Bumping up the benefit
A number of trends are occurring in the US and internationally in
the broad area of project and infrastructure finance. They indicate
leasing structures will be used more frequently as a vehicle for
financing infrastructure projects and privatizations.
These trends include:
? the increasing pace of global privatization;
? the continuing restructuring of the US electric utility industry;
? the maturation of US independent power projects; and
? the deregulation of utilities in Europe.
Until recently, infrastructure projects and privatizations have primarily been financed through the use of the traditional project finance or non-recourse lending paradigm.
Under this model, a financial institution (typically a commercial bank) makes a loan to a special purpose company which owns or operates one or more related projects, and virtually nothing else. In making this loan, the financial institution has recourse only to the assets and cash flows of the project company without further recourse to the owners or sponsors of the project company if the project goes into default (except to the extent that any of the owners have other contractual obligations to the project).
Project revenues generated from a long-term offtake contract for the commodity produced or service rendered by the project or privatized entity represent the principal (if not sole) source of debt repayment.
From the project lender's perspective, this model has been particularly well-suited to financing power projects, toll roads, water supply facilities, liquefied natural gas terminals and other infrastructure projects because such projects generate stable, long-term revenue streams which can be isolated and secured as collateral for debt (in addition to the hard assets of the project and its supporting contracts). Project sponsors and other project participants have found this paradigm desirable due to the off balance sheet treatment of the debt incurred (vis-a-vis the balance sheets of project owners), the insulation from liability it provides, and its inherent risk allocation flexibility as it allows project participants to allocate each specific project risk to the party most able to handle it.
The market trends delineated above have generated an ever-increasing demand for capital worldwide. At the same time, project sponsors have increasingly begun to look beyond the traditional project finance structure in order to capture embedded tax benefits in operating projects, lower the costs of financing and turbo-charge returns.
This has led to grafting of capital markets, mezzanine (in conjunction with other vehicles), and lease financing structures onto the traditional paradigm. Indeed, it can be argued that in the aggregate, structures incorporating these other asset finance technologies have, over the last three to five years, raised more infrastructure financing dollars than the classic non-recourse loan model.
Analyzed separately, however, structures incorporating leasing technology into an infrastructure project or privatization financing presently come in a distant third to the traditional commercial loan model or an infrastructure project financing or privatization incorporating a capital markets offering into the equation (or for some mega-deals, a hybrid of the two). Given the market trends discussed below, however, the use of lease structures in the project and infrastructure context should garner greater consideration from sponsors and financing parties alike, and, over the longer term, begin to capture an increasingly larger share of the infrastructure finance marketplace.
The leasing paradigm
For the uninitiated, leases come in many shapes and sizes ranging from simple operating leases to the more exotic lease-in lease-out and double-dip structures designed to take advantage of various peculiarities in the tax codes of the US and other foreign jurisdictions. For infrastructure finance ? particularly in the water/wastewater and power industries where the capital equipment employed there has an economic life of 25 or more years ? the leveraged lease presents many advantages to all of the parties involved in a transaction when structured correctly.
Under a leveraged lease, the leassee selects the capital equipment that will become the subject of the lease. The lessor in the leveraged lease becomes the owner of the leased equipment by providing a percentage (typically 20%) of the capital necessary to purchase the equipment. The remainder of the necessary capital is borrowed from either institutional investors or commercial lenders on a non-recourse basis to the lessor. The loan is secured by a first priority lien on the capital equipment, an assignment of the lease, and an assignment of the lease rental payments (although the cost of the loan is primarily tied to the lessee's credit risk).
The lessor in a leveraged lease transaction can claim all of the tax benefits incidental to the ownership of the leased capital equipment and the residual value of such equipment despite having provided only 20% of the capital necessary to procure the equipment. Thus, only efficient users of tax deductions and depreciation will act as lessors in such transactions. This ability to claim the tax benefits of the transaction while providing only a small portion of the capital required to purchase the equipment enables the lessor to lease the equipment to the lessee at a lower cost than the lessee could obtain if it financed the equipment either through a direct lease or some other form of non-recourse financing.
