When local currencies in Latin America were buffeted during the liquidity crisis at the end of last year, fears returned that the region’s hitherto stable monetary regimes might unwind abruptly.
For project financiers in the region, memories returned of the 1994 “Tequila crisis”, which overnight pushed into default toll road concessions financed in dollars, sparking a mass exodus of foreign investors.
The onset of the credit crunch, we are told by bullish observers, has come at a time when the region’s fundamentals are solid with thriving local currency markets. But if the rules of the international financial system have now changed, the bull run in Latin American infrastructure investment may yet be thrown off course. An abrupt and sharp rise in borrowing costs could freeze project financing in the region – by crushing cash flows and slamming debt coverage ratios while grinding crucial refinancing operations to a halt.
These exogenous risks come at a time when regional governments have redoubled efforts to jumpstart local capital markets and numerous charm offensives to court foreign investment.
After decades of failure to redress these structural deficiencies, the region requires 4–6% GDP growth annually at least to match Asian levels of investment, according to the World Bank. This is now becoming a politically charged mission led by trailblazers Mexico. Latin America’s second-biggest economy has committed billions of extra dollars from its fiscal surplus – a buffer against slowing external demand over the next two years.
Confident investors predict Latin America’s bold ambitions can be met, declaring the sector’s immunity from global liquidity risks and citing the long-term and cash flow-generating nature of most projects. What’s more, they argue, credit risks have been mitigated in most deals since hefty leveraged buyouts have rarely touched emerging markets.
“Yes, there is now less availability for debt so our equity portions will be increasing in the short term, but this is completely manageable because of the growth prospects,” says Pedro Batalla, partner at Santander Private Equity. Scott Swenson, partner in energy-focused private equity firm Conduit Capital Partners, is similarly sanguine. “Bank pricing has backed up a bit. It will cost you about another 100bps in spread versus a year ago, but these are cash flow-producing projects with reasonable leverage, so the region is safe.”
Cherian George, head of Americas project finance at ratings agency Fitch, explains the crisis in the dollar-denominated debt market has already sparked risk aversion and tightened liquidity to fund projects in the region. “There are fewer transactions than we would have expected six months ago. This is because we are finding it very difficult to set a benchmark price since spreads are widening, especially sub-investment grade deals,” says George.
Aggressive structures
Observers fear many projects are worryingly exposed to credit spread and interest rate risks as well as restricted access to refinance existing debt and pricing new deals. Moreover, the bull run for infrastructure investment has seen many transactions structured with complex financial engineering, especially in Mexico and Chile.
“In Latin America, there is a need for more conservative deal structures, since we have begun to see worryingly aggressive deals that have bullets or variable rate format. We are already seeing them being affected by the volatility,” explains George.
Mexican toll road assets, for example, have been boldly structured, driven by investor confidence in the close correlation of revenue growth to inflation. For example, Autopista Penon-Texcoco, Chihuahua and Fresnillo-Zacatecas toll roads have been financed with variable rate interest.
Reassuringly in the near term, hedges have been put in place, since many of these deals have short-term interest rate caps till 2011 covering the construction and traffic ramp-up phase. But projects like these still have substantial refinance exposures, and swaps have often been secured for a period less than the tenor of the refinancing.
Several other undertakings in the region, such as Venezuelan oil project Sincor, which has been funded with a $1.2 billion unhedged variable-rate bank debt, are now severely vulnerable.
With shallow and immature capital markets in the region, there is less flexibility to offset the timing risks of such deals. This could leave many refinancing operations wildly exposed to volatile market fluctuations. “Given the host of risks in the region – financial, regulatory and political – we caution against such engineering. We prefer to see fixed-rate, short-term maturities, rapidly amortizing deals, and equity should be there during the length of transaction,” advises George.
Nevertheless, conventional bank lending with post-construction capital markets takeout is the standard financing model across the region. Despite the gushing liquidity of the region’s banks, the malign global backdrop is provoking wariness to on-lend, and there are already fears that new projects could face difficulties getting off the ground. “We have lots of liquidity, but we are now more nervous to lend because global economic conditions could rapidly deteriorate,” says one senior project finance banker at a top Brazilian bank.
“It’s the struggle of uncertainty rather than liquidity strain per se,” says Eugene Mendoza, co-head of LatAm securitization at monoline insurer MBIA. This risk aversion will inevitably bring about more conservative and costlier financing arrangements. “We need stability in perceptions, but in this environment, you have to go for more simple transactions,” Mendoza says.
Nevertheless, there are signs that domestic capital markets are gradually maturing, propped up by more stable monetary and fiscal regimes. This is boosting the availability of local currency funding and enhancing the credit profiles of highly leveraged deals. In Chile, for example, most private toll-road projects have been financed with inflation-linked, amortizing debt in pesos, fundamentally limiting their exposure to external volatility.
Brazil’s stumbling block
But Chile’s capital market is in a league of its own, and the region’s largest economy, Brazil, has significant structural deficiencies that could thwart its investment quest this year. Observers question the feasibility of Brazilian President Lula’s Growth Acceleration Programme, with infrastructure and energy investment projected to grow to R503.9 billion by 2010. For example, foreign investors bemoan the acute foreign currency risks with the real’s non-convertibility and non-Euroclearable status.
“Brazil is a big anomaly as it’s the only country where you can’t have a dollar-based contract. You have to take the risk of real on the revenues, but with a thermal plant, when the cost of fuel is in dollars, you have a total mismatch,” laments Swenson.
There are also natural barriers to securing long-tenor dollar-debt from private banks for projects such as toll roads owing to the country’s infant and inflexible capital market. “You cannot finance transactions for more than seven years when we need longer tenors of 12 to 15 years. And when we need to hedge exchange rate risks, we find the derivatives markets very limited,” says Felipe Montoro Jens, head of project and export finance at Brazilian construction conglomerate Odebrecht.
This is the case when projects don’t have the support from development bank BNDES, which overwhelmingly subsidizes most long-term projects in the country. With the absence of a credible domestic environment in Brazil for such long-term financing, sponsors of capital-intensive projects are forced to wade into global market waters to secure fixed-income instruments with long maturities.
But there is clear evidence that the global liquidity strain is limiting financing options in the region. For example, Jens admits that funding strategies for a ground-breaking R2 billion, 30-year concession for Sao Paulo’s West Ring Road have now come to a dead end. “Six months ago we were hoping to access the international markets for a project bond in local currency, but the markets are effectively closed for us now. Without sponsorship from the IDB, IFC or CAF, our options are now very limited,” he says.
Before the onset of the liquidity strain, project backers were enthusiastically gearing up for refinancing and looking to extract equity while increasing leverage. Now, at least in the near term, things will have to change. Although there is no imminent risk of projects collapsing due to insufficient funds, governments and financiers sound complacent when they deny Latin America’s project market will be affected by a US slowdown.
This new era of risk aversion and costly credit will attack the timing, pricing and number of refinancing transactions. It will also inspire more conservative deal structures, and potentially deter crucial foreign investment. As Mendoza warns: “We will have to see more equity involved, and the cost of capital will increase so prices will have to increase. This is what people are too scared to talk about.”