A number of trends are occurring domestically and internationally in the broad area of project and infrastructure finance which indicate leasing structures will be used more frequently as a vehicle for financing infrastructure projects and privatizations. These trends include:
- the ongoing restructuring of the domestic electric utility industry;
- the maturation of domestic independent power projects;
- the increasing pace of global privatization; and
- the deregulation of electric utilities in Europe.
Until recently, infrastructure projects and privatization have been primarily financed through the use of the traditional "project finance" or non-recourse lending paradigm. Under this paradigm, a financial institution (typically a commercial bank) makes a loan to a special purpose company which owns or operates one or more related projects, and virtually nothing else. In making this loan, the financial institution has recourse only to the assets and cash flows of the project company without further recourse to the owners or sponsors of the project company if the project goes into default (except to the extent that any of the owners have other contractual obligations to the project). Project revenues generated from a long-term offtake contract for the commodity produced or service rendered by the project or privatized entity represent the principal (if not sole) source of debt repayment.
From the project lender's perspective, this paradigm has been particularly well-suited to financing power projects, toll roads, water supply facilities, liquefied natural gas terminals, and other infrastructure projects because such projects generate stable, long-term revenue streams which can be isolated and secured as collateral for debt (in addition to the hard assets of the project and its supporting contracts). Project sponsors and other project participants have found this paradigm desirable due to the off-balance sheet treatment of the debt incurred (vis-`-vis the balance sheets of project owners), the insulation from liability it provides, and its inherent risk allocation flexibility as it allows project participants to allocate specific project risks to the party most able to handle such risks.
Nevertheless, the market trends delineated above have generated an ever increasing demand for capital worldwide. At the same time, project sponsors have increasingly begun to look beyond the traditional project finance paradigm in efforts to capture embedded tax benefits in operating projects, lower the costs of financing and/or turbo-charge returns. This has led to an incorporation of capital markets, mezzanine (in conjunction with other vehicles), and lease financing structures into the traditional paradigm. Indeed, it can be argued, that in the aggregate, structures incorporating these other asset finance technologies have, over the last two to three years, raised more infrastructure financing dollars than the "classic" non-recourse loan model.
Analyzed separately, however, structures incorporating leasing technology into an infrastructure project or privatization financing presently come in a distant third to the traditional commercial loan model or an infrastructure project financing or privatization incorporating a capital markets offering into the equation (or for some mega-deals, a hybrid of the two). Given the trends in the market discussed below, however, the use of lease structures in the project and infrastructure context should garner greater consideration from sponsors and financing parties alike, and, over the longer term, begin to capture an increasingly larger share of the infrastructure finance marketplace.
Global Market Trends
In the broadest sense, each of these trends can be characterized as a subset of the global trend to market capitalism. This macroeconomic sea change has fueled an enormous growth in global demand for private capital requiring financial advisors to continually seek to exploit new pools of capital available for infrastructure project investment. The traditional project finance paradigm as a vehicle for getting this capital to the marketplace (i) has strained to keep pace with the needs of borrowers (indeed recently, due to the global liquidity crisis, the capital markets have been shut down to borrowers trying to finance projects in emerging economies) and (ii) does not always fit the requirements of private equity and debt providers. The following briefly discusses these individual external market trends and the potential opportunities available for the employment of lease technology as an enhancement to or, in some cases, a replacement for the traditional project finance model.
Restructuring of the Domestic Electric Utility Industry
The United States electric utility industry, which owns assets with an aggregate book value estimated at between $300 and $600 billion, has begun the process of restructuring from an industry subject to command and control regulation to one open to the vagaries of the free market. This process, similar to that which the natural gas, airline, trucking, and telecommunications industries have already undergone, will result in the sale, spin-off, acquisition, or divestiture of several hundred billion dollars of electric generation, transmission, and distribution assets. Indeed, several billion dollars of these assets have already changed hands. While a portion of these acquisitions will be financed by the purchasers through balance sheet financing, a significant portion of the purchase of these assets will be financed using off-balance sheet methods, most likely employing some form of the project finance paradigm. The incorporation of lease finance technology into these acquisitions would allow owners to recover embedded capital without losing control of a valuable asset, in the case, for example, of a sale-leaseback transaction.
