The Project Finance Law Review: Bond Markets and Debt Placements

I Introduction

For every project that cannot be financed by only equity, there is a range of financing sources that sponsors will consider in order to complete the project on limited recourse terms at the lowest debt cost, thus maximising the sponsors' return on capital.

There is a large range of lenders than may offer loans, from international and domestic commercial banks, to multilateral lenders and regional development banks, to export credit agencies and others. However, standing slightly apart from these sources are the capital markets, and when sponsors are preparing a finance plan for a project financing, this source must be considered early on, given it has some very different features and characteristics to loans, and also timelines must be aligned with bond market requirements (particularly in the case of listed bonds).

Project bonds are bonds issued by a project company (or sometimes, for regulatory or structural reasons, another company that on-lends to the project company) in the international or domestic markets to fund the whole or part of a project financing. Bonds that are not listed and are only issued to sophisticated investors are often referred to as 'private placements' to distinguish them from listed bonds that are referred to as 'public bonds'. These differences are considered further in Section II.

In theory, bonds should be an extremely attractive source of funding for many project financings, given they provide access to fixed-rate funding (rather than loans that are typically at floating rates that may need to be hedged at further cost to the project company), and the typical investors in bonds are looking for long-term investments that align with the long-term repayment profile many projects require. However, outside a few markets for specific types of projects, financing by way of loans (largely by commercial banks, but also by various other institutions such as development banks and export credit agencies) has remained the predominant source of funding for international project financings for decades, with project bonds often coming to the front when there are challenges with the other financing sources. There are a number of reasons that this is the case, with one notable one being the considerable challenge that project bonds have on how to handle the construction risk period, as discussed in Section III, and with various others being discussed in Section IV.

On a macro level,2 in 2020 global project bonds totalled circa US$50 billion, with nearly US$16 billion of that being issued in the United States with 30 project bonds (more than the next four countries add together, with France at US$7.2 billion with 13 bonds, the United Arab Emirates at US$4 billion with one bond, Israel at US$2.25 billion with one bond and the Netherlands at US$1.77 billion with two bonds). This global project bonds total was down 14 per cent year-on-year as compared to 2019, although the 2019 global project bonds total was up 25 per cent as compared to 2018 (and the 2019 global project finance loans total was only up 3 per cent as compared to 2018, so the project bonds performance was particularly notable), which may indicate the trend more accurately given covid-19 impacted the markets so dramatically during the majority of 2020. By way of perspective, the global project finance loans during 2020 totalled circa US$277.6 billion (with the United States constituting circa US$53.5 billion of this) and new exposure (loans and guarantees) by major export credit agencies and development banks totalled circa US$30.4 billion.

In context then and historically, while project bonds were at one point in the 1990s seen by some as likely to become a predominant funding source for project financings globally, their use has tended to ebb and flow with the comparative availability of loans, which have generally remained the 'default' financing source for project financings on a global level. This is region-specific to some extent, and many projects have been and continue to be funded by bonds in the United States, and to a lesser extent in Europe; for example, over the years a reasonable number of the UK's private finance initiative (PFI) projects have been funded by bonds. On the other hand, outside a handful of more developed markets (e.g., Nigeria, Kenya and South Africa), bonds have not been a major source of financing generally in much of sub-Saharan Africa.

The global financial crisis in 2008 provided a new opportunity for project bonds to become more emergent given new regulations such as Basel III made it increasingly more expensive for banks to provide long loan tenors, which are the lifeblood of traditional project financings, and many banks had and continue to have liquidity and tenor constraints compared to before that point. This has impacted banks from different regions differently, with US banks pulling back heavily from long-tenor project financings, whereas (for example) a number of Japanese and Chinese lenders have continued to be able to offer longer tenor debt to appropriate projects. The bond market has also had to adapt, for example the downgrading of monoline insurance companies has meant that more project bonds must proceed 'unwrapped' without the credit enhancement this traditionally given (see Section VI).

