Using Capital Markets in the Financing of Infrastructure: The Use of Liquidity Facilities

1
Using Capital Markets in the Financing of
Infrastructure The Use of Liquidity Facilities

• Inter-American Development Bank Business Seminar
• Capital Markets for Development
• Tuesday, June 3, 2003
• Washington, DC

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Discussion Topics

• Types of Liquidity Facilities 3
• Capital Markets Financing for Developing-Country
• Infrastructure Projects Current Issues 12
• Conceptual Structure of a Foreign Exchange
  Liquidity Facility 17
• Implementation of a Foreign Exchange Liquidity
  Facility
• The AES Tietê Transaction 27
• Applicability and Benefits of Foreign Exchange
  Liquidity Facilities 31
• Status of Liquidity Facilities as a New Financial
  Product 37

3
Types of Liquidity Facilities
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Liquidity Facilities Examples

• Debt Service Reserve Accounts
• Foreign Exchange Liquidity Facilities
• Contingent Partial Credit Guarantees
• Merchant Power Market Floor Price Facilities

5
Debt Service Reserve Accounts

• Self-funded
• In cash, with a portion of the projects senior
  debt,
• With a letter of credit provided by the sponsor,
  or less frequently,
• From project cash flow
• Typically sized at an amount equal to six months
  debt service
• Drawn upon in the event of a debt service
  shortfall
• Replenished from cash which would otherwise be
  available for distribution to the sponsor
• Used to cover the risk of
• Temporary operating problems which can be fixed
  within the short-term
• Insufficient cash to pay debt service until an
  insurer or other third-party provider of support
  can determine that it should provide funding
  (e.g., OPIC capital markets inconvertibility
  policy)

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Foreign Exchange Liquidity Facilities

• Liquidity facility is provided by a third party
• Bilateral or multilateral agency
• Private political risk insurer
• Size of the liquidity facility depends upon
• Historical volatility of real exchange rates in
  the projects host country
• Prospective debt service coverage ratio of the
  project
• Drawn upon when the projects cash available for
  debt service, converted into US dollars, is below
  a pre-established floor value and is
  insufficient to permit payment of scheduled debt
  service
• Draws are evidenced by a loan subordinated only
  to the project's senior lenders, repaid as soon
  as free cash flow allows
• Used to mitigate the risk of fluctuations in the
  real exchange rate of the projects host country

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Contingent Partial Credit Guarantees

• Contingent Partial Credit Guarantee (which
  functions as a liquidity facility) is to be
  provided by the IFC
• Size will typically equal two years debt service
• Guarantee becomes effective in the event of a
  major devaluation
• Applicable to both US dollar and local currency
  financings
• Used to mitigate
• the risk that an infrastructure project will not
  be allowed to raise prices adequately following a
  major devaluation
• IFC analysis indicates that after two years,
  economic recovery is usually sufficient to permit
  price increases
• Springing guarantee improves credit quality of
  the project and facilitates sale of securities
  denominated in local currency to investors in the
  projects host country
• the risk of higher interest rates on
  floating-rate local currency securities

8
Merchant Power Market Floor Price Facilities

• Liquidity facility is provided by a third party
• Financial institution
• Private insurer
• Size of liquidity facility depends upon
  independent market consultants estimate of
• Downside value of pure capacity
• Maximum duration of market overcapacity
• Prospective debt service coverage ratio of the
  project
• Drawn upon when the market price falls below a
  pre-established floor price and is insufficient
  to permit payment of scheduled debt service
• Draws are evidenced by a loan subordinated only
  to the project's senior lenders, repaid as soon
  as free cash flow allows
• Used to mitigate fluctuations in the market price
  of electric power

9
Rationale for the Use of Liquidity Facilities in
Infrastructure Project Financings

• Infrastructure financings are particularly
  suitable for liquidity facility providers to take
  a long-run view
• High coverage ratios provide a large margin for
  error in changes of the values of the risk
  factors covered by the liquidity facility
• Long tenor provides a long time for economic
  forces to return to equilibrium
• Long useful life (both physically and
  economically) of the assets of an infrastructure
  project provides the basis for repayment of any
  claims outstanding at the final maturity of the
  senior debt

