Project leases have had a tendency to be viewed as the poor relation to the formerly ubiquitous cross-border leveraged lease. This was never more the case than when the cross-border lease was riding high. At the time, few arrangers saw the point of a product that only added negligible value to the standard project finance. However, given the slow demise of the cross-border lease market and the subsequent concentration on domestic US lease and ?real risk' product, and the deregulation of the US power market, attitudes have begun to change.

The change in attitude has come from the more innovative of arrangers; those who kept faith with the project lease, whilst trying to extract the last breathe of life out of a dying US lease-in-lease-out (lilo) structure. According to a London-based arranger, ?The lilo was never really a particularly good product. The fees were too low and it was too much grief.?

Therefore, it should come as no surprise that only a handful of US arrangers have been at the forefront of inserting a domestic lease into a project finance structure. The only true players in the market are Babcock & Brown and Citibank/Salomon Smith; with the latter being one of the only institutions to have any leverage in both leveraged lease and project finance sectors.

The hope remains that a number of banks, having extricated themselves from the lease market in the 1980s and 1990s, will add to their project finance expertise by engendering the one-stop shop. However, in the short term this seems unlikely.

However, there remain marginal players, such as Morgan Stanley and Newcourt Capital, that will come into the market as and when they can clinch a mandate. Although both institutions have less in the way of market experience, they need to compete in order to make the project lease more transparent as well as competitive.

To date, the preferred add-on structure has been the synthetic lease, which simply provides the sponsor with an off balance sheet loan. Although styled as an operating lease for accounting purposes, the synthetic lease is structured as a financing for tax purposes.

According to a New York-based banker, ?Clearly what is driving this market is a combination of off-balance sheet financing, creation of a favourable rating and earnings per share (EPS). The lease is typically designed to increase earnings by substituting a lesser deductible credit.?

While project financiers and lease experts may differ as to the benefits of incorporating leases into power projects, there are important factors that look to drive the market forward. Utilities have begun to look to securitisation in order to monetise their equity in revenue generating assets. This then allows these companies off-balance sheet financing, which needs practically no rating agency debt attribution.

In addition, the painstaking attentions paid to reported earnings per share by all major US utilities make leasing a very attractive option. For leasing, both in its leveraged and synthetic formats, has the ability to allow any utility to manage its EPS and further influence its share price.

Those that opt for a synthetic structure look to enhance their earnings. This is achieved through allowing the given company to state higher income earnings on their income statement, while lowering earnings on their tax statement. This achieves a lower tax burden.

?Virtually all the major project acquisitions or new builds in the power sector have looked at using synthetic leases. They work best for long-life assets,? comments a US lease expert.

One of the more significant transactions to date was closed by PG&E Corporation in March. The $730 million financing, for the 1,048 MW La Paloma gas-fired power generating plant, marks the largest deal for a single greenfield competitive power plant.

Citibank/Salomon Smith acted as arranger on the synthetic lease as well as lead arranger of the project finance structure. SG and Deutsche Bank acted as arrangers, while co-arrangers were BNP Parisbas Group, Credit Lyonnais as well as Dresdner Kleinwort Benson. The parties to this groundbreaking transaction were identical to PG&E's first project financing and synthetic lease combination.

The financing included a $25 million debt service reserve facility, $15 million working capital, $374 million of PG&E Corporation-backed commercial paper, $295 million term loan B tranche and $21 million in certificates. Pricing on the deal started at 137 basis points (bp) over Libor rising to 237.5bp in stages.

The deal followed hot on the heels of PG&E's 792MW Lake Road financing. The $460 million transaction marked the corporation's first venture into the synthetic lease market, although it had looked at this type of structure before. The overriding reason for the use of this structure was the flexibility involved, not to mention the fact that PG&E has a further 10 merchant plants that it needs to finance over the next two years.

While transactions for synthetic deals have been steady, a noticeable growth in tax leases has occurred in the US market. Earlier this year, Edison Mission Energy (EME) mandated a $1.2 billion domestic tax lease for its generating assets. Babcock & Brown was awarded the equity arranger's mandate by the Rosemead-based power company.

The transaction follows an $860 million deal that closed in December 1999. The tax lease, on the 1999 deal, was part of a $2.5 billion financing, again part of a $5 billion acquisition project. While Babcock & Brown acted as equity investor, PSEG came in as the investor.

While the second deal looks to mirror the format of the first, structuring looks to become more competitive should new bids come in. However, it is rumoured that the leases are being utilised to engender optimal earnings, rather than produce an up-front net present value (NPV) benefit.

This example of optimising earnings seems to be a common trend, and puts paid to the suggestion that certain utilities are looking for a straight tax-play and NPV. According to a US-based arranger, ?These are real economic deals. There are tax payers on both sides of the fence.?

