lecture 9: financial innovations

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FIN 324, Anton Miglo

Lecture 9: Financial innovations

Anton MigloFall 2013

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Contents Project financing

What is a Project? What is Project Finance? Project Structure Motivation Underinvestment and project financing Real World Cases

Asset-backed securities Securitizable Assets How Asset Securitization Works Synthetic IPO Benefits/Incentives Examples

Income Trust

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The MM Proposition

“The Capital Structure is irrelevant as long as the firm’s investment decisions are taken as given”

Then why do corporations: Set up independent companies to undertake mega

projects and incur substantial transaction costs Finance these companies with over 70% debt even

though the projects typically have substantial risks and minimal tax shields, e.g. Iridium: very high technology risk and 15% marginal tax rate.

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What is a Project?

High operating margins. Limited Life. Significant free cash flows. Few diversification opportunities. Asset specificity. Projects have unique risks:

• Currency, interest rate, inflation.• Environmental.• Expropriation.• Technology failure.• Counterparty failure• Force majeure• Regulatory risk

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What Does a Project Need?

Customized capital structure/asset specific governance systems to minimize cash flow risk and maximize firm value.

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What is Project Finance?

Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt.

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Project Finance – An Overview

Outstanding Statistics Over $220bn of capital expenditure using project finance in 2001 $68bn in US capital expenditure Smaller than the $434bn corporate bonds market, $354bn asset backed

securities market and $242bn leasing market, but larger than the $38bn IPO and $38bn Venture capital market

Some major deals: $4bn Chad-Cameroon pipeline project € 10bn Eurotunnel $6bn Iridium global satellite project $1.4bn aluminum smelter in Mozambique €900m A2 Road project in Poland

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Total Project Finance Investment

$-

$50.00

$100.00

$150.00

$200.00

$250.00

Million USD

1 2 3 4 5

Years

Total Project Finance Investment

Equity Finance

Bonds

Bank loans

Others

• Overall 5-Year return of 18% for private sector investment.• Project Lending 5-Year return of 23%.

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Number of Projects

0

100

200

300

400

500

600

700

Number of Projects

1997 1998 1999 2000 2001

Years

Number of Projects

Project with Bond Finance

Projects with Bank LoanFinance

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Project Finance Lending by Sector

$-

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

Amount USD

1997 1998 1999 2000 2001

Years

Amount of Project Lending by Sector

IndustrialLeisurePetrochemicalMiningTelecomOil and GasInfrastructurePower

• 37% of overall lending in Power Projects, 27% in telecom.• 5-Year return for Power Projects: 25%, Oil & Gas:21% and

Infrastructure: 22%.

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Underinvestment and project financing Consider a firm with $5,000 worth of debt due in period 1

Cash flows in period 1 are stochastic, in the good state they will be $8,000, in the bad state they will be $3,000; each state has equal probability (50%)

The firm has an opportunity to undertake a project costing $1,500 that will generate cash flows of $2,000 in both states

Assume risk neutrality and risk-free interest rate equals 0

Will the firm undertake this positive NPV project?

The answer depends on how the project is financed

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Motivations: Debt Overhang

Problems: Under investment in

Positive NPV projects at the sponsor firm due to limited corporate debt capacity.

Structural Solutions: Non recourse debt in

an independent entity allocates returns to new capital providers without any claims on the sponsor’s balance sheet. Preserves corporate debt capacity.

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Motivations: other agency costs

Problems: High levels of free

cash flow. Possible managerial mismanagement through wasteful expenditures and sub-optimal investments.

Structural Solutions: Given the nature of projects,

investment opportunities are few and thus investment distortions/conflicts are negligible.

Separate ownership: single cash flow stream, easier monitoring.

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Motivations: Other Opportunistic behavior by host governments: expropriation. Either

direct through asset seizure or creeping through increased tax/royalty. Solution: since company is stand alone, acts of expropriation against it are highly visible to the world which detracts future investors. Multilateral lenders’ involvement detracts governments from expropriating since these agencies are development lenders and lenders of last resort. However these agencies only lend to stand alone projects.

A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the risky project can increase cash flow volatility and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it. Solution: project financed investment exposes the corporation to losses only to the extent of its equity commitment, thereby reducing its distress costs.

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Disadvantages of Project Financing

Often takes longer to structure than equivalent size corporate finance.

Higher transaction costs due to creation of an independent entity.

Project debt is substantially more expensive due to its non-recourse nature.

Extensive contracting restricts managerial decision making.

Project finance requires greater disclosure of proprietary information and strategic deals.

