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PROJECT FINANCE

LAW SURVEY/LISTS

INTERNATIONAL

Legal roles on PF deals over US$500m since January 1998 Lawyers’ roles

Asia Pacific Texas Utilities Australia US$1016m Power Mallesons Stephen Jaques – Banks, Baker & McKenzie – Sponsor Thelan Reid & Priest – US tax Southern Cr oss Cable Australia US$921m Telecoms Clayton Utz and Latham & Watkins – Banks, Allen Allen & Hemsley – Sponsor Kelley Drye & Warren – US counsel to sponsor, Minter Ellison – Cable & Wireless, Slaughter & May – Contractor Dampier pipeline Australia US$900m Oil & Gas Clayton Utz – Banks, Allen Allen & Hemsley – Sponsor Blake Dawson Waldron – Lessor, Freehill Hollingdale & Page – Contractual, Mallesons Stephen Jaques – Sponsor equity Dabhol Phase Two India US$846m Power White & Case – Banks, Skadden Arps – Sponsor Bhaishanker Kanga & Girdhor – Local, Denton Hall – Fuel supplier, Freshfields – Power purchaser, Linklaters & Allance – Sponsor gas, Simpson Thacher & Bartlett – Supplier, Thelan Reid & Priest – Contractor, Vinson & Elkins – Enron Power Partnership Australia US$756m Power Allen Allen & Hemsley – Banks, Freehill Hollingdale & Page – Sponsor AEP Citipower Australia US$720m Power Allen Allen & Hemsley – Banks, Corrs Melbourne – Sponsor Shandong Zhonghua Power China US$663m Power Allen & Overy – Banks, Clifford Chance – Sponsor Freshfields – ECGD, Herbert Smith – Banks on English law, Simpson Thacher & Bartlett – Local bank Stratus Australia US$653m Power Allen Allen & Hemsley – Banks, Blake Dawson Waldron – Sponsor Century Zinc Mine Pipeline Australia US$600m Mining Mallesons Stephen Jaques – Banks, Freehill Hollingdale & Page – Sponsor Blake Dawson Waldron – Pasminco Meizhou Wan Power China US$528m Power Chadbourne & Parke – Banks, Milbank Tweed – Sponsor Shearman & Sterling and Freshfields – InterGen, Simpson Thacher & Bartlett – Local bank Transmission Pipelines Australia Allen Allen & Hemsley – Banks, Mallesons Stephen Jaques – Sponsor

US$500m Oil & Gas

Americas Alliance Pipeline Canada US$3165 Oil & Gas McCarthy Tetrault – Banks Sullivan & Cromwell – Enbridge International

Homer City USA US$2675m Power Simpson Thacher & Bartlett – Bank and bonds, Skadden Arps – Sponsor Highway 407 Canada US$2389m Infrastructure Ogilvy Renault – Banks, Fraser Milner – Sponsor Sincor Venezuela US$2000m Oil & Gas Milbank Tweed – Banks, Sullivan & Cromwell – Sponsor Norton Rose – Sponsor agreement East Coast Power USA US$1706m Power Shearman & Sterling – Banks, Skadden Arps – Sponsor Vinson & Elkins – Enron Calener gy Skadden Arps – Bonds

USA

US$1400m Power

Iridium USA US$1140m Telecoms Milbank Tweed – Banks, Sullivan & Cromwell – Sponsor Globenet USA US$970m Telecom Mayer Brown & Platt – Banks, Vinson & Elkins – Sponsor Maritime Pipeline Canada US$910m Oil & Gas Mayer Brown & Platt – Banks, Vinson & Elkins – Sponsor Blake Cassel Graydon – Local Cer ro Negr o Venezuela US$900m Oil & Gas Davis Polk – Bank and bonds, Latham & Watkins – Sponsor Mader o Mexico US$880m Oil & Gas Milbank Tweed – Banks, Dorsey & Whitney – Sponsor Curtis Mallet & Prevost – Government owner Light Brazil US$876m Power Sullivan & Cromwell – Banks, Chadbourne & Parke – Sponsor Baker & Botts – Utility Light r efinancing Brazil US$854m Power Sullivan & Cromwell – Banks, Chadbourne & Parke – Sponsor Baker & Botts – Utility, Cadwalader Wickersham & Taft – BA Pacific Cr ossing USA US$849m Telecoms Latham & Watkins – Banks, Simpson Thacher & Bartlett – Sponsor Sullivan & Cromwell – Supplier Fer tinitr o Venezuela US$810m Petrochemicals Shearman & Sterling – Banks, Davis Polk – Sponsor Cader eyta Mexico US$804m Oil & Gas Milbank Tweed – Banks, Dorsey & Whitney – Sponsors Curtis Mallet & Prevost – Government owner AES Sul Brazil US730m Power White & Case – Banks, Chadbourne & Parke – Sponsor AES Southland USA US$712m Power Skadden Arps – Banks, Chadbourne & Parke – Sponsor

Issue 181 PFI November 17 1999

48

USA

US$711m Power

Por t Ar thur USA US$655m Industrial Sullivan & Cromwell – Bank and bonds, Simpson Thacher & Bartlett – Sponsor Comcel Colombia US$638m Telecoms Shearman & Sterling – Banks, Davis Polk – Sponsor Centarell Mexico US$623m Oil & Gas Sullivan & Cromwell – Banks, Shearman & Sterling – Sponsor Curtis Mallet & Prevost – Offtaker Antamina Peru US$603m Mining Milbank Tweed – Banks, Sullivan & Cromwell – Sponsor McCarthy Tetrault – Noranda

Q Chem Qatar US$750m Petrochemicals Skadden Arps – Banks, Latham & Watkins – Sponsor Clifford Chance – Foreign sponsor Beira Interior Portugal US$750m Portugal Allen & Overy and Viera D’Almeida – Banks, Clifford Chance and Luciano Marcos – Sponsor Shearman & Sterling – EIF, Simmons & Simmons – EIB Nor th Toll Road Portugal US$724m Infrastructure Freshfields – Banks, Ashurst Morris Crisp – Sponsor Herbert Smith – EIB Keyma Saudi Arabia US$680m Petrochemicals Clifford Chance – Banks, Gibson Dunn & Crutcher – Sponsor

Profer til Argentina US$600m Petrochemicals Milbank Tweed – Banks, Andrews & Kurth – Sponsor

Par tner Israel US$650m Telecoms Weil Gotshal & Mangers and Horowitz & Co – Banks, Linklaters & Alliance – Sponsor

Metr opolitana Brazil US$580m Power Sullivan & Cromwell – Banks, Chadbourne & Parke – Sponsor, Baker & Botts – Utility

KPN Orange Belgium US$646m Telecoms Allen & Overy – Banks, Linklaters & Alliance – Sponsors Shearman & Sterling – EIF

Metr opolitana Brazil US$580m Power Sullivan & Cromwell – Banks, Chadbourne & Parke – Sponsor Baker & Botts – Utility, Cadwalader Wickersham & Taft – BA

Connect Austria Austria US$630m Telecoms Norton Rose – Banks, Linklaters & Alliance – Sponsor Dr F Schwank – Supplier

Flag Atlantic USA US$575m Telecoms Clifford Chance and Skadden Arps – Banks, Morgan Lewis & Bockius – Sponsor Slaughter & May – Supplier

Tele2AB Sweden US$624m Telecoms Allen & Overy – Banks, Vinge – Sponsor

AES Easter n Ener gy USA US$550m Power Winthrop Stimpson Putnam & Roberts – Bonds, Chadbourne & Parke – Sponsor Globalstar USA US$500m Telecoms Cleary Gottlieb – Banks, Shearman & Sterling – Sponsor Eur ope, Middle East & Africa Telewest UK US$2400m Telecoms Norton Rose – Banks, Weil Gotshall & Manges – Sponsor Edison Mission Steamboat UK US$2006m Power Shearman & Sterling – Banks, Linklaters & Alliance – Sponsor Cr oss Israel Toll Road Israel US$1350m Infrastructure Allen & Overy and Herrzog Fox & Ne’man – Banks, Freshfields – Sponsor Chadbourne & Parke – Newcourt Capital, White & Case – Government UPC Netherlands US$1000m Telecoms Norton Rose – Banks, Home Robert & Owen – Sponsor. General Cable UK US$800m Telecoms Linklaters & Alliance – Banks Allen & Overy – Sponsor Attiki Odos Greece US$790m Infrastructure Allen & Overy – Banks, Norton Rose – Sponsor Linklaters & Alliance – Governemnt West Coast Trains UK US$774m Infrastructure Slaughter & May – Banks, Clifford Chance – Manufacturer Denton Hall – Train operator, Freshfields – Train owner, Linklaters & Alliance – Government, Shearman & Sterling – Sub lenders, Simmons & Simmons – Railtrack,

