Interview: A glass half full

Author: Danielle Myles | Published: 1 Dec 2012
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If you are a sponsor looking for finance, you’ve no doubt seen better days. Here’s the bank counsel’s perspective on how to navigate today’s market

Gavin Skene is an executive director at Morgan Stanley responsible for providing legal coverage to the firm's global project, commodity and infrastructure finance desk, which has been principally focussed on US and LatAm projects over the past 12 months. He spoke withIFLR on why project bonds are the way forward, how renewables will spur innovation, structuring in light of scarce bank liquidity, and the world's most successful public private partnership (PPP) programmes.

IFLR: What factors do you see spurring innovation in project finance over the next two years?

As a general matter, the uncertain economic climate – contributed to by the lingering eurozone crisis, impending debt maturity wall faced by many corporates, and looming US fiscal cliff set for the end of the year – will no doubt cast a shadow on the years ahead. As a result, I think there will be increasing momentum to finance projects in the capital markets, rather than in the traditional bank markets. But looking at innovation in project finance specifically, I think we'll see three emerging themes.

First, there is a huge, global and immediate need for infrastructure development. There is, of course, a serious lack of money at the government level to pay for this. So there will be – or in the US they are hopeful for – stronger development of PPP models. I think that will simply be a necessity to meet these infrastructure needs.

Secondly, the growth of international energy consumption markets, combined with relatively low gas prices, means that we are likely to see a stronger emergence of LNG [liquefied natural gas], gas to liquids, and regasification projects – at all levels of the upstream/downstream spectrum. We have been working on a number of projects in this space and expect the trend to continue over the next 12 months given the price and demand for gas.

Finally, I also think environmental policy will shape the next couple of years, certainly with respect to the impact of carbon emission trading schemes. Overall, I think this will foster greater development in the renewable industries. On the innovation front, there may be an opportunity for the development of co-build facilities – being the combination of fossil fuel and renewable energy generation at the same site – leading to a more valuable and sustainable product.

IFLR: You are a proponent of project bonds. Don't bondholders' aversion to construction risk and decision-making difficulties present hurdles to the instrument becoming a mainstream source of funding?

I think it's largely a myth that these risks are impediments to the success of project bond financings. Over the last five to 10 years there is an established track record of large greenfield projects in different sectors – from PPPs in Canada, to LNG projects in the Middle East – that have successfully used project bonds. Bondholders have become increasingly adept at assessing these risks and measuring the strength of any mitigants in the same way as project bank lenders.

That said, it does, however, somewhat depend on the type of the bond investor and market. For example, Rule 144A institutional investors typically take a more passive approach, and are increasingly happy to defer their decision-making responsibilities to independent third parties (such as an independent engineer), bank lenders in bank/bond financings (on the theory that whatever is good for the bank lender is also good for them), or upon the receipt of a ratings affirmation. However, by contrast, investors in the 4(a)(2) private placement market (usually insurance companies and pension funds) typically wish to take a more active role in the credit, meaning that the instrument becomes more like bank paper than bond paper – they want a heightened degree of control and reporting. I've recently worked on a transaction where the sponsor started with Rule 144A styled papers with broader covenants, but the 4(a)(2) private placement investors – once they get involved – started beating them back towards a set of bank papers.

Overall, I think the instrument will only increase in popularity as a viable source of capital in the financing of projects as years go on.

IFLR: Basel III capital charges have forced many banks to scale back their long-term lending programmes. How can sponsors structure their projects to attract the limited bank liquidity that remains in the market?

Basel III is one part of it. The general economic overlay surrounding the eurozone crisis, contraction in European project bank lenders (which have historically been the backbone of much of the market), and other regulatory capital legislation like Dodd-Frank have also had an impact. Taken together, that means a scarcity of bank finance, and limited ability to deploy what is left for long tenors – resulting in shorter dated tenors and a reduction in available capital. Perhaps one exception are the Japanese lenders. For the right project and the right sponsor (usually Japanese), many of them are willing to lend for the longer tenors that we saw pre-crisis.

But on the whole, sponsors have to think long and hard as to how to structure their projects with limited bank capital available. If you can't employ the use of bonds, say because of the cost of the negative carry, I think it can be increasingly difficult. Structurally, sponsors will need to ensure their project has sound economics, so in energy projects there will be a very high emphasis on fixed price take-or-pay without any merchant risk. I think you will also see for traditional bank debt a shift towards tighter covenant packages, along with mechanisms such as Libor [London Interbank Offered Rate] floors to protect pricing. But it will largely be relationship driven, so first time borrowers or soft sponsors will find it difficult.