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Comparison with Other Vehicles

Financing vehicle

Similarity Dis-similarity

Secured debt Collaterized with a specific asset

Recourse to corporate assets

Subsidiary debt Possible recourse to corporate balance sheet

Asset backed securities

Collaterized and non-recourse

Hold financial, not single purpose industrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backed companies

Concentrated equity ownership

Lower debt levels; managers are equity holders

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Real World Cases

Australia Japan cablePoland’s A2 MotorwayPetrolera ZuataChad CameroonCalpine CorporationIridium LLCBulong Nickel Mine

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Case : Australia Japan Cable

Background: 12,500km cable from Sydney, Australia to Japan via Guam at a cost of $520m. Key sponsors: Japan Telecom, Telstra and Teleglobe. Asset life of 15 years.

Key Issues: High risk from fast changing telecom market Risk from project delay Specialized assets Significant Free Cash Flow

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Another example

British Petroleum: North Sea and Trans-Atlantic Pipeline Constructed to move oil from the North Slope of Alaska

to the northern most ice- free port- Valdez, Alaska Joint venture between BP, Standard Oil of Ohio, Atlantic

Richfield, Exxon, Mobil Oil, Philips Petroleum, Union Oil and Amerada Hess

Cost: $1 billion—too much for any one firm to handle

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Case : The Chad Cameroon Project

Background: An oil exploration project sponsored by Exxon-Mobil in Central Africa with two components:

Field system: Oil wells in Chad, cost: $1.5bn. Export System: Pipeline through Chad and Cameroon to the Atlantic,

cost: $2.2bn.

Key Issues: Chad is a very poor country ruled by President De’by, a “warlord”.

Expropriation risk. Possibility of hold up by Cameroon. Allocation of proceeds – World Bank’s role and Revenue Management

Plan.

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Asset Securitization Asset Securitization: separating assets producing

a steady stream of income from other assets of a company, then selling securities that have a claim on the cashflows of these assets exclusively

Non-recourse finance: when the lenders to a corporation have claims to the profits of the corporation and not to the assets themselves

Asset securitization is an example of using non-recourse finance

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Securitizable Assets Some examples of what companies have

securitized: Receivables (i.e. A/R, credit card balances, etc) Commercial and residential mortgages Equipment Leases Intellectual Property Rights to future cashflows from mining/exploration

(Royalty Trusts) Strategic Business Units (Corporate Divisions)

• Recent example: Bell Canada Enterprises (BCE) recently securitized the profits from their Ontario and Quebec phone line services creating Bell Aliant, an income trust

• Commonly take the form of an income trust

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Fixed vs. Revolving Mortgage Backed Securities: a pool of

mortgages (commercial or residential) where the security holder owns the right to receive principal + interest on the mortgages A fixed MBS has an initial amount of

mortgages, the total value of mortgages declines as the principals are paid down

A revolving MBS will replenish the paid off principals by adding new mortgages to the pool

These securities discussed later

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Synthetic IPO Asset securitization, when done for business units, is

also known as a synthetic IPO The main difference is that securitization can be used

more broadly to include assets that are not business units/divisions of companies (e.g. mortgages)

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Formula One’s Synthetic IPO 6 different companies were involved:

SLEC: The originating company which owns Formula One Management

Formula One Management: owns Formula One business, sells broadcasting rights to TV and other mediums

2 SPVs were created• Formula One Administration: holds the securitized assets• Formula One Finance: issues the bonds to investors

Formula One Licensing: owns the Formula One trademarks

Formula One Holdings: owns Formula One Administration By observing the structure of this you can see why

good financial lawyers are needed in the underwriting process

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Improving Moral Hazard To reduce agency costs two conditions must hold:

Securitized cashflows are insensitive to managerial effort (no effort needed to produce cashflows)

Securitized assets are risky (but not as much as the assets of the firm)

Recall agency costs are those incurred when the manager’s incentives do not equal shareholder incentives

Securitization segregates the assets that manager’s do not impact as directly into the SPV, while retaining the assets they can directly impact

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Asymmetric Information and Securitization

Between Managers and Investors Segregating the assets makes the quality of the assets

and cashflow clearer, making it easier to quanitfy risk This helps avoid the “lemon’s premium” on issuing

equity (recall the MM argument) Lemon’s premium: increased cost of capital to firm

as a result of issuing equity (a signal that the firm is a low-type firm)

Securitizing signals to potential investors the firm is high-type

Signalling benefit: the benefit of avoiding lemon’s market premium on newly issued equity for firms with securitized assets

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ABS Example: Bowie Bonds Bowie Bonds: David Bowie issued $55 million in

bonds in 1997 to finance the purchase of the rights to his 287 songs from his manager

This was the first instance of intellectual property securitization

The bonds gave investors the right to receive royalties to Bowie’s music from 1997-2007, and turned out being a poor investment for those who bought them because of the movement away from buying CDs and into downloading music Subsequently other artists such as James Brown have done

this as well

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ABS Example: Bowie Bonds

lecture 9: financial innovations

Documents

project lending

project need

project costing

bn asset

anton miglowhat

anton miglonumber of

bn eurotunnel

bn ipo