The business of rating projects stands at a crossroads. The credit crunch had a direct impact on agencies' securitisation practices, but looming regulatory changes, not to mention developments in the infrastructure finance market will mean big changes for the agencies' franchises.

The United States has long since been the biggest market for project finance ratings. The depth of the US bond market has meant the rating agencies have been entrenched in the project finance market since the very earliest deals. Europe, with a smaller and more conservative investor base, has always run a distant second, about level with the Australian market.

The crunch – a blessing or a curse?

Two big sources of public ratings – monoline-wrapped bonds and leveraged, or term B loans – suffered precipitous declines during the credit crunch. In the US, government lending programmes such as TIFIA and the Department of Energy's loan guarantees have relied upon ratings for much of their credit analysis. These ratings, many of which are private, have been important new sources of work.

This is the context for the release late last year of default studies by the two largest agencies, Moody's and Standard & Poor's, which gave an insight into the pattern of project performance on a global scale. Moody's published 600 project finance ratings from 1992 to the end of 2008. Over half of the deals were done in the North American market, around a quarter were in Australia, and around 10% in the UK.

Activity in conventional power drove the development of ratings in the US, with infrastructure becoming more significant from the middle of the last decade. "Equally, we now have massive requirements for renewables, for the transmission of renewables, for climate change, carbon sequestration," says Paul Forrester, a partner at Mayer Brown in Chicago. "Those dollars have to be project finance dollars, because nobody has figured out how to finance that conventionally – this is all new requirement," he says.

In Europe, when banking markets enjoyed deep liquidity, projects were mainly funded with bank loans. The UK has been the focus in Europe for bond activity, especially the securitisation of project debt. The UK's creditor-friendly regime has encouraged the development of project securitisations, which were first developed in the US. The European Central Bank's repo rules have encouraged banks to parcel up illiquid, and often low-rated, project loans into well-rated securities that are eligible as collateral. "The secured loan structure is much more easy to rate through the UK insolvency regime than in continental Europe," says Chris Barratt, partner at Freshfields.

New money bond deals have been non-existent in Europe since the crunch, after the demise of the monoline bond insurers. This has meant the main area of work for the UK-based ratings agencies has been working on securitisations.
A liquid refinancing market, even one dependent on ratings and less accepting of construction risk, will continue to be a crucial way for banks to recycle capital outside of securitisation. For example, S&P notes in its default study that there significant maturities on several US project financings in 2011-2013, mainly from seven year term B loans closed in 2006-2007. "The bulk of these loans are minimum amortisation structures that constitute roughly $3.3 billion of debt maturing in 2012-2015 and which we believe are likely to require some level of refinancing," the agency said.

How to keep talking

In the absence of bond insurance, bond investors must have a closer eye on credit risk, says Dan Robertson, managing director and head of EMEA infrastructure at Fitch Ratings. "That's one of the biggest changes in the project finance market, as far as bonds are concerned, particularly in the social infrastructure sector" Robertson says. With AAA ratings now few and far between, bond investors will instead have to decide what their appetite is for BBB level risk, he adds.

Bond documentation must include clear decision-making rules, says Freshfields' Christopher Barratt. "Historically the monolines have been the ones who have taken decisions as controlling creditor. It will be a lot more difficult to extract decisions from a group of disparate bondholders than a small community of banks," he says. This could require the introduction, at a cost, of an adviser to navigate a project through setbacks in construction or operation and provide recommendations through the bond trustee to bondholders, Barratt adds. Not coincidentally, the major corporate trust firms have begun beefing up their product offerings, including third-party administrative agent services.

In the US, bond financing, which is slightly less dependent on monolines than in Europe, has held up better than in Europe. The global demand for energy and infrastructure projects remains and the loss of banking liquidity has meant there is substantial dialogue between banks, and rating agencies, at an early stage, whether the deal is moving towards a new money bond transaction or refinancing option.

The monolines also served as a single point of contact for getting deals rated, because they required a minimum investment grade rating to insure bank or bond debt, and this reduced the amount of time a sponsor would have to spend interracting directly with an agency. Instead, the credit crunch has increased the amount of time sponsors spend with analysts. "The markets have been so difficult over the last two years. The power sponsors generally want to optimise all avenues. They will come to us and ask for an indicative rating, which is a private rating," says one senior US-based official at an agency. "Depending on where that indicative rating comes out, they may use it to negotiate a bank loan. Or they may decide the markets are favourable and they will ask us to publish the rating and they will do a capital markets transaction," the official adds.

