Finance
First of Two Parts
A Project Finance Alternative: The Bond Market
As the WTE and WTF industry expands, the financing needs of developers will grow as well. Securing funding for these projects through traditional means such as bank loans and tax equity has proven challenging, but the bond market has opened up for these projects and has provided an alternative source of project financing capital.
John May, James Dack and Adam Pierce
As many existing landfills reach capacity, local authorities and waste management companies face significant opposition to new development from property owners, municipalities and environmentalists. Rather than enduring an arduous battle, some stakeholders are pursuing a new, 21st-Century alternative. The evolution of the waste-to-energy (WTE) and waste-to-fuel (WTF) industry is accelerating as players big and small attempt to turn these growing mountains of trash and other waste products into valuable commodities. They are partnering with a robust and growing pool of technology companies to end the flow of waste to landfills and increase their bottom line. WTE or WTF projects are capital-intensive undertakings tied to long-lived assets. A common practice in the energy space is funding the construction and operation of projects with a non-recourse debt, often referred to as “project financing”. In project financings, lenders are granted a security interest in all of the assets of the project. Lenders look past the credit of the sponsor’s balance sheet and base their credit assessment on the material contracts associated with the development, construction, operation, and management of the financed assets. With limited assets securing the loan, the “art” of project finance becomes allocating the associated risks of the undertaking to a party willing and able to bear or mitigate those risks.
Although common practice for decades, securing project financing has become more challenging in recent years. The much-discussed problems in the bank market have led this traditional source of capital to become even more risk adverse and less willing to loan money to the entire spectrum of alternative energy projects. The credit profile of alternative energy project financings, lacking a claim on the sponsor’s balance sheet, often falls below where banks are willing to fund regardless of the interest rate. WTE and WTF projects, sometimes using technology that has not been as established as wind or solar, can have additional credit risks. This, coupled with the smaller pool and appetite of tax-equity investors, has led WTE and WTF developers to seek new sources of capital to fund projects. A new source of capital has been established that developers should consider for WTE and WTF project, the institutional bond market.
The Bond Market
The main advantage that the bond market provides developers is a boarder and deeper pool of available capital. Bond buyers include insurance companies, pension funds, mutual funds, hedge funds, private equity funds and other strategic investors. Bonds can be the sole source of debt for projects or can provide a complement to bank debt. Compared to banks that have significant regulatory issues and a shorter investment horizon, many of these investors need to put money to work over longer investment horizons. This creates the opportunity to structure debt with maturities that more closely match the useful life of the physical assets and the commercial arrangements associated with both feedstock and off-take. Bonds also are a single financing vehicle that provides both construction and permanent debt at fixed rates, eliminating the interest rate risk associated with construction or mini-perm bank financing. More investors interested in a broader credit profile offering better terms at fixed rates will drive better and known returns for the developer and their equity partners. Projects in the WTE and WTF space also may qualify for tax-exempt financing through solid waste disposal bonds or other tax-exempt bonds available to both privately and publicly held sponsors. Tax-exempt bonds provide a lower interest rate relative to taxable alternatives. Although the bond market is more adept at understanding and accepting riskier projects than banks, key credit characteristics exist that each project must exhibit before bond investors are willing to put their capital at risk.
Contracted Cash Flows
Solely concerned with the timely payment of principal and interest, bond investors need commercial contractual arrangements generating enough cash flow for a reasonable debt service coverage ratio over the term of the financing. WTE and WTF projects are designed to take waste flows and convert them into other valuable products. Most generate revenue from the sale of their end products (electrons or fuels) and also generate material revenue from tip fees. As the main revenue generators for the project, agreements for tip fees and product sales are pre-requisites to securing project financing. These agreements must be “bankable” in that they are with credit-worthy counterparties and that there are limited terms under which the contractual obligations are terminable.
Bond investors are willing and able bear well-defined operating risk. However, in the current marketplace, there is little appetite on the part of bond investors to take risk associated with merchant or spot market pricing of their tipping fees or end products. The recent troubles of some first generation ethanol plants have left institutional bond investors sensitive to this issue. Bond investors will look for long-term agreements that establish the tipping fee for taking waste and the sales price of the end product over the term of the debt. With revenues fixed, the risk of debt repayment once the project is built boils down to the cost of operating the project and ensuring it is properly maintained over the term of the financing. Without contracted cash flows, if the spot market prices for tipping fees, electrons or fuels fall, the project may find itself unable to make those payments regardless of how well it operates the project. Investors want to know that once a project begins taking in and converting the waste, that they will receive timely payment of principal and interest.
Construction Risk
Bond investors are very sensitive to other types of risk, including construction risk. Bond investors want to know that there is sufficient capital on hand to construct and commission the project. Project financings employing bonds have a single closing in which all of the capital (including debt and equity) is funded and held by a trustee for disbursement during construction. Bond investors also want to know, if there are any issues during the construction and commissioning of the project, there are resources to promptly solve them. Lenders, including both bond investors and banks, generally prefer that the projects they fund are developed under a turn-key lump-sum Engineering Procurement and Construction (EPC) contract. The EPC contract allocates various risks to a single entity, the EPC contractor, who has the expertise and resources to absorb them. This gives the sponsor a single counterparty under the contract. These EPC contracts are usually backed by a payment and performance bond with liquidated damages. This gives bond investors comfort that the EPC contractor is highly confident that it can build the project on time and on budget. If issues arise, the payment and performance bond provides access to the additional resources needed to resolve them, either technically or financially.
