‘Interest Only’ Project Finance
Insurance instruments can provide valuable credit enhancement to capital risk, especially in environments such as, but not limited to, emerging and developing economies. Having mentioned ‘Interest Only’ financing in my last blog a description of this technique can only add weight to the intelligent use of the insurance markets as a valuable aid to project finance.
One of the major problems encountered with developing/emerging economies is that long-term capital for business development would be a preferred solution under normal circumstances, but the instability risks dictate short-term exposure. For certain types of project ( typically < USD 50 million requirement) where, for instance, there is a quality Western off-take to cover debt service, there is a technique that can be applied that utilises insurance products to change the country risk profile of the project and thus permit long-term financing on an attractive risk profile. This technique involves over-lending and traditionally works on the basis that the advance to the project includes an amount that is specifically used to purchase an asset, in the form of a deep-discounted instrument, to insert into the Balance Sheet of the borrower and which is pledged to the lender, and has a guaranteed maturity value equal to the total capital lending. The deep-discounted instrument is usually a stripped-USD Treasury or zero-coupon bond thus changing the risk profile of the borrower to that of the US Government for capital purposes. The borrower pays interest (albeit at a premium rate over a comparative rated borrowing, but much lower cost of finance than a straight borrowing) on the total borrowing through a lien over the off-take proceeds. (Please do not confuse this process with so-called leased assets that cannot be pledged)
The benefit of this structure is that all debt service by the borrower (which is all interest) is normally tax deductible, thus making the effective cost of money relatively cheap. Furthermore, so long as the borrower has no beneficial interest in any excess value of the US Treasury on maturity then it is normally possible to negotiate a tax exemption with the relevant tax authorities relating to the capital gains over the lending period. In reality all that has happened is that the lender has inserted a valuable asset, that can be pledged, into the borrowers Balance Sheet that otherwise would not be capable of providing suitable security.
The advantages of a stripped Treasury solution is the fact that it provides an “AAA” rated security which is easily disposed of in the event that the lending terminates early. What is not known is the discount price at the time of such disposal, or the value of the security/collateral at any point in time throughout the term. This can be a problem with booking such a transaction. Furthermore the current 10 year yield on US Treasuries is too low for such purposes making the over-borrow costs too expensive.
Let us examine how we might improve on this situation using insurance products rather than a stripped-bond.
There are a number of insurers that offer guaranteed growth funds in various guises currently producing yields in excess of 8% p.a. Many are investment grade credits and, over a 10 year term, tend to out-perform bond yields. What is more interesting is that many of these insurers are also now owned by major banks. If the lender were to use the over-lending amount to invest in such a fund and use the policy as the Balance Sheet asset with assigned rights to the total value of the proceeds (which are generally tax-exempt) then two prime advantages exist. Firstly, the value of the policy cannot reduce in value irrespective of market conditions as the price of units cannot go down in value. The only factor that can affect the value is if surrender occurs early in the term in which case there are likely to be early surrender penalties (around 5%). Secondly, as such a fund will normally out-perform bond yields, there is likely to be a profit which can be secured as a maturity fee. Therefore, for a reduction in credit rating from “AAA” to probably “AA” we have achieved a far more stable collateral value and with a probable profit.
This type of structure only really works for financings of 10 years or more but demonstrates that the insurance market can facilitate financings that otherwise would not have been possible on very attractive terms to both borrower and lender. Some guaranteed growth funds will also provide life assurance cover as part of the fund package thereby allowing the lender to assure the lives of key borrowers at no extra cost yet provides more risk mitigation.
We have successfully executed such structures where the lending bank has used its own subsidiary insurance company investment funds to generate the capital redemption amount thus accruing all of the fund fees and charges for their own institution.
Let us extend this type of structure one step further to provide some interest cover in the event that the off-take does not generate enough cash flow to service debt financing. Most of these guaranteed growth funds have an encashment facility which can be used by the policy holder to draw regular income up to a certain percentage of the profits of the fund. A very simple calculation will determine by what ratio the initial premium needs to be leveraged in order to secure the require exit value whilst providing the capacity to draw income for both the interest cost of the leverage, and any underpayments on debt service. This would be invisible to the borrower, and would not remove the liability on the borrower to make good any short-fall. However it would prevent the need to reclassify the risk on the original loan in the event of an interest payment default.
