Alternative source

Infrastructure (e.g., transportation, power, telecommunications and environmental) requirements are growing rapidly, both domestically and internationally, and in both developed and developing countries, far outpacing the public and other traditional sources of financing available for these requirements. A considerable "funding gap" has either already arisen or is widely predicted. This has led to the exploration and development of private sector alternatives to traditional public financing sources and has created a new lexicon of "public-private partnerships" and "infrastructure privatization" for these activities.

At the risk of oversimplification, the current universe of debt instruments issued to finance infrastructure comprises or is provided by the following:

Commercial Banks

Private Placements

Rule 144A/Public Offerings

ECA/RDB/IBRD Financing

Municipal Finance

Commercial Banks. Commercial banks have always had an active role in project finance transactions. .Commercial banks have successfully provided project financing because of their demonstrated ability to evaluate complex project financing transactions and to assess and assume the construction and performance risks usually involved in such financings. However, principally due to the short-term nature of a commercial bank's liabilities (i.e., its deposits), commercial banks usually limit in amount and otherwise closely monitor and control their project finance exposure.

The project's sponsor will normally request commitments from its commercial banks for both construction financing and, following completion, the permanent, long-term financing of its project. Typically, the commitment for construction financing will be for 2 to 3 years and, following completion and demonstration of operational performance, for permanent financing will be from 10 to 15 years, although in rare cases commercial banks have provided permanent financing commitments of 20 years or more. Most permanent financing commitments by commercial banks will include specified increases in the applicable interest rate ("step-ups" in the applicable margin or spread over the commercial bank's cost of funds) in an effort to create escalating incentives for the commercial bank financing to be refinanced before its scheduled maturity.

The successful commercial bank syndicate for a project financing will usually seek to "sell down" its underwritten commitments in a further coordinated syndication to a larger bank group. This subsequent syndication may occur before financial closing (i.e., the execution and delivery of definitive financing documents) or afterwards, depending upon the confidence of the original underwriting banks in the "marketability" of their transaction in the bank project finance markets (and their willingness to assume the risk of adverse change in such markets), the timing constraints of the project, the project sponsor's preferences in this regard or the original underwriting banks' desire to reduce their level of commitments or all or any combination thereof.

The project's construction financing, which will normally bear interest at a floating rate, will usually require interest rate risk to be hedged through an interest rate swap, cap or collar (although, if such hedging is under swaps and collars, because payments there under may be due from the project and thus the swap or collar providers may become creditors of the project, project collateral will have to be shared with such providers). Even though the commercial banks provide a permanent, long-term financing commitment, upon completion of construction and demonstration of the project's acceptable performance, most sponsors will seek to refinance the project with permanent, long-term and fixed rate financing. This refinancing will usually be on terms that allow the project more operational flexibility because construction risk has been eliminated from the project and because obtaining waivers from institutional holders is more difficult.

This traditional model has proven very successful over a considerable period of time and in a wide variety of industries and specific applications. It has provided and will continue to provide substantial capital to qualifying projects throughout the world.

Private Placements. Private placements have also played a prominent role in infrastructure finance. This market has demonstrated strong tolerance of "story credit" and transaction complexity, lacks registration requirements and offers less maturity sensitivity than commercial bank financing (because of the longer-term nature of an insurance company's assets and the reduced asset/liability mismatch). Project finance is a key element of recent and dramatic growth in the private placement market. However, insurance companies (the private placement market's most active buyers) face recently imposed risk-based capital requirements and there is a demonstrable "flight to quality" in this market which has made it much more difficult to obtain financing (or at least more expensive to obtain financing) for a marginal project. While an explanation of the National Association of Insurance Commissioners' ("NAIC") rating system is beyond the scope of this paper, the market "break" seems to be at NAIC 2 (the equivalent of S&P's "BBB" rating), below which there are significantly fewer available investors.

