S2 project bond – The first of many

Almost five years to the day after the Shuweihat S2 power and water purchase agreement was executed, Ruwais Power Company, the project company set up to build, own and operate the Shuweihat S2 1,507MW power and 100m gallons a day water project based in Abu Dhabi, successfully issued a US$825m project bond to partially refinance its existing debt facilities and become the first true I(W)PP in the GCC to issue a tradable project bond in the capital markets. By Charlie Seymour, financial adviser, ADWEA.

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This success promises to open up a significant new investor base for IPP/IWPP developers in Abu Dhabi and the wider Middle East region, which will have a significant impact on the financing and competitiveness of strategic domestic infrastructure. Before I explain the objectives behind the initiative that culminated in July’s successful closing, and the challenges faced and lessons learned, a quick look back to the past is useful to set the scene.

Background

For procuring authorities in the power and water sector such as ADWEA, and the developers that submit bids, the financing structure underpinning projects continues to be driven by competition. Competitive procurement remains an absolute necessity and is enshrined in Law No. 2 1998 relating to the water and power sector in the Emirate of Abu Dhabi; as a result ADWEA continually looks to adapt and refine its template to the ever-changing nature of the equipment contracting and financial markets to ensure that the power and water sector in Abu Dhabi continues to benefit as much as possible from competitive prices.

Historically the financing (and re-financing) of all of Abu Dhabi power and water projects since privatisation commenced in 1998 (there have been 10 competitive tenders and three refinancings to-date) have been closed in the commercial bank project finance market. This has been largely driven by a historically hugely liquid bank market that, after a period of familiarisation and education in the late 1990s, has now become fully comfortable with the underlying credit structure that forms the ADWEA I(W)PP template.

The PWPA risk allocation structure, the Abu Dhabi government guarantee backstopping the offtakers’ contractual payment obligations and the involvement of industry-leading EPC contractors, operators and developers have made the ADWEA IWPP template an extremely attractive lending (as well as investment) opportunity.

This level of comfort has been translated into the bank market offering its developer clients the most competitive pricing, terms and conditions as well as substantial liquidity. It is this wider bank market, (including ECAs in projects where the debt requirements exceed total bank capacity), that has been largely comfortable lending significant amounts on a 80:20 gearing, 1.2 debt coverage basis, often for maturities in excess of 20 years and at fine pricing largely immune to prevailing market volatility or global political events.

Why the capital markets?

So why did ADWEA and TAQA (ADWEA’s subsidiary, which is the majority owner of S2 and other operating domestic IWPPs) and their foreign Shareholder partners in S2 (namely GDF Suez, Marubeni and Osaka Gas) see merit in pursuing a refinancing in the capital markets, embarking on the necessarily time-consuming and costly journey ?

The reasons were predominantly twofold:

* Strategic – For both ADWEA and TAQA, accessing liquidity in the capital markets was a key strategic objective. Given the double whammy of the financial crisis and subsequent regulatory tightening in the financial markets leading to the introduction of more onerous capital reserving requirements on commercial banks, the days of plentiful, cheap finance from banks for maturities greater than seven to 10 years can be spoken of in the past tense. While there is still bank market appetite for providing long-term finance to match long-term concession or offtake contracts for strategic infrastructure assets, this is predominantly currently provided by Japanese financial institutions and government-owned organisations (ECAs and the like). In ADWEA’s view this liquidity is not sustainable indefinitely.

Strategically it is key to ADWEA, as procurer of future infrastructure, and TAQA, as owner of the infrastructure and future recipient of capital needed to expand its energy business internationally, to “churn” bank capital. A similar perspective is shared by the foreign shareholders in S2. Such a churn of capital will manifest itself either by refinancing existing long-term debt facilities (for existing projects) or by structuring short-term “mini-perm” types of structures (for new projects).