LAW SURVEY/LISTS

NRG Energy Skadden Arps – Sponsor

Thuraya UAE US$600m Telecoms Allen & Overy – Banks, Ashurst Morris Crisp – Sponsor Simmons & Simmons – Hughes Dam Head Cr eek UK US$585m Power Allen & Overy – Banks, Skadden Arps – Sponsor Herbert Smith – Sponsor equity Taweelah A2 UAE US$579m Power Shearman & Sterling – Banks, White & Case – Utility sponsor Baker & McKenzie – Contractor, Denton Hall – Government, Trowlers & Hamlin – Local Turkcell Turkey US$576m Telecoms O’Melveny & Myers – Banks and bonds, Altheimer & Gray – Sponsor Derman Ortak Avukat Burosu (White & Case) – Local banks and bonds, Slaughter & May – EKN Cor yton UK US$557m Power Shearman & Sterling – Banks, Clifford Chance – Sponsor Linklaters & Alliance – Sponsors, Norton Rose – Site owner Dutch Tone Netherlands US$540m Telecoms Clifford Chance – Banks, Shearman & Sterling – Sponsor Slaughter & May – Supplier credit ECMS Egypt US$520m Telecoms Allen & Overy – Banks, Shearman & Sterling – Sponsor Nodco Qatar US$510m Petrochemicals Shearman & Sterling – Banks, Clifford Chance – Sponsor West Toll Road Portugal US$500m Infrastructure Allen & Overy – Banks, Linklaters & Alliance – Sponsor Herbert Smith - EIB

Issue 181 PFI November 17 1999

49

PROJECT FINANCE

LAW SURVEY/US

INTERNATIONAL

Defending the home patch The internationalisation of banks and developers has meant that law firms have had to follow suit. Where clients go, law firms follow. UK law firms are now looking at the booming Americas project finance market, but are they cutting the mustard? By Gilbert Swann. When Freshfields hired a number of key US partners including Jonathon Rod from Milbank Tweed to spearhead its entrance into the Americas project finance market, through an office in Washington DC, US firms sat up and took notice. Here was a UK firm taking some well established partners signalling an understandable desire to break into a project finance market running from the tip of Chile to the northern reaches of Canada, the vast majority of which is financed under New York law. Home to the world’s largest energy developers, telecom companies and the world’s most sophisticated capital markets it is not surprising that UK firms want a piece of the action. The move was even more noticeable because American firms were faced with a downturn in project finance work following the Asian crisis, and here was an English firm opening an office in the capital going for established US clients. But breaking into a market is never easy. Both Freshfields and Clifford Chance have taken a notable approach by opening offices in Washington DC where they can tap into the projects work from the IFC, OPIC, the Inter American Development Bank and US Exim. The strategy has worked with both firms boasting a number of high profile mandates throughout the Latin American region. But Latin America is only half the prize. US lawyers point out the Latin American market has yet to pick up to the level of activity experienced in the mid nineties. And while some firms boast of a number of Latin American mandates, such as Sullivan & Cromwell and Shearman & Sterling, there are Wall Street firms which have admitted seeing a significant drop in project finance related work throughout the central and south American region. Commercial banks are much more selective and are unwilling to participate or arrange financings unless there is ECA coverage or the involvement of a multilateral. “They are all a lot more selective in financing projects in Latin America,” says White & Case’s Goodwillie. But despite this, projects are still be developed and financed, and what is more the market is developing from the initial power and telecom projects to the more quality of life project financings including toll-roads and water projects. “Latin America offers tremendous opportunities for law firms,” says Shearman & Sterling partner Jeanne Olivier. The involvement of multilateral institutions can prove to be beneficial for law firms. As Latham & Watkins partner Bill Voge says: “The more law firms the greater the complexity of the project, which equals more fees.” Voge concludes: “Sponsors of project are always better off minimising the number of law firms respresenting the lenders so they can minimise the costs and delays of a project.” The other half of the prize for the Americas project finance market is the resurgence in project finance work in the US. “Deregulation in the US power market has spawned a broad

number of transactions that have embraced project finance, M&A and a big dose of regulatory work,” says Goodwillie. City firms will continue to find it much harder to break into the domestic US market, where Wall Street firms maintain a vicelike grip. Looking at the projects which have reached financial close in the last two years there is a distinct lack of any presence by any city firms. The US$2.67bn Homer City transaction had Simpson Thacher & Bartlett acting for the bank and bonds and Skadden Arps acting for the sponsor, the US$1.7bn East Coast Power project had Shearman & Sterling acting for the banks, Skadden Arps acting for the sponsor with Vinson & Elkins acting for Enron. While the US$910m Canadian Maritime Pipeline project had Mayer Brown & Platt acting for the banks and Vinson & Elkins acting for the sponsor. As Clifford Chance’s head of project finance, Rodney Short explains: “That market is largely closed to firms without a strong US capability as it requires a number of skills that the non-US firms do not have at the moment. Clifford Chance has reinforced US capability with a merger with Rogers & Wells.” And it is not just the power projects that see an absence of UK firms. The US$1.14bn Iridium telecoms project had Milbank Tweed acting for the banks and Sullivan & Cromwell acting for the sponsor, Globenet had Mayer Brown & Platt acting for the banks and Vinson & Elkins acting for the sponsor. As Simpson Thacher’s partner Charles Carroll points out: “I’ve not yet bumped into London firms.” Latham & Watkins Voge says: “US firms have an edge.” Despite the recruitment of headline partners UK firms are not getting the choice pick of projects as US clients prefer the Wall Street firms. One large US investment bank felt that the UK firms are disadvantaged because of the way in which they approach projects. “The tradition of the European lawyer is that when presented with a problem, they come up with 15 different solutions. A US lawyer comes up with one solution and the problems gets solved a lot quicker,” says one senior financier. US lawyers get involved in transactions at a much earlier date, and according to investment bank clients are much more willing to make decisions. But it is the sheer size of the US market that will offer UK firms the greatest obstacle as they will find themselves challenged geographically. Chicago, Houston, Denver, Los Angeles, San Francisco, New Orleans and Miami are just a smattering of cities in which clients want to be served. According to a number of US lawyers UK firms will not be able to offer clients the whole range of serves they require, including environmental advice, planning device as well as a whole host of local issues. And unlike the UK market which is largely dominated by the top five firms, there are between 15 and 20 top flight US firms which offer serious competition, all of which have had some 20 years of experience in the US domestic project Issue 181 PFI November 17 1999

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According to clients the UK law firms miss out of a number of transactions because they do not have the capital markets expertise which their clients demand. The sophisticated project bond market means that clients want law firms that have experience, and while the UK firms have experience it can not match the US firms which have been practising project finance transactions since the 1970s. As L&W’s Voge points out: “The real stumbling block are the capital markets. It is very difficult to get retained work from the US investment banks since they do not have that sort of experience.” One way around the problem is to merge. The transatlantic merger has long been mooted; but it was Clifford Chance who took the unexpected lead earlier this year when the firm announced that it was merging with Rogers & Wells. “Clifford Chance and Rogers & Wells is a force,” says Latham’s Voge. But merging is not an easy task. Individual egos, profitability and client sharing all play a prominent role. UK firms will also be able to break into the US market by establishing stronger relationships with the sponsors then they can use that position to move onto the banking side. “If they can get in on the issuers side, they will eventually slip over to the underwriters side. the Brits will be a greater threat over time; but right now we are losing out to the US firms and not the Brits,” says L&W’s Voge. But it

would be wrong to wipe London competition off the books. Freshfields’ US practice has worked on some notable projects. Recently the firm has acted on the US$3bn Chase Infrastructure fund as well as acting for Newcourt Capital on an inside the fence power project for the casinos. “From my point of view they are formidable competitors. They are here and they are not going to go away. You can miss out on huge opportunities by being complacent and assuming things will stay the way they are,” says Simpson Thacher partner Charles Carroll. While these projects may not be the headline grabbing billion dollar power transactions the US firms boast, it shows that the UK firms finally have managed to get their foot in the door and will begin to act on an ever increasing number of projects. Take Cameron McKenna which acted on the deregulation of the California energy market, a notable mandate for any law firm, but even more notable for a UK firm. While Clifford Chance and Freshfields are both on the IFC’s panel of six law firms. But while the US domestic market is largely closed to UK firms, Latin America will continue to offer opportunities as European developers anhd financiers begin to take a more head long plunge into a region starved of infrastructure. As head of project finance at Sullivan & Cromwell Fred Rich points out: “You can’t talk about New York without looking at Latin America where something like 95% of all transactions are New York law governed.” One partner does not think that the City firms have made an impression on the Latin American market. “Linklaters, Allen & Overy and Clifford Chance have a trivial market share,” he says. “And we aspire to keep that market share.”

LAW SURVEY/US

finance market. City firms are faced with further competition from US firms which are faced with a downturn of work from the Asian project finance market have now started to throw a greater amount of resources into the US.

Skadden Arps AD 1/2 page horizontal

Issue 181 PFI November 17 1999

51

PROJECT FINANCE

LAW SURVEY/UK

INTERNATIONAL

Essential Kafka Franz Kafka probably didn’t know how close he was to a description of a project finance lawyer when he wrote: “Lawyers are persons who write a 10,000 word documents and call it a brief.” How times have changed. Now project documents run in multiple thousand-page documents; every conceivable problem is analysed, and what is more, it is all billed to the client. Gilbert Swann looks at the changing face of the UK project finance legal market. And while we’ve all heard the jokes, lawyers, as much as everyone hates to admit it, are an essential component to project finance. Without super tight legal documentation a project can explode in the developers face. The structure and internationalisation of project financings mean that only a few law firms actually have the ability to be able to handle international project finance. Not only are there the contracts between developers and financiers but governments, multilaterals and ECAs, as well as an assorted bunch of colourful local laws and characters that make legal teams essential. Despite their expense, lawyers can save projects millions of dollars. As Nicholas Buckworth, a partner at Shearman & Sterling points out: “Often clients have no choice to present you with what amounts to a total mess. Our job is to sort it out without totally rewriting the deal.” In 1988 no one would have imagined that Group 19 at Linklaters, now headed by Alan Black, would set the precedent for what we now know as the project finance department. Quickly followed by Clifford Chance, the project finance department has become an established feature in most major City firms. And with the birth of the private PFI in the early nineties, a number of opportunities have opened up for smaller regional firms like Pinsent Curtis and Dibb Lupton Alsop which now practice PFI transactions throughout the UK.

