THE INS AND OUTS OF INTEREST RATE SWAPS IN PROJECT FINANCE

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1 3. Does internal audit have sufficient standing and authority not only to carry out their responsibilities but also to have their evaluations and recommendations heeded? He concluded by saying OSFI will have increased focus on behaviour and risk culture not just on rules being followed. [Editor s note: Robert McDowell is a partner of Fasken Martineau DuMoulin LLP and Co-chair of the Firm s Financial Institutions Group. He advises financial institutions on a wide range of transactions, corporate matters, and regulatory issues. Koker Christensen is a partner of Fasken Martineau DuMoulin LLP and Co-chair of the Firm s Financial Institutions Group. He advises financial institutions on a wide range of transactions, corporate matters, and regulatory issues.] 1 International Institute of Finance, Reform in the financial services industry: Strengthening Practices for a More Stable System (2009), 31. THE INS AND OUTS OF INTEREST RATE SWAPS IN PROJECT FINANCE Simon Williams, Torys LLP This article aims to provide a high level primer on the ins and outs of interest rate swaps as they are used in project finance deals. We begin with a general overview of the project finance market in Canada and a look at how these deals are typically structured, with a focus on the management of interest rate risk. Moving beyond the commercial aspects of project finance interest rate swaps, we will then turn to the key principles underpinning the negotiation of an ISDA Agreement, being the legal instrument of choice governing the hedge arrangement for the vast majority of these deals. Project Finance Overview Project finance (PF) is alive and well in Canada. In 2012, there were 16 published project finance deals completed in Canada, representing nearly $9 billion worth of debt financing. 1 Through the first three quarters of 2013, 17 published deals were completed representing over $5 billion of financing. 2 On a sector-by-sector basis, per cent by deal size fell within the power, oil and gas, and transportation areas. But what do we mean by project finance? In contrast to traditional debt financing where a lender advances funds against the strength of a borrower s historical revenues or asset strength, in a project financing transaction, the loan is made against the future cash flows expected to be generated by the project once it has been completed. The unique structuring of a PF deal is driven by a unique set of risks inherent in the construction of a project. Whether it is the construction of a privately sponsored wind farm or the commissioning of a new hospital by a government agency, the design and construction of a project is often an expensive proposition where the lenders must put their faith in their ability to effectively mitigate and allocate project-specific risks to the appropriate transaction participants. For these reasons, project finance deals are usually characterized by the following hallmarks: 1. they are highly leveraged with debt-toequity ratios often falling in the per cent range 14

2 2. they are financed and developed off the balance sheet of the sponsor through a special purpose vehicle (the SPV is capitalized by the sponsor before the loans are made to the SPV, being the project borrower, and the SPV is the entity that owns the project assets and signs the project contracts) because of the large debt liabilities and complex risk management associated with them 3. they involve some manner of revenuegenerating plant or structure being built 4. they are typically structured in two phases: a. a construction period where loan funds are needed to pay the builder but no revenues are being generated b. an operating period beginning once the project has been built where no further advances are needed and revenues should be available to repay principal and interest on the project loan 5. the related project loan agreements are covenant heavy such that the Borrower lives and breathes to complete the project, generate revenues, and repay the loans with interest Interest Rate Risk Broadly speaking, the project-specific risks referred to above may be characterized as commercial risks (encompassing completion risk, operating risk, revenue risk, and environmental risk, to name a few) or financial risks. For a project that is both developed and funded within Canada (the most likely scenario), the most significant financial risk is interest rate risk. That is the focus of this article. Interest rate risk is a major consideration in project finance deals because the only source of funds available to repay the lenders principal and interest are the revenues generated by the project (more specifically, by the SPV borrower) pursuant to an offtake or similar agreement. Thus the amount of the project borrower s income is effectively fixed per the offtake agreement, meaning that any increase on the expense side of the ledger will squeeze the amount of cash available to service the project loans. Loan principal often reaches the tens or hundreds of millions in PF deals, so a rise in interest rates by only a few basis points can easily balloon a project s expenses. Consequently, in order for the sponsors or other equity stakeholders to preserve their expected return on investment, project expenses (including interest rate costs) must be managed accordingly. Typically, the borrower will manage its interest rate exposure by employing an interest rate swap. The economic result of the interest rate swap is to convert the floating rate of interest payable by the borrower to the project lenders into a fixed rate payable to the swap providers (usually the derivatives branch of the same banks providing the project loan). To illustrate, consider a hypothetical example of a $100 million solar project that will take one year to build and will be financed with $10 million in equity (contributed by the sponsor at closing), with the balance of $90 million funded by the project lenders over the construction period. A borrower looking to secure long-term project financing such as this would be highly motivated to lock-in a fixed rate, especially in today s low-interest-rate environment. Once the solar plant is operational and revenue positive, the loan converts from a construction loan to a term loan with a maturity of ten years from the completion date. During the operating period of the project, the borrower will be required to make quarterly payments of both principal and 15

