j. robert sheppard, jr. [email protected] 1 targeted risk mitigation using contingent facilities...

J. Robert Sheppard, [email protected]

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Targeted Risk MitigationUsing Contingent Facilities

World Economic Forum - Financing for DevelopmentWorkshop

Wednesday, March16, 2005Hong Kong


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Foreign Exchange Liquidity Facilities


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Conceptual Structure of a Foreign Exchange Liquidity Facility: Basic Assumptions

• Project with currency mismatch risk are likely to default in the event of a major devaluation

– FX-indexed output contracts have not performed well under stress

– Long-term currency swaps are typically not available

• Project Structure– Revenues are received in local currency

– Revenues are contractually committed to increase with the host country’s inflation rate

– The project will promptly convert all local currency cash available for debt service into US dollars at the then-current exchange rate

• Financing Structure– Project is financed with US dollar-denominated long-term debt

– Debt is fixed-rate or floating, swapped to fixed


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Conceptual Structure of a Foreign Exchange Liquidity Facility: Draws and Repayments

• Coverage is based on purchasing power parity, rather than hedging changes in nominal exchange rates

• The coverage establishes a “floor” for the value in US dollars of the company’s cash available for debt service

• Draws may be made when the project’s cash available for debt service, converted into US dollars, is below the floor value and is insufficient to pay scheduled debt service

• Draws from the liquidity facility will give rise to claims against the project, evidenced by a loan subordinated only to the project's senior lenders, repaid as soon as free cash flow allows

• Draws are subject to a maximum facility amount; recoveries through the subordinated loan mechanism will be available for payment of future claims


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Conceptual Structure of the Devaluation Coverage: Currency vs Operational Risk

• Coverage is structured to separate currency risk from operational risk

• Changes in the real exchange rate are measured by valuing the project’s expected cash available for debt service based on actual inflation and current exchange rates, rather than the projected (PPP) values used to create pre-closing proformas

• Value of the project’s cash available for debt service is measured on a per-unit-of-output basis

• A proforma calculation is performed to determine the extent to which a cash shortfall is a result of fluctuations in currency values (which give rise to a draw under the liquidity facility) versus negative operational results (which do not give rise to a draw under the liquidity facility)

• Senior lenders are exposed to all operational risks, just as if the liquidity facility were not in place


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Basic Structure of a Foreign Exchange Liquidity Facility

Line 2: 67%

Line 1: 100%

Value in US$

Debt ServiceCoverage Ratio

1.50

Line 3

Time (in years)0 15

Debt service shortfall amount to be paid from Liquidity Facility

Amount repaid to Liquidity Facility

Line 1: Projected value in US$ of cash in local currency, indexed to host country inflation rate (base case projection)Line 2: Annual debt service requirements in US$ (principal and interest)Line 3: Actual value in US$ of cash in local currency, indexed to host country inflation rate

1.0


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Sizing a Foreign Exchange Liquidity Facility

• Appropriate size of a foreign exchange liquidity facility depends upon:– The historical volatility of the real exchange rate of the project’s host country

– The project’s debt service coverage ratio

• Exposure created by historical volatility of the real exchange rate of the host country depends upon where the floor value is established for an individual transaction (i.e., how far the real exchange rate must decline before the project is eligible to draw from the liquidity facility)

• The debt service coverage ratio for a project can be increased by:– Improving the project’s economics, e.g., by charging more for the project’s output

– reducing the amount of debt in the project’s capital structure

– Lengthening the tenor of the project’s debt (which is likely to occur as a result of the use of a liquidity facility)


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Reduction in Exposure as a Project’s Debt Service Coverage Ratio Increases

Line 2: 67%

Line 1: 100%

Value in US$ Debt Service

Coverage Ratio

1.50

Line 3

Time (in years)0 15

Line 1: Projected value in US$ of cash in local currency, indexed to host country inflation rate (base case projection)Line 2: Annual debt service requirements in US$ (principal and interest)Line 3: Actual value in US$ of cash in local currency, indexed to host country inflation rateLine 4: Line 3 shifted upward to illustrate a higher DSCR than that of Line 3

1.0

Line 4


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Establishing the Floor Value for a Foreign Exchange Liquidity Facility