Hindrance or help? While law firms certainly reap the benefits of project finance, with fees piling into coffers, clients often feel that lawyers can prove to be a hindrance to the process. Tim Pearson a director at Innisfree says: “There are two kinds of lawyers. Those that act for their clients and there are those that act for themselves. Unfortunately there are not many of the former and too many of the latter.” Pearson feels that lawyers must be controlled by a client which understands the intricacies involved in projects otherwise fees will quickly escalate out of control. “Bank lawyers can run up staggering costs. But it not just the fault of the lawyer, but the failure of the banks to manage their lawyers properly.” And with developers paying both sets of fees this can prove to be an expensive business. Problems are further compounded with some financiers attitude. One senior banker points out: “Price is not an issue as the developer picks up the tab.” Pearson believes that lawyers must be controlled and unless law firms are properly managed they run out of control. Pearson refers to a recent PFI transaction for £20m, which a law firm offered a capped fee of £190,000, but presented him with a fee of £850,000.

Fees do vary for projects. The long running South Tees hospital project had fees of £4m for a transaction that totalled £160m while Greenwich Hospital cost £1.6m in fees for a £100m deal. It is not just the PFI transactions that have proved to be profitable for law firms. As one senior partner in a London based projects groups says: “I have never done an IPP where the firm has not billed less than £2m. They are profitable. Look at a corporate finance partner who bills for seven or eight hours a day or even shorter than that, while a projects partner is billing 10 hours a day and that goes on for years.”

US competition City firms are now finding themselves faced with serious competition from US firms which have embarked on strategic growth. In the early to mid nineties US firms hit the UK in force. Now more than 60 US firms have offices in London and more are expected. With huge personalities and large cheque-books US firms have lured away some notable project finance lawyers. What is more they have offered junior lawyers the chance to leap frog the lock step and become a driving force in the running of a firm. Peter Blake, head of Clifford Chance’s London projects department says: “Clifford Chance’s competition in London today is just as much American as it is English.” It all started when Kenneth MacRitchie and Nicholas Buckworth left Clifford Chance to new arrival Milbank Tweed. And over the few years there have been other moves: Geoff Haley left SJ Berwin for Arnold & Porter; Jane Templeton-Knight departed A&O for Milbank, Tweed, Paul Griffin left Ashursts to Cadwalader, while soon to merge Wilde Sapte lost partner Christoper Clement-Davies to Vinson & Elkins and recently lost head of its projects group Bruce Johnston to Weill, Gotshal & Manges. But it was Jamie Logie’s move from Norton Rose to Sullivan & Cromwell that really got the London legal market buzzing. This seemed to run against Sullivan & Cromwell’s strategy of not practising English law. But if Sullivan & Cromwell is to practice projects this side of the Atlantic then it can not survive purely by practising US law. But large cheque books are not the only lure. UK firms now offer similar profits per partner to many of the leading US firms as globalisation allows UK firms to share the US client base. Figures taken from the annual survey of Legal Business and The American Lawyer back this up. Legal Business figures for the UK leading project finance firms read as follows: Clifford Chance (£575,000), Linklaters (£490,000) and Allen & Overy Issue 181 PFI November 17 1999

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The real proof US firms offer serious competition is in the actual projects. US firms have acted in all four of the largest projects to reach financial close in the European arena since the start of 1998. In the US$2.4bn Telewest telecommunications project Weil, Gotshal acted for the sponsor, while Norton Rose acted for the banks, the US$1bn Edison Mission Steamboat project Shearman & Sterling acted for the banks, while Linklaters acted for the Sponsor. While for the Cross Israel Highway Chadbourne’s acted for Newcourt Capital and White & Case acted for the government, while UK firms A&O and Freshfields acted for sponsor and banks respectively. And it is not just because the clients are US based that US firms claim a number of mandates. A lot of clients prefer the US law firm mentality. “UK law firms are sometimes unduly pleased with themselves. They are paid to come to a deal and take their clients’ most aggressive position. Some handle this better than others. English lawyers have a tradition of navel gazing and thinking up different problem. People admire each other for the complicated approach. But a lot of the time project finance transactions are not terribly complicated and I think that there is a great deal of intellectualising which is time consuming and does not ultimately solve the problem,” says one financier. US firms also take the lead in the project bond market. While the Euro certainly offers opportunities for the European bond market, US firms still retain the lions share of the 144a project bond market. “Contrary to what the UK firms will claim, they are still far behind the UK firms in terms of relevant experience,” says one US investment banker.

Competition from the regions PFI has opened doors for smaller, less well-known firms into the project finance market. While the major project finance UK firms like Freshfields, Allen & Overy, Clifford Chance and Linklaters dominate the PFI market, the initiative has allowed the regional firms to tap into territory that was previously earmarked for the larger city firms. Large city firms claim that the sophisticated financing documents often prove to be difficult for the smaller regional firms to comprehend. But many state that the large firms are merely arrogant, and if the smaller firms are so terrible, then why are we finding them on an increasing number of PFI projects. “To tar everyone outside of the top six with the same brush is most unfair,” says Pinsent Curtis partner Cameron Woodrow. And the facts are there to back this up, with Pinsent Curtis winning an award from Legal Business for its work on the Birmingham Airport transaction. The smaller regional firms do offer benefits. One of which is cost. Average charge out rates per partner and assistant are cheaper than that of the City firms. And with much smaller budgets costs are an important issue for PFI transactions. The City firms argue differently. While they freely admit that the regional firms are cheaper on an hourly charge-out rate large City firms claim that they take longer to process documentation to their perceived inexperience. And on a small £25m project, which can take years to complete, these figures can make a dramatic difference. However Pinsent Curtis’ Woodrow feels that this is no longer the case, having been a partner at Freshfields with knowledge of the capital markets, as well as having worked on project bonds in recent months. “We have a track record of sophisticated closed deals. We have closed nine transactions in as many months - that gives the market a flavour of what we are capable of”

LAW SURVEY/UK

(£560,000). While The American Lawyer figures read: Milbank, Tweed (£538,000); Shearman & Sterling (£575,000); Latham & Watkins (£516,000) and Skadden Arps (£806,000).

DEWEY BALLANTINE LLP Dewey Ballantine LLP's International Project Finance Group has represented developers, investors, underwriters, lenders, financial advisors, multilateral institutions, contractors and governments in the development, financing, construction and operation of a wide range of capital intensive projects and facilities throughout the world, including power plants, resource recovery facilities, hazardous waste incineration facilities, industrial plants, pipelines, mines, telecommunications networks and facilities, transportation systems and equipment, toll roads, water supply and waste water systems and other infrastructure projects. Our international project finance practice has participated in energy, mining, industrial and other infrastructure projects and privatizations in Central and Eastern Europe and the former Soviet Union, Western Europe, Asia, Canada, the Caribbean and South America and represented developers and financiers from all parts of the world. Our offices in London, Budapest, Prague and Warsaw enhance our ability to handle complex project financing matters in Europe, the former Soviet Union, India and the Middle East. Our project finance practice draws upon the Firm's strengths in other practice areas as required to assist clients in consummating transactions. We have recently been ranked among the top in Project Finance league tables covering US/UK law firms generally and international law firms active in Central and Eastern Europe and the former Soviet Union.

NEW YORK ● WASHINGTON, D.C. ● LOS ANGELES LONDON ● WARSAW ● PRAGUE ● BUDAPEST ● HONG KONG

For further information, please contact: New York: Richard Shutran (1-212) 259-6710 London: James Simpson (44-171) 456-6071

Issue 181 PFI November 17 1999

53

PROJECT FINANCE

LAW SURVEY/ASIA PACIFIC

INTERNATIONAL

Modifying legal practice in Asia Since the onset of the Asian financial crisis in October 1997, outside legal counsel to international project developers and sponsors were required to modify their legal practices to match the new demands of their clients and the ever-changing economic, political and legal environment. Jack H. Su, Vice President of Vivendi Water Asia Pacific, discusses the trends from a sponsor’s viewpoint. In Southeast and North Asia, from the early 1990s until the fall of the Thai and other regional economies in October 1997, international infrastructure-related developers and sponsors created project portfolios largely by greenfield construction and traditional project financings. In the past two years, as a result of the change in sponsors’ strategies, legal matters involving mergers and acquisitions, restructurings and workouts, and refinancings now predominate. Greenfield development work and financings have continued on an exceptional basis in a few countries less affected by the Asian crisis. Although this article focuses on the trends regarding sponsors’ counsel, it should be noted that law firms commonly representing lenders and other financial institutions have also had to adjust their legal practice. Lenders’ counsel are now considering major issues such as whether currency devaluations and other macroeconomic events give rise to material adverse changes, resulting in perhaps defaults or interim arrangements such as standstill/ standby agreements. As a result of the regional conglomerates losing the international equity and debt markets as a fund-raising source, the international law firms have had to shift from a practice emphasizing equity and capital markets capability. Many lawyers do not claim a specialty in a specific field but the ability to crossover to other areas, from project finance, for example, to mergers and acquisitions relating to projects and/or project companies. Representative of the types of matters which now dominate the legal practices of the major firms in Asia Pacific are as follows:

Mergers. Scenarios here include diligence and transactional documentation relating to the sale of strategic or majority interests in infrastructure-related holding companies that have project assets and/or subsidiary companies. These may include companies based in the region, as well as overseas companies operating in the region (e.g., Vivendi Water’s acquisition of U.S. Filter for US$6.4 billion). ● Acquisitions (Single Asset). Individual projects or a basket of projects have been offered on a negotiated or bid basis (e.g., Sithe Asia’s recent US$170 million acquisition of the cogeneration plant at Hyundai Electronic’s semiconductor manufacturing park at Ichon). ● Acquisitions (Strategic Interest). These acquisitions involve the purchase of a strategic interest in a single asset (e.g., Singapore Power’s acquisition of a stake in EverPower’s IPP Project in Taiwan and Sithe Pacific’s acquisition of a stake in COCO in Thailand). Tractebel’s participation in the KEPCOdelayed Yulchon IPP, which was sponsored originally by Hyundai Engineering and Construction, represents an acquisition in a project yet to be completed. ● Restructurings and Workouts (Distressed Projects). Prior to the Asia financial crisis, such workouts were rare. Some of these types directly result from changes in macro-economic and political changes (e.g., Paiton in Indonesia and HUB.

