Driving the 1 st Project Bond to Success in Eastern Europe Adam Nicolopoulos, Executive Director, Infrastructure Group, UBS Investment Banking Division 3 September 2003 The concept of structuring and placing a bond issue for an infrastructure asset is a very intriguing one and can be viewed by some as a long shot, especially when this asset happens to be a road concession project based in Eastern Europe and does not have a government guarantee. There is no need to check for precedents because you won t find any. The appointment of a financial advisor and lead manager, UBS, took place in August 2002 and the launch of the bond occurred in February 2003, only seven months later. The recent bond was successfully placed, increased in size and oversubscribed by 50% and was a tremendous success. This is the story There were some very important factors that contributed to the success of the deal that are examined in greater detail below. Among other things there was the unique structure of the transaction, which was underpinned with an adaptive subsidy payment mechanism (establishing one major stream of the revenues). This payment mechanism effectively mitigates any traffic risk associated with the project. the unwavering commitment of the project sponsors of Bina Istra and the Croatian Government. Both parties had a clear vision of the issues that were important to them in regards to price, structure, timing and term structure, and wanted a strong deal that would satisfy their conditions. the strategic commercial rationale and location for the deal. Croatia is a growing economy with a real need for infrastructure projects, particularly in the Istrian region whose prosperous economy relies heavily on tourism and trade. A group of experienced and professional advisors on all sides of the deal. The advisors had previous experience working with each other on Phase 1A, which was completed successfully, and were committed to the project from day one. Finally there is the competitive financing structure of the bond. The bond had the longest possible tenor with the lowest price, which minimizes the potential of financial contribution for the government. In addition, the bond had a number of other innovative features and it was a financing that could only be priced in the bond market given its creative capital draw down terms. Simply put, this was a deal that the banks would not do. rating close to the sovereign Page 1 of 5
The unique financial structure at the heart of the success of the deal is a financial contribution (FC) from the Croatian government administered through an annually replenishing Debt Service Reserve Account (DSRA). This groundbreaking arrangement was introduced in 2000 and was amended as part of the recent deal to address certain project risks and make potential investors more comfortable over the project s ability to cover its costs. As part of the FC, the Croatian government undertakes to pay a monthly financial contribution (which is computed at the end of the previous operating year) by computing the difference between the project s annual costs and next year s (forecasted) tolling revenues. This mechanism differs from a shadow toll because the payment is not subject to traffic volume. This FC, after deducting all projected toll revenues, is meant to cover all Bina Istra projected operating and maintenance costs, debt service requirements and a guaranteed fixed return on the equity investors in Phase 1A. The unconventional FC structure helps to effectively mitigate many of the risks of the project. This structure provides ongoing liquidity protection as any draw down on the DSRA (due to, for example a cash shortfall) will be automatically replenished in the following year through an additional FC, to the extent utilised. In essence, the Financial Contribution effectively manages many of the revenue and cost risks typical in similar infrastructure financings, particularly in emerging markets. Furthermore it is flexible and allows the Government to set the level of tolls at a level that they feel optimal, given socio-economic and political considerations. Naturally the higher the level of toll revenues, the lower the annual FC. However depending on traffic growth rates and road utilisation the FC payment stream is phased away as the tolling revenues get to exceed the project annual costs, including debt service and return on capital for the project sponsors. The strength, commitment and experience of the Bina Istra shareholders also played a large role in the success of the transaction. The Bina Istra group comprises Bina Fincom, which owns 67% of the company, which in turn is owned 51% by Bouygues Travaux Publics S.A. (Bouygues), the internationally recognized French company with a strong history of constructing and operating roads. The rest of Bina Istra is owned 16% by Bouygues directly, Croatian Motorways with 14.8% and Istarka Autocesta with 2.2%. Overall, the combined Bouygues stake in Bina Istra is 50.2%. The combination of a strong, well regarded successful international developer with the backing and financial support of the Croatian government was crucial for successful conclusion of the deal. Phase 1A of the deal was an unqualified success, being completed on time and within budget by Bouygues in 1999. Page 2 of 5
The project was initially awarded to Bina Istra in 1995 and closed in 1998. Phase 1A was completed and became operational in 1999, and was successfully financed with 185 million of combined equity and commercial bank debt, toll revenues and an element of government support. Phase 1B involves the construction of the Mirna viaduct and continues with the development of a Y-shaped roadway that runs from the south into central Croatia before branching to the northeast and northwest, all the way to the Slovenian border. The funding profile of the deal is relatively conservative given the governments' FC, with 64.3% of the project costs funded by senior debt (a combination of bonds and bank debt) during the three year construction period (2003-2005) with the state contributing 18.6%, toll revenues and equity contributing 14.8%, and the remaining coming from interest income and cash released from the DSRA from Phase 1A. The strategic commercial rationale and location of the project was another key success factor. Croatia has experienced a sustained period of economic growth, with GDP growth of 4.0% expected in 2003, an investment-grade rating (BBB-/Baa3), and proposed entry into the European Union expected in 2007. All of these factors have been a further driver of Croatia s expansion as an important economic and tourist destination of Europe. Tourists have been increasingly drawn to the diverse and extensive history, unspoiled coastline, and ideal location of Croatia, driving tourism revenues up 30% from 1997 to 2001. Given the lack of extensive train and rail links throughout the country, the road network is the backbone