Notably, both Standard & Poor's Rating Agency Group ("S&P") and Duff & Phelps Credit Rating Co. ("D&P") have announced private placement rating systems which are more lenient than their respective public ratings (insofar as the private placement ratings express views about ultimate payment and unlike public ratings do not place the same stress on timeliness of payment).

Rule 144A/Public Offerings. Approximately $4 trillion of the U.S. capital markets is comprised of public and corporate pension assets, which usually seek high-quality, long-term investments. The U.S. capital markets are therefore naturally attractive to infrastructure projects which seek long-term financing.

The attraction of the U.S. capital markets for infrastructure financing has been enhanced considerably by the adoption, in 1990, by the Securities and Exchange Commission (the "SEC") of Rule 144A ("Rule 144A") under the Securities Act of 1933, as amended (the "Securities Act"). As discussed below, Rule 144A established a non-exclusive exemption from the registration requirements of the Securities Act for resales by investors to eligible institutions of privately placed securities, subject to certain limitations. By facilitating resales of securities issued in private placements, Rule 144A has created liquidity in the secondary market for privately placed securities, causing the U.S. private placement market to become more attractive to foreign issuers, including those offering debt securities to finance infrastructure projects.

With the adoption of Rule 144A, a broader market for private financing in the U.S. capital markets has become available, especially for foreign issuers, characterized by greater liquidity than existed prior to adoption of the Rule and ease-of-entry. Prior to the adoption of Rule 144A, privately placed securities were subject to significant restrictions upon resale under applicable U.S. securities rules, rendering such securities more illiquid.

Rule 144A provides a non-exclusive safe harbor from the registration requirements of the Securities Act for resales of certain se4curities to "qualified institutional buyers" ("QIBs").The expressed intention of the SEC in adopting Rule 144A was to increase the liquidity of privately placed securities by allowing unrestricted resales of such securities among QIBs, and to increase access to the U.S. capital markets by foreign issuers.

In a Rule 144A placement, an issuer will sell, in a traditional private placement (in reliance upon an exemption from the registration requirements ), its securities to one or more investment banking firms which will then resell, in reliance upon Rule 144A, the securities to a larger number of QIBs. From an issuer's standpoint, the way in which Rule 144A placements are conducted is very similar to traditional underwritten public offerings, especially in that securities are offered by the investment banking firm to potential investors on a "take it or leave it" basis. Instead of direct negotiation with investors, issuers rely upon the bank's perception of the marketability of the issuer's securities.

A sale in compliance with Rule 144A must meet four basic criteria not discussed in detail in this paper: (1) the securities must be offered and sold only to QIBs; (2) the securities must not, when issued, be of the same class as securities listed on a U.S. securities exchange or quoted in a U.S. automated interdealer quotation system (such as the NASDAQ System); (3) the seller and the prospective purchaser must have the right to obtain certain information about the issuer if such information is not publicly available ; and (4) the seller must ensure that the prospective purchaser knows that the seller may rely on Rule 144A.

Since 1990, in response to the adoption of Rule 144A, a large number of foreign and domestic companies have issued securities in the U.S. private placement market in reliance upon the resale exemption afforded by Rule 144A and, as expected, there has developed a liquid secondary market for these securities among QIBs. The creation of this market and the growing appetite among U.S. institutional investors for high-yield securities (which, by definition, includes those issued by private or public sector issuers in the emerging markets) have made it possible to structure a capital markets financing for infrastructure projects targeted to the U.S. private placement market .

Infrastructure financing using Rule 144A or public offerings seemed to offer the best of both worlds -- access to the deepest segment of the U.S. capital markets (because of its liquidity and required minimum credit quality) and availability of long-term, fixed rate debt capital. The latter is especially important to infrastructure projects because shortening the maturity of financing can dramatically increase debt service requirements which will drive infrastructure tariffs to higher levels. For this reason, the long-lived assets which characterize infrastructure investments ideally should be financed with comparable debt maturities. But, this market generally requires an investment grade rating. The use of a U.S. capital market financing for an infrastructure project is a "major development of the 1990s." 18 While S&P believes that some European and Asian issuers will obtain an investment grade rating, this will depend significantly on the transaction's structure and, in particular, on how currency and political risks are handled.

