Globally, 2009 was a difficult year for project finance, and the Middle East was no exception. For most of 2008, there was a common misconception that the region’s booming project finance market would be largely unperturbed by the deepening financial crisis that first took hold in the US and Europe.
However, the demise of US bank Lehman Brothers in September 2008 marked a watershed in the region. The subsequent and rapid drying-up of inter-bank credit lines led many international banks to retrench from the market because of the difficulty they had in accessing dollar liquidity, on which they had become heavily reliant. Meanwhile, local banks, in the very best cases, could only fund short-term local currency deals using their deposits.
New deal structures
From being a hive of activity, in which more banks were competing to provide funding than there were projects on offer, industry sources estimated that, by the end of 2008, there were just 12 banks seeking deals in the Middle East, compared with 45 two years previously.
“The capacity of local and regional banks to enter into project finance deals almost completely evaporated overnight,” says Jonathan Robinson, managing director and head of project finance for the Middle East and North Africa region at HSBC Middle East. “By the start of 2009, the outlook was pretty bleak.”
This scarcity of capital has forced the region to prioritise projects in sectors that are crucial to its future economic development. Consequently, most of the deals that secured financing last year were large-scale infrastructure or power projects that had some level of government backing. The diminished appetite for long-term debt funding has also resulted in new deal structures and alternative sources of funding coming to the fore as the market adapted to the new lending environment.
“At the start of 2009, the market was confronted with the realisation that there was no longer a proper secondary market on which to offload the risk, either regionally or internationally,” says Robinson.
Less than $20bn worth of project finance deals closed in 2009, about half the transaction value of 2008
The lack of appetite for syndication in the market meant that banks were simply unwilling to take any underwriting risk. This has resulted in banks joining forces to undertake ‘club financings’, whereby they pool their resources and lend collectively.
The mini-perm project finance structure, which involves using smaller, short-term loans that will be refinanced at a later stage, has also been deployed. The $2.1bn raised for Bahrain’s Addur independent water and power project (IWPP) in June last year, the first IWPP deal of its kind to close in the region, included an eight-year mini-perm financing. Pricing starts at 290 basis points above the London interbank offered rate (Libor) for the first two and a half years, steps up to 310 basis points for the next two and a half years, and hits 365 basis points for years six to eight.
Banks have also tapped into less familiar areas of financing to ensure that deals still got done. For example, the refinancing of Abu Dhabi’s $3.5bn Dolphin Energy pipeline, which closed in July last year, included a project bond of $1.25bn. While it proved difficult to secure the commercial debt tranche, the considerable demand for the bond meant that it secured $4.7bn of orders. This enabled it to be increased from the $500m- $1bn range that its sponsors were aiming for, and thus cover the shortfall on the debt facility, which was nearly halved in size to $1.42bn.
In the same month, Qatar’s Ras Laffan Liquefied Natural Gas Company (RasGas) issued a $2.23bn international bond as the final part of a $10bn debt programme established in 2005 to fund the construction of its liquefied natural gas (LNG) trains 3 to 7. RasGas’ bond issue also attracted an exceptionally high level of demand – the order book was eight times oversubscribed at $17.6bn when it closed, a record for a Middle East bond issue.
“Both Dolphin and RasGas accessed the bond market at about the same time, with very good results,” says a senior project finance banker active in the region. “The bond market recovered faster than the bank market and that was illustrated by their difference in pricing for Dolphin. Normally, you’d expect the pricing to be roughly the same, but the bond piece was priced about 100 basis points cheaper than the bank on an all-in cost basis.”
Indeed, while the bond was priced at 337.5 basis points over Libor, bank debt was priced from 175 basis points to 350 basis points among the 30 Gulf and international banks.
“The capacity of local and regional banks to enter into project finance deals almost evaporated overnight”
Jonathan Robinson, HSBC Middle East
Pricing in the banking market is driven by the availability of liquidity and, given that most banks remain constrained by their balance sheets, there is a need for that gap to be filled by other funding sources. Project bonds have proven themselves to be competitive in recent months and are seen to offer greater potential. “We should see bonds play a bigger role in the future,” says the senior banker.
