Challenges in Refinancing P3 Debt in Canada:

Transcription

1 November 0 Hugh Sutcliffe Director JCRA Canada Jean-Francis Strayer Director Operis North America Challenges in Refinancing P Debt in Canada: Swap Termination The international investment community has flocked to Canadian shores over the last years as a steady stream of project finance transactions has made it across the finishing line supported by the public sector. However, the financing of infrastructure deals has continually evolved, presenting new risks and challenges, particularly with refinancing bank loans and, more specifically, the impact of a P refinancing on underlying interest rate swaps. Operis and JCRA have been at the forefront of such major trends in both infrastructure financing and the procurement of projects. 1

2 Challenges in Refinancing P Debt in Canada - Swap Termination Challenges in Refinancing P Debt in Canada - Swap Termination Since 00, Operis has been active in the Canadian P sector working on more than 0 of the 0+ transactions completed. The largest to date was the Golden Ears Bridge, for which Operis provided due diligence and modelling advisory services. JCRA s involvement in the region has been steadily increasing over the last decade and it is now considered the leading capital markets advisor for the Canadian P sector. The track record for bond financing P transactions in Canada has steadily increased over the last five years. As a result, pricing margins have come in from a high of roughly 00 basis points (bps) in 009 to circa bps in 0. While, historically, most bond financings were structured as club deals, underwritten deals are now gaining traction. Canadian Greenfield Ps and renewables debt issued Type of transaction per year Environment Power Other Renewables Social Infrastructure Transport Canadian Greenfield Ps and renewables Number of deals per sector per year Bank/Bond Hybrid 0 Only Bank Only Bond Source: InfraDeals The global credit crunch from did not dampen appetite for bond-only deals. However, bankonly and bank-bond hybrid financing structures became alternate sources of capital for infrastructure projects. A bank/bond hybrid transaction typically has a construction financing facility along with a long term bond structure. Bank only deals are more frequently found in the form of mini-perm loans for renewables projects requiring shorter payback periods, along with P deals requiring construction financing only (s.a. DBF or DBOM transactions). 9 Source: InfraDeals As indicated in the above graph, the number of renewables transactions in Canada has significantly increased in recent years, the majority of which represent greenfield transactions that may require refinancing in the coming years. Mini-perm financing Mini-perms emerged as a form of P financing structure where financing maturity is set typically in response to the reduced tolerance of banks to under years (usually - years), forcing the project sponsor to refinance on or before maturity or the long tenors required by the conventional P structure. A mini-perm financing involves the face defaulting. Contrary to a hard mini-perm, extension of a medium-term financing facility a soft mini-perm is a structure without this default risk at maturity, there are instead contrac- which corresponds to the construction period and, in some cases, the early years of operations. tual rate increases in place to encourage the borrower to refinance. Soft mini-perms also often While interest rate swaps for a construction come with cash sweep requirements, locking-up financing will typically have maturities of - an excess cash for debt repayment (instead of year, mini-perm financings can reach years. equity distributions); hence strongly encouraging parent companies to refinance. There are two types of mini-perm structures: soft and hard. A hard mini-perm is a project finance

3 Challenges in Refinancing P Debt in Canada - Swap Termination Challenges in Refinancing P Debt in Canada - Swap Termination In the case of soft mini-perms, the European Investment Bank s P Expertise Centre ( EPEC ), for example, suggests that the procuring authority should ensure that: the sponsors fully underwrite the refinancing risk; the bidders adopt transparent and realistic refinancing assumptions, so that financing can withstand a potential downside scenario; the finance plan details the mitigation measures provided to cover a potential downside, (e.g., additional equity to be evaluated against the sponsor s or guarantor s balance sheets); the benefit of the primary refinancing is factored into the price, or the additional short-term costs still provide value for money; and there is an equitable sharing of any refinancing benefits between the authority and the sponsors, at least over and above what is assumed in the base case A Canadian sponsor had developed an infrastructure asset that had a year contracted revenue stream (e.g. power purchase agreement in place with a public utility for the production of renewable energy). While the project had been financed by way of a $00 million -year bank term loan, the liability profile had been extended to match the revenue stream by way of a year interest rate swap. Four years on, credit market conditions had improved, leading the sponsor to consider refinancing the $00mm bank debt at lower credit spreads. However due to a decline in interest rates and a general flattening of the yield curve the MTM liability on the swap had increased significantly. The sponsor had executed the swaps with a syndicate of banks, and the MTMs provided by the banks reportedly summed to a $mm liability. It should be noted that mini-perms are not an entirely new concept. Prior to the crisis, banks did lend from time to time on a medium term basis while expecting a rapid take-out through refinancing or cash sweeps, although this was subject to project performance. Hence, banks would impose a margin step-up after a period of to 1 years to compel refinancing. The cost of breaking-up Issues related to terminating an interest rate hedge when refinancing As credit conditions improve and/or a loan approaches maturity, sponsors have sought new financing arrangements. While these financing alternatives are being explored, an often overlooked financing item is the mark-to-market ( MTM ) liability on the existing interest rate hedges. The pricing of this liability is complex, opaque, and is an area of considerable savings for project finance sponsors if understood. However the banks calculation of the MTM on swaps for these rather unique project finance transactions is oftentimes unclear and not necessarily reflective of executable levels at which the swaps could be terminated. The difficulty in obtaining clarity on swap termination payments is illustrated by a recent renewable P refinancing example. As with most project finance hedging transactions, the banks counterparty credit risk exposure to the project is secured by the same assets as that of the loan. The loan and swap documentation outline the pari nature of this security relationship as an Automatic Termination Event ( ATE ). Simply put, if the loan is refinanced the swaps must be terminated and the MTM liability paid to the bank group. In our renewables example, further, new at the money swaps were required to be executed as a condition of the new loan agreement. Three critical elements in negotiating a swap termination Several factors must be taken into account when a refinancing package involves terminating existing hedges and replacing them with new at the money swaps. To negotiate these savings, a strong understanding of CVA/FVA calculation methodology and termination rights under International Swaps & Derivatives Association (ISDA) standards are critical. Here are three critical items that are part of the negotiation: 1. Transparency of bid/offer spreads Banks typically provide an MTM on existing swaps in absolute dollar terms, while the new hedges are quoted as a fixed rate. Care must be taken to reconcile the two methodologies and determine whether at market bid/offer spreads are being quoted.

