With the credit crunch looking likely to extend through 2008, project bankers are assessing which sectors to lend into, and are looking for a combination of low risk and slightly fatter margins to structure deals that will get approval from their internal credit committees.

Though bankers insist that the debt markets remain open for well structured deals, the process of establishing a new set of pricing levels still has some way to go. As a rule of thumb margins might be up by 50bp at the lower risk end of the spectrum, but this could rise to 200bp for riskier deals – if they can get done at all.

The biggest increases will be seen for hybrid financings that are half way between project debt and acquisition finance. Some of the worst excesses in the project finance market were seen in such deals in 2006 and early 2007, and bankers are now determined to be well rewarded or walk away from the sponsor's table.

At the other end of the market, public-private-partnership (PPP) transactions done on an availability payment basis still look attractive, and borrowers may be pleasantly surprised by the availability of cheap bank debt, as banks compete aggressively for this business.

Similarly, renewable energy is benefitting not only from high oil prices but also from growing government concerns about energy security, and debt pricing may actually fall for new technologies such as offshore wind, compared to 2007 levels.

Somewhere in the middle are market risk or traffic risk deals, such as toll roads and airports. But in spite of the long running saga of refinancing for the Ferrovial takeover of BAA (which took a step closer to resolution in early June when nine banks signed up to a £7.65 billion ($14.8 billion) backstop facility) bankers say that important airports will continue to attract both equity and debt finance.

At the end of May, Citi Infrastructure Investors and Abertis Infraestructuras won the bidding for a 75 year concession to operate the Pennsylvania Turnpike, paying $12.8 billion. The fact that a consortium made up of Goldman Sachs and Transurban of Australia were a close second indicates that the infrastructure funds will still be busy doing deals during 2008 in spite of the volatility on the financial markets and macro economic concerns.

Nonetheless, the winning bid was at the low end of the range anticipated by the State of Pennsylvania, which also indicates that bidders are going to be more cautious on valuations. And one banker suggests that the cost of the debt financing is likely to be in excess of 200bp in the early years of the loan, rather than the sub-100bp levels seen on similar deals two years ago.

Over-indulgence over

In addition, the complex financial engineering typical of 2006-7 is no longer available. In 2006, when Macquarie and Cintra acquired the Indiana Toll Road, the $4 billion debt package featured an innovative step up swap which allowed the project to defer some interest payments until maturity, thus increasing the amount of debt that the project could support.

"Aggressive structures designed to maximise the distribution of dividends in the early years will be very expensive, if do-able at all," the banker comments. "We wouldn't touch it, though in the past other banks tended to over-indulge their clients."
Another indulgence that private equity and infrastructure fund players can say goodbye to is negative flex. In recent years banks have been very aggressive in order to win coveted mandated lead arranger (MLA) positions with these clients, and were offering negative flex, earning themselves a bonus if the pricing could be tightened during syndication.

This practice came over from the leveraged buy-out sector, and was beginning to seep into the list of demands on project finance type deals. But the banks are no longer falling over themselves to win business at any price with the buyout specialists, and are protecting themselves from market volatility with market flex language. This could range from a simple pre-agreed right to increase pricing during syndication, to more complex language where the tenor or loan structure may be altered.

Margin flex

"There were many syndicated transactions in 2006 and early 2007 where we did not require market flex, but it is now a requirement on nearly all syndicated project financings," comments Bruno Mejean, head of corporate & structured finance at NordLB in New York. "The alternative, which may avoid the need for market flex, is that more club deals are getting done."

"Anything that has an acquisition finance nature carries the highest premium in terms of margins, followed by traffic or market based transactions such as roads, airports, ports or facilities not supported by long term availability based contracts," says Mejean.
"But we are not seeing so much price movement on the lower risk deals with long term contracts, for example infrastructure concessions with long term contracts of an availability nature, or renewables projects with long term contracts," he adds.

