PFI Japanese Project Finance Roundtable 2015: Part 3

Rajeev Kannan: Let me split the discussion into two parts: one, debt, and then equity. On the debt side, as I mentioned before, we have started working with a number of investors in Japan, both regional banks as well as life insurance companies and pension funds.

One example was we established a co-investment scheme using our in-house trust banking capability with three regional banks, which we announced late last year, and where we are actually moving some of our existing assets into that structure.

We hope to replicate that with other banks as well. And similarly, with a life insurance company, we have closed a transaction where we have moved an asset on our books to their balance sheet also. So, in that sense, we are co-working or participating with a different class of investors to basically expand the base.

But a key point to highlight is – unlike banks like us where we have 300 people globally working on this kind of business and have a strong in-house portfolio management team – it is unfair to ask every new entity coming into the market to have that kind of framework or base.

So we try to be a service provider where we can support such entities to manage their portfolio because we don’t believe that every entity can set up a monitoring team or portfolio management team of 20 or 30 people once you start getting into this business.

Talking about the equity side, again, that is important. As Yamamoto-san mentioned, projects are getting bigger and bigger. Obviously, Japanese corporates do have access to equity but it will be challenging as the sizes get bigger, so there are a couple of initiatives we have tried to take.

For example, in India, we established an infrastructure fund jointly with Kotak Mahindra Bank from India and Brookfield from Canada, which can provide equity capital for projects.

Similarly, the three megabanks and JBIC working with the Ministry of Land, Infrastructure & Transport have collectively set up a new entity. The English name is Join. I don’t know what the Japanese name is, but it basically is to provide equity capital to infrastructure projects that are done by Japanese companies.

So there are initiatives being taken individually by us and collectively by the organisations in Japan to support growth of Japanese companies outside in the world.

Rod Morrison: Just one quick point, Rajeev. You mentioned about the Japanese life companies. Given the size of the assets they have under management, isn’t it a surprise that we’re still only talking about one or two deals they have done?

Rajeev Kannan: Standard & Poor’s has done a study where they have confirmed that the probability of default is not very high for project finance. Even when there is a default, the loss-given default is normally quite low.

But, as an asset class, it’s fairly complex because no two transactions are the same. So, in that sense, we see the life insurance companies slowly getting used to such transactions, but once they have looked at multiple sectors, multiple countries, then they will get more comfortable and look at bigger portfolios.

We see the trend being sequential and actually it’s going to ramp up much more sharply probably three or four years from now.

Kohei Toyoda: Let me talk about how to utilise domestic huge savings. Japan can improve the competitiveness of the financial sector by utilising such savings; that’s the reason why we closed a liquidation deal two months ago, together with my colleague who is sitting in front of me.

And during that process we confirmed a strong, or at least a positive, appetite from regional banks and life insurance companies and so on. But, at the same time, we found there are difficulties, as Mr Kannan said: a lack of human resources, who can read English documents, and a very detailed project focus, et cetera, et cetera, and a lack of a worldwide network.

So the megabanks and JBIC may provide such services in order to support a lack of their capabilities. But at the same time, the biggest hurdle for the new investors and new financiers in the project finance market is the US dollar funding. Although the life insurance companies and other long-term financiers have a long-term yen asset, swapping into US dollars increases their funding costs so much. In the end, they will not meet the target rate.

So I have at this moment no good idea how to solve this issue. But if we can solve that hurdle, we will be able to improve the competitiveness of the Japanese finance sector. That’s the reason why we are trying to continue our efforts to liquidate our assets, scrutinising our project finance assets or utilising the trustee scheme, et cetera, in order to invite new Japanese investors into this market.

At the same time, they need to learn how to structure project finance from scratch because they do not have enough experience in this area. So we are providing a kind of training session to regional banks in order to transfer our experience and knowledge in this market. That’s our initiative, and we’d like to give this initiative in order to maximise Japanese money into the project finance sector.

Rod Morrison: The liquidation initiative you mentioned at the start, it was a few months ago, what was that?

Kohei Toyoda: Yes, we utilised a loan participation scheme in order to sell our project finance asset in the Middle East. The details are confidential so we cannot disclose them in detail, but at least some regional banks joined this structure.

