FALL 2002 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 5

An initial study conducted by Stan-dard & Poor’s Risk Solutions indi-cated that project finance loans atABN AMRO, Citibank, Deutsche

Bank, and Société Générale perform better ina default situation than corporate loans. Thisarticle examines the results of this study, pro-poses qualitative explanations for the conclu-sions, and proposes next steps for the industry.

STUDY BACKGROUND

While anecdotal evidence exists thatproject finance loans perform better thanunsecured corporate loans, there never hasbeen a rigorous analysis of project financeloan performance. A study of project financecredit statistics would be useful for refining therating agency process, educating credit com-mittees on the risks of project lending, andensuring that project finance loans are prop-erly managed and provisioned. However,banks had been reluctant to share data col-lectively until 2002, when the Basel Com-mittee on Banking Regulation put forth newregulatory proposals that would penalize proj-ect finance based on the hypothesis that thisclass of loans was riskier than corporate loans.

The Basel Committee on Banking Reg-ulation charged its Models Task Force (“MTF”)with the role of analyzing the unique credit con-siderations of structured credit products(including project finance) that merited specialattention. In its initial hypothesis, MTF deter-

mined that project finance should have a highercapital weighting than unsecured corporate loans,due to its unique risk characteristics. Indeed, theMTF hypothesized, in the absence of rigorousdata, that project finance exposures are inher-ently riskier than unsecured corporate loans:

The MTF has reviewed some initialevidence on realised losses for eachproduct line [including project finance].For the [project finance] portfolios, ourinitial evidence suggests that realisedlosses during difficult periods mayexceed those of senior, unsecured cor-porate exposures…[however] the MTFnotes that data limitations in this areaare particularly severe, and welcomesindustry comment and evidence on theloss data for each of these product lines.1

The MTF erred on the side of beingconservative in the absence of data and subse-quently proposed a punitive risk-weightingtable for project finance loans.2

Unless banks could present sufficient datato refute Basel’s hypothesis, the proposed reg-ulations could result in adverse effects on thesyndicated project finance loan market. Theincreased capital requirements at most bankswould reduce the economic returns of projectfinance lending, possibly resulting in higherloan pricing or diminished appetite for newtransactions. While larger banks in the projectfinance industry might be able to adopt the

Credit Attributes of Project FinanceCHRIS BEALE, MICHEL CHATAIN, NATHAN FOX, SANDRA BELL,JAMES BERNER, ROBERT PREMINGER, AND JAN PRINS

CHRIS BEALE

is global head of projectfinance at Citigroup inNew York, NY.chris.beale@citi.com

MICHEL CHATAIN

is head of project finance inthe Americas at SociétéGénérale in New York, NY.michel.chatain@us.socgen.com

NATHAN FOX

is assistant vice president,project finance at Citigroupin New York, NY.nathan.fox@citi.com

SANDRA BELL is a seniormanaging director and JAMES BERNER is anassociate in project andstructured finance atDeutsche Bank Securities,Inc. in New York, NY.sandra.bell@db.com

ROBERT PREMINGER

is head of the project financeportfolio management groupin the Americas at SociétéGénérale in New York, NY.robert.preminger@us.socgen.com

JAN PRINS

is head of structured products of ABN AMRO in Amsterdam, The Netherlands.jan.prins@nl.abnamro.com

Basel “advanced” approach (with a degree of self-regula-tion based on their own historical project finance loan lossexperience), such an approach might not be feasible forsmaller banks. Indeed, even if a few smaller banks were toexit the sector due to increased capital charges, overall liquidity would be reduced, further impacting the projectfinance loan sector and shrinking this important source ofcapital to several industries.

In response, early in 2002, ABN AMRO, Citibank,Deutsche Bank, and Société Générale—the “Four LeadBanks”—formed a small group to analyze the credit statis-tics of their combined project finance loan portfolios tocreate the first industry database—with a primary goal torespond to the regulator’s requests for more data. This project finance loan database would contain the combinedresults of all four banks’ portfolios, representing approxi-mately 24% of the global project finance loan market overthe past five years for all industry sectors, according to theProject Finance International/Thomson Financial Securities DataLeague Tables.3 Although 24% of the market is a statisticallyrelevant sample, the Four Lead Banks realized early on thata second phase of the study would be required, wherebyadditional banks would join the study and contribute enoughdata to enhance its validity and integrity. A broader studywould eliminate any question of statistical adequacy andmerit greater attention from regulators, investors, and therating agencies.