Privatizations. These include privatizations of companies (e.g., EGCO in Thailand) and specific assets (e.g., KEPCO and Korea District Heating Company’s Anyang and Buchon district heating plants). ● Project Financing (Traditional and Re-Financings). Economists and market watchers predict a recovery in most Asian countries – with Korea restructuring quickly, followed by Thailand and Malaysia, and with Indonesia far behind. In some countries, some projects continued, albeit slowly (e.g., Vivendi Water’s Chengdu No. 6 Water Plant project financing and the larger, ongoing deals in China – National Power’s Changsha BOT Project and Sithe China/Marubeni’s Puqi Project). ●

From the sponsor’s perspective, mergers and acquisitions represent a swift strategy to increase project portfolios and securing market shares in both the region and a particular market. Companies sluggish to arrive in the Asia-Pacific region, as well as stalwarts that have held steady during the Asian crisis, have been in the acquisitive mode. With the economic downturn, opportunities are created as a result of the downfall of some of the region’s infrastructure companies. The international law firms have aggressively marketed their M&A capabilities, coupled with back-up support from project finance, tax, workout lawyers and the leading local law firms. To remain competitive, project finance lawyers must adapt by picking up expertise in M&A and restructuring advice. Conversely, M&A specialists have had to learn how to manage offtake and financing agreements.

●

Critical to the success of any merger or acquisition is the completion of a thorough analysis of a target company or project’s financial, legal and business records. A review of documentation will not suffice, as some critical information is the result of discussions with off-takers and government officials. Whether to instruct the international law firm or the local counsel to take the lead in due diligence is the decision of the client, usually with guidance from the international lawyers. In some jurisdictions, such as Korea, which boast law firms with many lawyers who have western training and work experience, sponsors are likely to delegate the diligence activities to the local lawyers. In other countries, such as China and the Philippines, some transactions require guidance from the international lawyers. One area of concern for the sponsors is the efficient utilization of the foreign legal consultants employed by the international firms. Many of these senior lawyers (such as the PRC-barred lawyers who work for the U.S. and London firms) have in-depth experience in-country and in projects. These lawyers are helpful in liaising with local counsel, project structuring and drafting. However, with respect to local law issues, these foreign legal consultants are unable to issue legal opinions under the name of the international law firms (granted, some are critical in drafting initial drafts of legal opinions to be issued by local counsel). Issue 181 PFI November 17 1999

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In an M&A context, international and local counsel entertain a host of issues, most of which have to be resolved in a short period. Unlike traditionally financed projects, asset acquisitions have a limited gestation period (sometimes only months or weeks in duration).. Some deals are lost, or made more expensive, as the result of time passing and the improvement of the regional economies. Due to the ongoing economic recovery, some target companies have re-appraised the valuations of their assets and companies. Consequently, counsel are often requested to complete diligence and documentation to coincide with the commercial discussions. Although the issues associated with traditional project financing are similar to an M&A context, there are some differences, especially with respect to the timing which these issues are addressed. Common issues arising in both contexts are: tax, labor unions, employment, regulatory and environmental. The international law firms have reacted positively with respect to the changes in the M&A sector. With the exception of a few partners, most of the leading project lawyers in this area have remained in the region and, in fact have called upon their M&A counterparts for back-up. The international law firms have adapted to the realities associated with their clients’ projects. All project financings completed in the early 1990s contemplated a continued booming economy for the greater Asia-Pacific area. Even the most robust base case projections did not contemplate the downfall of region’s economies. Consequently, lawyers are deployed to the various project restructuring teams, comprised of financial advisers, accountants and other consultants. Clients with troubled projects tend to retain the original project lawyers. The same goes for the lenders and their counsel. The learning curve associated with retaining new counsel is too high and expensive, especially with respect to distressed projects.

tion, such as the PLN in Indonesia and the structuring of the BOT law in the PRC. Many of these sovereign representations require the law firms to bill on a discounted basis. Standstill or standby agreements – and in some cases, arbitrations – are now topics of the day. To support the clients in good times and bad, law firms must provide consistent personnel and advice for troubled projects. In some cases, project lawyers associated with financial closing have been repatriated or transferred to other hot markets. Paiton in Indonesia and HUB Power Co in Pakistan are representative of restructurings and workouts. In Paiton, PT Paiton Energy has initiated arbitration proceedings with PT Perusahaan Listrik Negara to settle an ongoing dispute with respect to

LAW SURVEY/ASIA PACIFIC

Although legal fees are discussed later, it should be noted that the international lawyers charge a premium, as compared to the local lawyers.

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The international law firms have focussed on two representations with respect to such projects – either representing foreign investors or the host country. Sovereign representation generally precludes the law firm from representing investors in that particular sector. Several international firms have been retained to handle the wholesale renegotiation of project documentaIssue 181 PFI November 17 1999

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power supply arrangements. PLN recently sought to nullify a power purchase agreement signed with Paiton in 1994. In Hub Power, the project company is in technical default to a syndicate of 46 international banks, which may trigger the banks to invoke World Bank-backed loans. In its PT East Java Power Corp. project, Enron has called on the World Bank’s Multilateral Investment Guarantee Agency to pay US$15 million on a political risk policy. It is good practice to marshal a law firm’s arbitration expertise with respect to boilerplate arbitration provisions. Cavalier agreement to arbitration rules and venues – off-shore is generally preferred by the sponsors – could result in losing situations when projects go under. Although privatizations abound in Europe, this is a recent trend in Asia. Much discussions has occurred with the Hong Kong water privatization but little movement has occurred, except with the commissioning of a study by Deloitte Touche Tohmatsu. The success and failures of other water privatizations (Manila and Jakarta) are yet to be determined. In other countries, such as Korea (Anyang/Buchon) and Malaysia (KAPAR), privatization is a method for countries to raise cash and utilities to restructure and recapitalize. Simultaneously, the technological and managerial expertise of the domestic sector and foreign sponsors are offered in exchange. In Korea, for example, chaebols have had to reduce their debt-to-equity ratios to 200 percent, in some cases from a pre-crisis high of 400 to 700 percent. Simultaneously, government-led privatizations have been spurred with the utilities. In late 1999, Seoul, which is home to a quarter of the nation’s population, is delegating operations and maintenance management of a wastewater facility to the private sector. Full-scale privatizations are stronger targets for revenue for the law firms. However, due to the competiveness of these bids, law firms are generally relegated to representing only one of the bidding consortia. Chinese walls are appropriate but not common in these types of bids. Due to the extreme confidentiality requirements of the final bidding process, it is common for sponsors to tap the resources of its regular outside counsel. Even in the pre-bid stage, counsel are required to comment on draft offtake and concession agreements. In the water sector, the long-awaited Beijing No. 10 Water Project may be released for tender in the coming months. Four international consortia have been short-listed. For some sponsors, the viability of participating in such bids is being questioned. Although considered landmark projects, the costs associated with bidding, development, negotiations and financing are extremely high, when compared with asset acquisitions or joint ventures relating to existing facilities. Second to financing costs and financial advisory fees, legal fees are one of the most expensive costs relating to project financings. In some cases, smaller projects are unduly burdened by such out-of-pocket fees, as it is well understood that the legal fees are similar for US$100 million deals as it is for half-billion dollar transactions. Once the domain of local counsel, domestic financing techniques and regulations now are being touted by the international firms. In Malaysia and China, local financing is considered an option, and in some cases, the only resort. In Malaysia, for example, local counsel take the lead in domestic bond financings and short-term paper. In China, RMB financing

