noTE NO. 1 – july. 2012 SNTABriefs Sharing knowledge, experiences, and innovations in sub-sovereign financing for infrastructure 73640 The Advantages of Structured Financing for Sub-National Authorities An Introduction to Structured Financing for Sub-Nationals David Painter and Joshua Gallo I n principle, sub-national authorities have several to determine which model is most attractive to local financing models to choose from for their infra- investors. structure projects. A common model involves the authority taking a long term loan from a bank. Since General obligation financing most commercial banks do not lend for the length of time appropriate for infrastructure projects (15 years General obligation financing involves sub-national or more), this type of loan is most likely to come from authorities’ issuing long term General Obligation a development bank or national government agency. (GO) bonds. The term “General Obligation� means Another model involves the authority entering into a that the authority’s pledge to repay bondholders obli- public-private partnership. In this model the respon- gates all revenue streams and assets belonging to the sibility for mobilizing the capital for the infrastructure authority. With a GO bond, debt service payments are project normally rests with the private sector partner a line item in the authority’s budget and the money rather than the authority. Neither of these first two comes from the general fund of the authority. One models involves the sub-national authority obtaining would think that an authority pledging all sources of long term financing from local capital market inves- revenue and all assets to bond repayment would be tors. In the right environment, institutional investors reassuring to investors. Indeed, in the municipal bond in a country’s local capital market can be an important market of the United States this is the most common source of financing for infrastructure development. financing model used by local governments for infra- structure development. Capital market financing for sub-national infrastruc- ture development has a long history in some countries, However, the degree to which investors feel reas- but is essentially unknown in many others. There are sured by a GO pledge depends on their perception three basic models for capital market financing: 1) of the issuing authority’s creditworthiness. The risk general obligation financing; 2) project financing; is that the authority may get into financial difficul- and 3) structured financing. ties and become unwilling or unable to repay their debt. If the issuing authority has a credit rating, then All three models use bonds (or similar securities) as investors can measure the risk of a default. If the PPIAF Approved Logo Usage the financing mechanism. In well developed capital authority’s rating is “investment grade� (BBB– ) or markets all three models operate successfully, and better on the country’s national rating scale, then Logo - Black sub-national authorities use the model that works local investors may be willing to buy the bonds. But best in their specific situation. In developing capital markets it is PUBLIC-PRIVATE likely that INFRASTRUCTURE someFACILITY ADVISORY or all of these models David Painter is a Development Finance Consultant, and Joshua Gallo is are untested, and sub-national authorities will have Program Leader for PPIAF’s Sub-National Technical Assistance Program. Logo - 1-color usage (PMS 2955) PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FAC ILITY An Introduction to Structured Financing for Sub-Nationals 2 A simplified example o The guarantor pledges to reimburse the authority’s lenders/investors 50% of any Let’s imagine that a sub-national authority wants principal lost in the event that the authority to borrow local currency (LC) to finance an LC 100 defaults on its debt. million infrastructure project. In this example, the • The credit rating agency reviews the partial credit rating agency gives the authority a national risk guarantee structure and determines that it scale rating of A+(ns) which is investment grade, reduces the risk of default enough to qualify the but below the national government’s bond rating total borrowing for a AA+(ns) rating which would of AAA(ns). Further imagine that research by the enable the authority to borrow at an interest rate authority’s public finance advisor shows that national of 7%. government bonds with a 15 year term carry an The municipal interest rate of 5%, but meetings with potential • The authority successfully borrows LC 100 million lenders and investors reveal that a 15 year borrow- for a 15 year term at an interest rate of 7% and pays bond market ing by an authority rated A+(ns) has to pay 10% another 0.5% per year for the partial risk guaranty. of the United interest to attract financial institutions into lending As a result, the annual cost of the borrowing to the LC 100 million. authority is LC 11.3 million but this is expected to States is the be covered from the LC 11.5 million annual net most common Let’s assume that debt service on a LC 100 million revenue available from the project. borrowing with a 10% interest rate for 15 years financing model (LC $13.1 million principal and interest each year) used by local is not considered affordable by the authority. So the authority asks their public finance advisor to the return (interest paid) has to be commensurate authorities propose a more affordable way to obtain long term with the risk. The better the rating, the lower will financing. be the interest that the authority has to pay. If the authority is not rated investment grade, or not rated Now imagine the following scenario… at all, they will not be able to sell their bonds in the local capital market. • The infrastructure project is expected to gener- ate user fees of LC 20 million annually with a total operating & maintenance cost of LC 8.5 million per The problem of using GO bonds in a developing capi- year. tal market is that most sub-national authorities are not rated BBB– or better (if they are rated at all). Local • The credit rating agency reviews the project and investors generally perceive sub-national authorities as determines that, due to a variety of project risks, a very risky or