Last year project bonds came of age in Australia with the launch of ETSA Utilities' long term financing programme. The transaction notched up a number of significant firsts, both in terms of project finance practice and Australia's debt capital markets.

The Medium Term Note (MTN) programme was set in motion to fund the A$3.25 billion ($1.8 billion) acquisition of ETSA Utilities by Hong Kong Electric (HKE) and Cheung Kong Infrastructure (CKI). The financing involved a domestic Australian issuance, arranged by National Australia Bank (NAB), Societe Generale (SG) and Salomon Smith Barney (SSB) and a Euro denominated Eurobond issue, arranged by Barclays, HSBC and UBS Warburg.

The deal was the epitome of the increasingly common hybrid project financing style; initially financed via an on-balance sheet acquisition facility and then refinanced off-balance sheet later. What made it unique in the Australian context, says Kevin Francis, head of originations at SG, was, instead of initially taking out the short term acquisition facility with a bank debt project financing, and then refinancing in the capital markets a year or more later, the ETSA funding progressed straight from the short term bridge to the capital markets, in the process saving sponsors a considerable amount in financing costs.

As bankers started to market the transaction to the capital markets in the first quarter of 2000, the MTN programme began to display a split personality. While the Australian launch met with strong initial investor interest, the eurobond issue was faring badly, troubled by documentation difficulties and poor market conditions. Rob Velins in NAB's Project & Structured Finance team reveals that the original plan was to split the programme evenly between the Eurobond and Australian capital markets. ?Considering the size of the underlying security the Eurobond market was initially thought to be a more comfortable home for the deal,? explains Velins.

That plan was quickly rejigged in the light of the initial market soundings and eventually A$1.6 billion of the total A$2.05 financing amount (or a little less than 80%) was sourced domestically. Sources involved in the deal say a large portion of the Eurobond issue eventually had to be sold through off-shore private placements.

The deal is clearly a testament to the rapid development of Australian capital markets.

What was particularly noteworthy was the investor response to the two credit wrapped tranches (tranches A and B), enhanced by AMBAC Assurance Corporation. Australia's first ever primary wrapped deal had only been done a few weeks earlier, in January, says Francis (the deal was a A$400 million transaction for AEP Citipower). Although credit wrapped transactions had been done before in Australia they were not for primary market bond issues, adds Francis.

As such, appetite for this structure, so new to the Australian market, was deeper than even the arrangers' bullish expectations. NAB, SG and SSB originally planned to market a wrapped portion of between A$800 million and A$900 million to investors. However, as the Eurobond issue faltered and the popularity of the Australian issue became apparent, the arrangers quickly pushed the Australian credit wrapped tranche up to A$1.1 billion. Francis says investors' bids eventually amounted to about one and a half times the launch amount.

Velins believes that, unwrapped, ETSA Utilities would probably not have been able to achieve the tenors that featured in the wrapped deal. ?Five years is typically the longest maturity an issuer can expect for an unwrapped tranche, although we might possibly have been able to extend that to seven years.? What is even more certain is that no deal lacking a wrapped portion would have met with comparable market enthusiasm.

Proof that the wrapped concept has now taken off in Australia, Francis says that other wrapped bond financings have closed post ETSA deal, including for Brisbane Airport, Adelaide Airport and TXU Australia. The airport and TXU deals were all refinancings of bank debt facilities. A fourth wrapped bond financing, a project bond for ElectraNet, the South Australia transmission network, was the closest facsimile of the ETSA deal to date.

The wrapped tranches formed the first phase of ETSA's domestic issue and were followed up a few weeks later with the launch of an unwrapped five year deal. This was launched against a backdrop of deteriorating conditions in global credit markets generally and continuing delays with the intended Eurobond issue. The deal was to be sold in two tranches for a planned, total size of A$300 million, says Francis. The response of Australian investors again surprised the lead arrangers. Strong domestic demand meant that the total volume of unwrapped paper could be increased to A$500 million. Tranche C eventually crystallized as a A$225 million, five year floating rate note issue. Tranche D emerged as a A$275 million, five year FRN deal.