"Pricing on these lower risk transactions has increased from perhaps 100bp to 125bp at beginning of the term, and from 175bp to 225bp at the end of the term," says Mejean. "But acquisition finance that was being done at 100bp a year ago could be priced at 250bp or even 350bp in today's market. The riskier transactions are definitely those where bankers are putting their risk premiums and passing on increased costs, so we are not passing the increased costs as fully as we could on the lower risk transactions, because there is a still a lot of competition on these deals."

There is also a growing trend towards the rating of bank loans on syndicated project deals. The rating agencies have come under a lot of criticism for their role in the subprime debacle in the securitisation market, but have thus far acquitted themselves better in the project finance sector. And having a rating is still an aid to the distribution process of project debt.

"There is a welcome return to a strong focus on credit risk in the project market, having moved somewhat into the background in recent years," says Bart Oosterveld, senior vice-president, Project Finance Group at Moody's Investors Service in New York. "We are seeing more demand for ratings on bank debt deals in order to smooth syndication, even if the rating is not public."

"We haven't necessarily adjusted our methodologies, though current market circumstances will lead us to focus more on certain aspects," he says. "Generally infrastructure benefits from the flight to quality, and there is a track record of solid performance of infrastructure assets through past economic downcycles."

Impact of oil on infra project economics

One of the big questions facing global concession type deals is what the effects of sustained high oil prices might be on assets such as toll roads and airports. American motorists are aghast at the series of price increases at the pump, even though they are still paying less than half the £1.10 per litre level seen in the UK. And the news in early June that airlines such as Continental and United were grounding aircraft may give airport operators some cause for concern.

Moody's recently launched an initiative of setting out a series of macro stress scenarios for 2008-2009, aimed at improving the consistency of the macro parameters used by its different rating groups, and having a more rigorous process through which analysts take into account external global risk scenarios.

These global scenarios will be incorporated into Moody's sector and industry outlooks, and will feature in the analysis of projects such as toll roads and airports.

"The sort of event that we are now seeing, with high oil and petrol prices, illustrates why one needs to apply caution to initial forecasts for projects such as toll roads, but does not mean that we have to radically change the downside sensitivities that we have been considering anyway," comments William Coley, senior analyst, Project Finance Group at Moody's in London.

"We will monitor with interest whether high oil prices are causing greater than expected downside scenarios," he says. "I suspect that the impact will be very different from country to country and road to road, depending on traffic patterns. For example a road that is heavily used by commuters will be less sensitive to high petrol prices than a road mainly used for leisure traffic, though that distinction between commuter and leisure is already reflected in the toll road methodology."

Airports still attractive

Airports will also clearly be a sector where a sustained period of high oil prices may impact revenues, though the airport sector remains a popular one for both sponsors and bank lenders.

The recent syndication of the Eu600 milion loan for Antalya Airport Terminal, led by Garanti Bank, WestLB and HVB, was heavily oversubscribed in spite of the dire conditions in the credit markets during the first half of 2008.
Some big airport financings are on the horizon in Europe, though bankers would like to see the BAA refinancing sorted out in order to clear the decks and allow banks to concentrate on new business.

The long delayed Eu2.5 billion debt financing for Berlin Brandenburg International should happen before the end of the year. And the Czech government is planning to privatise Prague Airport, after many years of discussion and delays, with one politician recently suggesting Eu4 billion as a floor price.

"The debt market is still there for good projects with strong sponsors, though debt pricing has clearly increased," comments a German banker. "If there are four or five consortia bidding and if they are supposed to put in bids with a committed financing group in place then it might cause some difficulties, but once the winner is announced I don't see any problem getting funding."

But he notes that each and every syndicated transaction will feature market flex, otherwise banks will not get approval from their credit committees. And club deals may also feature.

"Last year there were a couple of banks who told BBI that they would underwrite the whole thing, but now we are talking about a club deal of eight banks each taking Eu400 million each, which a year ago was nothing," he says.

Renewables benefits

In sharp contrast to airports and toll roads, which are facing new challenges if oil does settle permanently at over $100 per barrel, the renewable energy sector is a major beneficiary of high oil prices.

