Chapter 13
Sources of Project Funds
The project sponsors typically provide the greatest proportion of initial project equity. Often, the purchasers of the project's output are also asked to make equity investments in the project. Outside equity investors, usually financial institutions, may be offered the opportunity to invest equity in a project.
Commercial banks and life insurance companies have traditionally been the principal sources of debt for large projects. In the typical financing structure, commercial banks would provide construction financing on a floating-rate basis, and life insurance companies would then provide “permanent financing” on a fixed-rate basis by refinancing the bank loans following project completion. The development of the interest-rate swap market has given borrowers the flexibility to recharacterize floating-rate loans into fixed-rate obligations. Also, during the 1980s, commercial banks became willing to accept longer loan maturities. As a result of these developments, commercial bank loans were used to an increasing extent during the 1980s and became the principal source of long-term debt for project financing.
Stricter bank capital regulations instituted in 1989 forced many banks to cut back on their lending commitments, thereby reducing the availability of bank financing for large projects. However, investors in the public and quasi-public debt securities markets have been willing to invest in certain types of relatively low-risk projects. The development of these markets for project debt securities only partially offset the effect of the reduction in bank lending.
Since the 1990s, infrastructure projects have become a high priority. Oil and gas projects and power projects have attracted large amounts of financing. Commercial banks, having adjusted to the tighter capital standards, have expanded their role in project financing. They advise as well as lend. As discussed in Chapter 4, the public and quasi-public debt markets have become more receptive to project debt issues that are properly structured, including non-investment-grade debt. Those debt issues that qualify for an investment-grade rating enjoy the widest market. Finally, multilateral agencies, such as the World Bank and the Inter-American Development Bank, have stepped up their efforts to combine public and private sources of capital to finance infrastructure projects. Perhaps more than ever before, the financing package for a project is likely to draw on several sources of funds in order to tailor it to the particular needs of investors and project sponsors.
This chapter provides an overview of these sources of financing.
Equity
In evaluating the attractiveness of an investment in a project, prospective equity investors will assess the benefits that are expected from the operation of the project. Such benefits include, at a minimum, earning an acceptable rate of return on funds invested. They may also include obtaining an assured source of supply by taking some portion of the output of the project, or securing an assured market for their own output by selling raw materials or providing services to the project. The expected benefits must be commensurate with the project risks to the equity investor, in order to justify the equity investor's commitment to invest funds in the project.
Several factors bear on who will be most likely to make an equity investment in a project. In addition to the usual business and financial risks that equity investors must typically endure, sponsors of a project are often contingently liable for additional assessments in the event cost overruns occur or the project fails. Project failure typically triggers debt repayment. If the project requires a long construction period, equity investors will have to accept delayed dividends. A project cannot pay dividends before operations commence, and lenders normally restrict the payment of dividends during the early years of operation, until the debt has been substantially repaid. They naturally prefer that all available free cash flow be applied first to repay project debt.
The equity investors in a project typically are those parties who will directly benefit from the operation of the project: the purchasers of the project's output, the owners of any natural resource reserves the project will utilize, and the suppliers of essential products and services to the project, including engineering firms. It is generally not possible to offer common shares to public investors at the inception of a project. After the project entity has demonstrated a record of profitability and the period of time until the commencement of cash dividends has been reduced to an acceptable length, common equity or other forms of junior securities may be sold to the public and to other passive investors.
Large financial institutions and private equity funds are typically sources of equity for projects. Sovereign wealth funds, which are huge pools of capital, are good potential sources of equity for projects within the country or within the region.
Structuring the Equity Investments
Structuring the equity investments in a project involves four main areas of concern: (1) how to organize and capitalize the venture, (2) how to manage and control the venture, (3) how to resolve disputes among the sponsors/equity investors, and (4) how to terminate the venture. Organizational issues were covered in Chapter 8. Capitalization—in particular, determining how much debt a project can incur—was discussed in Chapter 9.
Management and control procedures, dispute resolution, and venture termination are issues that must be addressed in the contract to which the sponsors/equity investors are parties.1 First, consider management and control. Critical decisions, such as altering the capital expenditure schedule or incurring additional debt, might require unanimous approval. Management arrangements become particularly sensitive when public–private partnerships are formed to finance infrastructure projects. (These partnerships are discussed in Chapter 16.2)
Second, dispute resolution procedures must be put in place to handle disagreements. The sponsors may disagree about how to interpret various contract provisions. Arbitration may be needed to break the deadlock. However, differences that concern fundamental business issues, or alleged breaches of significant provisions of agreements between the parties, may not be suitable for arbitration. A buy–sell or a put–call arrangement may work better. Under a buy–sell arrangement, one party can offer to buy out the other's ownership interest. The offeree can accept the offer and sell, or buy out the offeror at the specified offer price. Under a put–call arrangement, a nondefaulting party has the right to sell its ownership interest to the defaulting party, or to buy the defaulting party's ownership interest. In either case, the original agreement between the parties should provide that the buy–sell price or put–call price is based on the fair market value of the ownership interest, as determined by independent business appraisers.
Committed Investment Funds
Fund managers have formed committed investment funds to make equity investments in certain specified types of projects. The fund's sponsors make all the investment decisions. One example is the Scudder Latin American Power Fund (“Latin Power”), which was formed to make equity investments in independent power projects in Latin America and the Caribbean.3 There are four lead investors; each has committed $25 million. They serve on the project review committee, which considers investing in projects that the fund's investment adviser (Scudder, Stevens & Clark) has analyzed and proposed.
