|
Project Finance CDOs: What? Why? Now? By: J. Paul Forrester, Mayer Brown & Platt, March 2001 Project finance collateralised debt obligations (CDOs) will allow portfolio investors a greater opportunity to participate in power and other infrastructure debts markets. This article reviews the structures and features of a CDO, and why project finance debt is an attractive asset for a CDO. What? Collateralised debt obligations (CDOs) and its more specific siblings, collateralised bond obligations (CBOs) and collateralised loan obligations (CLOs), are a successful application of sophisticated securitization techniques originally developed for collateralised mortgage-backed securities (CMBS) to facilitate the resolution of the Savings and Loan crisis in the US in the 1980s. According to Moody's, there were over US$120bn of CDOs in 2000, making CDOs the second largest type of asset-backed security (ABS) after credit card ABS. The core concept of CDOs is that a pool of defined financial assets will perform in a predictable manner (that is, with default rates, loss severity/recovery amounts and recovery periods that can be reliably forecast) and, with appropriate levels of credit enhancement applied thereto, can be financed in a cost-efficient fashion that reveals and captures the arbitrage between the interest and yield return received on the CDO's assets and the interest and yield expense of the securities (CDO securities) issued to finance them. Each of the recognized rating agencies (Fitch, Moody's and Standard & Poor's) have developed CDO criteria and statistical methodologies and analyses to "stress" a pool of CDO assets to determine the level of credit enhancement required for their respective credit ratings for the CDO securities to finance such pools. Typically, CDOs require the CDO assets to meet certain eligibility criteria (including diversity, weighted average rating, weighted average maturity and weighted average spread/coupon). A CDO will allocate the interest and principal proceeds of such assets on periodic distribution dates according to certain collateral quality tests (typically an overcollateralisation ratio and an interest coverage ratio). CDO securities are usually issued in several tranches. Each tranche (other than the most junior tranche) has a seniority or priority over one or more other tranches, with "tighter" collateral quality tests that are set to trigger a diversion of interest and principal proceeds that would otherwise be allocable to more junior tranches that will then be used to redeem or otherwise retire more senior tranches. The resulting subordination of such junior tranches constitutes the required credit enhancement for the more senior tranches and allows the CDO securities of such senior tranches to receive a credit rating that reflects such seniority or priority. Some CDOs utilize insurance "wraps" for the same effect. CDOs often allow principal proceeds to be reinvested in additional eligible CDO assets during a specified reinvestment period. In addition, the CDO is usually managed by a collateral manager, who must identify eligible CDO assets and monitor them for the CDO. Most CDOs allow a portion of the CDO assets to be traded annually, which allows an adept collateral manager to enhance the arbitrage opportunity of the CDO. Generally, CDOs are either "balance sheet" CDOs or "arbitrage" CDOs. Balance sheet CDOs are transactions structured as "sales" for accounting and regulatory capital purposes but are "debt" for tax purposes. Commercial banks use balance sheet CDOs primarily for portfolio management and regulatory capital efficiency. By contrast, arbitrage CDOs are structured as sales for all purposes, including tax. Arbitrage CDOs are either "cash flow" CDOs or "market value" CDOs, and are distinguished by an overcollateralisation ratio determined by reference to the par or principal amount of the CDO assets (adjusted for defaulted CDO assets), in the case of a cash flow CDO, or to the market value of the CDO assets, in the case of a market value CDO. Typically, a market value CDO will require more equity than a cash flow CDO, but will allow greater trading by the collateral manager. To facilitate such trading, the capital structure of a market value CDO usually includes a substantial revolving credit facility to allow the collateral manager to efficiently manage the capital of the CDO and to trade CDO assets more easily. While balance sheet CDOs are an important portfolio management and regulatory capital tool, especially for commercial banks, the remainder of this article will discuss typical arbitrage CDOs. The CDO issuer is usually established outside of the US (for example, the Cayman Islands) and must not be engaged in trade or business in the US in order to avoid US taxation. The offering of CDO securities must be carefully structured to satisfy other applicable legal requirements, including (but not limited to):