Bankers predict similar market appetite in 2001 in Australia, at least for deals with ETSA-like characteristics. ETSA Utilities enjoys an enviable position as a regulated natural monopoly. It is the only electricity distributor in South Australia and has no exposure to retail risk, receiving most of its revenue from electricity retailers in the form of regulated distribution charges. Other projects and acquisitions which operate in stable regulated marketplaces and which enjoy regular cashflows can be financed with similar success.

Bond specialists do note some current investor concerns about participating in wrapped bond deals due to the fact that most monoline insurers have significant levels of exposure to the troubled Californian utilities. ?But personally, I don't think this issue is going to substantially impact on the market,? says Francis.

Asia-Pacific ? powerKepco Ilijan

The Kepco Ilijan Corporation (KEILCO) project financing in the Philippines, which reached financial close on 10 November 2000, was the first time US Exim, Japan Bank for International Co-operation and Korea Export Import Bank have worked together. It was also the first international limited recourse financing for Kepco, which is the majority shareholder with 51%.

Having originally set out on a solo mission, Kepco invited other players to join in and, taking up their offer last year, Mitsubishi acquired 21%, Southern Energy 20% and Kyushu Electric 8%. It is thought that the former two will play the major role in the management once the project is in operation. Raytheon Ebasco Overseas and Mitsubishi Heavy Industries have the EPC contracts. It is estimated that the project will be completed in 2002 and following this, will be run under a build-operate-transfer contract for a further 20 years.

The financing for this 2 x 600 MW combined cycle IPP power plant was actually launched back in 1997. As the length of time taken suggests, a host of obstacles presented themselves along the way, indicative of a project that is breaking new ground in many directions. A number of deadlines, including one imposed by the sponsors of June 30, were overrun.

According to those involved, the delays largely centred around restructuring the energy concession agreement (ECA). In contrast to a traditional PPA structure where the power producer is responsible for the fuel supply, the Ilijan deal contains a clause demanding that the off-taker, National Power Corp. (NPC), source the gas. Further, the fuel required is natural gas, a relatively unfamiliar source in Asia. In fact, NPC has secured supply from the Malampaya gas field and Ilijan is to be one of three gas fired plants to be fed from the largest ever natural gas development project in the Philippines. Malampaya also marks one of the largest ever foreign investments in the country, with Shell Philippines Exploration, Texaco and the Philippine National Oil Company having formed a joint venture to tap the reserves, located off Palawan, in the South China Sea. Toshiya Yamamoto, manager of the infrastructure department at the Bank of Tokyo Mitsubishi (BTM), stresses the financial benefits of having a guaranteed supply from an indigenous source.

It is these solid economics, in addition to the strength of the sponsors, that instilled the confidence necessary to attract the significant backing from export credit agencies. Each guaranteed a separate tranche; US Exim $150 million, Korea Exim $70 million and JBIC $255 million, of which $255 is a direct loan and $102 million is co-financing. This latter facility is also 50% covered for commercial risk by Japan's Ministry of International Trade and Industry (MITI). Pricing on this is 85bp during construction and 120bp after, considerably lower than other recent IPPs in the Philippines. Lead arrangers Citicorp International Ltd., Bank of Tokyo-Mitsubishi Ltd., and Banque Paribas put the deal together.

In addition to setting a precedent as the first time in which these three export credit agencies worked together, Ilijan benefited from a US Exim comprehensive guarantee beginning from pre-completion. This goes one step further than their usual political risk insurance during construction, followed by a comprehensive guarantee and/or a direct loan after the development is in operation.

Explaining the level of support, Natalie Wice of the US Exim pointed to the fact that the bank has a history of supporting power projects in the Philippines and Ilijan was perceived as particularly beneficial because of its use of indigenous natural gas. By backing this one, the respective governments were visibly demonstrating their support for the Philippines in the wake of the Asian financial crisis of 1998.

