The Cross Israel Highway project has been at the forefront of Israel's innovative public-private-partnership (PPP) program. The original project financing by Derech Eretz Highways Ltd (DEC), which closed in the autumn of 1999, was Israel's first large-scale build-operate-transfer (BOT) Project and won Project Finance Magazine's Deal of the Year.

The original Cross Israel deal is the first stage in a planned 300km highway running from North to South through the central region of the country. Since its completion in 2004, traffic on the Cross Israel Highway has continued to grow at 10%-plus per year and traffic levels now exceed the original forecasts.

Israeli PPP market

Since the financing of the Cross Israel Highway, more Israeli PPP projects have also been successfully financed, including:
• two sea water desalination projects;
• The Jerusalem Light Rail Project; and
• Highway 431 – a shadow toll road (awarded Project Finance Deal of the Year 2006).

Each of the projects have included innovative financing and are evidence of a maturing PPP market as lessons are learnt from one project to the next and a more efficient risk allocation between the public and private sectors is developed.

Potentially the largest PPP infrastructure project in Israel to date – the first line of the Tel Aviv Light Rail Project (which comprises of the construction and operation of 22km light rail system through the heart of the Tel Aviv metropolitan region) was recently awarded to a Siemens/ Africa Israel led consortium which is now in the process of arranging financing.

In addition, the Ministry of Finance with the support of the Ministries of Transport and National Infrastructure continues to develop further PPP projects. Projects in the pipeline include:
• A shadow toll road connecting the Cross Israel Highway with the North – South Coastal Road, north of Tel Aviv;
• A bypass around the northern city of Haifa;
• Design Build, Maintenance Contracts for the National Highways Authority;
• Additional lines to the Tel Aviv Light Rail Project.

Section 18 project

The most recent PPP project to achieve financial close was an 18km northern extension to the original Cross Israel Highway, known as Section 18. Although an add-on to an existing project, implementation was not straightforward and required the state, the project sponsors, DEC, the existing lenders and the new Section 18 lenders to resolve a series of difficult problems. DEC's sponsors are Africa Israel Investments Ltd and Housing & Construction Holding Ltd – two of Israel's largest holding companies and both of whom are very active in the PPP market – and Aecon Group Inc. (one of Canada's largest construction companies involved in PPPs internationally) – all devoted time and resources to structure, develop and drive the transaction.

Financing structure

The original financing included two tranches of senior debt, a $850 million NIS denominated financing lead arranged by Bank Hapoalim (Israel's largest bank, responsible for having lead arranged most of Israel's project financings) and CIT Capital which lead arranged and syndicated a $250 million private placement.

For Section 18, Bank Hapoalim lead arranged a senior debt financing to DEC 18 of a NIS denominated amount of $130 million. Many of the participants in the financing to DEC 18 are existing senior lenders to DEC (as part of the NIS denominated tranche). The dollar lenders to the existing project did not participate in the Section 18 financing.

Section 18 concession structure

Because of the success of the original highway deal, all parties concerned were interested in DEC arranging the finance, construction and operation and maintenance of Section 18. However, each party had different constraints on how this would be achieved:
• the existing lenders' position was favourable to the implementation of Section 18 due to the additional traffic that it would bring to the existing project. However, the existing Concession Agreement and Finance Documents did not entitle DEC to take on the Section 18 project as it would involve exposing the existing lenders to additional construction risk and would require DEC to incur additional senior debt. Therefore, the existing lenders' position was that DEC should incorporate a sister company which would enter into a new and separate concession contract for the Section 18 Project, and the new concessionaire would enter into an operating contract with the existing operator.
• the state's position was that any extension to the existing highway had to be awarded to DEC (rather than an affiliate) as otherwise, Israeli tender law would require the Section 18 project to be put out to competitive tender. However, the state acknowledged that, although the concession contract included an option to instruct DEC to operate and maintain any extensions to the project, it did not include any provisions allowing the state to force DEC to construct additional sections.
To satisfy the requirements of Israeli law and the restrictions imposed by the existing lenders, a compromise structure was reached:
• DEC entered into an addendum to the concession contract, pursuant to which DEC was awarded the concession to develop Section 18.
• The state agreed that DEC could incorporate a fully owned subsidiary ("DEC 18") to which it would subcontract its obligations, and through which the financing of Section 18 would be organized.
• DEC and the existing lenders would be totally insulated from construction risk for Section 18 and partially insulated from operational risk.

Project risk allocation

The challenge – as outlined above – faced by the existing lenders was how to isolate themselves (and the existing concessionaire) from the construction and, to a lesser extent, operational risk of the extension. This was crucial since under the existing concession agreement, a concessionaire breach would entitle the concessionaire and the existing lenders to compensation that would not be sufficient to repay the senior debt. The risk that this would be triggered by a breach in relation to the Section 18 extension was not something that the existing lenders could accept.

The solution to this issue was for all parties to agree that breaches of the concession contract by DEC1 that related to the construction of the Section 18 extension would not entitle the state to terminate the entire concession contract in relation to the existing concession. The state also agreed to limit damages claims against DEC for such breaches and that any compensation payable by the state on termination would be calculated and paid separately by the state for each element of the project.

