Debt Sizing Flashcards
Key objectives
- Lender’s Goals: Ensuring the project’s debt can be serviced under various scenarios.
- Debt Structuring: Understanding the impact of changes in one factor on others in the quantitative project model.
- Cover Ratios: Detailed explanation of ADSCR and net-present-value-based ratios (LLCR and PLCR).
The Project Model
· Purpose: Used for debt sizing, sculpting repayment profiles, and conducting sensitivity analysis.
· Adaptation: Lenders adapt the sponsor’s model to include a CFADS line.
· Design Considerations: Avoiding circular errors, ensuring consistent page layouts, and simplifying calculations.
Debt Engine Overview
· Objective: Tailoring debt drawdown and repayment profiles to the project’s projected cashflow.
· Base Case: Constructing a conservative economic forecast to ensure debt serviceability.
· Debt-to-Equity Ratio: Balancing the sponsor’s desire for high returns with the lender’s need for a safety cushion.
Cover Ratios
Types: ADSCR and net-present-value-based ratios.
· Function: Determining how much of the CFADS is dedicated to debt service, providing a cushion against cashflow variations, and ensuring ongoing equity returns for sponsors
Sensitivity Analysis
· Purpose: Stress-testing the base case repayment schedule to identify factors sensitive to debt servicing security.
· Process: Running downside scenarios to ensure the project can withstand adverse developments.
Balancing Interezts
· Goal: Achieving a debt value and structure that maximizes gearing while providing adequate protection for debt servicing.
· Outcome: Ensuring both sponsors and lenders are satisfied with the project’s financial structure.
what is the shape of the cashflow
- Flat or Upward-Sloping Cashflow: Common in infrastructure and PPP projects.
- Downward-Sloping Cashflow: Seen in assets like oil fields
The Annual Debt Service Cover Ratio (ADSCR)
· Purpose: Used for projects with flat or rising cashflow profiles.
· Mechanism: Distributes debt service payments over the project’s life, allowing mostly interest to be paid in the early years and increasing principal repayments over time.
· Application: The ADSCR is applied to projected annual cashflow to determine the Debt Service Amount (DSA) for each year.
· Considerations: The predictability of CFADS influences the ADSCR value. More predictable cashflows allow for lower ADSCRs, while volatile cashflows require higher ADSCRs for a safety cushion.
Average life
Bankers often refer to the “average life” of a loan repayment schedule. Average life, in its simplest form, is the point where 50% of the initial loan amount has been repaid4. In a loan with a “straight-line” repayment schedule (equal principal instalments each period) the average life will occur half-way through the loan repayment period. In an ADSCR-driven profile the average life will tend to occur later, perhaps as late as two-thirds of the way to final maturity.
Debt service amount
Dividing projected annual cashflow by the cover ratio will give the “Debt Service Amount” (DSA) for each year. The model is programmed to dedicate this amount of CFADS to the servicing of debt – paying the interest due first and then using the rest of the DSA to make a loan repayment. As the debt remaining declines, so will the interest payable and therefore the amount of the DSA which is applied to the repayment of loan principal will steadily increase.
How do we know what value to use for the ADSCR?
My example uses 1.3:1 (which effectively means that we are dedicating about 76.9% of projected cashflow to the servicing of debt). But why not use 1.1:1 (90.9% dedication) or 2.0:1 (50% dedication)? The key deciding factor is predictability of CFADS. If the cashflow appears highly predictable, then the lender will be comfortable with using a low ADSCR such as 1.2:1 or even lower, because s/he will not need a very large margin of safety to protect the debt service against possible fluctuations.
If, for example, the project under consideration is a PPP road project where the SPV does not take traffic volume risk but receives a capacity-based charge covering all project fixed costs - including debt service - then the risk of future cashflow volatility will be small and the lender will be happy to dedicate almost all of the projected cashflow to debt service. The risk of cashflow being adequate to meet the scheduled debt service payments is very low.