The deal also had to incorporate new technology risk and Natalie Wice highlighted this as the most significant challenge facing the engineers of the deal. The Ilijan plant will run using Mitsubishi Heavy Industries latest 501G gas turbine, a piece of equipment that has never before been financed on a project finance basis. This was resolved in the end by a pledge of extra support from Mitsubishi in the event that the turbines do not perform to their expected levels.

The deal also stands out from its counterparts in the Philippines for the unusually low tariff, which may be a blessing in disguise. Although not great for margins, it may work in Ilijan's favour during the impending de-regulation of the power market. NPC is expected to renegotiate high tariffs in the run up, before handing over some of its power purchase obligations to private companies, who will be unwilling to buy into agreements above current market rates. Since the financing for Ilijan was launched before privatisation even became an issue, this would not have been the primary motivation for setting the tariff as such. The fact that it may turn out to be an attractive feature within the context of de-regulation, however, will go a long way to sweetening the initial blow of low tariffs and subsequently low margins.

Ilijan is certainly a successful deal. It is characterised by a very secure structure and has successfully attracted international players on both the investor and sponsor side. BTM's Yamamoto suggests that this high profile support may instil international confidence in the Philippines, opening the floodgates to future foreign investment.

If this does occur, however, it is unlikely to be in order to fund further power plants. As Wice states, there have already been concerns raised about insufficient demand for the supply that will be created once all of the plants currently in planning stages are actually in operation.

However, an obligation to replace old oil and gas plants may create a demand for limited recourse financing and if international investment was to start trickling in, there would undoubtedly be no shortage of infrastructure project in which it could invest.

Asia-Pacific ? PPPKazusa

The Kazusa project will make its mark in the history of Japanese project finance for introducing the private sector into ground traditionally monopolised by public entities. Signed in July 2000, the 20 year project entails the construction and operation of a waste disposal plant to serve four municipalities in the Chibu region. Kisarazu, Kimitsu, Futtsu and Sodegaura currently dispose of waste on four separate sites but with all facilities approaching the end of their natural life, the planned consolidation is projected to save up to 30% of total costs.

The tender was awarded to Kazusa Clean System, a special purpose consortium minority owned (49%) by Nippon Steel. Emuko and Ichikawa Environmental Engineering both have stakes in the company, 8.9% and 6.1% respectively. The remaining 36% is held jointly by the four municipal government bodies involved. Toshihiro Toyoshima, deputy director of the Development Bank of Japan's project finance department, highlights that despite having a stake, the municipalities will not be involved in the management of Kazusa Clean System, with each of the shareholders performing very specific tasks. Nippon Steel is carrying out the EPC work and has allegedly taken on board the majority of the construction risk.

The ¥15 billion demanded by the project has been raised through a ¥10 billion project finance facility provided by Bank of Tokyo-Mitsubishi (BTM) and Development Bank of Japan (DBJ) in addition to ¥1 billion equity and a ¥4 billion subsidy from central government. It is possible that BTM will invite further banks to join in a syndication of their portion but this is still uncertain and the two banks have pledged the full amount.

The plant should be in operation by 2002 but this is not to be the end of the story. The recent debt taken out is only intended to finance phase 1 of the Kazusa plant. A subsequent phase 2 will increase the waste treatment capacity from 200 tons of waste per day to 500, at an estimated cost of ¥25 billion. Toshiya Yamamoto, manager of the infrastructure department at BTM, suggests that this will probably be funded through another project finance facility in 2005.

True to the spirit of PFI, the debt is to be serviced through annual payments made by the municipalities and dictated by an offtake agreement that commits the municipalities to use the waste disposal facilities for 20 years. There are none of the guarantees characteristic of traditional Japanese public-private joint ventures and thus the first instance of direct negotiations between local government and sponsors is noted. DBJ's Toyoshima points to the significance of Kazusa as marking the creation of the first Japanese escrow trust account, with future receivables assigned to Tokyo Trust as part of a security package to lenders.

