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HIGH YIELD BONDS: A FINANCING SOLUTION FOR ENERGY PROJECTS
Natalia Sokolova
Dr, Ashurst LLP, London, United Kingdom.
Alexander Sokolov
Candidate of Engineering Sciences, Yaroslavl state technical university, Head of Departmen Yaroslavl Russian Federation. E-mail:[email protected]
Аннотация: A financing solution for energy projects Traditionally, energy project developers have obtained the majority of financing through their balance sheet or traditional bank debt. However, in response to heightened political and economic instability, energy companies, including traditional sectors such as upstream oil and gas as well as less established renewable energy technologies, have had to consider diversifying their sources of funding. The global financial crisis has resulted in stricter regulations on banks and higher capital requirements, leading to pressure on banks to reduce their loan books, particularly in relation to longer-term liabilities. This has meant, among other things, that energy projects can no longer rely on traditional debt alone for financing, leading to a gradual shift from bank-led financing to non-bank and capital markets-based funding. As a result, more innovative ways of funding, such as high yield bonds, are being considered and implemented. дложена структура инновационного потенциала малых научно-исследовательских и инновационных предприятий.
Ключевые слова: High yield, Energy projects, Green finance / green bonds, Project finance, Covenants, EBITDA, EBITDAX.
JEL: M21; O36
Traditionally, energy project developers have obtained the majority of financing through their balance sheet or traditional bank debt. However, in response to heightened political and economic instability, energy companies, including traditional sectors such as upstream oil and gas as well as less established renewable energy technologies, have had to consider diversifying their sources of funding. The global financial crisis has resulted in stricter regulations on banks and higher capital requirements, leading to pressure on banks to reduce their loan books, particularly in relation to longer-term liabilities. This has meant, among other things, that energy projects can no longer rely on traditional debt alone for financing, leading to a gradual shift from bank-led financing to non-bank and capital markets-based funding. As a result, more innovative ways of funding, such as high yield bonds, are being considered and implemented.
What are high yield bonds?
As the name suggests, a high yield bond is a type of corporate bond that offers a higher rate of return because of its higher risk profile. High yield bonds offer an opportunity for institutional investors to participate in energy-related projects through listed, tradable securities that can offer superior risk-adjusted returns due to their access to a deep and liquid market.
High yield bonds are securities that can be issued in public markets or placed privately. Publicly listed bonds tap into a very large investor pool, require regular financial reporting and offer the benefits of daily liquidity, pricing and higher levels of transparency. A private placement is the method of placing debt with a small number of selected, sophisticated investors, which debt may be listed or unlisted. Often, though not exclusively, such investors are non-bank institutions. Most bonds are issued in the public bond market,
although the private placement market also provides an important liquidity source. The attraction of private placement derives from the limited amount of disclosure, flexibility on maturity and greater certainty around execution.
A material distinction between high yield bonds and other forms of traditional energy project financings is that high yield bonds have incurrence (instead of maintenance) covenants. Such «incurrence covenants» control the issuer's ability to incur a non-ordinary course liability, based on a financial ratio, and are only tested when the issuer chooses to incur debt or take other relevant actions. Whereas the more pertinent maintenance covenants used in reserve-based lending (RBL) and other traditional funding require the borrower to maintain certain financial ratios on an ongoing basis. Therefore, energy projects exposed to political or economic volatility would benefit more from high yield incurrence covenants.
When issuing in the international bond markets, companies can choose between the Regulation S disclosure standard, which limits them to investors outside the United States, and the Rule 144A standard, which gives them access to US institutional investors. Complying with the Rule 144A standard is more demanding because of the broad anti-fraud provisions of US securities laws.
