1. The Quest for Leverage

Question 1

Equity

Answer 1

The providers of shareholder funds (equity) have an ownership interest in a company.

Bringing in more shareholders means diluting that ownership

Also an inherently expensive form of financing - shareholders expect to share in the success of the company and therefore their returns

This may be in the form of dividends

Question 2

debt

Answer 2

Providers of debt expect to receive a pre-agreed rate of interest no matter how well the company does.

Interest might even fall if the company does well as it is then considered lower risk

> leverage or gearing

Question 3

WACC

Answer 3

a) debt reduces the cost of financing for a company
b) some companies struggle to raise debt compared to others

The equation:

WACC = (MV of equity/total MV of equity & debt x cost of equity) + ((MV of debt/total MV of equity & debt x cost of debt) *1-corporate tax rate)

Question 4

How do we know the cost of equity?

Answer 4

This is the return need to be paid to investors to get them to invest in the company

> CAPM model

> Low risk = low cost of equity and vice versa

> Big oil exploration can be high risk (high cost of equity) as it might spend lots to find oil wells that turn out to be empty

Question 5

Tax benefit of debt

Answer 5

The taxable profit of a company is calculated after loan interest has been deducted. Tax incentive

the net, after tax, interest rate on debt is the gross interest rate * (1-tax rate)

Question 6

Why upstream exploration companies tend to rely on equity

Answer 6

the risk of exploration being unsuccessful and the fact that the company will mainly consume cash, rather than generating, means that lenders will not be prepared to provide debt funding

> lenders want to see a predictable source of cashflow

Question 7

Mezzanine finance

Answer 7

Upstream start up might be able to access mezzanine finance

> called such because it sits between equity and debt “floors” in a companies capital structure

> has some features of debt, some of equity

e.g. a mezzanine lender might agree to accept a low rate of interest and/or allow the interest to build up until the borrower begins to generate cash

> Mezzanine debt often hs a so-called “bullet” repayment basis - all the principal is repaid on the final maturity date of the loan

> may also be convertible - can be exchanged for shares in the borrower on the pre-agreed basis (perhaps at a pre-agreed price)

> mezzanine debt likely to be expensive because of the risk being accepted by the lender. A convertible loan also threatens to dilute the ownership of the original equity investors

Question 8

If an upstream start up is successful

Answer 8

More debt doors open…

Once the oil has been found, seismic studies done, government approval made etc

structured finance teams of commercial banks will be willing to consider being part of the financing of production

> this will be on a project finance basis with the lenders interest payments and debt repayments being dependent on the cashflow of the asset being developed

Question 9

oil field development finance

Answer 9

and especially single-field development finance is Among the riskiest form of financing by the banks

> given this reserve risk, banks will insist on using conservative reserve and production estimates when calculating projected field cashflow

> access to this source of financing would be huge for an upstream startup as it is not inexpensive and not the most flexible source of debt

Question 10

Costs associated with single field financing

Answer 10

would require a lot of documentation and security cost. A lot of legal fees would entail when trying to squeeze more value out of the asset

does allow access to a lot of gearing however > would then not dilute equity interests or involve sharing of performance upside

Question 11

Once the startup has assets through

Answer 11

the exploration, appraisal, development production cycle

the portfolio of field interests will grow

> leads to a steady reducing of risk concentration

Question 12

Reserve based lending

Answer 12

commercial bank lenders that are prepared to lend against a portfolio of oil and gas assets rather than against the projected cashflow of a single field

“RBL or Borrowing based finance”

> requires less cumbersome, less expensive documentation / security structures

> likely to insist on the most conservative reserve and production figures

> the funds borrowed under RBL terms do not have to be dedicated to the development of particular fields - they are available for general corporate purposes and can even be spent on exploration

> a start-up would wish to move to RBL as soon as it can to give it access to flexible funding at a lower cost than is possible for single-project financing

Question 13

Downsides of RBL

Answer 13

Lenders will require a forecasting of expenditures production and cashews at least every 6 months and anytime there is a change in portfolio assets

Because of this time consuming-ness and need to add technical consultants, companies will wish to persuade lenders they are “corporate”

Question 14

Being “corporate”