Project financings in the GCC region of the Middle East are illustrative of this history and the 'competition' between different funding sources, with a number of highly rated sponsors developing huge projects financed on limited recourse terms, with differing financing sources being preferred for projects over the years, but bonds yet to take an oversized share. In late 1996, the landmark US$1.2 billion project bond was issued for the Ras Laffan Project in Qatar, being twice oversubscribed in demand for the largest bond of any international project at that time. Bond financing was again present in 2005, with the Ras Laffan II and 3 Projects in Qatar (financed together) having both bond and bank loan financings, with both heavily oversubscribed. However, in 2007, for the Qatargas 4 Project, the original plan to have both bond and bank debt financing was switched to bank debt only to meet the desired financing schedule (also avoiding capital markets uncertainty following US sub-prime mortgage issues). Further, over the years, other similar gas projects in Qatar did not include bonds, including Qatargas 1 (1996), Qatargas 2 (2004), Qatargas 3 (2005) and Barzan (2012), with these projects being financed by a varying mix of commercial bank debt and (for some) Islamic financing and export credit agency financing and support. Project bond issuances in other GCC countries have also followed a similar pattern, with the majority of projects financed by loans but occasional large project bonds, such as Shuweihat 2 (2013) in the United Arab Emirates, and Sadara (2014) in Saudi Arabia. The availability of sufficient commercial bank liquidity (including strong domestic and regional commercial bank liquidity pools), together with Islamic financing, export credit agency and development bank support has meant that most project financings in the GCC have not to date resorted to project bonds. There are, however, positive recent signs, with an Abu Dhabi National Oil Company (ADNOC) related pipeline company issuing a US$4 billion bond in October 2020, described as the largest project bond ever raised, followed shortly after in February 2021 by a US$3.92 billion bond, in both cases to refinance existing bank financings (and related hedging and other costs).

II Project bonds, private placements and loans

Colloquially, reference to bonds often brings to mind public issuances of credit agency rated listed bonds, with the accompanying regulatory, disclosure and timing burdens this brings, and this initially leads to some sponsors discounting bonds as a financing source for their projects.

This can be misleading, as the private placement market in particular has developed strongly since the 2008 global financial crisis, giving access to the liquidity pools of insurance companies and pensions funds in particular that want to make fixed-return long-term investments to match their long-term fixed liabilities, while not necessarily increasing the regulatory and disclosure burden that much compared to the loan markets.

Private placements can in some ways be seen as a hybrid between a public bond and loan financing, in that they are financings between a issuer (borrower) and a limited known group of investors (lenders). This similarity is often reflected through the terms, with decision-making mechanics and financial commitment of investors pre-financial close sometimes being more akin to bank loans, and in some cases investors being able to provide flexibility with deferred drawdowns more similar to that offered by bank financings.

A major advantage of a private placement is that in most jurisdictions, provided requisite conditions are satisfied (e.g., only involve sophisticated investors), these issuances do not need to be registered in the same way that public bonds are (for example, with the UK Financial Conduct Authority and the US Securities and Exchange Commission), and importantly private placements typically lack many of the disclosure and filing requirements required for public bonds. Private placements will also typically not involve a credit rating, and will usually involve a cheaper, more streamlined process than a public offering. Conversely, the reduction in liquidity (both from not being listed and not having a credit rating) can mean a private issuance has a higher coupon (interest).

Private placements then, from a sponsor perspective, are perhaps best considered as being a product that gives access to fixed rate long-term financing from non-bank lenders such as insurance companies and pension funds that may not otherwise be willing or able to lend to project financings.

III The construction challenge and negative carry

The days of projects being financed and then the original lenders or investors committing to stay in the financing for the full term for relationship and other reasons are long gone, and equally sponsors may look for financing at different stages of the life of a project.

Loan financings and project bonds may thus be sought at different stages in a project, including in the initial construction phase of a project, to refinance an existing project after it is operational (i.e., post-construction), and to finance the acquisition of a project (typically also post-construction).

Financing of a project during the construction phase is seen as one of the greatest barriers to the use of project bonds in project financings. Bond investors have traditionally looked to invest in a revenue-producing asset that does not have a variable risk like a project financing has (i.e., absent sponsor support during this period, a much higher risk during the construction phase that repayment may not occur, as compared to the operating phase), nor are bond investors typically set up to monitor projects in the way that is often required during the construction phase and to be involved in the project completion process in the way bank lenders typically are.

A further challenge for bonds during the construction phase is that a project company often requires money over a number of years to pay construction and related costs as it incurs them (for example at construction milestones). In loan financings, commitment fees are paid to ensure these amounts are available, but lenders do not disburse them in one lump sum; rather they disburse upon request during an availability period when required to pay costs (for example, to cover costs anticipated in the next 30 days). In the case of bonds, particularly public bonds, the nature of the product means that bond proceeds are usually provided to the project company in one lump sum. While this may initially appear advantageous to the project company, until used for construction costs, documentation will require bond proceeds are held ring-fenced in very low risk investments that will have a yield below the interest payable on the bonds, and thus there is a 'negative carry' cost for the project company.