Fumio Inagawa: I used to be head of the cross-border syndicated loan department and so I understand Japanese regional banks’ approach to project finance. This is the general approach for the regional bank. They start to do the cross-border syndicated loans to provide financing in US dollars, as well as taking the non-Japanese corporate risk. Then, they come to the project finance field.

So these days I have found out there are many Japanese regional banks interested in doing project finance, and some of them have started to participate in transactions, even the primary stage.

At Mizuho, we are accepting trainees from regional banks to help them understand the scheme of project finance. And, similar to JBIC, we are hosting study sessions for the regional banks.

On the other hand, institutional investors, they are quite interested in project finance. But their approach to project finance is different from the approach of the regional banks because they are investing a bunch of money in one project.

So I understand the shortage of staff. If they are in the audience, I would like to get an opinion from them, but my view is that they like more to invest one big amount in one project. That, I think, is the approach of Japanese institutional investors.

On the other hand, the Japanese regional banks are going to increase the amount – at the beginning a small amount, then go to a larger amount. When we did the project finance a few decades ago, we had a similar approach. We took US$5m or US$10m from one project. Now we are ready to provide US$100m or US$500m. I think the Japanese regional banks are taking the similar approach to what we did before.

Rod Morrison: Do the institutional investors prefer projects that have gone through construction?

Fumio Inagawa: I don’t think they are ready to take construction risk, yet. Of course, they are in deep discussions internally, but they are more comfortable to do only operating risk projects.

Masahiro Morimoto: As you know, the LNG project has a critical aspect. Of course, it’s important for us to procure financing to make project final investment decisions but we expect some other aspect to manage political risk from the lender side.

As you know, the energy project loan tenor is very long, 20 years and 25 years. If an unexpected event happens, especially if it’s driven by a political event led by the government of the counter-side, then we have to manage such an unexpected event from the sponsor side, of course. But such a lender’s position would be the leverage, sometimes could be the leverage to the project side, especially towards the government. That’s a specific reason for us to expect JBIC and NEXI to take a majority in a project.

Rod Morrison: Shibata-san, does Standard & Poor’s encourage alternative investors?

Hiroki Shibata: Yes, exactly. As Toyoda-san of JBIC mentioned, we are having an increasing number of meetings with regional banks, insurance companies and pension funds. In line with recovering Japanese corporates’ financial performance, some regional banks and insurance corporations are really seriously considering new investment in project finance.

And in Asia, as you know, there is a continuous very low interest rate. In the domestic market, several regional banks and insurance companies are finally deciding to invest in project finance overseas.

So in Asia, pension funds are global. The Japanese government pension investment fund, what we call GPIF, finally decided to enter the infrastructure field. So this may trigger other pension funds’ investment policy over the next three to five years.

We are considering better training tools or better reports for market participants to understand what’s the key risk; country risk, political risk or cost overrun risk, for better development in the Japanese project finance market.

Takahide Yamamoto: Well, it is very good news. There is a lot of domestic liquidity. But from the contractor point of view, we would like to know which project would come first. Last year there were a lot of projects, especially for LNG, but due to the low oil and gas price, some projects were postponed or cancelled. In order to estimate the EPC price, we cost a lot, sometimes more than US$10m, so we would like to know from the financial institutions, which project will come first (laughter).

Alexander Borisoff: That was a question for the financial institution. Just because we’re Milbank it doesn’t mean we’re a bank. It doesn’t work that way. I’m unable to answer that question. But I do think Toyoda-san and Shibata-san both hit on a very key element here, which is the level of sophistication and training that some of these other investors in the market here in Japan have.

And I know a lot of them have much smaller teams, the experience level isn’t quite there, and it will require a lot of hand-holding to get them to a point where they’re comfortable assessing and looking at risks in the same way that some of the more experienced players in the market are able to do.

What Shibata-san was referring to with the GPIF diversifying the way they look at investments – they are looking basically to get away from the traditional government debt that they’ve been investing in and to some extent looking at overseas infrastructure investments. Primarily, in this first round, they’re looking at more operating assets in OECD countries and things that are safer to kind of get their feet wet and learn how to expand there.

It’s not just them, though. There are other institutional investors and other participants that are looking to get more experience and build up that experience train.

