Tunnel Vision
Also, Eurotunnel had much of its debt in the market trading at a
discount to par value. ?We wanted to find a way to capture that
discount for the benefit of our shareholders,? says Burge. This had
to be achieved without disturbing the existing capital structure.
Eurotunnel was not the first to realise the opportunities that lay with this unlisted, unrated bank debt. ?Institutions had previously tried to buy junior debt, put it into a fund and list it, in the hope of creating liquidity,? says Burge.
The idea behind this was that a simple repackaging could push the price of the debt up and produce a tidy profit for the repackaging institution. The new funds were aimed at high yield investors who had expressed an interest in the Eurotunnel credit.
However such attempts were small scale and a simple repackaging was of little interest to Eurotunnel. Eurotunnel believed that if it put its name behind a repackaging, and obtained a credit rating, then the company could sell itself to its long term target market ? fixed income investment grade investors.
On October 12, Merrill Lynch and DrKW announced a tender offer for the junior debt. The offer was conducted through special purpose vehicle, called Tunnel Junior Debt Holdings. Once this vehicle had accumulated enough junior debt, the vehicle would sell it to another vehicle, which would fund the purchase through the issuance of securitised debt.
Eurotunnel needed at least 28% of the junior tier to go ahead with the deal. Eurotunnel's waterfall capital structure puts the junior debtholders at the top of the structure, except for £352 million of senior debt, and holding all of the voting control over modifications to covenants or refinancings. Whilst this new deal did not affect the project financing, the vehicle needed to own at least a 25% blocking share of the voting rights, to ensure that no changes could occur to the underlying structure during the life of the securitisation.
Since the 1998 restructuring, approximately 50% of the project finance loans had traded into the market, and around 60% of the junior debt was now held by new investors. Most of these were US and Japanese hedge funds, who bought into Eurotunnel sensing the opportunity to make a quick buck. The hedge funds may have bought the junior debt at anything as cheap as 70% below par. Now that Eurotunnel's fortunes had improved somewhat, and the market price was up to around 30 below par, the hedge funds wanted to get out.
As Burge explains, ?the hedge funds had made around £300 million in three years, and they wanted to realise that profit. The risk-reward for them was not enough to interest them in waiting another six years to get another £200-£300 million.? As there are relatively few potential buyers of unrated, unlisted debt, Eurotunnel was in a strong position to negotiate a tender offer for this unwanted debt.
The tender offer was not aimed at banks who held Eurotunnel junior debt. Peter Kappel, director in asset-backed finance at DrKW says that, ?The banks who originally held junior debt and didn't sell out to hedge funds were quite happy to hold the debt until maturity. If they had sold now, they would have been forced to register a loss on the investment.?
The discount in the junior debt provided an element of overcollateralisation for the asset-backed notes, which was crucial if investment grade ratings were to be obtained. Because the junior debt was trading well below par, Eurotunnel could buy approximately £100 of junior debt with just £73 of funds. So there was a difference of 27% between the cash coming into the vehicle to pay the junior loans, and the money going out to repay the asset-backed notes. This provided a cushion for the asset-backed notes.
Fixed-Link Finance owns £1.1 billion of junior debt, but only has to repay a £900 million bond issue. Assuming that this cushion is not used, and that Eurotunnel makes all the loan repayments that it is supposed to, Eurotunnel is left at the end of the transaction with a £250 million reduction of debt.
The deal incorporates a wrap from monoline insurer MBIA on half of the single-A and triple-B rated paper. This feature was not in the original plan, but was added after the lead managers failed to get enough interest in the deal before Christmas, and postponed the launch until late February.
Peter Kappel explains that, ?We recognised that the Eurotunnel credit story was something that investors needed to get comfortable with. MBIA, on the other hand, is familiar with and likes infrastructure risk.?
The MBIA wrap was successful in giving investors extra confidence in the deal, which finally closed at the end of February. But from a syndication perspective, it is perhaps easy to see why selling the deal was tough. Essentially, the deal offers the same risk as the junior debt but less return.
One London-based fixed income investor comments that: ?the return on the bonds is not unreasonable, but there's no uplift.? He says that he prefers the junior debt: ?If you are happy with the fundamentals of the credit, why buy the securitisation?? The advantage with the junior debt is that there is potential with capital gain ? even buying in the mid 80s would bring a healthy profit for an investor. The investor adds that the securitisation is not badly priced ? but its just that the junior debt offers more value.
Its lucky that all of Eurotunnel's junior investors do not have this attitude. The reason why the repackaging is so unusual ? and unlikely to be replicated ? is that the debt should not be trading at the discount that it is. Maybe the project banks shouldn't have sold out to the hedge funds in 1998 after all.
Light at the end of the tunnel
Eurotunnel's present capital structure came out of the restructuring process, which was completed in 1998. When the Eurotunnel project was completed in 1995, it was apparent that the projected cashflow would not cover the rapidly escalating financing costs, because the project had gone so far over-budget.
