The financial adviser's role has been brought into sharp focus in the Middle East recently as sponsors and their advisers grapple with fallout from the US sub-prime crisis – at a time when projects' funding requirements are higher than ever, and increasing on the back of capital cost inflation, bank liquidity has been pinched and the capital markets have been shut or are unreliable.

In what are tough market conditions for experienced advisers, the climate is even tougher for new entrants. Ernst & Young's reputation has suffered after the plug had to be pulled on the Qasco transaction.

Although the deal's shortcomings have been attributed to poor financial engineering, the reality is that it suffered from exceptionally bad timing, straddling the unwinding of the US sub-prime effects on international bank liquidity.

Unlike the typical Qatari model of introducing a club of lead arrangers on a take-and-hold basis, the $1.34 billion Qasco financing was engineered with fewer banks underwriting. The process had progressed successfully, with Ernst & Young approaching around 15 banks in a funding competition and receiving commitments 2.2x the required amount. Five banks with indicative commitments were approached with a weighted average debt margin – so some banks were pulled up on pricing. However, as liquidity evaporated, despite approaching a greater number of banks, the market could not commit on the same terms. The Qasco financing will now proceed in 2008 as a club deal, without any significant changes to the structuring.

"The financing progressed in a perfectly advantageous manner," says Pearse Rutledge, partner of infrastructure advisory at Ernst & Young. "The deal was oversubscribed and we had no adverse comments on structure or risk pricing, which is why we are surprised to get such a negative press. The deal was just unfortunate in straddling the credit crunch."

Clubbing

The Qatari club model pioneered by Royal Bank of Scotland's (RBS) advisory team on deals such as Qatargas 2 and 4, and Ras Gas 2 and 3 seems particularly robust in the current market conditions, since the sweet spot for underwriting commitments among banks has fallen, especially for powerful clients such as Qatar Petroleum (QP) that will not entertain price and market flex.

The argument for pre-cooked club deals is that if the sponsors effectively run the syndication themselves and banks come in on a take-and-hold basis, there is a fixed commitment from banks on margin and upfront fees, so no market risk is borne by the sponsors in syndication and the all-in debt cost should be lower because banks are holding the debt on their balance sheet, rather than skimming the fees and redistributing into the syndications market.

The Qafco 5 financing, which is now being structured as a corporate deal and has HSBC as its adviser, had to drop a planned bond component due to adverse market conditions. The deal, which comprises a 10-year term loan of $1.1 billion and a $500 million working capital facility, is priced at about 45bp with upfront fees of 35bp and is now being done on an entirely club basis, with $80 million tickets on offer.

Probably the biggest drawback to club deals is the time required putting together the term sheet on the back of thorough modelling and market testing, though RBS is adamant that club deals can be done on a tight schedule and that the cost benefits usually outweigh timing issues. There are fewer banks with the necessary expertise to carry out thorough due diligence on complex deals, in which case a select few technically adept project finance banks may come in at lead arranger level and sell into the wider market.

The pyramid deal

Conversely, Citigroup favours the traditional pyramid distribution model with a fully formed term sheet in place. This approach was seen on the Sohar Aluminium project, which was also underwritten by Citi, along with ABN Amro, SMBC and EDC.

Citi is currently advising on the Emirates Aluminium (Emal) smelter project, which requires around $6 billion of funding, and is being developed with roughly $2 billion of 16-year bank debt, a $2 billion equity bridge and a $2 billion bond component comprising 20 and 30-year notes.

Banks are being asked to write large tickets of around $750 million, with a final hold of around $250 million, on model pricing of 40bp to 85bp over time. The bank portion could be partially covered by EDC. The bonds, which are A-rated, are being run by Citi, Goldman Sachs and NBAD.

The reason cited by Citi for such large underwriting commitments is to keep a manageable number of parties at the negotiating table to expedite financial close. Citi is also confident about keeping to its timetable for a bond launch on 10 December.