Answer 14

assets have a stable cashflow

track-record of successful exploration

satisfactory financial history

good reserve replacement etc

> if banks agree a firm can be considered this, responsibility of the account relationship goes away from the banks structures finance team to the corporate teams

> facilities to the borrower will now largely be approved on the basis of the companies historical performance rather than its projected cashflows

with an oil company however, the future can never be ignored

Question 15

corporate loan facilities

Answer 15

almost certainly will be cheaper than borrowings against future cashflows

will also avoid much tie and resource-intensive projection work associated with PF and RBLs

once a company reaches an appropriate scale and credit quality it may also decide to issue corporate bonds directly into the investor market

> needs a borrower credit rating from agencies

Question 16

Advantages of corporate bonds

Answer 16

despite the time and cost of getting a rating:

• bank debt is usually a floating rate, whilst bond debt is generally a fixed rate (predictable)
• bond investors may offer maturities of 15-20 years often on a bullet repayment basis, whereas banks rarely offer term loans to corporate of more than 7 years maturity

Question 17

Ordinary shares

Answer 17

Known as common stock in there US - the most expensive source of funding for a borrower

> confer rights of ownership and issuing new shares dilutes stake of original shareholders

> can be issued on SE’s or by the company directly to investors

> return paid out in dividends, which in the case of early stage exploration companies (who won’t generate cash for a while) could be tricky

> relatively locked in source of finance when compared to debt. Repayment of shareholder funds may well require a winding-up of the company, or at least a court-supervised reconstruction whereas the repayment of debt is quite straightforward

> shareholders stand to gain the most if a company does well, but heavily exposed to the downside risk of losing their investment in bad times (bottom of the stack)

Question 18

Preference shares

Answer 18

issued in the same way as ordinary (issue shares and receive value of them in return)

However:
- preferred stock has a right over ordinary to receive dividends
- dividend rights may also be cumulative (payment cn be deferred)
- may acquire voting rights if its dividends are unpaid beyond an agreed period

• often have a fixed % dividend, so their exposure to upside is less than ordinary, but they are more likely to get paid
• they rank ahead of the ordinary in case of liquidation (behind debt tho)
• can be made callable in which case the company will have the right to repay the preference shareholders and cancel the preference shares at its option

> can be issues if a company doesn’t want to dilute its ownership and/or voting rights

> a common tool of VC is the “convertible pref share”, a preference share investment which is convertible to ordinary shares of the company at a pre-agreed price at the investors option

Question 19

Mezzanine Finance (more detail)

Answer 19

Range from subordinated to bank debt with significantly higher return

can also feel very equity ( a mezzanine slice that receives a portion of any oil-price upside or return paid in shares rather than cash)

> to qualify as mezzanine, financing needs to demonstrate a significantly higher risk than that which can be rewarded simply by a higher interest return.

> a financing which requires the success of a company or project before there is a prospect of the financier being paid back - or at least being paid his return - is more mezzanine than a loan which receives a higher interest retain as a result of a deeper subordination

Question 20

Second-Lien financing

Answer 20

A US term to coin mezzanine financing that is secured by mortgages or liens which rank behind those granted to the primary debt providers

Question 21

Patient capital

Answer 21

another term for mezzanine debt as mezzanine lenders are prepared to wait for their returns (bullet repayments, roll-up interest which cannot be paid when due)

> patience naturally comes at a price in terms of the cost to the investee

Question 22

Definition of Project Financing

Answer 22

A financial structure where lenders have recourse primarily to the revenue-stream of the project or asset they are financing, rather than the balance sheet of the sponsors

> lenders have limited recourse (access) to the balance sheet and revenues of the owners of the project (the sponsors)

Unless other rights are negotiated, the lenders will typically have recourse only to the amount of equip which is being injected by the sponsors

> if problems arise, such as construction cost increases or time delays, the lenders will not have a contractual right to call for more equity
This coins the phrase “limited-recourse” or non-recourse financing

> sponsors usually want to ensure a wall being built between the lenders into being required to inject more equity.

Question 23

Corporate structures

Answer 23

Often two sponsors will work in a Joint venture with an SPV that they inject equity into.

Project lenders are to provide loans to finance the remainder of the cost

the lenders and sponsors will agree the % of equity to be injected with the balance of funds required to finance construction being provided by the lenders.