Committed funds enable sophisticated investors to pool their resources. They reap the benefits of diversification, and they benefit from the investment adviser's experience and expertise in evaluating projects of a particular type. When more than one experienced sponsor/investor is involved, they realize economies from pooling information and sharing responsibility for monitoring their joint investments. These efficiencies make it cheaper for the sponsors/investors to invest jointly rather than separately. These benefits are likely to be greater in the emerging markets than in the developed markets because information tends to be more difficult and expensive to obtain in the emerging markets.
Pooled Equity Vehicles
A pooled equity vehicle is a separate company that is formed by an existing operating company to own and manage certain specified types of projects. One example is Enron Global Power & Pipelines L.L.C. (EGP&P).4 EGP&P was structured as a limited liability company.5 Enron Corporation owned 52 percent of EGP&P, which owned and managed Enron's natural gas pipelines and power plants outside the United States, Canada, and Western Europe. Initially, EGP&P's assets consisted of two power plants in the Philippines, one in Guatemala, and a 4,069-mile natural gas pipeline system in Argentina. Enron granted EGP&P the right of first refusal to purchase all of Enron's ownership interests in any power plant or natural gas pipeline project Enron developed or acquired (outside the United States, Canada, and Western Europe) that commenced commercial operation prior to 2005. Enron planned to manage all the projects.
Pooled equity vehicles provide investors with geographic diversity and the opportunity to invest in projects of a particular type alongside an experienced operator. EGP&P enabled investors to benefit from Enron's experience in selecting power and pipeline projects for development and from Enron's expertise in operating them. Pooled equity vehicles can raise funds publicly (as EGP&P did), which enables them to tap the retail equity market. Pooled equity vehicles, like committed investment funds, reflect the growing role of intermediaries in project finance. Pooling investment funds represents an efficient means of investing in a targeted class of projects, particularly when the individual projects are relatively small and the costs of obtaining information, evaluating projects, and monitoring construction and performance are high.
Long-Term Debt Market
There is an extensive market for long-term debt financing for projects in the capital markets in the United States, Europe, and Japan. Financial institutions such as life insurance companies and pension funds provide fixed-interest-rate financing, and commercial banks provide floating-interest-rate financing. For most project financings, commercial bank construction financing or precompletion private placements with financial institution lenders constitute the initial phase of the financing plan. Three primary factors contribute to their predominance in the initial phase:
Several factors influence the breadth of the international long-term debt market for financing a project. They include:
Other factors that may influence the availability of funds to a project include the degree of competition for capital from other projects being constructed and financed, the rate of inflation, and the general attitude among institutional investors toward investment in projects of the type and in the locale of the project being financed. Life insurance companies have historically been the most important source of debt funds for large industrial and utility projects. They are likely to continue to be an important source of project loans in the future.
Table 13.1 summarizes the relative sizes of the different segments of the long-term debt market as of December 31, 2011.
Table 13.1 Sources of Long-Term Fundsa.
Commercial Bank Loans
Commercial banks have played an active role in project finance since the 1930s, when a Dallas bank made a nonrecourse production payment loan to develop oil and gas properties (see Forrester, 1995). Commercial banks have demonstrated an ability to evaluate complex project credits and a willingness, at times, to bear completion and other noncredit risks that other types of lenders usually shy away from.
Four alternative types of bank credit facilities may be arranged to finance a project:
Credit facilities should, in each case, provide for alternative borrowing bases, including (1) U.S. prime rate, (2) LIBOR (one or more specified alternatives), and (3) the lender's CD rate (one or more specified alternatives).
Comprehensive Credit Facility
Instead of negotiating a separate loan commitment in each category, commercial banks may propose to arrange a comprehensive credit facility covering all of a project's loan requirements. This frequently involves a revolving credit facility during the construction period, some portion of which converts to a term loan upon completion. The revolving credit facility may also allow a portion of its availability to be used as a standby letter of credit facility. For large projects, the credit facility would be provided by a syndicate of banks. A comprehensive credit facility can often provide greater financial flexibility both to the bank(s) and to the project.
Legal Lending Limits
The constraints placed on individual banks with regard to loans to a single borrower can limit the availability of bank financing to a very large project. For national banks, the legal limit for investment in obligations of a single issuer is 15 percent of the bank's capital plus surplus. Up to another 10 percent may be invested if the additional loans are fully secured by collateral that is marketed easily. In addition to legal lending limits, banks normally have internal policy guidelines that restrict their ability to provide funds to a single borrower. These internal policy guidelines base the amount the bank can lend on (1) the credit strength of the borrower, (2) prevailing money market conditions, (3) the type(s) of facilities requested (shorter maturities are preferable to long-term loans), (4) the interest rate necessary in light of the project's financial leverage and its business and other risks, and (5) the expected overall profitability of the bank's relationship with the project's sponsors, which will depend on the fees and other revenues the bank expects to earn from loan, cash management, and other services it will provide to the sponsors and to the project entity.
Terms of Bank Loans
Project sponsors usually seek commitments from commercial banks for both construction financing and permanent financing. The construction commitment depends on the length of the construction period; a two- or three-year commitment is typical for many projects. As illustrated in Table 3.2, most project construction periods are shorter than three years. Permanent financing has a longer maturity. Maturities as long as 15 years from date of completion are often possible for infrastructure projects.7 But the maturity of a natural resource project, for example, will be limited by the size of the resource deposit and how long it will take to exhaust it. Convincing banks to loan for periods exceeding half the expected life of the deposit is usually difficult because they want a significant margin of safety to protect against misestimation of the size of the deposit.
Bank loans are usually at floating interest rates, expressed as a margin over some specified benchmark, such as prime rate or one of the LIBOR rates. Loans for permanent financing usually specify increases in the margin every few years. These increases are designed to encourage project sponsors to refinance the bank debt prior to its scheduled maturity. Most sponsors will refinance the bank debt in one of the fixed-rate debt markets described later in this chapter.
