Looking at the year ahead, Cynthia Urda Kassis of Shearman & Sterling assesses the appeal of refinancings, restructurings and reprofilings transactions in a market with liquidity constraints.
This year, the consequences of several years of liquidity constraint across many of the industries that have been the main users of project finance are combining with other market forces, such as depressed commodity prices in the oil and gas and mining sectors and reduced usage, due to the economic downturn in the transportation sector. As a result, we may well see greenfield project financings significantly outweighed by refinancings, restructurings and acquisition financings accompanying corporate reprofilings (as corporates shed non-core assets or bring in partners to de-risk their core assets).
Immediately following the financial crisis in 2008, liquidity in the project finance sector from commercial banks, traditionally one of the main sources of such financing, nearly disappeared. Between the financial institutions, which were liquidated or absorbed by others, and those that exited the project finance product, limited funding remained available. Conditions have since significantly improved as a number of banks have re-entered the market, and those that never left increased their lending activity. Although the market has recovered significantly, the availability of long-term funding remains well below the levels pre-2008. The availability of long-term funding is further constrained for larger projects, because for such projects the number of banks required to participate is significant. The continued unwillingness of banks to underwrite significant amounts means that most project financings today are club deals. In such a structure, the tenor of the financing is determined by the “lowest common denominator”. Thus, to the extent there are insufficient banks willing to lend long-term, the tenor will be determined by the shorter tenors required by the banks needed to fill out the club. For the larger projects, this is a particularly acute issue.
To address this reduced availability of long-term funding, the market has turned to mini-perm and bridge structures and adopted them for use in funding greenfield projects. This has introduced a number of concerns among the main players in the project finance market. Sponsors are concerned with the refinancing risk which such structures introduce including not only the ability to find refinancing when needed, but also the interest rate risk associated with such refinancing. Export credit agencies and development finance institutions that lend side-by-side with the commercial banks are concerned regarding the above, as well as the general instability which having a mini-perm or bridge facility next to their long-term loans introduces and the related intercreditor issues.
Notwithstanding the above concerns, the liquidity gap which arose in the market post-2008 and continues in effect today has resulted in an acceptance of the use of mini-perms and bridge loans to fund greenfield projects. Although a number of sponsors took advantage of market conditions in 2014 to execute refinancings in the bond and bank markets, a number of mini-perm and bridge facilities remain which will reach a stage in 2015 at that refinancing is either required or recommended. Thus, we may well see a number of such facilities rollover this year.
Metals and Mining Industry
The consequences of the liquidity constraints in the traditional funding sources for the metals and mining industry (being mainly the commercial bank and equity capital markets) over the past several years has resulted in the need to develop non-traditional funding solutions to finance greenfield projects in the sector. Rather than turning to mini-perms and bridges, the sector has turned to the so-called alternative sources of financing. These alternative sources include streaming and royalty financings, private equity debt and equity solutions, the high yield bond market, funding provided by commodity traders, strategic investors, sovereign wealth funds, state-owned enterprises and corporate users of the relevant commodity as well as construction contractor financing.
As a result of the availability of funding from these alternative sources together with the available funding from traditional sources, greenfield development continued in the sector at a fairly exurberant rate during much of the period since 2008. However, the precipitous decline across the board in commodity prices in the past couple of years (including a drop to historic lows for iron ore, near-lowest prices in a decade in copper and coal, and anaemic precious metals prices), with no upturn anticipated in the near term, has put a number of companies in this sector under significant financial strain. This includes a number of companies which only recently concluded greenfield project financings. As a result, the market is seeing a number of restructurings and even some insolvency filings by companies in this sector including project companies. It is quite likely that more will follow this year if commodity prices remain depressed and liquidity constrained.
It will be particularly interesting to see how the alternative sources of financing which were developed over the past eight or so years in this sector behave in this general market downturn and as the specific assets in which they have invested come under duress. It will also be interesting to see how a variety of their terms and structures are analysed and addressed by insolvency courts in the various key jurisdictions. Unlike the traditional sources and structures used in project financing with which we have significant experience in distressed scenarios, the alternative sources are all so recently developed that we have no or limited such experience.