as an option for wholly foreign-owned project companies was not possible in previous years. Now, with the limited pool of international commercial banks interested in lending to China due to the GITIC and Itic bankruptcies, mixed USD and RMB financing may be the only viable option available. In Korea, local financing – on a project basis – is a new phenomenon, initiated by the Hana Bank-led financing for Sithe’s Ichon project in Hyundai Electronics’ industrial park. Labeled the first of its kind, the Ichon transaction involves a limited recourse loan funded by local banks. Previously, the only project-related loan transactions were secured by corporate guarantees or crossguarantees by various chaebol subsidiaries – the latter of which is now prohibited by the Korean government. The trend toward the increased use of local financing should prompt many international firms to localize their practices, perhaps by hiring local lawyers where the can. Obviously, this is a case-by-case issue as each jurisdiction will have different policies with respect to the hiring of local lawyers and the extent to which international law firms can provide “local advice.” In both traditional project financings and even M&As (especially with acquisition financing contemplated), legal fees represent the second most expensive out-of-pocket costs. Legal fees continue to hover in the million dollar-plus range in many project financings. Although some firms claim a freeze in hourly fees charged, there have been no reports of a reduction of fees charged. Nevertheless, some creative fee structures have evolved. For budgeting purposes, some sponsors are zealous about receiving fee estimates from the international law firms. In the past few years, the local law firms have also learned to play this game as well. Fee estimates are generally non-binding (fixed fee arrangements still do not predominate) and are replete with exceptions or “outs.” For example, a law firm may estimate its fees to be a specific range, depending upon various factors, such as timing of financial or transaction close, the amount of diligence required, days of negotiations, etc. Fixed fees are sometimes possible in IPOs and bond issues, as well as friendly and hostile mergers. Clients are now demanding that law firms be flexible in the determination of legal fees. In recent mergers and acquisitions, many law firms – including local lawyers – are willing to quote success fees and even discounted rates for lawyers, from the partners to associates. A common practice is to reduce the actual fees to 10 or 20% of actual billings – with an additional premium mirroring the discount to be paid upon a successful closing. For busted deals, the reduction is not charged but borne by the law firm. It may be premature to discuss a pure success fee basis (with a minor monthly retainer for a short period), which is possible with some U.S. investment banks. Generally, the US lawyers tend to be less expensive on an hourly basis but tend to bill more hours per year. The UK lawyers charge more per hour but rarely hit 3,000 hours billed per year. Clearly, there are variations in billing structure, such as what fractions of an hour are used as units. Invoicing by the London and Hong Kong law firms continue to be on the spartan side, although law firms are willing to provide detailed billing upon request. The local firms continue to fall behind the international law firms with respect to hourly charges – sometimes a quarter or half of the hourly rates charged by their international counterparts. Not present in the budgets of local law firms are high overheads. Issue 181 PFI November 17 1999

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The real buzz in the limited recourse bond market is merchant power projects (MPPs) which are exposed to price risks. Infrastructure, particularly with the UK private finance initiative (PFI), is providing some healthy and interesting deal flow but these financings are overshadowed by the merchant plants. Can the merchants make the grade? By Rod Morrison. The main geographical area of merchant activity, certainly by amounts raised, has been the US. A comprehensive article by Lehman Brothers’ John Veech in Project Finance International this August (PFI issue 175, p52) set the scene for what has been issued in the US bond markets, US$2.7bn in six deals over the last year. Elsewhere Entergy’s Dam Head Creek was to have shortly become the first fully merchant UK plant to be bonded. The issue has been postponed due to current high pricing in the bond market (see UK news this issue) but not before the deal was rated investment grade. Looking forward there is a whole range of greenfield and M&A assets seeking or about to seek finance. This article does not look into these deals as such, they have been well covered elsewhere, but looks at the attitude and criteria of the rating agencies on giving deals investment grades, a key determinant to the cost of funds on these bonds. This is not just important for bonds, in addition the agencies are starting to publicly rate bank debt for merchant plants, again with important pricing consequences. Have the agencies modified or mollified their stance on the sector since MPPs started to emerge three years ago? Standard & Poors’ would say not. Indeed maybe it has got tougher. In one chilling sentence for developers, it says in its latest October criteria report “S&P expects that investment grade will continue to be the exception rather than the norm.” The report was penned by Peter Rigby, the same Peter Rigby who wrote the original merchant power rating report two years which generally set the MPP scene. His previous conclusion was slightly less tough, “stronger MPPs can reach investment grade,” but then again two years ago there were fewer genuine merchants around. Enron’s UK Sutton Bridge, which is only merchant for the last few years of the debt, was in the MPP category back then. For its part, Duff & Phelps (DCR) said two years ago investment grade would be the exception rather than the norm. In its latest report, issued in October on the US market, DCR’s John O’Connor said “the thresholds remain appropriately high.” What about the reality? One adviser, who has taken two similar merchant plants to the raters in the last couple of years, believes the climate has actually improved for projects. It is not that the tests have lessened, it is there is not such a presumption against an investment rating. For their part, the raters have now seen many merchant proposals, mainly in the US and UK. This has given them greater

knowledge about what is important to the success or otherwise of a deal. One thing that has struck them, particularly in the US with so many deals, is the diversity of project information provided by sponsors. Much initial time is spent standardising this information so it can be properly analysed. Armed with this greater level of information Rigby, in the annual S&P project finance division world tour this autumn, is telling audiences about what are the key breakers to achieving a rating. Inadequate liquidity comes top, market uncertainty comes next, structural weakness is next followed finally by weak business strategy.

CAPITAL MARKETS/MPPS

MPPs making the grade

Certainly a lot of work on the most recent MPP rated (BBB-), Dam Head Creek, focused on the financial support to the deal. The plant is a single asset 790MW development currently being built by Entergy in the UK. It was due to be bonded last autumn but bond prices rocketed after the emerging markets crisis. This has unfortunately happened again with the issue being out off until at least the new year. The bank debt put in place last autumn will be taken out when the bond is finally issued. The proposed 24 year £271m senior bond on the deal is backed by a minimum debt service cover ratio (DSCR) of 2x with an average DSCR of 2.58x. There is a 18 year £54m subordinated non investment grade piece, rated BB-, where the ratios drop to 1.54x and 1.95x respectively. There is a 6 month debt service reserve account on the senior bonds with 12 months for the sub bonds. As securitisation techniques become more honed on these types of deals, the structural enhancements to an investment grade become more important. On Dam Head, there is a distribution lock up on total debt of 1.3x, a senior lock on all equity distributions of 1.5x which can increase to 1.7x after the 16 year gas contract runs out. These lock ups last for a year. There is a 2 year forward looking test which can lock up all cash flow distributions in case the project economics appear to be moving towards trouble. In addition, the project keeps cash in the debt service reserve account of coverage are above 2.5x. This should smooth out significant market fluctuations. Dam Head is aggressively geared. Equity account for only 10% of project cost, with 15% coming from the sub bonds and 75% from the senior bonds. Two years ago, and recently, S&P said capitalisation on MPPs “should reflect a much higher sponsor equity position than the typical 20-30% range that characterises IPP project financings.” It added limited amounts of subdebt on top helps a credit rating. It would safe to assume therefore the structural enhancements are now more important.

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What else helped Dam Head jump the hurdle? The gas contract provided the project with a good deal of flexibility. The 16 year gas supply agreement (GSA) on Dam Head is provided by Shell. On a take or pay basis, the GSA covers 75% of the output. Entergy is, however, under no obligation to actually use the gas and can sell it on in the daily spot market. The contract itself can be rebased, in price terms, after five years of operation four times if the prevailing market price is 20% higher or lower than the contracted price. In addition the GSA carries the now standard, for UK deals, prices indexation to pool prices of 50%. Linked in with the GSA is the place a project has on the dispatch curve, another area where there was said to be a lot of discussion between raters and developer. The raters are not only keen on the position now but the expected position in 15 years when the GSA runs out. The rating agencies are not too keen on predicting future prices, hence the desire for a flexible GSA. They use the expensive consultant reports from gas and power forecasters but only to test assumptions. (It is not clear why they can provide the assumptions themselves!). The forecasts are not said to be the basis for ratings. Selling the Dam Head bonds was not easy. A longer than usual roadshow period was earmarked by issuer Warburg Dillon Read. As a fully merchant deal, this is a new class of asset for the UK. The sterling bond market is led by just a few players who are key to the success of an issue. In addition, the sale came as coverage of the New Electricity Trading Arrangements (NETA) grows in the UK press. Regulator Ofgem is hoping power prices will slump when NETA comes in next autumn (or shortly after). That has yet to be seen. On Dam Head, the DSCR on the senior bonds drops to 1 if prices fall 40% to 1.43p and to 1.58 if the price falls 27% to 1.8p. Dam Head is a stand alone greenfield asset, which perhaps makes its rating more notable. By comparison, the other merchant asset in the UK to achieve a rating recently is the acquisition financing for AES’s £1.86bn purchase of the 4000MW Drax coal fired plant from National Power. This was funded by a £1.3bn bank loan arranged by Chase, Deutsche and IBJ. This deal utilised a technique which has been used in the USA, the bank loan is rated and the pricing on the loan adjusted according. The rating was BBB-, the same as Dam Head. Perhaps this is surprising. Drax is covered by hedging agreements, presumed to be with Eastern, for 50% of the output in the first seven years reducing to 30% by the end of the loan, year 15. It is an established plant, with expensive FGD installed. The gearing is slightly lower than Dam Head with 70% debt, 10% subdebt and 20% equity. There is a cash sweep mechanism supporting the debt. On the down side the ratios however, are lower than on Dam Head. Minimum DSCR is 1.6 with the average, 2.05x. The raters are concerned by the merchant risk, of course, but additionally by the financial structure backing the deal. To reduce tax liabilities, an AES company will issue an internal bond which