Around half of these sponsors decide to go to the bond markets for debt and the agency and the developer pursues an "iterative dialogue," which involves questions from the sponsor on whether suggested changes would affect the rating of the project, says the official. According to one Europe-based ratings analyst, the dearth of bond-financed newbuild PFI projects in the UK has meant that the agency would be asked for its view before such a proposal is completed. "Anyone who is getting a proposal together would be talking to us about how we would analytically approach such a proposal," the analyst says. "It may be that the market would prefer shorter tenors and larger reserve funds," says the US official, adding "there is a lot of fine-tuning as the transaction gets closer to the actual financing."

Given the huge number of variables in a project financing, this sort of approach is more workable than sending a fully-documented deal to the agencies each time for a pass/fail. But the practice flies against the current regulatory consensus for more distant dealings between agencies and issuers. Among the charges directed at the agencies working in structured finance was that by becoming so enmeshed in the structuring process they lost their objectivity and encouraged issuers to push structures too aggressively.

Regulators in the US and European Union have clamped down on rating agency practice with a range of legislation, some of which is already enforced. One piece of rule-making, introduced by the US Securities and Exchange Commission in October 2009, prohibits ratings agencies from providing structuring advice to the asset-backed securities they rate. The EU has brought in a similar body regulation, which is to be enforced later this year.

Paying the piper

Another area that has received much attention is how the rating agencies are paid. Chee Mee Hu, team managing director in Moody's project finance group, stresses that the agency's receivables are dealt with by a business unit totally separate from the team of analysts, and those people working on the project rating are ring-fenced from all commercial considerations. The terms and conditions of the ratings work is settled by the business team before any ratings work is carried out, she says
A "robust" middle office receives all enquiries from banks, and sponsors before any rating mandate, which is then handed over to the analytical team once the mandate is signed, she says. The role of the lead analyst is to present the transaction to a rating committee, where the rating is assigned, Hu says.

From one country to another, there can be large differences in project finance ratings between projects in the same sector, differences that banks, even though they have more opaque credit processes, are keen to highlight. This can be seen, for example, in ratings published in the US and Canada. Canadian bond investors have sought higher credit ratings than in the US and because of this, Canadian projects have tended to be structured with higher credit ratings than in the US, Hu says.

In Canada there are fewer banks, underwriters and sponsors, and in the deeper and more specialised US market, a lower investment grade is "financeable", Hu adds. " [Canadian projects] tend to provide much more robust structural features. Also, the offtakers in Canada tend to be the provinces, which are very highly rated," she says. Banks nevertheless accuse the agencies of loosening their standards in the pursuit of business from bond deals, which compete with their offerings.

Default studies

Around November 2009, Moody's and S&P made public their studies of default and transition rates of project finance ratings, which also offered a comparison to corporate ratings. Moody's said ratings on project finance debts have on average been "as stable as or more stable" than the corporate analogues.

One of the hindrances in collating project finance data is the limited number of projects. Moody's collected the data from around 600 deals with published ratings, but did not include privately-monitored deals. Some 370 of these were unwrapped by a monoline, and 229 were wrapped. The study focuses on the underlying project rating, rather than the rating of any bond insurer, though not all underlying ratings for wrapped deals are made public.

Most project finance ratings lie within the Baa1-Baa3 range, in the Moody's notation, the last being the lowest investment grade. Project finance credits had higher default rates than their corporate counterparts across virtually all time horizons, but the average recovery rate for senior secured bonds was also higher for project finance, Moody's said.

William Coley, group credit officer for project and infrastructure finance at Moodys, says this is because the nature of project finance structures means they are likely to experience a lower loss given default if they do suffer a default. Moody's ratings are based on expected loss, which is the product of the probability of default and the loss given default. A project financing within a certain rating category would usually have a higher recovery rate than a corporate in that same category, so to get to a similar expected loss band, the default rate of the project would likely be higher than the corporate.

He uses the Metronet London underground deal as an example. "When we rated the Metronet credits, the underlying ratings were positioned at Baa3; but our research made it clear that that Baa3 was a combination of an unusually high recovery expectation, based on the contractually underpinned amount of at least 95%, combined with a higher default probability than would be typical for a Baa3 credit," Coley says.

One factor that might affect loss given default would be the tail length on the project, or period remaining on a project's concession beyond the term of its debt. "A recent case in point would be the 2009 $4 billion Dolphin Energy refinancing – a project with 10-year debt structured against a concession with 23 years remaining. Even if the project defaults during the 10 year debt service period, there is still potentially a very rich tail to the project, and there is value there which could potentially be recovered by senior funders," Coley says.

In its default study, for the period 1992-2008, Standard & Poor's said the average and median ratings for projects four years prior to default were one or two notches higher than those of corporate ratings for 1981-2009. Of the rated debt, 56% was issued in the US, with Europe, Middle East, and Africa (EMEA) the second largest region at 21%.

