The Role of Project Finance in Developing a Region: Trends and Considerations
This is an Insight article, written by a selected partner as part of Latin Lawyer's co-published content. Read more on Insight
Recent trends in Latin America continue to reinforce the importance of project finance, not only in the development of projects in the region, but also in the growth and viability of the region as an attractive centre for foreign investment.
Prior to the Great Recession, project finance in the region was driven primarily by soaring commodity prices, largely the result of factors during the unprecedented GDP growth of China and low-cost financing available from Japanese and South Korean economies. As a result, investments in mining and other natural resource projects across Latin America, particularly in Brazil, Mexico and Chile, were actively pursued and represented a disproportionate amount of the investment activity in the region. As the global economy recovered from the Great Recession, commodity prices dropped or remained stagnant resulting in a significant slowdown in natural resource and export-oriented projects. However, the explosive growth in many of these countries prior to the financial crisis provided a basis for domestic-driven growth, namely through a burgeoning middle class, that in turn created a need to invest in social infrastructure (with a strong focus on renewable energies and transportation infrastructure). The transition from an export-focused model of project development to a more balanced model that focused on domestic growth and long-term stability has allowed many countries in Latin America to weather what would otherwise have been a turbulent period for project development.
Project development and finance in Latin America continues to reflect this trend, but we also are witnessing the growth of the region as an attractive investment centre for new forms of capital to take advantage of asset sales and the need for new greenfield projects. As a result, increased M&A activity and related financing needs continue to drive project development in the region.
This chapter revisits these trends and looks forward to 2018 and beyond to identify key drivers of project finance as Latin America continues its efforts to stabilise growth and promote future sustainability in the form of energy projects and core infrastructure.
The year in review
The end of 2016 and 2017 thus far has been an active period for project finance and has seen a shift in activity since the last edition of this chapter. At this time last year, Colombia’s 4G programme and Chile’s energy projects were leading the wave of activity while Mexico was still struggling with the implementation of its recent energy reforms. This year, Mexico has come to the forefront and emerged again as the hub of energy-related project finance transactions as well as the source of much of the project-related M&A activity. In addition to the strong pipeline of energy and infrastructure projects in Mexico, 2017 has seen continued infrastructure and renewable work in Colombia and Chile, respectively. For the first time in several years, 2017 also marked the return of mining projects across the region, including in Peru, Ecuador, Chile and Panama. All in all, 2017 has been a dynamic year of activity where the scope of the project finance world in the region continues to broaden in a way that is attracting traditional and non-traditional sources of investment. Set out below is a brief summary of the trends we have seen this year followed by a look ahead to 2018 and beyond.
The rise of Mexico
In the early part of 2016, Mexico was still in a transitional phase as it sought to implement the much-lauded energy reforms. Investors, while excited about the market-friendly reforms, generally remained on the sidelines as they digested the drop in oil and gas prices. However, 2017 has seen a resurgence of the Mexican market led by gas pipeline projects and power and other energy projects. Financial sponsors have capitalised on the availability of assets to complete large power plant acquisitions and financings that have involved complex structures relatively new to the region. In the case of the Norte III project, the transaction involved not just the refinancing of the existing debt but also the careful negotiation and purchase of an asset from a distressed seller. The distressed nature of the transaction and the need to partner with the CFE in finding a viable solution made the transaction both challenging and unique. We expect it to serve as a case study for future transactions involving distressed assets in the region.
In 2016, the market continued to experience the aftershocks of the corruption scandals plaguing Brazil. These aftershocks were focused to some extent on the Brazilian market, which spurred some of the tainted Brazilian companies to explore divestment programmes required to fund settlements or to refocus their strategies on core markets. Once international settlements were reached with high-level executives at many of these companies, the scandals spread to other jurisdictions as more information came to light, including in Peru and Colombia. In Peru, the Gasoducto Sur Peruano project was terminated by the Peruvian government as a result of Odebrecht’s alleged violations in connection with the project while in Colombia several projects have been directly and indirectly affected by similar allegations involving Odebrecht and certain tollroad projects. In the latter case, the effects of the allegations have caused a noticeable slowdown in financial closings under Colombia’s 4G programme as lenders wait to see how the situation evolves, particularly with respect to the termination payment under the relevant concessions, since this will be the most recent test of this crucial mechanism. Unfortunately, it is likely that we will continue to see fallout from the various corruption scandals across Latin America. Any project that has even an indirect link to one of the companies involved in the ongoing investigations faces tremendous scrutiny from lenders, credit committees and even potential purchasers.
Key international project developers and contractors continue to experience financial difficulties that affect the project finance market. As mentioned above, an ongoing divestment programme by Abengoa continues to spur project acquisitions and financings. However, the ongoing difficulties of other contractors present in the region, including Duro Felguera and Isolux, have created issues for some projects where those entities act as contractors. Lenders are much more focused on the risk and effects of a contractor insolvency and, in many cases, are requiring additional contractual mitigants in EPC contracts even with comparatively healthy contractors. This increased emphasis on contractual protections is the result of recent experiences by many of these lenders where projects found themselves with unpaid subcontractors in the wake of a contractor insolvency. As a result, we expect this trend to continue in the foreseeable future with much greater emphasis on transparency over subcontractor payments and, in the more extreme cases, direct control by project companies in the making of those payments.
Oil prices have rebounded compared to 2016 but that has not necessarily translated into the development of large-scale oil and gas projects. Developers appear to be cautious about making such investments in the short term and are instead focusing on the development of projects with a longer investment horizon, particularly LNG and gas-to-power projects that are expected to come online in the early part of the next decade when LNG prices are expected to rebound and stabilise. On the other hand, metal prices have rebounded to the point where we are now seeing several large-scale mining projects coming to market, including in countries such as Ecuador, where project finance has been relatively dormant in the past decade. The Fruta del Norte project has entered the financing market with a stream of transactions and continues to contemplate a long-term financing, which would certainly go a long way to opening up the market in Ecuador. In other jurisdictions, such as Panama and Chile, large projects are preparing to come to market in the next year with the hope of achieving completion towards the end of this decade in order to meet the expected surge in metal price and demand.
Bank and bonds
The project finance bank market has continued the trend of shorter tenors and more bank-favourable terms. While there are some exceptions for strong sponsors, lenders continue to assess their risk appetite closely and we expect that to continue in the short and medium term. Interestingly, this has allowed the private placement market to come in and provide long-term financing solutions for certain projects, both in the development and completion phase. Private investors are now increasingly interested in the region as they search for yield and we expect this trend to continue for the foreseeable future.
The future looks to largely continue recent trends; additionally the expected re-emergence of once active markets in the region will present several opportunities to further drive growth. As discussed below, we expect project development to continue to be driven by renewable energy, an expected rise in the development of natural resource projects timed to come online when commodity prices are projected to have recovered, an expected increase in activity from re-emerging markets and M&A activity.