Gulf markets need long-term debt instruments

The region needs a long-term instrument to refinance mini-perms. But, as Victoria Mesquita Wlazlo of Morgan, Lewis & Bockius argues, its capital markets must deepen if project bonds are to be effective.

Historically, large infrastructure projects in the Middle East – particularly those with long-term concession or offtake agreements with creditworthy sovereign and quasi-sovereign entities – were mainly financed by European commercial banks looking for stable, revenue-generating assets.

However, following the 2008 financial crisis, the liquidity ratios and capital requirements under Basel II, and otherwise imposed by European governments and regulators, reduced European banks’ appetite for long-term debt. Uncertainty and diminished confidence in the viability of many of those banks contributed to the offloading of their exposure to long-term infrastructure project debt.

The resulting vacuum has, to some extent, been filled by other sources of finance for long-term projects, including export credit agencies, multilateral and bilateral agencies, local financial institutions and Japanese banks. Commercial banks have also helped by lending for shorter maturities through the use of bridge and mini-perm loans.

More than a decade after the 2008 financial crisis, local and international banks’ preference for shorter tenors has led to a resurgence in mini-perm structures. Mini-perms are short-term loans – typically with five- to seven-year maturities – that are used to fund the construction phase of a project. They must then be refinanced with permanent funding shortly after the project reaches its commercial operation date.

The mini-perm may be ‘hard’ or ‘soft’. A ‘hard’ mini-perm requires full repayment at maturity, with failure to refinance before maturity resulting in default. A ‘soft’ mini-perm provides for a sweep of most, if not all, of the project’s available cashflow for payment of the loans after the maturity date. This cash sweep is usually accompanied by an increase in the margin to incentivise the sponsor to refinance the loan. In any case, the sponsor bears the refinancing risk.

Sponsors prefer soft mini-perms. However, lenders usually prefer hard mini-perms to ensure repayment at the maturity date. This type of structure also enables lenders to reprice their loans at current market rates. However, the hard mini-perm carries default risk: if credit markets tighten before maturity and make refinancing too expensive or non-bankable, this failure to refinance may result in the acceleration and termination of the project. As a result, there have been a number of soft mini-perms used on projects in the Gulf Cooperation Council states, such as the Dumat al-Jandal wind project and the Rabigh 3 independent water project in Saudi Arabia and the Al Maktoum Solar Park in Dubai.

Why project bonds and greenfield don’t match

Project bonds have four main characteristics that make them difficult to use in greenfield projects.

Whereas a project will only require funds to be disbursed in instalments as required under the relevant EPC or turnkey contract, project bonds require the upfront issuance of the full amount of the face value of the notes, deriving negative carry.

Underwriting commitments and pricing typically occur shortly before issuance, and these may be affected by macroeconomic events unrelated to the project itself. This means that project bonds carry additional market risk.

The amendment and waiver process, which is necessary to reach a large number of bond holders that are often not known to the project company, brings complications. However, this issue is mitigated by the fact that project bonds have looser covenants than bank financings.

Bond investors may have less appetite for construction risk and are, in any case, reluctant to take an active role in monitoring projects. This makes them more comfortable with covenants that are looser, but which involve less risk.

Rise of the project bond

Another instrument that has resurfaced in recent years is the project bond. Before the 2008 financial crisis, the international project loans and bonds markets generally competed with each other to provide loans with tenors of 15 to 20 years. However, since then such long tenors have become associated with the bond rather than the loan market. Bonds are inherently suited to financing large infrastructure projects backed by stable returns, since their tenors can be tailored to match long-term concession or offtake agreements. Bonds also give the issuer access to a greater pool of investors than commercial bank debt does. Although the yields on project bonds are higher than the commercial bank rate, the spread between the two has narrowed in recent years. This is because bank funding is subject to the higher costs resulting from Basel II, and a greater number of institutional investors in search of higher yields are seeking to purchase project financing bonds.

This trend became apparent in the GCC in 2017 with a range of projects. Among these were ACWA Power’s 22-year, $814 million project-backed bond; the Emirates Sembcorp Water & Power Company’s 18-year, $400 million paper; and the Abu Dhabi Crude Oil Pipeline’s debut $3.04 billion dual-tranche paper, which was split over a 12-year, $837 million bullet bond and a 30-year, $2.2 billion amortising bond.

Yet project bonds may not be adequate for the construction phase of a project. As such, companies will be more likely to issue project bonds once the project has been completed and commercial operations have begun – preferably, after one or two cycles from the start of commercial operations, so as to have a track record. That makes project bonds the ideal instrument for the refinancing of mini-perm structures.

ACWA Power’s project bond, which was backed by dividends on eight water-desalination and energy projects, was oversubscribed. However, there are concerns about the depth of the market in the GCC for these types of instruments. In this respect, it is worth highlighting that two of the key traditional buyers of long-term paper internationally – insurance companies and pension funds – seem to be, for the most part, absent in the Gulf Arab states.

Insurance companies, and particularly those in the UAE and Bahrain, have not scaled up their investments in long-term fixed-income paper. To a great extent, this is a consequence of the regulatory environment (the position is slightly different in Saudi Arabia, but such details are beyond the scope of this article).

Another class of major players that are absent from this market are pension funds, since many GCC countries have not yet developed pension systems. In the UAE, for example, employees are not required to contribute to pension schemes; instead, an employee will receive an end-of-service gratuity when their employment is terminated. As such, large institutional investors requiring long-term paper are missing from the Middle East’s investor landscape. In fact, some regional sponsors have even turned to the US for long-term financing of projects through private placements to US pension funds.

Wanted: deeper capital markets

For the past few years both local and European banks have displayed a preference for shorter term financing, which has created a vacuum in the sources of available financing for large infrastructure projects. This vacuum has been filled by ECAs, multilateral and bilateral agencies, as well as through the use of short-term financing structures such as mini-perm loans.

As mini-perms mature over the next few years, sponsors must consider alternatives for refinancing. Project bonds would appear to be ideal in these circumstances, but demand for such long-term paper may not be immediately forthcoming in the GCC.

A deepening of the Gulf’s capital markets, in particular for long-term fixed-income instruments, must take place to create the demand required to finance large infrastructure projects.

Victoria Mesquita Wlazlo is a partner in the Dubai office of law firm Morgan, Lewis & Bockius