With respect to the operating period, the position was more difficult. On the one hand, the state already possessed the right to require DEC to operate any extension on substantially the same terms as the current highway. On the other, the existing lenders were wary about accepting risks arising from Section 18. The compromise that was reached was that, in principle, an operating breach in Section 18 would be considered a breach in relation to the existing concession as well, unless it fell into certain pre-agreed categories (such as low volume of traffic on Section 18 causing the Section 18 lenders to declare a default). In such a case, the breach would not affect the existing concession. Although not a perfect solution, the existing lenders accepted this for two main reasons: first that the state could force DEC to open Section 18 anyway and second that, given that the operation of both sections of the highway would be carried out by one operator under one agreement, the chances of a breach occurring in only one section of the highway were relatively small.

Interproject agreement

The above allocation of risk was the basis for determining the relationship between DEC and the existing lenders on the one hand and DEC 18 and the Section 18 lenders on the other. The fact that the concession rights flowed from the state to DEC and from DEC to DEC 18 meant that DEC 18's relationship with the state had to take into account DEC's rights and those of the existing lenders. This was achieved by means of an agreement between all of these parties – the "Interproject Agreement", addressed the following key points:

1. Payment of tolls – in order to avoid the need to have existing registered customers sign new agreements in relation to Section 18, it was agreed that the tolls and other revenues paid in relation to journeys on Section 18 would flow through DEC's bank account to DEC 18's bank account (and that while held in DEC's bank account, the funds would be held on trust).

2. Payments by state – it was agreed that DEC would issue an irrevocable payment instruction to the state ordering the state to make any payments in relation to Section 18 to DEC 18 directly.

3. Defaults – the parties agreed that, while both the rights and remedies of the existing lenders in the case of a default under the existing finance documents and the rights and remedies of the Section 18 lenders in the case of a default under the Section 18 finance documents during the construction period would not be limited by the Interproject Agreement, during the operating period, the rights of the Section 18 lenders would be limited to remedies that do not affect the existing project (such as drawing on Section 18 guarantees) unless the default met one of the following criteria:
a) it constitutes one of the exceptions to the cross default rule set out in the amendment to the Concession Agreement;
b) DEC was insolvent;
c) the existing lenders accelerate their loans or realise their major security interests; or
d) the default relates to key undertakings such as non-payment of amounts due in excess of an agreed minimum amount.

4. Reserved discretions – the Interproject Agreement specified which concession agreement rights DEC 18 could require DEC to exercise/ prevent DEC from exercising, together with rights of the existing lenders to override any such action in relation to certain rights, in the event that the action/inaction could have a material adverse effect on the existing project.

5. Security Interests – another limitation imposed by the state was that the shares in DEC 18 held by DEC could not be charged in favour of the Section 18 lenders (on the grounds that this could, in theory, result in separate ownership of DEC and DEC 18). Therefore, in order to ensure that where the existing lenders realised their security interests over the project, the Section 18 lenders would receive the value of DEC 18 in order to repay their loans, the two groups of lenders agreed that any proceeds received on such realisation would be allocated between the two groups of lenders, based on the relative values of the rights under the Concession Agreement with respect to the main section and Section 18, as determined by an external valuer.

As can be seen from these issues, the basic position agreed was that during the construction period, the rights of the existing lenders in relation to Section 18 were minimal since there was no risk of cross default. However, as soon as the operating period commences, in the event of any conflict between the two groups of lenders, it was almost always resolved in favour of the existing lenders. This was a key consideration for the existing lenders in approving the Section 18 project.

Mezzanine

Another innovative aspect of the Section 18 financing was the raising by DEC of third-party mezzanine financing. DEC raised a NIS denominated amount of $90 million through a tender to Israeli institutional investors. Of the aforesaid amount $50 million was earmarked for investment by DEC in the equity of DEC 18 to finance part of the construction of Section 18. The remaining amount of the mezzanine finance was used to pre-pay part of the existing sponsor subordinated loans. The mezzanine financing was raised by DEC rather than by DEC 18 because DEC had the proven track record and the ability to repay the mezzanine. In addition, although the proceeds of the mezzanine financing were used to partially finance the construction of Section 18, the mezzanine lenders are not assuming direct construction risk and DEC is financially robust enough to support repayment of the mezzanine loans. The mezzanine loans received a local rating of A3.

The mezzanine financing is structured with a repayment profile from 2011 until 2020. However, if for any reason, DEC is unable to make scheduled repayments of principal or payments of interest, payments will be deferred until such time as DEC is able to make such payments, without such delayed payment constituting an event of default or entitling the mezzanine lenders to take any enforcement action. In addition, although the mezzanine lenders were granted a second ranking security interest over the assets of DEC, they undertook not to commence or support any enforcement action against DEC, unless the senior lenders were enforcing at such time, their first ranking security interest. Each of the mezzanine lenders became party to the intercreditor agreement and confirmed their subordination to the rights of the senior lenders.

Conclusion

The unique characteristics of the Section 18 project created a number of serious problems, any one of which could have torpedoed the entire project. However, in the words of Mr. Ehud Savion, CEO of DEC, "creative thinking and a willingness to be flexible by all parties allowed the project to proceed to financial close."

It is to be hoped that this flexibility will continue to be demonstrated in the future projects currently being tendered or financed in order to ensure the continued success of Israel's PPP market.

Mark Phillips, a partner at Herzog, Fox, Neeman acted for the existing NIS Lenders and the Section 18 Lenders; Jonathan Finklestone, a partner at Tadmor & Co., acted as co-counsel to DEC & DEC 18.

Footnote:
1 Although in practice the breach would be by DEC 18, since DEC was the party to the concession agreement, it would be deemed to be a breach by DEC.