Technology Risk
In addition to construction risk, WTE and WTF projects involve various degrees of technology risk. Broadly defined, technology risk encompasses the risk that the physical assets as designed and/or built will not perform at the required capacity or specifications, jeopardizing the project’s ability to operate and generate cash flow. Bond investors are wary of technology risk and cost effectively mitigating this risk is an important part of project financing. EPC contractors can provide performance “wraps”, which is most common with technologies that they have built in the past or are widely deployed. If the EPC contractors work is unable to meet the obligations of its contract, the surety bond provider will step in to protect bond investors. EPC contractors may not be comfortable wrapping newer or innovative technologies which they have limited experience with or exposure to. In this case alternative arrangements can be made to allocate the technology risk to willing parties able to assess and bear that risk at a reasonable cost through insurance or warranty products from technically savvy insurers.
Third Party Verification and Formal Credit Ratings
Investment bankers engaged in structuring and placing bonds for project financing complete a due diligence review similar to a bank. Bond investors often times do their own due diligence as well before investing. Similar to due diligence for a bank loan, the assessment of these projects is supported by attorneys responsible for drafting the disclosure and legal documents as well as recognized third-party experts. This requires a detailed and holistic review of the project, including the business plan, the contractual arrangements, the design of the physical assets, and the management team responsible for operating and maintaining the assets securing the debt. The subject experts provide analyses such as feedstock reports on the availability, price and sustainability of the feedstock and an Independent Engineer’s reports opining that the process and/or technology will work as designed and that the O&M plan meets industry norms.
In addition to the use of these third party experts during due diligence to establish a credit profile for bond investors, developers may also pursue a formal project credit rating from one of the three major rating agencies (Fitch, Moody’s and S&P). Project financing can be done with or without a formal rating. A credit rating maximizes the potential pool of investors able to buy the bonds due to regulatory or self-imposed restrictions but is not a requirement for all institutional bond investors.
A deeper and broader investor pool generally yields better terms. Several factors influence the pursuit of a credit rating, including both the cost and the likely outcome. A project rating for a WTE or WTF project from one of the three major rating agencies costs at least $150,000, so it may not make economic sense for smaller projects. In addition to economic considerations, the rating agencies criteria may mask the true credit quality of a project. This is especially true for projects with a small, private non-rated sponsor or parent company. If a project has a small, non-rated sponsor, the rating agencies may not provide an investment grade rating or even a high non-investment grade rating for the project, no matter how strong the underlying credit characteristics are for the project.
Market Norms for Bonds
The overall terms for bonds in project finance vary from deal to deal, but there are a few market standard norms. As discussed previously, bonds investors will want to see a reasonable ratio of cash flow available for debt service and scheduled debt service payments over the term of the bonds. The required debt service coverage ratio will vary depending on the overall credit quality of the deal and could range between 140 percent to more than 200 percent. Interrelated is the requirement for some form of hard equity (or “skin in the game”) from the sponsor or its financial partners. As the debt service coverage ratio varies so will the hard equity required. For typical project financings however, hard equity will make up 20 to 50 percent of the overall capital structure. Bond investors want to see others make a financial commitment to the project whose return on that investment is second in line to the debt, aligning their interests for generating ample cash flow available for debt service.
As bond investors are requiring contracted cash flows, the maturity of the bonds will be equal to or less than the length of the off-take agreement. The bonds will be fully amortizing over their life. Interest only will be paid on the bonds during the construction and commissioning of the project. Once the project begins producing revenue, the revenue will be used to repay the principal amount as well as the interest on the remaining balance. Typically interest is paid semi-annually and principal is paid annually.
Call provisions for the bonds will vary as to the type of bonds issued, either taxable or tax-exempt. Tax-exempt bonds typically have an eight- to 10-year par call for 20-year bonds. In some situations it may be possible to negotiate five-year premium call. Taxable bonds typically have make-whole calls.
Other market norms include a debt service reserve fund that is at the minimum six months of maximum principal and interest of the bonds. Bond investors will also require the funding of operation and maintenance reserve funds consistent with industry standards and asset needs per an independent engineer’s report. There will also be covenants (including minimum debt service coverage ratios, cash traps and reporting requirements), waterfalls for cash flows and additional bonds tests.
As the WTE and WTF industry expands, the financing needs of developers will grow as well. Securing funding for these projects through traditional means such as bank loans and tax equity has proven challenging due to the recent trouble in the financial markets over the last few years, but the bond market has opened up for these projects and has provided the market with an alternative source of project financing capital. Although bonds have become a more liquid source of capital for project developers, there are still key credit characteristics that projects must display in order to get bond investors attention at competitive rates. In part two of this article credit enhancement strategies will be discussed for projects that lack one or more of the key credit characteristics. These enhancement strategies can bolster the credit of the project allowing the bonds to be priced at competitive rates that make sense for the project and its developers.
John May, Managing Director, is head of the firm’s Renewable Energy Practice, which he founded in 2003. He is a seasoned project finance investment banker who has financed more than $1 billion in loan and par values for over 100 clients in his 20-year banking career. He can be reached at (314) 743-4026 or [email protected].
James Dack, Vice President, opened the firm’s Seattle office in March 2010. He brings a unique perspective to project finance, having participated as an investment banker, a developer and an equity sponsor deploying institutional capital in highly structured investments. He can be reached at (206) 652-3564 or [email protected].
Adam Pierce joined Stern Brothers in 2010 as an associate in the firm’s Alternative Energy group. Prior to joining Stern Brothers, he spent three years as an analyst at Wells Fargo Securities in its Energy and Power investment banking group where he was involved in a broad range of equity, debt and M&A assignments. He can be reached at (314) 743-4003 or [email protected].