Leverage Ratio? Debt Service Coverage Ratio? Or something else altogether?
Project finance transactions are usually large and costly things. Let’s think about some examples from a wide variety of sectors: rail (Sydney Light Rail PPP, $1.64 billion), bridges (Tappan Zee Bridge, $4 billion), airports (JFK terminal 6/7, $3 billion), energy projects (Project Clover: 1.7 GW of wind and solar, $670 million), and toll roads (Indiana Toll Road, $3.8 billion), etc. So how do investors effectively spread billions of dollars of risk across a financing syndicate for one transaction? This post will walk you through the “how’s” and “why’s” of sizing debt for a project finance transaction.
The “why’s”: debt and equity
Let’s start by identifying two different sources of capital for these projects, debt, and equity. First, debt: what is it? Debt involves a contract to borrow principal today and repay it over time with interest. What happens if my project can’t repay its principal? Well, the debt provider can usually take possession of the asset and either find a new operator or sell off the parts to repay itself. This last point is an important one and we’ll come back to it in just a second.
So, what is equity then? Equity is pretty much everything else. Equity can be structured in a wide variety of ways (cash equity, tax equity, shareholder loan, preferred equity, etc.) and can even share some basic features with debt. For example, preferred equity can be structured to pay coupons, just like debt. Shareholder loans are also amortized over time. The key difference between debt and equity comes in what happens if the project defaults. As we’ve described above, if the project defaults, debt will assume control of the hard assets.
So where are equity’s interests represented during a default? Equity may control board seats and hence be able to guide the process for restructuring. But debt still controls the asset itself.
Cost of capital
Why is all that important? Because all else equal, if you know that you can sell the hard assets of a project if it fails to pay you back (debt), chances are good that your cost of capital for making the loan in the first place will be lower than for someone who knows they may not be paid back at all (equity).
So, what then is the first job of every equity investor in the project finance space? Fill the project with as much low-cost debt as possible before investing your relatively high-cost equity. This means we all want the leverage ratios in our capitalization tables to be as high as possible.
Debt sizing
So, based on the above mandate, we can simply set our leverage ratio to 100% and be done, right? Not quite. If we don’t invest any equity, we don’t make any return.
Ok, then 99%? Here we run into some rules that vary by country pertaining to “thin capitalization.” Usually, there’s a tax advantage associated with taking on loans.
Since this tax advantage is a zero-sum loss for tax collectors (less tax revenue), most governments are quite keen to manage this exposure. While regulations will vary by jurisdiction, 90% leverage is the place where lots more questions start to get asked. Generally, we can feel a bit safer with our sizing below this level. In fact, leverage ratios of 70% – 85% are not uncommon in the US.
But is this the most optimal way to think about leverage, to just take as much as possible without any thought for how we’ll pay it back?
First alternate sizing methodology: DSCR
What is a DSCR? The acronym stands for debt service coverage ratio. By definition, the ratio is: Cash flow available for debt service (CF ADS) for the period / Debt service for the period. A ratio of 1.50x means that in the given period, the project possesses 1.50x more cash than the required debt service. As the DSCR goes up, the required amount of cash over debt service goes up commensurately. If you’ve got to reserve cash to meet a DSCR requirement, the amount of debt one can assume will go down as the DSCR goes up.
The process of sizing debt involves dividing each period’s cash flow available for debt service by the DSCR target ratio, then taking the sum of all periods. This ensures that the debt service will match the cash flows of the project through any seasonal change.
When considering whether DSCR represents the optimal method of sizing debt, it’s important to drill into a few concepts. First, what is the cash flow available for debt service? Second, how does each individual period’s result relate to the next? And to the whole?
Cash flow available for debt service and EBITDA
How we calculate CF ADS is of paramount importance when sizing debt. If you’ve arrived at project finance from a corporate finance background, you’re likely to equate CF ADS with EBITDA, or revenue-less operating expenses. In corporate finance, that would be a fine way to proceed. However, we must remember that there is no parent company from whom to borrow to pay things like working capital or tax. And these costs are not obtuse – they are very real. The government will not stand behind a lender in the cash waterfall for its tax revenue. Nor will other creditors who need to get paid, like O&M or Capex providers. These two values will need to be calculated and backed out of CF ADS before sizing debt properly.
Ok, we’ve built our cash waterfall properly, so we’re backing out taxes and working capital from the calculation of CF ADS. But remember, DSCR sizing is a snapshot, accounting simply for CF ADS and debt service in each period. Is there a more robust way to account for the project’s riskiness over its entire lifecycle?
Loan Life Coverage Ratio (LLCR)
When looking for a ratio that measures the project’s true risk over its lifecycle, there’s likely no better candidate than the loan life coverage ratio or LLCR. The formula for LLCR goes as follows:
NPV of project cash flows/debt service in the period
What makes this ratio unique is the forward-looking nature of the NPV. By taking into account all future project cash flows, NPV and LLCR provide the best forward view of the project’s ability to handle its debt burden. In our scenario above, if the DSCR we’re sizing to is around 1.50x, we might expect an LLCR of around 1.55x.
Conclusion
All project financiers want to include as much low-cost debt in their projects as they possibly can. It’s just simple economics – because debt has direct recourse to the assets, its cost to provide a loan will generally be lower than equity. But just because you can take all that debt, doesn’t mean you should. Your project needs to be wary of thin capitalization requirements in your area. It also needs to ensure the cash waterfall is calculating CF ADS properly, with both tax and working capital included. Once we understand our CF ADS, using a DSCR target ratio to size debt is a great start.
However, given the forward-looking nature of the NPV calculation embedded in the formula, sizing debt using the LLCR yields the most robust accounting for risk in your project.