• If the floor value were to be established at a level equivalent to a 1.0 debt service coverage ratio, a small operational problem could cause the project to default

– Liquidity facility provider would reduce its exposure to project operational risk, but

– Fixed-income investors and rating agencies would put little value on the structure (it would resemble a US project with a 1.0 debt service coverage ratio)

• The floor value should be established at a level sufficient to provide an adequate margin for deviations of operational performance from the performance levels projected at closing


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Structure of a Liquidity Facility with a Floor Value Equivalent to a DSCR of 1.20

Line 2: 67%

Line 1: 100%

Value in US$

Debt ServiceCoverage Ratio

1.50

Line 3

Time (in years)0 15

Debt service shortfall amount to be paid from Liquidity Facility

Amount repaid to Liquidity Facility

1.0

Line 4: 80% 1.20

Potential amount to be paid from Liquidity Facility (payments at this level of real exchange rate will be made only if necessary to pay debt service; i.e. only if the project is operating below projections)

Line 1: Projected value in US$ of cash in local currency, indexed to host country inflation rate (base case projection)Line 2: Annual debt service requirements in US$ (principal and interest)Line 3: Actual value in US$ of cash in local currency, indexed to host country inflation rateLine 4: A line showing the level of cash at which the project has a debt service coverage ratio of 1.20 (“Floor Value”)


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Status of Liquidity Facilities as a New Financial Product

• The concept has been successfully implemented in one transaction (AES Tietê) in one country (Brazil):

– US$300 million issue, 10 year average life, 15 year final maturity

– Rated Baa3 by Moody’s, BBB- by Fitch

– First electric power project financing in a below-investment grade country to achieve an investment-grade rating

– Longest tenor ever achieved by a Brazilian corporate issuer

– Priced at a level equivalent to 237 bp less than Brazilian sovereign debt (vs. 150 bps for the 7-year Petrobras transaction which priced one week earlier)

• However,– AES Tietê has been downgraded for as a result of conditions in the Brazilian electric

sector and the effect of macroeconomic factors on its ability to distribute cash

– Further use of liquidity facilities within the Brazilian electric sector was impeded by the rationing which occurred in 2001-2002


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Status of Liquidity Facilities as a New Financial Product

• The initial transaction utilizing a foreign exchange liquidity facility received favorable press coverage and industry awards:

– Infrastructure Journal: Global Deal of the Year

– Project Finance: Latin America Deal of the Year

– Project Finance International: Latin America Deal of the Year

– Euromoney: Best Structured Bond, Latin America

• Rating agencies have recognized the enhancement provided by coverage

• Report of the Panel on Financing Global Water Infrastructure (the Camdessus Panel) endorsed the use of foreign exchange liquidity facilities as a means of facilitating financing for the water sector


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Interest Rate Liquidity Facilitiesfor

Local Currency Financing


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Conceptual Structure of a Local Currency Interest Rate Liquidity Facility

• Developing-country interest rates are sufficiently volatile to create default for projects financed with floating-rate local currency debt

– Interest rates can vary by ratios of 2:1 or 2.5:1 within short periods– If long-term, fixed-rate local currency financing is not available, long-term interest rate

swaps will not be available to hedge floating-rate risk

• Project Structure– Revenues are received in local currency– Revenues are contractually committed to increase with the host country’s inflation rate

• Financing Structure– Project is financed with long-term, floating-rate debt denominated in local currency– Debt is floating rate


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Conceptual Structure of a Local Currency Interest Rate Liquidity Facility: Draws and Repayments

• Draws may be made when the project’s cash available for debt service is below the floor value and is insufficient to pay scheduled debt service

• Draws from the liquidity facility will give rise to claims against the project, evidenced by a loan subordinated only to the project's senior lenders, repaid as soon as free cash flow allows

• Draws are subject to a maximum facility amount; recoveries through the subordinated loan mechanism will be available for payment of future claims

• Coverage is not structured to separate interest rate risk from other project risks


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Sizing a Local Currency Interest Rate Liquidity Facility

• Appropriate size of a foreign exchange liquidity facility depends upon:– The historical volatility of interest rates of the project’s host country– The project’s debt service coverage ratio– A downside operating case that may require draws earlier than the base case (equivalent to the Floor