The involvement of banks in funding infrastructure in Abu Dhabi of course remains key, particularly given their deep understanding of the project finance structure and in particular the related construction risk. However, limiting banks involvement for the first five to seven years of a project’s lifespan optimises the cost of debt. The capital markets, with certain components (ie, life insurance companies and pension funds) keen on duration, are the natural take-out of bank debt to provide long-term financial support.

* Tactical – The second reason for looking to refinance in the capital markets was tactical. Given that the original S2 transaction signed its PWPA in July 2008, simultaneously transacted its interest rate hedging programme when long-term swap rates still hovered around 5% and sought to close a highly competitive 25-year financing, meant that following the collapse of Lehman in September 2008 and the subsequent withdrawal of the original S2 financing plan as bid, ADWEA was forced to restructure the transaction, bringing in Marubeni as a key investor together with substantial JBIC liquidity.

The consequence of this perfect storm of events, and the fact that increasing the tariff as bid was never a feasible option, meant that the costs of debt increased dramatically and S2 shareholder projected returns were accordingly depressed from the levels seen in previous ADWEA transactions. The S2 bond refinancing therefore offered the chance for S2 shareholders to normalise their projected rate of return and for ADWEA/TAQA to ensure their returns were brought back to an equal footing with their foreign shareholder partners.

Challenges

Looking to the liquidity of the capital markets, and in particular to the US capital markets, was one thing but accessing such liquidity introduced significant challenges for S2 and its shareholders.

* Rating – The main historical stumbling block to the capital markets providing a viable and competitive alternative to bank finance for Middle East based power/water projects has been to get a strong enough credit rating to justify competitive pricing while preserving the economic benefit of a tight debt service cover ratios and high gearing traditionally provided by the commercial bank market.

Given the lack of track record of rating IWPPs in the Middle East region, and the regular access to the bond markets by US utilities, the rating agency methodology and accompanying scorecard was/is understandably strongly influenced by the US IPP market. Unique features of the Abu Dhabi IWPP credit story, namely the steep summer power peak and low winter trough, the need to generate power at part load in winter to meet what is relatively stable year-round water demand, the critical nature of a power and water plant to a dynamic and fast growing economy such as Abu Dhabi, the strength of the PWPA risk allocation and offtaker credit, the minimal operating risk and the government’s explicit and implicit role in managing issues within a non-recourse structure, all needed to be presented and explained. It was gratifying to all sponsors and advisers that S&P and Moody’s understood the credit story and rated the project A–/A3 in spite of the project‘s relatively high gearing levels/low DSCRs.

* Documentation and intercreditors – For those of us new to the world of project bonds, the documentation process was a rude awakening. In commercial bank deals with, for example, ECA involvement, intercreditior discussions tend to lag the main finance documentation process, both in priority and focus as well as on the physical timeline.

For a project bond nothing could be further from the truth. Even though the three main creditor groups in the S2 deal (namely the commercial bank syndicate, bondholders and JBIC) are all senior secured on a pari passu basis, all have markedly different perspectives of how, when and in what manner waivers, consents and theoretical defaults should be dealt with. While precedent from the region (namely the Dolphin and RasGas bonds) helped with the basics, the S2 intercreditior discussions broke new ground.

The challenge facing lawyers, sponsors, bookrunners (representing bondholders’ interests) and existing lenders alike was how to accommodate bondholder interests within the existing deal’s heavily negotiated suite of covenants and events of default, where in particular JBIC’s role was clearly defined. The “standard” treatment of standstill periods, voting rights and voting percentages within each creditor class and across the senior lenders as a whole all had to be carefully re-thought through and negotiated while ensuring that no one strayed into each creditor class’s “no-go areas” (of which there seemed to be numerous!). Ultimately, the majority of issues were resolved and a final agreement was reached as deal fatigue/exhaustion set in. The resulting magnus opus will hopefully act as a template for future multi-sourced power deal intercreditors!

* Competitive tension – As mentioned above, issuing bonds for S2 was a key strategic aim for ADWEA and TAQA. The existing financing that closed in October 2009 imposed certain constraints on the project’s flexibility to refinance. By early 2012 the existing interest rate swaps were significantly “out of the money” given the continuation of the low interest rate environment.