This is but one example of the precedent that was set at the interface of public and private bodies throughout this deal, paving the way for a new relationship facilitating the future development of PFI in Japan. Kazusa can stake a claim to be the first company with private stockholders to receive a government subsidy, a benefit formerly reserved solely for public bodies. This subsidy, to be made fully available during the construction period, is said to be crucial to the perceived financial viability of the financing package put together, particularly in light of the absence of any guarantees. Further, Japanese local governments have traditionally been prohibited from entering into long-term contracts with private companies. In the interests of developing a PFI model, this key legal principle has been waived.

The Japanese PFI market has thus been born, but is still clearly in developmental stages. The Kazusa financing falls well within the camp of public private partnerships, following the broad form set out in the ?Basic Policy of PFI' published by the Japanese government in March 2000.

The trend towards this can be clearly seen in the history of Japanese project finance, the foundations for Kazusa perhaps mostly clearly noted in the Tokyo Water Authority cogen plant deal. This saw the Tokyo Metropolitan Government awarding a ¥1.1 billion build-own-operate concession to a consortium comprised of Ishikasajima-Harima Heavy Industries, Electric Power Development Co. and Shimzu Corp. Despite the use of an open tender system, however, this deal came too early to be awarded PFI status.

Interest has been aroused and confidence is growing, but there is still considerable ground to cover before PFI becomes a norm within Japanese financing markets. Subsequently to the signing of Kazusa, the Japanese market has seen a very small deal reach financial close that goes one step further down the road. The ¥1.1 billion Kanamachi power generating project is to be run by a special purpose company made up entirely of private sector entities. This is a significant development in a financing culture that has traditionally resisted passing all responsibility over to the private sector for fear of comprimising the best public interest. In fact, this historical tendency to favour the public sector in Japan has made much of the banking community wary of getting involved in PFI during its early stages. Some comfort has been granted through the PFI law and additional legal documentation. However, public private ventures are an alien concept in Japan and much of the private sector is sitting on the sidelines waiting to see how the situation will pan out.

The Kanamachi deal, although worthy of recognition for the contribution that it has made to the development of project finance, was too small to reach the international markets. There is a general feeling that this will remain the trend for the forseeable future, with international play thus being kept to a minimum.

Asia-Pacific ? telecoms AJC

The submarine cable to be built by Australia Japan Cable Limited (AJC) will be the largest international telecommunication into/out of Australia, providing direct international interconnection to other major cables in Asia and across the Pacific. This is not the only precedent it is to set, however, with the financing that signed on August 30 2000 incorporating many aspects likely to form a template for future deals.

Submarine cable developments have typically been welcomed in to the markets with more enthusiasm than other telecommunication projects. This can be partially explained by their relatively small number set against the and continually growing, demand for large capacity, long distance cable transmission. It is believed that current capacity into Australia is nearing its limit as a result of the huge growth in Internet traffic in recent years. Chris Tomkin, head of project finance for Australasia at ANZ adds that construction and operating risk are usually passed through to the contractors. However, the financing packages put together for submarine cable deals have traditionally incorporated forms of guarantees and other characteristics that have provided comfort for investors. It is in this field that AJC broke much new ground, putting together a funding in which the investors took considerable market risk and the sponsors were awarded a considerable degree of flexibility.

The $556.8 million project finance facility cover a 15-month construction period and 5 year amortisation period post construction completion. It breaks down into a $387.7 million tranche backed by Qualifying Capacity Sales Agreement and a $159.1 million commercial tranche subject to real market risk. The pricing on the latter was considerably below market expectation at 135 bps, compared to previous submarine cable deals in which it has generally been pitched at between 175 and 200 bps. Pricing on Tranche A was 25bp. Lead Arrangers were ANZ (documentation agent), IBJ Australia (technical report), Toronto-Dominion Bank (syndication bookrunner) and Westdeutsche Landesbank (modelling, insurance, tax and accounting). Together with co-arrangers Dai-Ichi Kangyo Bank and Westpac Banking, these all held $50 million. Joining in at lead manager level for upfront fees of 30 bps for tranche A and 50 for B was CBA-CLA, National Australia Bank and HypoVereinsbank.