Global market trends
In the broadest sense, each of the trends discussed in this article can be characterized as a subset of the global trend to market capitalism. This macroeconomic sea change has fueled enormous growth in global demand for private capital. The traditional project finance model as a vehicle for getting this capital to the marketplace has strained to keep pace with the needs of borrowers, does not always fit the requirements for debt and equity providers, and does not always optimize returns for the private equity providers. The following briefly discusses these individual market trends and the potential opportunities available for the employment of lease technology as an enhancement to, or in some cases, a replacement for the traditional project finance model.
The privatization wave
The rate of privatization of state-owned assets has increased dramatically over the past decade, particularly in developing countries. Since 1991, for example, Brazil has sold approximately 50 state companies worth almost $15 billion. In November 1996, Germany's Deutsche Telecom was privatized for DM20 billion ($13 billion), Europe's largest privatization to date. Estimates by the Economist call for the privatization of state-owned enterprises in western Europe valued at $250-300 billion over the next few years.
Indeed, even the recalcitrant People's Republic of China has tentatively embarked on a liquidation of its government-owned enterprises. In circumstances where sovereigns desire the functional benefit of privatization (ie, private managers and operation of a facility) but are mindful of the political and legal ramifications of transferring title of valuable state assets to foreigners, leasing may provide a politically convenient way to retain ownership, while at the same time, shifting control and profit and loss accountability. This is a particularly important consideration in the water and wastewater industries where sensitivities about having foreigners own the water supplies can run quite high. A lease structure can allow a government to turn over operation of a water system on a basis that allows for easy recovery of control if the operator/lessee does not perform to expectations while at the same time maintaining some semblance of ownership. Upon a failure to perform, however, the lease is then simply cancelled, without having to effect an actual buy-back of the assets. In addition, in this context, leasing structures may also be more attractive from a bankruptcy-risk perspective, forcing the operator/lessee to more quickly assure or reject (eg, under US law) the lease ? that is, to perform properly or return the facility in question. Even a short term interruption in the delivery of potable water or the treatment of wastewater has greater political implications than interruptions in power or telecommunications.
Even in jurisdictions and industries where retention of local control is not an issue, lease structures have been considered and used with great success. For example, in Australia, at least two electric industry privatizations have been accomplished in which a leveraged lease was an integral part of the project finance structure. These were the A$4.7 million ($0.0 million) privatization of the 2000MW Loy Yang A generator in the State of Victoria and the privatization of the Australian Electric Transmission Company in which Mission Energy of the US was both a debt and equity provider. Lease structures have been widely employed in the UK's privatization and financing of its electric utility assets.
While most of the UK's power leases have employed UK tax leases because of UK land laws and other local regulatory issues, Chase Manhattan using an innovative financing structure closed the first US cross-border lease in the UK power sector late in 1997 with the financing of the UK generator Eastern Electric. In addition, leases have become a favoured approach to privatization in the US ? particularly in connection with the privatization of water, wastewater, and electric power assets that were initially financed using tax-exempt or otherwise tax-advantaged debt. Certain US tax code rules and regulations applicable to such debt can make leasing a more attractive method of privatizing facilities without triggering adverse tax consequences. The success of these types of transactions should serve to rekindle interest in employing a variety of lease structures in any further financings in these sectors.
Restructuring of the US electric utility industry
The US electric utility industry, which possesses assets with an aggregate book value estimated at between $500 and $600 billion, has begun the process of restructuring from an industry subject to command and control regulation to one open to the vagaries of the free market. This process, similar to that which the natural gas, airline, trucking and telecommunications industries have already undergone, will result in the sale, spin-off, acquisition or divestiture of several hundred billion dollars of electric generation, transmission and distribution assets. Indeed, several billion dollars of these assets have already changed hands. While a portion of these acquisitions will be financed by the purchasers through balance sheet financing, a significant portion of the purchase of these assets will be financed using off balance sheet methods, most likely employing some form of the project finance model. The incorporation of lease finance technology into these acquisitions could allow owners to recover embedded capital or tax benefits without losing control of a valuable asset, in the case, for example, of a sale-leaseback transaction.
