External Credit Enhancement in Infrastructure Financing

Infrastructure projects continue for a long period of time. Sometimes these projects continue for decades. Hence, they need long term finance. On the other hand, there are entities such as insurance companies and pension funds which are looking to invest their money for long periods of time. Ideally, insurance companies and pension funds should be the biggest source of infrastructure financing since their needs are complementary to that of infrastructure companies.

However, in most cases, insurance companies and pension funds are unable to invest their money directly into an infrastructure project. This is because such investments may be risky and since these organizations have a lot of public money, they are required by law to be careful about the riskiness of the investments that they make.

It can therefore be said that the higher risks inherent in an infrastructure project prevent it from getting finance. Therefore, if there was a way to somehow de-risk the cash flows, it would open a new avenue for infrastructure companies which would help them raise funds much faster and at a lower cost.

The mechanism of de-risking the cash flows is called credit enhancement. Credit enhancement can be done either internally or by external parties. In this article, we will understand what external credit enhancement is and what the various methods of implementing external credit enhancement are.

The Anatomy of External Credit Enhancement

External credit enhancement is a mechanism of involving a third party with a stronger credit profile than the issuer in the finances of the infrastructure project. The basic idea is that all the responsibilities of repaying the debt related to the project will still remain with the infrastructure company itself. However, in the event of a crisis, its finances will be supported by a different party with a much stronger credit profile. Since external credit enhancement is a kind of guarantee, it can only be provided by organizations which have good financial strength such as banks, insurance companies and governments.

Also, for credit enhancement to be effective, it is important that too many terms and conditions are not built into the contract. This means that in a crisis situation, the infrastructure company must be able to drawdown the finances from the guarantor with relative ease.

The funds provided by external credit guarantors are generally provided after some sort of a trigger. However, it is important that these funds are provided proactively i.e. to prevent a default rather than reactively after a default has already taken place. The timeliness of the external credit guarantee is one of the most important factor which helps de-risk the cash flows and make them more palatable to institutional investors.

Methods of External Credit Enhancement

The different methods of external credit guarantees commonly used by infrastructure finance companies have been listed below:

• Bank Guarantees: In many infrastructure projects, a syndicate of banks is the main financier. Sometimes, infrastructure companies will ask one of these banks to guarantee their cash flows in return for a fee. For the other creditors, this improves the situation drastically. This is because they no longer have to rely on the cash flow generating potential of the underlying infrastructure company. Instead, they can rely on the cash flow generating potential of a stronger institution such as a bank. However, banks will only agree to offer a guarantee if they are provided some control over the process. In most cases banks want the authority to constantly monitor the project as well as the books of the company before they give out a bank guarantee.

• Monoline Insurance: There are many insurance companies which specialize in providing insurance to external debt holders. This means that these insurance companies accept a premium and promise to make good the investor’s loss in the event of a default. Many infrastructure companies pay the premiums of behalf of their investors. By doing so, the company makes its own credit profile irrelevant in the short run as investors are directly dealing with the insurance company.

• Mezzanine Finance: Mezzanine debt is another mechanism which can be used to enhance the credit of the infrastructure project. Mezzanine debt lies between senior debt and equity loans. If the company does not face a cash flow squeeze, mezzanine debt continues to exist as a high yield debt instrument. On the other hand, if the company does face a cash flow squeeze, the debt may be converted to equity. Since it poses no risk to senior creditors, it allows companies to sell senior bonds at considerably low rates of interest.

• Supplemental Income: In some cases cash flow from other projects is bundled along with the cash flow from the underlying project. The certainty of the cash flow of another project reduces the inherent riskiness of depending upon the cash flow from one project. This is similar to the concept of over collateralization in bond issuance. It reduces the risk for prospective investors and as a result reduces the interest rate which needs to paid out in order to avail the funds.

To sum it up, there are many ways of enhancing the credit profile of the infrastructure bonds in order to make it more palatable to institutional investors.