New investors
Energy project finance has proved to be an attractive new asset class for alternative investors, such as insurance companies and pension funds, which are facing pressures (for example, under Solvency II and other regulatory regimes) to diversify and ensure the profitability of their portfolios and to match investments to their long-term liabilities, while often subject to a relatively conservative risk appetite. Within the past five years, non-bank investors have significantly increased their commitments and exposure to energy financing, given the long-term nature of the liabilities for many types of institutional investors and their corresponding need for suitable long-term assets, coupled with significant policy support for clean energy. This is particularly true for established renewable energy technologies, where the risks are relatively well understood and government subsidies are encouraging investment. As a result, there have been increases over the last few years - particularly across Europe - in investment from non-bank lenders, in both the public bond markets and private placements, and most large energy businesses are now funded at least in part through corporate bonds (high yield or investment grade, depending on the rating of the issuer).
Historically, high yield bonds have been widely used in the construction, refinancing or expansion financing of large LNG, pipeline and petrochemical projects. However, there is also a growing potential for the high yield capital market to provide further support to the independent oil and gas sector as well as to renewable energy projects.
Independent oil and gas companies are the largest users of RBL facilities. These players typically use RBL structures for development financing and general corporate purposes. However, the cheaper price of public bonds and the covenant-light nature of alternative funding sources is shifting companies towards non-traditional sources of finance and away from the bank markets. Bond markets are increasingly being accessed to finance new development opportunities within the mid-cap exploration and production sector. For example, Hellenic Petroleum, DEA Finance and Seven Energy took out their RBL facilities with senior high yield bonds, while each of Aker, Ithaca and Tullow Oil placed high yield bonds alongside their existing RBL facilities.
More recently, high yield bonds have also been successfully used to finance alternative energy projects. Among examples of the alternative energy projects financed with high yield bonds are multiple iterations of the Abengoa and Areva transactions, which tend to issue high yield bonds typically on an annual basis, as well as the more recent UK examples of Melton (MEIF) and Drax (both of which issued bonds to finance biomass fuel projects).
Financing at various stages of the project
In general, large energy projects can be divided into three pha ses: the planning phase, the construction phase and CtoopcratihnalpShse. IPte most commonly used types of financings for each of the phases are listed in figure 1.
Planning (pre-development, including exploration in the upstream oil and gas context) Development/construction Fully operational project
0 Project balance sheet 0 Reserve-based lending 0 High yield bonds (public or private placement)
0 Private equity 0 High yield bonds (public or private placement) 0 Bank loans
0 IPO 0 Retail bonds 0 Cash flow from operations
0 Bank loans 0 Project finance 0 Infrastructure funds
0 Project finance 0 0 Multilateral development banks Mezzanine finance 0 Proceeds from divestments
Increased predictability of cash flows and business maturity
Figure 1: Principal sources of energy project funding through the different stages of development
Due to the lack of cash flows to service debt, resulting in negative carry, and high risk of non-completion during the planning stage, high yield bond issuance is not one of the common sources of energy project funding during this stage. It is often observed that the capital markets are unlikely to be available to support development projects with no track record. Instead, bonds have focused on the refinancing of existing indebtedness once a project is operational (and thus generating sufficient revenues), rather than financing prior to project completion. Recently, institutional investors have been seen to take construction risks on properly structured greenfield projects where what is key is (i) meeting the rating agency requirements and (ii) providing appropriate credit enhancement in the structure through, for example, shareholder or parent guarantees, equity backstop or government support. Note for example Abengoa Greenfield Euro- and USD-denominated bonds due 2019. Additionally, ContourGlobal, KCA Deutag, International Power and Puma each had a number of greenfield projects in their portfolios and were contemplating launching several more at the time they issued their senior notes (though each of them already did have a number of revenue-generating assets - either operational or development phase projects - in their portfolios at the time).
Bond financing is making even greater inroads in the construction phase, where there is more certainty around the project completion timeline and predictability of future cash flows. An increasing number of
energy projects are refinanced with high yield bonds during the construction stage, and this is where the new frontier lies for energy related bonds - see for example the Greenko bond transaction highlighted in figure 2.