Credit Agricole Indosuez Australia, Sumitomo International Finance and Bank of Tokyo ?Mitsubishi came in as managers for tickets of 25 bps for tranche A and 50 for B. ANZ provided a further $10 million, to be made available as a working capital. Bankers also pointed to the speed at which the financing was implemented as a noteworthy aspect of the deal. Financial close was reached 12 weeks after the release of the Information Memorandum and syndication two months after that.

Investor confidence was noted by the marking of a further two important benchmarks. Past submarine cable financings have all included a cash flow sharing mechanism whereby mandatory pre-payments are made if the cable, once running commercially, performing better than expected. Typically these have been equivalent to 50% of the surplus above the expected revenue targets. In the case of AJC, not only was this waived but the deal also stipulates an unprecedented level of support from investors to continue funding in the event of a delay in the construction.

Bankers involved outline a range of reasons to explain this unusual display of confidence, including the strong sponsor group, the high pre-sales amount and the close attention to permitting risks. The sponsors are Telestra (39.9%), Teleglobe Inc (15%), MCI WorldCom Global Networks (15%), Concert Global Network Services (10%), Japan Telecom (10%) and NTT Communications Corp (10%). All of these have both a strong history in telecommunications developments and a vested, strategic interest in the development. In particular, the commercial ramifications for majority holder Telestra would be very severe if they were to lose control of the pipeline as a result of a default on payments.

Attention to permitting skills also allows AJC to stand out from its counterparts. Specific stipulations have been worked into the documentation to allow for a failure to obtain the necessary permits. That this is a key risk to be countered in submarine cable deals emerged during the Southern Cross cable construction, in which prolonged delays in securing the environmental permits meant that the project fell well behind its schedule originally set out. AJC have anticipated this by securing a mechanism which allows them to continue to fund construction and other costs whilst the event causing the delay is addressed. Chris Tomkin stated that this was an important factor in providing the necessary comfort to investors.

Construction completion is projected for the end of June 2001. The 640-gigabyte direct fibre-optic link is to have landing points on the east coast of Australia, Guam and Japan, with interconnectivity to the US and other Asian cable stations. Moreover, the capacity can be expanded by 200 to 300% with the addition of new multiplexes to the landed asset, at a cost far less than that necessary to finance a totally new cable. However, because AJC is a collapsed loop system with branch protection and is not comprised of so called self heating architecture and because there is not enough restoration capacity to deal with a failure of the cable, another high capacity restoration cable will be necessary. Such a construction would probably run through the Pacific.

Asia-Pacific ? petrochemicals Polymirae

An increasing reliance on private investment for infrastructure and other industrial development has encouraged a flourishing Won-based project finance market in South Korea. Numerous greenfield and acquisition deals have come to the markets over the last few years, but all have been notable in their omission of any foreign currency. The Daelim Polypropylene plant acquisition that signed on 27 September 2000, however, broke this pattern and marked the first instance of a significant foreign tranche within a limited recourse financing in Korea. At a total cost of $284 million, the mixed won and dollar facility is to finance the acquisition of Daelim Industrial's polypropylene business by PolyMirae, a new venture made up of Daelim itself and the Montell Group. In an era when all deals attempt to stake claims of setting a precedent, PolyMirae can genuinely be seen as leading the way into multi-currency financing initiatives for Korean projects.

Previous reluctance of foreign investors has primarily been based on the complex legal and documentation hurdles, enhanced by the cost of exchange rates. Foreign sponsors who assumed that it may be cheaper to finance projects in foreign currencies, have discovered that this is not so when risk premiums and hedging costs are taken into account. The ability of PolyMirae financing to break down these barriers stems from its place within the international arena. More specifically, PolyMirae's revenues are derived from polypropylene sales and its main expense is the cost of propylene, both of which are dictated by international US dollar linked prices. It is thus an ideal project to tap the US dollar market.