The other dynamic is interesting. We’ve been working with some domestic sponsors here and Japanese sponsors, looking at outside of Japan at alternative markets – things like institutional investors or bond markets in other countries, within the US looking at 144A markets. There’s a lot of diversification of sourcing of the capital, and it would be good to see a lot of the funds that are available here in Japan able to kind of accelerate their ability to get deployed quicker.

There’s plenty of cash here. It’s just a question of getting it out the door and getting it there to support the projects, support projects that you’re looking for. It’s making sure that support for them is available, and where that support comes is going to be a big question.

Rod Morrison: We’ve already heard from our sponsor panellists about some of the challenges that they’ve been facing – heightened competition, merchant risk over power or LNG, and having to go into new markets, new riskier essentially markets.

So in terms of the Japanese corporate sector, what do our panellists think is driving the overseas ambitions of project sponsors and which markets do you think they find more attractive?

Koichiro Oshima: Let me open up by saying we’re starting to see two things. One is that although historically all the major trading houses have been a strong force in investing in projects overseas, we’re starting to see, as Yamamoto-san mentioned earlier, JGC is even trying to start investing in new projects overseas.

We’re starting to see companies, other companies as well, who are starting to expand on their expertise, whether it’s on their EPC end or taking a risk in certain projects they have experience in. So I think that’s new, a little bit of a new trend there.

And second, for the export type of transactions, typically, historically if you go back to the good old days, the Japanese trading houses were always mostly working with Japanese manufacturers. But with the heightened competition, they will always try to find the right partner, whether it’s a local entity in that country or it could be an EPC contractor, sometimes not from Japan. So that’s a new trend we’re seeing in the market and the competition that the sponsor side is facing.

Rod Morrison: And to back them, do you think you’ll have to take more risk in terms of merchant risk or political risk?

Koichiro Oshima: In terms of merchant risk, I think it’s not like black and white any more. It’s a combination of contracted and market risk, and obviously at some point there is always a solution to the combination.

Toshi Fukumura: Before talking about the overseas market, I think Japan is a very interesting market for IPP investment. In 2016, the retail market will be completely deregulated, so that might open up good opportunities for the equity investment on the generation side as IPP business.

We are seeing big articles in the Nikkei newspapers every couple of weeks, big clients, between the energy companies and sogo shosha. There may be a good opportunity in the domestic market for the power investment in the near future.

The overseas market, our company, Marubeni, is basically following the market. Obviously, in the emerging markets they have to build a power plant and due to the lack of money, funds of the local government, they tend to launch the IPP project or programme. So that’s a space to go for the equity investment.

In the developed country, we don’t see much growth in terms of megawatts but the M&A market is very active. Investors are selling and buying assets and clearly that’s another space to go for the investment.

But, as I mentioned in my opening remarks, whichever way you go projects are not easy. They are becoming more and more challenging and you have to take some additional risk. But looking at the market, the question is how to allocate your capital between emerging or established or developed markets. The types of risks are different, but you have to take some additional risks.

When I was based in New York, I was very vocal that we should invest in the developed countries because Marubeni has a pretty large portfolio, power portfolio, in the global market, but looking at our portfolio it’s really skewed to the emerging markets. So I was very vocal that we should invest in the US, Canada, developed countries, but now I am the strategy guy for the company, so I have to be very neutral.

And talking about assuming some additional risks, that’s the additional risks in terms of the financial return. This is really related to financial analysis, how much money you should put in and what would be your valuation and so forth. And as I’m repeating, in order to achieve the growth, you have to take some additional risks in this very, very competitive market environment.

But personally, I think there is some room for us to improve, maybe qualitatively, such as investment schemes or contractual structure. One good example is – let’s take the example of a merchant asset, a quasi-merchant asset.

We are very much exposed to market fluctuation, which is unavoidable, but if you have the right structure, contractual terms, you may be able to exit from the project whenever it becomes necessary. So we should focus on that qualitative part in addition to very detailed financial analysis so that you may be able to protect your stake in the project.

Rod Morrison: And renewables? In terms of your strategic role, do you look at renewable energy as strategic or simply a profit-making activity?

Toshi Fukumura: Let’s discuss wind projects. We were very scared about the wind volatility. When we started investing in wind projects, how many years ago – let’s say, maybe eight, 10, maybe 12 years ago – it was volatile and we got some surprises on some of the projects, both in the domestic market and the overseas market.

