating on a projects bonds from low investment grade to triple-A, enhancing the marketability of the issue.
Meanwhile, various European governments are considering how they need to change their domestic procurement laws to make projects more deliverable. Italys cumbersome procurement system is being revised, and France is easing laws that make it illegal for a private-sector entity to build a prison in the country.
While the Continent will see increasing activity in infrastructure financing, Britain will remain active. Prime Minister Tony Blair told members of parliament during question time at the House of Commons in October that a $17 billion plan to build an east-west rail link under London, known as the Crossrail project, was well worth supporting. The project will require innovative funding that will combine some government financing with some support from the fare box.
Project Finance in 2004:
Part of an Essential Corporate Diet
By Chris Beale, managing director, global head of project and structured trade finance, Citigroup, New York City
Project sponsors have once again validated limited-recourse finance as an important corporate finance tool. The project finance market is growing again, rebounding from a contraction in 2002 and 2003. The sectors with the most promise in 2004 are energy, power and transportation infrastructure.
l Raising the Energy Bar
LNG is expected to represent a significant portion of global project finance activity in 2004. At least 30 new or expanding LNG projects are at various stages of planning and development around the globe, and significant transactions are expected throughout the LNG supply chain, from gas-field development to pipelines, liquefaction plants, ships and import terminals.
l Choking on the Power Lunch
The collapse of merchant power prices in the US and the UK, virtually ending development activity over the last 18 months, is a well-covered story. Banks, once preoccupied with restructurings of power sponsor and project debt, have recognized losses and stabilized most situations. While the end game is not crystallized (there has been very little trading of foreclosed assets to date), most banks seem to be prepared to ride out the down cycle until market prices recover.
l Power to the People
There are regions of the world where power is still in critically short supply. There will be financing opportunities for new generation capacity (and fuel supply and delivery systems) in Mexico, Chile and Brazil, in the Middle East and Eastern Europe, and in Asian nations such as Sri Lanka and Bangladesh.
Under-investment in the transmission sector over the last 20 years has resulted in a need for significantly more capacity. A few pioneering transmission projects in 2003, such as the United States PATH 15 expansion, have laid the groundwork for more transactions.
l In For Structure
Traditional infrastructure projects will continue to be a large proportion of the project finance market globally. Because of federal and municipal budget constraints and debt limits, PPP and PFI schemes will continue to flourish. Governments in additional countries will take the experience of the United Kingdom and other developed markets, where PPP/PFI is an attractive form of procurement for developing infrastructure.
In 2004, rail and renewables are expected to be key growth sectors for greenfield projects in the EMEA (Europe, Middle East and Africa) region. More project financings of roads are expected in Australia and Chile.
l The Name Is Bond
While the number of banks active in the project market has contracted, significant and growing capacity exists in the project bond market. This capacity is helped by monoline insurers, both the traditional players and newer entrants. The long maturities and flexible structuring offered by investors in the United States and Europe will likely be replicated in some local currency bonds in emerging markets.
l A Capital Idea
A group of about 20 banks worked with S&P; Risk Solutions during 2003 to expand the Project Finance Industry Database. The study demonstrates empirically that project loans perform substantially better than corporate loans. The database has served as the widely accepted primary source of evidence to the Basel Committee that requiring the allocation of more capital to project loans than to corporate loans is faulty. Bankers who have led the study have met with the Basel Committee, as well as regulators in key markets, to explain the results. The final draft of the Basel II accord is eagerly awaited.
l Banks Go Green
During 2003, close to 20 major project finance banks adopted the Equator Principles, an industry framework created this year for managing environmental and social risk in project financing. These banks were co-arrangers of more than 75% of the project finance loan market, as measured by Dealogic. Given the combined market share of the banks that have adopted the Equator Principles, no major project is likely to be financed from now on without these guidelines being applied. The Equator Principles ask bank clients to apply the World Bank and International Finance Corporation pollution standards and the IFC Safeguard Policies on social issues to their project development activity. Early tests have demonstrated the efficacy and widespread application of the standards.