Value for a Foreign Exchange Liquidity Facility)– An estimate of the “worst-case” interest-rate policy that may be pursued (or forced upon) the host-

country government in the event of a crisis

• The debt service coverage ratio for a project can be increased by:– Improving the project’s economics, e.g., by charging more for the project’s output– reducing the amount of debt in the project’s capital structure– Lengthening the tenor of the project’s debt (which is may occur as a result of the use of the liquidity

facility)

• Ability to structure an appropriate liquidity facility and close a transaction will depend upon the level of interest rates at the time closing

– Unusually high current interest rates will provide the base case, notwithstanding the fact that they are unlikely to remain at current levels

– No transaction will close if it requires an immediate draw upon the liquidity facility


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Foreign Exchange vs Local Currency Interest Rate Liquidity Facilities: Brazil

Maximum Liquidity Facility BalanceLevel at which liquidity facility draw occurs: 1.2 1.0Assumed closing date of transaction:

Q1:1997 – Foreign Exchange LF: 13.0% 2.2%Q1:1997 – Local Currency LF: 27.2% 15.6%

Q1:1999 – Foreign Exchange LF: 0.83% 0.06%Q1:1999 – Local Currency LF: 9.0% 6.1%

• Ratio of maximum interest rate, post Q1:1997 to rate in Q1:1997 = 2.0 :1• Not surprisingly, the maximum balance for type of facility will be smaller if the

transaction closes just after a major devaluation, rather than just before• In a high interest-rate country such as Brazil, the maximum balance for a local

currency facility may be much larger than for an FX facility


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Foreign Exchange vs Local Currency Interest Rate Liquidity Facilities: The Philippines

Maximum Liquidity Facility BalanceLevel at which liquidity facility draw occurs: 1.2 1.0Assumed closing date of transaction:

Q1:1997 – Foreign Exchange LF: 13.4% 0.02%Q1:1997 – Local Currency LF: 0.12% 0%

Q1:1999 – Foreign Exchange LF: 0% 0%Q1:1999 – Local Currency LF: 0% 0%

• Ratio of maximum interest rate, post Q1:1997 to rate in Q1:1997 = 2.5 :1• Interest rates in the Philippines remained low after the 1997 crisis; therefore, the

real FX rate has remained low, hence:– The FX Liquidity Facility has a significant balance, while– The Local Currency Liquidity Facility shows no usage


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Foreign Exchange vs Local Currency Interest Rate Liquidity Facilities: Implementation

• Sizing Liquidity Facilities:– Historical analysis is a reasonable indicator of the “worst case” for movements of real

FX rates because devaluations reflect market movements after the host country government has failed to maintain a target FX rate –i.e., the government has exhausted its ability to control the situation

– Both before and after devaluation, host country governments retain more ability to affect the level of local currency interest rates (and may be subject to external pressure to raise rates); therefore, historical analysis may not reflect the potential “worst case”

• Providing a local currency liquidity facility may protect an infrastructure project but may not induce local lenders to provide long-term financing

– For countries that already feature long-term, floating-rate local currency financing, a liquidity facility may be decisive in facilitating local currency financing

– Lenders in countries that do not currently provide long-term, floating-rate local currency financing can be assumed to be motivated by other concerns than the prospect of borrowers default in a high interest rate environment; a local currency liquidity facility does not address these concerns


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Foreign Exchange Rate Indexation Liquidity Facility for

Local Currency Financing


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Conceptual Structure of a Foreign Exchange Rate Indexation Liquidity Facility

• Countries that do not provide long-term, floating-rate financing are characterized by volatile FX rates; thus,

– Ability to demand even partial repayment of short-term local currency loans, and

– Even limited ability to shift assets among different currencies are likely to produce superior returns in comparison with long-term floating rate local currency assets

• Project Structure– Revenues are received in local currency

– Revenues are contractually committed to increase with the host country’s inflation rate

• Financing Structure– Project is financed with long-term, floating-rate debt denominated in local currency

– Debt is floating rate

– Principal payments (and the balance of remaining debt) are indexed to a percentage (e.g., 50%) of the change in the nominal FX rate since close of financing – i.e., the local currency lender automatically receives a fixed percentage of FX gains