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A Comparison of Derivatives, Insurance, and
Liquidity Facilities
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Applicability of Different Risk Mitigation
Techniques to Currency Risk

• Insurance products are seldom used to mitigate
  purely economic risks
• Derivatives frequently are not offered for tenors
  sufficient to mitigate the most significant risks
  in project financing
• Power markets
• Currency markets
• If derivatives with a sufficient tenor to use in
  project financing exist for the currency of a
  developing country, the country will have a
  long-term fixed-rate local currency debt market
  and is likely to have investment-grade foreign
  currency debt ratings
• Liquidity facilities are likely to remain the
  best option for dealing with currency risk in
  countries for which currency risk is an issue

12
Capital Markets Financing for Developing- Country
Infrastructure ProjectsCurrent Issues
13
Financing Developing-Country Projects with Local
Currency Revenues Old Model

• Project sells its output for local currency
• Output prices contractually linked to US dollar
  exchange rate
• Project contractually shifts devaluation risk to
  output purchaser, but remains exposed if,
  following devaluation, purchaser should default
  and attempt to renegotiate output contract
• To gain protection from devaluation /
  renegotiation risk, project may be structured
  with co-financing from ECAs, OPIC, or
  multilateral agencies
• To gain protection from inconvertibility risk,
  political risk insurance and/or co-financing with
  a preferred creditor are likely to be used
• Rating of the projects senior debt is limited by
  sovereign ceiling of the host country

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Problems with the Old Model for Infrastructure
Finance

• Examples of Argentina and Indonesia highlight the
  limitations of the old model
• Regulators may deny output purchasers sufficient
  tariff increases to avoid default on US dollar
  debt
• If devaluation is sufficiently severe, output
  purchasers may default regardless of the
  consequences
• Renegotiation process, even if successful from
  the projects point of view, may interrupt the
  projects cash flow so as to prevent timely
  payment of interest and principal
• Currency mismatch risk limits transaction rating
  to the sovereign ceiling
• Fewer investment-grade developing countries than
  in the mid-1990s
• Fixed-income investors reluctant to purchase low
  investment-grade debt issued by
  developing-country infrastructure projects
• Linkage of project output prices to FX rate
  stresses credit capacity of the output purchaser
• Output purchasers ratings are likely to cap the
  ratings for their suppliers
• Foreign currency rating is a more appropriate
  measure than local currency rating of output
  purchasers ability to honor FX-indexed
  contractual purchase obligations

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Limitations of Co-Financing

• Co-financing is better received in the bank
  markets than in the capital markets
• Co-financing will not induce capital markets
  investors to purchase a transaction which they
  would not purchase without co-financing
• Some capital markets investors appreciate the
  security of being pari passu with ECAs, OPIC, or
  multilateral agencies, but
• Other investors feel that the presence of
  agencies in a financing increases the likelihood
  of contract renegotiation and debt rescheduling
• Capital markets investors believed that
  co-financing structures would protect issuers
  from adverse regulatory actions and were
  disappointed when this did not occur in Argentina
• Co-financing structures consume significant
  capacity from governmental and multilateral
  agencies
• Pari passu financing tranche likely to represent
  25 or more of total debt
• Agency participation likely to be
  disproportionately weighted toward longer
  maturities, either in direct funding or put
  structures
• Partial risk structures designed to upgrade
  ratings likely to require support equal to at
  least 40 of principal amount of project debt

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Need for New Approaches

• Project output contracts which link prices to the
  FX rate contain an inherent risk of default /
  renegotiation
• The most significant risks to lenders are
  inconvertibility, devaluation, and regulatory
  risk (which tends to be linked with devaluation)
• Failures of FX-indexed output contracts to cope
  with major devaluations will greatly limit their
  future use
• Currently-available political risk insurance can
  mitigate currency transfer and convertibility
  risk
• New approaches must be able to mitigate
  devaluation risk
• Foreign exchange liquidity facilities for US
  dollar debt
• Greater use of local capital markets to avoid
  currency mismatch risk between revenues and debt
  service

