Structured finance and derivatives Flashcards
What is structure finance?
- Structured finance is ‘anything that is not plain vanilla’ finance.
- Typical features of a structured finance transaction
- Whilst credit risk is involved in all forms of finance, structured finance can involve greater amounts of risk from different sources. The credit risk evaluation needs to be thorough. Market risk (whether the financed product or project will be attractive to the market and produce revenue), operating risk (risks that come with the operation of the product or project), environmental and political risk (including the risks of regime change and political intervention) are all examples of other risks that need to be considered as part of the due diligence process.
- It is a common element of many forms of structured finance transactions that the entity raising the finance is a special/single purpose vehicle (SPV) (sometimes it is referred to as a special purpose entity or SPE or a Newco).
- In structured financing, if the borrower is an SPV, it will not have a financial track record and at the time of the financing, the SPV will usually own nothing.
- Going forward, its only assets may be the assets whose purchase or construction is being financed. Further down the line, these assets may produce revenue. This revenue stream will be a further asset of the SPV and generally its only income stream with which to service the debt.
- The credit analysis of a structured finance transaction will be very different to that of a plain vanilla financing. For example, a plain vanilla syndicated loan to an investment grade company will often be on an unsecured basis. The underlying principle is that the lenders are happy to rank pari passu with other creditors and they take their protection from the negative pledge restricting the borrower’s ability to create security.
- This is far too simplistic for a structured finance transaction. The SPV borrower will often have few assets and the lenders will want to ensure they have security over those assets and that they will rank ahead of any other creditors as far as possible.
- If lending to an SPV is riskier for lenders (banks or bondholders), why does structured finance often use an SPV? There are several reasons why SPVs are used:
commonly, there are tax advantages for using an SPV; it may be that the owner of the SPV is concerned about the risks involved in the transaction and wants no exposure beyond its equity contribution; for insolvency remoteness – because structured finance creditors do not want to have to compete for access to the assets owned by the SPV as they would have to do if lending to an operating business.
Using a SPV ensures assets are ‘ring-fenced’;
SPVs incorporated in other jurisdictions such as Ireland, the Netherlands and Luxembourg can often be associated with lower costs than English incorporated entities;
And using an SPV gives the sponsors (and, following default, the financiers) the ability to sell the project by way of a share sale.
- Project finance- transaction structure
They are usually companies experienced in carrying out projects. Typically, the sponsors will form an SPV (special purpose vehicle) (also called the project company) and will be its shareholders. The sponsors will be responsible for promoting, developing and managing the project. The sponsors may have other roles in the project e.g., as lead contractor under the construction contract or as project operator under the operating contract.
* The SPV will own and operate the project and act as the borrower from the lenders (banks or bondholders).
* Under the terms of a concession agreement, the government, municipality or other public body (the Concession Authority) awards the SPV/project company a concession granting it exclusive ownership of an asset for a number of years. At the end of the concession, the SPV/project company may hand back the asset to the public sector. Before this happens, if all has gone well, the project company should have produced sufficient revenue from operating the project to have repaid the amounts owed to the lenders and to have paid dividends to the sponsors.
* Project financing allows the Concession Authority to develop an infrastructure resource without committing funds to the project. This takes the financing “off balance sheet” which means the debt incurred to finance the project will not feature as part of government debt.
* The lenders (under syndicated loans or bond issues) will not normally have recourse to the sponsors, the shareholders of the project company. The lenders therefore focus on the projected cash flow from the project and ensure that they have security over all the project company’s key assets. This underlines the fact that project finance is focused on repayment of debt out of cash-flow generation rather than relying on high value asset recovery.
* The sponsors will invest equity into the SPV/project company and may also lend money to the SPV/project company via subordinated debt. The lenders will be the “senior” debt providers (either by way of loan or bond issue) which means they will have first rights to the assets of the project on default. Other lenders may rank as “junior” or “mezzanine” (mezzanine rank before junior and after senior lenders).
* The mixture of debt and equity investment will vary from project to project. The sponsors will need to consider carefully the level of equity investment as the cost involved in financing through equity and debt will vary from project to project.
* The lenders will want to see a comfortable level of equity in the SPV/project company. The more equity the sponsors invest in the SPV/project company, the greater their financial commitment to the project.