In certain transactions, there is equal offsetting between income and expense, no loop debt as well as no purchase options. Purchase prices remain the same through the deal as they do at the outset.

While this may be the case, other arrangers do not concur. ?These deals have a tax motivated function ? tax benefits. The utilities are full taxpayers that trade away below line earnings for higher GAAP. It makes sense.? In addition, a number of true lease deals may implement purchase options at a later date.

According to another US arranger, these leases are cookie-cutter structures that have not incurred the wrath of the US treasury. If, at any future date, the treasury comes down hard on deals that raise capital, it will have been purely inadvertent.

Although the demise of certain lease products has raised the profile of true and synthetic leases, US power deregulation has driven the market forward. Moreover, it has been the new merchant power class that has looked to utilise the more complex of financing tools.

According to US project financiers, since 1998 over 24 utilities have reported plans to auction off some 90,000MW of capacity. In addition, over 25 utilities across 12 states are expected to sell in the region of 75,000MW. Much of this divestiture has already taken place over the past three years. However, some 32,000MW of generation assets should be sold by 2002. Assets that have recently gone under the hammer include utilities in California, Connecticut, New Jersey, New York State, Pennsylvania and Maryland.

Given the extent of this divestiture, power specialists expect in the region of $20 billion to be invested into power projects by 2002. In addition, the merchant generation market is expected to increase to160,000MW over the same time period.

Greenfield development, which is said to grow to a market value of $15 billion by 2002, is expected to take advantage of the project lease. Given the success of the $730 million La Paloma greenfield transaction, other similar deals are bound to follow.

While US project finance pundits believe that the mini project lease boom will continue, past transactions have not always run smoothly. In 1998, one of the largest ever deals to include non-recourse financing fell foul of the Australian authorities. The A$4.7 billion Loy Yang ?A' transaction was split between A$3.4 billion of debt and A$1.3 equity; in addition to a $750 million sale-and-leaseback.

However, even given their scarcity, European deals have hardly fared better. The 1997 Finance Act in effect killed off the UK version, though a handful of deals closed. Other European deals have been few and far between.

Therefore, the project lease looks to remain a US domestic product, which may catch on elsewhere should the climate prove auspicious. Another factor is the belief, amongst US arrangers, that there is a significant number of deals, which should be coming on stream with a steady flow.

An overriding reason for this is that fact that purchasers of power assets will continue to have a finite equity base. There will not be the breadth of base to fund all proposed projects, not to mention a global trend for cheaper equity volumes.

In addition, the risk profile of the merchant power market is better suited to more bespoke financing structures. Arrangers also dwell on the fact that through a separate capital structure, a differentiation between regulated and non-regulated businesses can be made.

A further advantage of utilising non-recourse debt, is that a given utility can elect to drop any business, which is not financially viable. This then allows the utility to mitigate the loss of its equity investment as well as further financial flexibility.

While a climate of project lease speculations exists, there is no clear indication that a real glut of deals will occur. On the one hand, sponsors and bankers continue to trot out the same platitudes of structural complexities and timing factors. However, a likelier assessment is that many project financiers remain ill at ease with more innovative structures; which tend on the whole to be outside their remit.

If project lease combinations are to become more commonplace ? rather a handful of transactions closed by a few ? arrangers will have to be more aggressive in marketing this product elsewhere. According to a US arranger, ?It is hard to predict a deal flow for this or other sectors. Oil and gas, for example, has had few deals.?

Throughout the 1990s, arrangers on both sides of the Atlantic marketed leveraged and synthetic lease products to the most intransigent of potential clients: municipal transportation authorities, public water and sewerage utilities as well as municipal authorities. Although many transactions were finally closed, a sizeable number fell by the wayside.

Thus, if the project lease combination product is to have any longevity, lease arrangers will have to work hand-in-hand with project financiers to order to exact a steady deal flow in a number of different markets. As with many of the less transparent and more difficult financial structures, success will have to be measured in deal volumes and sectoral transference.

One of the overriding problems that will face any sponsor looking at a project lease combination, is the dearth of decent arrangers in this field. Citibank/Salomon Smith Barney and Babcock & Brown remain among the only arrangers with a good enough knowledge of the product to apply it to other sectors.

Telecommunications and chemical sectors could see some interesting deals in the near future. It is rumoured that arrangers have been close to clinching mandates in the chemical sector. Earlier this year, Oxy Chem, Occidental's chemical operation, mandated a $550 million tax lease. Whether this proves to be the shape of things to come remains to be seen.

If project leasing is to have any viable longevity, other players will have to get in on the act. In addition, sponsors need to be made aware of the suitability of both synthetic and true leases. Given that a sizeable number of utilities are driven by their ratings, project leases provide increased value for shareholders. Thus, in a financial culture, which increasingly compensates its management in stock, leasing seems more than just an add-on product.