Lecture 9: Financial innovations

1. Lecture 9: Financial innovations Anton Miglo Fall 2013

2. Contents • Project financing • What is a Project? • What is Project Finance? • Project Structure • Motivation • Underinvestment and project financing • Real World Cases • Asset-backed securities • Securitizable Assets • How Asset Securitization Works • Synthetic IPO • Benefits/Incentives • Examples • Income Trust

3. The MM Proposition “The Capital Structure is irrelevant as long as the firm’s investment decisions are taken as given” Then why do corporations: • Set up independent companies to undertake mega projects and incur substantial transaction costs • Finance these companies with over 70% debt even though the projects typically have substantial risks and minimal tax shields, e.g. Iridium: very high technology risk and 15% marginal tax rate.

4. High operating margins. Limited Life. Significant free cash flows. Few diversification opportunities. Asset specificity. Projects have unique risks: Currency, interest rate, inflation. Environmental. Expropriation. Technology failure. Counterparty failure Force majeure Regulatory risk What is a Project?

5. What Does a Project Need? Customized capital structure/asset specific governance systems to minimize cash flow risk and maximize firm value.

6. What is Project Finance? Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt.

7. Project Finance – An Overview • Outstanding Statistics • Over $220bn of capital expenditure using project finance in 2001 • $68bn in US capital expenditure • Smaller than the $434bn corporate bonds market, $354bn asset backed securities market and $242bn leasing market, but larger than the $38bn IPO and $38bn Venture capital market • Some major deals: • $4bn Chad-Cameroon pipeline project • € 10bn Eurotunnel • $6bn Iridium global satellite project • $1.4bn aluminum smelter in Mozambique • €900m A2 Road project in Poland

8. Total Project Finance Investment • Overall 5-Year return of 18% for private sector investment. • Project Lending 5-Year return of 23%.

9. Number of Projects

10. Project Finance Lending by Sector • 37% of overall lending in Power Projects, 27% in telecom. • 5-Year return for Power Projects: 25%, Oil & Gas:21% and Infrastructure: 22%.

11. Underinvestment and project financing • Consider a firm with $5,000 worth of debt due in period 1 • Cash flows in period 1 are stochastic, in the good state they will be $8,000, in the bad state they will be $3,000; each state has equal probability (50%) • The firm has an opportunity to undertake a project costing $1,500 that will generate cash flows of $2,000 in both states • Assume risk neutrality and risk-free interest rate equals 0 • Will the firm undertake this positive NPV project? • The answer depends on how the project is financed

12. Problems: Under investment in Positive NPV projects at the sponsor firm due to limited corporate debt capacity. Structural Solutions: Non recourse debt in an independent entity allocates returns to new capital providers without any claims on the sponsor’s balance sheet. Preserves corporate debt capacity. Motivations: Debt Overhang

13. Problems: High levels of free cash flow. Possible managerial mismanagement through wasteful expenditures and sub-optimal investments. Structural Solutions: Given the nature of projects, investment opportunities are few and thus investment distortions/conflicts are negligible. Separate ownership: single cash flow stream, easier monitoring. Motivations: other agency costs

14. Opportunistic behavior by host governments: expropriation. Either direct through asset seizure or creeping through increased tax/royalty. Solution: since company is stand alone, acts of expropriation against it are highly visible to the world which detracts future investors. Multilateral lenders’ involvement detracts governments from expropriating since these agencies are development lenders and lenders of last resort. However these agencies only lend to stand alone projects. A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the risky project can increase cash flow volatility and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it. Solution: project financed investment exposes the corporation to losses only to the extent of its equity commitment, thereby reducing its distress costs. Motivations: Other

15. Disadvantages of Project Financing • Often takes longer to structure than equivalent size corporate finance. • Higher transaction costs due to creation of an independent entity. • Project debt is substantially more expensive due to its non-recourse nature. • Extensive contracting restricts managerial decision making. • Project finance requires greater disclosure of proprietary information and strategic deals.