STUDY METHODOLOGY

The four banks provided their loan data to Standard& Poor’s Risk Solutions (“Risk Solutions”—the con-sulting division within the rating agency with significantexperience in developing and analyzing credit statisticsfor corporate loans). The Four Lead Banks workedtogether with Risk Solutions to develop a standardmethodology for the analysis of three key credit statistics:

• the probability of default of a project finance loan(“PD”);

• the portion of the loan principal lost in the eventof a borrower default (“Loss Given Default,” or“LGD”); and

• the expected loss (“EL”) for project finance loans,essentially the product of the first two concepts.(Refer to Exhibit 1 for an overview of these terms.)

A pivotal component of this analysis is the use of auniform, appropriate definition of “default.” An appropriate

definition of default would be narrow enough to incorpo-rate the unique experiences of project finance, yet broadenough to be used in comparisons with corporate finance.This study settled ultimately on a definition of default sim-ilar to that used by Standard & Poor’s and Moody’s InvestorsService for corporate lending (see Exhibit 2). It incorporatessituations where banks restructure loans in anticipation of theborrower missing a payment, but does not consider simplya technical covenant violation as a default. Finally, this def-inition is intentionally broad and conservative, leaving openthe possibility of conducting statistical analysis on the databaseusing a narrower definition of default, if requested.

STUDY RESULTS

The initial results of the Risk Solutions study of theFour Lead Banks’ portfolios confirm the anecdotal expe-rience that the LGD of project finance loans is quite low.The LGD of the Four Lead Banks’ combined projectfinance portfolios was approximately 25%. In addition,the majority of the defaulted project finance loans in thisstudy resulted in a restructuring with 100% of loan valuemaintained. Each of the Four Lead Banks had an individualaverage recovery rate significantly above 50%.4

The loss given default of the Four LeadBanks’ combined project finance

portfolios was approximately 25%. In addition, the majority of the

defaulted project finance loans in thisstudy resulted in a restructuring with

100% of loan value maintained.

Risk Solutions concluded that the average recoveryrate of project finance loans in the Lead Banks’ portfo-lios was at or above all other asset classes in the Standard& Poor’s PMD Loss/Recovery database (including lever-aged loans, unsecured bank loans, and bonds). The globalproject finance loans in this study displayed recovery ratessimilar to North American leveraged loans and the project finance loans had better LGD rates than secureddebt, senior debt, and senior unsecured debt.

Regarding probability of default, Risk Solutionsdetermined that the historical default rates of projectfinance loans are comparable to “BBB+”-rated corporate

6 CREDIT ATTRIBUTES OF PROJECT FINANCE FALL 2002

FALL 2002 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 7

E X H I B I T 1Credit Statistic Terminology

Term Explanation

Probability of Default (PD) A borrower’s PD is the statistical probability that a borrower will default within one year. PD is a number (such as 1.0%) equal to a credit rating (such as “BB”—the rating assigned toborrowers with a 1.0% PD). Borrowers with a lower annual PD receive a higher credit rating.

Loss Given Default (LGD) LGD is the financial loss a bank incurs on a facility when the borrower defaults. It repre-sents the value of the loan in a default, through the subtraction of one minus the recoveryrate (represented as a percentage of the facility amount). For example, a loan that experi-enced a 67% recovery of principal would have a 33% LGD.

Expected Loss (EL) EL is the mathematical product of PD and LGD. For example, a “BB”-rated portfolio witha 33% LGD and a 1.0% PD would have a 0.33% expected loss rate (33% � 1.0% = 0.33%).

Loss Rate The actual loss rate of a portfolio is the mathematical division of the total loan amountsoutstanding by the real credit losses experienced in a single year. For example, a $25 million annual loss on a $500 million portfolio has a 0.5% loss rate. Credit analysts try to predict the actual loss rate by estimating the EL of a portfolio.

E X H I B I T 2Different Definitions of Default

Source of Definition Definition

Project Finance Recovery Study Borrower was unable to make a contractually scheduled payment of principal and/orinterest. This would include bankruptcies that disrupt payments, including default and cure within the grace period, consensual restructuring, amendment of the credit facility’s repayment terms, and/or refinancing of the facility with the original lenders inorder to give the borrower more time to repay the loan.a

Standard & Poor’s A default is recorded upon the first occurrence of a payment default on any financial obli-gation, rated or unrated, other than a financial obligation subject to a bona fide commercialdispute; an exception occurs when an interest payment missed on the due date is madewithin the grace period. Distressed exchanges, on the other hand, are considered defaultswhenever the debtholders are coerced into accepting substitute instruments with lowercoupons, longer maturities, or any other diminished financial terms.b