If, on the other hand, the project in question is one which tends to have significant cashflow swings – a refinery, for example, where the refining margin per barrel can swing from positive to negative and back again very quickly – then the lender will not want to take the risk of dedicating most of the projected CFADS to the repayment of debt. S/he will want a substantial cushion. I have seen refinery transactions with ADSCRs for structuring purposes set at 2.0:1 (50% of cashflow being used for debt repayment) or even higher. Merchant power stations (ones which have no offtake contract for the sale of their power) also tend to have high ADSCR levels for debt-sculpting purposes. Again, this is because the lender will not wish to take the risk that cashflow shortfalls will put the servicing of debt at risk.
Impact of ADSCR on other variables
As we decrease the ADSCR, because we believe cashflow to be predictable, we dedicate a larger and larger percentage of the CFADS to debt servicing. This will tend to shorten the period required to repay debt, but it will also reduce the amount which falls out of the bottom of the cashflow waterfall as cash available to the sponsors.
Conversely, as we increase the ADSCR, the period required to repay the debt will tend to increase also, but (if the cashflow predictions prove accurate) large cash surpluses will be available for the sponsors after debt service, with beneficial effects on their rate of return.
cash sweeps and cash traps
cases is that the lenders incorporate a “cash-sweep”, whereby an agreed percentage of any surplus cash after debt service is used to pre-pay debt. This helps to reduce the final maturity of the loan, which would otherwise (because of the high ADSCR) tend to be quite long. It also, of course, reduces the level of distributions and is therefore generally seen by sponsors as an unacceptable “cash trap”. Given the volatility of this type of cashflow, however, a high ADSCR and a cash-sweep may be the only basis on which a bank will be prepared to lend.
Adjusting ADSCR
But if the debt cannot be repaid using such an ADSCR level during a period with which the lender is comfortable, it may be necessary to revisit the debt amount or the ADSCR level or to adjust the ADSCR-driven repayment schedule manually to fit the repayment within an acceptable time envelope
A projected cashflow can be affected by seasonal variations, for example, or major equipment overhauls may reduce CFADS at regular intervals. A sponsor may request that the debt repayment schedule be even further back-ended than is the case with a single ADSCR, in order to lift IRR levels. Of course the scope for further back-ending will be limited by its impact on the debt’s average life which, as noted above, banks are quite sensitive. A repayment schedule which has been structured using a single ADSCR with subsequent manual adjustments to meet the needs of a particular case is often referred to as a “sculpted annuity”.
Structuring Repayment Schedules for Wasting Assets – The Loan Life Cover Ratio (LLCR)
Purpose: Used for assets with declining cashflow profiles, like oil & gas fields and mines.
· Mechanism: Bases debt amount and repayment rate on the net present value (NPV) of future cashflow, using a cover ratio (LLCR) to provide a safety margin.
· Reserve Tail: Ensures the loan is fully repaid by the time a reserve tail (remaining economically-recoverable reserves) is reached.
· Calculation: The NPV of loan-life CFADS is divided by the LLCR to determine the maximum debt amount that can be safely lent.
· Risk-free rate typically SONIA/EURIBOR
For such assets we need a different method of sculpting the repayment profile
– one which: 1. ensures that there is not excessive reliance on the later years of the project’s life as far as debt service is concerned;
2. matches the debt repayment profile to the remaining store of value left in the project;
3. provides an adequate cushion in case cashflow is significantly less than expected.
In single-asset upstream oil & gas and mining financings the way in which this is done is to base the amount of debt and the rate of repayment on the net present value of future cashflow, using a cover ratio (the Loan Life Cover Ratio or LLCR) to provide the necessary margin of safety.
NPV differences
Worth emphasising that when project lenders use NPV they are not using it in the same way as sponsors. When sponsors use NPV (or IRR), they are generally trying to establish whether a project offers an attractive return for risk. When project lenders use NPV they are calculating the maximum potential debt capacity of a project before the cover ratio is applied.
Example
A very simple example will illustrate this. If we discount the CFADS projected to be generated by a project over its whole project life at, say, 5% (banker’s estimate of the risk free reference rate of 2% plus a risk margin of 3%) and the NPV generated is US$150 million, this is effectively the same as saying that if:
* the project were to borrow US$150 million at the start of its operating life; and
* the project generated cashflow exactly as expected; and
* the interest rate was 5% throughout the project’s life then the project would exactly repay the US$150 million – but without a cent to spare! The discounting provides us with a measure of maximum potential debt capacity. But a banker would surely not lend US$150 million in this case? Certainly not. The project’s cashflow will only just service US$150 million – even assuming that the project performs exactly as planned without any adverse factors such as lower commodity prices, higher interest rates or increased operating costs.