Let us now attempt to define the benefits to such a financing through an example of a privately (socially) owned food processing factory in a emergent economy that suffers from the aftermath of a period of undemocratic control where asset values are difficult to define, and the legal framework makes any form of security charge unacceptable. The company requires to modernise its facilities in order to comply with the requirements of its major (good covenant) Western customers. The company has exported over 70% of its production to these customers with hard currency payments for a number of years, and their customers are prepared to enter into long-term off-take contracts with the company. The cost of the required modernisation is $25 million which would require a term of 10 years to service with no capital repayments in the first 2 years. Political Risk insurance is available at 2.75% p.a. but only for 2 years with renewal options at the discretion of the insurer. The off-take commitments would provide at least 2.5 times debt service cover after operating costs over the term. There is no active bourse. Corporate tax rate is 48%. Local borrowing costs, if such funds were available, would exceed 16% p.a.
As a banker this is an attractive project, and if this was a company located in a stable Western democracy this requirement would be a reasonably trivial project finance possibly using a combination of export credits, leasing structures, equity placement, term loans, etc. Given the environment in which the company resides, and through no fault of the company, the required financing using conventional finance solutions is practically impossible, especially with the lack of term political risk (primarily business disruption) cover. Even if a two year rolling facility were negotiated the company would be restricted on what it could do knowing that there was a possibility that the facility could be called if the political risk cover were withdrawn. Furthermore the combination of high interest rate charges and insurance premiums would make the cost very unattractive in terms of cash flow and investment strategy for the borrower.
We need to change the risk profile in order to structure a financing that will provide a financial environment that can reasonably be supported by the borrower, and will be an acceptable credit to the lender. Having determined that we can achieve the tax exemption for a stripped-Treasury solution on condition that we advance 10 year term funds we establish that the deep discount price is 44¢ thus requiring $22.5 million of over-lending. Let us assume after all costs and fees the total advance is US$ 50 million. Using a real template from a suitable guaranteed growth fund using a conservative 7.5% growth (8.5% yield) our $22.5 million will grow to US$50,659,488 after 10 years after all costs. As this yield is only nominally above bond yields it would be reasonable to suggest that expectation would be for a higher return. I should mention that once the gains in any years are rolled into the capital amount the guaranteed amount by the insurance fund is the new capital amount. We have now moved most of the capital risk to a friendly domicile and enhanced our credit rating to investment grade.
We now need to structure the interest payments. As we have an investment grade covenant on the capital repayment the interest rate can be set at a level which reflects this partial credit enhancement. If we assume that an “AA” rated lending would be LIBOR+1%, the covenants from the borrower’s customers would warrant no more than LIBOR+2%, and we can achieve cover for political risk inclusive of business disruption and force majuere albeit on a renewal basis at 2.75% on exposure adding 21 bps to the cost. Therefore we calculate that LIBOR+2.5% would provide an attractive return to the lender.
Loan: US$ 50,000,000
Term: 10 years, bullet repayment at maturity secured by major insurer
Interest: 3 month LIBOR+2.5%, payable quarterly in arrears
Security: “AA” covenant on capital, Quality off-take covenants for interest,
“AAA” rated political insurance for disruption of business
Fees: US$ 2,500,000
Bonus: Uplift on Guaranteed Growth Fund policy proceeds
Loan: US$ 25,000,000 for modernisation, US$ 22,500,000 asset purchase
Term: 10 years, interest only
Fees: US$ 2,500,000
Assuming for simplicity of illustration that US$ LIBOR was 5% throughout the term which would result in a total repayment by the borrower over the 10 year term of US$37,500,000
Equivalent Cost of funds pre-tax; 8.6% + Insurance Premium of 21bps
Equivalent Cost of Funds post-tax: 4.5% + Insurance Premium of 10bps
As can be clearly seen the introduction of insurance products has made an otherwise difficult transaction into a very attractive proposition for both the borrower and the lender. Furthermore there is the goodwill element between the bank and borrower for future business as the emergent country stabilises. As a footnote, the fund management fees indicated by the example were US$18,383,979 thus making this financing substantially more rewarding for all financing parties than an alternative conventional lending.
There is a further level of sophistication to this solution which reduces the initial capital risk to the lender, but requires more attention to the capital risk at the ultimate exit. If it is anticipated that the instability of the country of the borrower will significantly improve over the financing period, and the insurance fund is a consistent performer, then it is possible to reduce the over-borrow amount by gearing the amount placed into the insurance fund at a much lower cost (capital and interest of the gearing amount guaranteed by the insurance fund and thus LIBOR+1% is achievable) benefiting from the yield on the growth of the gearing amount less the interest cost). We have successfully geared at 3:1 with good results but a full explanation of the dynamics of this enhancement is beyond this blog discussion.