Historically, however, high yield bonds were most often used during the operational phase of an asset, which is the time period after construction risk has ended and the asset begins to generate positive cash flow and the initial bank loans are being refinanced. With stable underlying cash flows in the operational phase, energy projects are akin to fixed income securities and therefore bond financing is a natural and economically appropriate financing instrument.
Nonetheless, the above dichotomy is somewhat artificial, and capital structures of varying degrees of complexity may make sense to energy companies at different stages of development, based on a number of factors such as the number, types and geographies of projects under development within the portfolio and the interested investor pools. Some of the energy-related financing structures incorporating high yield bonds include the following:
• smaller sized, bond-only deals to fund national power (both conventional and renewable), and other utility and energy infrastructure projects in developing countries;
• a bond tranche inserted or pre-packed into a multisource bank/bond financing structure for major petrochemical projects; and
• bond financings for established sub-investment grade energy corporates to fund expenditures on major assets under development.
Key features of high yield bonds in the context of energy project finance
A side-by-side comparison of the most salient features of a typical high yield bond and the typical terms of project finance is set out in figure 3. Several of these features merit a more detailed discussion, as outlined below.
Economics
High yield bonds are long-term non-amortising instruments typically issued in the form of fixed rate funds (though floating rate notes are also available), which makes financial modelling for the project easier. Longer-tenor bonds ensure financing costs that are fixed for the life of the project, thereby avoiding refinancing risk. The longer interest payment profile and bullet principal payment at maturity have the effect of extending the debt service payments over a longer term, which reduces the size of each payment, making the project more affordable for the issuer in the project finance scenario where predictability of cash flows increases as the business matures.
Recourse to the corporate balance sheet
Instead of bearing the risks of an individual project, high yield corporate bonds bear the risk of the issuing corporate entity. Thus creditworthiness is determined by an issuer's general ability to service the debt, making them less risky than project bonds. Market prices for such issuances are readily available and credit quality of issuances is independently observable by many market participants. High yield bonds may be issued either by the project company or by a separate (usually sister) company (FinanceCo) incorporated to issue the bonds and on-lend the proceeds to the project company.
Public disclosure and reporting
The one feature of high yield bond financing that is typically cited as its disadvantage is the time-consuming and costly regulatory requirements of listing, public disclosure (offering memorandum or prospectus preparation, which means exposure to potential liability for misleading disclosure), ratings, planning and implementation of a road show marketing process and preparation of final transaction documentation and placement. As part of the public disclosure, the provision of two to three years of audited financial statements is usually expected by market participants. However, these features are strongly mitigated
in the private placement context, where the parties can bilaterally agree on the amount of disclosure being provided. Moreover, even in the public bond context, often the issuers do not mind the burden of the additional documentation drafting, disclosure and regular public reporting, especially if the company is considering a subsequent equity raise, an IPO or another debt or equity capital markets transaction as the next step of its growth and capitalization. All that work on public bonds will have laid a strong foundation for such a capital markets transaction, as it will have prepared the framework for future disclosure documentation and will have sensitized the company's management to periodic public reporting.
Cash drawdown
High yield bonds are structured to have one closing upon which the whole amount is drawn down, with no subsequent drawdowns (versus committed funding and drawdowns when required in project finance or a bank revolving credit facility). Without staged drawdown to match capital investment needs, surplus funds received under the bond financing at financial close will need to be held in a bank account or otherwise invested until required. Given the current low interest rate environment, the yield on the bank account will almost certainly be well below the interest rate of the financing, leading to what is known as «negative carry». In contrast, traditional bank loans can be disbursed to the project company according to a predetermined schedule, although banks do charge commitment fees (a percentage of the margin) on available, but undrawn, facilities. The counterbalancing factor is that the bond financing is generally cheaper (due to the depth of the bond market). An «all in funding cost» should be calculated (which will take into consideration the cost of carry on bond proceeds) when determining the most appropriate type of financing. Another factor in the cost calculation is the normally longer maturity of bond financing relative to bank financing, which may increase the equity returns and decrease the risks and costs of refinancing. Note also that there has been some discussion among practitioners of structuring a staged drawdown bond, though we are not aware of any such instruments currently in the market - this is a space to watch.