“A lot of the up-coming projects are investment-grade and the bond market is still very liquid if you have the right deck of cards.”
But, while the closing of these deals provided a much-needed boost to the market, Robinson argues that Saudi Arabia’s $2.5bn Rabigh independent power plant (IPP) and its $2.6bn Shuweihat S2 IWPP have been more significant in helping restore market confidence.
“The closing of the Rabigh deal in July last year was the first real sign that the long-term project finance market wasn’t dead,” says Robinson. “I would say Shuweihat 2 was seen as the first mega-scale, international project finance deal to close in 2009 across the region.”
The Rabigh deal was significant because the sponsors managed to secure 20-year debt at a time when the market was still struggling to get back on its feet.
Similarly, Shuweihat 2, which closed in October 2009, was also successful in securing 22-year debt. In this way, both deals were hugely important in reaffirming the value of the private investment model. Indeed, the IPP and IWPP models had been coming under increasing threat as a result of the financial crisis, with governments in the region losing faith in Western, crisis-hit banks and shifting their focus to funding their infrastructure projects themselves.
Furthermore, both these deals have highlighted the central role that export credit agencies (ECAs) have assumed in the Gulf’s project finance market. Half of Shuweihat 2’s $2.2bn debt portion was provided by the Japanese Bank for International Co-operation, with the remaining 50 per cent covered by commercial banks.
In Rabigh’s case, Korea Export Insurance Corporation, a Korean export credit agency, came on board to cover the dollar-denominated tranche, of about $400m. The Export-Import Bank of China also expressed an interest in joining the lending, although, in the event, it was not involved.
“Outside of Saudi Arabia any project that has a bank requirement of $800m-$1bn will need export credit financing”
Irfan Said, Samba Financial Group
“The market has become very reliant on ECAs,” says Irfan Said, head of project & structured finance at Saudi Arabia’s Samba Financial Group.
“Outside Saudi Arabia and in the rest of the GCC, any project today that has a commercial bank requirement of $800m-$1bn will need export credit financing.”
Less than $20bn-worth of project finance deals closed in 2009 – about half the transaction values of 2008. Given that this has been the worst financial crisis for more than 50 years, with all the uncertainty that has prevailed in the market, the consensus among industry insiders is that $20bn is a very respectable number.
“The market last year was more active than I expected it to be,” says Robinson.
Indeed, GCC project financing activity continued its march throughout 2009, albeit at a much slower pace compared to 2005-2007.
“I think the level of activity is pretty decent, given where we are today,” says Said. “However, it is worth mentioning that most of the deals have had a sovereign or quasi-sovereign backing – we haven’t seen much private sector project financing.”
Despite the squeeze on liquidity, the Middle East remains among the most active project finance markets in the world.
“Overall, banks are becoming more comfortable with longer tenors,” says Said. “A few European banks that had completely dropped out are coming back into the market. [Germany’s] Bayern LB, [France’s] Societe Generale and [Germany’s] West LB are now looking at projects and we are going to see a lot more banks engaging in deals.”
Furthermore, while debt margins remain high, Libor base rates have been falling rapidly – dropping to a record low of 0.25 per cent after the US Federal Reserve said it would keep interest rates low for an extended period.
Lower materials and construction prices are also helping to enhance the investment climate. A number of projects were put on hold in late 2008, because of the high engineering, procurement and construction contract prices.
With roughly $100bn in power and water projects alone due to be completed across the region in the next 10 years, the recovery of the project finance market is crucial for the Middle East. But this will take time.
“The system is still recovering from the shock of what has taken place,” says Said. “Liquidity remains limited and financing options constrained.
“For example, I think it will take from 12-18 months for underwriting to make a convincing comeback.”
The health of the sector will continue to be tested in the next year as projects come to market. Oman alone is currently moving ahead with four major power and water schemes. This year is also expected to see the closure of Kuwait’s first IWPP, while the UAE last month awarded to a South Korean consortium the $40bn contract to build Abu Dhabi’s first nuclear power station.
For the rest of 2010, lenders will be prioritising how they allocate capital and will be favouring clients with the strongest credit stories. In most cases, those clients that secure financing for a project will have links back to their respective governments.