The benchmark for the debt margin and upfront fees on Emal will be the recent club deal for the Qatalum project. Although some of the pricing differential will be due to market conditions, it is a certainty that the Emal debt will still be more expensive. Qatalum achieved favourable pricing of 40bp pre-completion, rising to 60bp till year 8.5, 70bp till year 11.5 and an eventual 85bp thereafter, since these levels were agreed in May.

Citi is also adviser on Yemen LNG, which has Total and Hunt oil as investors. The deal is likely to include at least two ECAs from Coface, Kexim and JBIC, and may reach financial close by the end of the year. Calyon is advising the ECAs.

Different advisory business approaches

Just as an adviser's approach to financial engineering varies, so do the advisers' business models. Arguably, the most visible advisers in the Middle East include Citibank, HSBC, RBS and SG followed by BNP Paribas, Calyon and Standard Chartered.

Streaking ahead in terms of volume of advisory mandates won in the region is HSBC. The HSBC project business is arguably at its strongest in the Middle East and contrary to a widely held belief among its rivals, its advisory business is not subsidised by the arranging side of its business, rather HSBC is able to post low bids in advisory tenders on the back of the volume of work it does.

As well as Qafco 5, HSBC is currently working on more than a dozen mandates in total, including two IWPPs in Saudi – Ras al-Zour and Marafiq Yanbu IWPPs. HSBC is also working on the port in the new free zone (KPIZ) in Abu Dhabi, a Sipchem project, a wastewater project and advising the Saline Water Company in Saudi, and an Omani wastewater project with BNP Paribas.

A large part of HSBC's success is due to its regional presence. "Traditionally we have been the only global bank with a full-scale presence on the ground in investment banking and this has also been the case in project finance," says Darren Davis, managing director and head of project and export finance MENA HSBC. "We have had a project finance advisory execution resource on the ground for over three years now and this has been a major competitive advantage as it allows us to (1) provide people with a better understanding of the region; and (2) be more responsive to clients needs during assignments as we are right on their doorstep. It is interesting that a number of banks have been following this strategy this year and trying to build up local teams."

HSBC is in the market – along with ABC, BNP Paribas, Samba and ABN Amro – with the Sabic-sponsored Saudi Al Kayan deal. The deal is notionally underwritten by a club of banks, an approach that mimics that used by ABN Amro on Yansab last year . The lead arrangers are going out to market with a margin of 65bp rising to 75bp over Libor, which was agreed with the sponsor and with banks asked to bid on underwriting fees. The invited banks will then come in at the same level as the lead arrangers.

The financing comprises a $1.8 billion commercial bank tranche, a $2 billion ECA tranche (see 'Changes in the funding mix' below), a $1.5 billion tranche from the Public Investment Fund (PIF) and $530 million from Saudi Industrial Development Fund (SIDF). There is also a $635 million Islamic facility from Al Rajhi bank.

Novel engineering is nothing new in the Middle East. When advising on the Greater Equate project in Kuwait, SG went initially into the market without any specific ticket sizes, gauged the interest, and then asked banks to bid on tickets of $100 million and $150 million. Unusually, the same participation fee applied across both tickets.

The upfront fees usually reflect the ease or difficulty with which banks can distribute the debt. In an uncertain market upfront fees are likely to be higher than they otherwise would have been despite the presence of capped price flex clauses applied to the margin. There is anecdotal evidence that syndication desks have talked up the need for lender-friendly terms that are divorced from actual market conditions. But, as one banker argues, what is the point of underwriting fees in the presence of flex, where the borrower bears the pricing risk?

Of course the argument is not that simplistic: some powerful sponsors (such as QP) will not entertain flex; banks are accepting some underwriting risk with modest price flex clauses; underwriting fees are not payable on a pre-packaged club deal yet club deals are sometimes not possible to put in place. As one banker says, "the reason that all deals are not necessarily executed as clubs is that clubs are a nightmare to execute, with a group of banks typically demanding lowest common denominator terms."