Redemption
High yield bonds ordinarily carry early redemption costs (non-call periods of up to half of the tenor of the bonds, which means during this period voluntary redemption of the bonds may not be permitted or permitted only with the payment of a «make-whole» amount, which is rather expensive). The make-whole amount is calculated so as to guarantee a certain rate of long-term minimum returns to the investor on the basis of the amount which the prepaid investor would need to invest at a risk-free or low-risk rate (such as the Bund rate or the UK Gilt rate plus a premium) to achieve the same return as the bond, over what would have been the life of the bond. In contrast, project financing carries limited or no prepayment penalties. However, in the context of construction/early stages of operation of an energy project, it is highly unlikely that the project will start generating excess cash and thus drive an early prepayment during the first few years after the financing is put in place. It is worth noting that high yield bonds contain a change of control set at 101 per cent of the principal amount so that, if the project changes ownership, the bonds may be redeemed in whole or in part (which may or may not make economic sense to the investors depending on the price at which the bonds are trading at such time).
Conclusion
While energy projects have traditionally been financed through banks, the implementation of Basel III regulations, requiring stricter monitoring and disclosure, ultimately leading to higher costs and higher capital requirements, has opened the door to high yield bonds as an alternative source of finance. By accessing the institutional bond market, companies are able to reduce their project funding cost. As a result, high yield bond financing is now being used during the construction and operational stages of energy projects, and occasionally even during the planning stage, and we believe this trend will continue.
Green bonds are corporate bonds, project bonds, and sub-sovereign bonds that finance investment in green infrastructure assets such as clean energy. From a financial markets perspective, green bonds are not different from other bonds. However, green bonds are worth a separate mention in this context due to their role in financing clean energy.
Corporates in Western countries and in developing countries alike are looking at green bonds. These offerings add to the supply of bonds available to project developers who previously had to focus on financings from development banks and equity. UN Environment estimates that the number of policy measures to "green" the financial system has more than doubled to over 200 measures across 60 countries. These policies translate into the rapid growth of green finance in the marketplace. Financial centers including London, Hong Kong, Paris and Casablanca have set out plans to seize the green finance opportunity. Climate Bonds Initiative, an international organisation working on mobilising the bond market for climate change solutions, reported that there was a record-breaking issuance of US$81 billion of climate-aligned bonds in 2016, with the largest number of new issuers and the largest single month of issuance to date. The issuance of the RMB 30 billion (US$4.3 billion) green bond by Bank of Communications in China in November 2016 is recognized as the largest single green bond issued to date.
Green bond case study: A leading hydro, wind and thermal power Indian green bond offering - late brownfield phase and beyond
Greenko Group is one of the largest clean energy independent power producers in India, with more than 1 GW of projects across hydro, wind and thermal energy. The Group's portfolio includes operational run-of-river hydropower projects and wind projects, as well as two run-of-river hydropower projects that at the time of the initial bond issuance were under construction and near operational. Greenko Investment Company's issuance of US$500 million of senior notes due 2023 at 4.875 per cent enabled the company to access the international capital markets for a competitive source of financing to address the ongoing need for green energy for India. The high yield notes are guaranteed on a senior basis by Greenko Energy Holdings and represent an innovative structure that addressed the company's financing needs during the construction/early stages of operations of its portfolio assets (which have subsequently been refinanced with an upsized high yield bond issuance)
Ashurst advised the joint bookrunners and lead managers as well as the lead green structuring agent in this transaction, which was India's first high yield green bond issuance (and Asia's largest dollar green bond offering). This transaction won High Yield Deal of the Year by Asian Mena Counsel 2016 and was shortlisted for High Yield Deal of the Year by IFLR Asia Awards 2017. For coverage of our recent work on Greenko bond refinancing, please go to: https://www.ashurst.com/en/news-and-insights/news-deals-and-awards/ashurst-advises-underwriters-in-asias-largest-dollar-corporate-green-bond-offering/
Figure 2: Spotlight - green bonds
Green bonds are corporate bonds, project bonds, and sub-sovereign bonds that finance investment in green infrastructure assets such as clean energy. From a financial markets perspective, green bonds are not different from other bonds. However, green bonds are worth a separate mention in this context due to their role in financing clean energy.