International Commercial Banks
The large international banks headquartered in the United States and Canada; the large clearing banks in the United Kingdom; large commercial and universal banks in France, Germany, Japan, and Switzerland; and, to a lesser extent, the consortium banks based in London are likely candidates for providing funds to a major project. These banks may lend to a project through their participation in one or more syndicates of bank lenders to the project, or, in the case of the larger European or Japanese banks, they may facilitate the project financing by placing bonds with institutional investors. Table 13.2 lists the 10 leading arrangers of project bank credit facilities in 2007–2011, and Table 13.3 indicates the 15 largest syndicators of bank loans in 2011 (for project financing as well as other purposes).8
Table 13.2 Leading Arrangers of Project Bank Credit Facilities, 2007–2011 (Dollar Amounts in Millions).
Source: Thomson Project Finance International.
| Rank | Bank | Amount |
| 1 | State Bank of India | $79,095 |
| 2 | BNP Paribas | 46,071 |
| 3 | Credit Agricole | 39,738 |
| 4 | Royal Bank of Scotland | 34,598 |
| 5 | Mitsubishi UFJ Financial | 32,107 |
| 6 | Sumitomo Mitsui | 31,973 |
| 7 | Société Generale | 28,143 |
| 8 | Dexia | 25,776 |
| 9 | Mizuho Financial | 23,752 |
| 10 | IDBI Bank | 22,377 |
Table 13.3 Largest Syndicators of Bank Loans, 2011 (Dollar Amounts in Millions).
The international banking market has developed into one of the most dynamic financial markets in the world. Because it is not subject to national regulation, the market is free to intermediate on a flexible basis between depositors and borrowers from different countries. Virtually all the major banks in the United States, Canada, the United Kingdom, Continental Europe, and Japan actively participate. The U.S. dollar and the Euro are the dominant currencies. Other important currencies are the British pound and the Swiss franc. Substantial growth occurred in the 1970s, with the large inflow of deposits from the Middle East's oil-producing nations, and since the 1980s, as the United States continued to run enormous balance-of-payments deficits.
The tighter capital standards that were imposed on commercial banks beginning in 1989 made it more difficult to arrange large, syndicated bank loan facilities for major projects. Banks generally decreased the magnitude of the underwriting commitments they were willing to make. Interest-rate spreads widened, loan maturities were shortened, credit standards became more demanding, and bank fees were increased. Nevertheless, bank loan financing was available for projects that were fundamentally sound. In recent years, the situation in the bank loan market has improved as banks have adjusted to the new capital standards. Banks have expanded their role in project financing by becoming more active as advisers, as project loan syndicators, and as lenders.
Over the past decade, bank loans have provided 47 percent of the financing, bonds have furnished 9 percent, multilateral development agencies have provided 14 percent, and equity has furnished 30 percent of the funds (Esty, 2004). The percentage of funds provided by bank loans has ranged from 33 percent to 52 percent. The percentage of funds provided by bond issues varied between 5 percent and 13 percent during the same period, and it has trended upward over the past 10 years. The percentage of equity funds provided by sponsors and outside equity investors has held steady at about 30 percent.
Banks generally syndicate their project finance loans. Syndication facilitates monitoring of borrowers and risk-sharing. One study of 495 project finance loans in 61 different countries found that bank lenders create smaller and more concentrated syndicates in countries with stronger creditor rights and more reliable legal enforcement (Esty and Megginson, 2003). It also found that lenders create larger and more diffuse syndicates in order to protect their interests by deterring strategic project loan defaults when they believe that they cannot rely on the host country's legal enforcement mechanisms to protect their claims.
Fixed-Rate Debt Market
Historically, life insurance companies have been the principal source of long-term fixed-rate loans for major projects, and pension funds have served as an important source of debt and equity funds for corporations. Other financial institutions that provide long-term debt financing for projects include: sovereign wealth funds, private equity funds, open-end and closed-end investment trusts, university endowment funds, charitable foundations, property and casualty insurance companies, and professional investment advisers. Property and casualty insurance companies are typically more tax-conscious than life insurance companies.
Compared to the public securities markets, the private placement market has generally been much more receptive to project debt financings. Historically, projects were able to tap the public securities markets only after having completed at least a few years of profitable operations. The complexity of the security arrangements usually made it difficult for the rating agencies to evaluate the true credit risk and assign debt ratings. This situation began to change in the early 1990s. The rating agencies have become more sophisticated in their credit analysis. Also, their experience in rating complex mortgage-backed and receivables-backed financings enhanced their ability to rate complicated debt security structures. As a result, the public market for project bonds has grown dramatically since 1995, as discussed in Chapter 4.
Figure 13.1 illustrates the issuance of bonds by domestic nonfinancial corporations between 2008 and 2011. Total annual issuance rose by more than half in 2009 and has stayed relatively steady since. These figures do not differentiate between public offerings and private placements, but total domestic private placements (issued by both financial and nonfinancial corporations) totaled $22 billion and $19 billion in 2010 and 2011, respectively.
Figure 13.1 Gross Issuance of Bonds by Domestic Nonfinancial Corporations in the Public and Private Markets, 2008–2011
Source: Board of Governors of the Federal Reserve System Website, Economic Research and Data, New Security Issues, U.S. Corporations (July 2012 and December 2011 Updates).
The private placement market is dominated by life insurance companies. Carey et al. (1993) examined a sample consisting of 351 private placements. Life insurance companies purchased 83 percent of these issues, as measured by aggregate dollar amount. Table 13.4 indicates the market shares of the other participants in this market.
Table 13.4 Lender Shares in the Traditional Market for Private Placements.
