Combining LBO and Project Finance

Infrastructure Acquisition Finance: an encounter of the third kind?
01 May 2007
Infrastructure Journal (please visit: www.ijonline.com)

(IJ Online) In the wake of last year's multi-billion French toll road deals, 'hybrid' acquisition transactions combining project finance and LBO features have entered the mainstream - but the two structures contain diffuse and potentially contradictory elements.

In a thorough analysis, Herbert Smith's Jacques Bertran de Belanda explores the tensions between the priorities of the two financing classes and heralds the emergence of the new structure - 'Infrastructure Acquisition Finance'.

In the debt finance family, 'leveraged finance' and 'project finance' each follow their own rules and have their own jargon and market practice. The clients are a priori different: private equity funds and large groups of companies on the one hand and specialised funds (which are of more recent origins than their private equity counterparts), construction and civil engineering companies, and specialised operators on the other.

However, this situation is evolving. It is a slow evolution which has its origins in Canada and Australia during the 1990s, when the governments of these countries started programmes of infrastructure privatisation by surrendering the businesses concerned.
The first large scale transaction of this type in Europe was the acquisition by Macquarie of South East Water in Britain for £426 million.
It is, therefore, a market that is still young and essentially concentrated in the British Isles and central Europe. However, in the current context of liberalisation/privatisation in Europe, it is a market that is undoubtedly destined to grow.

The acquisition of infrastructure assets can be effected on the basis of a loan to the purchaser, at least when the purchaser is perceived to have a satisfactory credit rating (which was the case, for example, when Vinci acquired Autoroutes du Sud de la France in 2005-2006). However, for various reasons, leveraged finance structures, with ad hoc vehicles ('SPVs') principally financed by debt and owned by the sponsors (industrial and financial sponsors) are often being used for these acquisitions.

This article will examine the specific details of financing these often sizeable operations (for example the US$5 billion Indiana Toll Road project in the USA; or the £3.9 billion refinancing for Thames Water in the UK).

At the outset: two different approaches
In the context of LBO financings, the debt capacity of the borrower is traditionally considered to be based on its balance sheet and the capacity of the target to generate revenue. This capacity is itself a function of its competitive position on a given market.
Several essential characteristics emerge as a result of this:

The tracking tool which is most commonly used by the banks is EBITDA (Earnings before interest tax and depreciation allowance), which enables a review of business performance1

The terms and conditions of the financing are designed to reduce the debt of the borrower as quickly as possible - mandatory repayments in the event of a disposal or excess cash flow, ratchet mechanisms over the margin and lock-in mechanisms for investors which fade away gradually as the debt reduces

Only one fraction of the debt is amortised (and market trends are increasingly moving away from this); the main part has bullet repayment

Ultimately, the underlying hypothesis is that the financing will be either be repaid or refinanced before the end of its term
On the other hand, in the field of project finance when dealing with 'greenfield' projects, the focus is on the discounted value of the capital revenue compared to the duration of the financing.

Why is this?
Unlike an industrial or commercial company operating in a competitive environment, an operator in the infrastructure sector owns an asset that generates stable and predictable revenues (but conversely, has fewer expansion possibilities) based on long term concession contracts3. Its operation, if not an effective or legal monopoly, is at least closely associated with strong entry barriers. The exposure to market risk is limited or at least well controlled.

Consequently, it is not surprising that the financing structure is different from that of an LBO in several respects:

The length of loans is much longer (up to 35 years compared to 9 years maximum for an LBO) and bond financings, whether direct (for example A28) or indirect (for example Viaduc de Millau) if not usual, are at least known and common

The amount of the loan is much higher; multiples of more than 10 times EBITDA are not uncommon

In order to maintain the stability and the frequency of cash flow, the amortisation of senior debt is the rule and not the exception4
Finally, and above all, the lenders' margins are much lower

How can investing a lot more money over a longer period of time with conditions that are more advantageous to the borrower be justified?

The answer to this question is simple: it is because, in the field of structured finance, the risks that lenders are prepared to take, as well as the mitigation measures to be put in place, are identified and managed in a very precise manner . It is the elimination or the management of such risks which results in a lower cost of financing because the rates of total loss from these types of matters are low and the rates of recovery in fine are higher.