The capital markets have not stood still in light of these challenges. In Section V, approaches on credit enhancement are discussed that can help alleviate construction-related concerns. In Section IV.ii, approaches to disbursement are discussed, which can help alleviate negative carry concerns, and in Section IV.iv, approaches to decision-making are discussed that can help mitigate the challenge that decision-making processes pose for bond investors.

In recent years, extremely innovative bonds have come to the market that resolve a number of these construction related challenges adequately from both a sponsor and investor perspective. For example, in 2018 a €1.77 billion bond financing for the construction of the Superstrada Pedemontana Veneta toll road in Italy completed, which involved listed senior and junior notes, and a delayed draw financing structure whereby issue proceeds were put into a liquidity management transaction and made available to an escrow account in instalments (the size of which could be varied within limits) and then released for construction costs upon satisfaction of pre-agreed conditions.

IV Other key features of project bonds

Project bonds are most typically considered as an alternative or supplement to commercial bank debt, and thus sponsors will typically consider the features of project bonds as compared to commercial bank debt. While both these categories are wide and varied (with some private placements being closer to bank financings than public bonds), in addition to the considerations set out in Section III, there are some other general threads of difference that can be critical to consider.

i Tenor and mini-perms

Project financings typically require long-term financings. As discussed elsewhere in this work, while historically commercial banks could provide loans of up to 25 years, many commercial banks post-2008 financial crisis struggle to have tenors extending beyond seven to 12 years. In contrast, bond investors typically have no institutional concerns with tenors in the 25 to 30 year range, and in fact this is often in line with their preferences given their liabilities are occurring over an extended period also. Thus, to the extent that a project financing using bonds can overcome the construction challenge referred to in Section III, bonds appear to be an ideal candidate for project financings.

Once innovative way that the construction challenge can be handled, led by financings in the United States and Middle East in particular, is an innovative approach of structuring transactions with shorter term bank financing with the expectation of bonds refinancing at a later stage has become highly attractive, allowing banks to provide value at the stage of a project when more active lender involvement is required, while allowing bonds to provide the long-term financing the projects require. This financing approach is typically described as a 'mini-perm loan' with a take-out by project bonds. While use of this approach is growing, it is most appropriate for projects with strong sponsors in markets where bond take-outs have a good history of success, given that the mini-perm financing must be refinanced (at least in the case of a 'hard mini-perm'), and so lenders to that facility must be sufficiently comfortable refinancing will be achievable in the future.

ii Lump sum drawdown

As mentioned in Section III, traditionally bonds provide the issuer with the bond proceeds in one lump sum, which leads to negative carry for projects that require monies over a number of years to pay construction costs as they accrue, which has made project bonds unattractive for financing many projects with longer construction periods. This contrasts with loans that typically have an availability period, and the project company can draw down amounts as and when required (subject to minimum amounts and maximum drawdowns, and so project companies would typically draw down the next 30 to 90 days of upcoming construction and other costs and expenses).

The bond markets have recognised this and there are a couple of innovative approaches that are collectively referred to as forward purchase bond products. First, some project bonds involve a payment schedule whereby the bond investors invest in accordance with a pre-agreed investment timeline. An even more flexible project bond product involves the project company being able to require bond investors to invest when it chooses, and paying a commitment fee in the interim – this approach substantially replicates a loan financing's availability period and commitment fees. An example of this type of structuring is the October 2019 4.3 billion Kenyan shilling bond set up by Acorn to part-fund a student accommodation project in Nairobi. The bond, dual listed in London and Nairobi, was structured as an upfront commitment with a deferred drawdown schedule as well as an early redemption clause.

iii Interest, sizing and timing of certainty

Sponsors look to gain substantial comfort from commercial banks and other lenders (such as development banks and export credit agencies) relatively early in the financing process, with lenders providing commitments that are specific as to interest rates and other fees, and amount of loans they are able to offer. This does not reflect in the process for public bonds in particular, where the coupon (interest rate) and size is only formally confirmed a few days before the issuance of the public bonds.