Source: Carey, Prowse, Rea, and Udell (1993), p. 27.
| Type of Lender | Share of Dollar Volume |
| Life insurance companies | 82.6% |
| Foreign banks | 3.6 |
| U.S. commercial banks | 3.3 |
| Pension, endowment, and trust funds | 1.7 |
| Finance companies | 1.4 |
| Property and casualty insurance companies | 1.4 |
| Mutual funds | .7 |
| Thrifts | .7 |
| Others | 4.6 |
| Total | 100.0% |
Figure 13.2 compares the characteristics of the bank loan, private placement, and public bond markets. The bank loan market tends to prefer shorter-term floating-rate loans with relatively tight covenant restrictions. The public bond market is generally willing to accept longer maturities and larger issues with relatively nonrestrictive covenants. The private placement market falls in between the other two markets with respect to average borrower and loan size, covenants, collateral requirements, and intensity of monitoring. However, lender reputation is most important in the private placement market. Lenders in this market perceive that they have significant reputational capital at stake when they make a decision to loan money to a project. Consequently, the lending standards they apply tend to be rigorous.
Figure 13.2 Comparison of the Characteristics of the Bank Loan, Private Placement, and Public Bond Markets
Source: Carey, Prowse, Rea, and Udell (1993), p. 33.
Life Insurance Companies
The major life insurance companies possess a high degree of investment sophistication. Their analytical ability allows them to make judgments on their own as to the credit risk and other risks present in highly complex undertakings, such as a project financing. Smaller life insurance companies do not have this capability. Consequently, they have traditionally been influenced in their commitments by the participation of the major life insurance companies and by the debt rating(s), if any, assigned by the major rating agencies.
Because of the nature of their business, life insurance companies have a relatively assured annual cash flow, which they are willing to commit, under certain circumstances, for takedown up to several years in the future. Once they are satisfied with the creditworthiness of a project and the adequacy of the security for their loans, life insurance companies are influenced primarily in their investment decisions by the attractiveness of the rate of return offered by the project relative to the rates of return offered by competing investments. It is necessary to offer an acceptable commitment fee to lenders when asking them to commit their funds in advance of the takedown dates.
Project debt is typically sold to life insurance companies through private placements. Privately placed securities are not registered with the Securities and Exchange Commission (SEC). They generally have shorter maturities than comparable publicly traded debt securities. Twenty-year money is available from some institutions, but a 15-year term is preferable. The growth of the managed money/guaranteed investment contract business has made life insurance companies enthusiastic buyers of intermediate-term (i.e., 5- to 10-year) debt.
Security arrangements and restrictive covenants tend to be important issues in private placement negotiations. The public securities market generally accepts less onerous arrangements. Project loan agreements typically include limitations on indebtedness, on liens, and on cash distributions, and they impose liquidity/working capital tests.
It is sometimes advantageous to obtain a rating from one of the major rating agencies. The issue of a rating involves a trade-off between the more stringent security and credit arrangements required to obtain a favorable rating on the one hand, and access to a broader market on the other.
Life insurance companies are very sensitive to the creditworthiness of project debt securities. The National Association of Insurance Commissioners (NAIC) has instituted a rating system for private placements, and the reserves that life insurance companies are required to maintain against the loans they hold in their portfolios are dependent on the NAIC ratings. Because of these reserve requirements, life insurance companies have exhibited a strong preference for debt that is rated minimally as investment grade (NAIC-2).9 Figure 13.3 shows the distribution of credit ratings for privately placed debt held in the general accounts of life insurance companies.
Figure 13.3 Distribution of Credit Ratings of Privately Placed Debt Held in the General Accounts of Life Insurance Companies
Source: ACLI Data. Compiled by R. Rubrich of Actuarial Research.
Standard & Poor's has a separate private placement rating system.10 In general, private placement rating systems are more lenient than the respective public debt rating systems because the private placement ratings express a view concerning the likelihood of ultimate repayment. Public debt ratings also stress timeliness of payment.
The life insurance industry is characterized by a concentration of investable funds in the largest companies. Table 13.5 lists the 14 largest buyers of private placements in the United States. From a borrower's perspective, such concentration can be important. Often, the need to approach only a few institutions in order to secure commitments for the full amount of the financing desired reduces the cost and time required to arrange the project financing.
Table 13.5 Largest Buyers of Private Placement Senior Debt Investments in the United States, 2011 (Dollar Amounts in Millions).
Source: Private Placement Letter, Buyside Survey, Top Purchasers of Total Private Placements (2011).
| Rank | Institution | Amount |
| 1 | Prudential Capital Group | $9,600 |
| 2 | MetLife | 8,700 |
| 3 | Northwestern Mutual Capital LLC | 4,505 |
| 4 | New York Life Investments | 4,300 |
| 5 | Sun Life Assurance Company of Canada | 4,284 |
| 6 | Babson Capital/Mass Mutual | 3,100 |
| 7 | ING | 2,925 |
| 8 | Aviva Investors North America | 1,981 |
| 9 | John Hancock | 1,914 |
| 10 | Delaware Investments | 1,293 |
| 11 | Mutual of Omaha | 1,100 |
| 12 | CIGNA | 874 |
| 13 | PPM America | 626 |
| 14 | Assurity Life Insurance Company | 104 |
Although it is not always at its most robust, the private market remains a substantial source of funds for complex project financings or for one portion of the overall project financing—for example, for equipment financings, production payments, or other specialized funding.
