Plenty of room for derivativesin project finance space

Project finance deals seem to be so fraught with risk that the uninitiated might suppose the deals are routinely laced with derivatives and backed by multiple hedging programmes. In fact, this is far from the truth. Simon Elliston, head of European energy and infrastructure finance at Citi, explains: “Derivatives are undoubtedly central to a large number of project financings and the ability to put deals in place with the appropriate hedges is very important. But, that said, derivatives hedges are by no means used in all deals.”

Instead, Mr Elliston says, the tension between investors (those initiating the project) and their financiers (the banks) will usually dictate whether derivatives are used to hedge risks. If that sounds a little haphazard, there is a fairly established formula for determining when and where hedges are used.

“Some investors want to leverage up their investments quite significantly, in which case financiers will typically demand more stable cash flows and insist that future revenues be hedged out. But in deals with relatively low leverage – say, 50% debt and 50% equity – the decision on whether to hedge is often left with the investor,” says Mr Elliston.

Typically, private equity-type investors will want to leverage projects up as much as they can and therefore financiers will require them to hedge their risks, he says. Other, less experienced investors will take advice from their advisers and then make their own decision about whether they are happy to put on hedges or are willing to absorb the commodity and interest rate volatility while taking on less leverage.

Oddly, it is the third category of investors, the more sophisticated large companies that are most fluent with hedging techniques – such as the oil majors – which are most averse to hedging out their risks. “Most large energy companies will take the view that their shareholders expect them to take on and manage energy price risk, so they will often be very reluctant to hedge against movements in energy prices. They would also be unlikely to want to hedge their interest rate risk at a project level, preferring to do this instead (if at all) at the parent company,” says Mr Elliston.

Different risks

Again, that might sound as if the financiers are being forced to take on some unwanted risks but, as Robin Baker, managing director, head of energy project finance at Société Générale Corporate and Investment Banking (SG CIB) explains, the risks are somewhat different in these deals. “Most oil and gas project financings tend to have lower leverage – 50%-70% is typical for many projects so the financing risks are less material. Sponsors often want the commodity price upside and lower rates of leverage, which often means that commodity price hedging is not essential. Sometimes there will be some interest rate hedging on these deals, and sometimes we might ask the investors to hedge the oil price risk, but a lot less than one might think. And, for oil and gas production, the intrinsic hedging provided by the progressive tax rate regimes granted to the projects make it unnecessary in many cases.”

Commodity, interest rate and currency are the most commonly hedged risks in project finance deals. Typically, these risks are hedged out with straightforward swaps but there have been some recent innovations. For instance, Gavin Munro, managing director, infrastructure project finance at SG CIB, says he has started to see so-called stepped interest rate swaps or step-up swaps – interest rate swaps with rates that increase in one or more steps over the life of the swap – gain increasing acceptance in the funding markets. “These might be used in toll road projects, which have income growth dependent on inflation, traffic ramp up and rising traffic growth,” he says.

“It takes a while for drivers to get used to paying the tolls, so there is often a slow ramp-up period before traffic growth increases and revenue streams stabilise. As a result, the project’s financing can be very tight in the early years. To get around this, we might propose using step-up swaps, which will offer lower interest rate funding in the early years, compensated later with above-market rates.”

Taking account of inflation

Inflation is often a major risk, particularly in infrastructure deals such as toll road projects, where revenue streams are usually linked to inflation. Mr Munro says that in some cases banks can easily use inflation swaps to hedge this risk out, but this depends on there being an appropriate liquid inflation swap market, as there is in the UK, France and Germany. “In Ireland, for instance, there is no inflation market and no real substitute either because there is very little correlation between the most obvious proxy, the European HICP index, and Irish inflation,” he says. In contrast, in the UK market – where there is a very well developed inflation swap and bond market – several of the Private Finance Initiative (PFI) projects have been financed with index-linked bonds, as an alternative to swaps, he says.

