European Infrastructure Finance Yearbook - Investing In Bonds ...

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PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS 106 ■ NOVEMBER 2007 risk of refinancing is introduced while performance risk can have increased at an even higher debt burden. At this point, default risk increases significantly. Compared to an amortizing profile--all else being equal, including the proportion of equity contribution to a project--an accreting debt structure will have weaker credit quality. Accreting debt establishes a more aggressive financial risk profile and defers repayment of debt, often well into the future. The longer the debt repayment profile, the greater the cash flow uncertainty could lead to deterioration in a project’s financial risk profile, thereby raising default risk. Moreover, accreting debt and swap structures allow significant early period dividends paid to equity sponsors (before debt repayment) as a result of the excess cash flow produced by the accretion or “deferral” component of the debt structure. This practice and its effect on credit quality are discussed in Question 6. Even for infrastructure assets with strong business risk profiles, the presence of accreting debt in the capital structure would temper credit quality. Standard & Poor’s believes that the more aggressive the financial structure, the less robust the business risk profile; the weaker the legal provisions and the greater the contractual risk allocation to the concessionaire, the weaker the rating on a long-term concession or infrastructure asset will be. In addition to accreting debt’s influence on default probability, characteristics of transactions that, in the absence of offsetting credit strengths, are likely to experience weaker debt ratings, include the following: • A weaker business risk profile. The importance of the project rationale and business profile to credit quality cannot be understated and is discussed more fully in Question 4; • A shorter concession term and shorter equity tail; • Notable construction risk without commensurate offsetting third-party credit supports or cost and schedule risk mitigation strategies; • Annual increases in debt service payments that significantly exceed those in total project revenues; • Refinancing risk; • Unhedged currency risk; STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK • High country risk, including political stability, currency transferability and exchange matters; and, • Weak swap or transaction counterparties. Question 2: Why is early return to equity (through cash distributions) a concern? Project ratings address not only the ability but also the willingness to pay obligations in full and on time. An equity party that had already received a full return on an investment early in the concession would have reduced incentive in resolving issues in times of distress, as preserving the equity return might no longer be a consideration. As such, where an equity party reaped a full return in the early stages of the concession, Standard & Poor’s would want to be confident that the sponsors had sufficiently strong incentives to ensure the project would operate successfully throughout the debt’s life. In general, we consider that a more closely aligned interest of debt and equity is a project strength. In addition, the equity participants, through their agents--management--can also make decisions about timing of capital expenditure and other revenue or profit enhancing measures- such as toll increases, which could bring forward returns at the expense of the project’s viability. Question 3: In what asset classes have you observed accreting debt structures? Accreting debt structures arise in volume-driven transactions. The assumption in these transactions is that an increasing debt level can be absorbed as usage (traffic, tonnage, and containers, for example) and increases in revenue (tariff/toll increases) generate higher net cash flows. Assets that lack this characteristic will unlikely see accreting debt as a long-term funding source. The breadth of potential infrastructure acquisition and concession interests by private equity and public pension fund sponsors has increased with project finance structures becoming more aggressive and complex. Standard & Poor’s has observed a growing universe of potential asset classes to which long-term concessions might apply. Some of those sectors include airports, port and port terminal operators, parking facilities, toll roads and bridges, water and waste water facilities, lotteries and mass transit projects. Accreting structures are not only
found in project and concession financing but in corporate securitizations of the aforementioned sectors as well. Question 4: Why is the business risk profile so important to the credit quality of infrastructure transactions that use accreting debt? A project rating is a composite of many factors. To narrow the analysis to two factors--business and financial risks--some straightforward observations can be made. The stronger the business risk profile, the weaker the financial risk profile (including accreting debt and swaps) can be to achieve a certain rating, and vice versa. To gauge the appropriate financial risk at investmentgrade, the prime focus should be on the underlying business risk. Accordingly, to assess whether at investment-grade an accreting debt structure is commensurate, it is important to understand the business risk first, hence the importance of the business risk to the rating. As we view accreting debt structures to be more aggressive, for a similar rating an accreting transaction would need to have other strengths to compensate for this credit weakness. The strong business risk profiles and generally robust cash flow streams of infrastructure assets, together with strong covenant packages, compliance with SPE bankruptcy remoteness criteria, and supportive structural features allow infrastructure projects to be more highly leveraged and use accreting debt compared with a corporate entity at the same rating level. A strong business risk profile for long-term concessions and infrastructure providers would include a combination of the following characteristics (the listing below does not imply any ranking of relative importance): • An essential or high-demand service; • Where user fees are involved, a high degree of demand inelasticity with respect to rate increases; • Monopoly or near-monopoly characteristics, or, alternatively, few providers in the industry with substantial barriers to entry and limited incentives for competition among these service providers; • A limited reliance on increases in volume growth rates (for example, market exposure to traffic, parking activity, tonnage, or maritime containers), and aggressive STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS assumptions of price inelasticity to rate or tariff increases to meet base case revenue projections; • A favorable legal environment and regulatory regime; • Limited government interference probability, either through public policy changes and/or change-in-law risk; • A favorable rate-setting regime, although we recognize that it is rarely unfettered and, even then, can face challenges or political contention; • Strong bargaining power in relation to suppliers and customers; • Low, contained, or manageable ongoing capital expenditure requirements; • Strong counterparty arrangements with, for example, contractual offtaker agreements or remittance of payments from a highly rated public sector entity; • Strong historic track record of the asset. To this end, a project that is exposed to greenfield or start-up operations with no usage history (for example, a complete reliance on independent consultant projections) would be considered to have a weaker business risk profile; and • Proven technology for construction and major maintenance activities, as applicable. Question 5: Do you differentiate between the forms of debt increase in an infrastructure transaction? In our credit evaluation of long-term concessions, we attempt to understand the economic substance and evolving profile of the debt structure: its rise and repayments over time relative to the business risk profile of the project and the term of the concession. The project debt balance could increase based on a contractually agreed to schedule. Alternatively, the debt balance could vary based on required cash flows procured from an alternate financing source to meet debt service requirements and equity distribution targets. Finally, the project debt could rise due to a direct contractual link to an inflation index that increases during the term of the debt. Standard & Poor’s has observed several forms of debt instruments that can cause a project’s debt to increase early in a concession and result in overstated traditional DSCRs. For comparative NOVEMBER 2007 ■ 107
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November 2007 Infrastructure Financ
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CONTENTS Introduction STANDARD & PO
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INTRODUCTION 2007: New Challenges A
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ject Finance Rating Distribution: I
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COMMENTARY Publication Date: Sept.
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(Bil. ) 140 120 100 80 60 40 20 0 F
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UTILITIES EUROPEAN UTILITIES Once a
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UTILITIES approach to ownership unb
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UTILITIES Publication Date: Aug. 29
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UTILITIES Publication Date: Nov. 12
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UTILITIES Publication Date: Sept. 3
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UTILITIES Publication Date: Aug. 17
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UTILITIES Publication Date: Sept. 3
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UTILITIES 50 ■ NOVEMBER 2007 stro
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TRANSPORTATION INFRASTRUCTURE 54
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Page 152 and 153: CONTACTS KEY ANALYTICAL CONTACTS Fr
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