Rule 144A Quasi-Public Market
In April 1990, the SEC adopted Rule 144A under the Securities Act of 1933. Rule 144A liberalized the restrictions that had existed on trading unregistered debt and equity securities. Prior to the adoption of Rule 144A, the U.S. securities laws imposed significant restrictions on the resale of unregistered securities. These restrictions rendered such securities illiquid, causing private placement buyers to demand an illiquidity premium (e.g., a higher interest rate). As a result of the SEC's adopting Rule 144A, large, sophisticated, qualified financial institutions (“qualified institutional buyers” or “QIBs”) can trade unregistered debt and equity securities with each other without regard to the private placement restrictions that otherwise apply to unregistered securities.11 Consequently, debt and equity securities issued under Rule 144A are considered “quasi-public” securities because of the absence of these restrictions.12 The Rule 144A market came of age in 1992.
A Rule 144A private placement can be underwritten. The issuer can sell its securities to one or more investment banks (in reliance on a private placement exemption from registration under the 1933 Act). The investment banks then resell the securities to QIBs. This method of issuance is very similar to the sequence in an underwritten public offering, but without the extensive documentation being made publicly available as occurs in connection with a public offering.
Rule 144A issues can generally be arranged more quickly than public offerings because the securities do not have to be registered with the SEC. Covenants are normally less restrictive than private placement covenants. The absence of private placement trading restrictions makes Rule 144A issues more liquid than privately placed securities, and the greater liquidity makes possible a reduced interest rate.
The principal buyers of Rule 144A debt offerings are large life insurance companies. They are receptive to Rule 144A debt offerings that are rated investment-grade (e.g., Moody's Baa3 or better, or Standard & Poor's BBB or better). The major rating agencies apply the same rating criteria to Rule 144A debt issues that they do to public debt issues. These agencies have made it clear that only a select group of completed, successfully operating projects will merit an investment-grade rating. It would be rare indeed for a project to be rated investment-grade prior to construction (except possibly when there is an airtight completion undertaking from a strong investment-grade credit). The debt-rating requirement essentially limits the Rule 144A debt market, as well as the public debt market, to the funding of construction loans for projects with clearly ascertainable and easily managed risks.
Two examples of large project financings that have been arranged in the Rule 144A debt market are:
The Rule 144A market has reached critical mass. Volume has increased, liquidity has improved, and yields have moved much closer to the yields available in the public debt market. The Rule 144A market has thus become relatively more attractive for project financing—particularly for infrastructure projects, for which long-term fixed-rate debt is desired.
Public Pension Funds
Public pension funds consist primarily of state and local government employee retirement funds. Because they generally maintain a high proportion of fixed-income securities in their portfolios, they represent an important potential source of long-term funds for a project financing.
The decision-making characteristics of public pension funds are different from those of life insurance companies. The flow of funds into state and municipal pension funds depends on current legislation, the salary levels of state and municipal employees, and, in some instances, the cash management requirements of the sponsoring state or municipality. Because of these uncertainties, as well as a reluctance to attempt to predict future market conditions, public pension funds, unlike life insurance companies, tend to be unwilling to commit to extend loans far in advance.
Most public pension funds are quality-sensitive buyers, either by preference or by statute or regulation. Many are required by statute or policy to invest in securities that are rated single-A or higher. Many are also prohibited from buying securities of foreign corporate obligors. Other legal investment requirements, such as a minimum length of corporate existence or a minimum coverage of fixed charges, may preclude certain public pension funds from purchasing the debt securities of a particular project.
Private Pension Funds
Private pension funds consist primarily of corporate pension funds. They have historically been an important supplier of capital to corporate borrowers. Prior to the mid-1960s, private pension funds invested primarily in fixed-income securities. With the increased emphasis on performance that began developing in the mid-1960s, these funds began to increase substantially their equity commitments; nevertheless, they continue to invest substantial portions of their available funds in fixed-income securities. Private pension funds can serve as an important source of funds to a major project if the rate of return offered is attractive to them. Liquidity is also an important consideration for these investors.
Many large corporations manage their own pension funds. However, most corporate pension funds are managed either by the trust departments of commercial banks or by private investment management firms. As with life insurance companies, a high percentage of the investable assets are managed by a relatively small number of institutions.
Private pension funds are normally not restricted as to the credit quality of the securities they may purchase. Therefore, the rating of a project's bonds is a less important consideration than it would be for a public pension fund. In addition, private pension funds normally face few, if any, restrictions—other than the requirements of ERISA—on their ability to purchase securities issued by foreign corporations.
Other Financial Institutions
Other classes of financial institutions, when considered class by class, tend to be relatively less important purchasers of a project's bonds. However, taken collectively, they may, in certain cases, turn out to be significant purchasers. These institutions have diverse investment policies, so it is difficult to generalize about the investment objectives of the group as a whole. Normally, they will look on a project's bonds as an alternative investment to corporate bonds and common stocks (just as private pension funds do). Accordingly, the rate of return offered on a project's securities is the most important factor in obtaining significant participation from these institutions.
Market Comparison
Table 13.6 compares the terms on which funds could be borrowed for project financing purposes in the U.S. debt market as of 2011. The loan terms that are available at any point in time within each market segment may change because of economic, regulatory, or other factors.
Table 13.6 Comparative Analysis of Project Financing Borrowing Alternatives.
International Capital Market
The international capital market, broadly defined, is the market for medium-term and long-term securities that functions outside the national capital markets of the world. Its existence reflects (1) the accumulation of dollar and foreign currency balances by foreign investors and (2) the willingness of those investors to purchase securities of issuers that are located outside the country that issued the currency. Such international markets are often referred to generically as the Euromarkets (e.g., the Eurodollar market, the Eurosterling market, and so on).
Credit Sensitivity
Although international investors are very conscious of security quality, historically they have not calibrated credit risks as finely as the U.S. debt market does. This situation is changing because credit ratings have become widely relied upon for bond pricing in the Euromarkets. As a general rule, however, a borrower that is large and well-known will be able to borrow more cheaply than an otherwise comparable but less well-known entity. Commitments made by major U.S. institutional lenders or large international banks also provide strong endorsements for borrowers in the international capital market.