3 interest on the term loan based on an 18-year amortization schedule (resulting in a residual principal balance at maturity that must be repaid or refinanced). In these circumstances, a project borrower with a reputable sponsor standing behind it might be able to secure loan financing from a bank at the bank s prime rate plus a credit spread of 2 per cent per annum. Assuming the prime rate is currently 3 per cent per annum, the all-in interest rate payable by the borrower would be 5 per cent per annum. Because the prime rate is a floating rate and therefore subject to change with the macroeconomic environment over time, the all-in interest rate would fluctuate commensurately with the movements in the prime rate. Given that interest rates are near historical longterm lows, the market interest rate is likely more liable to rise than fall over the ten-year life of the term loan. Rather than risk what could become an interest rate of 7 or 8 per cent in five or six years from now, the borrower decides to fix its debt service costs by entering into an interest rate swap under which the borrower pays a fixed rate of 4.5 per cent to the hedge provider for a ten-year period (matching the term of the underlying loan). In order to sync up the loan and swap cash flows on each quarterly payment date, the swap must also match the size of the loan. Accordingly, the notional amount of the hedge will initially be $90 million (the starting balance of the term loan upon conversion from the construction loan) and, from there, will ratchet down quarterly in line with the amortization schedule of the term loan. The cash flows under the swap and loan are illustrated in the figure below. The Borrower pays a fixed rate (4.5 per cent) to the hedge provider (a swap-dealer affiliate of the project lender), and the borrower receives a floating rate (prime) from the swap dealer, which the borrower effectively flows through as an interest payment on the term loan to the project lender. A key element of a swap arrangement is that the fixed and floating rates are netted, resulting in only one cash payment payable by the party obligated to pay whichever happens to be the higher of the two rates at the time. That is, so long as the prime rate is lower than 4.5 per cent, the borrower will owe a quarterly net payment to the hedge provider. If prime moves above 4.5 per cent, the borrower will receive the difference from the hedge provider. From a risk mitigation perspective, by entering into an interest rate swap the borrower is trading short-term upside for long-term certainty: the borrower will pay 4.5 per cent per annum regardless of how much interest rates rise or fall over the ten-year life of the loan, but the price for that financial insurance is the premium baked into the 4.5 per cent fixed rate offered by the hedge provider (being higher than the prevailing prime rate at the time the swap is struck at closing, or 3 per cent in our example). In terms of credit risk profile, both the lenders and the hedge providers rank equally in respect of collateral security and priority of payments: each sharing ratably as a first lien creditor with loan payments (principal and interest) and swap payments (net scheduled payments and applicable breakage costs) having equal status in terms of payment priority (both as to timing and amount). A key distinction between the relative rights of the lenders and hedge providers, 16