4 Challenges in Refinancing P Debt in Canada - Swap Termination Challenges in Refinancing P Debt in Canada - Swap Termination. Credit Value Adjustment (CVA) At the time a bank executes a hedging transaction with a counterparty, it must take into account the risk of the counterparty defaulting on its obligation during the life of the contract. This counterparty exposure is particularly important for project finance transactions given the increased probability of default when compared to a typical public finance deal (with recourse on the authority s full faith and credit) and due to the long dated nature of the hedges. Banks price this risk by way of Credit Value Adjustment (CVA), which takes into account: the expected exposure profile of the derivative over its life, the probability of the counterparty defaulting at any point in time, and the amount recoverable by the bank in the event of default. This CVA is then held in reserves and is managed by bank trading desks over the life of the hedge. That said, at time of the hedge termination the bank is relieving itself of future risk of its counterparty defaulting, and CVA reserves that have been set aside are released into bank trading book earnings. That is, the bank is generating profit while eliminating future counterparty exposure. In our example, the CVA release was estimated at $.1mm, which can be negotiated as a rebate to the sponsor as an offset to the MTM owing.. Funding Value Adjustment (FVA) A similar bank reserve concept relates to the asymmetric nature of collateral support for transactions with project finance counterparties relative to interbank transactions. In the case of our renewables project, the bank syndicate acting as the swap counterparty had a $mm MTM receivable for which its security were the assets of the project. However at time of initial swap execution, the bank had hedged its market risk in the interbank market, in which transactions are typically supported by documentation requiring banks to exchange cash collateral. So in this case the bank had a $ million MTM payable for which it must pay funding charges on the pledged cash collateral. The forecast of these funding charges over the life of the derivative is held in reserves as Funding Value Adjustment ( FVA ). As in the case of CVA, these reserves can be released at time of swap termination. In our renewables project, our estimate of FVA held against our client s position was $.1mm. Bank Debt refinancing The way forward The interest rate swap MTM liability has become a significant issue for project finance sponsors. Not only has the size of these liabilities increased due to the almost 00 basis point decline in long term interest rates in the wake of the 008 financial crisis, but banks are increasingly taking these liabilities into account when sizing debt capacity on refinancing transactions. This issue will become increasingly relevant to the interests of project finance sponsors and their investors as the secondary market for P assets increases. About the authors Hugh Sutcliffe, CFA is a Director of JCRA based in Toronto, with responsibility for JCRA s business in Canada. He was the founder of Nauset Derivative Advisory, a practice providing cross-asset class derivative and hedging advice to corporations and financial sponsors in a variety of sectors including renewable power and infrastructure. Hugh has over years of capital markets experience, predominantly in the derivatives area. Prior to advising clients, he was at RBC Capital Markets for years where he structured, and executed hedging transactions referencing most asset classes, including interest rate, foreign exchange, equity, and credit. He has been involved on assignments for energy producers, power developers/operators, diversified corporations, and financial sponsors. Prior to joining RBC, he worked in various client facing capacities at General Re Financial Products and CIBC World Markets. Jean-Francis career in project finance and infrastructure spans over 1 years. Jean-Francis has served as Director both in a banking context and as a financial advisor to public authorities and bid-side players, leveraging complimentary roles as lender and financial advisor to public entities and to private sector companies of all sizes. His typical engagements have centered on providing support to private sector clients in the preparation of P bid models, the elaboration of financial and commercial strategies and responding to RFQ /RFP in the context of large public sector infrastructure projects At Operis, Jean-Francis advises clients on high profile project finance and infrastructure transactions covering most asset classes across in Canada and the USA.

5 Established years ago, JCRA provides financial and treasury advice to private and public clients, including capital market and hedging advice related to the P, project finance, and energy sector. JCRA initiated its P capital markets advisory service in 199 and now operates in Canada, USA, UK and Europe. Following our expertise in the PPP sector, we then initiated our Canadian capital markets advisory services in 0. In order to serve the growing needs of our Canadian clients, we opened our Toronto office in 01. Our services generate improved profitability and reduce costs through client-oriented, independent and transparent financial risk management advice. Bloor St. West, Suite 00 Toronto ON MW R1 T: info@jcraus.com jcragroup.com Operis provides Financial Advisory; Model Auditing; Model Development; Training; and Financial Modelling Software services to public and private sector clients across multiple sectors. The firm has its origins as a specialist in the financial modelling of project finance and P transactions. That expertise remains a distinctive strength. Over time, Operis s activities have widened to cover Model development, Financial advice, Model audit and due diligence services. With experience on more than 90 projects over years, the Operis team has advised on nearly 0 highway P projects and more than: rail projects; airport and seaport projects; and street lighting projects. 1 Bay Street, Suite 0 Toronto ON MJ T T: info@operis.com operis.com