Its position as such has arisen as a knock on effect of the process of rationalisation undertaken in Korea following the financial crisis. With the exception of Japan, Korea is the largest polypropylene producer in Asia Pacific, accounting for 38% of the regional production capacity and the petrochemical industry was thus a significant focus for the consolidation program. As part of this, Daelim Industrial Company Ltd. and Hanwha Chemical Co. entered into negotiations at the end of 1999, with Daelim acquiring a polypropylene plant in exchange for some polyethylene producing capacity. In its new position as Korea's largest polypropylene producer, Daelim then approached the world's leading polypropylene producer, Montell, who have subsequently merged with Targor GmbH and Elenac S.A. to become Basell Polyolefins, owned 50% by Shell and 50% by BASF.

Following these, and other related shifts in the Asian Pacific petrochemical landscape, then, Daelim and Montell agreed to establish a new company, PolyMirae, to acquire Daelim's existing polypropylene activities. PolyMirae is thus positioned at the base of the industry cycle within the global polypropylene market, benefiting from Daelim's leading position in Korea and Basell's international presence. It is this sound economic base that is the key to PolyMirae's ability to attract the foreign investment for a limited recourse financing that previous Korean project finance deals had failed to do.

The debt was put together by lead arrangers Societie Generale, Fuji Bank and Hana Bank and reflects the projection that 70% of revenues will be generated in US dollars. It is comprised of three separate tranches. A $122 million note purchase facility was issued by Societie Generale Finance (Ireland) Limited in order to benefit from the specific tax relief agreement between Korea and Ireland. This was syndicated successfully on the international markets, reaching close well oversubscribed. A Won 46.5 billion ($42 million equivalent) was syndicated to a group of Korean banks and finally, a Won 22 billion ($20 million equivalent) revolving credit was made available by Hana Bank. The first two will be used to finance part of the acquisition cost and fund operations for the first two years, whilst the latter will be used for working capital requirements. A was priced at 325 basis points over Libor and B at 230 basis points over benchmark three year A+ local corporate bond rates.

The revolving credit acts as a form of guarantee for tranches A and B, providing a back up that can support their repayment in the event that this becomes necessary. Further confidence has been instilled in investors by a contract signed by PolyMirae's sales agents, obliging them to buy polypropylene from the company, so long as they have the customers themselves. Since the agreement does not oblige the agents to buy any specific amount, it clearly does not eliminate market risk. It does, however, provide some comfort for investors by going some way to establish a security against future receivables.

Certainly sufficient confidence was instilled to drum up the support needed, but the deal was not without its own problems, largely centring on legal complications. The tranches are dictated by differing markets and thus had to conform to international and Korean law respectively. Striving to avoid having to create and regulate two differing but compliant sets of covenants and conditions, the engineers of the financing issued a common terms agreement. This basically set out common conditions of precedent, representations, covenants and events of default under English law and although quite common across the project finance world was a first in Korea.

The structure of the note facility itself and a need to structure the security arrangements to comply with Korean regulatory requirements while providing the basis for an acceptable security packages also both allegedly emerged as obstacles obstructing the way to financial close. Having overcome these to successfully become the first multi-currency project finance deal in Korea, PolyMirae has set a precedent and aspects of it will be used as a model for future financings.

These can be expected. Although embedded in a set of unique circumstances, PolyMirae will have instilled international confidence in the plausibility of a Korean project finance market and can be expected to be the first of more to come. Infrastructure projects in particular will form the backbone of these, with the Promotion of Private Capital into Infrastructure Investment Act having been passed in 1994. The end of last year saw the establishment of the Private Infrastructure Investment Centre of Korea (PICKO), a government body dedicated to promoting private investment in social infrastructure projects. Currently working to establish guidelines, PICKO will encourage the development of a market in which foreign investors and sponsors are likely to play a significant role.