Long term infrastructure or natural resource projects challenge the rigidity of traditional funding models and mechanisms. These projects have large initial capital costs and carry significant levels and variety of risk, both in their development and operational phases. They require long term financing but do not always neatly fit the risk profile for traditional low risk longer term funding. Projects of this nature require a more flexible and bespoke financing package. In this blog we consider the increasing role of hybrid funding packages in the project finance space.
What is hybrid financing?
Hybrid financing can mean different things depending on the sector and the project, but essentially, for project finance, it implies striking a balance in any funding package between medium term bank debt and long-term bank debt or bond finance.
Traditional project financings such as PPP projects have typically been funded principally with long term bank or bond debt, with a small sliver of subordinated debt and true equity being pinpoint only. The debt-to-equity ratio has generally been lower in renewable energy project financings - commonly around the 80:20 or 75:25 mark - reflecting the risk profile of these projects. So, to some extent, traditional project financing already includes some basic "hybridisation" given the mix of debt and equity/subordinated debt in that model.
However, developing hybrid project finance models will need to look at skewing not only traditional debt-to-equity ratios, but also the traditional debt tenors that apply to the different tranches of debt involved. And it is changes to tenor that may be one of the main development areas for project finance.
For example, long term debt or bond financing – typically amortising over the lifetime of the project – may continue to be used alongside a 'mini-perm' tranche of debt, i.e. debt with a tenor less than that of the project lifetime. This will require, among other issues, considered modelling of capital and interest repayments of all tranches to ensure that they are affordable within project cashflows. These structures have been made to work on renewable energy projects in particular.
Hybridisation using project bonds
In the projects sector the use of project bonds has also rebounded somewhat. Project bonds involve the issue, or placement (either publicly or privately) of long-term bonds at financial close of the project to fund its development stage. Fixed repayments of capital and interest are then made under the bonds throughout the bulk of the lifetime of the project.
Bond financing is not new, and particularly pre-credit crunch, was routinely used for larger scale infrastructure projects. A project with development costs above £100m was typically seen, at the time, as being the starting point for considering bond financing, due to the higher transaction costs relative to those incurred when putting in place bank debt.
Post-credit crunch, the inability of monoline insurers to underwrite bonds made securing the necessary bond ratings required to attract institutional investors to invest in them very difficult. But this is now changing. In Scotland the Scottish Government announced at the end of 2023 its intention to issue sub-sovereign Scottish bonds before the next election in Scotland. These bonds are being specifically considered and are earmarked for infrastructure projects.
As scoping work on these Scottish Government bonds continues, market participants and observers will have a close eye on how much can be raised through these bonds (within the Scottish Government's borrowing rules), what the appetite for such bonds will be in the institutional investor market, and where the proceeds will be deployed. It will also be interesting to see the place these bonds, if not used as standalone funding, may have in a hybrid project funding package alongside long term bank debt funding.
Other possible components of hybrid finance
There is a plethora of other funding tools that can be considered when looking at hybrid funding models. Again, use of any of these may go further than what may typically be regarded as "hybrid financing". Sitting alongside debt funding, these tools could include:
- national or supra-national central funds: typically, in the UK this involved the availability of EU grants, although, of course, these are no longer available in the UK;
- central investment or development bank funding: again, in the UK and up until Brexit, the EIB participated in funding of a number of infrastructure projects and continues to do so in the EU. The UK has established the UK Investment Bank to plug this gap, and its involvement in a variety of projects is being carefully watched. Similarly, Scotland established the Scottish National Investment Bank which is active in funding in a number of areas;
- natural capital: this is still a somewhat emerging trend and actual project opportunities are not perhaps as easily identified as in other traditional infrastructure sectors;
- pension fund investment;
- trade credit insurance;
- guarantees: particularly public sector guarantees, carefully structured to cover specific potential loss/cost;
- credit enhancement products: for example, the use of letters of credit, bonds and guarantees; and
- ECA involvement in projects with a multinational aspect.
Considerations in hybrid finance models
While hybrid financing has the benefit of flexibility, giving borrowers the ability to structure their capital stack more flexibly and to reduce the overall cost of capital, any hybrid project finance model is typically complex to set up and manage. It necessarily involves a balancing of differing interests of the funders. Typical considerations are:
- priorities of debt;
- ranking of securities;
- enforcement controls;
- the treatment of distributions and adaptation of the cash cascade throughout the lifetime of the project;
- the different risks at different project stages, balancing and pricing those risks and the impact on margin for all tranches of a hybrid project financing and considering and, perhaps, hard-wiring the ability to refinance at key stages where risk may change;
- the possible role for hedging in the debt tranches; and
- the political climate.
Comment
Increased hybridisation of the traditional project finance structure may be useful to fit the funding needs and reflect the risks of long-term infrastructure and natural resource projects. Putting in place the optimal finance package is a key factor for the long-term success of any major project. Hybrid finance models are continuing to evolve to fill project funding gaps.
If you would like to discuss any project finance issues please contact the authors.
Our guide to project finance can be accessed here.
A recording of our webinar 'The Project Finance Model : effective uses and future trends' can be accessed here.