So from 1996 to 1998, Eurotunnel and its advisers put together a massive restructuring programme, in an attempt to stabilise the financing, and avoid it lurching from crisis to crisis.
The £8 billion of debt was sliced into a number of different financial instruments, with the bulk of it (£4 billion) left as syndicated senior and junior debt, and £1 billion of it in the form of 50 year resettable bonds.
The aim of that restructuring was to give Eurotunnel as much flexibility in the early years of the project. For example, the junior debt payments were originally expected to be from 2000-2012, but this was termed out to 2005-2025. The core £5 billion of debt was yielding a fixed average rate of 6.1% until 2003 ? which for such a large amount of debt was extremely cheap funding.
The remainder of the debt was restructured into equity, convertible bonds, and a participating loan. The participating loan structure was fairly new to UK project finance, and pays out a fixed rate coupon of 1% until 2006, after which time the lenders receive 30% of cashflows after debt service and repayments.
The result of that two year restructuring was a 40% reduction in interest rates, through both the conversion to equity and the lowering and fixing of coupons on the debt. However, net cashflow after capex would still not fully cover interest charges until 2004. So the final limb of the new structure was the introduction of a stabilisation facility, which at a rate of 0% until 2006 could be used to pay unpaid interest.
The restructuring was undoubtedly successful, as Burge explains. ?The restructuring has proved that the project is working. We have had no breaches of covenant and have stopped lurching from crisis to crisis.?
On the verge of success
Eurotunnel is the classic example of a mega-project that nearly didn't make it. Upon completion of the tunnel between the south of England and the north of France in 1995, Eurotunnel was in the tricky situation whereby its revenues were substantially less than its debt repayment obligations. Which makes its recovery, six years later, all the more surprising. With growth in HGV and Eurostar passengers exceeding expectations, the project's lenders ? about 170 banks in total ? will be glad they stuck with it through thick and thin.
Eurotunnel's primary operations consist of two cross-Channel rail shuttle services, one for heavy goods vehicles and one for passenger vehicles. In addition, it receives fees from Eurostar and other freight train operators who use the tunnel. By 2002, the purchase of new rolling stock is expected to double the capacity of Eurotunnel's shuttle service. Eurotunnel is steadily gaining ground on its primary competitors, the ferry services that run across the Channel. With a market share in the HGV industry of 46%, Eurotunnel has significant opportunities to increase revenue.
The use of Eurostar, the passenger service that runs from London to Paris and Brussels via Eurotunnel, is also steadily increasing. The new Channel Tunnel Rail Link (CTRL) is expected to be completed by 2006 ? this will replace the old rail line that Eurostar trains currently use, and cut journey times to Paris by 36 minutes.
Eurotunnel was not the first to realise the opportunities that lay with this unlisted, unrated bank debt. ?Institutions had previously tried to buy junior debt, put it into a fund and list it, in the hope of creating liquidity,? says Burge.
The idea behind this was that a simple repackaging could push the price of the debt up and produce a tidy profit for the repackaging institution. The new funds were aimed at high yield investors who had expressed an interest in the Eurotunnel credit.
However such attempts were small scale and a simple repackaging was of little interest to Eurotunnel. Eurotunnel believed that if it put its name behind a repackaging, and obtained a credit rating, then the company could sell itself to its long term target market ? fixed income investment grade investors.
On October 12, Merrill Lynch and DrKW announced a tender offer for the junior debt. The offer was conducted through special purpose vehicle, called Tunnel Junior Debt Holdings. Once this vehicle had accumulated enough junior debt, the vehicle would sell it to another vehicle, which would fund the purchase through the issuance of securitised debt.
Eurotunnel needed at least 28% of the junior tier to go ahead with the deal. Eurotunnel's waterfall capital structure puts the junior debtholders at the top of the structure, except for £352 million of senior debt, and holding all of the voting control over modifications to covenants or refinancings. Whilst this new deal did not affect the project financing, the vehicle needed to own at least a 25% blocking share of the voting rights, to ensure that no changes could occur to the underlying structure during the life of the securitisation.
Since the 1998 restructuring, approximately 50% of the project finance loans had traded into the market, and around 60% of the junior debt was now held by new investors. Most of these were US and Japanese hedge funds, who bought into Eurotunnel sensing the opportunity to make a quick buck. The hedge funds may have bought the junior debt at anything as cheap as 70% below par. Now that Eurotunnel's fortunes had improved somewhat, and the market price was up to around 30 below par, the hedge funds wanted to get out.
As Burge explains, ?the hedge funds had made around £300 million in three years, and they wanted to realise that profit. The risk-reward for them was not enough to interest them in waiting another six years to get another £200-£300 million.? As there are relatively few potential buyers of unrated, unlisted debt, Eurotunnel was in a strong position to negotiate a tender offer for this unwanted debt.
The tender offer was not aimed at banks who held Eurotunnel junior debt. Peter Kappel, director in asset-backed finance at DrKW says that, ?The banks who originally held junior debt and didn't sell out to hedge funds were quite happy to hold the debt until maturity. If they had sold now, they would have been forced to register a loss on the investment.?
