While 2014 was a quiet year for the Middle East and North Africa’s private power and water sector, one of the few deals concluded may have provided a key juncture for the future of project financing in the utility sector.

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Financial close for Abu Dhabi’s long-awaited Mirfa independent water and power project (IWPP) was reached in October using a mini-perm loan, a new structure for the region’s project finance sector. While the mini-perm loan has been used in the region before (for Bahrain’s Al-Dur IWPP in 2009, during the global financial crisis), the financing model is still at a very nascent stage in the Middle East and the adoption of it for the Mirfa scheme is expected to provide a platform for its further use in the power and water industry.

Changing market

The structure should also facilitate the wider use of project bonds, another new financial instrument for the region’s utility projects sector, which debuted in Abu Dhabi in 2013 for the refinancing of the Shuweihat 2 (S2) IWPP. With several major private power and water projects planned to be tendered and awarded in 2015, Abu Dhabi’s recent innovations in the project financing of major utility schemes may have provided a blueprint for the future of the region’s power and water market.

Abu Dhabi’s broadening of the financial instruments used to fund major utility projects is a result of the weakening of the regional and international commercial banking sector, initially caused by the global financial crisis, which was compounded by the Arab uprisings, the eurozone banking crisis and other global political conflicts.

Mini-perm loan

The implementation of the Basel III banking regulations is also likely to encourage the use of alternative structures to long-term commercial bank loans, which have characterised the region’s project financing deals in the utility sector over the past 20 years. One of the new structures expected to play an increasingly prominent role is the mini-perm, or short-term, loan.

“The soft mini-perm loan structure will be one of the major financing models in the future, along with the long-term conventional financing,” says Naoki Tamaki, chief representative for Japanese export credit agency (ECA) Japan Bank for International Cooperation (Jbic) in Dubai.

“It depends on the sponsor and the case. The sponsor needs to think about after the initial financing - how this applies, and the margins they are looking for. Mini-perm was an option for Mirfa, and they went for it. And they succeeded, and the previous year they succeeded with the refinancing of S2 with a project bond. So that is one of the alternatives - mini-perm plus refinancing through project bond after completion of the project - if they wish.”

The mini-perm loan for the Mirfa IWPP is for a period of seven years, much shorter than the traditionally used long-term commercial loans that were for the duration of the development agreement, usually for a period of 15-25 years. The Mirfa loan will cover the 3-4 year construction period and a 3-4 year period post completion.

Bank restrictions

The region has been slower than Western markets to adopt the shorter-term loan for major projects. The opportunity for introducing the model has come as a result of continued capacity constraints and restrictions on banks providing long-term loans, which has had the knock-on effect of creating difficulties for bidding consortiums to acquire finance to develop major projects.

A mini-perm structure offers potential benefits for sponsors, banks and project owners. For owners and utilities, it should, in theory, make the tender process more competitive by attracting more bidders, with more firms having access to financing on a shorter tenor and therefore able to participate in bidding for the project.

For sponsors, the structure enables an improvement in financing terms in the future when the scheme is refinanced, particularly if the bidders believe an improvement in debt markets is likely in the short term. For banks, the structure lowers risk by enabling an early exit from the project, and stops them from committing to long-term tenors without the option of improving the financing arrangements.

Refinancing risk

However, while the mini-perm structure can offer potentially more attractive financing terms for the latter part of the project, the risk for refinancing will rest with the sponsors.

“It is the sponsor that takes the risk,” says Tamaki. “In the case of soft mini-perm structures, if the refinancing fails, then the cash will be swept to the banks - not 100 per cent, but most of the cash will be swept to the banks in order for the project to make repayment in full before [power purchase agreement] maturity. So the banks should be comfortable, as they are able to get repaid through cash flow from the project. The banks do not take the real refinancing risk.

“But if the project fails with refinancing then normally sponsors need to give up their dividend as, once refinancing fails, prices will go up, so the project company has to pay more interest. So it is completely a sponsor’s risk.”

