Project Finance & InsurancePF Bond Market: Final Comments

Bauer College of Business

Professor S.V. Arbogast

Class 10: Spring 2005

Discussion Topics

• Project Finance and Insurance– Standard Coverage

– Negotiating Points with Lenders

– Special Issues

• Final Comments on PF Bond Market– Markets & Ratings

– ‘Wrapped’ Offerings

• Petrozueta Case Redux

Project Finance and Insurance

• An Insurance Package is essential to complete Project Financing– Since recourse to sponsors ‘drops away’, insurance is needed to protect

lenders security (cash flow and assets)

• Lenders seek basic insurance package as operating companies– Material Damage (property) and Freight/Cargo (when shipping goods)

– Third party liability

– Coverage required by local regulation (e.g. Workmen's Compensation)

• Will also seek coverage that operating companies often forego– Business interruption

– Political risk

– Sabotage and Terrorism

PF and Insurance: Some Principals

• While PF ‘allocates’ commercial risks, force majeure risks that usually are ‘contractual exceptions’ must be insured– E.g. accidents, disasters & Acts of God, war & violence, political risks

• Coverage must be sufficient to allow loans to be repaid out of proceeds or reconstitute the project

• Cover must be insured or reinsured into hard currency and payable into ‘offshore’ escrow accounts

• Sponsors are ‘named insured’ and Security Trustee is ‘additional insured’– In case sponsors ‘walk’ or default

PF Lender’s Approach to Insurance differs from Operating Management

• Lenders’ view is ‘not an equity investor; return is limited; absolute protection of collateral against loss is essential’– Operators’ view is ‘balance insurance protection against cost to

maximize long term profit’

• Consequently, lenders press for:– Broadest array of policies

– Maximum policy limits

– Minimal deductibles

– Minimal sponsor choice on adjusting coverage

• Lender’s approach broadly antagonistic to operators approach

Two Other Lender Requirements that Vex Operators

• The Insurance Consultant: Typical IC Covenant

“To appoint a common Insurance Consultant on behalf of the Senior Lenders and reimburse the Senior Lenders for the reasonable and documented fees and expenses of the Insurance Consultant incurred in connection with certain expressly identified activities”

• Required coverage is then ‘set’ at time of loan closing, per recommendation of IC– Why is this a problem? See below

Operator’s Typical Approach to Insurance

• Insure against catastrophic loss, i.e. loss the firm can’t bear– Not insuring against everything that might go wrong

• Insure Maximum Probable Loss, not Maximum Possible Loss or Site Replacement Value

• Use deductibles and ‘vertical slices’ to share risk with insurers

• Review policy coverage annually and adjust cover in response to market conditions

Where will these principals conflict with Lender’s approach?

Lender vs. Operator Approach to PF Insurance

• Operator approach– Insure catastrophic loss

– Insure Max. Probable Loss

– Use deductibles to manage cost of cover

– Adjust policies to market conditions

• Lender approach– Insure loan collateral; assume

sponsors will not cover losses

– Set policy limits to assure debt repayment

– Minimize deductible to amounts which project company can fund under distress

– Retain necessary cover to protect collateral and pay what that costs

An Example

• Firm A builds $1 G chemical plant, using $700 M PF– Assesses Maximum Probable Loss to be from explosion in steamcracker; cost of

reconstruction = $400 M– Normal property cover would be:

• $400 M policy limit with $50 M deductible• No business interruption insurance• Adjust limits and deductibles annually

• Lender position:– Seek $700 M policy limit, $1 M deductible– Full business interruption insurance– No adjustments to limits or deductibles until loan repaid

• Implication is added cost for project, which lender sees as ‘necessary transaction cost’

– Another ‘disguised’ cost of PF

Another Example

• Situation: Sponsor gives completion guarantee to lenders– Insurance package required to meet completion test

• (Certificate from independent consultant that insurance is in place)• Coverage limits and deductibles set at loan closing

• Two years later, project completes but insurance market is in turmoil– “Normal” cover now very expensive