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Conceptual Structure of a Foreign Exchange
Liquidity Facility
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Conceptual Structure of a Foreign Exchange
Liquidity Facility Basic Assumptions

• Project Structure
• Revenues are received in local currency
• Revenues are contractually committed to increase
  with the host countrys inflation rate
• The project will promptly convert all local
  currency cash available for debt service into US
  dollars at the then-current exchange rate
• Financing Structure
• Project is financed with US dollar-denominated
  long-term debt
• Debt is fixed-rate or floating, swapped to fixed

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Conceptual Structure of a Foreign Exchange
Liquidity Facility Draws and Repayments

• Coverage is based on purchasing power parity,
  rather than hedging changes in nominal exchange
  rates
• The coverage establishes a floor for the value
  in US dollars of the companys cash available for
  debt service
• Draws may be made when the projects cash
  available for debt service, converted into US
  dollars, is below the floor value and is
  insufficient to pay scheduled debt service
• Draws from the liquidity facility will give rise
  to claims against the project, evidenced by a
  loan subordinated only to the project's senior
  lenders, repaid as soon as free cash flow allows
• Draws are subject to a maximum facility amount
  recoveries through the subordinated loan
  mechanism will be available for payment of future
  claims

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Conceptual Structure of the Devaluation Coverage
Currency vs Operational Risk

• Coverage is structured to separate currency risk
  from operational risk
• Changes in the real exchange rate are measured by
  valuing the projects expected cash available for
  debt service based on actual inflation and
  current exchange rates, rather than the projected
  (PPP) values used to create pre-closing proformas
• Value of the projects cash available for debt
  service is measured on a per-unit-of-output
  basis
• A proforma calculation is performed to determine
  the extent to which a cash shortfall is a result
  of fluctuations in currency values (which give
  rise to a draw under the liquidity facility)
  versus negative operational results (which do not
  give rise to a draw under the liquidity facility)
• Senior lenders are exposed to all operational
  risks, just as if the liquidity facility were not
  in place

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Basic Structure of a Foreign Exchange Liquidity
Facility
Debt Service Coverage Ratio
Value in US
Line 3
Line 1 100
1.50
Amount repaid to Liquidity Facility
1.0
Line 2 67
Debt service shortfall amount to be paid from
Liquidity Facility
Time (in years)
0
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Line 1 Projected value in US of cash in local
currency, indexed to host country inflation rate
(base case projection) Line 2 Annual debt
service requirements in US (principal and
interest) Line 3 Actual value in US of cash in
local currency, indexed to host country inflation
rate
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Sizing a Foreign Exchange Liquidity Facility

• Appropriate size of a foreign exchange liquidity
  facility depends upon
• The historical volatility of the real exchange
  rate of the projects host country
• The projects debt service coverage ratio
• Exposure created by historical volatility of the
  real exchange rate of the host country depends
  upon where the floor value is established for an
  individual transaction (i.e., how far the real
  exchange rate must decline before the project is
  eligible to draw from the liquidity facility)
• The debt service coverage ratio for a project can
  be increased by
• Improving the projects economics, e.g., by
  charging more for the projects output
• reducing the amount of debt in the projects
  capital structure
• Lengthening the tenor of the projects debt
  (which is likely to occur as a result of the use
  of a liquidity facility)

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Volatility of Real Exchange Rates Brazil
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Reduction in Exposure as a Projects Debt Service
Coverage Ratio Increases
Value in US
Debt Service Coverage Ratio
Line 4
1.50
Line 1 100
1.0
Line 2 67
Line 3
Time (in years)
0
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Line 1 Projected value in US of cash in local
currency, indexed to host country inflation rate
(base case projection) Line 2 Annual debt
service requirements in US (principal and
interest) Line 3 Actual value in US of cash in
local currency, indexed to host country inflation
rate Line 4 Line 3 shifted upward to illustrate
a higher DSCR than that of Line 3
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Establishing the Floor Value for a Foreign
Exchange Liquidity Facility

• If the floor value were to be established at a
  level equivalent to a 1.0 debt service coverage
  ratio, a small operational problem could cause
  the project to default
• Liquidity facility provider would reduce its
  exposure to project operational risk, but
• Fixed-income investors and rating agencies would
  put little value on the structure (it would
  resemble a US project with a 1.0 debt service
  coverage ratio)
• The floor value should be established at a level
  sufficient to provide an adequate margin for
  deviations of operational performance from the
  performance levels projected at closing