Comparison of the two methods
Clearly, infrastructure acquisition finance requires a combination of the two methods, because although infrastructure funds have investment criteria and objectives which differ from those of private equity funds, they share with the latter the fact that they are professional shareholders waiting for a precise return on their investment.

Financing structures being put together at the moment are often done on a case by case basis with some common characteristics; for example, there will generally be a higher level of due diligence than for an LBO, but the provisions relating to mandatory repayment will be very close to provisions seen in large acquisition finance operations. The choice of the financing structure is often dictated, at least in part, by the conditions of syndication i.e. whether it will be sold principally on the leveraged debt market or on the project debt market. The very nature of the acquired asset and the cash flow that the asset generates leads to the use of finance structures that are a mixture of LBO financing and project financing (sometimes known as 'hybrid financings')6.

Before examining in more detail the characteristics of hybrid financing, one last point should be noted: financings that are limited to 'single asset' infrastructure acquisitions (for example motorway concessions or the distribution of water/gas) are more 'project' oriented than others (notably ports and airports), whose operating conditions are close to those of the private sector.

The main issues
Due diligence
In both cases, the role of due diligence is the same: to give the purchaser a clear idea of the risks, in particular, legal and tax, but also, market related and environmental risks etc., of the transaction, then to determine the value of such risks (taking account of them in the price to be paid) and allocating them via representations and warranties and disclosures.

In the LBO market, this stage has been standardised and is now often reduced to its simplest form. This is due to the maturity of the market, the competition between the candidates (funds, but also trade buyers looking for strategic acquisitions) and the increase in secondary, tertiary and even quaternary and other LBOs. It is not unusual nowadays for the purchaser to settle for a review of only a few days to confirm the findings of the 'vendor due diligence' which has been prepared by the vendor and which has been provided to the purchaser during the preliminary stages.

In the case of acquisitions of infrastructure, the situation is different:
Firstly, the organisation and the provision of detailed vendor due diligence is not something which the state and other public bodies are used to (since target companies are often listed, this would not necessarily be compatible with one of the main rules of the stock exchange which provides for equality of access to information to all investors)

Furthermore, producing an 'exceptions only' report does not involve reviewing a complete set of commercial and financial contracts, but, more often than not, reviewing one or two 'key' contracts which are crucial to the business and which must be reviewed in their entirety (for example, concession agreements as well as supply contract/s)

Finally, the legislative environment and regulations specific to the business are very important, especially because, as these are 'regulated' businesses, a change in law/regulations could have a direct affect on the ability of the company to generate cash flow.
Due diligence is more thorough in the case of 'traditional' leveraged finance operations, but it is carried out at a quicker pace than in 'traditional' project finance operations i.e. at the pace of the timetable of an LBO operation.Certain representations and warranties are drafted into the finance documents following due diligence. They can principally be divided into two types:

Detailed reporting obligations on the state of the assets and the project. This is particularly the case for assets which are subject to a risk of demand (airport, motorway concessions) and/or those for which the operator may be liable to penalties (for example, for defective maintenance) which could put the operator's revenue at risk

Obligations to do or not do something linked to the project itself (for example to submit certain decisions, such as the renegotiation of rates or amendments to the contracts, to the prior consent of the lenders in various situations).

Financial ratios and undertakings
In the two types of financing, these clauses serve various functions:
To monitor the project
To increase or decrease the margin (the 'ratchet' effect)7
To provide for the possibility of the target company making dividend payments or other distributions ('cash trap'8
To increase the lenders' rights of control
In extreme cases, to accelerate repayment if the ratios fall foul of the pre-agreed event of default level

In the LBO model, these obligations are based mainly on the consolidated and corporate accounts of the target company and the most significant ratio is that of the consolidated debt to EBITDA. To get a better idea of the performance of the target, others are also used, in particular, fixed charges cover, interest cover, retrospective cover to debt service, etc. Due to the lack of predictability of revenues and, above all, the recent changes in the debt finance market, financial undertakings are quite flexible, and it is not unknown for them to be renegotiated during the life of the transaction. In the field of project finance, they are based on the financial model which is prepared during the structuring phase, then regularly updated. Insofar as the financing depends on the estimated value of the project ('discounted net cash flow'), the most important ratio is that which covers the servicing of debt during its lifetime: 'loan life cover ratio' and 'project life cover ratio'. Annual debt services cover ratios are also used, but prospectively (on the basis of the last update of the financial model) as well as retrospectively (as with LBOs).