ECA/RDB/IBRD Financing. One of the most interesting recent developments in infrastructure finance is the growth in export credit agency ("ECA") and regional development bank ("RDB") activity, as well as significant growth in infrastructure finance activity at the World Bank and International Finance Corporation ("IFC"). This growth is evident in the "reengineered" Export-Import Bank of the United States ("US ExIm"), which has formed a Project Finance unit and has been very proactive in educating potential users about its services and in streamlining its application requirements and approval procedures. A similar proactivity has been exhibited by the Overseas Private Investment Corporation ("OPIC"), which has likewise established a special Project Finance unit, increased its maximum project loan amounts and has both sponsored and made significant investments in several country-specific funds.

IFC has created and expanded its infrastructure department, sponsored and invested in several infrastructure funds and increased its cofinancing (the so-called "B loan") program. In a laudable transaction this year, the IFC Latin America and Asia Loan Trust 1995-A (some 2 years in gestation) sold interests in a pool of LIBOR-indexed, dollar-denominated loans to non-governmental borrowers in Argentina, Brazil, Colombia, Chile, Mexico, Venezuela, China, India, the Philippines and Thailand. This transaction introduces the potential benefits of secondary liquidity and diversification to investors. One can only hope that this transaction will provide the same stimulus to the capital markets and create the same secondary liquidity for similar instruments as did the groundbreaking RTC transactions for mortgage-backed securities.

More controversially, the IFC has sought and obtained several significant financial advisory engagements and syndicated many of its B loans.

The World Bank has attracted a lot of recent criticism and calls for reform. Most of this criticism concerns the delay in obtaining World Bank financing, conceded by the World Bank to be over 2 years (although, in the case of the Hub River project in Pakistan, it was 6 years), and inflexible rules that limit its guarantees to less than 5% of its lending volume and prevent guarantees from being extended to low-income countries that qualify for its concessioned loans.

Similar criticism has been made about the ECAs and RDBs, although several ECAs have implemented reforms aimed at expediting approvals increasing the use of guarantees and other credit enhancements to increase the total value of supported projects. US ExIm has admitted that it subsidizes its insurance premiums (although it claims to do so only to the same extent as other ECAs). The OECD arrangement or consensus, to which US ExIm and most other ECAs subscribe, provides only general rules and guidelines which result in substantial differences between ECAs.

While the participation of multi- and bi-lateral institutions in infrastructure finance is necessary at least in the near term, it inherently distorts free competition to provide capital to infrastructure projects and may significantly influence whether and, if so, which projects will be financed.

Municipal Finance. Municipal bonds are debt securities issued by states, cities, counties and other governmental entities to finance capital projects, such as building schools, highways or sewer systems, and to fund day-to-day obligations. Investors who buy municipal bonds are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” The date when the issuer repays the principal, the bond’s maturity date, may be years in the future. Short-term bonds mature in one to three years, while long-term bonds generally will not mature for more than a decade.

Individual investors hold about two-thirds of the roughly $2.8 trillion of U.S. municipal bonds outstanding, either directly or indirectly through mutual funds and other investments. Bond investors typically are seeking a steady stream of income payments, and compared to stock investors, they may be more risk-averse and more focused on preserving rather than accumulating wealth.

Benefits to investors in municipal bonds include the fact that interest on such bonds generally is exempt from federal income tax and may also be exempt from state and local taxes for residents in the state where the bond is issued. Given the tax benefits, the interest on municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.

The two most common types of municipal bonds are general obligation bonds (bonds backed by the “full faith and credit” of the issuer) and revenue bonds (bonds backed by the revenues from a specific project or source). In addition, municipal borrowers sometimes issue bonds on behalf of private entities such as non-profit colleges or hospitals. These “conduit” borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds.

Investors who buy municipal bonds face a number of risks, including: call risk, credit risk, inflation risk, interest rate risk, and liquidity risk