Maturing US independent power projects
The independent power industry in the US came into being, for the most part, with the passage by Congress of the Public Utility Regulatory Policies Act of 1978 (commonly referred to as PURPA). Since 1978, approximately 6,000 independent power projects have come on line. These projects were primarily financed through the use of the traditional project finance paradigm using commercial loan financing. The bulk of these projects are now reaching what can be termed as maturity. They are somewhere between their fifth and fifteenth year of existence with between five and 15 years remaining on their long-term (typically 20 year) take-or-pay power sales contracts with one or more utilities. Numerous opportunities exist for the refinancing of existing project loans through leasing structures as many of these assets may be ripe for re-conditioning or re-powering using newer technologies. When the tax benefits associated with the newer equipment are more efficiently used by a third party (as discussed above), leveraged leasing of entire projects becomes feasible, and perhaps desirable.
Deregulation of electric utilities in Europe
As Europe continues to move to a unified market with a single currency, the European electricity, telecommunications, cable, and water and wastewater industries, similar to their counterparts in the US, are facing a period of significant restructuring. Unlike the US, however, most utilities are not privately owned. Nevertheless, some of these utilities, particularly those located in the Netherlands, have focused on the use of financial technology in lowering their costs.
Indeed, this is one area in which industry participants have completely ignored the project finance model and focused solely on lease technology. Over the last several years, several Dutch utilities have employed cross-border tax-drive lease structures to lease their generating assets as a means of creating liquidity on the balance sheet given that Dutch state-owned utilities are tax-exempt at the corporate level. Several of these utilities are exploring the viability of applying these structures to transmission assets as well. It has been reported that similar transactions have been under consideration in the UK, Ireland, Germany and Austria. As a truly competitive market for electricity, telecommunications, and water further develops in Europe, the appetite for financial engineering to lower costs and/or boost returns will only increase. Since the circumstances so clearly favour lease structures, it can be anticipated that Europe will be a watershed market for the use of lease structures in connection with the financing/refinancing of infrastructure. Up until recently, lease technology has had only limited application in the financing of infrastructure projects and privatizations.
Given the trends taking place in the global marketplace, the ever-growing demand for private capital to finance new and newly-privatized infrastructure, and the limitations of the traditional project finance model, lease structures will find increasing relevance in infrastructure finance.
These trends include:
? the increasing pace of global privatization;
? the continuing restructuring of the US electric utility industry;
? the maturation of US independent power projects; and
? the deregulation of utilities in Europe.
Until recently, infrastructure projects and privatizations have primarily been financed through the use of the traditional project finance or non-recourse lending paradigm.
Under this model, a financial institution (typically a commercial bank) makes a loan to a special purpose company which owns or operates one or more related projects, and virtually nothing else. In making this loan, the financial institution has recourse only to the assets and cash flows of the project company without further recourse to the owners or sponsors of the project company if the project goes into default (except to the extent that any of the owners have other contractual obligations to the project).
Project revenues generated from a long-term offtake contract for the commodity produced or service rendered by the project or privatized entity represent the principal (if not sole) source of debt repayment.
From the project lender's perspective, this model has been particularly well-suited to financing power projects, toll roads, water supply facilities, liquefied natural gas terminals and other infrastructure projects because such projects generate stable, long-term revenue streams which can be isolated and secured as collateral for debt (in addition to the hard assets of the project and its supporting contracts). Project sponsors and other project participants have found this paradigm desirable due to the off balance sheet treatment of the debt incurred (vis-a-vis the balance sheets of project owners), the insulation from liability it provides, and its inherent risk allocation flexibility as it allows project participants to allocate each specific project risk to the party most able to handle it.
The market trends delineated above have generated an ever-increasing demand for capital worldwide. At the same time, project sponsors have increasingly begun to look beyond the traditional project finance structure in order to capture embedded tax benefits in operating projects, lower the costs of financing and turbo-charge returns.
This has led to grafting of capital markets, mezzanine (in conjunction with other vehicles), and lease financing structures onto the traditional paradigm. Indeed, it can be argued that in the aggregate, structures incorporating these other asset finance technologies have, over the last three to five years, raised more infrastructure financing dollars than the classic non-recourse loan model.