– Operators would normally reduce limits and raise deductibles to control costs until market stabilizes

– Lenders expect full package to be implemented or loan stays recourse

• Borrowers thus should try to obtain ‘Material Adverse Change’ or Market-Flex type clause in order to adjust insurance

Sponsor Tactics to Manage Insurance Costs

• Negotiate Hard: Lenders will accept ‘economic approach’ to cover– MPL approach to property limits– Deductibles which project company can afford– Limits that reduce as debt is repaid– Business interruption insurance not needed, too expensive

• Somewhat ‘fungible’ with DSRA

Other Tactics/Terms• No requirement to purchase insurance not available on commercial rates/terms

– Dispute on ‘reasonable’ referred to expert arbitration

• Sponsors should be able to aggregate project insurance with non-financed associated projects to lower costs

• Sponsor should have clear right to use proceeds to rebuild facilities– Sponsors must satisfy Security Trustee that interim expense, including

debt service, will be covered – otherwise, proceeds used to repay debt

Sponsor Tactics, continued

• If Sponsors have Captive Insurance Company of good credit:– Consider having Captive provide required coverage on terms negotiated

with Banks

– Captive Insurer then reinsures with 3rd party market only those risks it would normally insure outside

– Captive should only insure up to sponsor’s % ownership• E.g. if sponsor owns 50%, Captive can write 50% of each policy

• Captive ‘cover’ is effective to ‘neutralize’ high cost of conventional insurance, e.g. business interruption that can’t be avoided

• Captive should not be used to underwrite risks unavailable in commercial market on commercial terms

Special Issues: Sabotage & Terror

Sabotage and Terror Cover• Since 9/11, lenders have asked for S&T cover for project finance

– Coverage has been limited and very expensive

• Increasingly Sponsors have been resisting as ‘not available on commercial terms’– Successful so far because no loan has defaulted due to terror attacks

“Friendly Local Insurance Firm”• Local governments say Project Financing insurance must be placed

through local firms (owned by friends); premiums = local retention!– Replace by sponsor guarantees, paid for by project, then reinsured

offshore

Other Uses of Insurance in PF

• Political Risk Insurance– Enables banks to lend when either:

• Don’t have country limit or• Deal uneconomic because of uncovered capital requirements

– Generally covers expropriation, political violence, convertibility/transfer risks• Public Sources: OPIC, MIGA, some ECA’s

• Private Sources may also cover contract abrogation– Some reinsure MIGA (Lloyds); others write primary cover (AIG, Zurich, Chubb)

• Credit Enhancement– Insurers will provide commercial risk cover that enables Rating

Agencies to provide higher Debt Ratings for bond offerings

PF and Insurance: Conclusions

• Tends to be treated as Very Important by Lenders and ‘A Detail’ by Borrowers– Borrowers find out later when bills come or can’t meet completion test

that should have ‘Read the fine print’

• Many strategies available to control PF insurance costs– Use of Captives to write cover is a form of co-lending, so sponsors

should not underwrite risks they normally would insure outside

• Insurance can be used in sophisticated risk mitigation strategies that also enable other financing objectives to be achieved– Get banks to meet project leverage targets

– Get into the bond market

Final Comments on Project Bond Market

• PF Bond Market has 4 segments– Private Placement

– SEC Registered

– Rule 144A Private Placement

– 144A ‘High Yield’

• Most PF Bonds are 144A Private Placements sold to Qualified Institutional Buyers (QIB’s)– Requires Ratings and substantial public disclosure in Offering Circular

• 144A Deals can be executed fast (4-6 months)– ‘How soon can you get 2 Ratings?’