As regards negative undertakings such as restrictions on the acquisition of capital assets ('capex controls'), the two models differ noticeably. In the case of infrastructure, the concession contract provides for a programme of maintenance, which can - and often does - include the restoration of assets at the end of the concession. The financial model must inevitably take account of this expenditure. This is not a completely foreign concept in the world of leveraged finance since the financing structures often take into account acquisition lines ('capex lines'). However, these do not last very long (generally 2 to 4 years) and are more flexible to use (there is little or no need for the prior consent of the lenders if the planned operation is in keeping with the parameters set at the start). They are made to facilitate a further expansion of the business, not to account for mandatory future capital expenditure.

Security Package
It is common for security to be taken over both assets and cash flow, in order to isolate the underlying assets, as far as possible, from any third party creditors ('ring fencing').

Nevertheless, the approach taken to the two situations is different.
LBO transactions are, these days, broadly standardised, in that, save for some fundamental security interests (a pledge over the shares of the target company for the acquisition debt and an assignment of trade receivables of operational companies for working capital debt), the taking of security interest charges is made on the basis of a cost benefit analysis (which is enshrined in contractually binding 'agreed security principles'). With regard to projects, 'ring fencing' is generally much stricter, and greater emphasis is placed on the effective control of cash flows through 'cash waterfall' mechanisms, with accounts dedicated to certain income streams (for example trading, insurance, etc) with strict rules for operation; assignments of receivables by way of security and pledges over all accounts.

In relation to security interests, the specificity of acquisition financing (of whatever type) is that it has to comply with the rules on misuse of corporate assets and the prohibition on financial assistance by the target company for the acquisition of its own shares. As a result, acquisition debt cannot be secured by the shares of the target company, which leads to a structural subordination of the acquisition debt.
Such concerns do not exist in the financing of a 'greenfield' project, since such projects involve the construction of a new infrastructure, which will appear on the balance sheet of the borrower. Nevertheless, the difficulty is that, in relation to the assets dedicated to concession, or whose use is heavily regulated, it is often difficult, or even impossible, legally or in practice, to take an effective security interest over the asset (at the very least, the realisation of such security interest will first need to be authorised by the public sector). The idea in 'greenfield' project financing is to transfer the project (or rather allow the project to be transferred) to a special purpose vehicle controlled by the lenders with step in and substitution rights. This method is now widespread (notably in relation to motorway concessions) but has not escaped criticism9.

One could infer from this, that infrastructure acquisition finance is laden with difficulties: restrictions relating to the misuse of corporate assets and the prohibition on financial assistance on the one hand, and restrictions linked to the proper regulation of assets on the other.
Such negativity should not however give way to defeatism, for a number of reasons:
First, because the taking of a pledge over the target company's shares is simple to put in place, and, if necessary, to enforce. Of course the charge is subject, as all other security interests under French law, to the uncertainties of French insolvency legislation; however in most cases, its realisation allows the underlying infrastructure asset to be transferred immediately (but inclusive of liabilities) without the prior agreement of the public sector10

Secondly, because it is often possible, after the acquisition, to implement debt push down techniques, which, where properly structured11, will result in the target bearing the debt12

Negative covenants
In all limited recourse financing transactions, the special purpose vehicle which carries the debt is submitted to a number of restrictions, in particular in relation to its indebtedness, the disposal and acquisition of assets, the granting of security (negative pledge13), distributions to its shareholders, etc.

The aim of these provisions is to ensure that, as far as possible, the special purpose vehicle remains that which carries the project (or the acquisition) and does not incur any liabilities outside of this ambit.