Industry Looks to 2004:
A Credit Perspective
By William Chew, managing director, corporate and government ratings,
Standard & Poors, New York City
Project debt remains a challenge in many markets after two of the worst years in memory. For many institutional and bank lenders, project debt continues to carry a Biblical mark reflecting its role in some of the more extreme recent credit meltdowns.
There remain some important exceptions:
l Contract-backed projects with off-takers manifestly distant from any visible credit problem;
l Projects in sectors with strong credit fundamentals, such as oil and gas; and
l Projects favored, and in some cases supported, by current governmental policy trends, such as power from renewable resources, carbon-sequestration projects and other environmentally oriented projects.
And some current financial market trends will likely favor project finance in various forms. The return to favor of the high-yield bond market in the United States, and record liquidity in the bank-loan market in particular, have helped to open the way for well-structured projects free of any exposure to current or potential credit problems.But even as the project finance market begins, at least selectively, to show some signs of life, it will remain important that projects address some of the key credit challenges that have demonstrated the potential to bring projects down, such as the collapse of tenor, or severe margin squeezes.
As credit pressure has risen, lenders have reacted by reducing tenor. For many lenders, especially lead banks, this became a preferred approach to managing rising credit risk. Banks have long held that by reducing tenor, they increase their ability to actively manage a borrowers credit standing. But experience shows that for the power sector in particular this approach also has the potential to cause concentration of near-term maturities that can, in the aggregate as well as for individual companies, become a negative credit factor in and of itself.
Under more normal market conditions, this risk could be assumed to be immaterial, but the sharp contraction of both the bank and bond markets in 2002 leaves the potential that refinancing may again become an issue, particularly for higher-risk credits, which may face a challenge even under less-stressed market conditions.
For projects, credit strength often depends on the match of revenues and expenses at levels not possible in many other areas. This capacity stems in part from regulated monopolies, especially utilities and their ability to pass through costs to end-users. It also reflects markets ability to match key components in revenue and expenses, such as by hedging between power and fuel prices.
Optimistic assumptions about deregulated markets have led some borrowers to depart from basic matching practices on the assumption that, like financial markets, input and output markets offer relatively continuous opportunities to roll over hedges. But recent experience shows that, just as financial market assumptions on continuity became overly optimistic, many assumptions about the continuing ability to roll over or extend project-level hedges proved to be unrealistic.
In power, in particular, many borrowers missed the extent to which power and key fuel-input prices not only could de-link but also, in the case of gas-fired generation, could rapidly put projects into severe margin squeezes. Some of these squeezes may abate as declining power prices, driven by factors well beyond fuel markets, may force cancellation and deferral of gas units. But failure to match long-term revenue with expenses will continue to be one of the key factors marking weaker, as opposed to stronger, credits for some time.
Credit strength, a hallmark of well-structured projects, has remained an issue for both borrowers and lenders in 2003. For individual credits, and even more for overall credit trends, positive developments were few and hard to find. But there are some encouraging signs. Above all, the focus on credit, intermittent at best during the credit expansion, returned with a vengeance across most areas of project and infrastructure finance. The continuing issue for lenders and borrowers has become how long this focus will last.
Financing for Oil and Gas Projects
By Erik Codrington, director, global specialized finance Americas, WestLB, New York branch
The global market fundamentals for oil- and gas-related projects are quite positive, pointing to a substantial increase in financing and advisory activity in 2004. Robust oil and gas prices on both a current and forward basis are generating increased upstream investment.
Another bullish factor is rising demand for natural gas, which is necessitating large midstream investments in pipeline and LNG assets. Finally, the current ‘frontier’ sources of hydrocarbon supply are generally in countries with substantial sovereign risk. This could further contribute to market activity, since project financing is viewed as a means of diversifying political risk and accessing attractive export credit and multilateral funding.