Moody’s Investors Service Includes three types of default events:• There is a missed or delayed disbursement of interest and/or principal, including

delayed payments made within a grace period;• An issuer files for bankruptcy (Chapter 11, or less frequently Chapter 7, in the

U.S.) or legal receivership occurs; or• A distressed exchange occurs where: 1) the issuer offers bondholders a new

security or package of securities that amount to a diminished financial obligation (such as preferred or common stock, or debt with a lower coupon or par amount), or 2) the exchange had the apparent purpose of helping the borrower avoid default.c

aStandard & Poor’s Risk Solutions, Project Finance Recovery Study: An Analysis of Aggregate Data from ABN AMRO, Citigroup, Deutsche Banc Alex.Brown, and Société Générale (unpublished; New York, March 18, 2002), p. 4.bBrooks Brady and Roger J. Bos, Record Defaults in 2001 the Result of Poor Credit Quality and a Weak Economy, Standard & Poor’s, February 2002, p. 11.cDavid Hamilton, et al., Default & Recovery Rates of Corporate Bond Issuers (Special Comment), Moody’s Investors Service, February 2002, p. 23.

unsecured loans in the long term, but “BB+”-rated loansin the short term. Based on the aggregate experience ofthe Four Lead Banks, static pools of project finance loansfrom the 1998 to 2001 period would have a 10-year cumu-lative average probability of default of approximately7.5%—comparable to a “BBB+” corporate rating—anda one-year average probability of default of approximately1.5%—comparable to a “BB+” corporate rating.5 Thisdiscrepancy between the short-term and long-term rat-ings confirms the project finance sector’s experience thatproject finance loans become less risky as they mature.

EXPLANATION OF THE RESULTS

Project finance loans have a better LGD than seniorunsecured corporate loans due to their unique structural fea-

tures. Indeed, project finance loans include a number of creditenhancements that mitigate risk, such as first-priority liens,cashflow sweeps, covenant triggers, limitations on indebted-ness, etc. (Refer to Exhibit 3 for more detail.) Since bank loansare the primary source of non-recourse capital available tonew projects, banks use their favorable negotiating positionwith the project sponsors to implement favorable structuralenhancements specific to project and leveraged finance. Estab-lished corporate borrowers, on the other hand, have accessto a number of different sources of capital, including thebond and equity market, securitizations of receivables, etc.These various capital providers (bank loans, bonds, equity)compete with each other on cost and deal terms. Since pro-ject finance loans have less direct competition from otherforms of non-recourse capital, banks can use their advantageto negotiate terms in their favor. These include construction

8 CREDIT ATTRIBUTES OF PROJECT FINANCE FALL 2002

1. Perfected first priority liens on and pledges of the project’sassets (including shares, physical assets, and material contractsand funds on account) that preserve exclusive project financelenders’ access to repayments from a liquidation of the pro-ject or for negotiating purposes with sponsors and otherlenders.

2. Involvement of “deep-pocket partners” with stakes in theprojects, including central governments, sponsors, contrac-tors, insurers, suppliers, off-takers, etc. These parties oftenhave key stakes in the success of the project. While not obli-gated contractually to support the project, these groups mayhave vested interests in the project’s success and frequentlyare willing to protect their interest in a troubled project bor-rower by injecting equity into the project to preserve thevalue of their investment or strategic relationship.

3. Step-in rights (which allow the lender to “step in” to the bor-rower’s shoes and take over a contract) and covenant triggers that serve as “early warnings” to banks to renegotiatea structure before the borrower’s credit quality deterioratesbeyond a curable point. While corporate loans also have thesefeatures, project finance loans are structured deliberately withtighter covenants to trigger a renegotiation of loan termsbefore any significant credit deterioration.

4. Sponsors often act as counterparties in the projects, givingthem vested interests in the success of the project.

5. Restrictions on facility drawdowns, use of proceeds, andmandatory prepayments in favor of the lenders.

6. Contractual obligations, penalties, and remedies to influencethe activities of the sponsors in favor of the lenders.

7. Offshore and debt service accounts to mitigate cash flowvolatility, where appropriate.

8. Prohibition on additional indebtedness, which, when com-bined with the typically steady or increasing cash flows ofprojects, increases debt service coverages over time.

9. Transparency of the project’s performance due to its single-asset nature. This contrasts with corporate borrowers that fre-quently have diverse streams of revenues, complicatedsubsidiary structures and accounting treatments, and cash flowstreams that are difficult to analyze.

