Though talked up for several years, project finance CDOs have yet to make the dent once anticipated, considering the size of the potential collateral market and the drive of structurers into new products.
The overseas market saw a project finance loan CDO called RMPA Services Ltd. earlier this year, which contained all U.K.-based collateral. The top A-rated, 10-year average life tranche priced at Gilt plus 59 in February.
In the U.S., a $250 million John Hancock-managed CDO currently in the pipeline has a small bucket for project finance, but that's about it.
Still, the demand for capital is strong in the PF market, according to attorneys at Cadwalader, Wickersham & Taft, speaking recently at a briefing in New York. Cadwalader said there could be an uptick of these CDOs as the economy picks up, calling project finance and securitization "a natural hybrid."
The near-desperate level of additional capital in project finance, banks' progression of credit risk and changes in risk-based capital rules, are expected to generate more issuance in this area.
"Project finance is a very conservative area," said partner Matthew Williams. However, Williams pointed out bank lending to the area of project finance hasn't kept pace with demand. Whereas in 2002, bank lending to project finance was $62.1 billion, that figure only increased to $69.5 billion in 2003. "Capacity for bank lending is very important to project finance...[however] there is not enough money to meet demand," Williams said.
The energy sector alone suffered from a $499.91 billion shortfall in fresh capital for project finance last year, said Robert Vitale, head of Calawalader's U.S. and Latin American Project Finance and Privatization Group. The only major increase in growth came in the project bond deals, where volumes increased from $13.8 billion to $32.2 billion from 2002 to 2003, according to Cadwalader figures.
The attorneys contend the capital markets are the natural fit for project finance given its enormous funding capacity. Borrowers benefit by raising debt at lower cost, and longer tenors and investors gain diversity. Banks experience expanded lending capacity and regulatory capital relief by moving a once illiquid portfolio of project finance loans off their books. However, the history on these types of transactions is not extensive and the collateral suffers from a shortfall of experienced professionals, an unfortunate hindrance to seeing more of these vehicles.
Sources at rating agencies felt project finance as collateral for CDOs has, for the most part, been a beneficial pairing. But their opinions were limited to deals that were rated though there has been activity even below the rating radar.
The first deal credited as being a project finance hybrid CDO, Project Funding Corporation 1, issued in 1998, was a $617 million CLO launched by Credit Suisse First Boston. Containing a pool of 41 loans, mainly derived from U.S. power plants, the transaction has not received any downgrades to date, and was rated by Moody's Investors Service and Fitch Ratings. The CDO is currently not on credit watch.
While tax implications were cited as one factor that may be hindering more issuance from the sector, legal local issues and depending of the nature of the asset currency risk, were more likely challenges, said two rating analysts familiar with these CDOs.
Some CDOs, like Project Funding Corp. CLO 2, via CSFB (which hit the market in 2000) and Citibank's Project Securitization 1 contained loans originated outside of the U.S., a hearty number of which were emerging-market projects.
"The problem is you have more due diligence than if the company were to issue just plain debt," said one analyst. Oftentimes, the project finance loans coming from a bank's portfolio are not rated, unlike bonds, the second analyst noted, adding time and cost to structuring the CDO.
Cadwalader's Williams and Vitale believe the limited activity is attributable to a disconnect between the two sets of market practitioners. The fact that there's no generic model means structuring is perceived to be difficult and costly when, in fact, it can be very beneficial. But they urged caution when undertaking this type of securitization without experienced professionals on board, particularly when the project finance collateral may be cross-border in nature.
"Outside the U.S... if there are transfer restrictions [of the collateral to a bankrupt-remote SPE] that can be the death knell to funding via securitizations," noted James J. Croke Jr., a partner in Cadwalader's capital markets department.
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