Corporates in Western countries and in developing countries alike are looking at green bonds. These offerings add to the supply of bonds available to project developers who previously had to focus on financings from development banks and equity. UN Environment estimates that the number of policy measures to «green» the financial system has more than doubled to over 200 measures across 60 countries. These policies translate into the rapid growth of green finance in the marketplace. Financial centers including London, Hong Kong, Paris and Casablanca have set out plans to seize the green finance opportunity. Climate Bonds Initiative, an international organisation working on mobilising the bond market for climate change solutions,
reported that there was a record-breaking issuance of US$81 billion of climate-aligned bonds in 2016, with the largest number of new issuers and the largest single month of issuance to date. The issuance of the RMB 30 billion (US$4.3 billion) green bond by Bank of Communications in China in November 2016 is recognized as the largest single green bond issued to date.
Green bond case study: A leading hydro, wind and thermal power Indian green bond offering - late brownfield phase: and beyond
Public high yield bonds1 Project finance
Depth of market Very deep and liquid. Investors are mutual funds, hedge funds, insurance companies, pension funds, private wealth and sovereign wealth management accounts. Bank markets continue to provide majority of capital. Infrastructure funds, pension funds and other institutional investors increasingly looking to invest in long-dated infrastructure.
Interest rate Typically, fixed rate funds (though floating rate notes are also available). Floating rate (with interest rate hedging).
Documentation Documentation process longer and more costly - requires OM disclosure and road show2. No disclosure requirements.
Size Borrowing capacity linked to credit strength. Minimum size US$150m. Variable dependent on size of project, structuring and risk profile.
Drawdowns Single drawdown at closing - cost-of-carry considerations. Multiple drawdowns when required by the project's timetable.
Recourse Gives rise to a claim against the corporate balance sheet. None or limited recourse finance projects -limited to the project balance sheet and are more highly structured for credit enhancement.
Maturity Long-dated capital available (typically matures in 5-10 years). Maturity of 7 years (mini perm) or 15 years with debt sizing and amortization period linked to asset life. Capital often structured to incentivize refinancing post-construction of projects.
Hedging Bonds are typically issued in local currencies to minimise potential currency mismatches -no swap required. Interest rate hedging.
Mandatory prepayments No mandatory prepayments. No amortization payments. Bullet repayment at maturity. Traditional loans have amortization payments (with a balloon payment for mini perm structures).
Optional prepayments Early redemption costs (non-call periods of up to / of the tenor of the bonds and thereafter repayable at decreasing premium (e.g. / coupon and stepping down to 1A and par depending on tenor)). Limited or no prepayment penalties.
Covenants Lighter covenants: generally a more flexible incurrence covenant package than traditional project finance debt (resulting in less intrusive oversight of project-level decision making). Maintenance covenants: debt service coverage ratio and loan life coverage ratio testing apply for debt sizing, distribution tests and events of default. Covenants include timelines and milestones.
Amendments Expensive to amend - requires consent solicitation and payment of consent fee. Amendments relatively common and straightforwa rd.
Reporting Public reporting (quarterly + annually)3. Private reporting (monthly or quarterly + annually).
Ratings Rating required (typically Moody's/S&P)4. External ratings not required.