These issues strike at the heart of the club versus pyramid approach, and raise the perennially thorny issues of Chinese walls among the advisory and lending practices of banks and whether banks truly act in the best interests of the borrower.

"You have to separate the two to avoid conflicts of interest or at least the appearance of them: an adviser's role in achieving the best possible borrowing terms is clearly different to the goal of a lender which is to maximise their return," says Davis.

Some advisers, such as RBS and new entrant Deutsche, make great play of the fact that they run a distinct and separate advisory service, with none of their advisory team working on lending. Deutsche's six-strong team based in Dubai is trying to leverage its European infrastructure expertise in the Middle East. Deutsche is advising the Binladen consortium on the Saudi Landgbridge rail project, and is hoping to move into oil and gas mandates following the hire of Dolan Hinch from Calyon.

Some of its peers point out that Deutsche, which has pulled out of project finance lending, may find the going difficult because sponsors like to see a balance sheet behind advisers – hence the idiom according to one banker: "Is the butcher prepared to eat his own sausages?" Yet regional head Frank Beckers is confident he can successfully pitch clients his model.

Where banks' advisory and arranging businesses are intimately linked, advisers and arrangers can sit on the same side of the table to expedite closing or there may be a matching clause (the so-called sweetheart clause) from the arranging side of the advisory bank to allow the bank to arrange at the same terms as the market.

The number of PF advisers capable of putting together a multi-million dollar multi-sourced financing is relatively small, and the variety and needs of clients relatively large and diverse, so no one type of financial engineering or advisory business model suits all clients.

The general trend in structuring is toward projects using contracting strategies that push completion risk away from contractors and on to sponsors' shareholders. The challenge posed by higher capital costs also means that phasing of projects will become more prevalent or lead to procuring authorities bucking the trend and reducing the scope of projects such as Ras al-Zour IWPP to ensure greater EPC competition.

These issues, coupled with the currently less-liquid bank market and capricious capital markets, make the role of an adviser more critical than ever.

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Power due for a shake up?

Aside from Qasco, the biggest story in the advisory market is Ras Laffan C, where QP is employing its oil and gas model, of raising financing itself, to the power sector. The thinking is that given QP's standing, if Ras Laffan C can successfully raise the financing at a price close to QP's LNG projects, the template will be replicated in power projects in other countries in the region. RBS is the financial adviser. However timeliness could be an issue – and one participant in the deal notes, "the new approach is unlikely to catch on – it has been much less straightforward than expected."

The rationale behind the Ras Laffan C model is that QP has the bargaining power to command better terms and pricing compared with the usual power template, where developers put their own financing in place. Ras Laffan C should therefore be able to get the cheapest EPC price and the cheapest cost of financing.

The model is a consequence of the progression of the national sovereign ratings of the GCC to high investment grades, as all power projects in the region are backed by a sovereign offtaker. That the old model has lasted so long seems to be an overhang of emerging markets mindset that export-driven projects with oil majors are far safer credits and perhaps a hangover at credit committees from the power troubles in the US, UK and emerging markets, such as the Dabhol default in India.

The one potential hiccup with divorcing the financing from the EPC tender is that the lowest all-in solution will not be picked if competitive ECA funding is not factored in – particularly if, say, a JBIC Overseas Investment Loan supports a Marubeni bid. However, the EPC price is usually the principal determinant and RBS is believed to be working on a model that incorporates ECA involvement.

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Changes in the funding  mix

As well as the increase in pricing and the move towards more club deals, a further consequence of the credit turmoil is a quiet shift in the funding mix. In the recent National Chevron Phillips deal Saudi banks are believed to have taken tickets of $154 million as opposed to the $73 million tickets of international banks at the same upfront fee of 90bp, a clear indication of greater local liquidity (see Deals and Developments in this issue for more).
Also noticeable has been the absence of many international project banks on the Qatalum and Sohar-Oman Refinery Company deals. Regional and local banks usually have a higher cost of funding compared with their international peers, but they appear to be more insulated from the credit crunch and are therefore more competitive.

