Worldwide: Why The World Needs Project Bonds (and Project Finance Lawyers)

Why Project Bonds?

Project finance is a financing technique used to fund investment across a broad spectrum of industrial activities, notably in the natural resources, telecommunications, transportation, social infrastructure, power generation, and transmission sectors. One of the primary attractions of project finance for a project's owner, typically referred to as a "sponsor", is that the cost of financing a project using this technique can be minimised to the extent that the debt incurred to finance the project will be repayable over a long period of time using the proceeds of the project's net revenues.

At the outset of any project, a sponsor will keenly assess the financial markets so as to consider how best to finance its project. As one would expect, one of the sponsor's principal considerations at this stage will be obtaining the cheapest source of debt to finance the construction of its project. Factors that will impact on a sponsor's cost of financing its project will include the project's location, the industry in which the project will operate, the identity of the sponsor(s) and the project company's contractual counterparties; however, the crucial determinant will often be one over which a sponsor has no control – the liquidity of the debt markets (bank, capital and public) at that moment in time.

Capital market project financings have evolved rapidly, covering a broad range of electricity, renewable energy, oil and gas, mining and water sector projects, as well as infrastructure-related assets, such as toll roads, railways and rolling stock. In addition, project bonds have been used to finance social infrastructure such as hospitals, schools, and prisons (as a result of private financing initiatives in countries like the UK).

Further afield, project bonds have played critical roles in financing oil and gas and other energy-related projects in the Middle East, Africa, and the former Soviet republics of Central Asia, presenting opportunities to connect international institutional investors seeking to diversify their portfolios with interesting new projects and geographic regions. As new markets focused on green energy sources continue to emerge, project bonds are likely to find a place in the financing of a variety of new project classes.

Historically, commercial banks have been the primary source of project financing. However, as has been well publicised, in recent years commercial banks in developed markets have faced tighter credit constraints due to a combination of the effects of the financial crisis (and more recently the COVID-19 pandemic) and the need for commercial banks to increase their capital bases. This has resulted in a period of (relative) decline in lending from these traditional providers of project finance.

Many commentators predict that this trend appears unlikely to be reversed any time soon, given the effects of Basel III, which requires commercial banks to match their liabilities (loans) to their assets, impacting the ability of commercial banks to provide loans with long tenors (which, as alluded to above, is an important attribute for the use of project finance loans). As an illustration, in the period up to 2007, it was not unheard of for commercial banks to provide project finance loans with tenors of up to 30 years. In recent years, most commercial banks have struggled to provide uncovered loans with tenors exceeding 15, let alone, 20 years. Indeed, although attractive pricing is still (at least for the time being) available in the commercial bank market (mainly due to declining swap rates), tenors are typically much shorter, and some sponsors have used "mini-perms" (shorter-term loans with tenors of five to seven years) to finance the construction and early-operation phase of their projects, with a view to refinancing the debt with other banks or in the project bond market.

The regulations have also impacted banks from different regions in different ways. For example, US banks have been pulling back heavily from long-tenor project financings, whereas a number of lenders from Japan or China have continued to be able to offer longer-tenor debts where appropriate.

The reduced liquidity in the commercial bank project finance market, combined with the need to finance large-scale "mega-projects" (where the debt requirement runs into billions of dollars), has necessitated the mobilisation of increasingly diverse sources of capital. Sponsors (and their respective financial and legal advisers) have sought to meet this challenge by carefully structuring multi-sourced financing packages to raise funding for projects from a wide variety of existing or "new" sources of debt, which have included (i) commercial banks from Asia, the Middle East, and Latin America, (ii) increased involvement by export credit agencies, multilateral lending agencies and development financial institutions ("public debt"), and (iii) for the stronger projects, the capital markets.

We should note at this point that although project bonds are currently in vogue, they are not a new phenomenon. Sponsors have accessed the international and domestic capital markets to raise financing for projects since the 1980s. The attractiveness of the project bond market as a source of financing tends to be cyclical and, unsurprisingly, holds more appeal when the comparative cost and availability of funding from the traditional sources of project financing make it challenging or more expensive to construct a financing plan based solely on bank and/or public debt.

In these circumstances, sponsors may look to fund all of their debt requirements using project bonds or integrate the project bonds with other forms of debt in a multi-sourced financing structure. The U.S. project finance market has a long history of utilising project bonds (and indeed, to date, most project bonds have been issued in the U.S. market for predominantly U.S. projects).

Although there is a perception amongst some sponsors that issuing project bonds can be problematic, the pricing and tenors available in today's capital markets have meant that this is a financing option that cannot be ignored by sponsors seeking to optimise their financing plans.

Problematic Project Bonds

The steady, predictable nature of a typical infrastructure project's revenues makes projects particularly suitable for capital market investors. In most cases, a project will have an offtake agreement (for example, a power purchase agreement or a concession) that will provide a secure and predictable revenue stream over a period of time exceeding the tenor of the project's debt.