A number of companies that were not going concerns at the time of their initial financing have been able to arrange financings in the international capital market. Accomplishing such a financing for a project would require, at a minimum, demonstrating the economic viability of the project beyond a reasonable doubt. It is equally important that entities that are well-known, established, and creditworthy provide sufficient supplemental credit support for the project requesting the financing.
Maturity Choice
Even under very favorable market conditions, investors in the international capital market generally are not willing to accept debt maturities as long as those available in the United States. The typical maturity for long-term debt in the international capital market does not exceed 10 years, although there have been longer-dated issues. Under weak market conditions, maturities of between 5 and 7 years become prevalent.
Currency Considerations
The flow of funds to the international capital market is volatile, for a number of reasons. Most investors in this market can also invest in their respective domestic capital markets, as well as in other national markets. Few investors commit funds on a regular basis exclusively to the international capital market. Instead, investors move their funds from one market to another—primarily on the basis of short-term considerations. The short-term outlook concerning the strength of the currency in which the investment is denominated is one of the principal investment considerations. Changes in currency expectations have led, from time to time, to costs of borrowing that are lower than those achievable in a particular national capital market. This situation often occurs when a currency is deemed particularly attractive. At the other extreme, diminished expectations have led to the virtual closing of one or more sectors within the international capital market when the currencies involved were deemed especially unattractive.
Inflation has a significant impact on the international capital market. In general, when one country has a rate of inflation that is high relative to other countries, its currency is less attractive to international lenders. At the very least, the rate of interest will have to be high enough to compensate for the higher inflation rate. When all countries are suffering from very high rates of inflation, investors tend to eschew long-term fixed-interest-rate debt obligations. In addition, the investors' view of world stability and the political and economic stability of their respective countries will influence the international capital market. Investing funds outside the domestic market on a medium-term or long-term basis requires that investors pay close attention to political events that might alter the value of their investments.
Types of Investors
Investors in the international capital market generally fall into three categories. Historically, the largest group, which accounts for a substantial proportion of the invested funds, consists of individuals buying for their own account through banks. The clients of Swiss banks and other banks where client anonymity is protected are prominent in this category. Not all of these accounts are discretionary; nevertheless, the attitudes of the banks involved can be crucial. The second group of investors, which has become larger than the first and continues to grow in relative importance, consists of institutions in several countries that purchase international issues for their own account. These institutional investors, which include banks, insurance companies, pension funds, investment trusts, and certain government agencies, buy private placements as well as public issues.
The third group consists of sovereign wealth funds. These funds are large pools of capital that seek attractive rates of return in investment projects that satisfy their investment constraints. Many were established to invest national wealth that has accumulated from royalties and carried interests in projects that develop the nation's resources. For example, Norway's Government Pension Fund invests wealth from Norway's valuable North Sea oil fields. The fund is intended to build wealth to support Norway's standard of living after the oil is depleted. Sovereign wealth funds will make long-term debt or equity investments in project securities that provide acceptable rates of return for the risks involved. However, political considerations are sometimes as important because national wealth is involved.
Investors judge the attractiveness of the expected rate of return for a given international security in relation to the expected rates of return for comparable domestic securities. Investors in the international capital market therefore usually require that interest payments be free of withholding tax. Withholding tax is levied on dividend payments and interest payments made to entities that reside outside the country in which the borrower is located. The tax is designed to compensate for the difficulty tax authorities face in trying to collect income taxes from nonresidents. In countries where there is a withholding tax, offshore finance subsidiaries have been created in non-withholding-tax (or at least in low–withholding-tax) jurisdictions to avoid having to collect withholding tax. Trust indentures normally provide that the issuer will gross-up interest payments sufficiently to allow holders to receive the originally stated rate of interest in the event of a future imposition (or an increase in the rate) of withholding tax.
Supplier Credits
Project sponsors frequently arrange supplier credits to finance the purchase of equipment. These credits often serve as an attractive means of financing equipment that will not be part of the permanent structure of the project but is necessary during construction. Supplier credits covering equipment to be used in operating the project may extend as long as 7 to 10 years. The security arrangements for such supplier credits must be integrated into the corresponding security arrangements for the long-term financing for the project. Like bank loans, supplier credits generally require a commitment fee on the undrawn balance.
The structure and terms of supplier credits may vary, depending on the countries involved. Under certain circumstances, which depend principally on where the project is located, government export credits may be available on concessionary terms. Alternatively, insurance or direct guarantees may be procured. More frequently, however, project sponsors arrange for a syndicate of banks in a country to provide commercial credit for a large portion of the project's purchases of equipment in that country.
Governmental Assistance
A project may be eligible to receive some form of government support, or support from a supranational agency, for its financing. Included in the government support category are export credits and loan guarantees. In the second category are loans from the World Bank and from any of the regional development banks.
Export Credit Financing
Each of the major developed nations has established an export-import bank. Such institutions were set up to promote the export of equipment manufactured within that country. Export credit financing has been an important topic of debate among the industrialized countries in recent years. Generally, it appears that the trend is away from the degree of subsidization that applied in the past. The terms and conditions on which the export credit financing agencies advance credit are governed by the “Arrangement on Officially Supported Export Credits” (or, more cryptically, the “Consensus”) negotiated by the Organisation for Economic Co-operation and Development (OECD) countries. Annex X of the Consensus provides terms and conditions applicable to project finance transactions. The Consensus is not legally binding. Often, significant differences in the terms and conditions available from different countries have developed, depending on specific circumstances.