Wind and solar energy are viewed as extremely attractive by project lenders, especially in countries that have a simple feed-in tariff. And new and riskier technologies such as offshore wind are establishing themselves.

In early June alternative energy company Econcern inaugurated its Q7 wind farm off the coast of the Netherlands, renaming it Princess Amalia Wind Farm.

Q7 was developed with a very high level of equity, and more expensive debt than onshore wind, with the 11 year post-construction loan starting at 165bp and rising to 185bp. But in spite of increased margins of anywhere between 50bp and 100bp in many areas of project finance, debt pricing on offshore wind is unlikely to be any more expensive than in 2006 or 2007.

"We have a series of four planned offshore wind parks totalling 1,500MW for which we are putting in place framework contracts for the installation work, turbine supply and financing," says Kees van der Leun, Member of the Board at Econcern.

"Q7 was financed with 48% equity, and we think we can go substantially lower now that we are building up a track record with offshore wind, though obviously not as low as the 10% or 15% seen in onshore wind farms," he adds. "In general we do not expect debt pricing to be higher than on Q7. Offshore wind is becoming more established, and there is more government support not just for environmental reasons but also for reasons of energy security."

"We are talking to a number of banks to take the lead on the framework agreement, and they are likely to want to syndicate the debt, because 1,500MW of offshore projects involves a total investment of Eu4 billion, and well in excess of Eu2 billion of debt, which is too big for a club deal," says van der Leun.

"In the framework agreement you cannot possibly determine all the conditions for the future projects so there must be quite a bit of flexibility, but for the upcoming financial close of the Eu800 million Belwind wind park off the coast of Belgium we will aim to have fixed debt conditions," he explains, rather than a loan agreement that features market flex provisions.

Interbank funding costs

Firm pricing should not be a problem for lenders such as Rabobank, Dexia and BNP Paribas who did the Q7 financing. But for some second tier banks loan pricing is more complicated because of the well publicised problems with the calculation of the London Interbank Offered rate (Libor). The Wall Street Journal has run an extensive investigation into how banks are reporting their interbank funding costs, and has suggested that the real cost of funds for banks can be a long way off published Libor, with the discrepancy sometimes reaching 80bp for some banks over the past six months.

"This is a big issue," says a banker. "The real cost of funds for some banks is clearly above quoted Libor, and until Libor settles to reflect the real cost of funds banks are going to be struggling to pass on through the margins that higher cost that is not reflected in the Libor rate. That is an uncertainty that we all face since Libor is our benchmark and if it doesn't reflect our true cost of funds then the margins have to go up, which is a challenge."

Feeding the GCC debt appetite

Geographically, the region facing the biggest squeeze in the project finance sector may be the Gulf Co-operation Council (GCC) area. This is ironic, since the vast shift of wealth associated with high oil prices is primarily benefiting the GCC, but it is simply a function of the huge volume of projects that need to get done.

The Qatar government alone made a forecast in May 2007 that it would be looking for $70 billion worth of project debt over five years.
Even at the height of the market between 2005 and early 2007, deals were tapping every available source, including ECA cover, direct loans from JBIC, Islamic tranches, uncovered bank debt and even bond offerings.

And even then bankers were talking about the need to bring new names in on syndications. For example, the Qatargas 4 loan had some new names like Santander, Lloyds TSB and Caja Madrid. Unlike in the corporate loan market, where loans were heavily syndicated to hedge funds and Collateralised Loan Obligations, these players never really bought into project loans.

But in the current environment it is not likely that the universe of potential bank investors is going to be widening. It is more likely to be narrowing, especially since good quality corporates are doing short term loans at 100bp or 200bp. As a banker notes, project loans may have gone from 60bp to 120bp, but they have 12 to 15 year tenors, and do not compare favourably to shorter term corporate paper.

