Project Challenge 2000
In the aftermath of the most successful year the Project Finance
market has ever experienced, with unprecedented deal volumes and
unparalleled creativity in the solution of problems, it is useful
to turn our attention to the very large challenges sponsors and
financiers will face in the year 2000. The challenges include:
1. the equity valuation problems of some of our clients
2. liquidity and availability of capital in both the bank and capital markets
3. maturity and pricing constraints resulting from bank use of RAROC models
4. limitations on emerging markets exposure
5. electronic disintermediation.
The Legacy of 1999
For the global project finance markets, 1999 was a year of unprecedented innovation and transformation. The techniques of project finance, corporate finance, acquisition finance and structured finance (including securitization and leasing) came together to fund previously unimaginable volumes of financing, which challenged the liquidity of the project finance markets. The US power market was the hot spot of the global project finance arena, with some $17 billion of debt financing dwarfing the previous levels of $5-7 billion per year in the US market.
Project financiers rose to the challenge by expanding the capacity of the markets through the massive use of commercial paper backed by 364-day lines of credit, short-term bridge-like maturities for funded loans to be taken out in the capital markets, and other innovative solutions. Syndication strategies changed to accommodate deals of size, with more joint leads, more co-arrangers, and higher hold positions for lead banks.
As the year came to an end, the bank markets began to open again for the strongest sponsors of Asian and Latin American acquisitions and greenfield projects, beginning a recovery from the paralysis that followed the Asian, Russian and Brazilian crises of 1997-99. The combination of the strengthening of key Asian and Latin American countries, the continued restructuring of the US and European power markets, the launch of new oil and gas projects in an environment of higher oil prices, the rapid development of the telecommunications business, and the expansion of private finance initiative concepts in the UK and elsewhere all promise to make 2000 a year of strong activity in the project finance markets.
The Challenges of 2000
The challenges we overcame in 1999 have not gone away. And as the year began, we acquired some new ones.
The Equity Valuation Problems of Some of Our Clients
The large volume of acquisitions in the power markets of the US and the UK, in particular, were carried out as part of a growth strategy by the acquirers with the intended effect of improving their valuation. The result was mixed and surprising. Unregulated power and gas companies enjoyed equity market success in 1999. Some of the major players have seen high and sustained valuations ? with Price-Earnings ratios in the 30s to 50s for companies such as AES, Calpine, Dynegy and Enron ? as investors bought the story of sustainable growth and high profitability for these unregulated companies.
At the same time the utility holding companies owning outstanding unregulated companies languished in the traditional utility ranges of 12-15x during 1999. It didn't matter in 1999 whether a utility holding company was a buyer or seller of generating assets in the disaggregation auctions or did nothing ? the price-earnings ratios were in the same range. Indeed, no power utility has succeeded yet in breaking out of the utility range.
Then in 2000 some did break out ? but in the wrong direction. The announcement of profit shortfalls by Edison International and CMS caused institutional investors to dump their stocks. Their prices collapsed, losing 40-50% of their value virtually overnight and leaving their stock prices at levels many knowledgeable observers consider remarkably low.
Analysts and institutional investors had never bought into the growth story of the best utility affiliates in the business. These profit shortfalls confirmed their view that these were not businesses which would achieve consistent, predictable, high levels of growth.
The elements of successful valuation have not changed ? they just have not been achieved in the eyes of major analysts and investors. These elements include a simple, clear strategic vision, communicated consistently by a company's respected entrepreneurial leadership; a high tempo of activity that bolsters growth expectations and reduces the impact of the isolated individual deal that may be less successful; the velocity of assets resulting from the willingness of the best players to stay clear-eyed about the value of individual assets and to buy, reconfigure, break up, sell opportunistically, and thus add value to their portfolios; and, finally, investor belief in the sustainable, profitable growth of these companies.
The challenge for 2000 is for utility affiliates to persuade the equity markets that their massive investments will achieve superior returns and consistent growth ? and to regain credibility by delivering on investor expectations.
Liquidity and Adequacy of Capital
The primary challenge on the debt side is liquidity, adequacy of capital and the resulting pressures on pricing stemming from four primary factors bearing on the supply of capital into the project finance market:
? Mergers and Market Withdrawals ? A challenge to the adequacy of capital is presented by the merger of the world's leading project finance banks, reflected in this month's announcement of the Deutsche-Dresdner merger and earlier consolidations. These transactions reduce the amount of capital available from the combining entities for individual deals (even for the best deals in the US and Western Europe) and at worst result in the withdrawal of key players (such as UBS) from the market. Although the market has benefited in recent years from the entry of a few new players of importance, such as the German Landesbanks, it is unrealistic to expect that future new players will offset the loss of capital resulting from the current spate of mergers.