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Structure of a Liquidity Facility with a Floor
Value Equivalent to a DSCR of 1.20
Debt Service Coverage Ratio
Value in US
Line 3
Line 1 100
1.50
Amount repaid to Liquidity Facility
1.20
Line 4 80
1.0
Line 2 67
Debt service shortfall amount to be paid from
Liquidity Facility
Potential amount to be paid from Liquidity
Facility (payments at this level of real exchange
rate will be made only if necessary to pay debt
service i.e. only if the project is operating
below projections)
Time (in years)
0
15
Line 1 Projected value in US of cash in local
currency, indexed to host country inflation rate
(base case projection) Line 2 Annual debt
service requirements in US (principal and
interest) Line 3 Actual value in US of cash in
local currency, indexed to host country inflation
rate Line 4 A line showing the level of cash at
which the project has a debt service coverage
ratio of 1.20 (Floor Value)
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Implementation of a Foreign Exchange Liquidity
Facility The AES Tietê Transaction
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A Summary of the AES Tietê Transaction

• Issuer Tietê Certificates Grantor Trust, a NY
  grantor trust which made
• a back-to-back loan to the Brazilian parent of
  AES Tietê
• Securities US300,000,000 aggregate principal
  amount
• Tenor 15 years / 10 year average life
• Ratings Baa3 (Moodys) / BBB- (Fitch)
• Assets 10 hydroelectric generating facilities
  operated by AES Tietê in
• the State of São Paulo, Brazil, with 15-year
  PPAs
• Flow of Funds Dividends from a 44 economic
  interest in AES Tietê go to the
• Brazilian parent, which pays debt service to
  the Issuer

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AES Tietê Transaction Inconvertibility Coverage
and FX Liquidity Facility

• Country Risk mitigated through
• OPIC Capital Markets Inconvertibility Coverage
• FX Liquidity Facility, which protects against
  risk of devaluation
• Inconvertibility Coverage
• Standard OPIC capital markets policy covering
  inconvertibility and transfer risks and
  expropriation of funds
• US85 million policy limit, with policy limits
  which may be re-instated
• Claims may be made simultaneously with draws
  under FX Liquidity Facility
• Foreign Exchange Liquidity Facility
• Provided in the form of the FX Liquidity
  Facility, a revolving credit facility
• US30 million FX Liquidity Facility amount
• The FX Liquidity Facility insures that a
  devaluation of Brazils currency will not cause
  the Issuer to be unable to meet is debt service
  obligations

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Significance of the AES Tietê Transaction

• First electric power project financing in a
  below-investment grade country to achieve an
  investment-grade rating
• Longest tenor ever achieved by a Brazilian
  corporate issuer
• Priced at a level equivalent to 237 bp less than
  Brazilian sovereign debt (vs. 150 bps for the
  7-year Petrobras transaction which priced one
  week earlier)

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Applicability and Benefits of Foreign Exchange
Liquidity Facilities
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Applicability of Foreign Exchange Liquidity
Facilities

• Asset Types Infrastructure projects with
  revenues in local currency
• Electric power generation and distribution
  facilities
• Water supply and distribution companies
• Oil gas pipelines
• Any type of facility in which a capacity
  payment is typically used
• Countries Most Emerging Markets Countries
• Exchange rate should be either floating or
  managed, but subject to a reasonable amount of
  market pressure
• Only countries with pegged exchange rate
  regimes should be avoided
• Market Conditions Value of the host countrys
  currency is not decisive
• Coverage may be prudently offered if the price of
  the projects output is increased to compensate
  for overvaluation and to increase debt service
  coverage ratios

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Benefits of a Foreign Exchange Liquidity
Facility Sponsor Perspective