If project bonds, however, can be introduced into a capital structure, another option is for borrowers to utilise a short-dated amortising bank tranche and a longer-term bond (or the ability to later add bonds to refinance the bank tranche or supplement the capital structure), with the bond proceeds being applied before the bank proceeds. Nevertheless, the use of a short-dated bank tranche does expose a sponsor to refinancing and market risk down the road – but at least post-construction.

IFLR: Where in the world do you see the most effective PPP programmes and what factors, in your view, have contributed to their success?

UK, Canada and Australia are probably the top three on my list. I've personally worked on some extremely successful programmes in Australia, largely because there was a clear and transparent government mandate and process to get it done. Execution has been swift and risk has been appropriately transferred from the government to the private sector, and there has been a clear set of principles to achieve that outcome. A successful PPP programme will also provide for alternatives to a pure availability-based pricing model, meaning that demand risk for the asset can be fully transferred to the private sector.

The US, by comparison, seems to have fallen behind the rest of the world due to a host of systemic and political issues. Optimistically, I see this improving over time, but historically there has been a lack of political will and a cohesive framework of PPP enabling legislation at the state level. One bright light, however, has been the US federal Tifia programme [Transportation Infrastructure Finance and Innovation Act], which provides qualifying transportation projects with cheap, subordinated financing. It's not designed to be a permanent piece in the capital structure, but it has been incredibly effective in bridging the gap for many US tollroads in reaching financial close.

However US military housing privatisation as a unique bright spot for PPPs in the US. The programme raised more than $20billion using innovative financing structures in a highly efficient fashion.

IFLR: Renewable energy is often criticised as being prohibitively expensive. Is it feasible for clean power to rival fossil fuel generation?

In the near-term, for renewable energy generation to be cost-competitive with fossil fuel generation, those industries will continue to rely heavily on government subsidies, either in the form of feed-in tariffs or tax credit programmes. I think what has dogged the industry, certainly in the US, has been the lack of clear and established policy on how to support these industries on a long-term basis.

For example, the US federal production tax credits for wind facilities is set to expire at the end of this year. While the market is cautiously optimistic, no one knows if Congress is actually going to renew the programme. In context, the programme has already expired three times in the past, with Congress retroactively extending it several months later. All of this has placed the wind industry in a state of flux. These legislative uncertainties make it difficult to create an established and cost-effective renewable energy industry – especially in solar and wind. While technology and production cost efficiencies are improving, uncertainty over the receipt of government subsidies also puts the renewable manufacturing chain at risk, as it's forced to stop and start every time there is a change in policy.

Nevertheless, over time, I think that we will see a converging trend in the cost of renewable and fossil fuel generation. For example, there are certain markets in which the cost of peaking power in solar and wind is cheaper than fossil fuel generation. However, given the relatively low price of gas at the moment, this trend may be slow coming.

IFLR: What is the ideal private practice lawyer/bank counsel dynamic when working on a project financing? What can they do to be most useful to inhouse?

Like most things in life, it's open communication and establishing a relationship of trust, which naturally evolves over time and after having worked collaboratively on a number of transactions. Project financings are inherently more complicated than other types of corporate financings, such as leveraged acquisitions. They involve a larger suite of documents and complexities that aren't inherent in mainstream corporate financings. In addition to the project finance desk, I also cover two additional desks within the firm's global capital markets, all of which could have up to 15 transactions going at any one time. It means that you can't be on every call or across the drafting of every document, so you rely heavily on your external lawyers to steer the ship in a way that protects the firm but is also constructive in getting the deal done. In short, you are really reliant on your external lawyers to be your eyes and ears, and have the right measure of legal and commercial acumen to meet the firm's and its client's objectives.

IFLR: Reflecting on your career, what is the most interesting project you have worked on?

I've been practicing for 12 years throughout Asia, Australia and now New York, but I think one of the more interesting projects was a gold loan for a Papua New Guinea gold mine in 2005. The loan was actually in bullion (with a small revolver alongside) and was repaid in bullion – providing a natural hedge to the project. The general loan agreement had to be recast to provide for actual delivery and other legal aspects that we'd not had to consider previously.

Even aside from that, it was an interesting and complicated project. It involved political risk insurance placed in the commercial market, the need for a complex swap overlay to take out an existing swap, plus all the other legal and commercial issues that come along with constructing and operating a mine in PNG.