? Reduced Bank Capital Allocations to Lending. The reduction of capital dedicated by major banks to lending activities (hold positions) in an effort to increase returns on equity is likely to have an adverse effect on the capital raising activities of project sponsors. At best it will have a neutral effect if these banks are able to reduce assets through a combination of portfolio securitization, credit derivatives, capital markets exits, secondary market sales and, of course, effective syndication. Thoughtful sponsors have supported these activities as a recycling of capital available for their projects. To increase capital availability from banks, we can expect in 2000 to see a number of major banks complete the rating of their portfolios (a process begun in 1999) and to securitize their portfolios through classic collateralized loan obligation structures or through more innovative credit risk derivative structures. Several large deals will come to market in 2000, as this approach becomes a common method of recycling bank capital into new projects.
? Limited universe of capital markets buyers. The project finance asset class took a big hit as a class in the past several years. There exists today a more limited universe of capital markets buyers of project finance bonds than existed several years ago. Indeed, the spread between 144-A and private placement deals has narrowed, reflecting the fact that they are purchased today by virtually the same buyers. Traditional bond investors continue to question both the credit upside of this asset class and the adequacy of ?market making? and liquidity in secondary markets for project finance and other ?story paper? bonds, thus constraining demand for these bonds and increasing spreads above the levels that the bond ratings would justify. Still, institutional investors are an important segment of the debt universe for long-term fixed-rate lending and a refocused marketing effort is needed to expand the universe of bond buyers.
? Growing constraints on the use of bank conduits and likely future constraints on unfunded 364-day lines. Innovative use of bank conduits and unfunded 364-day lines backing commercial paper were an important part of the low-cost funding solution for the mega-deals of 1999. There will be increasing limitations on the use of conduits in 2000 and, over a longer period, on unfunded 364-day lines.
? Conduits ? The nature of conduits is likely to be affected in the not-too-distant future as a result of liquidity, consolidation and regulatory capital issues. Concerns over liquidity mismatch (longer maturities of underlying assets funded by short-term commercial paper) can be addressed through the use of medium term notes (MTNs) as a conduit funding device. Structured liquidity (liquidity that funds defaulted assets) may not be treated over the long term as zero risk weighted for capital adequacy purposes. Pressure will grow for the consolidation of conduits with their bank sponsors as accountants start to question 100% credit enhancement and control/management features of conduits. This is likely to lead to the sharing of first loss with co-investors and the sharing of ownership of conduit vehicles. Over a period of time the imposition of a regulatory capital charge for first loss and for liquidity facilities is likely to occur. The practical effect of these changes is that the cost of using these vehicles will increase, and we will need to dig into our arsenal of creativity to develop other approaches to reduce the cost and increase the supply of bank capital, including direct commercial paper funding of the highest quality projects and acquisitions with sufficiently high ratings.
? Unfunded 364-day lines. This trend will be reinforced by the likely imposition in the next year or two of regulatory capital charges for most unfunded 364-day lines under the Basle proposals currently being considered.
Bank RAROC Models and Deal Structures
The near-universal application by banks of RAROC (risk adjusted return on capital) models, by penalizing the longer maturities typical of project finance deals, will continue to push the bank markets towards shorter maturities, with refinancing risk assumed by the sponsors and (as a practical matter) by the banks. Other structural adaptations will be applied to take advantage of the more favorable treatment which RAROC models give to specific structures. Pricing issues will arise under the RAROC model in cases where low-rated transactions are priced favorably in the market based on a sponsor's implicit support. At the end of the day RAROC models will have to be adapted to reflect the real risks of a deal.
Continuing Constraints on Emerging Markets Deals
Although improved from the levels of the past two years, bank appetite for emerging markets credits will continue to be severely constrained as a result of the losses experienced by banks in the recent Asian and Russian crises and the severe pounding bank stock prices took as a result of perceived emerging markets exposure.
