The project finance industry that is emerging from the recent global downturn looks very different than it did in the late 1990s.
In recent years project finance banks have had it tough. In 2001 and 2002 the merchant power debacle, the virtual collapse of the telecom sector and the legacy of crises in Asia, Russia and Latin America took their toll. By 2003 many of the industry’s stalwarts such as Enron and Global Crossing had disappeared, and project finance bankers were licking their wounds. Have they learned lessons from those turbulent times?
According to Richard Burrett, global head of project finance at ABN-AMRO, the answer is yes:“2002 was a year of massive provisioning for bad loans for project finance banks,” he says,“and [consequently] 2003 was a more conservative year, with deals more tightly structured.”
Given the cyclical nature of the industries that project finance serves, there is always a danger the business will lapse into over-exuberance again, but for now it appears both banks and investors are taking a cautious approach to the recovery. As Jonathan Lindenberg, managing director and head of the Americas for project finance at Citigroup, notes,“The market has experienced a flight to quality.”
So where is that recovery taking place? “The oil and gas industry is looking robust, and we will see a continuation of the geopolitical shift from the Middle East to Eastern Europe and the former Soviet Union,” says Burrett. James Pope,director in project and infrastructure finance at Credit Agricole Indosuez, adds that Egypt is due to open its first liquefied natural gas (LNG) project shortly, while the rehabilitation of Libya should spur activity.
“LNG is a driving force, with projects under way in the Americas and in Asia, where Guangdong is due to close in a couple of months,” says Burrett. In more mature markets the importance of LNG will also continue to increase. As Burrett says,“The big question for North America is how it will secure a supply of gas over the next 25 years.” ExxonMobil has just announced a new $600 million LNG receiving station off the coast of Texas in a bid to answer that question.
Meanwhile the UK is set to become a net importer of LNG at some point in the near future, driving growth in project financing for gas transportation in the region.“The UK has the interconnector [linking it to continental Europe] at the moment, but its volume is limited,” says Pope. “There are numerous schemes afoot to bring in Russian and Norwegian gas. In many ways the experience of the UK is following a similar route of that of the US, which went from self-sufficiency to net importation.”
The Power Outlook
In power the picture is patchier, according to Steven Greenwald, managing director and global head of project finance at Credit Suisse First Boston.“In the US much of the activity in 2004 is likely to be refinancing of existing power plants,” he says.ABN-AMRO’s Burrett explains:“Overcapacity continues to dominate the North American and UK markets.The focus is likely to be on restructuring and acquisition financing in 2004 in those markets.”
However, Burrett is more upbeat on the prospects for the power industry elsewhere, with activity picking up in the Middle East and Asia—especially Indonesia.“But we are a long way from the high deal flow of the mid-1990s,” he says.“In many ways the burst of activity that accompanied privatization in those years is responsible for the lull currently affecting the sector.” In Latin America the only country with significant activity in the power sector is Brazil, where attention is focused on the reinforcement of transmission lines, according to Burrett.“Activity in Brazil only really picked up again in the second half of 2003 following a slow period after the election at the end of 2002,” he explains. CSFB’s Greenwald says that the Brazilian government’s indecision surrounding gas fired power plants—encouraging investment and then withdrawing support—has meant that investors are reluctant to put their money into that sector in the near future.
An IFC/World Bank Retreat?
Richard Burrett, global head of
Mining continues to be steady, but Burrett says that some companies are concerned about the IFC/World Bank review on extractive industries. The study has claimed that local communities often do not benefit from large-scale projects. If the IFC/World Bank accepts the report, it might become more reluctant to undertake some projects.“That could make the market more difficult, as some projects in more challenging emerging markets clearly need the support of an organization like the IFC/World Bank if they are going to succeed,”says ABN-AMRO’s Burrett.
CSFB’s Greenwald dismisses any suggestion that the IFC/World Bank is going to stop funding projects.“It will continue to play an important role in the project finance market regardless of any reports produced about social and environmental factors,” he says.“But if the World Bank does decide to do less in project finance, issuers may choose to go to the bond markets.”