One year before default, project ratings were on average at BB-, compared with B or B+ for corporate defaults. The US power crisis in 2001-2002 hit several power project ratings, S&P said. Traffic volumes hit the Eurotunnel deal in Europe, which defaulted in 2006, and Metronet Rail and Lane Cove struggled with construction and traffic issues resulting in defaults in 2008. Together, these five defaults seriously impacted the overall figures, the agency said.

The power and transport sectors "may be more vulnerable to sudden swings in market dynamics compared to other project finance sectors," it said. Jonathan Manley, senior director at Standard & Poor's, says some of the volume-based ratings such as those on toll roads have suffered and been downgraded. "Furthermore, other natural resource projects such as LNG have been impacted, but not to the extent that this has resulted in ratings or outlook changes," he says.

The studies provide some evidence for the stability of ratings, and by focusing on public ratings, in which bonds have an outsize presence, should provide some comfort to potential bond investors. But bankers sense weaknesses.

Within the studies, the agencies analysed payment defaults, and further statistics on technical and potential defaults would give more transparency on the performance of the projects, says one banker. When technical or potential defaults are triggered, the project has the opportunity to resolve issues before a payment default is made, for example if a material project contract is terminated

"There's a lot of time and a lot of room to renegotiate before things hit the fan, " he says. Showing the percentage of defaulted bond loans has "no correlation" and "no predictability value" for the bank's activities within the project, he says. "Because the controls and the early warning signals on the types of assets are so different," he says.

Banking on ratings

Bankers and agencies may need to learn to play better together. The Basel 2 capital adequacy regulations are set to bring the ratings agencies and banks closer together, says Mayer Brown's Paul Forrester. "US banks will be much more likely to involve rating agencies much earlier in the process. They may require that the borrower gets the rating from the agencies for their own bank financing, because the banks may have preferential capital treatment if they get an external rating," he says. This reduces the cost of funding for the bank and the securitisation of the loan might also be more painless, he adds. US banks, however, have a limited grip on the market.

In Europe, it is unclear whether banks will want more of their project loans rated, since by and large they monitor their lending through internal ratings. "Normally the banks have their own rating system, and that is benchmarked once in a while by the rating agencies," says one Europe-based banker. "I don't see a pattern in the market that banks are moving, for capital reasons or for Basel 2 reasons, to external ratings on their project finance exposures," says Olivier Delfour, managing director, Fitch Ratings. "The primary need for ratings remains in the capital markets," he says.

The agencies have pushed for several years for banks to get more of their loans rated. Outside of the particular, and now discredited, class of wrapped bank debt, only the largest deals have been deemed worthy of a rating. On large PFI deals, banks may feel more comfortable with a project rating, and in one example, Moody's rated the UK's Future Strategic Tanker Aircraft (FSTA) defence deal, despite the disappearance of a bond component following the downgrades of the monolines. The £13 billion ($21 billion) project was the largest PFI transaction to date and was closed in March 2008. When the sponsor took the bank debt route, Moody's credit research was made available to around 50 banks, published during the syndication process.

"We hear informally from a number of sector bankers that there is an increased interest in ratings of project finance loan assets," says Andrew Davison, a vice-president and senior credit officer in Moody's project finance group. A project rating may benefit the sponsor, through benchmarking credit quality and increasing the range of banks able to lend to the project, or the lender, through reducing internal cost of funds, he says. "I think this is something which could evolve over time, particularly if liquidity and cost benefits can be captured," he says.

Banks may also be wary of creating a lending structure that would not be refinancable in the bond markets post-construction. An overly aggressive structure, with high leverage, low coverage ratios or stretched out tenors, could make re-financing difficult. A bank would show the agency an indicative bond term sheet, and ask what the structure would need to look like to get a rating of, for example, minimum investment grade, says one Europe-based banker.

The UK's Offshore Transmission Owner (OFTO) power scheme, tendered by UK regulator OFGEM, is an example of where the agencies have been consulted at an early stage, the banker says. Due diligence is taking place on the £15 billion program to ensure links to offshore wind farms, which could total 33GW of capacity by 2020.

OFGEM's regulatory framework for the scheme looks to be "reverse engineered" to allow bond market financing, the banker says. "At a high level, most of these assets are looking fairly compliant with a debt capital markets approach," he says, adding that the rating agencies have been approached by OFGEM, as well as by a number of the bidders and advisers. Another banking source involved in the OFTO negotiations says the most likely outcome is the re-financing of bank lending. "It could be a private placement...or maybe an inflation-linked swap with a conventional bond from a more interest-based player," he says.