Export credits can take the form of either “buyer credits” or “supplier credits.” In general, the export credit agencies are reluctant to bear the credit risk associated with a start-up project without some form of identifiable credit support. Figure 13.4 provides the standard loan terms that were consistent with the “Consensus” as of August 2012.
Figure 13.4 Standard Loan Terms According to the Consensus.
Source: “Arrangement on Officially Supported Export Credits,” Organisation for Economic Co-operation and Development, TAD/PG(2012)9, August 27, 2012.
| Maximum Percentage of Export Contract Value Financed | 85 Percenta |
| Maximum Maturity: | |
| Category I Countriesb | 5 yearsc |
| Category II Countries | 10 years |
| Principal Repayment | Equal semiannual installments beginning six months from the closing date for the loan. |
| Interest Payments | Semiannual payments beginning six months from the closing date for the loan. |
| Interest Rate: | The Commercial Interest Reference Rate (“CIRR”) for the currency in which the loan is denominated plus an appropriate Minimum Premium Rate (“MPR”) for country and sovereign credit risk. |
| CIRR base rate | Either: |
| (a) 3-year government bond yield for loan maturity up to 5 years; 5-year government bond yield for maturity more than 5 years and up to 8.5 years; and 7-year government bond yield for maturity over 8.5 years.
or |
|
| (b) 5-year government bond yield for all maturities.
Plus |
|
| CIRR margin | 100 basis points. |
| MPR | The risk-based credit risk premium is based on the applicable country risk classification.d Country risk is classified in eight categories from category 0 (no MPR required) to category 7. For categories 1 through 7, the MPR is calculated according to a six-part formula. |
| Special Provisions for Project Finance Transactionse | |
| Definition | A project finance transaction is the financing of an economic unit in which the lender is satisfied to consider the cash flows and earnings of that economic unit as the source of funds from which the loan will be repaid and to the assets of the economic unit as the collateral for the loan. |
| Maximum Maturity: | (a) 10 years if the project is in a high-income OECD country and the export credit financing provides more than 35 percent of the debt financing for the project. |
| Otherwise: | |
| (b) 14 years. | |
| Principal Repayment: | |
| Initial repayment | Must begin no later than 24 months from the closing date for the loan. |
| Maximum weighted average life | (a) 5.25 years if the project is in a high-income OECD country and the export credit financing provides more than 35 percent of the debt financing for the project. |
| Otherwise: | |
| (b) 7.25 years | |
| Interest Payments | Interest must be paid no less frequently than annually, and the first interest payment must be made no later than six months from the closing date for the loan. |
| Interest Rate | (a) CIRR if the final maturity is no greater than 12 years. |
| Otherwise: | |
| (b) CIRR plus 20 basis points. | |
| a. Excluding local content, which can be financed up to the amount of the down payment. | |
| b. Countries that appear on the World Bank's “graduation list.” All other countries belong to Category II. | |
| c. Maturity can be extended to 8.5 years in certain circumstances. Loans for non-nuclear power plants can have a maturity of up to 12 years. | |
| d. Each country's risk classification indicates the likelihood that it will be able to service its external debt. | |
| e. Source: Annex X. | |
The U.S. Export-Import Bank (“Eximbank”) is one example of a major export credit agency. Eximbank provides direct loan and loan guarantee programs to finance the purchase of products manufactured in the United States by projects located outside the United States. An Eximbank loan typically covers 30 to 55 percent of the cost of the equipment. Availability and amount of the loan vary, depending on the particular type of equipment and the availability of foreign financing for competing foreign-built equipment. Eximbank charges ½ percent per annum as a commitment fee on any undrawn balance on direct loans. The maximum term for project loans is 14 years unless the project is in a high-income OECD country and the Eximbank loan provides more than 35 percent of the debt financing for the project. In that case, the maximum maturity is 10 years.
Eximbank's project finance group is proactive in promoting its services to project sponsors. It has also simplified Eximbank's application requirements and approval procedures.
Eximbank may guarantee an additional portion of the purchase price that is funded by commercial banks at a commercial bank rate of interest. The guaranteed amount, which may be borrowed outside the United States, is typically extended at a floating rate of interest. The fee for an Eximbank guarantee is between ¾ and 1½ percent per annum, depending on the country where the project is located. Eximbank cannot provide loans and guarantees that exceed 90 percent of the cost of any item of equipment. The balance of the equipment cost is considered the down payment on the transaction and is usually financed from non-U.S. sources.
In cases where the Eximbank does not extend a loan, it may guarantee up to 85 percent of the cost of the project's facilities. The fee on this type of guarantee is also between ¾ and 1½ percent of the outstanding balance. In addition, the Eximbank charges a commitment fee of 
of 1 percent for its guarantee.
Eximbank was established to promote exports, but it will not assume imprudent credit risk. In special cases, Eximbank requires a guarantee from a creditworthy bank or from the host government. The guarantee increases the financing cost by the amount of the guarantee fee.
Direct Federal Agency Loans and Insurance
The Overseas Private Investment Corporation (OPIC) is a profit-making U.S. government agency that was established in 1971 to encourage long-term American private investment in emerging markets and developing nations. Its mission is threefold: (1) to further American competitiveness and domestic economic interests, (2) to promote the economic development of emerging nations, and (3) to advance foreign policy goals. OPIC financial support is available only to projects that take steps to protect the local environment and workers' rights. Like Eximbank, OPIC has a project finance group. It has increased its project financing efforts in recent years. It typically provides between $350,000 and $250 million of support to an individual project, but it can provide up to $400 million in special cases. However, OPIC generally does not support more than 75 percent of the total investment.