simply not creditworthy at all. In such an borrowing based solely on repayment from user fees environment, it will be difficult (if not impossible) for would be rated BBB(ns) and would have to offer 15% interest to raise LC 100 million, and this would a sub-national authority to obtain long term financing increase annual debt service to LC 17.1 million. This with a GO bond issue. would make the project financially unviable. Project financing • At the authority’s direction, the public finance advi- sor designs a structured obligation based on a 50% Project financing using the local capital market typi- partial risk guarantee purchased from a guarantor cally involves a sub-national authority issuing long that has a AAA rating. term revenue bonds which pledge only the fee reve- nues that are to be derived from the operation of o The structure makes 50% of the borrowing the infrastructure project itself. The issuing authority’s “risk free� and equivalent to AAA(ns) while the other 50% of the borrowing remains an other revenues and assets are not obligated to repay- A+(ns) risk. ment of the debt. With a revenue bond, bondholders have first claim on revenues from the project but the o The partial risk guarantee requires the money still flows through the authority’s accounts. authority to pay the guarantor an annual fee The fundamental risk is that the project will not of 0.5% on the outstanding balance of the generate sufficient fee revenues to repay the debt, borrowing. and there is no recourse to any other revenues of the authority. 3 Revenue bond repayment risk is compounded by from the debt service account established by an SO risks associated with the project itself such as: bond (and administered by an impartial third party) are those that are disbursed directly to bondholders. Revenue bond repayment risk is compounded by risks associated with the project itself such as: SO bonds avoid the risks inherent in project financ- • the risk of construction falling behind schedule or ing, and they can also achieve credit ratings that are going over budget higher than the GO rating of the issuing authority itself. Credit rating agencies can analyze the structural • the risk that the infrastructure will not work prop- elements of an SO bond to determine the risk that erly after the project is built the structure may fail to repay the bond holders. If • the risk that there are fewer users of the infra- the bond is carefully structured (a task that should be structure than projected performed by an experienced public finance advisory firm) then it will be assigned a high credit rating. • the risk that user fee increases fail to keep up with rising costs of operation and maintenance The SO bonds of some sub-national authorities have even been rated near AAA on their national scale. In countries with developing capital markets, local Because of their high credit quality SO bonds are very investors are likely to believe that the repayment risk attractive to local investors in countries with develop- on an infrastructure revenue bond is very high. While ing capital markets. In more than one country SO a credit rating can be obtained for a specific revenue bonds were the financing model first used to intro- bond, if the revenues pass through the authority’s duce long term sub-national debt securities in the accounts, then the bond’s rating can never exceed capital market. the rating of the authority itself. As a result, revenue bond project financing has not proven to be a success- The Sub-National Technical ful financing model for infrastructure development in Assistance (SNTA) Program countries with developing capital markets. As more and more countries decentralize, the Structured financing provision of infrastructure is increasingly becom- ing the responsibility of sub-national authorities Structured financing involves a sub-national authority (local governments and public utilities). These issuing long term structured obligation (SO) bonds authorities are finding it necessary to seek long which differ from GO financing and project financ- term private financing for their infrastructure ing in several important ways. SO bonds pledge debt projects. Using annual budget allocations to repayment based on one or more specific revenue build infrastructure is difficult to manage because sources available to the issuing authority. Unlike proj- the funds required vary greatly from year to year. ect financing, the revenue need not be generated Long term debt financing allows sub-national only by the infrastructure itself, but can be a combi- authorities to smooth out the annual funding nation of revenue streams that have proven to requirement by borrowing a large amount of be reliable from long experience. Unlike GO SNTAbRIEFS PPIAF Approved financing, the SO bond repayment mech- Logo Usage capital at one time and then repaying the debt in predictable annual increments small enough to SNTAbriefs share emerging knowledge on anism is typically structured so that the sub-sovereign financing and give an overview Logo - Black make the project affordable to the people served. of a wide selection of projects from various obligated portion of the pledged reve- The Public Private Infrastructure Advisory Facil- regions of the world. Related notes can be found nues bypass the authority’s general at www. ppiaf.org. SNTAbriefs are a publication of ity (PPIAF) works with sub-national authorities fund and are PUBLIC-PRIVATE IN F Rheld in ASTRUCT U R EaADseparate V IS O RY FA C IL IT Y PPIAF (Public-Private Infrastructure Advisory Facility), a to enable access to private financing on the best multidonor technical assistance facility. debt service account that cannot possible terms, and shares the lessons learned be accessed by the authority. The views are those of the authors and do not necessarily from its global experience. reflect the views or the policy of PPIAF, the World Bank, or The only withdrawals permitted any other affiliated organization. Logo - 1-color usage (PMS 2955) c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA For more information visit the PPIAF website at Phone (+1) 202 458 5588 FAX (+1) 202 522 7466 www.ppiaf.org. general EMAIL ppiaf@ppiaf.org web www.ppiaf.org PUBLIC-PRIVAT E INFRASTRUCTURE ADVISORY FACILITY