There is, however, a convergence of approach, with early commitments as to interest, fees and size by investors into private placements in particular similar to bank financings, and equally banks increasingly look to have some conditionality in commitment letters for loans such that pricing may be adjusted for changes in the market, or even simply difficulties in syndication (although relationship concerns may make banks hesitant to exercise these rights with repeat sponsors). Equally, while bond pricing may not be certain as early in the process, financial advisors typically can give enough of an indication of anticipated pricing for sponsors to compare bonds to other financing options.

iv Repayment, prepayments and refinancing

One of the features of a project financing is that the risk profile typically changes over the life of the project. This is particularly the case during the construction phase, when the risk of the investors or lenders not getting repaid is highest as the project is not revenue-generating, although conversely in the case creditworthy sponsors provide completion support, the construction period may be the lowest risk period for lenders.

The varying risk profile of a project over its life can provide financial incentives for sponsors to look to refinance during the life of a project, typically post-completion when an established revenue generating period can be demonstrated, over and above the usual refinancing situation where borrowers look to refinance due to liquidity in the market offering a better price than available at incurrence.

Commercial banks, development banks and export credit agencies have generally accepted that borrowers may look to prepay (in whole or part) and refinance their loans, with different markets varying as to whether prepayment fees will be payable, and also hedging breakage costs in particular may be payable. Additionally, loans on occasion have different interest rates applicable during construction and operational phases which align with the changing risk profile of the project more closely (or, in some cases, be used to encourage a refinancing but not require it). Overall, prepayments and refinancings do not generally raise substantial issues for these lenders, and fees for project companies to prepay or refinance tend to be relatively small (although they can be substantial enough to make an otherwise attractive refinancing unattractive).

The situation is very different for a bond investor that has chosen to invest in project bonds in part due to the long-term nature of the funding, which matches its liabilities. Furthermore, EU-regulated insurers may have applied to regulators that a 'matching adjustment' be applied to their project bond portfolio to mitigate the impact of below investment grade project bonds on their solvency calculation, and thus larger compensation will be required if early prepayment of such project bonds is desired. These considerations mean that project bonds typically involve a sizeable 'make-whole amount' being payable for prepayments, such make-whole amount reflecting the difference between what the project bond would have paid to full term compared to a reference rate or similar that is seen as low or no risk.

v Covenant package and decision making

Project bonds typically have lighter covenant packages in comparison to loans, which reflects that bond investors do not expect to be involved in the project on a day-to-day basis, and tend not to be set up to be involved in monitoring projects or being involved in anything other than a passive investor role.

Project bond covenant packages thus are, in general terms, restrictive on an incurrence basis rather than being maintenance or performance based, allow various actions to be taken (subject in appropriate cases to objective criteria on having no material impact on the project) that typically require consent in equivalent loans, and do not involve as much interaction or reporting to investors as typically required to lenders in equivalent loans.

These differences typically work in the project company's favour as compared to loans, from a perspective of the restrictions on their actions, the required interactions with investors, and the likelihood of a default being triggered by any particular event.

There is, however, a related downside, in that if in the future the project company does need a consent, waiver or other action by bond investors, the decision-making process is typically slower and more challenging than it would be under an equivalent loan financing.

V Credit enhancement

The investor base for project bonds typically comprises of insurance companies, bank treasuries, pension funds and asset managers looking for long-term assets with predictable and relatively safe revenue flows. While more bond investors are becoming increasingly involved and sophisticated in analysing projects, there continues to be less appetite for more risky projects, particularly during the construction phase. In some cases, project sponsors have been willing and able to provide completion guarantees or other support to mitigate the completion risk; however, this is not always possible and other credit enhancement may be necessary.

Credit enhancement has historically provided a key way of allowing bond investors to invest in projects that would not otherwise meet their required risk profile. Starting in earnest in the 1990s and particularly in the United States and other developed markets in Europe, commercial monoline insurers that held high ratings (e.g., AAA) were able and willing to guarantee bonds issued by project companies. This gave the project bonds the same rating as the monoline insurers, with the project bonds being described as 'wrapped'. However, substantially all such major commercial monoline insurers were heavily impacted by the 2008 global financial crisis, and many downgraded, or have adjusted the price of the wrap dramatically, and so wrapping by a commercial monoline insurer is no longer a practical option for many projects and project bonds.

Nevertheless, governments have paid heed to the role commercial monoline insurers played in opening up the capital markets for project financings, and given the importance of private finance for required infrastructure and other projects, governments and multilateral institutions have been willing to step in.