Furthermore, more often than not, offtake agreements are entered into with governmental agencies or supported by creditworthy entities, further enhancing the attractiveness of the revenue stream. As the long-term reliability of the offtake revenues underpins the repayment of a project bond, investors will focus close attention on ensuring that the project will in fact be able to generate robust revenues over the payback period of the project bond. An offtake agreement backstopped by good credit and a solid pricing structure will enable potential project bond investors to be assured of a long-term, stable and predictable revenue stream.

Notwithstanding the above, issuing a project bond is a labourand time-intensive process. And once a sponsor has issued a project bond, it then has to interact with a large pool of bondholders during the life of a project (rather than a group of lenders accustomed to the demands of a project financing). These two factors have meant that historically, where possible, sponsors have tended to finance their projects using the loan markets. Notwithstanding the benefit of (currently) competitive debt costs and longer tenors available from the capital markets, a decision to issue project bonds is not, therefore, one that is taken lightly by a sponsor. We have set out below some of the more pertinent considerations that need to be taken into account when making a decision to raise finance for a project in the capital markets.

Regulatory requirements

Project bonds are tradeable securities and are therefore subject to extensive and complex securities laws which seek to protect investors from abuses such as fraud, insider trading and market manipulation. The securities laws to which a project bond will be subject, and which do not apply to loans, inevitably make the process of issuing a project bond more laborious than entering into a loan due to the regulatory work entailed (which can be extremely time-consuming).

Historically, the largest market for project bonds has been the U.S. market and therefore generally, issuers (both U.S. and foreign) will seek to structure their project bond offering so that they can make offers and sales into the U.S. market to ensure access to sufficient investor demand and competitive funding terms for their bond. As with any jurisdiction, raising capital from the public markets in the U.S. is heavily regulated by both state and federal law.

The body which regulates these matters in the U.S. is called the United States Securities and Exchange Commission (SEC) and the principal legislation which applies to offerings in the U.S. is the Securities Act of 1933 and the Securities and Exchange Act of 1934. This legislation requires all offerings to be registered with the SEC and imposes extensive disclosure and reporting obligations on the issuer, both prior to and after the offering. Project bonds issued to U.S. investors under Rule 144A require underwriters to obtain so-called "10b-5" disclosure opinions, which will require both sponsors' and underwriters' counsel to carry out extensive due diligence in relation to the project.

Credit rating requirements

Credit rating agencies such as Standard & Poor's, Moody's and Fitch regularly rate debt issuances by projects. These rating agencies publish details of the criteria they use to rate power and other projects, which, unsurprisingly, are very similar to those used by commercial banks in making their own credit assessments. The minimum required credit rating level to allow many classes of investors to acquire project bonds is an "investment grade" rating. Regardless of the strength of the sponsors or the project's risk mitigants, achieving such a rating will always be challenging if the sovereign rating of the host country lies below that level. One of the primary reasons for which project bonds have in the past held little appeal for sponsors as an alternative to loans is that many project companies located in emerging jurisdictions have lacked the ability to obtain a sufficiently robust credit rating.

Consent and intercreditor issues

One of the advantages of a project bond for sponsors is that bondholders will typically have less onerous documentation requirements, which affords the project company greater flexibility as to how it constructs and operates the project (it should be noted that a sponsor will not benefit from this flexibility if the project bond forms part of a multi-sourced financing).

Despite the extensive documentation governing the project participants' relationships, issues that had not been contemplated at the time of signing can (and often do) arise during the life of any financing and, when this happens, lender consent will usually be required for an amendment or waiver of the relevant terms of the finance documentation.

In the context of project bonds, this process can be problematic for sponsors, as it is generally more difficult to obtain the consent required to amend (or obtain waivers of) finance documentation from a large pool of bondholders than a group of commercial banks or agencies accustomed to the demands of a project financing. In those cases where a modification of the project bond documents is required (e.g. a delay to the project beyond the specified contingency period), the typical mechanism of seeking consent through a trustee to procure approval for the relevant change or waiver is more complicated and potentially more time-consuming than liaising with a bank with project finance experience to reach a solution.

As mentioned in the introduction, sponsors will now frequently employ multi-sourced financing structures for their projects, which means that it is not unusual for a project to be financed by both straight debt from the commercial loan market, public debt and project bonds from the capital markets. Incorporating a bond offering into a project's capital structure and harmonising the intercreditor relationship between commercial banks, export credit and development agencies and bondholders (who will rank on a pari passu basis) requires careful handling by the lawyers. A project's financing will now often involve weaving together the intricate requirements of a wide variety of lenders.

Divergent currencies, tenors and interest rate mechanisms are now only the more technical issues to address; harmonising the interests of a large group of lenders, some of whom may have a long-term focus on development or other policy matters, while others may not (capital market investors being particularly driven by short-term gains from trading their project debt), can be particularly challenging.

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Originally published by 11th Edition of ICLG: Project Finance 2022

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.