16. Comparison with Other Vehicles

17. Real World Cases Australia Japan cable Poland’s A2 Motorway PetroleraZuata Chad Cameroon Calpine Corporation Iridium LLC Bulong Nickel Mine

18. Case : Australia Japan Cable Background:12,500km cable from Sydney, Australia to Japan via Guam at a cost of $520m. Key sponsors: Japan Telecom, Telstra and Teleglobe. Asset life of 15 years. Key Issues: • High risk from fast changing telecom market • Risk from project delay • Specialized assets • Significant Free Cash Flow

19. Another example • British Petroleum: North Sea and Trans-Atlantic Pipeline • Constructed to move oil from the North Slope of Alaska to the northern most ice- free port- Valdez, Alaska • Joint venture between BP, Standard Oil of Ohio, Atlantic Richfield, Exxon, Mobil Oil, Philips Petroleum, Union Oil and Amerada Hess • Cost: $1 billion—too much for any one firm to handle

20. Case : The Chad Cameroon Project Background:An oil exploration project sponsored by Exxon-Mobil in Central Africa with two components: • Field system: Oil wells in Chad, cost: $1.5bn. • Export System: Pipeline through Chad and Cameroon to the Atlantic, cost: $2.2bn. Key Issues: • Chad is a very poor country ruled by President De’by, a “warlord”. Expropriation risk. • Possibility of hold up by Cameroon. • Allocation of proceeds – World Bank’s role and Revenue Management Plan.

21. Asset Securitization • Asset Securitization: separating assets producing a steady stream of income from other assets of a company, then selling securities that have a claim on the cashflows of these assets exclusively • Non-recourse finance: when the lenders to a corporation have claims to the profits of the corporation and not to the assets themselves • Asset securitization is an example of using non-recourse finance

22. Securitizable Assets • Some examples of what companies have securitized: • Receivables (i.e. A/R, credit card balances, etc) • Commercial and residential mortgages • Equipment Leases • Intellectual Property • Rights to future cashflows from mining/exploration (Royalty Trusts) • Strategic Business Units (Corporate Divisions) • Recent example: Bell Canada Enterprises (BCE) recently securitized the profits from their Ontario and Quebec phone line services creating Bell Aliant, an income trust • Commonly take the form of an income trust

23. Fixed vs. Revolving • Mortgage Backed Securities: a pool of mortgages (commercial or residential) where the security holder owns the right to receive principal + interest on the mortgages • A fixed MBS has an initial amount of mortgages, the total value of mortgages declines as the principals are paid down • A revolving MBS will replenish the paid off principals by adding new mortgages to the pool • These securities discussed later

24. Synthetic IPO • Asset securitization, when done for business units, is also known as a synthetic IPO • The main difference is that securitization can be used more broadly to include assets that are not business units/divisions of companies (e.g. mortgages)

25. Formula One’s Synthetic IPO • 6 different companies were involved: • SLEC: The originating company which owns Formula One Management • Formula One Management: owns Formula One business, sells broadcasting rights to TV and other mediums • 2 SPVs were created • Formula One Administration: holds the securitized assets • Formula One Finance: issues the bonds to investors • Formula One Licensing: owns the Formula One trademarks • Formula One Holdings: owns Formula One Administration • By observing the structure of this you can see why good financial lawyers are needed in the underwriting process

26. Improving Moral Hazard • To reduce agency costs two conditions must hold: • Securitized cashflows are insensitive to managerial effort (no effort needed to produce cashflows) • Securitized assets are risky (but not as much as the assets of the firm) • Recall agency costs are those incurred when the manager’s incentives do not equal shareholder incentives • Securitization segregates the assets that manager’s do not impact as directly into the SPV, while retaining the assets they can directly impact

27. Asymmetric Information and Securitization Between Managers and Investors • Segregating the assets makes the quality of the assets and cashflow clearer, making it easier to quanitfy risk • This helps avoid the “lemon’s premium” on issuing equity (recall the MM argument) • Lemon’s premium: increased cost of capital to firm as a result of issuing equity (a signal that the firm is a low-type firm) • Securitizing signals to potential investors the firm is high-type • Signalling benefit: the benefit of avoiding lemon’s market premium on newly issued equity for firms with securitized assets

28. ABS Example: Bowie Bonds • Bowie Bonds: David Bowie issued $55 million in bonds in 1997 to finance the purchase of the rights to his 287 songs from his manager • This was the first instance of intellectual property securitization • The bonds gave investors the right to receive royalties to Bowie’s music from 1997-2007, and turned out being a poor investment for those who bought them because of the movement away from buying CDs and into downloading music • Subsequently other artists such as James Brown have done this as well

29. ABS Example: Bowie Bonds