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

J. R. Sheppard & Company, LLC 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


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


Types of Liquidity Facilities


Liquidity Facilities: Examples

• Debt Service Reserve Accounts

• Foreign Exchange Liquidity Facilities

• Contingent Partial Credit Guarantees

• Merchant Power Market Floor Price Facilities


Debt Service Reserve Accounts

• Self-funded:

– In cash, with a portion of the project’s 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)


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 project’s host country– Prospective debt service coverage ratio of the project

• Drawn upon when the project’s 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 project’s host country


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 project’s host country

– the risk of higher interest rates on floating-rate local currency securities


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 consultant’s 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


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


A Comparison of Derivatives, Insurance, and Liquidity Facilities

Derivatives InsuranceLiquidityFacilities

Risk MitigationTechnique

Risk intermediation(running a “book”)

Pooling ofuncorrelated risks

Risk analysis andtransactionstructure

StructuralApproach

Portfolio Portfolio Individualtransactions

“Recovery”Opportunities

None None Repayment ofdraws


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


Capital Markets Financing for Developing- Country Infrastructure Projects:Current Issues


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 project’s senior debt is limited by sovereign ceiling of the host country


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 project’s point of view, may interrupt the

project’s 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 purchaser’s ratings are likely to cap the ratings for their suppliers– Foreign currency rating is a more appropriate measure than local currency rating of output

purchaser’s ability to honor FX-indexed contractual purchase obligations


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


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


Conceptual Structure of a Foreign Exchange Liquidity Facility


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 country’s 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


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 company’s cash available for debt service

• Draws may be made when the project’s 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


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 project’s 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 project’s 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


Basic Structure of a Foreign Exchange Liquidity Facility

Line 2: 67%

Line 1: 100%

Value in US$

Debt ServiceCoverage Ratio

1.50

Line 3

Time (in years)0 15

Debt service shortfall amount to be paid from Liquidity Facility

Amount repaid to Liquidity Facility

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

1.0


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 project’s host country

– The project’s 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 project’s economics, e.g., by charging more for the project’s output

– reducing the amount of debt in the project’s capital structure

– Lengthening the tenor of the project’s debt (which is likely to occur as a result of the use of a liquidity facility)


Volatility of Real Exchange Rates: Brazil

050100150200250300350400450500

Q21977

Q11980

Q41982

Q31985

Q21988

Q11991

Q41993

Q31996

Q21999

Q12002


Reduction in Exposure as a Project’s Debt Service Coverage Ratio Increases

Line 2: 67%

Line 1: 100%

Value in US$ Debt Service

Coverage Ratio

1.50

Line 3

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 rateLine 4: Line 3 shifted upward to illustrate a higher DSCR than that of Line 3

1.0

Line 4


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


Structure of a Liquidity Facility with a Floor Value Equivalent to a DSCR of 1.20

Line 2: 67%

Line 1: 100%

Value in US$

Debt ServiceCoverage Ratio

1.50

Line 3

Time (in years)0 15

Debt service shortfall amount to be paid from Liquidity Facility

Amount repaid to Liquidity Facility

1.0

Line 4: 80% 1.20

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)

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 rateLine 4: A line showing the level of cash at which the project has a debt service coverage ratio of 1.20 (“Floor Value”)


Implementation of a Foreign Exchange Liquidity Facility: The AES Tietê Transaction


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: US$300,000,000 aggregate principal amount

• Tenor: 15 years / 10 year average life

• Ratings: Baa3 (Moody’s) / 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


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

– US$85 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

– US$30 million FX Liquidity Facility amount

– The FX Liquidity Facility insures that a devaluation of Brazil’s currency will not cause the Issuer to be unable to meet is debt service obligations


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)


Applicability and Benefits of Foreign Exchange Liquidity Facilities


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 country’s currency is not decisive – Coverage may be prudently offered if the price of the project’s output is increased to

compensate for overvaluation and to increase debt service coverage ratios


Benefits of a Foreign Exchange Liquidity Facility: Sponsor Perspective

• Ability to sell project’s output with pricing linked to host country’s 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


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 Project’s output contract

• Local currency rating of output purchaser is not stressed by contractual commitment to purchase Project’s 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 Mexico’s sovereign rating was upgraded


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)


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 US$30 million liquidity facility supported a US$300 million financing

– Sizing of the liquidity facility will vary depending upon the host country and the project’s coverage ratios, but should range from 10% to no more than 25% of the principal amount of the capital markets issue


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



• 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


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

Documents

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