Sponsors equity will be in proportion to their ownership

The project vehicle is almost always a LLP as the sponsors will want to have the protection which this provides against the banks “looking through” the project vehicle and being able to have recourse against the balance sheet and non-project revenue streams of the sponsors

Question 24

How sponsors inject equity and why it is preferred

Answer 24

Sponsors typically inject equity using a mi of ordinary share capital and inter-company loans (preferred).

1. Ease of distraction of loans :

• it’s quite possible for a company to be cash-positive before accounting profits
  > injecting a large proportion of equity funds as inter-company loans allows a quicker return of capital - through interest on the loans and repayment of principal - than would be possible if all of the equity were injected as ordinary shares

2. Tax efficiency

• interest on inter-company loans can usually be applied as a deduction against profits tax payable by borrower

> Sponsors often have agreements to protect their own rights and make sure that their debt is higher priority than the lenders debt

> this may be subject to negotiation

Question 25

Host governments role

Answer 25

Might subsidise, or grant exclusive right to construct, own, operate and maintain a road, tunnel or major asset used by the public

> often ministry of energy grants an upstream exploration licence

Question 26

Role of regulator

Answer 26

Ensure businesses which operate as near monopolies (water, gas power etc) ensure the security of supply for the end-user

Question 27

FPTK Contracts

Answer 27

Fixed price turnkey contracts (such as those to construction companies) have the benefit of transferring to the contractor a significant portion of the risk that the project may suffer time delays or cost overruns

Question 28

Feedstock

Answer 28

SPVs will need to enter into feedstock contracts for the supply of the feedstock for a long duration

Question 29

Insurance

Answer 29

insurance contracts will need to be entered into to protect equipment, physical damage etc

Lenders will also feel much more confident if there is a long term contract in place with a reliable O&M contractor (experience etc)

Question 30

Structuring to a cashflow “envelope”

Answer 30

From the envelope, the sizing is an estimate, the certain costs willl need to be paid in a struct order in a given operating period:

1. Operating costs
2. Taxation (failure to pay will shut it down)
3. Interest - interest liabilities
4. Debt repayment
5. Equity return - dividends on ordinary share capital and/or interest payments/capital repayments on intracompany loans

> defining this cashflow waterfall means that the project revenues can be evaluated to make sure that there is no overspend in OPEX that might endanger the making of debt service repayments

> CFADS - as pre-cfads is not available to the lender, it is the starting point for the lender’s structuring of the limited recourse financing

Question 31

Driver of the gearing ratio

Answer 31

CFADS

> if it is predictable high, there can then be a higher gearing ratio

Question 32

Structing RBL

Answer 32

Usually has the maximum amount for the loan facility being determined by the NVP of the projected cashflows within the borrowing base asset portfolio

Question 33

Two main sources of vanilla corporate debt

Answer 33

1. Commercial banks
2. Corporate bond market

Question 34

Balance sheet based commercial bank facilities

Answer 34

Borrowing facilities are usually of the revolving credit or term loan type.

A revolving credit is one where amounts which are repaid are capable of being redrawn

In a term loan structure, this cannot happen.

> term loans have a period for utilisation (often referred to as drawdown) and a period for repayment

> amounts repaid will not be capable of being redrawn and repayments will either be made at the final maturity date of the loan (called a bullet repayment) or in line with a pre-agreed payment schedule

• revolving credits will be extended for periods from one to three years and may be either committed or uncommitted

> where a loan is committed, the lenders will have to comply with a borrowers request for a drawing. Where it is uncommitted the lenders may withdraw the facility at their discretion.

Committed facilities usually require a commitment fee

Question 35

Guarantees

Answer 35

Guarantee or letter of credit facilities may be made available allowing the banks to guarantee their clients credit in commercial or financial transactions

Question 36

Corporate bonds

Answer 36

Bonds are securities which are sold directly to investors

The debt comes directly from the bond investor who buys the bond

> typically pension funds or insurance companies seeking long term investments which match the maturity of long term liabilities (e.g obligations to pay the pensions)

Givernments also issue bonds

Question 37

Bonds on the market

Answer 37

Bonds are tradable which means that their holders have access to liquidity

Securitisation packages large volumes of standardised loans (car loans, student loans and mortgages)