European Infrastructure Finance Yearbook - Investing In Bonds ...

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PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS Publication Date: Sept. 19, 2007 Primary Credit Analyst: Andrew Palmer, Melbourne, (61) 3-9631-2052 Kurt Forsgren, Boston, (1) 617-530-8308 Terry A Pratt, New York, (1) 212-438-2080 Secondary Credit Analysts: Paul B Calder, CFA, Toronto, (1) 416-507-2523 Lidia Polakovic, London, (44) 20-7176-3985 Santiago Carniado, Mexico City, (52) 55-5081-4413 116 ■ NOVEMBER 2007 CREDIT FAQ: THE EVOLVING LANDSCAPE FOR SUBORDINATED DEBT IN PROJECT FINANCE Emboldened by active competition and continued demand for project and infrastructure assets, the landscape for subordinated debt structures in project finance transactions continues to evolve. Indeed, some debt arrangers are pushing new boundaries to structure and fund ambitious greenfield and brownfield asset developments or leveraged acquisitions (see “The Changing Face Of Infrastructure Finance: Beware The Acquisition Hybrid” on page 8). Notwithstanding the recent upheaval in credit markets, the driving force behind debt structuring is usually simple: lower the after-tax weighted-average cost of capital while providing flexibility to project sponsors and investors and enhancing cash returns on equity. The result is most often higher leverage and added complexity through a mix of senior and subordinated debt--more eloquently referred to as “structural optimization” by debt arrangers. As employed in project finance for many years, market participants are “tranching” a project’s liability structure into senior debt, subordinated debt, and in more recent years--depending on the window of opportunity--“payment in kind” (PIK) notes (see “LBO Equity Hybrids: Too Good To Be True” published on RatingsDirect on Aug. 10, 2007). Importantly from a credit perspective, regardless of the underlying project, the common theme is increased gearing and more complex funding and documentation structures--both which have varying effects on a project’s debt ratings and recovery prospects in terms of the potential level of default and loss given default. This FAQ will highlight the criteria issues related to analyzing senior and subordinated structures in the context of issue ratings and recovery analysis. Frequently Asked Questions What is project subordinated debt? In its purist and simplest form, a project’s subordinated debt typically ranks behind a project’s senior debt in terms of priority over predefault cash flows and security over collateral, and in the event of insolvency behind any enforcement proceeds, assuming there is anything left. In this context, project subordinated debt is used in structures as a form of credit enhancement for senior debt that establishes the distribution of a project’s default and recovery over the life of the financing structure. STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK Typically, the rights for project subordinated debt are defined under a project’s structural, contractual, and legal framework. This structural framework for projects should incorporate a “ring-fenced” entity, a pre-default cash-flow waterfall, cash lock-up and sweep triggers, a debtservice reserve account, and post-default liquidation processes. Consequently, given the varying characteristics of subordinated debt the default and loss given default of any tranches of project subordinated debt may occur at different time intervals over the term of a transaction’s life cycle. Why is subordinated debt used in project transactions? Subordination gives project finance transactions the ability to create one or more classes of debt, which can allow access to more debt or alternate investor classes. One of the main objectives of using subordinated debt is to improve a project’s after-tax weighted-average cost of capital through improving the rating on senior debt while segregating credit risk and enhancing the return on equity. At the same time, sponsors of a project often use subordinated debt for tax and accounting reasons, particularly where there may be restrictions in distributing cash from a specialpurpose-vehicle structure due to retained accounting losses. Subordinated debt may also be an option explored by debt arrangers if seniorsecured financing options have be exhausted or capped out. Can subordinated debt be treated as equity for analytical purposes? Often project sponsors use subordinated debt as a substitute for equity. Depending on the underlying project ring-fence structure, security, contractual, and legal framework in each jurisdiction, Standard & Poor’s may consider treating subordinated debt as equity for analytical purposes on a case-by-case analysis. Such an analytical scenario may occur if a project’s debt: is deeply subordinated within a strongly ring-fenced vehicle with a structural waterfall and distribution triggers; has no rights to call default or accelerate payment; ranks after senior debt under predefault and post-default cash-flow waterfalls; and matures after senior debt. Like most financing structures, however, the answer will reside in the detail of a particular transaction in its relevant jurisdiction.
What are some of the key types of project subordinated debt? While there are project-specific nuances, in most instances the type and level of subordinated debt has been tailored to the cash-flow characteristics of each project. Standard & Poor’s has identified a variety of structural, contractual, and legal forms of subordinated debt in project finance transactions: Deeply subordinated (pre- and post-default) debt. A form of deeply subordinated debt is shareholder loans, which display many of the characteristics of equity, and have no rights to call default or rights on enforcement, or calls on the post-default recovery proceeds. This form of subordinated debt is often used in the public-privatepartnership (PPP) space as tax-efficient equity for sponsors. Residual value subordinated debt. This debt is structurally reliant on residual or dividend cash flow from another project-financed vehicle with senior-ranking debt and possibly even subordinated debt obligations. These residual cash flows or dividends are usually only available subject to certain debt lock-up tests being achieved at the underlying project funding vehicle. Dividends or residual flows may also be dependent on the ability of a project company to distribute cash flows due to retained accounting losses. PIK notes. Typically, PIK notes are structurally subordinated to senior debt or second-ranking lien debt in a project’s pre-default and post-default cash-flow waterfall, with coupon payments at the discretion of the issuer. If coupon payments under the PIK notes are not made in the form of cash distributions, the coupon is usually made whole by the issuance of PIK notes of equivalent value. Unlike true equity, PIK notes usually have a maturity date and at least some rights against the issuer to help ensure repayment. Standard & Poor’s will treat PIK notes as debt in calculating credit metrics. While it may be possible to carve-up a project’s cash flows to create a subordinated instrument in a number of forms, there is no “free lunch”, and at some point the key consideration is how a subordinated debt instrument will or will not STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS affect default or recovery of senior-ranking debt from a credit and legal perspective. What are the key structural elements considered by Standard & Poor’s? In examining a project’s liability and capital structure, we are often asked what the main structural and documentation considerations it undertakes to assess how a project’s debt is structurally, contractually, or legally subordinated. The objective is relatively simple: if subordinated debt obligations are to provide credit support and collateral to senior rated debt, then subordinated debt must have no rights that could accelerate or cause default or increase the level of loss given default of any senior-ranking debt. Nevertheless, Standard & Poor’s will typically review several aspects in any assessment: The rights of subordinated debt to call a default or cross default to senior classes of debt. It is not appropriate that a payment default on a tranche of subordinated debt could cause a default under the senior debt provisions. The rights of subordinated debt to accelerate payment while senior debt is outstanding. Subordinated debt should not have any right to accelerate while senior debt is outstanding. Senior debt rights to lock-up or sweep cash flow. Following any breach of a senior debt cash-flow lock-up trigger or cash-flow sweep trigger, subordinated debt should not be entitled to any cash flow, other than what might be available from reserves that are specifically dedicated to the subordinated debt obligations. Similar to the point above, this should also not give subordinated debt any rights to call or trigger default or acceleration as a result of a senior lockup or sweep trigger being breached. The pre-default and post-default cash-flow waterfall and transaction documentation. This is necessary to understand how subordinated debt is structurally and legally subordinated. This would include an understanding of how cash flows are distributed and shared in a transaction’s cash-flow waterfall. Typically, subordinated debt should be serviced after payments to operations, senior debt interest and principal, any net hedging settlements, and any senior debt-service reserves NOVEMBER 2007 ■ 117
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CONTENTS Introduction STANDARD & PO
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INTRODUCTION 2007: New Challenges A
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