– No need for SEC level disclosures and clearance for Registered deal

PF Bond Offering Circular

• Resembles Syndicated Loan IM

• Requires:– Audited financials by Public Accounting Firm

– Third party expert assessments of:• Risk factors and business plan assumptions• Project viability, commercial potential and timetable

– Independent expert reports on such matters as:• Reserves, marketing/transportation, environment, technology & insurance

– Disclosure opinion from sponsor’s legal counsel

– Management analysis of financial performance and outlook

Some Other Pros/Cons of PF Bonds

• Pros– New capacity for PF loans

– Major public relations exercise for host country Sponsors

• Can open markets for other financings, improve other ratings

– Ratings Process brings some measure of political protection & risk mitigation

• Bad behavior reflects back on Sovereign and state company credit ratings

• Cons– Lump sum drawdown often

creates ‘negative carry’ on cash

– Costs fees to get/maintain ratings

– Extensive public disclosure of proprietary information

– Not easy to prepay and refinance PF bonds

– Bond markets can shut with little/no notice

Rating Agency Strategies

When Approaching the Rating Agencies:

1. Make case for the highest possible rating • Don’t aim for minimum IG if higher is conceivable

2. Anticipate and address major risks/concerns up front– Especially sovereign risks, DSCR/DSRA, Limits on Security

3. Make the case why the project is strategic to the sponsors• But also make clear why financing must be non-recourse

4. Present analysis of comparable deals with the desired rating– Qualitative & quantitative assessment

• Prepare to respond to ‘Preliminary Rating’ w/appeal, negotiation– Have a ‘credit enhancement’ strategy in reserve

PF Bond Credit Enhancement

• Specific risk ‘Carve-out’ for Sponsor support (discussed last time)

• Alternative is to ‘Wrap’ bonds w/insurance from Bond mono-line insurer (as is done with tax-exempts)– Can achieve high rating and limit public disclosure

– Expensive and considerable due diligence by insurer

– Less precise/flexible than sponsor risk carve out

• Can also go with one rating or split rating– Probably means high yield issue and 1%+ higher interest cost

• Choice of Agencies to approach are broader than Moodys/S&P– Fitch, Duff & Phelps gaining some ground in niche markets

Introduction to Petrozueta C.A. Redux

• Do you believe the borrowers have been executing a fully thought-through financing strategy? (Did they have a Sponsor Finance Plan?)

– Is this a strategic financing

– Do they have an assured finance plan?

– Do they have leverage for their negotiations?

• Would you have reorganized the borrowers’ approach to executing in these markets (What should a SFP have included?)

– What are they doing well, not so well?

– What do they need to do now to improve their chances of success?

Analyzing the Petrozueta C.A. Case

Project Background & Context1. Timetable2. Sponsor fallback plan & tactics in

reserve3. Political Risks4. Venture structure5. Completion support & tests6. Sponsor commercial support7. Offshore accounts and

DSRA8. Reason to do Project Financing9. Project Capital Structure

Project Finance Plan10. Equity funding plan11. Initial debt funding plan12. Reasons to consider PF bonds13. Sovereign ceiling issue &

comparables14. Rating agency risks to anticipate15. Case and Story to Rating Agencies

Financial Issues:1. Is Petrozueta likely to get IG rating?

– Key RG concerns?

2. Consequences of Fallback plan?3. Strategy to negotiate with RAs?

– Reserve tactical concessions

4. Other options?

What Should the Petrozueta SFP have included?

• On Must-have objectives?

• On Challenges?

• On Tactics?

What Should the Petrozueta SFP have included?

• On Must-have objectives?– Decide if must have non-recourse financing during construction, or if

refinancing at project completion is satisfactory– If must have, need tight coordination of project schedule with finance plan

• On Challenges?– Bank/PRI/MLA timetable puts schedule in jeopardy– Bond market solution involves piercing Sovereign Ceiling

• On Tactics?1. Approach bond market first and early

2. Package of sponsor limited supports to negotiate w/RA’s– Price floor on offtake; PdVSA escrow cash offshore for equity and ‘early oil’ shortfall

3. Plan for Sponsor construction loans to top up equity if PF not ready

4. Negotiate with OPIC/WB that must act quickly or deal will go to bond market, now or later

Next Week & Thereafter

• Next Week:– Lecture on Executing w/ECAs & MLAs

– Introduction to ‘An Ex-Im Loan for Soro Dondar’

• Final Week:– Case Presentation

– Review for Final Exam