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Rationale for a Foreign Exchange Rate Indexation Liquidity Facility

• Project Sponsor perspective:– If only currently available long-term financing is in US dollars, the project will bear

100% of FX risk; local-currency value of project’s US dollar-debt will reflect 100% of FX changes since closing

– Indexation to give local lenders an automatic percentage (less than 100%) of FX gains is preferable to bearing 100% of the risk in the form of US dollar financing

– In high interest rate countries (such as Brazil), lenders may be willing to accept a lower interest rate in return for FX upside

• Lender perspective:– Guaranteed percentage of FX gains will increase expected returns in comparison to

conventional local currency assets (and may represent an acceptable trade-off for lower interest rate)

– A guaranteed percentage of FX gains may be preferable to market risk

– Tenor extension increases chance of FX gains (FX gains are based on changes in the nominal rate, not the real rate)


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Role of the Liquidity Facility in the Foreign Exchange Rate Indexation Structure

• To cover local-currency interest rate risk

• To cover risk of excessive changes in the nominal FX rate

• To extend the tenor of the transaction if an outstanding balance remains in the liquidity facility after the project’s senior debt has been repaid


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Implementation of a Foreign Exchange Rate Indexation Liquidity Facility: Brazil

Assumptions:– R$ revenues will produce a 1.50 coverage ratio for US$ debt in initial quarter– R$ debt at beginning of period of analysis is equal to assumed amount of US$ debt– “Best Case” represents perfect market timing in switching assets between currencies– Interest rate is money market rate for Brazil for “R$ Only Case”, money market rate for

Brazil and US for “Best Case”, and 2% below money market rate for Brazil for “50% FX Index Case”

Period of analysis R$ Only Best 50% FX Index

1995-2004 33.3% 40.1% 37.7%1997-2004 23.4% 36.6% 30.1%1999-2004 20.7% 50.4% 28.0%

The “Best Case” is based on 12 switches of currency during the period 1995-2004.


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FX Rate Indexation Liquidity Facility vsFX Liquidity Facility: Brazil

Assumptions: Same as previous slide

Maximum Liquidity Facility Balance

FX Rate Index FX Liquidity

Period of analysis 1.2 1.0 1.2 1.0

1995-2004 70% 31% 2.5% 0.4%

1997-2004 37% 17% 12% 2.2%

1999-2004 12% 4.6% 0.8% 0.06%

Note: High maximum balances for (local currency) FX Rate Index Liquidity Facilities indicate a need to de-leverage. To reduce balances to approximately the same level as those of the (US dollar) FX Liquidity Facility, the amount of debt needs to be reduced by 30% to 40%.


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Implementation of a Foreign Exchange Rate Indexation Liquidity Facility: The Philippines

Assumptions:– Peso revenues will produce a 1.50 coverage ratio for US$ debt in initial quarter– Peso debt at beginning of period of analysis is equal to assumed amount of US$ debt– “Best Case” represents perfect market timing in switching assets between currencies– Interest rate is money market rate for the Philippines for “Peso Only Case”, money

market rate for the Philippines and US for “Best Case”, and 1% below money market rate for the Philippines for “50% FX Index Case”

Period of analysis Peso Only Best 50% FX Index

1995-2004 11.4% 11.4% 15.3%1997-2004 11.0% 11.0% 16.9%1999-2004 8.9% 8.9% 11.0%

The fact that the “Best Case” equals the “Peso Only” case indicates that a Philippine lender could not improve returns by switching currencies (if limited to quarterly changes).


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FX Rate Indexation Liquidity Facility vsFX Liquidity Facility: The Philippines

Assumptions: Same as previous slide

Maximum Liquidity Facility Balance

FX Rate Index FX Liquidity

Period of analysis 1.2 1.0 1.2 1.0

1995-2004 0% 0% 0.9% 0%

1997-2004 2.7% 0.68% 13.4% 0.02%

1999-2004 0% 0% 0% 0%

Note: Low maximum balances for (local currency) FX Rate Index Liquidity Facilities indicate the substantially more local currency debt could be used with the FX Rate Indexation structure.