To American corporations or private investors who are considering investing in a foreign project, OPIC can give assistance in four principal ways. OPIC can: (1) extend direct loans to small projects; (2) provide loan guarantees of up to $200 million; (3) insure foreign investment projects against a wide range of political risks, including currency nonconvertibility, expropriation, and political violence also up to $200 million; and (4) provide guidance regarding economic, business, and political conditions, as well as possible local business partners, in the political jurisdiction(s) the project sponsors are considering. All of OPIC's guarantee and insurance obligations are backed by the full faith and credit of the U.S. government. OPIC is active in more than 150 countries.
Since 1991, OPIC's funding commitments have approximated $3 billion to more than 30 private equity funds. These funds invested in 390 privately owned companies in 53 developing countries. In 2011 alone, OPIC invested $2.8 billion in 99 projects worldwide.
Loan Guarantees
Many other government guarantee programs are available, depending on the type of project. For example, the U.S. Maritime Administration (MARAD) offers financial assistance to projects involving the construction, reconstruction, or reconditioning of vessels built in U.S. shipyards. To be eligible, the ships must be owned and operated by citizens of the United States and must be registered in the United States.
The Title XI program is the best known of the MARAD programs. Under Title XI, bonds or notes guaranteed by the U.S. government may be issued to finance up to 87.5 percent of the actual cost of an eligible vessel. The portion guaranteed depends on several factors. One of the most important of these factors is whether a construction differential subsidy is involved in the transaction. In return for its guarantee, MARAD receives a mortgage on the vessel and an annual guarantee fee (at least ½ of 1 percent, but not more than 1 percent, of the amount of bonds guaranteed). Title XI bonds may also be issued to fund the long-term debt portion of a leveraged lease involving an eligible vessel.
Other U.S. government guarantee programs for projects include those sponsored by OPIC and those sponsored by the Energy Research and Development Association (ERDA). As already noted, OPIC was established to facilitate the participation of U.S. capital and skills in the economic and social development of less developed countries. ERDA assists sponsors in demonstrating the commercial feasibility of energy projects and promotes the development of such projects in other ways.
World Bank Loans
The World Bank Group (“World Bank”) includes three institutions that play a role in international project finance:
IBRD, IFC, and MIGA often cooperate to put together a financing package for a project. According to the World Bank, roughly two of every three projects the World Bank finances include some support for private-sector development.15 Many others involve the public financing of investments in infrastructure or other projects that are critical to private-sector development.
IFC has created an infrastructure department. It has also sponsored and invested in several infrastructure funds. The IFC typically syndicates its loans, just like the large commercial bank loan syndicators. Other lenders find these lending opportunities attractive because of the IFC's well recognized expertise in evaluating project loan credit risk.
Inter-American Development Bank
The Inter-American Development Bank (IDB) is a multilateral agency that promotes development in Latin America and the Caribbean. The IDB's board of governors has authorized IDB to expand its financing for privately owned and operated infrastructure projects in those regions. For example, IDB agreed to lend $10 million for the renovation, modernization, and operation of a major port terminal in Buenos Aires.16 This loan funded approximately 20 percent of the project's total cost.
IDB is willing to lend directly to the private sector.17 Loans to support private-sector infrastructure projects are generally limited to 5 percent of IDB's total loan portfolio. IDB's participation in any single project cannot exceed the lesser of (1) 25 percent of total project cost and (2) $200 million.18 IDB will try to attract additional funding from other sources for the infrastructure projects in which it participates.
IDB, like the World Bank and a variety of other multilateral and government agencies, represents an attractive source of long-term funds for infrastructure projects because of its experience and well recognized expertise in project lending.
Local Sources of Capital
Borrowing funds or raising equity in the local capital market is often a good way to reduce political risk. Any event that harms the profitability of the project will affect local lenders and investors. This prospect tends to furnish a disincentive for the local government to take adverse actions. The strength of the disincentive depends on how much local investors and local lenders have at stake in the project.
The capital markets in the developing countries are potentially good sources of funding. However, in many of these markets funds availability is limited and maturities are short. As of year-end 2010, Argentina, Brazil, Chile, China, India, Indonesia, Kazakhstan, South Korea, Malaysia, Mexico, the Philippines, Russia, South Africa, and Ukraine all had viable corporate debt markets.19 Brazil has taken several steps to attract foreign investors to its local bond market, including exempting them from withholding tax on interest income. In Mexico, the longest maturity available for corporate debt is 30 years. For example, Southern Copper Corporation sold $200 million of 10-year bonds and $600 million of 30-year bonds in Mexico in 2005 (World Bank, 2006). Issuance of corporate debt in Latin America reached nearly $100 billion in 2010 alone.20
As the economies within the emerging markets develop, so will the local capital markets. Where such markets exist, project sponsors should carefully consider raising at least a portion of the funds they need in those markets.
Conclusion
This chapter has reviewed the main sources of funds with which to finance projects. It is important to keep in mind that the world capital markets have become more closely integrated over the past two decades. Also, the Euromarkets represent a truly international capital market.
At different times, different capital markets may provide funds on the most attractive terms. Also, new financial instruments, such as interest-rate swaps and currency swaps, increase the array of financing alternatives available to a project. A project can borrow in one capital market, use these instruments to transform the characteristics of the loan, and possibly achieve a lower all-in cost of funds than the project could obtain from one of the traditional sources of project-type loans. These new instruments offer opportunities to recharacterize a debt obligation's interest rate or currency characteristics. Consequently, they have expanded the menu of financing alternatives available to a project.
Multilateral agencies, such as the World Bank and IDB, and various government agencies, such as Eximbank and OPIC, have stepped up their funding of private infrastructure projects. Local capital markets are a useful source of funds in many emerging markets. Raising funds locally can reduce a project's political risk exposure. Project financial engineering requires examining all likely possible sources of debt and equity—not just the traditional ones—to determine which markets can provide the needed funds on acceptable terms at the lowest possible cost.