While the use of mini-perm loans increases the flexibility for both sponsors and banks, the suitability of the structure will depend on the country and project. “I don’t think you will get a one-size-fits-all answer,” says a project financier at a major regional bank.

“If it is a big deal that requires locals attending, then you will be in the land of mini-perm. But if you are doing IPPs [independent power projects] in Saudi Arabia or Kuwait and you still have sufficient market liquidity - you’d have some international banks alongside ECAs. Where there is plenty of local liquidity, then you would still go towards long-tenancy.”

Project bonds

The emergence of the mini-perm structure will also create increased opportunity for using project bonds for refinancing major private power and water projects, another new addition to the region’s project finance portfolio.

The Middle East and North Africa region’s developer market has traditionally relied heavily on project finance debt from commercial banks, with long-tenor loans covering the duration of the project. However, since the beginning of the financial crisis, commercial bank debt has become much more difficult for sponsors to attain as the number of banks in the long-term market has declined. Lending terms, including pricing and loan volumes, have also become much less attractive for bidders on large infrastructure projects. As a result, bond financing has increasingly been mooted as a way to plug the funding gap for major schemes.

Rather than a commercial loan, project bonds are debt instruments issued by project companies, which are then bought by institutional investors such as insurance companies or pension funds. The bonds can also be traded on secondary markets.

Moreover, the impending Basel III regulations will impose stricter rules on banks and lending requirements, which will prevent projects from being funded by commercial debt alone. While ECAs have frequently been tapped as further funding sources, project bonds offer an alternative financing mechanism for major power and water projects.

Shuweihat 2

While project bonds have been used in the region before, with Qatar’s Ras Laffan LNG Company and the UAE’s Dolphin Energy tapping the bond market in 2006 and 2009 respectively, the S2 IWPP is the first power and water project to refinance through the bond market. The success of the S2 bond issuance may lead to other sponsors in the region’s power and water market turning to tradeable bonds to refinance loans that were agreed in the aftermath of the global financial crisis.

“Project bonds will play a bigger role going forward,” says Tamaki. “The S2 project bond was successfully subscribed; it was the first one and was very well structured. We could see appetite from the bond market.”
The development of the project bond market in the Middle East has been slow in comparison with other major financing markets such as the US, which saw a sharp uptake of project bonds in the late 1990s and early 2000s. A major part of the reason for this was due to cheap long-term bank debt, which was readily available to sponsors in the Middle East before the global financial crisis.

However, the utilisation of tradeable project bonds for the first time for a utility project for S2 was not a major surprise, given the timing of the initial agreement. “Deals done in 2009 and 2010, like the [original] S2 deal, were highly priced because that’s where the market was then, and so they are going to be ripe for some form of takeout, and the bond market is the natural diversification and recycling of capital. And [S2] was also fairly competitive last year,” says the project financier.

Scepticism

However, while bonds can offer a suitable tool for refinancing and can complement mini-perm loans, there is still much scepticism within the project finance sector about whether bond financing will properly take off in the region for new projects due to the construction risk.

“Project bonds will be used as an interesting refinancing tool, but on a relatively light-touch basis; I don’t think there will be that many project bonds,” says the project financier.

“For project bonds to be effective, you need a highly priced deal moving from construction into operation to actually achieve the credit rating required by bond holders. Are any sponsors willing to wrap completion risk? Historically, that would be a no.”

Bond ratings

A cornerstone of bond financing is that the issuer must have the bonds rated, and for a project that needs to be constructed this can prove difficult.

“It is not comfortable for bondholders to take completion risk, so it is after completion that projects are refinanced via bonds,” says Tamaki. “It is difficult to get ratings during the construction period.”
While the potential for growth of the region’s projects bond market is still up for debate, the success of the S2 project has shown that, in the right circumstances, it can offer an effective tool for bridging the financing gap on major projects.

With the long-term commercial debt market showing no signs of returning to pre-crisis levels, mini-perm structures and project bond financing are welcome additional options for firms seeking the required finance and guarantees to bid and win work on some of the largest utility projects in the region.