As international banks become more cautious, underwriting smaller pieces and doing more club deals, the pace of activity seen between 2005 and the first half of 2007 cannot be sustained, even with aggressive lending from players such as JBIC and heavy ECA support.
The search is on for new funding sources, from initial public offerings (IPOs) and equity investments by sovereign wealth funds, and non-recourse project debt may to become a smaller part of the overall financing package.

Some projects may be delayed until market conditions improve in 2009, and for those that do proceed the sponsors will have to get used to market flex agreements. A few players such as DP World even had negative flex on some deals, though in general negative flex had not become a feature of the GCC bank debt market.

"Progress on some GCC deals has slowed, and that is not only because of the effects of the subprime crisis, but also because EPC costs have gone up and there is a dearth of EPC contractors," comments Ravi Suri, head of Middle East Project Finance at Standard Chartered Bank.

What price GCC project debt?

"Pricing has moved up, partly because of subprime and partly because a natural correction was needed since margins on project finance deals had fallen to very low levels, but for well structured projects deals are still getting done," Suri says. "However most banks do not want to underwrite very large pieces at the moment, so we are seeing larger groups of underwriters on syndicated deals, and also more club deals."
Standard & Poor's sees generally solid performance from GCC banks. However, for dollar deals with long tenors they needed access to the wholesale markets, and there are very few fixed income offerings from GCC banks at present, either syndicated loans or bonds.

"Projects are going to need very strong sponsors in order to attract debt financing, and we are likely to see more club type arrangements," comments John McWall, Head of Syndications at Arab Banking Corporation in Bahrain.

"Deals are testing the waters at the moment, and we are still in the process of pricing discovery," he adds. "There is obviously a lot of liquidity in the region as a result of high oil prices, but the regional bank market remains relatively small, and big projects continue to rely upon the international banks to complete financings. These international banks will not be able to shoulder the levels of project lending that we have seen over the past few years."

"EPC costs have also been rising pretty dramatically, and there have been delays on projects that probably would have been in the market by now, both because of higher financing costs and also rising project completion costs," McWall says. "Some additional source of capital is needed, and perhaps there could be some involvement of Sovereign Wealth Funds," he suggests.More projects across the GCC region are looking for funding, including a large number of independent water and power projects (IWPPs), which are getting bigger in scale. To take one example, the Ras Laffan C IWPP was recently awarded to a consortium including Suez Energy (20%), Mitsui (20%), Qatar Electricity and Water Company (45%) and Qatar Petroleum (15%).

This is the biggest IWPP yet seen in Qatar, with costs totalling $3.9 billion, and will soon be looking for non recourse project debt. The output is being sold to Qatar General Electric and Water Company under a 25-year PWPA.

The credit quality of such projects remains high, and they will be attractive to banks. Even so, there is still an overstretch, given current market conditions.

There is an overhang of unsyndicated loans on GCC projects, but nowhere near as big a problem as in sectors such as the European and US LBO markets, and bankers view it as a manageable problem.

There are some mini-perms and short term bridge financings coming up for refinancing, and they may find temporary solutions. High profile sponsors are not going to want to set new benchmarks with expensive long term debt, and may prefer to work with a core group of relationship banks on short term debt packages, hoping that market conditions will improve in 2009.

Initial public offerings (IPOs) will be one source of additional capital, perhaps allowing sponsors to put more equity into projects and bring the leverage down somewhat.

State owned Saudi Arabian Mining Company (Maaden) has an IPO planned for July, which will raise around $2.5 billion. Maaden is currently developing one of the world's largest aluminium projects in a joint venture with Rio Tinto.

Back to basics

The story from around the various regions is that the debt markets remain open, though there are some major challenges still facing lenders, and firm indications of the new pricing levels and overall appetite may not be seen until the fourth quarter.
In the meantime project bankers are dusting off the old rule books that used to strictly govern lending conditions, as the global credit crunch brings some discipline back into the market.

"Our rulebook on acquisition finance says no more than X times EBITDA debt leverage, but in 2006 and early 2007 we saw deals above that level and were prepared to make an exception," comments one banker. "This year we won't make exceptions – we are going back to the rulebook. Things like good old leverage ratios."