* Historically, the debt finance in a project has been provided by bank lenders. Increasingly, bonds are being used to provide part of the debt financing. There are advantages and disadvantages for the sponsors in involving bond finance. The interest rate on bonds tends to be fixed, and bond maturities are generally longer than for loan finance.
* Bond finance is also generally cheaper than loan finance, although the initial costs of raising the finance are greater.
* The disadvantage of bond finance is its lack of flexibility compared to loan finance. Should the financial predictions for the project be wide off the mark in practice, it is easier to negotiate a variation to the transaction documents or restructuring where there is a borrower default with a syndicate of banks than an unknown body of bondholders.
* It is possible to have a mixture of senior and subordinated loans and bond issues to finance the project. To do so increases the range of the transaction’s risk profile (lower to higher risk) and is done to attract a wider spread of lenders. In such a case, to negotiate a variation of the transaction documents or a restructuring will be especially challenging.
* In some countries, the lenders may require the involvement of a multilateral agency such as the European Bank for Reconstruction and Development (EBRD) or the International Finance Corporation (IFC) (the private sector lending arm of the World Bank) to lend alongside them or to assume a variety of political risks such as failure of a host government to make payments or to provide currency exchange.
* Without the involvement of such agencies in some projects, either the pricing may be too high or the lenders may refuse to be involved, particularly those located in emerging markets or weak economies. The lenders may also require sovereign guarantees from the host government or the financial support of export credit agencies.
* Once the development phase (including construction) of the project is completed, the project moves on to the operational phase. At this point, the project will start to produce revenue and the financial risk of the project changes.
* The Concession Authority may pay the SPV/project company a performance-related fee for operating the asset. The sponsors will often want to refinance the original debt on financing terms that reflect the lower risk of the project.
- Project finance- security
- Lenders will aim to take security over the asset developed and operated by the SPV/project company, the future revenue streams arising from the operation of the project and the shares in the project company.
- The lenders will also take security over other the SPV/project company’s rights under key contracts. They will include the Concession Agreement, Construction Agreement, Supply Agreement, Purchaser Agreement and any licence to operate the project (e.g., from a government or public authority).
- The lenders will want to sign Direct Agreements under which they have step-in rights under key contracts allowing them to take over the SPV/project company’s contractual rights and obligations if it defaults. The Direct Agreements are made between the lenders and the contract counterparties. They may also require the counterparty to give the lenders time to remedy any default by the SPV/project company or the project operator (see below) before they exercise their contractual termination rights.
- As the lenders may have no recourse to the owners of the SPV/project company (i.e., the sponsor), the cashflow generated from the operation of the project will be the main source for paying interest and repaying principal on the debt.
- Project finance- documentation
- Key project documents include the following:
Concession Agreement/Licence/Project Agreement: This is the contract between the Concession Authority and the SPV/project company granting the project company rights in relation to the project. It normally entitles the SPV/project company to build, finance and operate the project for a fixed period. The Concession Authority may pay the SPV/project company a performance-related fee for operating the project.
Shareholders Agreement: If there are several project sponsors**, they will enter into a shareholders agreement to regulate the relationship between the various project sponsors in their capacity as project company shareholders. If, in addition to the investors, the sponsors are providing junior or mezzanine debt to the SPV/project company, then if the lenders are party to the shareholders agreement, the agreement may include subordination provisions. The subordination arrangements could be agreed in a separate subordination agreement.
Construction Agreement: The SPV/project company has few, if any, employees and resources and therefore, it will sub-contract its obligations to build the project to construction specialists and experts under construction agreements. They will usually be fixed price turnkey contracts where the contractor has to design and build the project in phases and the SPV/project company will pay it on completion of the contracted works (the idea being on completion, the SPV/project company can simply turn the key and the project will be fully operational and start to generate revenues which the SPV/project company will apply in repaying debt and ultimately in paying dividends to the sponsors). The fixed price feature of the construction agreement is important to the lenders as they are keen to ensure that as much of the risk of cost overruns and late completion as possible is placed on the contractors. Such factors can otherwise disrupt the proposed servicing of the debt.