4 however, is that all voting decisions (including whether or not to waive or enforce a default) lie solely with the lenders. Negotiation of the ISDA Agreement As noted earlier, interest rate hedges for project finance deals are customarily documented under an ISDA Master Agreement. At its core, the ISDA Agreement creates a framework for fixed and floating payments to be netted and made between the two hedge counterparties. It sets out the rules governing how and when those payments are to be made, whether collateral must be posted by one or both parties, and how breakage costs are to be calculated in the event the swap is terminated (by a party defaulting or otherwise) before the scheduled maturity date. Ancillary to that, the ISDA Agreement contains many of the same contractual elements one would expect to find in a traditional loan agreement, such as reps and warranties, positive and negative covenants, and events of default. A borrower arranging project financing with an accompanying interest rate hedge will be required to enter into two principal finance documents: the loan agreement pursuant to which the project finance loan is made and the ISDA Agreement pursuant to which the borrower hedges the interest rate risk deriving from the underling project loan. Given the risk profile of a project financing and its highly structured nature, project finance loan agreements are often very long and highly negotiated documents. Lenders will often impose a comprehensive regime of conditions precedent, reps and warranties, covenants, and events of default on the borrower. Many of these provisions will need to be specifically tailored to reflect the nature of the particular project being developed. By contrast, the standard form of ISDA Agreement contains a much sparser suite of reps, covenants, and events of default by virtue of the form being designed to be of generic application and, in the context of interest rate swaps, governing a purely financial arrangement (the exchange of fixed and floating payments). To contrast the two documents by numbers, the 2002 ISDA Master agreement is less than 30 pages long, whereas it is not uncommon for a project loan agreement to reach 130 pages. In negotiating the loan agreement with the lenders and the ISDA Agreement with the hedge provider, the borrower will want to ensure that it is not subject to two parallel but differing contractual regimes. For example, the borrower may have negotiated a cure period right with the lenders in the loan agreement in respect of the borrower s performance under an operation and services agreement. The ISDA Master Agreement, however, contains a cross-default provision that might otherwise be triggered immediately upon a default by the borrower under a third-party contract. The solution to the potential inconsistency between the loan and ISDA agreements is relatively simple: (1) the events of default under the ISDA agreement should be disapplied as they relate to the borrower and (2) the events of default under the loan agreement should be incorporated by reference into the ISDA agreement. This prevents the tail wagging the dog so to speak, by effectively neutering the hedge banks enforcement fights under the ISDA Agreement, with the hedge banks ceding all enforcement decisions to the project lenders. It is for this reason that the project lender and swap provider are usually the same entity or an affiliate, as the hedge desk will be relying upon its lending counterpart to make decisions that reflect a holistic 17

5 consideration of the financial institution s interests, both as a lender and hedge counterparty. In a similar vein, legal counsel will want to ensure that the ISDA Agreement dovetails with the provisions of the loan agreement in other respects as well. A case in point is the assignment provisions of the loan agreement relative to the transfer rights under the ISDA Agreement. Given that the fixed rate payments under the hedge are modeled on the corresponding principal amount of the project loan outstanding at a particular time, generally speaking, assignments of the loan will be accompanied by corresponding transfers of the interest rate swap. In terms of substantive legal rights, the default provisions of the ISDA Master Agreement permit either swap counterparty to transfer its leg of the swap with the consent of the other party. In contrast, the assignment provisions under a project loan agreement are often highly negotiated, particularly in respect of the borrower s right to assign its interests in the loan and project. For example, the conditions under which a project borrower is permitted to assign the loan will often be driven by such considerations as whether the project is in construction or operational phase, whether the sale involves a minority or controlling interest, and whether the creditworthiness and experience of the proposed assignee are acceptable. To summarize, negotiating a project finance deal requires careful attention by counsel to ensure that the respective rights and obligations of the borrower, the lenders, and the hedge providers are carefully considered and appropriately reflected in both the loan agreement and the ISDA Agreement to ensure consistency between the two documents. [Editor s note: Simon Williams s practice focuses on corporate and structured finance law. Simon has experience representing banks, hedge funds, institutional investors and other market participants with various debt offerings, and structured finance and derivatives transactions.] 1 2 Thomson Reuters, Project Finance Review: Full Year 2012, < Files/Q42012_Project_Finance_Review.pdf>. Thomson Reuters, Global Project Finance Review: Managing Underwriters, First Nine Months 2012, < 3_Global_Project_Finance_Review.pdf>. 18