Analyzed separately, however, structures incorporating leasing technology into an infrastructure project or privatization financing presently come in a distant third to the traditional commercial loan model or an infrastructure project financing or privatization incorporating a capital markets offering into the equation (or for some mega-deals, a hybrid of the two). Given the market trends discussed below, however, the use of lease structures in the project and infrastructure context should garner greater consideration from sponsors and financing parties alike, and, over the longer term, begin to capture an increasingly larger share of the infrastructure finance marketplace.
The leasing paradigm
For the uninitiated, leases come in many shapes and sizes ranging from simple operating leases to the more exotic lease-in lease-out and double-dip structures designed to take advantage of various peculiarities in the tax codes of the US and other foreign jurisdictions. For infrastructure finance ? particularly in the water/wastewater and power industries where the capital equipment employed there has an economic life of 25 or more years ? the leveraged lease presents many advantages to all of the parties involved in a transaction when structured correctly.
Under a leveraged lease, the leassee selects the capital equipment that will become the subject of the lease. The lessor in the leveraged lease becomes the owner of the leased equipment by providing a percentage (typically 20%) of the capital necessary to purchase the equipment. The remainder of the necessary capital is borrowed from either institutional investors or commercial lenders on a non-recourse basis to the lessor. The loan is secured by a first priority lien on the capital equipment, an assignment of the lease, and an assignment of the lease rental payments (although the cost of the loan is primarily tied to the lessee's credit risk).
The lessor in a leveraged lease transaction can claim all of the tax benefits incidental to the ownership of the leased capital equipment and the residual value of such equipment despite having provided only 20% of the capital necessary to procure the equipment. Thus, only efficient users of tax deductions and depreciation will act as lessors in such transactions. This ability to claim the tax benefits of the transaction while providing only a small portion of the capital required to purchase the equipment enables the lessor to lease the equipment to the lessee at a lower cost than the lessee could obtain if it financed the equipment either through a direct lease or some other form of non-recourse financing.
Global market trends
In the broadest sense, each of the trends discussed in this article can be characterized as a subset of the global trend to market capitalism. This macroeconomic sea change has fueled enormous growth in global demand for private capital. The traditional project finance model as a vehicle for getting this capital to the marketplace has strained to keep pace with the needs of borrowers, does not always fit the requirements for debt and equity providers, and does not always optimize returns for the private equity providers. The following briefly discusses these individual market trends and the potential opportunities available for the employment of lease technology as an enhancement to, or in some cases, a replacement for the traditional project finance model.
The privatization wave
The rate of privatization of state-owned assets has increased dramatically over the past decade, particularly in developing countries. Since 1991, for example, Brazil has sold approximately 50 state companies worth almost $15 billion. In November 1996, Germany's Deutsche Telecom was privatized for DM20 billion ($13 billion), Europe's largest privatization to date. Estimates by the Economist call for the privatization of state-owned enterprises in western Europe valued at $250-300 billion over the next few years.
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Indeed, even the recalcitrant People's Republic of China has tentatively embarked on a liquidation of its government-owned enterprises. In circumstances where sovereigns desire the functional benefit of privatization (ie, private managers and operation of a facility) but are mindful of the political and legal ramifications of transferring title of valuable state assets to foreigners, leasing may provide a politically convenient way to retain ownership, while at the same time, shifting control and profit and loss accountability. This is a particularly important consideration in the water and wastewater industries where sensitivities about having foreigners own the water supplies can run quite high. A lease structure can allow a government to turn over operation of a water system on a basis that allows for easy recovery of control if the operator/lessee does not perform to expectations while at the same time maintaining some semblance of ownership. Upon a failure to perform, however, the lease is then simply cancelled, without having to effect an actual buy-back of the assets. In addition, in this context, leasing structures may also be more attractive from a bankruptcy-risk perspective, forcing the operator/lessee to more quickly assure or reject (eg, under US law) the lease ? that is, to perform properly or return the facility in question. Even a short term interruption in the delivery of potable water or the treatment of wastewater has greater political implications than interruptions in power or telecommunications.
