When an export finance banker complains that export credit agencies are not sufficiently commercial, they usually point to two areas. The first complaint is that they are too slow, often as shorthand for burdensome insurance, environmental, or even commercial requirements. The second is that they need to become creative, and in this respect both the ECAs and the multilaterals have been delivering.

The most popular, and best-regarded innovations have been in new types of insurance coverage. These include devaluation insurance, partial risk guarantees, and even a swap loss insurance policy. But equally significantly, several agencies have begun to explore products that operate at different places in a project's capital structure than straight debt.

Insurance products for sponsor equity are a staple of project finance, although they seldom receive the attention that debt policies attract. Equity insurance has existed for longer than project finance, and still covers most of the smaller cross-border investments into markets that lenders will avoid even with export cover. For instance, the Overseas Private Investment Corporation (Opic), founded in 1971, has a mission structurally separate from the United States Export-Import Bank (US Ex-Im). While Ex-Im provides debt to buyers of US goods and services, Opic covers equity investments by US corporations and the debt raised behind these.

The distinction between debt and equity usually persists within export credit agencies. The UK's Export Credits Guarantee Department, for instance, tends to offer cover of equity through its Overseas Investment insurance scheme. According to Harry Katechia, an underwriter in the division, the ECGD has not received any firm requests for insurance of subordinated debt, "but we'd look at it, if it could be classed as a UK investor. We have supported shareholder loans in the past."

Germany's DIA - open for business

In Germany, the federal government has used the Garantie für Kapitalanlagen im Ausland (Guarantee for capital investments in foreign countries, or GKA) insurance product for equity investments. This facility is explicitly reserved for equity, or equity-like investments. Insurance under the GKA programme is provided by Hermes, approved and backed by the federal government, and administered by PricewaterhouseCoopers.

The GKA has since been renamed the DirektAnlage (DIA), but has a relatively long pedigree. According to Nicole Haubold, Senior Consultant at PricewaterhouseCoopers, which manages the DIA for the consortium formed with Hermes, "German government support for equity investment abroad has existed since the 1960s, but the widespread use of the guarantee in project finance has increased with the number of project financings. And there is now more interest in publicising the product."

This increased interest in publicising the product has led to the creation of new guidelines (these are available, in German, at http://www.agaportal.de). According to Haubold, "We recently adopted a new set of regulations for the DIA that should be even more flexible and adaptable. The previous set, which dated back to 1993, featured a closed list of types of instruments - loans, equity, and endowment capital. The new rules allow us to accommodate new instruments."

Haubold stresses that the new guidelines, and the DIA product, are largely about providing greater security for German investors, although she notes that there are innovative potential uses. "Sponsors have been looking for more comprehensive country risk coverage for their BOT and infrastructure investments, and we can also use the guarantee for loans from German lenders that have participation-like features."

The most recent DIA facility in a project financing made use of just such a subordinated structure. The Alunorte deal, a $310 million debt financing for an aluminium refinery expansion, featured a $200 million tranche covered by the DIA, and provided by ING, KfW, and WestLB. Alunorte, based in Brazil, is increasing its capacity from 2.4 million tonnes per year (tpy) to 4.2 million tpy by the first half of 2006. Alunorte's sponsors are CVRD, which is providing 57% of the project's $233.1 million of equity, and Norsk Hydro, with 34%.

It is the connection to Norsk Hydro, which has a German subsidiary, that made the DIA possible, and the fact that there was no direct German content, which would allow a more straightforward political risk policy, that made the use of the DIA rather than senior debt insurance necessary. As such, an ECA-backed senior debt package would have made much more sense, at least purely in economic terms.

According to Jan Klasen, head of KfW's natural resources team: "the product is useful in the basic and general industrial sectors. But there are some conditions attached, including that the provider of DIA-covered debt cannot be the first person to call a loan, and the debt should have a flexible margin."

The lenders say that the senior debt has a 10-year tenor, and a margin of between 200bp and 300bp over libor. But this may refer to the two additional tranches - a $30 million NIB facility arranged by Nordic Investment Bank and a $80 million GIEK facility arranged by DnB NOR Bank. The DIA facility also features additional equity-like features that increase the risk transfer, such as grace periods, although the lenders have been sparing with details of the structure, since the deal is in syndication.

The Alunorte financing is best viewed as a creative solution to the constraints of the German export finance market. But it gives some indication of the challenges of structuring a subordinated debt package, as well as the potential uses for subdebt. Some lenders express scepticism as to whether there is a real need for mezzanine debt capacity in cross-border project financings. According to Roberto Vellutini, head of the Inter-American Development Bank's private sector department's power group, "most of the instances where I have seen sponsors provide subordinated debt have been for tax reasons."

Where sponsors are lenders

Such loans have often also been provided where a sponsor is less willing to provide the additional equity that international lenders require. Venezuelan telco Digitel, a subsidiary of Telecom Italia Mobile, closed a financing in 2002 that used a sponsor loan featuring equity insurance from Sace, the first time Sace had done so. The $230 million loan replaced a hoped-for vendor finance tranche that fell through, and complemented $250 million in senior debt from Citigroup and JP Morgan.

Sace has not built up a substantial equity insurance book, and has not responded to questions about its current position on equity and equity-like insurance. Market sources say that Sace is currently more focused on supporting big-ticket oil and gas financings, often alongside US Ex-Im.