10. The essential commercial value of projects allows them to sur-vive the bankruptcy or credit deterioration of a sponsor, sup-plier, contractor, etc. Indeed, a handful of projects with sponsorbankruptcies have demonstrated that projects often maintaintheir ability to service their loans, despite the bankruptcy ofthe sponsor or off-taker. This ability is due to the inherentindependent viability of the project’s value and cash flow.

11. The syndication of project financing loans encourages con-servative structures that appeal to a broad retail market, limitsthe possibility of unsophisticated banks being able to offeraggressive bilateral loans, and ensures that all lenders benefitfrom a controlled recovery process in a default situation irre-spective of the size or importance of their respective partici-pations. Project financings generally are so large that thedemands of syndication preclude any market participant beingable to set imprudent terms successfully. The syndication pro-cess creates a de facto “checks and balances” relationshipamong the participants so no single lender or small group oflenders (depending, of course on the terms of the credit doc-uments) can commit the entire syndicate to unfavorableworkout terms. In addition, the pari passu nature of syndica-tion ensures that smaller lenders will have the same recoveryexpectations as larger, more sophisticated lenders.

E X H I B I T 3Typical Project Finance Loan Characteristics

features, cash traps, dividend restrictions, etc.Although project finance loan agreements generally

do not contain all of these structural enhancements, banksdo use a number of these features as “early warning” mech-anisms to notify them when projects are having difficulties,thereby providing an opportunity for the parties to restruc-ture the transaction or otherwise develop an acceptablesolution to avoid a default. As a result, project finance loansexperience lower LGD rates than comparably rated cor-porate loans that do not incorporate these features.

Since the loss-given-default andexpected-loss results for project

finance loans are lower than corporatefinance loans of an equivalent rating,

less capital is required to reserveagainst their expected losses.

IMPLICATIONS OF PROJECT FINANCECAPITAL REQUIREMENTS

Since the LGD and EL results for project financeloans are lower than corporate finance loans of an equiv-alent rating, less capital is required to reserve against theirexpected losses. This is especially true as projects mature.Indeed, based on the results of this study, project financeloans should require roughly one-half the capital of cor-porate loans of a comparable rating. Since project financeloans in this study have default rates very similar to corporatedefault rates, with more favorable LGD figures, they shouldrequire less capital reserves than corporate loans.

INDUSTRY’S NEXT STEPS

The project finance industry should pursue two keynext steps:

First, the industry should expand the study to includemore participants. While the initial four-bank sample is

generally representative of the broader bank market (sincenearly all the loans studied were widely syndicated), alarger study would serve to validate the results and be ofvalue to the existing and additional participants. In addi-tion, there are a number of analytical possibilities with alarger sample size: the study could incorporate statisticallyrelevant analysis of project finance credit statistics basedon region/country of borrower (jurisdiction), industrysector, leverage, quality of collateral, and correlation, ifany, between PD and LGD.

Second, project finance banks should continue theefforts initiated in this expanded phase of the study tocreate in the future an ongoing industry-wide databaseuseful for credit analysis, bank regulation, and credit ratingagency analysis. This database should incorporate inputfrom Basel, national supervisors, banks, and rating agen-cies. The database could serve as a useful tool for futurecredit analysis and evaluation of project finance regulations.

ENDNOTES

The information in this article is accurate as of August2002. Basel’s regulatory process and the S&P study results aresubject to modification from time to time.

1Working Paper on the Internal Ratings-Based Approach toSpecialised Lending Exposures, p. 12.

2Models Task Force on Specialized Lending, Revised Out-line Proposals for Specialized Lending Exposures (unpublishedmemo, January 2002), p. 1.

3Project Finance International, January 23, 2002, Issue 233,p. 56.

4Standard & Poor’s Risk Solutions, Project Finance RecoveryStudy: An Analysis of Aggregate Data from ABN AMRO, Citi-group, Deutsche Banc Alex. Brown, and Société Générale (unpub-lished; New York, March 18, 2002).

5Standard & Poor’s Risk Solutions, Project Finance DefaultStudy: An Analysis of Aggregate Data from ABN AMRO, Citi-group, Deutsche Banc Alex. Brown, and Société Générale (unpub-lished; New York, July 18, 2002), p. 6.

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Reprinted with permission from the Fall 2002 issue of The Journal of Structured and Project Finance.Copyright 2002 by Institutional Investor Journals, Inc. All rights reserved.

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