Even in jurisdictions and industries where retention of local control is not an issue, lease structures have been considered and used with great success. For example, in Australia, at least two electric industry privatizations have been accomplished in which a leveraged lease was an integral part of the project finance structure. These were the A$4.7 million ($0.0 million) privatization of the 2000MW Loy Yang A generator in the State of Victoria and the privatization of the Australian Electric Transmission Company in which Mission Energy of the US was both a debt and equity provider. Lease structures have been widely employed in the UK's privatization and financing of its electric utility assets.
While most of the UK's power leases have employed UK tax leases because of UK land laws and other local regulatory issues, Chase Manhattan using an innovative financing structure closed the first US cross-border lease in the UK power sector late in 1997 with the financing of the UK generator Eastern Electric. In addition, leases have become a favoured approach to privatization in the US ? particularly in connection with the privatization of water, wastewater, and electric power assets that were initially financed using tax-exempt or otherwise tax-advantaged debt. Certain US tax code rules and regulations applicable to such debt can make leasing a more attractive method of privatizing facilities without triggering adverse tax consequences. The success of these types of transactions should serve to rekindle interest in employing a variety of lease structures in any further financings in these sectors.
Restructuring of the US electric utility industry
The US electric utility industry, which possesses assets with an aggregate book value estimated at between $500 and $600 billion, has begun the process of restructuring from an industry subject to command and control regulation to one open to the vagaries of the free market. This process, similar to that which the natural gas, airline, trucking and telecommunications industries have already undergone, will result in the sale, spin-off, acquisition or divestiture of several hundred billion dollars of electric generation, transmission and distribution assets. Indeed, several billion dollars of these assets have already changed hands. While a portion of these acquisitions will be financed by the purchasers through balance sheet financing, a significant portion of the purchase of these assets will be financed using off balance sheet methods, most likely employing some form of the project finance model. The incorporation of lease finance technology into these acquisitions could allow owners to recover embedded capital or tax benefits without losing control of a valuable asset, in the case, for example, of a sale-leaseback transaction.
Maturing US independent power projects
The independent power industry in the US came into being, for the most part, with the passage by Congress of the Public Utility Regulatory Policies Act of 1978 (commonly referred to as PURPA). Since 1978, approximately 6,000 independent power projects have come on line. These projects were primarily financed through the use of the traditional project finance paradigm using commercial loan financing. The bulk of these projects are now reaching what can be termed as maturity. They are somewhere between their fifth and fifteenth year of existence with between five and 15 years remaining on their long-term (typically 20 year) take-or-pay power sales contracts with one or more utilities. Numerous opportunities exist for the refinancing of existing project loans through leasing structures as many of these assets may be ripe for re-conditioning or re-powering using newer technologies. When the tax benefits associated with the newer equipment are more efficiently used by a third party (as discussed above), leveraged leasing of entire projects becomes feasible, and perhaps desirable.
Deregulation of electric utilities in Europe
As Europe continues to move to a unified market with a single currency, the European electricity, telecommunications, cable, and water and wastewater industries, similar to their counterparts in the US, are facing a period of significant restructuring. Unlike the US, however, most utilities are not privately owned. Nevertheless, some of these utilities, particularly those located in the Netherlands, have focused on the use of financial technology in lowering their costs.
Indeed, this is one area in which industry participants have completely ignored the project finance model and focused solely on lease technology. Over the last several years, several Dutch utilities have employed cross-border tax-drive lease structures to lease their generating assets as a means of creating liquidity on the balance sheet given that Dutch state-owned utilities are tax-exempt at the corporate level. Several of these utilities are exploring the viability of applying these structures to transmission assets as well. It has been reported that similar transactions have been under consideration in the UK, Ireland, Germany and Austria. As a truly competitive market for electricity, telecommunications, and water further develops in Europe, the appetite for financial engineering to lower costs and/or boost returns will only increase. Since the circumstances so clearly favour lease structures, it can be anticipated that Europe will be a watershed market for the use of lease structures in connection with the financing/refinancing of infrastructure. Up until recently, lease technology has had only limited application in the financing of infrastructure projects and privatizations.
Given the trends taking place in the global marketplace, the ever-growing demand for private capital to finance new and newly-privatized infrastructure, and the limitations of the traditional project finance model, lease structures will find increasing relevance in infrastructure finance.
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