ECA facilities have become marginally more competitive as commercial bank pricing rises towards the OECD benchmark rates. More significantly, some ECAs are following the lead of JBIC and extending direct loans while others are loosening their conditions for ECA facilities.

JBIC has been flexing its balance sheet with its Overseas Investment Loan programme (OIL). In March, JBIC extended $110 million to the Amman East IPP project in Jordan co-financed by OPIC and SMBC. It recently contributed $836 million on the Marubeni Mesaieed A project in Qatar and is about to commit to $1.2 billion for International Power and Marubeni's Fujairah 2 IWPP in the UAE.

EDC has become more active again as a direct lender. It was a mandated lead arranger for the $1 billion financing of the EAgrium fertiliser project in Egypt and it is a co-lender under the $540 million US-Exim tranche backing the National Cheveron Phillips deal.

The Korean agencies are also active in the region. In the upcoming Saudi Al Kayan financing a $1.5 billion ECA-covered tranche is being divided equally among ECGD, Sace and KEIC, and Kexim is providing a direct loan of $500 million. KEIC covered a $650 million portion of a $3.4 billion debt for the Marafiq IWPP in Jubail, Saudi Arabia. JBIC and KEIC are competing for a role on Ras al-Zour in Saudi Arabia which is due to close next year. The ACWA bidder is working with Kexim, while Suez is likely to be involved with JBIC on its deal.

Both ECGD and Sace have significantly relaxed their rules to better reflect commercial reality increasing the proportion of non-national content they will cover, with the ECGD announcing in June that the maximum amount of non-UK content in UK contracts it covers has increased significantly from 30% to 80%. The OECD has recently intimated that the rules regarding local content under ECA facilities will be relaxed from a maximum of 15% of contract value to 30%.

Although the Qafco 5 transaction is testimony to the volatile nature of the capital markets, as the scope of projects increases and capital costs continue to rise, the capital markets are likely to have an increasing role, particularly for refinancings of projects past construction and the anticipated transport infrastructure projects such as the Landbridge rail project. Qatargas 4 is structured to allow a bond to take out of all or part of the debt, and the $2 billion bond component in the Emal transaction should set a useful benchmark in the current market.

Several investment banks – such as Barclays Capital, Deutsche and Goldman Sachs – have increased their regional presence in the hope of a surge in capital markets work. However, consensus in the bank market is that their plans have probably been put back by 12 to 18 months by the crunch. As project bond activity has been so limited, newcomers to the advisory market with bond expertise are likely to be less disadvantaged than newcomers with bank debt. However, according to another source: "These firms will still suffer from a lack of PF advisory credentials, which will hinder them because capital markets will almost always be just one part of a financing package."

The largest test on the Middle East advisory horizon is the Ras Tanura project, which will almost certainly involve ECAs and probably a bond component. Ras Tanura, a $22 billion petrochemical complex to be located in Saudi Arabia, part-sponsored by Dow Chemicals, is likely to tender for an adviser by the end of the first quarter of 2008.

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Track changes

Financing of the Saudi Landbridge Railway will be a key test of how big a role project finance will play in the GCC's next big growth sector.
Most fledgling PPP markets kickstart with road projects. But in the GCC it is the $5 billion Saudi Landbridge Railway Project that could ste the region on the path to a long anticipated transport infrastructure boom.

The Landbridge is one of three major rail projects in Saudi Arabia, though only two will be project financed. In the wider GCC, feasibility studies are also underway for a 1,500km railway passing through six countries along the length of the Arabian Peninsula from Kuwait to Oman, and possibly even Yemen.

Including a 950km line linking the Saudi capital Riyadh with the Red Sea port of Jeddah and a 120km stretch between Dammam and Jubail, it is estimated the Landbridge will transport 23 million passengers per year. But its biggest value will lie in its freight carrying capacity of 30 million tonnes per year, saving five to six days of shipping time around the peninsula.