Maturing Domestic Independent Power Projects
The independent power industry in the United States came into being, for the most part, with the passage by Congress of the Public Utility Regulatory Policies Act of 1978 (commonly referred to as PURPA). Since 1978, approximately 6000 independent power projects have come on line. For the most part, these projects were financed through the use of the traditional project finance paradigm using commercial loan financing. The bulk of these projects are now reaching what can be termed as "maturity." They are somewhere between their fifth and fifteenth year of existence with between five and fifteen years remaining on their long-term (typically twenty year) take-or-pay power sales contracts with one or more utilities. Numerous opportunities exist for the refinancing of existing project loans through leasing structures as many of these assets may be ripe for re-conditioning or re-powering using newer technologies. When the tax benefits associated with the newer equipment are more efficiently used by a third party, leveraged leasing of entire projects becomes feasible, and perhaps desirable.
Global Privatization Wave
The rate of privatization of government owned assets has increased dramatically over the past decade, particularly in developing countries. Since 1991, for example, Brazil has sold approximately fifty state companies worth almost $15 billion. In November 1996, Germany's Deutsche Telecom was privatized for DM20 billion ($13 billion), Europe's largest privatization to date. Estimates by The Economist call for the privatization of state-owned enterprises in Western Europe valued at $250-300 billion over the next few years. Indeed, even the recalcitrant Peoples Republic of China has embarked on a liquidation of its government owned enterprises. In circumstances where sovereigns desire the functional benefit of privatization (i.e., private managers and operation of a facility) but are mindful of the political and legal implications of transferring title to valuable state assets to foreigners, leasing may provide a politically convenient way to retain ownership, but shift control and financial responsibility.
Moreover, even in jurisdictions where retention of local control is not an issue, lease structures have been considered and used with great success. For example, in Australia, at least two privatizations have been accomplished in which a leveraged lease was an integral part of the project finance structure. These were the A$4.7 million privatization of the 2000 MW Loy Yang A generator in the State of Victoria and the privatization of the Australian Electric Transmission Company (ETSA) in which Mission Energy of the U.S. was both a debt and equity provider. Furthermore, lease structures have been widely employed in England's privatization and financing of its electric utility assets. While most of the power leases in England have employed U.K. tax leases because of U.K. land laws and other local regulatory issues, Chase Manhattan using an innovative financing structure closed the first U.S. cross-border lease in the U.K. power sector late last year with the financing of the U.K. generator Eastern Electric. The success of this transaction should serve to rekindle interest in employing a variety of lease structures in any further financings in this sector.
Deregulation of Electric Utilities in Europe
As Europe continues to move to a unified market with a single currency, the European electricity industry, similar to its counterpart in the U.S., is facing a period of significant restructuring. Unlike the U.S., however, most utilities are not privately owned. Nevertheless, some of these utilities, particularly those located in the Netherlands, have focused on the use of financial technology in lowering their costs. Indeed, this is one area in which industry participants have completely ignored the project finance model and focused solely on lease technology. Over the last year, several Dutch utilities have employed cross-border tax-drive lease structures to lease their generating assets as a mans of creating liquidity on the balance sheet given that Dutch state owned utilities are corporation tax-exempt. Several of these utilities are exploring the viability of applying these structures to transmission assets as well. It has been reported that similar transactions have been under consideration in England (as mentioned above), Ireland, Germany and Austria. As a truly competitive market for electricity develops in Europe further, the appetite for financial engineering to lower costs and/or boost returns will only increase. Since the circumstances so clearly favor lease structures, it can be anticipated that Europe will be watershed market for the use of lease structures in connection with the financing/refinancing of infrastructure. Moreover, it appears that some of this enthusiasm for the use of lease structures in deregulating industries in Europe may spread to the telecommunications area as a number of telco and cable financings employing cross-border lease structures are said to be in the pipeline.
Until recently, lease technology has had only limited application in the financing of infrastructure projects and privatizations. Given the trends taking place in the global marketplace, the ever-growing demand for private capital to finance new and newly-privatized infrastructure, and the limitations of the traditional project finance paradigm, lease structures will find increasing relevance in infrastructure finance transactions.