will be bought by InPower, the rated subsidiary, and then funded by the banks. S&P said if this structure was unravelled it “may expose lenders to potential cashflow deterioration.” Some bankers suggest another reason for the rating was the link with AES’s corporate rating, BB. “They don’t like to project ratings too far above the corporate. It is the same as not giving project ratings above the host sovereign country,” said one. Not so say the raters. They say they look at project ratings as being isolated from the corporate. The sovereign rating is far more important to a deal as the project’s success depends on the host economy. Acquisition deals are all the rage in the USA. Many are not just single assets but a portfolio of assets. Finance has come from a variety of sources but many have short term bank loans which are taken out with bonds. The structures are hybrids with elements of acquisition, corporate and limited recourse finance. Having a portfolio of assets should improve the rating prospects of generator, even if they are exposed to merchant risk. “Higher rated gencos (generating companies) will have a well balanced portfolio of efficient, well run generating assets with strong heat rates and excellent availability factors,” says DSR in its recently updated MPP report on the US sector. “Primary credit protection measures will have to meet or exceed a consolidated 60/40 debt equity mix with EBITDA/interest coverages and EBITDA/debt of at least 3x and 25% respectively. We will also look for a prudent mix of shorter term contractual sales to minimise cash flow volatility,” it adds. As in the UK, the raters do not want to be in game of predicting prices. “As past precedents have proven, actions by players in a heavily commodised market can be far from rational,” says DCR. Additionally in both the UK and the US, there is uncertainty about the market itself and the way it will operate. NETA will change the UK pool as we have seen, with the hope of much lower prices, and in the USA, the regional markets have yet to settle. This uncertainty creates higher risk. On top of that the US regions have different characteristics which have yet to smooth out in a fully liberalised market place. On a basic level, what happens if cheap power from one state or regional pool begins to be sold into another? To cope with the differences, raters have adopted extreme downside scenarios to test the stresses within an individual financing. DCR says the further down the dispatch curve the better. Baseload is best followed by intermediate then peakers. Much of the acquisition activity has been for base load coal plant. These will be threatened by new, more efficient combined cycle gas turbine plant (CCGT). However coal plant can still be competitive on a marginal cost basis. “DCR considers not only the current comparison of CCGTs and base load coal fired units but also how much the efficiency factors for CCGTs would needs to improve and/or how much gas commodity prices would need to decline before base load coal units are displaced.” On Homer City, CCGTs would need to improve efficiencies 34% to displace the plant in the dispatch queue. Mid merit deals can be attractive if linked to a steam host but achieving investment grade for the more volatile peakers will be “extremely difficult.” Issue 181 PFI November 17 1999

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INTERNATIONAL

Private placements look for niche The private placement market looked as if it could become the bees and eees in global project finance a couple of years ago. But like many financing tools, it suffered some body blows as a result of the emerging markets crisis. It is still around, however, offering some benefits in niche markets. By Rod Morrison. The private placement market is debt sold principally to US insurance companies and pension funds with some Europeans in the market too. The main benefit of this type of debt is it offers longer tenor than the banks can offer in areas where bonds are a tough sell. In addition, it can be highly structured, with initial payment grace periods for instance, to give longer average lives. The debt can be arranged by an investment bank or by one of the institutional investors. It is then sold down to other institutions. The takes are usually much higher than on a bond or even a bank deal and the debt is usually held rather than traded. The buying institutions are, however, usually looking for investment grade product, particularly after the emerging markets crisis. There is still some appetite for non investment grade but pricing has become very expensive. One Middle Eastern project was quoted margins in the mid teens for private placement debt and quickly gave up on the idea. Another feature of the market is the fact the buyers , like bond buyers, do less due diligence than banks in a syndicate. The final deal will usually be presented to them and they then decide whether to invest for not. The buyers are looking for a good yield on top of investment gradings. Therefore, private placements have not replaced the banks or the bonds in the developed world. They can look expensive. On the other side of the coin in the developing world, the private placement debt is now too expensive. So where can private placement squeeze in? Two of the most recent deals have been in Israel and Iceland. The Cross Israel toll road project is a huge deal by any standards at US$1.35bn. The funding came from local banks, led by Hapolim, US$850m, the US private placement market, US$250m, and the rest, equity from the sponsors. The concession runs for 30 years. It is an unusual deal in many respects but in financing terms, the main goal was to reduce front end payments to allow the cash flows to build up.

Part of its risk was selling down to other buyers. John Hancock has bought US$50m but the rest is on Newcourt’s book. The high arranger fee should give it some latitude if it wants to sell more. The deal is backed by a BBB- investment grade rating from Standard & Poor’s. This was because the project has a unique revenue protection mechanism from the Israeli government. If traffic falls below the base case level, the government compensates the concessionaire for 72% of the lost revenue. As a result, the project can still repay its debt with traffic nearing 50% of the base case. If traffic is above the base case, the extra monies are shared by the concessionaire and the government. The rest of the finance, both the local debt and equity, was high structured as well. The local debt was arranged by Hapolim with a 28 year tenor. The grace period on this part of the debt is during the first five years, during the construction phase. Average margin is 180bp to 210bp with the figure starting low and increasing throughout the term of the loan. Principal repayments are largely made later on in the deal with just 30% repaid by year 20. Average life is 21 years. The rate is fixed rate for 15 years. It had been planned to raise the local funds from a combinations of banks, insurance companies and pension funds but in the end the banks took much of the deal with just US$40m of the local debt fixed for 28 years. The equity is highly structured too. Dividends build up in an account for the first10 years of the project and the Derech Eretz Highways sponsors, Africa Israel Investments, Canadian Highways Investment Corporation (CHIC) and Housing & Construction Holdings, then receive a big cheque at year eleven. Annual debt service cover ratio is low at 1.38 due to the government support.

In this regard, the private placement was a help. It has a 28 year tenor, well beyond what any international bank could offer. In addition the margin is fixed rate for the term. In terms of grace period, there is an interest holiday from years 5 to 10 of the project, the first full five years of operation.

The deal took a very long-time to put together, mainly due to discussion between the government and Derech. Intercreditor issues between the local and US were nevertheless significant. It is clear private placements take longer to put together than bonds. Currency risk to the US investors is taken care by an annual adjustment to toll, taking into account the dollar rate and local inflation. Every three years the toll is adjusted to take into account ongoing traffic levels.

The debt is priced at 325bp over US Treasuries, low for the emerging markets. It had to be increased by 100bp earlier in the year as the international markets tightened and Israeli US dollar bonds increased in price. The arranging fee was said to be high, nearing 5%. The arranger was Newcourt.

Newcourt’s eventually successful experience on this deal contrasts with that on another CHIC deal, Highway 407 in Canada. CHIC held the concession for the road but had to rebid to include an extension. Despite its advantage, it did not make it to the shortlist of two. It is believed there were Issue 181 PFI November 17 1999

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problems between the monoline insurance wrapper and the private placement debt leading up to the first bid. In the end the winning Dragados team put the deal in the bank and bond markets. Iceland, perhaps the ultimate niche market, has proved a good market for private placements. As in Israel, the private placement market is able to go much further in term of tenor than the banks. Back in 1996 the Havalfjourudur tunnel scheme was financed under a mini perm private placement take out structure. The banks, led by ING Barings, provided the US$64m of construction finance, split between international and local debt, and John Hancock took out the US$40m of international debt on completion. Initially the private placement market was due to finance the whole lot from start to finish but the US Prudential eventually decided not to pursue the deal. In addition a 10 year all bank solution was on the table from UBS. The BBB rated private placement runs for 20 years during operation. In addition it held the commitment for the three year construction period and was compensated via a spreadlock fee. Margin was 275bp with the underlying US treasury viable until the take out was completed. Interest rate risk was hedged through cash settled forward start swapoptions during construction and the currency exposure was hedged in a basket of four currencies. John Hancock is fully exposed to traffic risk. The tunnel, however is said to be performing well, more than one year after opening. A second deal is now being worked on. Colombia Venture Corporation (CVC) is extending and refinancing it aluminium smelter project via a private placement arranged by ING Barings. The start up project was finance by an 11 year, US$110m project loan from ING Barings and Paribas. It is now operating. It intended the original financing will shortly be replaced by a US$160m investment grade BBB issue and a US$80m subordinated issue. Both will run for 20 years, well beyond what the banks can offer. Indeed this is beyond the tolling contracts in operation on the plant. Billiton supplies the alumina and buys the completed product for 10-12 years. The new US$240m deal will take out the US$120m of existing debt, including US$10m from the Icelandic government, provide US$75m for the expansion projects, taking the plant from 60,000 to 90,000 tonnes a year, and pay back the shareholder US$45m of equity from the US$60m in the original deal. In return, CVC has to put up US$10m of contingent equity during the construction of the extension. The new deal is expected to be priced shortly. Elsewhere private placements remain an option but perhaps the experience in the UK private finance initiative (PFI) market gives an idea why they remain niche. The longer tenors and fixed rate the private placement offers would seem ideal for the long concession of PFI. Very quickly, however, the

bond market and then the bank market responded to this new market with long tenors and reduced pricing. Private placements are around but in specialist areas. The UK Prudential’s fixed income division has done a number of waste to energy deals, the latest being the 22 year, £55m refinancing of the Selchp CNIM/Vivendi plant in south London this summer. This would have posed problems in the bank or bond market. The debt runs for much longer than the power contract and runs for longer than the waste contract. Paribas refinanced the Vivendi Tyseley waste to energy project in Birmingham a year before in the bond market. One of the advantages to Selchp of the private placement was the lack of any general disclosure requirements. Another deal currently being done by private placements is the £100m Tay Scottish build, own and operate (BOO) water project. This came about in slightly unusual circumstances. The Morrison/Bechtel/United Utilities Catchment team had originally selected Barclays Capital to fund the deal with an unwrapped bond but unwrapped product jumped in price last year. It then decided to arrange a private placement with Barclays as the lead, and project adviser, and Abbey National, DNIB, Halifax and Prudential taking part in the placement. In essence the deal will be still be fixed rate but with the banks swapping back to floating rate. The development of PFI or public private partnerships (PPP) in Europe could open more opportunities for the private placers. Newcourt hired three of SG’s top infrastructure people in London earlier this year and is now about to launch a E750m fund to invest in PFI/PPP. The fund has three investors, Newcourt, one US and one European institution. The fund could provide fixed rate money in sterling or euros. It is not likely the fund can write huge amount of UK PFI business, particularly given how competitive the other funders are at present. James Stewart of Newcourt said he hoped the banks had reached rocked bottom in terms of what they currently offer, 30 year plus money at under 100bp. But he added with swap rates having jumped , Newcourt could still be competitive on price particularly in one off deals such as London Underground. In continental Europe, deal flow is not as pronounced but is picking up. Portuguese roads, Dutch ail and water, Brussels water are just an example. However even in some of these markets, not as yet developed, the banks are very competitive. In Portugal there is 20 year, 100bp mo9ney with fixed rates provided by the European Investment Bank (EIB). Local Dutch project loans have always been cheap. In Spain, the banks are very very competitive. Newcourt will be able to offer long tenor and flexible structures, as usual, and if Euro PPP takes off, there will be opportunities. Thus far it has proven difficult to get the institutional investors into European project market, in spite of the introduction of the Euro. Getting them involved is one of the challenges for European infrastructure in the next decade. Certainly the funds, across Europe, are there. Issue 181 PFI November 17 1999