I personally was very much involved in a couple of wind projects in the US and we did lots of analysis. I had just a series of discussions with engineers, wind analysts, and all the project players in that space.

But my observation is that wind analysis is very much improved these days and the actual performance is following the original assumption. So I think we can be a little more aggressive on the renewables side, especially onshore wind projects.

But there is another interesting space to go, which is offshore wind. We have already invested in two offshore projects in the UK. We are still learning. It’s a good investment. We are getting stable cashflow but the construction risk is much bigger compared with the onshore wind projects. So we are cautiously analysing the new project and we are trying to be very selective in choosing the right project to invest in.

Rajeev Kannan: It’s true the Japanese power market is getting quite interesting because until now there wasn’t as much activity in the market. But now, in the last three years, there are a lot of mega-solar or regular solar projects and in the next few years there are going to be a number of thermal projects.

So, in that sense, we have tried to gear up for that by setting up our new power team, which is working across projects, not just in Japan but globally. We can use the expertise that you have gained outside of Japan to support our customers in Japan. So it’s one team working on transactions, be it in Japan or outside. That’s how we are trying to bring our knowledge base from outside to Japan.

Similarly on the renewables sector, the market is quite interesting because, particularly if you talk about offshore wind, it is getting bigger and bigger. Now we are talking about a single turbine of 6MW to 8MW, which is very, very large. In the past we were talking about much, much smaller capacity.

The banks are pushing themselves to take these new risks that in the past we haven’t taken. And there have been structures where there are multiple contractors rather than one single contractor. So again, that’s a new risk element that the banks have been analysing and trying to take to support our Japanese customers.

In that sense we are trying to work with the Japanese sponsors to meet their aspirations globally.

Morimoto-san talked about LNG. He mentioned that historically LNG projects have been based on very stable SPA contracts but the new trend could be that you may need to have more flexibility in the SPAs. I think that’s something that banks like us have to start looking at because it’s true that historically the LNG projects that have been done until now have been based on long-term SPAs or a tolling structure.

The element of risk is probably a bit managed. But we were most worried about completion risk because the size of these projects was getting bigger and bigger. The new trend could be that we may have to take a different pricing structure. Maybe we have to take more risk or we may have to take not a full tenor SPA for example. Those are risks that banks like us have to think about.

The third point was Yamamoto-san mentioned about multi-sourced EPC contracting. That’s something that is going to be more and more important because even for Japanese EPC contractors, they have to work on the most competitive package, which will mean working with maybe European sourcing or other sourcing or South Korean sourcing.

We as a bank have tried to establish ourselves in terms of an EPC or ECA network that can support a multi-sourcing strategy of entities like JGC. But obviously we haven’t been able to simplify documentation. We will leave that to Alex. Thank you (laughter).

Fumio Inagawa: I would like to show some examples we supported in the new areas for the sponsors. One is the one just mentioned, the offshore wind farm in the UK. We are going to take a construction risk so we share the risk profile.

And the second one, this is a new area – CCS, the carbon capture storage project in the US. Together with JBIC we successfully closed a financing two years ago.

And also, when I visited a couple of clients, they raised an issue. This concerns IPP projects in Indonesia. Most of the projects will still require the governmental guarantee, but last year we finally closed the financing to the power project in Indonesia without the government guarantee requirement.

Masahiro Morimoto: For the LNG market we are looking for new opportunities, especially in East Africa, which is a new frontier for us and for our lenders. But almost all of the LNG cargoes will be imported to Japan because our DNA is still to import energy cargo to Japan and to contribute to the energy security. This would be a comfort to the lender side. It’s difficult for us as a trading company to change our business model to the portfolio player dramatically, drastically.

Hiroki Shibata: From our global photo study covering about 300 places of finance in the world, the mean and average of rating distribution is BB plus and BBB minus. IPP projects are mostly investment-grade without lower country risk. So IPP and LNG projects are the most stable projects in our rating analysis so far.

On the other hand, mining projects and merchant power, without a stable PPA with utility companies – their ratings levels are usually BB plus or lower. So in the mining projects, most of them, their ratings are Single B category. That’s an overview of the ratings distribution in our analysis.

