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Project finance needs to learn new tricks

Project finance has long been associated with steady cashflows and minimal risk. But, with long-term capital costly, sponsors will have to consider a variety of new funding models.

Project finance bankers took heart last week when the £925m senior bank facility for the widening of the UK’s M25 motorway was signed. They were especially impressed that banks were willing to commit to a 27 year deal. But this should not be taken as a sign that everything is well in project finance. The sector needs to adapt as it can no longer rely solely on banks.

Adherents of project finance insist that such deals are among the safest the capital markets have to offer. Defaults in EMEA have always been low and recovery rates are high. They also point out that since mid-2007 banks have had to take almost no writedowns on project finance debt. Thus they say that banks should still be willing to commit to such facilities, even on a long term basis.

But banks no longer want to lend long-term funds. The syndicated loan market has seen tenors reduced significantly since September last year, with lenders insisting on short-dated deals for both new money and refinancing facilities. Five year money is virtually unheard of, let alone seven year debt.

This will continue to be the case until banks can easily fund themselves beyond three years.

Banks also have to deal with Basle II, which places much higher capital restrictions on long-dated lending. Project finance assets receive a lenient treatment compared to other long-dated lending under the accord. But this does not come close to fully compensating banks for the small returns they are typically offered.

Quite simply, sponsors need to offer banks something different. Some progress in being made. Cash-sweeps (provisions stipulating that after a certain period any excess cash be used to pay down principal, effectively shortening the tenor) have become common. A cash-sweep on the M25 deal shortens its average tenor to 22.5 years from 27 years.

An even more effective tool is the mini-perm, which gives a deal a tenor of about ten years, forcing the sponsor to refinance at that point. The $1.7bn loan for the Al Dur independent water and power plant (IWPP) project in Bahrain is the most recent example of mini-perms’ effectiveness. The facility is set to sign oversubscribed next month after about 15 lenders committed, no doubt attracted by the eight year tenor.

The other prospect is for sponsors to tap bond markets, something those on the Al Dur project are expected to do to secure long-term financing. This makes sense. Investors in western Europe’s bonds markets have been calling out for long tenors on non-financial corporate deals, hoping to lock in high spreads for as long as possible.

Sponsors may not like the thought of having to diversify their funding, especially if this results in shorter borrowing and higher refinancing risks. But they have little choice.

Project finance will continue to be a vital aspect of the debt markets. Infrastructure and energy projects are vital to countries’ economies and cannot be halted. But to be funded by the private sector, more innovations, such as mini-perms and cash sweeps, will be needed.

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