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Contingent Guarantees to MitigateRegulatory Risk


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Need for Mitigation of Regulatory Risk

• Regulatory regimes are subject to change because:– Infrastructure projects provide basic services that are important to the public– Devaluation may trigger tariff increases that are unpopular with the public

• Local currency ratings for infrastructure projects are generally capped at the sovereign local currency rating because of the likelihood of political interference in regulatory regimes

• Traditional expropriation and breach-of-contract clauses in political risk insurance have not been effective as a way of dealing with this issue

• Change of regulatory regime in many developing countries starting in 1997 has caused project sponsors to avoid new infrastructure investments


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Basic Structure of a Contingent Guarantee to Mitigate Regulatory Risk (1)

• Host-country government will issue a guarantee to a specific infrastructure project committing that the government will not change the rules governing:

– The tariff adjustment mechanism

– The timing of tariff adjustments, or

– The basic performance standards governing the project

which were in place at the time of the initial infrastructure investment

• Failure to honor the guarantee gives rise to a payment from the host-country government to the project in an amount equal to 40%-50% of the project’s senior debt, subject to:

– Actions that could mitigate the adverse impact of the breach on the project and, therefore, the payment made by the government

– A right to cure the breach during a period not to exceed a pre-defined number of months (time will depend upon size of the project’s debt service reserve, but will maintain the project’s ability to make timely payments of principal and interest)


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Basic Structure of a Contingent Guarantee to Mitigate Regulatory Risk (2)

• The obligations of the host-country government under its guarantee will be defined in a clear cut fashion and will not be contingent upon the project’s performance of any counter obligations

• Host-country government’s obligations will be guaranteed by a multilateral or other creditworthy institution, with a counter-guarantee from the host-country government

• In the event of a breach by the host-country government of its obligations, payment will be made by the multilateral (or other) guarantor, which can then pursue its remedies against the government; payment to the project’s bondholders will not be dependent upon a successful outcome of an arbitration or other process confirming that a breach has occurred


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Critical Features of a Contingent Guarantee Program

• The process of selecting private firms to provide infrastructure services must be:– Transparent– Subject to competitive bidding, where firms bid with respect to:

• Supply of certain hardware and services, and• Compliance with pre-established contractual terms and regulatory regime

– Supervised by recognized technical, financial, and legal advisors representing the host-country government

• Acceptable tariff adjustment mechanisms should include provisions for:– Market-based benchmark standards for pass-through to the public of costs such as

fuel– Adjustments based on the host-country’s inflation rate for costs that are expected to

be controllable by the service provider (as opposed, for example, to FX-indexed adjustments)

• The program should be terminable if infrastructure projects are able to obtain investment-grade local currency ratings without use of contingent guarantees


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Benefits of a Contingent Guarantee Program (1)

• Addresses a major concern preventing project sponsors from making new infrastructure investments

• Addresses lenders’ major concerns:– regulatory risk– The lessening credibility of partial credit and co-financing schemes

• For distribution companies (in all sectors), removes risk of political interference and focuses credit analysis on ability of public to pay for service

• For generation companies (and direct suppliers to distribution companies in other sectors), lessens emphasis on credit strength of purchaser (distribution company) and focuses analysis upon ability of public to pay for service

• Can de-link project ratings from the sovereign rating if used in conjunction with inconvertibility coverage and FX liquidity facilities


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Benefits of a Contingent Guarantee Program (2)

• Will lengthen tenors and lower financing costs, enabling infrastructure services to be provided at a lower cost to the public

• Potential liability under the guarantee remains within the host-country government’s sole control

• More efficient use of the host-country’s borrowing capacity

• Least onerous means of mitigating regulatory risk; minimizes host-country government’s liability as measured by both

– Risks covered by guarantee– Amount of financial exposure


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Targeted Risk Structures: Summary

• Promote more careful and precise risk analysis

• By reducing the amount of financial support necessary to mitigate a specific risk, can make it more feasible for host-country governments to offer coverage (with enhancement of their credit by international institutions)

• Leverage the resources of those governments and bilateral and multilateral agencies that provide support in the form of targeted risk structures – far more efficient than comprehensive debt guarantees

j. robert sheppard, jr. [email protected] 1 targeted risk mitigation using contingent facilities...

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