Energy Project Finance Securitization To Make Gulf Debut
International banks have funded the bulk of the Gulf and wider MENA region’s projects in the last decade. But with energy, infrastructure and real estate sectors likely to require in excess of $1 trillion worth of investment over the next 10 years, meeting these needs would have been difficult, even if the US subprime mortgage crisis had not dented their appetite for lending. However, Sumitomo Mitsui Banking Corporation’s (SMBC) planned securitization of Gulf project finance assets will pave the way in freeing up bank capacity. Not only will a new pool of funding be created in the form of institutional investors, but a previous source of liquidity that had recently dried up – that from local banks – could be tapped again, writes Melanie Lovatt.
After the global credit squeeze hit markets in late summer, its ramifications have been the focus of discussions on MENA and especially Gulf project finance (See Global Credit Squeeze Cutting International Bank Funds For Gulf Project Finance, MEES, 1 October). However, even before events started to unfold, the ability of banks to continue to lend long-term at the low prices that characterized recent Gulf energy projects was questionable. However, collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs) could help provide a solution to the funding problem. These deals are complex, but essentially transfer the risk of loan assets (via real or more commonly “synthetic” means) on a bank’s balance sheets to a special purpose vehicle (SPV) that can then be sold to third parties and listed on stock markets – hence securitized.
SMBC Europe plans to launch the Gulf’s first ever securitization of project finance assets in the first quarter of 2008, with the $1bn portfolio comprised of around 30 of the bank’s project finance loans (including LNG, petrochemicals, power and water assets). These loans originate in the six GCC countries and will be offered to investors in the form of rated notes traded on both the Dubai International Financial Exchange (DIFX), to attract regional investors, and the Irish Stock Exchange in Dublin. Ireland was chosen because SPVs are easily domiciled in the country, which also carries favorable tax treaties. The notes will be placed with institutional investors, such as hedge funds, pension funds, and insurance companies, thus allowing distribution of risk into the capital markets and away from the international bank market, SMBC Europe’s Head of Securitization, Structuring and Placement, Mark Gordon, told MEES.
Attractive To Local Banks
Mr Gordon suggests that the securitization, with a seven-year tenor, will also appeal to local banks in the region. These used to feature more heavily in project finance, but over the past few years many have limited their participation as a result of the fall in margins and trend for longer tenors which can extend to 15 years on oil and gas deals and over 20 years on power project financings. With a base of shorter-term funding, local banks experience an assets/liabilities mismatch on long-tenored financing. By pooling its project finance assets, SMBC can give investors access to Gulf project finance risk at higher returns than they would receive by participating in the original project finance deal. “The local banks understand the geopolitical risk in the region, they understand the underlying project finance, because it’s a sector they used to lend into,” said Mr Gordon. “The response we’ve got from them has been very strong, so we expect a lot of this risk will be placed back into the Middle East-based banks that used to support project finance in the past.” The assets will be packaged into different tranches that are rated separately, and SMBC will place them with the investors according to risk appetite. For example, with a higher risk tolerance hedge funds are expected to compete to take lower rated tranches, while pension funds will be attracted to the tranches with a higher rating.
Securitization of project finance assets will benefit banks like SMBC because it allows them to release capital, which can be put back to work on new projects in the region. “It fuels our appetite for new business,” Mr Gordon said. Release of capital has been necessary to allow banks to comply with changes in banking regulations which stipulate risk weightings for specialized lending and the capital that must be applied against it on the balance sheet. Basel I and the early form of Basel II regulations (foundation IRB) acted as a spur to securitization because banks were required to keep a higher level of capital against project finance assets. The latter forms of Basel II banking regulations (advanced IRB) will, when in place, permit banks to keep less capital against project finance portfolios. However, many banks are not yet in a position to calculate the potential reductions and during this transition period are expected to continue to look to securitization to release capital.
Capping Potential Losses
SMBC’s Gulf project finance assets securitization is what bankers describe as “synthetic,” involving transfer of part of the risk associated with the portfolio of loans, but not the loans themselves. In an event of a default SMBC retains a portion of the risk, and after a certain threshold, investors are responsible for losses. Thus, SMBC’s potential losses are capped at a certain level. However, default is unlikely because all assets have been approved by SMBC’s credit committee. The synthetic structure allows the bank to continue to service the loans and preserves its relationship with the borrower. “We’re able to tell borrowers – project sponsors – that their loan will not change,” Mr Gordon said. “Synthetic securitization was devised to allow banks like SMBC to keep their relationships intact with borrowers.” SMBC has just completed a tour of sponsors (state entities and energy companies) across the region and received a good response, he revealed. Listing of the notes necessitates a credit rating and this involves disclosure to the ratings agencies of project information. SMBC therefore had to obtain the consent of the project sponsors.
As a result of the domino effect of the subprime crisis, the securitization market has been volatile and is “all but closed at the moment,” said Mr Gordon, but he expects it to open up again soon: “Certainly by the start of next year we should be back to business as normal, so we’ll roadshow in the Middle East, Europe and possibly Asia in the first quarter of 2008.” When it comes to market, the transaction will represent the first securitization of Middle East project finance assets. But there have not been many of these types of project finance securitizations worldwide. Five have been conducted by European banks using assets from UK private finance initiatives (PFI) and public-private partnerships (PPP). “The pricing has generally gone down across the board because the banks that have these securitization structures in place are able to manage their risk a lot better and can be more competitive when bidding for project financing” said Mr Gordon. The ratings agencies are working on another 6-8 forthcoming project finance securitizations, so this niche market is growing, but is still a tiny portion of the global securitization market. The securitization market in the US is large, but so far has not been applied to project finance.
Recycling Bank Debt Capacity
Moody’s Investors Service Team Leader for EMEA (Europe, Middle East and Africa) Project Finance, Andrew Davison sees the transaction as not only “pivotal to the development of the region’s capital markets,” but also key to recycling bank debt capacity. If another 10 international banks were to follow suit with similar scale transactions it could bring another $10bn of net new capacity, he told MEES. He stressed that international banks’ lending abilities were already threatened by “aggregation of country risk exposure” which is a long-term credit risk issue, distinct from the recent credit squeeze/liquidity crunch brought on by the subprime crisis.
If banks’ lending appetite weakened, either due to regional exposure concerns, or as a result of fallout from the subprime crisis, even strong sponsors in the region might consider other financing solutions for their vast array of projects. With oil (and other commodity) prices at record high levels, expansion plans are being pushed along; and if bank funding is insufficient to meet these needs, other funding sources will be sought more aggressively, especially for large, $2bn-plus projects. “Strategically over a longer time frame I could see a number of compelling reasons why securitization of project finance loan assets would be very attractive to banks that have an active and sizeable lending presence in the Gulf,” Mr Davison said. Other banks are expected to follow SMBC’s lead and securitize project finance assets in the region. “It makes a lot of sense for banks to get low yielding assets off their balance sheets. It’s a natural progression,” one banker commented.
Copyright MEES 2007.