Net private capital flows to emerging economies in 2000 are forecast to remain at about the same low level as 1998 (about $136 billion, according to the Institute for International Finance). While equity investments are estimated to have increased to $142 billion in 1999 from $127 billion in 1998, bank and other creditor investments were negative in 1999 (i.e., more money was repaid to lenders than was advanced in new loans). This contrasts with a net increase of $200 billion in 1996, telling in a nutshell the story we all experienced. Net credit flows are predicted to increase to $25 billion in 2000 from the negative levels this year.
In the first quarter of 2000 we are already seeing a major increase in the deal flow for Asian projects, and deals for the best sponsors will be financed in numerous sectors of the economy, particularly oil and gas, power, and ports. But in Asia and Latin America, we will continue to see the need for governmental and private political risk insurance (including enhanced cover for payment risk of governmentally related entities in many countries) and B-loan umbrellas to attract the full level of bank participation needed to fund these deals.
Constraints on the volume of emerging markets financings will exist notwithstanding the fact that the banks' project finance portfolios have withstood crises well and the losses in emerging markets from project finance loans have, for most banks, been small in relation to their income from their project finance activities. The challenge for project financiers is to present effectively to their senior managements the true story of the resilience of the project finance portfolios to the more general shocks of the emerging markets crises.
In addition, the need continues to exist for the more rapid development of local capital markets in Asia and Latin America. Domestic markets need to be used to a much larger extent to fund domestic currency denominated assets, with major global project finance institutions encouraging the entry of local players in the market by providing credit support against the occurrence of a limited range of project risks.
Electronic Disintermediation
One of the greatest challenges to all existing financial institutions in the project finance arena, as in all areas of finance, lies in the growth of the internet and its potential for electronic disintermediation. In the US alone there are 25 Electronic Debt Auction platforms at various stages of development, which will significantly reduce the cost of distribution and improve liquidity in the market via easier, more timely and wider dissemination of information. In addition, a specialist investor/dealer market place will allow for more transparent pricing of secondary trading of bonds. It may also significantly change the banking landscape, as it is a direct challenge to the existing distribution platforms, which are the major comparative advantage of many major investment and commercial banks.
Conclusion
In summary, the project finance business continues to reinvent itself as the field's creative sponsors and bankers address the fundamental transformations of the world's key industries. Very large volumes of financings will be done in 2000 through corporate and project structures. And in each of the key industries we serve, we will have the pleasure of solving new challenges we have not yet begun to imagine.
1. the equity valuation problems of some of our clients
2. liquidity and availability of capital in both the bank and capital markets
3. maturity and pricing constraints resulting from bank use of RAROC models
4. limitations on emerging markets exposure
5. electronic disintermediation.
The Legacy of 1999
For the global project finance markets, 1999 was a year of unprecedented innovation and transformation. The techniques of project finance, corporate finance, acquisition finance and structured finance (including securitization and leasing) came together to fund previously unimaginable volumes of financing, which challenged the liquidity of the project finance markets. The US power market was the hot spot of the global project finance arena, with some $17 billion of debt financing dwarfing the previous levels of $5-7 billion per year in the US market.
Project financiers rose to the challenge by expanding the capacity of the markets through the massive use of commercial paper backed by 364-day lines of credit, short-term bridge-like maturities for funded loans to be taken out in the capital markets, and other innovative solutions. Syndication strategies changed to accommodate deals of size, with more joint leads, more co-arrangers, and higher hold positions for lead banks.
As the year came to an end, the bank markets began to open again for the strongest sponsors of Asian and Latin American acquisitions and greenfield projects, beginning a recovery from the paralysis that followed the Asian, Russian and Brazilian crises of 1997-99. The combination of the strengthening of key Asian and Latin American countries, the continued restructuring of the US and European power markets, the launch of new oil and gas projects in an environment of higher oil prices, the rapid development of the telecommunications business, and the expansion of private finance initiative concepts in the UK and elsewhere all promise to make 2000 a year of strong activity in the project finance markets.
The Challenges of 2000
The challenges we overcame in 1999 have not gone away. And as the year began, we acquired some new ones.
The Equity Valuation Problems of Some of Our Clients
The large volume of acquisitions in the power markets of the US and the UK, in particular, were carried out as part of a growth strategy by the acquirers with the intended effect of improving their valuation. The result was mixed and surprising. Unregulated power and gas companies enjoyed equity market success in 1999. Some of the major players have seen high and sustained valuations ? with Price-Earnings ratios in the 30s to 50s for companies such as AES, Calpine, Dynegy and Enron ? as investors bought the story of sustainable growth and high profitability for these unregulated companies.
