The prospect of rising interest rates discussed in the last Comment piece leaves myriad questions for financing in the energy and infrastructure space. Who is hedged and who is not? Who has long-term swaps in place and who does not? Have equity funds laid off their interest rate exposure? When will midcos need to be refinanced? Will soft mini-perms not be so soft? And so on. That is just for starters on existing deals. New paradigms will be needed for new deals.
It is a crazy world right now. Who would have thought a year ago that a range of European governments would be stepping into their power markets to pay consumer bills and provide widespread collateral back-up for energy companies trading in the market? The situation over the weekend was even described as akin to the global financial crisis of 2008, a more than slight exaggeration. Still, the European energy markets have been spooked by the Russians shutting down supplies on the Nord Stream gas pipeline. This leaves one obvious, if minor in the scheme of things, question – will the Nord Stream project finance loans still be serviced?
We are probably only seeing the start of the ramifications of these events but it is possible they will be shortlived – just over this winter as Europeans rush to get alternative supplies.
Rising interest rates are another matter, a step change from the ultra low interest rate quantitative easing-fuelled decade to a return to pre-2008 levels, a step change up of perhaps 5 percentage points plus any debt margin increases on top. From revolvers to long-term fully hedged project financings, there are implications for all. Higher interest rates directly impact internal rates of return (IRR) and lead to reductions in debt sizing.
The revolving credit facility (RCF) market for infra funds has been a nice little earner over the years. It involves short-term funding commitments, with the debt frequently undrawn and the banks simply taking the fees. But according to PFI's sister publication LPC, "banks have become increasingly reluctant to provide revolvers after market conditions soured following the outbreak of the war in Ukraine in February". For a unitranche deal, the revolver is just uneconomical, especially when a re-pricing of the cost of capital is under way.
Moving up the curve to debt held by infra funds on their operating assets, how fully are these funds hedged out? We have seen, for example, a lot of leverage put in place on a midco and holdco basis, which is short-term by its very nature. That will have to be refinanced, with the sponsors either accepting higher costs or lower debt levels. Given the predictable and strong revenue streams on infra assets, leverage is usually high, leaving little headroom when debt costs jump. What is a strength, the revenue stream, could become a weakness if it has encouraged over-leverage.
Even without leverage, rising rates can be problematic. Equity investors in green assets have been taking narrow returns to get into the sector, returns that could look even lower if underlying rates jump.
There is a significant overhang regarding the financing or refinancing of greenfield assets. Short-term construction finance has become more popular, leaving more deals exposed to a refinancing risk when construction is complete. Some deals have a hard mini-perm structure, where the debt ends and the project takes full refinancing risk. Some deals have a soft mini-perm structure, with the refinancing of the asset encouraged via margin step-ups and dividend lock-ups after construction is complete.
Data from Refinitiv show the amount of five to seven-year project loans, as a percentage of total project loans, has jumped in the last couple of years. In 2017, the figure stood at 26.6% of the total market, in 2018 27.3%, 2019 23.9%, and in 2020 26%. But in 2021 it jumped to 33% and this year to-date it stands at 50.1%. In dollar terms, the figure over the last 5-1/2 years of debt raised on a five to seven-year year basis is US$500bn. The numbers look big but plenty of that debt will be safety refinanced. It is always the deals on the margin that get knocked sideways.
The situation for deals in syndication right now is interesting. There are reports that bank loan margins are finally going up, following the increases in bond pricing earlier this year. So will banks be prepared to go into deals put together before the recent hikes in underlying interest rates, or will they wait? There are some signs of push-back in the syndication market. The attraction of offshore wind as an asset that gives banks a big green balance sheet boost remains, but the pull of an increasing underlying cost of capital cannot be held at bay forever.
As for entirely new deals, at least assumptions on those can start from scratch – even if the assumptions might well be unpleasant.