Nevertheless, getting the project funded will be a serious challenge for the Saudi government with lenders expressing an unwillingness to finance the level of risk initially asked of the private sector. Their reluctance is understandable given the heavy rail sector's notorious reputation, cemented by the Channel Tunnel, for being difficult to correctly assess the risks. A long concession period of 50 years compounds the difficulty of forecasting traffic.

Landbridge bids

Four consortia submitted bids for the project in November – the Saudi BinLadin group, the Saudi Mada group, the Kuwaiti Agility PWC Logistics consortium and the Tarabot consortium of South Korea's Samsung Corporation and Australia's Pacific National. What shape the financing takes will become much clearer after the Saudi Railway Organisation (SRO) announces a winner, planned to happen in the first quarter of 2008. The debt-equity split will be 50/50. So far each proposal has a financial backer and provisional term sheet in place, but the feeling is that tricky negotiations remain between the government and whoever becomes the preferred bidder.

"The government has put out a pretty aggressive risk allocation in its request for proposals," says one banker. Strict terms of confidentiality make it hard to know what each consortium has bid, but it is extremely unlikely that any of the consortia has bid the risk allocation that the government is asking for. While the Landbridge Railway will definitely be built, it is not out of the question that a project financing may be ditched in favour of a traditional procurement.

BOT remains the likeliest outcome, however, given the determination of the government so far in pursuing this route.
"It all depends on value for money," the banker says. "The government wants to push this because it feels it can get a good all in package, in terms of risk transfer and price, that is more interesting than a standard procurement. The Saudis have closed many large-scale complex projects before, so they know how to get things done. And there are large Saudi families involved in the bidding, so the government will listen."

The other big project in the Saudi pipeline is the $6 billion Makkah-Madinah Rail Link (MMRL) project, a 444km track that will serve Muslims on the Hajj pilgrimage. The SRO will issue the request for proposals by the end of the year, with the bid submission deadline on March 27, though some bankers suggest this timetable may be on the aggressive side. There were six consortia pre-qualified in June.
As the reasons for this project are more political than commercial, the RFP will almost certainly feature a much higher degree of government subsidy than for the Landbridge.

"The Landbridge stands up alone, whereas Makkah-Madinah is more politically charged," the banker says. "It relies on passengers who have many transport options available so it becomes very difficult to predict how much traffic it will receive. With a cargo container, it either moves by rail or road. It's a question of pure economics."

A third major railway in Saudi Arabia, the North-South minerals railway, is being run as a traditional procurement.

Regional expansion
Leaders from across the GCC will be keeping a close eye on MMRL and the Landbridge in particular to test the viability of using project finance for their own plans. The indications are that Arabian Peninsula could be about to see a period of rail network expansion unprecedented since in the region since Ottoman-German efforts to construct a Berlin to Baghdad railway were cut short by the First World War.

The results of feasibility studies for the GCC Railway are expected by the end of 2008 and it is hoped that construction on sections of the project, estimated to cost $2.5 billion, might even start by 2010. The railway would run from Kuwait City through Saudi Arabia, where it would link up with both the Landbridge at Dammam and the North-South Railway at Jubail, onto the United Arab Emirates, passing both Dubai and Abu Dhabi, and finally onto Muscat in Oman. Another branch will probably run to the Omani port of Salalah, while it is possible that the railway will be extended into Yemen.

Saudi Arabia is not the only country in the region with plans for an expanded domestic rail network to link with the GCC Railway. Kuwait is planning a railway link between the Iraqi and Saudi borders, while the UAE intends to build an 800km domestic network.

But Saudi Arabia is by far the most experienced country in the region when it comes to rail, with a stretch of railway, forming part of the Landbridge that will be upgraded, already in operation and commercially successful. The Kuwaiti project has strong potential at an estimated total cost of $14 billion, split equally between heavy rail and a light rail network in Kuwait City.