Finance documents: There will be a credit agreement and/or bond issue documents depending on whether the project is to be financed by a loan or a bond issue. The lenders will not normally require any of the principal to be repaid during the construction phase. If a bond issue is used, more detailed undertakings and events of default will be included than would be found in a plain vanilla bond and a bond trustee will be appointed. The bond trustee will both monitor the project’s performance for the bondholders and enable these provisions to be waived. - Security documents : Security agreements will create the security required by the investors (i.e., over the project assets and the shares in the project company).
- If the project is in the UK, taking a fixed and floating charge over all the assets of the project (whether held by the project company or the project operator)will allow the lenders to appoint an administrative receiver provided that the project falls within ss.72A to G of the Insolvency Act 1986 (the ‘Act’). This section includes utility projects and other projects involving debt of at least £50 million. They are the exceptions to the prohibition of appointing administrative receivers introduced into the Act to allow lenders to applicable structured financings to continue to have the right to appoint administrative receivers.
- Intercreditor agreement: There may be a separate intercreditor agreement, particularly if both a syndicated loan and a bond issue are providing the debt finance.
- Accounts agreements: The SPV/project company will agree to ensure that its receipts are paid into certain accounts and the parties involved will agree the order in which payments will be made from them (waterfall payments).
- Supplier and Purchaser/Offtake Agreements: The supplier agreements usually relate to the supply of energy to the SPV/project company or project operator. Under an offtake agreement, a buyer will, often over a long period, agree to buy the end product or service which the project produces. Supply and offtake agreements can be essential in securing project financing. If a continuous supply is required for a project to operate, such as fuel for a power station, a long-term supply agreement will guarantee that supply. For certain types of project such as a power station, the lenders will want to know in advance who will be the purchasers and the basic terms (such as price) on which the purchases will take place. The amounts paid by the buyers will be a primary source of repayment of the debt financing.
- Operating/Maintenance Agreement: We have referred already to the ‘project operator’. A SPV/project company will often appoint a project operator to manage and operate the project on its behalf. The project operator is often a subsidiary of a sponsor and its role is to ensure the project is properly run in accordance with the various project agreements and that the projected revenues are earned. The operating and maintenance agreement is made between the SPV/project company and the project operator dealing with arrangements during the operational phase. The lenders will wish to review the agreement to ensure that the operation and maintenance standards of the project will ensure that its ability to produce revenue is protected.
- Securitisation definition?
the sale of identifiable cash flows to an insolvency remote vehicle to secure securities (i.e., bonds), issued on the basis that recourse is limited to such cash flows and any related assets” or “a technique for raising finance from income-generating assets (e.g., loans) by redirecting their cash flow to support payments on a related issue of securities (i.e., bonds)”.
What happens during securisation?
- In a securitisation, a large company or financial institution (the originator) will pool a number of assets producing a cash flow (i.e. receivables) and procure the issue of a bond supported by those assets.
- Usually, the originator sells the assets, most commonly by way of an assignment, to an SPV (owned by the originator) which will issue the bonds. The bondholders will only have recourse to these cash flows for payment of interest and principal on the bonds. An example is the securitisation of a portfolio of mortgage loans.
- The mortgage lender sells (by assigning) its rights under a collection of domestic mortgage loans to the SPV. The SPV issues the bonds, relying on the cash flow from the mortgage loans to provide interest and principal payments on the bonds.
- The issue proceeds from the bond issue are used to pay the purchase price to the mortgage lender. The SPV may create security over its assets in favour of a trustee for the benefit of the bondholders.
- For the sake of simplicity, we have only described what is known as the true sale securitisation model in this element. You should be aware that this is only one example of a securitisation structure, and you may encounter other forms in practice.
- There are three notable reasons as to why a company would wish to securitise a pool of assets:
The first reason lies in the ability of the originator to use the assets to raise finance at a better cost of funding than it would otherwise obtain. The originator will have a variety of liabilities and the credit rating of the pool of assets may be greater than the originator’s own credit rating (assuming that the assets are of a sufficiently high quality). The originator could itself issue debt secured on the future revenues but it may achieve a better result for itself via a securitisation. This will happen if the interest payable on the securitisation bond is lower than the interest it would have to pay on bonds which it issued even though the assets in both cases are the same.
Secondly, it enables the originator to convert illiquid assets into tradeable capital markets instruments. This in turn also diversifies its funding sources.