Oil and gas sector
Another industry sector which is a traditional user of project finance, the oil and gas sector, is also struggling with depressed prices. After a long period of price stability, the oil and gas sector has entered a turbulent period in which prices have dropped dramatically. The result, like in the metals and mining industry, has been to put in question a number of the mainly upstream projects which are viable only when the price per barrel of oil is much higher than it is today. For example, for US-based “fracking” projects, a break-even price of closer to $80 per barrel is required – compared to the $65 per barrel price currently in play. The Canadian tar sands sector has been similarly impacted.
Like the metals and mining sector, the oil and gas sector is very capital-intensive. Ongoing investment for exploration, development and expansion are fundamental. Notwithstanding the omnipresent need for liquidity, some companies in the sector (outside major national oil companies and supermajors) have limited financial reserves on hand. Many projects financed in the past five to eight years, both upstream and mid-stream, relied on substantial leverage as a result. With the depressed prices, such companies and projects may come under pressure. Like in the metals and mining industry, restructurings and insolvencies have become increasingly common. Popular industry publications regularly publish “watch lists” of companies or projects likely to need restructuring or which they predict are heading into an insolvency.
At least in the United States, the effects of the economic downturn which followed the 2008 financial crisis continue to unfold not only due to the consequences of the ongoing liquidity constraints, as in the industries indicated above, but in other industries as well. As the decline in economic activity drags on – improving steadily but over an extended period, the traffic projections and therefore anticipated revenues in the toll road sector in the US are proving to have been overly optimistic by a wide margin in a number of cases. As a result, the clock has run out on several of those projects in the past 12 to 18 months and a number of others are likely to follow in 2015.
This experience is not unlike the experience in Asia, after the Asian financial crisis which began in the late 1990s; or the experience in the global port sector of several years ago. As commerce declined following the 2008 crisis, the different links in the global transportation chain began to suffer: first the port sector, and now the toll road sector in the United States. In both cases, the companies were burdened with significant leverage which ultimately has proven unsustainable under the new market conditions. Consequently, major restructurings and even insolvency proceedings will likely be required to address the consequences.
As a result of the financial pressure on companies in the commodity industries, as well as the ongoing liquidity constraints in the market particularly for companies in these industries, a number of the larger companies have turned inward to examine their portfolio of assets and determine whether it is appropriate to dispose of non-core assets to raise liquidity. In addition, some have determined that bringing on partners as co-investors in their core assets is an efficient way to raise funding. Finally, a number of companies in significant distress are finding or are soon likely to find they have little choice but to sell assets if not sell themselves. These reprofiling transactions began to surface in the market in 2014, but are likely to increase in 2015.
These reprofiling transactions create interesting opportunities for mid-tier and in some cases major companies in the sector and financial and other investors to acquire quality assets at prices below the highs seen in recent years. In situations in which the seller is particularly distressed it may even result in some bargain purchases. Given the recent history in these sectors, savvy investors will need to examine closely not only the traditional fundamentals of businesses and projects in these sectors, but also the consequences of the liquidity constraints of the past several years. Those consequences take the form particularly of the various alternative financings and other transactions executed to address the liquidity gap. These financings and other transactions could well affect the valuation of the company or asset, its borrowing capacity and the flexibility available to affect a restructuring.
Refinancings, restructurings and the acquisition and other financings which will accompany reprofiling transactions are likely to keep those in the international project finance legal community quite busy in 2015 – busier than greenfield financings. Certainly in the case of restructuring and reprofiling transactions, they will no doubt prove intellectually very interesting as the traditional project financing issues are focused on from a new vantage point, and as the new sources and structures for financing projects in these industries accessed and developed to address the liquidity crisis following 2008 are tested in a distressed environment.