The main question is therefore whether the lenders have any flexibility in light of this theoretical objective

In relation to LBO financing, a relatively large amount of flexibility exists:
Dividends and other distributions made by the target company to its investors are authorised earlier and earlier (subject to financial ratios being observed) whereas, traditionally, these payments were not possible whilst the acquisition debt was in place14

It is not uncommon that, at the time the transaction is structured, provision is made for the sale of non-strategic business (the resulting income is then set aside to be used for repayment of the debt), or conversely, banks will sometimes provide the necessary finance ('capex lines', cf. above) so that acquisitions can take place within the given parameters of the business, size and conditions of the acquisition
Given that the target company operates on a competitive market, it is necessary to provide for adaptability;
Less obvious, but just as important, the methods of decision-making inside senior and mezzanine banking LBO syndicates, are becoming more flexible in favour of the borrower: 'yank the bank' clauses allow for the forced sale of the shareholding of a lender which does not consent to modifications or waivers when a large majority of its fellow lenders have consented; and 'snooze and lose' clauses ensure that lenders which have not responded to requests within the time limits, will neither be counted in the quorum nor have their votes counted. There are also increased restraints on the conditions of transfers of shareholdings etc.

By its nature, project finance is less flexible, since it is a long term activity. It is hardly conceivable that a 'single asset' concessionaire could be authorised to sell the asset which holds the concession. That said, a certain margin for manoeuvre is possible, particularly when the asset in question is part of a network, which can be easily broken down or sold in parts. Similarly, the restrictions on indebtedness and the creation of charges, will be in principle more strict than in the world of LBO financing, in order to preserve the balance provided for by the financial model.

Certain funds clauses
The origin of these clauses can be found in take-over financings. To the extent that the stock exchange rules require bidders to make irrevocable undertakings to acquire the shares which are part of the offer, the conditions precedent which normally govern the disbursement of funds by lenders are dispensed with, save for the most fundamental conditions precedent (validity of the constitution of the company, absence of bankruptcy procedures, for example).

Due to the very competitive nature of the private equity market, these clauses have been adapted to LBO acquisitions, and, over the last few years, have become more the norm than the exception. One specific clause relevant in this context is the MAC (material adverse change) clause. In brief, the idea behind the MAC clause is to allow a purchaser to be released from its obligation to continue with an acquisition under an acquisition agreement, upon the occurrence of an event qualifying as a 'material adverse change'. The definition of a 'material adverse change', a purely contractual term, is heavily subjective16, and this subjectivity can give rise to disputes among lenders and borrowers which go beyond the scope of this article17.

Nonetheless, in the field of acquisition finance (except for public acquisitions) when negotiating the conditions precedent, the bank will want to be afforded the same protection as that provided by the MAC clause contained in the share purchase agreement (the bank will generally have reviewed this clause beforehand, and will try to monitor its implementation), and this can lead to difficult negotiations between borrower and lenders.

The above comments on certain funds clauses also applies to the acquisition of infrastructure.

Conclusion
At this point it is difficult to predict how this market, which is still in its infancy, will evolve, but some points stand out:
The structure of financing today depends on the nature of the asset and (probably to a lesser extent) on the syndication of the financing
The distinction between 'infrastructure' and 'regulated sector' is not yet clear cut

Acquisitions of infrastructure are financed with debt based on very high multiples of EBITDA. This could have an undesirable secondary effect, in that when rates are being negotiated, the public sector may detect an implicit acceptance of a lesser rate of return on the part of purchasers

Whether monoline insurers (whose intervention improves the liquidity and the costs of the financing) will become involved remains to be seen18