At the same time the utility holding companies owning outstanding unregulated companies languished in the traditional utility ranges of 12-15x during 1999. It didn't matter in 1999 whether a utility holding company was a buyer or seller of generating assets in the disaggregation auctions or did nothing ? the price-earnings ratios were in the same range. Indeed, no power utility has succeeded yet in breaking out of the utility range.
Then in 2000 some did break out ? but in the wrong direction. The announcement of profit shortfalls by Edison International and CMS caused institutional investors to dump their stocks. Their prices collapsed, losing 40-50% of their value virtually overnight and leaving their stock prices at levels many knowledgeable observers consider remarkably low.
Analysts and institutional investors had never bought into the growth story of the best utility affiliates in the business. These profit shortfalls confirmed their view that these were not businesses which would achieve consistent, predictable, high levels of growth.
The elements of successful valuation have not changed ? they just have not been achieved in the eyes of major analysts and investors. These elements include a simple, clear strategic vision, communicated consistently by a company's respected entrepreneurial leadership; a high tempo of activity that bolsters growth expectations and reduces the impact of the isolated individual deal that may be less successful; the velocity of assets resulting from the willingness of the best players to stay clear-eyed about the value of individual assets and to buy, reconfigure, break up, sell opportunistically, and thus add value to their portfolios; and, finally, investor belief in the sustainable, profitable growth of these companies.
The challenge for 2000 is for utility affiliates to persuade the equity markets that their massive investments will achieve superior returns and consistent growth ? and to regain credibility by delivering on investor expectations.
Liquidity and Adequacy of Capital
The primary challenge on the debt side is liquidity, adequacy of capital and the resulting pressures on pricing stemming from four primary factors bearing on the supply of capital into the project finance market:
? Mergers and Market Withdrawals ? A challenge to the adequacy of capital is presented by the merger of the world's leading project finance banks, reflected in this month's announcement of the Deutsche-Dresdner merger and earlier consolidations. These transactions reduce the amount of capital available from the combining entities for individual deals (even for the best deals in the US and Western Europe) and at worst result in the withdrawal of key players (such as UBS) from the market. Although the market has benefited in recent years from the entry of a few new players of importance, such as the German Landesbanks, it is unrealistic to expect that future new players will offset the loss of capital resulting from the current spate of mergers.
? Reduced Bank Capital Allocations to Lending. The reduction of capital dedicated by major banks to lending activities (hold positions) in an effort to increase returns on equity is likely to have an adverse effect on the capital raising activities of project sponsors. At best it will have a neutral effect if these banks are able to reduce assets through a combination of portfolio securitization, credit derivatives, capital markets exits, secondary market sales and, of course, effective syndication. Thoughtful sponsors have supported these activities as a recycling of capital available for their projects. To increase capital availability from banks, we can expect in 2000 to see a number of major banks complete the rating of their portfolios (a process begun in 1999) and to securitize their portfolios through classic collateralized loan obligation structures or through more innovative credit risk derivative structures. Several large deals will come to market in 2000, as this approach becomes a common method of recycling bank capital into new projects.
? Limited universe of capital markets buyers. The project finance asset class took a big hit as a class in the past several years. There exists today a more limited universe of capital markets buyers of project finance bonds than existed several years ago. Indeed, the spread between 144-A and private placement deals has narrowed, reflecting the fact that they are purchased today by virtually the same buyers. Traditional bond investors continue to question both the credit upside of this asset class and the adequacy of ?market making? and liquidity in secondary markets for project finance and other ?story paper? bonds, thus constraining demand for these bonds and increasing spreads above the levels that the bond ratings would justify. Still, institutional investors are an important segment of the debt universe for long-term fixed-rate lending and a refocused marketing effort is needed to expand the universe of bond buyers.
? Growing constraints on the use of bank conduits and likely future constraints on unfunded 364-day lines. Innovative use of bank conduits and unfunded 364-day lines backing commercial paper were an important part of the low-cost funding solution for the mega-deals of 1999. There will be increasing limitations on the use of conduits in 2000 and, over a longer period, on unfunded 364-day lines.