Much of the needed investment, particularly in the upstream sector, is likely to be funded by major oil companies and the state sector in developing nations. Nevertheless, the outlook is for increased project financing activity, primarily for joint ventures, sponsors that are more capital constrained, and for midstream assets with stable, utility-type returns. Although 2004 deals are likely to clear the market on cautious terms, due to the smaller number of banks and investors and recent adverse results in the power sector, more-conservative deal structures are only part of the story. Project sponsors should be in a good position as a result of low underlying interest rates.
Transactions in the OECD countries will continue using banks as a primary source of funding for projects in 2004, with US private placements and Rule 144A offerings playing an important supporting role for longer-term, investment-grade deals. Emerging markets deals, however, will be primarily done ‘old style,’ by piecing together multi-tranche packages of funding from banks, export credit agencies and multilateral lenders.
For North America, the predominant theme appears to be increasing the supply of natural gas to the US market. A number of natural gas-driven transactions are slated for 2004, including the Cheyenne Plains pipeline, capital markets refinancing of the Gulfstream pipeline, and construction financing for one or more LNG receiving terminals. The US thirst for natural gas is also driving a variety of LNG expansions elsewhere in the world and in deeper water in the Gulf of Mexico.
Despite the regions substantial potential, energy investment in Latin America and the Caribbean could continue to suffer from political instability. Financing of Trinidad and Tobagos Atlantic LNG Train 4 and supporting pipeline investments should be significant market events. Financing a portion of the upstream programs of Pemex and Petrobras may also be important. LNG-related activity in Bolivia, Peru, Mexico and Venezuela could result in some advisory activity in 2004, but few closed transactions.
The EMEA market (Europe, Middle East, and Africa) will be dominated by jumbo, multi-tranche project financings in the former Soviet Union. Such transactions will include the $1.2 billion Baku-Tbilisi-Ceyhan oil pipeline, the even-larger Sakhalin II gas project, and potential deals related to the Caspian Pipeline Consortium and Tengizchevroil. In the Middle East, substantial financing is expected for the UAE-based Dolphin natural gas project. A steady stream of deals is likely, based on export of the regions plentiful and inexpensive gas supplies, with Qatar remaining in the forefront of activity.
In Asia, the trend is for a moderate but improving level of activity, with few landmark deals. Investment to meet Chinas demand for raw materials, including crude oil, natural gas and petrochemicals, will be the focus. Despite strong demand, few deals are expected to materialize this year, due to the difficulty of putting together satisfactory financial, legal and market structures in China.
Regional bright spots will include LNG-based transactions from Malaysia and Indonesia and possible pipeline refinancing in Australia.
Central and Eastern Europes Trickle
By Mark Henderson, director, London project finance energy group, SG
The past 18 months has been a period of transition for project finance, with lower volumes of deals, higher provisioning and, as a consequence, banks withdrawing from the market. As we look to 2004, the question is, will this persist, or is the upturn about to arrive?
Our view is that the deal flow is returning, as SGs project finance team was busy across all sectors in 2003, particularly in infrastructure, private finance initiatives, and oil and gas. We also did more financing in the power sector than we had expected. What is significant in this transition is that the financing structure of deals has changed. As international banks have retreated from project finance, new players have entered the arena, especially banks based in the same country as the project. For example, the Italian Genco financings and refinancings have involved a significant number of Italian banks. Spanish banks continue to dominate Spanish projects. Even less traditional markets for the project finance world, such as Bulgaria, the Czech Republic and Poland, are bringing their domestic financial institutions into project finance.
It is important that these banks are gaining the experience and desire to expand into this financial sector, as it promotes projects domestically, teaches offshore banks more about domestic issues and introduces much-needed liquidity into the arena. Does this mean that project sponsors can relax and tear up their term sheets? No, it does not. In fact, the opposite is true: Banks are being more conservative, as new players need to see clear but robust structures and, most important of all with Basel II looming, a healthy return on their valued capital. This means that the trend of higher financing costs and shorter tenors is expected to continue.