• Ability to sell projects output with pricing
  linked to host countrys rate of inflation
  shortens development time for new projects
• Access to capital markets shortens time to
  achieve financing for new projects
• Longer tenor financing may enable some projects
  to be developed which would otherwise not have
  been economically feasible (local market in host
  country cannot absorb output pricing at levels
  necessary to cover debt service for short-tenor
  debt)
• Longer tenor financing can increase the Net
  Present Value of investments in projects which
  could be financed with shorter tenors by
  traditional structures

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Benefits of a Foreign Exchange Liquidity
Facility Lender / Rating Agency Perspective

• Credit profile of rated transactions is improved
  as a result of significant reduction in risk of
  default or renegotiation of Projects output
  contract
• Local currency rating of output purchaser is not
  stressed by contractual commitment to purchase
  Projects output at prices indexed to the US FX
  rate
• Project rating is not constrained by the
  sovereign ceiling
• Project rating is de-linked from sovereign rating
• All previous capital markets financings in the
  electric sector have been downgraded as sovereign
  ratings have dropped
• Mexican power sector transactions were upgraded
  when Mexicos sovereign rating was upgraded

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Benefits of a Foreign Exchange Liquidity
Facility Economic Development Perspective

• Linking project output prices to the local
  inflation rate rather than the US FX rate avoids
  price shocks for consumers of basic services
  provided by infrastructure projects and enhances
  long-term sector stability
• Use of devaluation coverage to obtain
  investment-grade ratings for infrastructure
  projects will result in lower cost financing and
  lower costs to consumers
• Investment-grade issues will price at narrower
  spreads than sovereign debt of a below
  investment-grade host country
• Cost of inconvertibility coverage and liquidity
  facility for capital markets issues will compare
  favorably to costs incurred using other
  approaches
• Inconvertibility coverage will be purchased in
  reduced amounts
• Cost of the liquidity facility is much less than
  the cost of a currency swap (in the rare
  instances in which such swaps are available for a
  tenor sufficiently long to contribute to a
  successful project financing)

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Benefits of a Foreign Exchange Liquidity
Facility Economic Development Perspective

• Capital markets transactions require less
  inconvertibility coverage than bank market
  financings
• Bank market financings typically require 100
  coverage of principal
• Capital markets financings may require coverage
  for only 18-24 months (i.e., only 25-30 of the
  amount required by banks)
• A foreign exchange liquidity facility will
  require a smaller commitment than other forms of
  credit support traditionally provided by
  governmental and multilateral agencies
• In the AES Tietê transaction, a US30 million
  liquidity facility supported a US300 million
  financing
• Sizing of the liquidity facility will vary
  depending upon the host country and the projects
  coverage ratios, but should range from 10 to no
  more than 25 of the principal amount of the
  capital markets issue

37
Status of Liquidity Facilities as a New Financial
Product
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Status of Liquidity Facilities as a New Financial
Product

• The concept has been successfully implemented in
  one transaction (AES Tietê) in one country
  (Brazil) however
• AES Tietê has been downgraded for as a result of
  conditions in the Brazilian electric sector and
  the effect of macroeconomic factors on its
  ability to distribute cash
• Further use of liquidity facilities within the
  Brazilian electric sector was impeded by the
  rationing which occurred in 2001-2002
• Rating agencies have recognized the enhancement
  provided by coverage
• The initial transaction utilizing a foreign
  exchange liquidity facility received favorable
  press coverage and industry awards
• Infrastructure Journal Global Deal of the Year
• Project Finance Latin America Deal of the Year
• Project Finance International Latin America Deal
  of the Year
• Euromoney Best Structured Bond, Latin America

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Status of Liquidity Facilities as a New Financial
Product

• Two institutions are currently offering to
  provide foreign exchange liquidity facilities
• OPIC, using its FX Liquidity Facility structure
• Sovereign Risk Insurance, with its Real Exchange
  Rate Liquidity product
• IFC is developing a Contingent Partial Risk
  Guarantee which is functionally equivalent to a
  liquidity facility
• Report of the Panel on Financing Global Water
  Infrastructure (the Camdessus Panel) endorsed the
  use of foreign exchange liquidity facilities as a
  means of facilitating financing for the water
  sector

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Robert SheppardManaging Director(704) 363-9304
J. R. Sheppard Company, LLC2910-365 Selwyn
Ave.Charlotte, NC 29209