? Conduits ? The nature of conduits is likely to be affected in the not-too-distant future as a result of liquidity, consolidation and regulatory capital issues. Concerns over liquidity mismatch (longer maturities of underlying assets funded by short-term commercial paper) can be addressed through the use of medium term notes (MTNs) as a conduit funding device. Structured liquidity (liquidity that funds defaulted assets) may not be treated over the long term as zero risk weighted for capital adequacy purposes. Pressure will grow for the consolidation of conduits with their bank sponsors as accountants start to question 100% credit enhancement and control/management features of conduits. This is likely to lead to the sharing of first loss with co-investors and the sharing of ownership of conduit vehicles. Over a period of time the imposition of a regulatory capital charge for first loss and for liquidity facilities is likely to occur. The practical effect of these changes is that the cost of using these vehicles will increase, and we will need to dig into our arsenal of creativity to develop other approaches to reduce the cost and increase the supply of bank capital, including direct commercial paper funding of the highest quality projects and acquisitions with sufficiently high ratings.
? Unfunded 364-day lines. This trend will be reinforced by the likely imposition in the next year or two of regulatory capital charges for most unfunded 364-day lines under the Basle proposals currently being considered.
Bank RAROC Models and Deal Structures
The near-universal application by banks of RAROC (risk adjusted return on capital) models, by penalizing the longer maturities typical of project finance deals, will continue to push the bank markets towards shorter maturities, with refinancing risk assumed by the sponsors and (as a practical matter) by the banks. Other structural adaptations will be applied to take advantage of the more favorable treatment which RAROC models give to specific structures. Pricing issues will arise under the RAROC model in cases where low-rated transactions are priced favorably in the market based on a sponsor's implicit support. At the end of the day RAROC models will have to be adapted to reflect the real risks of a deal.
Continuing Constraints on Emerging Markets Deals
Although improved from the levels of the past two years, bank appetite for emerging markets credits will continue to be severely constrained as a result of the losses experienced by banks in the recent Asian and Russian crises and the severe pounding bank stock prices took as a result of perceived emerging markets exposure.
Net private capital flows to emerging economies in 2000 are forecast to remain at about the same low level as 1998 (about $136 billion, according to the Institute for International Finance). While equity investments are estimated to have increased to $142 billion in 1999 from $127 billion in 1998, bank and other creditor investments were negative in 1999 (i.e., more money was repaid to lenders than was advanced in new loans). This contrasts with a net increase of $200 billion in 1996, telling in a nutshell the story we all experienced. Net credit flows are predicted to increase to $25 billion in 2000 from the negative levels this year.
In the first quarter of 2000 we are already seeing a major increase in the deal flow for Asian projects, and deals for the best sponsors will be financed in numerous sectors of the economy, particularly oil and gas, power, and ports. But in Asia and Latin America, we will continue to see the need for governmental and private political risk insurance (including enhanced cover for payment risk of governmentally related entities in many countries) and B-loan umbrellas to attract the full level of bank participation needed to fund these deals.
Constraints on the volume of emerging markets financings will exist notwithstanding the fact that the banks' project finance portfolios have withstood crises well and the losses in emerging markets from project finance loans have, for most banks, been small in relation to their income from their project finance activities. The challenge for project financiers is to present effectively to their senior managements the true story of the resilience of the project finance portfolios to the more general shocks of the emerging markets crises.
In addition, the need continues to exist for the more rapid development of local capital markets in Asia and Latin America. Domestic markets need to be used to a much larger extent to fund domestic currency denominated assets, with major global project finance institutions encouraging the entry of local players in the market by providing credit support against the occurrence of a limited range of project risks.
Electronic Disintermediation
One of the greatest challenges to all existing financial institutions in the project finance arena, as in all areas of finance, lies in the growth of the internet and its potential for electronic disintermediation. In the US alone there are 25 Electronic Debt Auction platforms at various stages of development, which will significantly reduce the cost of distribution and improve liquidity in the market via easier, more timely and wider dissemination of information. In addition, a specialist investor/dealer market place will allow for more transparent pricing of secondary trading of bonds. It may also significantly change the banking landscape, as it is a direct challenge to the existing distribution platforms, which are the major comparative advantage of many major investment and commercial banks.
Conclusion
In summary, the project finance business continues to reinvent itself as the field's creative sponsors and bankers address the fundamental transformations of the world's key industries. Very large volumes of financings will be done in 2000 through corporate and project structures. And in each of the key industries we serve, we will have the pleasure of solving new challenges we have not yet begun to imagine.
Request a Demo
Interested in IJGlobal? Request a demo to discuss a trial with a member of our team. Talk to the team to explore the value of our asset and transaction databases, our market-leading news, league tables and much more.