Having said that, as Mr Kannan mentioned, a new LNG pricing mechanism may change this picture and we are taking a bit conservative view on the LNG projects. As you know, several LNG projects are delayed. Oil prices and a JGC-linked pricing mechanism may be changed in the future, so we may take a bit conservative view.

Takahide Yamamoto: In order to survive the very harsh competition among EPC contractors, we are looking at new markets or new technology. As for LNG, floating LNG projects will now be materialised. We are already engaged in some FLNG projects in South-East Asia.

In the future, the cracking of extra heavy oil is very important for the crude oil supply. We are testing new technology with JOGMEC using super-critical water. I’m not aware in detail but we are challenging a new market. So I hope the financial market can also challenge taking the new technology.

Alexander Borisoff: I have to address the questions about the complexity of documentation (laughter). It’s interesting because it does tie in really to some of the themes here that Yamamoto-san mentioned and Inagawa-san mentioned with new technologies and new kinds of risks that need to be addressed.

Inagawa-san mentioned the carbon capture project, which I had worked on and in which there were a lot of new technology risks involved. Any time you’re dealing with new things, new products, new challenges, it always raises new questions about risk analysis, risk assessment and risk allocation. That’s a big driver, of course, and as the projects get bigger and more participants are involved, inevitably you’re going to have different interests that need to be reflected and addressed.

In terms of general observations about where we’re seeing activity and what the prognosis is for the future, it’s obviously very sector-specific and sector-driven. Coming up to the end of the last fiscal year in Japan, which ended on March 31, there were a lot of very big oil and gas deals, LNG deals, that had been worked on and pent up over certainly a significant period of time, Many closed and now there’s some interest in seeing where that goes from here.

Shibata-san mentioned there are projects that are being delayed, and some that are being potentially cancelled. It’ll be interesting over the next couple of months to see the impact of pricing, other world events and what impact that has on those projects going forward.

On natural resources, very depressed commodity prices means that some of the projects that have been worked on, or have been in the process of being developed over a long period of time, are going a little bit slower than expected.

We are seeing in the power sector significant uptake and there’s a lot of big solicitations going on around the world – in Latin America and Mexico, certainly with the recent energy reforms in the Middle East, and in South-East Asia and Indonesia still a lot of interest. So that’s a trend that we expect will continue.

And in the power sector what’s interesting is seeing the re-emergence of other players in this market from Japan. The utilities are starting to come back and starting to look at overseas power generation as a meaningful revenue source. It is the first time in the last couple of years that we’ve seen that dynamic happening.

So as more players are coming in, there’s more competition and more challenges that need to be addressed.

Rod Morrison: I think we’ve had an extremely full discussion this afternoon. Do we have any questions from the audience?

Shigeki Okatani: Thank you for a very informative and interesting discussion. I am Shigeki Okatani from Mori Hamada & Matsumoto law office. Some of you have mentioned infrastructure funds. I would appreciate if some of you could give us your views on the role and function or contribution to the global PFI projects by infrastructure funds.

And from the banks, from a debt financer perspective, is there any difference between the projects in which the infrastructure fund is a major equity investor and projects in which the usual business co-operations are equity investors?

Fumio Inagawa: Our infrastructure fund, Asian infrastructure fund, as I said it’s a little bit unique because usually the infrastructure fund is focusing on an operational asset, in other words the brownfield project.

But in our case we are focusing more on the greenfield project. So I cannot comment on the infrastructure fund market in general. But the reason why I explained we established this fund in Asia is there are certain issues and an infrastructure gap between demand and supply. One of the reasons is the governments; their understanding is not good enough to bring the funding from the outside.

So the purpose of this fund is to support both the regional governments and the developers in understanding each other on how to share the risks so that the project goes on.

Rajeev Kannan: I introduced a couple of funds that we are involved in, for example the infrastructure fund for India. It has invested in a couple of assets in the renewable sector.

For example, one asset it invested in was establishing a solar energy platform in India. That is going to develop into a 200MW platform. That’s trying to take risk on projects where we are not able to be a lender because we think that market is not fully mature from a lending role and therefore we use this fund to get introduced or get active in the market. So that was one example.

The other fund that I introduced related to the fund that was established jointly with MLIT, the Ministry of Land, Infrastructure and Transport. That is just going to start investing and in fact my colleague who has just moved from SMBC to the fund is here in the audience, Mr Okuma.