It would not be alone in maintaining a distance from the product, since several of its peers have said they see little business from the lower end of the credit spectrum. Export Development Canada, for instance, is one of the best-regarded ECAs in terms of its ability to act as an arranger and move at the same pace as commercial banks. But Derek Layne, EDC's head of project finance, says that EDC does not provide mezzanine finance, and prefers to concentrate on arranging and PRI provision roles.

"We do have a business providing PRI to equity investments, and natural resources firms are among our biggest customers," says Layne. "But we haven't used it on subordinated facilities. Where we are seeing increased interest is from sponsors seeking PRI that covers their entire global portfolio. We also did our first capital markets financing - for Telemar of Brazil - last year."

JBIC steps up

While many ECAs are wary of the use of subordinated debt, the Japan Bank for International Co-operation (JBIC) is moving ahead with the creation of an ambitious new subordinated facility. According to Ryuichi Kaga, the director general of JBIC's project finance department, the bank has developed the facility over the last two years, in response to the needs of Japanese investors.

"There have been large numbers of power assets coming on to the market in recent years, and brownfield opportunities are more common than greenfield ones," notes Kaga. "We have been trying to devise a product that enables Japanese trading houses to buy these assets." Japanese corporates are fairly risk-averse, and may often be looking at projects with substantial existing non-recourse debt.

JBIC has created two facilities, a mezzanine facility designed to replace some of the equity on single asset purchases, and a subordinated holding company loan that would assist in the purchase of a portfolio of assets. The most immediate candidate would be Mitsui, which, alongside International Power, won the bidding for Edison Mission Energy's international IPP portfolio. That acquisition is likely to proceed with a subordinated loan facility, possibly in the Term B market, but without JBIC assistance.

"We cannot comment on any clients at this stage, but while Mitsui would be able to use the facility, we are not currently negotiating it with them," says Kaga. But, according to Kaga, the deal will be suitable for any assets with strong enough cashflows to support a second layer of debt, such as water projects. "For us, making sure there is sufficient revenue to support this lending is key," he says. JBIC has about $1 billion earmarked for subordinated facilities, and a per project limit of $200 million to $300 million

But Kaga does believe that there is some due diligence left to do. "Any financing agreements are likely to be conducted under New York or UK law, but there are still some jurisdictions where subordinated debt may not be recognized. The US, Europe, and Japan are fine, it is emerging markets that present the biggest challenges," says Kaga, "and we need to look at securing standby agreements from sponsors or governments to mitigate such risks."

The outer limits

And senior lenders will have their own issues with subordinated debt, since in some jurisdictions, and under some circumstances, such debt could be treated as pari passu with senior debt.

As the IDB's Vellutini points out: "some senior lenders might be wary of coming in alongside subordinated debt, the possibility of it becoming pari passu makes them nervous." The IDB is in the business of providing subordinated debt - insofar as it provides a partial guarantee facility that is subordinated to senior debt. These partial guarantee facilities are drawn upon in the event of certain political risk events occurring (for more details, see an interview with the IDB's capital markets unit in Project Finance, November 2003).

Such subordinated insurance policies have yet to be fully tested, although since they are dedicated too making lenders whole, there is much less likelihood that they would compete with these lenders for available collateral in a bankruptcy. Sponsors are warier - the devaluation policy that Opic extended to AES Tiete in 2001 for its $300 million bond issue was recently dropped during a refinancing.

That deal used a $30 million subordinated liquidity facility that could be drawn upon if the real dropped below certain predetermined levels against the dollar. The deal would have in theory allowed any borrower with the appropriate PRI cover and rating to access the dollar markets, but has been difficult to repeat. AES has suggested that the policy, while a welcome development, was not worth the difficulty (see Project Finance, Power Report, p.4).

The subordinated facility with the longest track record is the C loan product from the IFC. The C loan is a traditional feature of its corporate business, but it does feature in project deals - $50 million of the $250 million refinancing for CMS and Endesa's GasAtacama project in Chile is in the form of C loans. According to the IFC's own website 'Quasi-equity investments are made available whenever necessary, to ensure that a project is soundly funded,' and it should be noted that the C loan encompasses a wide variety of investments, including convertible, as well as subordinated, financing. But several other multilaterals have suggested that the C loan is in essence a way for the IFC to earn a better spread from project. The IFC has not responded to questions about the programme.

But it looks unlikely that pure private mezzanine finance, for instance, will be a big feature of cross-border financings in the coming years. Indeed, the last headline deal with a private mezzanine was Centre Solutions' $85 million tranche of the $175 million Termocandelaria financing for KMR in Colombia - back in 1999.

Indeed, Philippe Valahu, who recently returned from heading MIGA's Asian operations to running infrastructure in Washington, cannot recall an instance since the late 1990s where he has been approached to cover a third party subordinated debt financing. "We have not seen that many deals using it," he says. "We are concentrating on new insurance products that would provide cover for sub-sovereign projects, as well as political risk cover that would include being unable to gain an arbitration award." MIGA does, however, provide some quasi equity cover on some infrastructure financings.

Valahu says that MIGA and its counterparts within the World Bank Group and elsewhere are examining devaluation risk solutions, given that private insurers are not in a position to provide such coverage. But he acknowledges, however, that innovative coverage solutions will develop alongside the efforts by development banks such as the Asian Development Bank and the IDB to promote domestic capital markets.