which requirements, together with a description of the innumerable variations of and refinements to the basic CDO structures described here, are beyond the scope of this article. Why? Project finance loans, leases and other debt are regarded as attractive assets for CDOs due to their higher recovery rates and shorter recovery periods than comparable credit-quality corporate debt obligations. This allows the CDO securities to be issued at a corresponding lower cost (since less credit enhancement is required to obtain the same credit ratings), which effectively "expands" the arbitrage opportunity for such CDO. The higher recovery rates and shorter recovery periods of project finance debt is primarily attributable to the tighter covenants and events of default under typical project finance documentation. Moreover, when an event of default does occur, that project participants are relatively limited in number and are highly-motivated to consensually resolve such default as expeditiously as possible. The rating agencies also report a steady and growing amount of rated project finance bonds and other debt that can serve as a supply for project finance CDOs. For several years, issuance of project finance debt has exceeded US$100bn annually. The rating agencies have extensive experience with project finance and have elaborate rating methodologies and criteria for project finance debt. For example, Standard & Poor's (S&P) has issued comprehensive guidance for project finance debt in its August, 2000 Debt Rating Criteria for Energy, Industrial and Infrastructure Project Finance that is based on S&P's extensive experience in rating over 500 projects in 35 countries. Additionally, commercial banks and other originators of project finance debt can have their project finance portfolios "shadow" rated in a process in which the rating agency will "map" the rating system of such originator to its own rating system and determine its rating of a particular project finance debt obligation by application of such mapping. This process requires the rating agency to undertake substantial due diligence regarding the originator's rating process (including its underwriting criteria and credit approval procedures) and historical information regarding the performance of the originator's project finance portfolio. Commercial banks are uniquely positioned to take advantage of the opportunity presented by CDOs of project finance debt. Generally, commercial banks are experienced and capable originators of project finance debt and have a competitive advantage over other financial institutions in their ability to provide flexible funding for a project's precommercial development, including construction during which draws may be accelerated or delayed. However, projects are usually capital intensive and project assets will have long useful lives requiring a corresponding longer tenor financing. Commercial banks are constrained in their ability to provide such longer tenor financing by the shorter duration of the assets on the balance sheet of a typical commercial bank (that is, such bank's demand or short-term deposits). While a commercial bank could provide shorter-term project financing, it (and the project's sponsors) would face a refinancing risk at the maturity of such financing. Other originators of project finance debt, even if not balance sheet constrained, can benefit from project finance CDOs: by the additional liquidity that a project finance CDO brings to an otherwise illiquid asset class and, as stated above, by using a CDO to release otherwise required regulatory capital and promote regulatory capital efficiency. Significantly, in October 1999, S&P issued its Rating Considerations for project finance CDOs. Now? S&P's Rating Considerations for project finance CDOs are based on its belief that project finance CDOs will be an important step in expanding the participation of portfolio investors in the broader infrastructure debt markets. S&P expects to refine its rating methodology for project finance CDOs based on its experience with respect thereto for three inherent key credit issues; namely,
Notwithstanding that, at this time, project finance CDOs may be more art than science, Credit Suisse First Boston ("CSFB") has taken 2 important steps towards answering these issues in its 2 project funding transactions:
As one might expect, an international portfolio presented substantially more difficult structuring and rating challenges, including sophisticated structural features to mitigate otherwise applicable withholding tax on the project finance debt from several troublesome jurisdictions. Notwithstanding such difficulties, the promise of project finance CDOs is so strong that S&P and other rating agencies report that a significant number of other financial institutions have expressed interest in, and are pursuing, possible project finance CDOs. Only time will tell whether the substantial promise of project finance CDOs will be realised, but results to date are encouraging. By: J. Paul Forrester, Mayer Brown & Platt, March 2001 By: J. Paul Forrester, Partner, Mayer, Brown & Platt, 190 South LaSalle Street, Chicago, Illinois 60603-3441, USA.
|
|