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Bond issues are now a familiar part of the UK PFI/PPP scene, having been successfully used to finance major road, water and hospital projects. There are several major PPPs now starting to develop in Continental Europe which offer a substantial opportunity for competitive financing through the capital markets, but there are questions about how suited bonds are to the European PPP market and how quickly they will emerge. By Nigel Middleton, Project Finance Partner, PricewaterhouseCoopers. Since its formation at the start of 1999, activity in the Euro financial markets has outpaced that of the sterling and dollar markets. Compared with the first half of 1998, Euro corporate debt issuance in the first half of 1999 was almost four times as great, with a value of some E80bn. The Eurozone had a market share of over 50% of new issues worldwide, and therefore eclipsed the US/US$ markets. Altogether, at October 1999, there were over 14,000 Euro denominated bonds in issue. At first glance therefore, the Euro denominated bond market is most certainly large, and would be expected to have the depth and liquidity to finance a wide range of activities - projects as well as the corporate and financial sectors and government. The amount of Euro project debt yet financed through the capital markets is extremely low. The market is also characterised by much activity at the high investment grade level, and growing interest for high yielding issues. Over 70% of new issues this year have been Aa rated or above, a fairly constant characteristic. Sub-investment grade issues did not increase notably in the first part of 1999 (reflecting concerns following the Russian crisis), but several large corporate issues, particularly in the telecom and media industries, are currently planned, with the expectation of issues in 1999 exceeding Euro 20 billion, and substantially more in 2000. The European institutional market is still significantly fragmented with many players having strong national presence, but limited international reach. Their appetite is characterised by a demand for highly rated investment grade issues, with little resource to undertake more sophisticated analysis of less highly rated, less liquid issues. There are some small signs of movement here. As stable, low inflation economies in Western Europe result in consistently low yields on highly rated issues, there is increasing pressure for investors to seek value elsewhere. Project issues should be ideally suited to meet this demand, depending on how well inherent risks involved can be understood compared with higher yielding corporate issues. Another current characteristic of the Euro market is the short tenor of issues compared with sterling and US dollar markets. Of the Euro denominated bonds in issue at September 1999, over two thirds were less than 10 years, and only 3% went out further than 20 years. To a large extent, this reflects the requirements of, and the nature of, the issuers. However, most projects will require tenor of substantially greater than 20 years, and the Euro investor market will need to be able to demonstrate to project sponsors that this is achievable.

Connected with tenor diversification is the willingness of Euro investors to accept the comparatively poor liquidity of project bonds compared with other issues. Even though the markets are more developed, many long dated sterling and US dollar project bonds are not actively traded, with investors prepared to take a view on these investments as part of a long term portfolio. In the UK there is presently a severe mismatch between the supply and demand for long-term good-quality assets. The UK Government has decreed that pension funds must rebalance their portfolios as they mature, thereby increasing demand for long-term indexed gilts, just at the time when the Government is actually repaying debt. The Government can therefore create such long-term assets itself only by restructuring its existing debt. There is a clear opportunity for utilities and projects to meet this suppressed demand, which BG Transco has seized it with its recent issue.

CAPITAL MARKETS/EUROPE

Potential for Euro PPP bonds

The effect of EMU in the long-term is expected to be firstly a reduction in Government borrowing and secondly a shifting of both infrastructure and pension provision to the private sector. In due course we can expect the Eurozone to follow the UK trend. There are signs that diversification to longer tenor is emerging within the market, with the successful issue of some long dated Euro denominated government bonds. Although there is likely to be growing demand within Europe for long term, quality investments, particularly as the burden of pension and welfare costs starts to move from the state to the individual, institutional demand is currently patchy with real interest only being shown in a few countries to date, most notably the Netherlands. In summary therefore, whilst there are many potential attractions of Euro denominated project bonds to the investment community, the market is only slowly moving toward recognising the virtues of these investments. That a Euro denominated project bond market has not developed is not least due to the fact that in recent years, unlike in the UK, there has not been a regular flow of suitable PPP type projects to be financed. This situation is likely to change significantly in the next two years or so. During that time, there is expected to be some E20bn of projects taken forward in countries comprising the EU 11, or whose currency closely follows the Euro. In the Netherlands, there are a number of transport related PPP projects being taken forward, the most advanced of which is the High Speed Link currently due to move in to tender stage. AENOR, a real toll road in Northern Portugal has recently closed, with another real toll road project being developed.

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There is also a programme of shadow tolled SCUT concessions which has recently been extended. One of these has closed, and several others are at an advanced stage. In Spain, similar shadow tolled schemes have been developed in Madrid and are being considered by other municipalities. Elsewhere in Europe, there is considerable interest in road PPPs with real toll projects being considered in Poland, Italy, Germany and Greece. Airport development throughout Europe is increasingly likely to be dependent on PPPs with private sector investment facilitated by partial privatisation of state owned entities or through concession structures. The DM4-5bn of investment required in Frankfurt airport is likely to be funded in this way. Utilities will also increasingly resort to PPPs for operation and investment, particularly as regulatory pressures increase and the industries are forced to liberalise and become more competitive. In the Netherlands, the Delfland waste water treatment involving investment of E500m will be the largest BOT of its kind come to the market. A similar scheme is also being taken forward for the City of Brussels. Whilst the sporadic flow of PPP opportunities in the recent past may not have been seen as attractive, that is unlikely to be the case going forward. Whilst the advent of the Euro has opened up the prospect for a Continental European project bond market, it should not be forgotten that many projects have in the past been financed in the European market by a traditional combinations of project debt and sponsor equity. Many of the major lenders in the international project market are based in, and have been active in the Continental European market, and will continue to be so. In the last two years or so, direct competition between the major project debt lending banks and the international capital markets for UK PFI markets has led to changes in terms (including margins, cover ratios and tenor) offered by lenders in the sterling market. Many of the lenders active in the UK market are likely to be leading in the Continental European market as well, and so one can expect a similar response to any threat posed by the Euro capital markets. Furthermore, close corporate relationships exist between many of the major project sponsors in Continental Europe and lenders active in the market which lead to highly competitive terms for project type risks, which the capital markets will need to improve on in order to make ground. Favourable terms are not the only reason for bank rather than bond finance being preferred for recent European projects. Take for example, the privately financed road concessions which have recently closed in Portugal. Both the AENOR real toll road concession which closed in July, and the Beira SCUT shadow toll road concession, were bank debt funded. A major reason for this is a legal restriction on bond issues by Portuguese companies with less than two years trading history, making capital markets issues impractical by a newly created SPV. Whilst dispensations can be made by the government, pragmatism dictated that, in the cases described above, much greater comfort and certainty accompanied a bank financed approach rather than pioneering a bond issue in the Portuguese market. Many countries in Continental Europe follow civil code rather

than common law principles. In most cases in these jurisdictions, amendments to the law are required to facilitate the delivery of projects. Again, in most cases these can be implemented easily where there is a genuine desire by the government concerned to take the project forward. Necessary changes to the law were made to effect road PPP projects in Finland and Portugal, and are being considered for the A1 road PPP project in Poland. Unfortunately, little attention has been paid to date to making wider amendments to allow unrestricted financing in all cases via either bank debt and/or bonds. A further competitive disadvantage which capital markets issues currently face compared to bank debt is a feature of the steeply rising yield curve which typifies the Euro and the requirement of most investors for bonds to be structured wit immediate repayment of interest. Most of the PPPs currently being developed involve an initial construction and commissioning phase before the project will earn substantial revenues. Projects being funded by Euro denominated bonds will therefore suffer a high cost of carry (that is, the net cost of interest on surplus bond proceeds raised to service interest and capital payments required to be made before sufficient project revenues are earned). Euro project debt funded by banks can be drawn down over the construction phase thereby avoiding most of this cost, commitment fees on bank debt being much lower than the current spread on Euro denominated issues. In contrast, the current sterling yield curve (which rises sharply in the short term and then falls back) eliminates the cost of carry problem for long term projects funded in this way, making this a particular difficulty for the Continental European market. Similar difficulties have been overcome in the US market by the issue of deferred start bonds. In its comparatively early stages of development, such issues are unlikely to be a feature of the Euro denominated bond market, certainly at a price that is likely to be competitive. The creation of the Euro has been a vital step in the development of a Continental European project bond market. There are now signs of further changes (lengthening tenor of Euro denominated issues, and some highly attractive project financing opportunities) which could catalyse the emergence of Euro project bonds in the next year or so. At the same time, the Euro market will still be looking mainly for high investment grade issues (Aa and above). The monoline insurance will therefore be critical to the development of this market. Already well established in the UK, the main players here are already looking to the Continental European market as a real opportunity. The key question as to whether a Euro project bond market will develop quickly is competition from the major European banks. As noted above, simply structured Euro denominated bonds currently suffer a cost disadvantage compared to bank finance for projects where revenue is dependent on an initial construction and commissioning phase. In project refinancings, where the ‘cost of carry’ problem does not arise, the wide spreads on long dated Euro swaps currently make bonds much more competitive. For this reason, it is in refinancings that most Euro denominated capital markets issues are likely to be seen in the short term, and where the foundations for the |Euro project bond market will be laid. Issue 181 PFI November 17 1999