It was decided at an early stage by the sponsors that the swaps should not be unwound; given the need to maintain hedge accounting effectiveness, this translated into maintaining approximately US$1.5bn of floating-rate debt in place, split pro rata between JBIC and the commercial bank facilities. Working with Citibank, the project’s financial adviser, an optimal structure was agreed upon whereby the sizing of a long-term project bond was set at US$825m, the proceeds of which would be partially used to prepay JBIC and the commercial banks up to an aggregate of US$484m pro rata between JBIC and the bank syndicate. Not only was a bond of this size economically optimal, it was also seen by the syndicate desks of the bookrunners to be the perfect size for a debut issuer in a new asset class – large enough to be easily tradable and liquid, but not too large to jeopardise competitive pricing.

The challenge for the sponsors and our financial adviser was how to maintain competitive pressure on the existing bank syndicate to reduce the original S2 pricing down to 2012 “market” pricing. Fortuitously, the existing bank syndicate split into three distinct groups: (1) those that wanted to play an active role in the bond and as a result were prepared to commit significant debt capacity at the sponsors’ required pricing in order to obtain a key role in the bond; (2) those that wanted to play an active role in structuring the bank deal and as a result were also able to provide significant debt commitments; and (3) those that had little or no appetite for a long-term (18-year) asset, but were prepared to retain swap positions and a nominal level of debt in order to assist the sponsors to achieve their pricing aspirations. Incredibly and almost without precedent, the sponsors were able to meet each banks objective.

* Market volatility – A quick glance at the short history of the S2 project shows that it faced many challenges along the way: the fallout from the Lehman bankruptcy and resulting financial crisis; the need to restructure the deal to preserve the EPC contract; and the need for ADWEA and GDF Suez to provide corporate bridge loans and support to allow ADWEA to identify and bring in Marubeni Corporation as a shareholder and JBIC as a provider of scarce long-term finance. It was therefore not surprising that at the time that the sponsors were ready to roadshow the S2 bond they would face a background of severe market volatility following comments made by the US Federal Reserve chairman signalling a change of policy in relation to the pace and timeframe of quantitative easing.

While all sponsors and bookrunners expected volatility to subside relatively quickly given the lack of any radical change in the underlying economic fundamentals, particularly in the US, the concern was that many potential natural investors in the S2 bond, particularly hedge funds, and traditional “mark-to-market” investors, would be unable to participate given the overall market retreat from long-term emerging market paper.

Citibank and the bookrunner group had spent much time laying the groundwork to explain the key credit features to US and Asian investors with the aim to bring in US infrastructure investors (typically the large pension funds and insurance companies) and Asian accounts familiar with TAQA (but less familiar with project bonds) into the deal. This work became more critical given the retreat from long-term paper by many trading-oriented investors. The roadshow and execution process went remarkably smoothly, a testament to Citibank as lead bookrunner and the bookrunning group of BNPP, BTMU, HSBC, National Bank of Abu Dhabi and Standard Chartered.

The future

So what impact will the successful S2 bond issue have on our sector?

1 – It now introduces a credible, new source of liquidity for funding infrastructure;

2 – Consequently, it allows ADWEA as a procuring authority to structure tenders that can credibly anticipate refinancing in the capital markets and/or the banking market depending on prevailing market conditions;

3 – Already the signs are encouraging. Out of six Mirfa bidders, three offered mini-perm structures at very competitive rates;

4 – It allows ADWEA and TAQA to optimise their existing project finance portfolio for the benefit of both the shareholders and potentially the sector, assuming that there is sufficient upside to share with the procurer through a tariff reduction; and

5 – However, the S2 bond’s main success is in starting a dynamic relationship with a new investor base that will hopefully encourage greater participation in the Abu Dhabi power and water sector and also beyond the borders of the UAE in the region.

Facts & Figures

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