of the Croatian economy. Croatia has over 28,000 km of roads, of which only 625 km is motorway standard. Spending on roads accounts for a sizeable 80% of the Republic s annual transport budget, which by itself is 10-12% of overall government spending. The Croatian government has also placed great strategic importance on the Istrian Motorway project. The Istrian region, with an incredibly diverse geography, which includes secluded bays, stunning cliffs, mountains and valleys, is one of the richest and most economically diverse regions in the country. The region accounts for 15-20% of Croatian GDP and 39% of its tourism revenues, and by facilitating the development of greater commercial traffic through the Istrian region from within Croatia and from neighbouring countries such as Italy and Slovenia, the government hopes to further develop the economy of the region. The role of experienced financial advisors was vitally important. In conjunction with the planning for Phase 1B of the project, the company in August 2002 approached UBS, who had worked on the Phase 1A financing (which was voted the 1998 Eastern European Deal of the Year by Project Finance International magazine), and asked for its advice in arranging a financing Page 3 of 5
package which would be used to refinance 89 m of Phase 1A debt and to finance the construction of Phase 1B of the project. The timing of this appointment took place immediately after Bina Istra led by Bouygues had signed a Memorandum of Understanding (MOU) with the Croatian Government which explicitly laid out the implementation plan for Phase 1B. The MOU fixed the price of construction of the new section of the roadway and gave Bouygues an extremely ambitious timetable of six months to raise the necessary financing and close the deal. The challenges were immense the deal needed a creative structuring like Phase 1A and needed to amend the financial contribution mechanism (to simplify it and accommodate the additional debt). A critical challenge was to achieve a credit rating on the project as close as possible to the sovereign ceiling. This meant presenting and persuading two international credit agencies on the robustness of the financial and commercial structure as well as the effective management and mitigation of all project risks. With good co-operation and input from all the project advisors and legal counsel, this was achieved and the project achieved ratings of one notch below the sovereign ceiling. Raising 210 million of bonds was not an easy feat, especially due to a lacking precedent in sector and region. Furthermore, the bond market is a very unforgiving market of execution. Unlike the commercial bank market (a highly iterative process whereby the deal structure keeps getting refined following progressive and successive input from lenders), in the bond market you only have one shot to get it right. The bond market one can take soundings, however investors do not take a serious stance and consideration until the deal is finished. If they do not approve of the deal, for whatever reason, that is the end of the deal. No second chances. The experience with the Bina bond was very positive from the outset as the UBS team was receiving comments that investors were pleased to see a bond with an interesting structure and a project story behind it. It was also priced just right, low enough to ensure that the lowest possible level of debt service and high enough to attract the interest of European investors. Our client called it the art of pricing the deal, our team calls it having a good market judgement and being very close to the market. The strength of the financing package was another key success factor in the deal. The deal consisted of 210 million in senior secured bonds maturing in 2022 (with a 19-year term which is unusually long for Croatia), a 72 million three-year construction term loan also maturing in 2022 with the same repayment profile. The finance plan included a 30 million cost overrun facility. The improvements in the financing package from Phase 1A to 1B were dramatic, with the amount of debt increasing from 128 million to 282 million, and the tenor of the debt almost doubling from 11.5 years to 19 years. The bond rating agencies, Moody s and S&P, did a thorough examination of the proposed deal, looking at the potential risks (many of which had been mitigated by the unique Page 4 of 5
FC structure), the project costs, the project shareholders, the history of Phase 1A, and a variety of other factors in determining the appropriate credit ratings for the bond. The culmination of months of hard work coupled with extensive financial planning and work with the rating agencies and deal structure was obtained when Moody's and S&P rated the bonds Ba1 and BB+, respectively, only one notch below the sovereign ceiling of BBB-, remarkable for an issue of this type. Given the high non-investment credit rating of the project together with the level of payments by the government, the deal had all the benefits of a quasi-government deal which appeals to a diverse array of investors. The bond was primarily distributed to funds, with investors in the UK and Germany buying over 60% of the issue and domestic investors coming in as the third largest purchasers. The bond was priced at 364 bp over the relevant Bund benchmark (the 15 year bund rate) and has performed very strongly since its issue, currently trading at 285 bp over the relevant benchmark. The bond issue was the first ever dual listed issue on both the Zagreb and Luxembourg exchanges, satisfying the Croatian government who wanted local investors to be able to participate in such a high quality bond issue. Eastern Europe not only has substantial but also urgent plans to upgrade its infrastructure, and in particular its highway network, in the foreseeable future. The need has been exacerbated as a number of the leading economies in Eastern and Central Europe are part of the proposed expansion of the EU. Where is the capital going to come from? Most of the governments are under heavy pressure due to the restrictive Maastricht fiscal measures and performance targets that they have to comply with. It seems that the viable funding alternatives may be in PPP schemes, although the PPP experience of these governments so far has not been a particularly positive one, hence the reason for having very few projects completed in the region. The Bina Istra experience proves that this does not have to be the case. This deal has proved that it is possible for a PPP project deal to deliver a win-win case for all parties involved (both government and private sector). We hope that this deal will be a harbinger of things to come, and will open up the Eastern and Central European bond markets for future infrastructure projects. Doing this deal may have been intense but it was a lot of fun for us, and the good thing is.. everyone in the deal feels the same way. Page 5 of 5