Notes
1 Although the relevance of this figure is sometimes questioned. - c/f "Putting EBITDA in Perspective - Ten Critical Failings of EBITDA as the Principal Determinant of Cash Flow", Moody's Investors Services, 2000.
2 Or even the entire senior debt, as in the recent Vivarte and Elior transactions. However, cash sweeps on excess cash permit some repayment before final maturity provided that the target company performs above the contractual excess cash flow levels.
3 In this respect, the recent tendency to include all acquisition transactions in a 'regulated' sector as infrastructure acquisitions could cause confusion. For example, a company holding an operation concession, known in French as an "affermage" (frequently the case in water distribution projects) or the right to operate car parks will usually hold contracts of a shorter duration than a concession so that the stability of income is less certain and, conversely, the maintenance/investment needs of the asset are lower. The risk profile is therefore substantially different.
4 There is a significant exception to this principle: the financing of motorway concessions since 2005 (the A19, A41, and A65), are all based on 'mini-perm' structures of a term of 8-12 years. However, in reality, as well as being an exception to this principle, the 'mini-perm' structures reflect the confidence of the banks in the ability to refinance the project by real long-term solutions (bonds, enhanced bonds) once the asset has been built and the level of traffic has been verified.
5 An important piece of the project finance equation also lies in the fact that where a concession is terminated for whatever reason, the public sector has to indemnify the concessionaire for a greater or lesser amount depending on the cause of termination. Such obligation is a source of comfort for the financiers, who ensure that (a) the debt - or at least the senior debt - is commensurate with that payment even in the worst case scenario (termination for fault of the concessionaire) and (b) they obtain the benefit of that obligation through an assignment by way of security. Naturally, none of this exists in usual acquisition financings.
6 In this respect, it should be stressed that the term 'hybrid financing' is used in situations which are fairly diverse but which reflect the fact that there is a lot of bank debt available on the market. Therefore, techniques of 'debt push down', by way of securitisations (for example, Fraikin or Frans Bonhomme), and real estate outsourcing (Buffalo Grill) have appeared in recent years under the heading of 'classic' LBO transactions (Les Echos, 29 January 2007 "Les Techniques de Financement Convergent").
7 In 'greenfield' project finance, based on a PPP model, the principle is not to have a ratchet because of the need to ensure that the public authority pays a fee/base rental etc. that is fixed throughout the duration of the contracts. This would apply to hospitals, prisons and other projects based on availability as opposed to demand risk.
8 In the financing of LBOs, the possibility of making dividend payments or other distributions to the shareholders of the acquisition 'NewCo', which was some years, or even some months ago practically unthinkable, is becoming more widely acceptable, but it remains subject to strict conditions. That is another example of the relaxation of 'money out' clauses due to the liquidity in that part of the debt market.
9 "Eurotunnel et la validité des clauses de substitution: step-in right versus droit des faillites " Luc Marie Augagne, Michael Karpenschif; La Semaine Juridique, Ed. Générale 25 January 2006, I 106
10 Even though, in the case of concessions, the purchaser has to show that it has the technical and financial capacity to meet the obligations of the security of the concession, and in certain cases (for example in the standard specifications for large regional airports of 23 February 2007, article 89) it must be specifically approved by the competent administrative authority.
11 Taxation plays an important role here: notably the "Charasse" amendment which penalises intragroup by the non-deductability of corresponding financial charges. Cf. notably C. Motol "LBO: quand la cible aide son acquisition"; Option Finance No 899, 25 September 2006.
12 For a recent example: the refinancing by Vinci of the ASF acquisition (Option Finance, No 917, 29 January 2007).
13 The efficiency of which has been brought into question by jurisprudence: Cas. Civ. 1ere, 13 December 2005; La Semaine Juridique Ed. Entreprise et Affaires 7 December 2006, No 2743
14 Cf. note 6 above.
15 Article 231-13 of the Règlement Général of the AMF (the French stock exchange watchdog).
16 Essentially, one distinguishes the 'market MAC' (event affecting the market in which the target operates) from the 'borrower MAC' (event affecting the borrower or the target).
17 Cf. "Material adverse change et financement bancaires syndiqués", Jean-Marc Lamontage, Franck Julien, Banque & Droit No. 91 September/October 2003.
18 However, in this respect, it should be noted that the refinancing of the Viaduc de Millau (toll bridge) project is made on the basis of long term bank debt enhanced by a monoline insurer's (FSA) guarantee. Will this be transposed to infrastructure acquisition?