Thirdly, securitisation allows the originator effectively to exit the mortgage lending market and allow other lenders to assume the risk of its lending portfolio.
Securitisation - structure
- The SPV will be run so that it is, as far as possible, insolvency remote. Its only assets will be the securitised receivables. It will have no employees and will carry out no other business. The SPV may take a “liquidity loan” from the originator or a third party to ensure that it has access to funds other than the receivables. As such loans may give rise to increased regulatory capital costs, in the event of a liquidity shortfall, other options or increased reliance on cash reserves are sometimes explored.
- The documentation will include a cash flow waterfall showing the order in which payments received by the SPV will be paid. Usually, transaction parties such as the trustee and the principal paying agent will be paid first. Thereafter, the bondholders will be paid in accordance with their ranking (senior, junior or subordinated) reflecting any issue of bonds in different tranches with differing payment priorities (these tranches will have different interest rates to reflect the risk that each bond tranche has). The liquidity loan will be subordinated in the waterfall to the bondholders. The waterfall may provide for surplus amounts to be paid to the originator as profit.
Securitisation- transaction issues
- Parties: The originator has been mentioned above. It is the entity (financial institution, large corporate etc.) that creates and sells the assets to the SPV. The originator may be responsible for continuing to service (i.e., collect) the receivables, but this will be done as agent for the SPV. Alternatively, a third party can play this role.
Where the pool of assets will fluctuate, a collateral manager will need to be appointed to manage the assets. The SPV may also appoint a collateral administrator, whose duties will include obtaining valuations of the assets.
As a secured bond will be issued, a trustee will be appointed (to hold the security) and a paying agent(s). - Security: Key in the security due diligence will be ensuring that there are no restrictions on assigning the receivables to the SPV. Such restrictions do not prevent the securitisation, but they will add a layer of complexity. The assignment from the originator to the SPV may be notified to any underlying debtors. Alternatively, the only notification to the debtor may be that payment should be made into a specific account, which is charged to the trustee and operated as a blocked account.
Securitisation - documentation
- Security agreement: The SPV will grant security to the trustee on behalf of the bondholders over the receivables and any other assets of value such as the benefit of the swap agreement and any bank accounts.
- Legal Opinions: The legal opinions for a securitisation are more detailed than those for other loan arrangements. The transactions are generally far more complex and the opinions will address tax issues and whether the assignment of the receivables is a true sale transaction.
- Liquidity loan agreement: This may be provided by the originator or a third party to the SPV.
- Bond documents: Subscription agreement, trust deed, paying agency agreement and offering document. The bond may be admitted to trading or offered as a private placement.
- Servicing agreement: Covering such issues as the collection of the receivables and the treatment of defaulting debtors.
- Sale agreement: This will set out the terms of the sale from the originator to the SPV. It will set out the representations and warranties the originator makes regarding the receivables.
- Swap agreement: The SPV may be required to hedge any interest rate, currency or other exposure.
What are derivatives?
- A derivative is a contract whose value derives from an underlying asset. Derivatives may be traded on an exchange or over the counter (OTC). Exchange traded derivatives are beyond the scope of this knowledge stream. Derivatives can be used to make money (investment) or to protect against specific financial risks (hedging).
- Derivatives-documentation
- The main trade association for the derivatives market is the International Swaps and Derivatives Association Inc. (‘ISDA’). Amongst its functions, ISDA produces standard form documentation for derivatives transactions to standardise and minimise the documentation required for the derivatives market.
- The main document to be aware of is the ISDA Master Agreement which contains market standard terms. It is accompanied by a customised ‘Schedule’ which amends the standard terms in the ISDA Master Agreement for a particular transaction.
- Derivatives- structure
- Derivatives are extremely flexible with products capable of being tailored to cover all sorts of risks – from stock market volatility to changes in the weather. Bankers are constantly devising new products and it is an area riddled with jargon.
- The most common forms of derivatives are swaps (such as interest rate swaps, currency swaps and credit default swaps), options, forwards and futures. As far as swaps are concerned, the detail of how a swap operates (see below) is not examinable. This information is included in order to assist your understanding of the concept of a swap.
- You do however need to be able to identify certain financial risks, which may be mitigated using swaps. We look at fluctuations in interest rates and currency exchange rates and briefly explain how a swap can be used to protect against these risks.