An example of this is the European Union's Project Bond Initiative (PBI), which started development in 2010 and is explicitly in place to facilitate investment by institutional investors such as pension funds and insurance companies. Under this initiative, the European Investment Bank (EIB) (which has a rating of AAA) can provide subordinated financing, funded or unfunded guarantees and contingent credit lines designed to enhance the credit quality or credit rating of the senior project bonds debt. Similarly, the International Finance Corporation (IFC), a part of the World Bank Group, utilises its AAA rating to offer credit enhancement of project bonds under a 'partial credit guarantee' programme, and similar programmes are in place from other key development banks. Export credit agencies have also stepped in and provided credit enhancement for project bonds. ECA guarantees for project bonds, while similar to ECA guarantees of bank loans, have tended to adopt certain aspects of monoline guarantees, to support an uplift in the bonds' rating, for example. This is particularly helpful in emerging markets projects, where it is advantageous for attracting investment to obtain a credit rating for a project that is higher than that assigned to the country in which the project is located. This can be achieved by the inclusion of credit enhancements satisfactory to the rating agencies.

Finally, while some specialist debt funds have examined the use of mezzanine project bonds, including structures that involve subordinated bonds designed to provide a 'first loss' debt tranche for the project, this is not yet a developed market that has taken off in earnest for most projects.

VI Use of bonds in a multi-sourced financing

Bonds are also sometimes used in multi-sourced project financings. It has become an increasingly common occurrence for project bonds to sit alongside loans from commercial banks, and sometimes also export credit agencies and multilateral lenders and other sources, particularly for large scale energy projects. Furthermore, in some cases, even for some project financings that do not involve project bonds, the use of project bonds was under active consideration until late in the financing process, and sponsors may require that documentation be set up such that project bonds could take out some or all of the facilities under the project financing in the future.

There are differing choices on how to handle these different groups from an intercreditor, covenant and voting perspective. Documentation can be set up that has a core covenants package that applies to bond investors and lenders, with a further covenant package that applies to lenders of loans only, or alternatively a blended covenant package can be negotiated that reflects a midway between a typical bond package and loan package. The approach must be considered up front in consultation with the financial advisor, given the dramatic impact this can have on the liquidity available to the project financing from different sources.

Similarly, informational requirements and decision-making needs careful consideration, to manage the contrast between lenders that would expect disclosure of substantial amounts of information, and to monitor operational and credit issues on a real time basis and be able to provide consents and waivers to the extent needed, particularly through construction, compared to bond investors who would expect only to be notified of more fundamental matters and not to have consents and waivers required from them. From a decision-making perspective, developing appropriate intercreditor mechanics for multi-sourced financing requires a clear picture of the make-up of each debt source relative to the others and a consideration of minority rights. Where bondholders are in the minority, they may well be willing to allow majority creditors (banks, multilateral lenders and export credit agencies) to decide non-fundamental waivers and consents without their involvement, but this can be complicated if the maturity of the project bond is very different to that of the loans, so that this changes over time.

VII Outlook

Project bonds are a well-established financing source for project financings, particularly (from a sector perspective) in the oil and gas, power and transportation sectors, particularly (from a geographic perspective) in the United States, and particularly (from a project life perspective) for refinancing of existing project finance debt post-construction.

There are signs that each of these historical areas of focus of project bonds is opening up in the future, given the wide recognition that accessing the deep liquidity pools of insurers, pension funds and other institutional investors will be critical to finding long tenor liquidity pools given the constraints on commercial banks, that are likely to continue into the future.

2020 has added even further to the political and societal impetus behind renewables, green financings and ESG considerations, and a convergence of the rapidly developing green bond market and project bonds market offers the opportunity of providing the institutional investors' deep resources to finance the multitude of green projects necessary to meet the globally committed environmental targets, while also offering institutional investors a way to participate in asset classes that they are being directed to invest in.

While the United States is likely to remain the dominant issuer of project bonds in the near future, the continued bank market liquidity constraints globally will continue to encourage the use of project bonds to access further and different liquidity pools. A number of innovative products such as mini-perms will continue to evolve (and migrate from the United States where already in use, as mini-perms have from the United States to the Middle East in particular), providing a way for bank debt to finance the construction phase of projects, while project bonds take out the debt post-completion allowing the bank debt to be redeployed for other projects.

At the same time, particularly for projects with strong sponsor support during construction, project bond investors are increasingly starting to be willing to cover the construction phase.


Footnotes

1 Adrian Lawrence is a partner and Chloe McWeeny is an associate at Ashurst LLP.

2 Figures in this chapter are derived from Crédit Agricole CIB's Project Bond Newsletters accessed at https://www.ca-cib.com/project-bond-newsletter in April 2021.

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