Nowhere is this more likely to be true than in Central and Eastern Europe. While the stream of Western European projects has slowed to a modest trickle, further east the trickle has perhaps not exactly reached a raging torrent, but it is steadily growing. In fact, 2004 could just be the year when the pipeline begins to gain momentum and project structures begin to develop form and consistency. To do this, sponsors need to adhere to the ‘back to basics’ structuring lessons (can Poland accept that merchant power is not going to be bankable?), and banks need to discover the pricing levels that the market needs to end the pricing flexibility debates that mire projects in syndication.
One feature that will become particularly relevant in financing projects in Central and Eastern Europe is the use of the EBRD (European Bank for Reconstruction and Development) and Export Credit Agencies, or ECAs. These institutions will be of varying importance, depending on the country and sector, but they will, nevertheless, be instrumental in attracting project finance lenders to most, if not all, these countries, including some in the EU Accession group. Banks that will prosper will be those that can lead both a range of ECA-sourced debt, structure robust projects for the syndication market and make use of domestic banking networks to attract new sources of debt and top up the financing mix beyond the ECA coverage.
Slowdown in Project Finance?
Not in Australasia
By Chris Tonkin, director, project and structured finance, ANZ Investment Bank,
Melbourne, Australia
Against a backdrop of global economic uncertainty, the major Australasian economies have managed to record continued growth, while simultaneously sustaining low inflation and increasing employment. This is enabling project finance to remain active in the region, albeit not without challenges.
Enduring low pool prices and regulatory pressures in the power industry led to restructurings and asset sales, such as the well-publicized exit of US-based multinationals. However, the region is attracting investment by the Asian majors, including interest in Australias largest privately owned generator, the Loy Yang A power station in Victoria. In New Zealand, a large hydropower project and a number of geothermal projects are planned to address growing demand-supply imbalances and declining natural gas reserves. Meanwhile, an estimated 3,000 megawatts of wind farms are currently at various stages of planning in the region. An early success story is the recent completion in western Victoria of Pacific Hydros 52.5-megawatt Challicum Hills wind farm, jointly financed by ANZ Investment Bank and Westpac.
In contrast to the low pool prices in the power market, commodity prices recently have surged across the board. Although the price recovery in the metals sector has been counteracted to an extent by the rising Australian dollar, the overall profitability and financing activity in the industry has returned. This is leading to the emergence of a number of resources projects that are being financed via successful equity raisings and structured bank debt. Small or ‘junior’ companies are also quickly filling the void left by the vacated mid-cap sector.
The sale of Sydney Airport in June 2002 marked the start of a slowdown in the number of major privatizations coming to market, with most of the rail, power, utilities and airport asset-sale programs ending. In turn, the focus of the infrastructure sector has now shifted toward a series of refinancings and restructurings. There also has been a spate of new toll-road BOOTs (build, own, operate, transfer) coming to the market, with further projects currently being tendered under various state-government initiatives. These include the $1.4 billion Mitcham-to-Frankston tollway in Victoria and the $700 million M4 East expressway in Sydney. Deal flow is also expected to grow under the framework of public-private partnerships, or PPPs, although a consistent deal flow is yet to be established. The PPP market in New Zealand is also in the early stages of evolution.
In comparison to other sectors, project finance opportunities in the oil and gas industry have been relatively few in recent years. However, strengthened energy prices, continued rationalizations, and strategic divestments are expected to significantly increase both primary and secondary market activity over the medium term. In Australia, ExxonMobils Delhi, Wandoo and Woollybutt assets are expected to change hands. Several offshore projects are contemplated, and the Perth Basin in Western Australia is expected to be active. Coal-seam methane is gathering momentum in the east. Meanwhile, development decisions are expected shortly on three or four fertilizer projects based on gas-to-liquids technology. Several billion dollars of existing pipelines may be sold, and numerous new project-dedicated and network pipelines are ready to go ahead. In New Zealand, recent oil and gas discoveries and a looming energy crisis will drive renewed activity.
However, the telecommunications and media sector is expected to remain subdued in the near term.
Gordon Platt