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The development of PFI in the UK has been something of a roller coaster ride. Launched in the mid 1990’s, initially in the face of strong opposition from Treasury officials and much of the public sector (as well as from large sections of the then Labour Opposition), PFI struggled to become established. It was only in 1995 and 1996 that transactions with significant capital values began to be concluded. By William Moyes and Ralph Eley, Bank of Scotland. The future for bond funding Looking forwad, are we likely to see bond funding predominate for larger PFI transactions? It is impossible to answer that question with any certainty. The public sector’s yardstick is primarily value for money, which they typically measure either by comparing the risk-adjusted year 1 price with their estimate of the comparable figure under public sector procurement or the discounted value of the stream of payments throughout the concession life, again compared with the equivalent stream of payments under traditional procurement. Construction cost and timetable, and services cost are both major determinants of the year 1 price and of the net present value of payments over the concession life. The cost of funding is not the dominant factor but it is important. Therefore, the balance between bank senior debt and bond funding will ultimately depend to a significant extent on the relative price of each. In current market conditions there is little to choose between the all in cost of funds for a wrapped publicly issued bond and for bank senior debt. In the wake of the 1998 credit shock gilt yields fell but have since recovered to pre-credit shock levels. Similarly, the swap rate rose sharply in the second half of 1998 but has since recovered although it still remains considerably above pre-crisis levels. There are, however, other features which have tended historically to improve the value for money of bond finance and thus its attractiveness to the public sector. Traditionally, bonds have been able to offer significantly longer maturities than has bank senior debt. However, as discussed below, the banks are catching up. Perhaps more importantly, the bond market has historically been more amenable to heavily sculpted profiles than the bank market, although again the banks are beginning to move in this direction. Perhaps the clinching arguments from the point of view of the public sector are two. First, bond finance can offer the option of index linking, which the banks so far have not been able to match. Index linking is attractive to those areas of the public sector, such as NHS Trusts, where income has historically tended to increase annually as a minimum in line with RPI. It suits such bodies if their main costs – wages and salaries, property costs and support service costs – follow a similar pattern. For these components of the public sector a flat annuity structure tends to be intrinsically unattractive. The annuity profile tends to generate payments in the early years beyond what

the public body will be currently spending, while the gains in the later years of repayment levels lower than what can by then be afforded are too far away to be of much interest. An index linked structure, which allows the public sector to match relatively closely its income and outgoings, is intrinsically attractive.

CAPITAL MARKETS/UK

The development of bond funding for PFI projects in the UK

There are, however, disadvantages for the private sector’s point of view. Indexation, even under conditions of very low inflation, tends to generate a profile in which for 2-5 years the aggregate exposure for funders exceeds 100% of the initial amount advanced. In conditions of what is now regarded as relatively high inflation (RPI = 5%), the total exposure substantially exceeds 100% for a significant part of the concession period. In transactions where compensation on termination equates to the total amount of the outstanding senior debt, the public sector could find itself facing a hefty bill if projects with index linked funding were to fail. However, under the Treasury Taskforce’s Guidance on Contractual Terms, there is scope for compensation on termination to be less than the full amount of senior debt outstanding, which must given the public sector some cause for comfort. However, if inflation in the UK ever returns to the high levels experienced during parts of the last twenty years, index-linked structures are likely to be unsustainable. A second significant argument for the public sector in favour of bond financing may be that there is generally little or no scope to create upside gains from refinancing after construction. The concept of investors enhancing their returns by refinancing projects once they have demonstrated satisfactory performance in the operational phase is never one that the public sector has been entirely comfortable with, although it has had to accept. It has coped by negotiating a variety of upside sharing arrangements. However, from the point of view of demonstrating value for money and of the public presentation of transactions, the public sector will be a lot more comfortable with funding structures which will usually offer the certainty of a lower year one price rather than the possibility of refinancing gains of unknown scale or timing. A criticism levelled at bond finance is its lack of flexibility. Senior debt providers often argue that in a few years time, when some PFI projects inevitably have experienced problems, the limitations of bond finance will be more apparent. This may well be true. It may well be a great

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comfort to a public sector manager to know that, if he is facing severe financial problems, he can lean on the concession company to reduce its payments for a period by restructuring the funding of the project. It can of course be argued that the public sector has contractual obligations to pay, which it cannot avoid. So it does. But, in the face of pressing financial difficulties the public sector will behave like any commercial organisation and ask its funders to be accommodating. PFI project companies may well find that the very flexibility of senior bank debt can be a problem for them and that there may be comfort in being able to tell the public sector that bond repayment schedules are not renegotiable and that any attempt to do so is likely to lead to a project default and to a demand for compensation. Another important consideration – and one which is becoming increasingly influential – is confidence on the part of the public sector that bond finance can be delivered. My impression was that early in the life of PFI the public sector was sceptical about the relevance of bond finance. The financial structure, the project documentation and the disclosure requirements all seemed excessively complex. Moreover, because discussions were with intermediate organisations rather than the final lenders, there was doubt about whether the deal would eventually conclude. These uncertainties coupled with the higher initial costs of bond funding left the public sector unsure whether the benefits were worth the difficulties. Although the balance began to shift in favour of bond finance as the financial benefits became clearer, it was only in the early part of 1998 that the Department of Health in particular began almost to assume that bond finance should be the funding route of choice for the larger hospital projects. The use of bond finance for the Stirling Water deal in March of this year confirms that confidence in the use of bond funding is now well-established. The next phase will perhaps include establishing bond funding can be used for smaller projects and whether the market will return for unwrapped issues.

The impact of bonds on the bank debt market Developments in bond finance have had a real impact on bank senior debt, wholly to the advantage of the public sector. In the early years of PFI bank senior debt maturities were seldom greater than 20 years. More recently the trend has been toward tenors of 25-28 years. At the time of writing it seems that the competition to fund the Treasury Building has driven tenors out beyond 30 years. Similarly, on pricing, until well into 1998 margins of 120bp during construction and very little less during the operating phase were not uncommon. But during the course of this year, the pressure on margins has been intense and it is now not uncommon for banks to quote a margin of 100bp or less during the construction phase and of around 90 basis points during the operational phase. Again the Treasury Building has apparently pushed margins down further. This trend is despite the concerns of funders that the compensation

arrangements in the Taskforce guidance on contractual terms offers no certainty that senior debt will be paid out in full if the project company defaults.

Wrapped or unwrapped? If current evidence suggests that for larger projects bond finance is likely to prove an increasingly important source of funding, what is less clear is what balance will be struck between wrapped and unwrapped public issues and between public and private placements.The emergence of unwrapped publicly issued bonds was stopped in its tracks by the credit shock in the second half of 1998, and so far unwrapped bonds have not re-emerged as a significant source of funding. The credit shock added 50bp onto the spread for a wrapped publicly issued bond. For unwrapped bonds, the impact was of the order of 90bp on the spread. Although spreads have fallen back a little, the underlying cost of funding of an unwrapped bond will in most cases still make it uneconomic. But for that, it is a fair bet that the unwrapped and private placement markets would have been stronger than seems likely to be the case for the foreseeable future. The two monoline insurers active in the UK PFI market (MBIAAMBAC and FSA) have acted in many ways as a central research unit for the institutions, who do not generally themselves have the capacity to analyse individual transactions in the degree of detail and over the period of time that has been required for the initial PFI transactions. The monolines have been successful in analysing, shaping and presenting to the institutions the nature of PFI transactions. This coupled with the reducing levels of gilt issuance and the higher returns available from project bonds as compared to gilts, have created demand on the part of institutions for PFI project bonds. But for the 1998 credit shock, the chances are that the institutions would by now have felt comfortable enough for unwrapped public bond issues or private placement issues to have grown from their current very low levels. But for the moment, there is no sign that that is the case and it seems likely, therefore, that bond issues over the next 1-2 years will be dominated by wrapped public issues. There is currently limited appetite on the part of institutions for unwrapped paper. In 1999, half the new sterling bonds issued have so far been AAA rated and that situation is likely to continue for the foreseeable future.

Conclusion Although bond finance is currently a small proportion of the total funding requirement for PFI transactions, it has influenced the market and it has established itself as a competitive and reliable alternative to senior bank debt. It has firmly established itself in the health sector and probably would have done so in the transport sector had the flow of deals not been restricted by changes of policy after the General Election. It will be interesting to see whether bond finance can make inroads into sectors of the PFI market such as property, local government and the smaller health deals, which in the longer term will all be significant in aggregate. Issue 181 PFI November 17 1999

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