Mending project finance

Global Finance, May 2003 by Johnson, Mark

This market has taken a battering but lenders are going back to basics

Times are tough in the project finance market as lenders pull in their horns, equity investors scuttle home with their tails between their legs, and project after project gets its credit scorched.

"Not since we began rating projects have we seen such credit erosion," says William Chew, managing director of corporate and government ratings at Standard & Poor's in New York. "And it's not just isolated project problems-but real defaults."

It's in the US power sector where the pain has been felt the most. Desperate to take advantage of deregulation, gung-ho power companies had borrowed $435.8 billion by the end of 2002, according to Charlottesville, VA-based research firm SNL Financial.

"A massive debt bubble," is how Karl Miller, senior partner at Miller McConville, describes the situation. His New Yorkbased firm was set up to stalk the wreckage of the US power sector. Increasingly, Miller and his like will be buying from bank lenders who have been left holding the keys to bust projects.

Combine that chastening experience with a whirlwind ride in emerging markets such as Brazil and Argentina and it's little wonder that risk appetite has been sharply curtailed for projects across the globe. New issues of bonds and loans for projects almost halved, from $138 billion to $77 billion, in 2002, according to figures from data providers Dealogic in London. Players have been bailing out from both sides. Portuguese power company Electricidade de Portugal is typical in deciding to retreat to its home market after forays into Brazil left it bruised. In March, German airport operator Fraport wrote off the entire euro293 million investment it had made in a new terminal in Manila, after protracted wrangles with Philippine governments. Credit losses, emerging marKet volatility-and looming changes to the regulatory capital regime-have prompted a number of banks to exit from the markets. That's included onetime big hitters from Germany, Japan and the US.

"The disappearance of so many banks has had an inevitable effect on liquidity," says Tom Hardy, global head of project and export finance at the Royal Bank of Scotland in London. But it's not all bad news. Batul Sharif, a senior analyst at Dcalogic, says European and Australian banks are still opening their pocketbooks in areas such as infrastructure and partnerships with state bodies. And a small circle of banks remain committed to project markets across the globe. They are not about to jump ship. "This market is battered, not bust," says Chris Beale, global head of project finance at Citigroup in New York. he points out that project financings typically held up far better than mainstream corporate lending in recent sector meltdowns.

For leading lenders it's a question of taking a deep breath, looking at new ways of doing things-and going back to square one. "Banks have learnt a tremendous amount of lessons over the past couple of years," says RBS' Hardy. "We've reasserted some of the basic principles of project finance-cash inflows and cash outflows," says S&P's Chew. He argues that in the go-go days investors placed too much faith in contracts with parties such as power users that proved illusory when it came to the crunch. "It proves the absolute importance of stand-alone analysis," says Chew. AES Drax, the largest power plant in the UK, was forced to renegotiate some $1.5 billion of bonds and loans in November 2002 when its principal customer TXU Europe went into administration.

That new caution is being reflected in the structures arranged by project financiers. Sponsors such as a power company now have to stump up more equity and typically at the beginning of a project rather than at the end. "There has been a dramatic refocusing by banks on key facets of risk and risk strategy," says Hardy.

In truth, credit committees have often struggled to cope with the intricacies of project loans. Complex, often opaque, project financing has also suffered by association with other out-of-favor forms of structured lending-and that's made it harder to get deals past internal committees. Projects are often big and lumpy, involve lending to newly set-up entities and can involve parameters such as political risk that are hard to monitor. All of that makes fitting project financings into the actuarial risk models that dominate the portfolio management structures of most modem banks a little like fitting a square peg into a round hole.

But that's a trick bankers are trying to pull off. With large areas of the globe desperate for infrastructure investment, the game is worth it.

Citigroup's Beale points out that almost all arenas of project finance-energy, power, communications and transport-are likely to grow at a faster clip than headline GDP. Even wealthier countries are seeking to use private money to deliver public goods. In August 2002, the Italian government set up a new agency called Infrastrutture, a key part of whose task will be to mobilize project finance to overhaul the country's ageing railways, roads and bridges.