The discount in the junior debt provided an element of overcollateralisation for the asset-backed notes, which was crucial if investment grade ratings were to be obtained. Because the junior debt was trading well below par, Eurotunnel could buy approximately £100 of junior debt with just £73 of funds. So there was a difference of 27% between the cash coming into the vehicle to pay the junior loans, and the money going out to repay the asset-backed notes. This provided a cushion for the asset-backed notes.
Fixed-Link Finance owns £1.1 billion of junior debt, but only has to repay a £900 million bond issue. Assuming that this cushion is not used, and that Eurotunnel makes all the loan repayments that it is supposed to, Eurotunnel is left at the end of the transaction with a £250 million reduction of debt.
The deal incorporates a wrap from monoline insurer MBIA on half of the single-A and triple-B rated paper. This feature was not in the original plan, but was added after the lead managers failed to get enough interest in the deal before Christmas, and postponed the launch until late February.
Peter Kappel explains that, ?We recognised that the Eurotunnel credit story was something that investors needed to get comfortable with. MBIA, on the other hand, is familiar with and likes infrastructure risk.?
The MBIA wrap was successful in giving investors extra confidence in the deal, which finally closed at the end of February. But from a syndication perspective, it is perhaps easy to see why selling the deal was tough. Essentially, the deal offers the same risk as the junior debt but less return.
One London-based fixed income investor comments that: ?the return on the bonds is not unreasonable, but there's no uplift.? He says that he prefers the junior debt: ?If you are happy with the fundamentals of the credit, why buy the securitisation?? The advantage with the junior debt is that there is potential with capital gain ? even buying in the mid 80s would bring a healthy profit for an investor. The investor adds that the securitisation is not badly priced ? but its just that the junior debt offers more value.
Its lucky that all of Eurotunnel's junior investors do not have this attitude. The reason why the repackaging is so unusual ? and unlikely to be replicated ? is that the debt should not be trading at the discount that it is. Maybe the project banks shouldn't have sold out to the hedge funds in 1998 after all.
Light at the end of the tunnel
Eurotunnel's present capital structure came out of the restructuring process, which was completed in 1998. When the Eurotunnel project was completed in 1995, it was apparent that the projected cashflow would not cover the rapidly escalating financing costs, because the project had gone so far over-budget.
So from 1996 to 1998, Eurotunnel and its advisers put together a massive restructuring programme, in an attempt to stabilise the financing, and avoid it lurching from crisis to crisis.
The £8 billion of debt was sliced into a number of different financial instruments, with the bulk of it (£4 billion) left as syndicated senior and junior debt, and £1 billion of it in the form of 50 year resettable bonds.
The aim of that restructuring was to give Eurotunnel as much flexibility in the early years of the project. For example, the junior debt payments were originally expected to be from 2000-2012, but this was termed out to 2005-2025. The core £5 billion of debt was yielding a fixed average rate of 6.1% until 2003 ? which for such a large amount of debt was extremely cheap funding.
The remainder of the debt was restructured into equity, convertible bonds, and a participating loan. The participating loan structure was fairly new to UK project finance, and pays out a fixed rate coupon of 1% until 2006, after which time the lenders receive 30% of cashflows after debt service and repayments.
The result of that two year restructuring was a 40% reduction in interest rates, through both the conversion to equity and the lowering and fixing of coupons on the debt. However, net cashflow after capex would still not fully cover interest charges until 2004. So the final limb of the new structure was the introduction of a stabilisation facility, which at a rate of 0% until 2006 could be used to pay unpaid interest.
The restructuring was undoubtedly successful, as Burge explains. ?The restructuring has proved that the project is working. We have had no breaches of covenant and have stopped lurching from crisis to crisis.?
On the verge of success
Eurotunnel is the classic example of a mega-project that nearly didn't make it. Upon completion of the tunnel between the south of England and the north of France in 1995, Eurotunnel was in the tricky situation whereby its revenues were substantially less than its debt repayment obligations. Which makes its recovery, six years later, all the more surprising. With growth in HGV and Eurostar passengers exceeding expectations, the project's lenders ? about 170 banks in total ? will be glad they stuck with it through thick and thin.
Eurotunnel's primary operations consist of two cross-Channel rail shuttle services, one for heavy goods vehicles and one for passenger vehicles. In addition, it receives fees from Eurostar and other freight train operators who use the tunnel. By 2002, the purchase of new rolling stock is expected to double the capacity of Eurotunnel's shuttle service. Eurotunnel is steadily gaining ground on its primary competitors, the ferry services that run across the Channel. With a market share in the HGV industry of 46%, Eurotunnel has significant opportunities to increase revenue.
The use of Eurostar, the passenger service that runs from London to Paris and Brussels via Eurotunnel, is also steadily increasing. The new Channel Tunnel Rail Link (CTRL) is expected to be completed by 2006 ? this will replace the old rail line that Eurostar trains currently use, and cut journey times to Paris by 36 minutes.
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