Reserve tails
In a single-field oil & gas financing it is normal for the lender to insist on a “reserve tail” amounting to 25–30% of the original economically-recoverable reserves within the field to be developed. Mining reserve tails tend to be even larger than this. What this means in other words is that the loan must be fully repaid by the time the reserve tail point is reached. Thus, the reserve tail date defines the maximum potential life of the loan.
If the reserves are subject to a downgrade, then this will accelerate the date at which the reserve tail is reached, and it will also accelerate the final maturity of the loan. In single-asset upstream oil and mining transactions no value is generally given to the cashflow to be generated by the reserve tail. The lender will calculate the net present value of the CFADS to be generated during the life of the loan up to the reserve tail date (not the project life).
LLCR in example
If we first calculate the NPV of the project’s loan life cashflow and then divide the NPV by a cover ratio greater than 1 in order to derive our loan amount, then we shall build in a cushion. So, if we use 1.5 as our LLCR (which happens to be the ratio that tends to be used for single-field oil & gas financings), then on an NPV of US$100 million we might be prepared to lend US$66.66 million. This is, of course, effectively a two-thirds loan-to-value calculation, with one-third of the NPV providing a buffer.
The maximum debt which can comfortably be lent at the beginning of Year 1 is the net present value of loan-life CFADS divided by 1.5, assuming this case to be a single-field oil & gas project. By the beginning of Year 2 the remaining NPV of loan-life CFADS will have declined. The maximum amount which can safely be lent will also have declined, reflecting that amount of the project’s limited store of value which has been used up. The maximum amount which can safely be lent at the beginning of Year 2 is once again the reduced level of remaining loan-life NPV divided by 1.5.
The amount of interest to be paid will simply be driven by the amount of debt which has not yet been repaid.
If we continue this process year on year, with the debt repayments being determined by the amount of loan-life NPV still left, we shall achieve our objectives of matching the remaining debt to the remaining store of value within the project and front-loading the repayment profile.
This methodology also provides a safety cushion. In fact, it provides two. The banker is lending only two-thirds of the NPV of loan-life CFADS, leaving one-third as a buffer. There is also, however, the cashflow to be generated during the reserve tail period – which has not been given any value in the debt capacity calculation - to serve as a further protection in case of need.
When using the LLCR, the repayment due in year 2 of the repayment schedule will be determined by calculating ((Year 1 Loan Life NPV / Cover Ratio) - (Year 2 Loan Life NPV / Cover Ratio))
“Why 1.5:1 for an oil & gas project?”
Historical precedent is certainly part of the answer. While the safety margin may seem quite large, it should be remembered that petroleum and other extractive industry projects do have significant risk factors which are quite difficult to estimate – not least the likely level of the commodity price. Even more difficult to estimate with a high degree of accuracy is the level of recoverable reserves within a field.
The Project Life Cover Ratio (PLCR)
· Purpose: Provides an additional check on debt repayment profiles, especially for projects with abrupt cashflow stops.
· Mechanism: Compares the NPV of project life CFADS with the planned loan amounts to calculate the PLCR, indicating the loan extension capacity.
· Application: Used in upstream portfolio-style “Borrowing Base” facilities and increasingly as a sanity-check in sectors where ADSCR is typically used.
Key Points - Cover Ratios
· ADSCR: Suitable for projects with stable or rising cashflows, allowing for a back-ended repayment profile.
· LLCR: Essential for wasting assets, ensuring debt repayment is front-loaded and matched to the asset’s declining value.
· PLCR: Provides a holistic view of the project’s cashflow, offering a cushion for loan extensions if needed.
Intro to debt sizing and stress testing
Focus: The process of developing a banking base case and running downside sensitivity cases to stress-test the debt repayment profile.
· Objective: Achieving an optimized debt-to-equity structure that maximizes project debt while providing a sufficient debt-service cushion for lenders.