Credit Agricole Indosuez’s Pope says that multilaterals are already playing a smaller role than in the past in some sectors.“There is a lot of competition among banks for the energy market, and they are now prepared to finance projects which would have previously required multilateral support,” he says. One development not directly linked to the IFC/World Bank’s report but certainly pertinent to it was the formation of the Equator Principles group in summer 2003 with 10 banks. The group has committed itself to a voluntary set of guidelines “for managing social and environmental issues related to the financing of development projects,”according to the launch statement.A total of 20 banks have now signed up.
“Banks have recognized that there is a benefit to managing social and environmental risks in a systematic way,” explains Burrett. “By benchmarking ourselves off the World Bank, we have effectively become a stakeholder, and they are aware that anything they change has wider repercussions.”
“We expect the bond market to remain strong for project finance,” says CSFB’s Greenwald.“As long as long-term rates remain low,projects will increasingly be funded by the bond market,” he says.
Greenwald says that the market has successfully taken up the slack that resulted from the traditional project finance banks being reluctant to lend as a result of credit problems in the past two years.“While the banks have now come to grips with many of their problems, the fixed-income investors can provide longer and cheaper funds and have developed a greater appetite for project finance structures. That has broadened the range of deals that the public market is capable of funding.”
Local Bond Markets Join The Party
One interesting development in Latin America that is expected to continue in 2004 is the use of local bond markets.“In Chile we did the largest non-sovereign bond for the Autopista Central toll road, which was half in local currency and half in dollars,” recalls Citigroup’s Lindenberg. Local and regional investors—principally pension funds and banks—are becoming much more open to project bonds. Traditionally these investors would have put their money into the best-known companies in their country, but increasingly these issuers are doing structured deals, and there is a corresponding shift among investors.
“It makes sense to finance projects in local currency to as great a degree as possible, as the projects’ revenues are in local currency,” says Lindenberg. Local currency deals are still less than 10% of the entire market, but they could grow to 50% as transactions are completed in countries like Mexico and Brazil.
One major success story has been the use of bonds in Public Private Partnership (PPP) deals—particularly in the UK and Australia. The long government-backed contracts and stable cash flows make these long-dated, often index-linked bonds very attractive to investors, especially pension funds. As PPP contracts spread throughout Europe in 2004, observers expect to see a greater use of the bond markets to fund them.
While appetite among investors for project finance bonds has increased, it is still not true that bonds are suitable for just any project financing.“Oil and gas needs a flexibility that is only offered by banks at the current time,”says ABN-AMRO’s Burrett. For smaller UK oil producers— which are currently buying up projects as the major oil producers exit the North Sea market to focus on cheaper and larger reserves elsewhere—the problem of seeking non-bank funding is even starker.
Smaller firms tend to have a strong requirement for capital, but as the scale of reserves in the North Sea reduces, the risks become larger.“It is difficult for many equity and bond investors to model expected returns from a declining resource base,” notes Credit Agricole Indosuez’s Pope.
According to Citibank’s Lindenberg, there will be a greater use of derivatives and physical commodity trading to credit-enhance project deals in 2004.“We will also see a growth in export securitization of commodities— deals like the Petrobras bunker fuel oil securitization and the Aracruz cellulose pulp export securitization in 2003,” he says. “Driven by the high commodity price environment and the need to diversify funding sources, clients are increasingly willing to utilize reserves to secure limited recourse financing that is both low cost and long term.”
Lindenberg also believes that the market could see new industries like agriculture and industrial goods manufacturers using the project finance market.“Many of these types of firms are looking at project finance because of its non-recourse nature,” he says. “Clients value the off-credit treatment afforded some project financings by rating agencies.”
Finally, progress appears to have been made on Basel II. There had been concerns that project finance loans would be disadvantaged under new capital adequacy requirements imposed as part of Basel II.
But project finance banks have showed through research there is a superior recovery rate for project finance loans compared to similarly rated non-project finance loans and therefore they should be treated differently.“The Basel II committee appears to have recognized this fact,and we may have seen off the threat of a high-risk rating for project finance loans,” says ABNAMRO’s Burrett.
By Laurence Neville