African project finance: Bonds and alternative financing
What impact does capital reserve regulation have on banks and borrowers doing project finance in Africa?
The 2008 economic crisis revealed how perilously thin many banks' capital reserves were and a complete collapse of the entire system was only narrowly averted. Spooked regulators responded with the Basel III accords, a regulatory framework intended to prevent any future financial sector melt down. These regulations impact project finance structuring, leaving commercial banks less flexibility to participate in longer tenor lending. All this has an impact on project finance lending in Africa too.
Basel III demands banks hold significantly greater capital reserves, making traditional, commercial bank loans more expensive. Consequently, some banks have withdrawn from the market, with others shying away from long-term project financing. The consequence can be that projects funded with traditional commercial bank debt finance are less profitable due to the higher costs of debt and reduced rate of internal return.
Is there an alternative?
Outside Basel's supervision, the institutional bond market might provide an alternative. This market can raise finance through the issuance of debt securities on capital markets. Hybrid approaches, somewhere between traditional loans and the capital markets, are also possible. Commercial banks may no longer be the first stop for all project developers.
While bond financing of projects is commonplace in the US, Canada and Australia, project bonds are relatively new to Africa. Nevertheless, project bonds have been used on the continent, in Nigeria and Kenya for example. The result has been further development of their institutional investor bases. Both of these countries incentivise project bonds: Kenyan infrastructure bonds enjoy certain exemptions, with Nigeria's being tax exempt.
Institutional investors, including, development finance institutions (DFIs), have either entered the market, or have announced that they will. The African Development Bank is advocating project bonds to tackle Africa's investment shortfall. It highlights that governments need to incentivise investors. Appealingly, bonds generally carry less onerous terms than loans, with more flexible restrictive covenant packages, and less project micro-management. Bonds can also attract a broader investor base, providing long maturities and fixed rate funding. Risk concerns can be addressed through upfront credit enhancement, through debt subordination or third party guarantees.
What’s the catch?
Institutional investors demand project bonds be rated investment grade or higher, which is not always possible. Investors are often unwilling to assume construction risk, particularly for greenfield projects, and some frontloading of formalities may be required. Many of the African markets have yet to be bond tested, and review of markets conditions and investor appetite may be needed. Bonds might also trade in secondary markets, leading to bondholder change. None of these problems is insurmountable though.
A hybrid approach?
Hybrids can mitigate early-phase construction risk, through loan finance coupled with bonds, and the option to repay the initial loan on reaching project completion through a bond issuance. Hybrids have a good record in Europe and America. Hybrids might sacrifice some flexibility when a multi-source structure is utilised. In such cases documentation will need to carefully manage inter-creditor relationships between banks and bondholders who might want to rank pari passu with the banks.
Expect the African bond market to expand
Project bond finance in Africa is set to grow. Although the legalities of project bond finance will be new to most players, these novelties, and attendant risks, can be managed. Basel III makes project bonds attractive and inevitable.
The Inside Africa team would like to thank Chloe Taylor, Trainee Solicitor, for her contribution to this blog post.