Some of the other risks are less easy to hedge with derivatives. For instance, financing high-profile infrastructure projects not only requires lenders to commit for long maturities, exposing them to considerable inflation, currency and interest rate risks, but also makes them particularly exposed to the risk of political interference by host governments. Absent direct derivatives proxies for these political risks, project lenders have made use of political risk guarantees, especially in emerging economies.

Mr Baker says: “In projects involving significant political risk, lenders seek political risk cover, for instance from export credit agencies. These agencies would provide part of the debt funding or provide political risk insurance on part of the bank debt. This would typically not provide direct political risk cover on the swap exposures, but the presence of these agencies in the overall credit would reduce lenders’ overall exposure and allow them to accept exposure on their swap exposures as part of their overall exposure to the project and country.”

Guarantees

There are two forms of guarantee: explicit guarantees, which are formal insurance contracts against specific political risk events, also provided by some commercial insurers; and implicit guarantees underwritten by G10 government agencies or supranational development banks. The latter work as follows: the financing is typically divided into tranches, one of which is underwritten by the agency. The borrower cannot default on any tranche without defaulting on the agency tranche as well – a factor that acts as a major deterrent because defaulting on the agency has additional political and financial costs that the host country would not want to incur because agencies are usually lenders of last resort for host countries in financial distress.

TYPICAL PROJECT FINANCE STRUCTURE

Project finance bankers are constantly scouting for new ways to offset the risks they encounter. For instance, according to Marco Sorge, author of a recent Bank for International Settlements study on project finance, some banks have begun using forms of credit protection in deals, such as credit derivatives. Mr Munro recounts how SG had started to look at whether it could use oil derivatives to offset the rising costs of fuel and bitumen when the oil price started rising, only to find that the correlation between the available oil derivatives and bitumen was not that good and that the amounts of fuel tended to be too small.

Steel price risk is another risk that SG has sought to hedge out because many large infrastructure projects have been hurt by the recent steel price rise. “There are no iron or steel futures traded and we even spoke to London Metal Exchange to see if it might be feasible to develop some sort of contract to hedge this risk but, according to them, the many types and qualities of iron and steel available make it impossible to settle on a benchmark standard,” says Mr Munro. Instead, investors have tried to pass that risk down to their subcontractors.

The scope

Bizarrely, given that project sponsors carry the costs incurred in hedging, bankers say that they sometimes find themselves having to convince their clients to hedge less. For instance, Mr Munro says that in some early deals in the South African market, SG found that the local entities wanted deals to be 100% hedged. At the time, there was high inflation and high interest rates in the country, but the government was targeting a sizeable inflation reduction. Putting on the full-term hedges would have been detrimental to the project, were inflation and interest rates to fall significantly in the future. “Instead, we proposed that clients implemented a flexible rolling hedging programme, which protected the project against short-term shock interest rate rises, without exposing it to the risk of a low inflation and low interest rate scenario as expected,” he says.

It is particularly odd for banks to be in the position of convincing their clients not to hedge deals, or to hedge deals less, for two other reasons. First, because they, as the financiers, are the ones being protected by the hedge. Second, because they benefit economically from providing such hedges.

In fact, in almost all cases the major financing house provides the hedging programme on deals – and jealously guards that role because it is the hedging side of the deal that is the more lucrative.

Mr Elliston says this means that banks can be active in project finance without a strong derivatives business, but only as long as they have low return hurdles. “To support a really profitable project finance business, you do need good derivatives capabilities because the loan piece of the economic pie is the smaller one,” he says.

The good news for banks such as Citi and SG, which have strong derivatives units, is that the development of derivatives contracts and technologies will undoubtedly be helping to make derivatives-based hedges more feasible in these projects. Moreover, the fact that the more heavily leveraged private equity and financial investors have been moving deeper into the infrastructure world is undoubtedly fuelling the more lucrative hedging side of the economic pie. “We have definitely seen more hedging take place, as these companies typically want to leverage up quite significantly,” says Mr Elliston.