Figure 3: High yield bonds vs project finance - key features and considerations
Greenko Group is one of the largest clean energy independent power producers in India, with more than 1 GW of projects across hydro, wind and thermal energy. The Group's portfolio includes operational run-of-river hydropower projects and wind projects, as well as two run-of-river hydropower projects that at the time of the initial bond issuance were under construction and near operational. Greenko Investment Company's issuance of US$500 million of senior notes due 2023 at 4.875 per cent enabled the company to access the international capital markets for a competitive source of financing to address the ongoing need for green energy for India. The high yield notes are guaranteed on a senior basis by Greenko Energy Holdings and represent an innovative structure that addressed the company's financing needs during the construction/ early stages of operations of its portfolio assets (which have subsequently been refinanced with an upsized high yield bond issuance)
Ashurst advised the joint bookrunners and lead managers as well as the lead green structuring agent in this transaction, which was India's first high yield green bond issuance (and Asia's largest dollar green bond offering). This transaction won High Yield Deal of the Year by Asian Mena Counsel 2016 and was shortlisted for High Yield Deal of the Year by IFLR Asia Awards 2017. For coverage of our recent work on Greenko bond refinancing, please go to: https://www.ashurst.com/en/news-and-insights/news-deals-and-awards/ashurst-advises-underwriters-in-asias-largest-dollar-corporate-green-bond-offering/
Oil and gas high yield bonds - features and terms unique to the industry
The oil and gas industry presents an array of perhaps the most geographically diverse issuers, with probably the highest percentage of emerging markets issuers (typically from the Middle East, North Africa, Nigeria and the CIS). Because of the variety of jurisdictions involved, the terms of the bonds tend to vary quite a bit as well, and certain very bespoke terms can be found in this market. Nevertheless, some trends emerge. As a general matter, the issuers tend to have higher EBITDA(X) and Total Assets than issuers in other industries, and tend to be less levered (the long-term oil price dip notwithstanding). Despite that, the covenants in the oil and gas deals are generally more conservative than average, probably due to the oil price volatility and geopolitical risks faced by some of the issuers.
Some recent representative oil and gas high yield deals include Corral Petroleum Holdings AB (Preem AB) €570 million 11.75 per cent/13.250 per cent senior PIK toggle notes and SEK 500 million 12.255 per cent/13.750 per cent senior PIK toggle notes (Sweden); DEA Finance SA €400 million 7.5 per cent senior notes (Germany); KCA Deutag UK Finance plc US$535 million 9.875 per cent senior secured notes (Scotland) and Motor Oil (Hellas) €350 million 3.250 per cent senior notes (Greece).
A few peculiarities of the oil and gas high yield deals to highlight:
• The use of EBITDAX as a metric of performance: Earnings Before Interest, Taxes, Depreciation, Amortizations and Exploration Expenses - this is a variant of EBITDA commonly used in the oil and gas industry to measure performance.
• Grower baskets: These tend to be based on a percentage of Total Assets. While grower baskets based on a percentage of EBITDA are generally considered more issuer-friendly, for this industry baskets based on a percentage of Total Assets make more sense because these issuers tend to be asset-heavy and the value of the assets tends to be rather stable, while their EBITDA depends heavily on the oil prices, which may be volatile.
• Maturity, non-call periods: The oil and gas issuers tend to be fairly disciplined in this respect, with the average tenor for the bonds hovering around five years, and the non-call period at around half of the tenor.
• Portability: While this concept is making a comeback in 2017 in the European high yield space, it is yet to make much headway in this industry. Leverage-based portability is unheard of, though several of the larger public issues do have the ratings decline trigger in the definition of «Change of Control».
• Ratio debt test: The standard test for incurrence of ratio debt in the high yield bonds is 2x FCCR. In this area, the oil and gas issuers tend to be subject to a more conservative 2.25x FCCR test (and an additional senior secured leverage ratio test, if such ratio debt is to be secured).
• Contribution debt: There is still no contribution debt basket in the majority of oil and gas deals (though it is making an appearance in the most recent deals), while this basket has become almost the norm in some other sectors.
• Sponsor management fees: There is no addback and no restricted payment carve-out for sponsor management fees (primarily a reflection of a small number of private equity sponsor-backed deals in this sector).
• Sector-specific permitted investments: Often uncapped business investments (JVs) in oil and gas businesses are permitted, as well as investments in community development projects and economic development activities.
