By Marc Naidoo, sustainable finance partner in the London office of international law firm, McGuireWoods
History will tell you that sponsors within emerging markets have had to work harder to obtain debt finance than their counterparts in more developed markets. Market and industry volatility, as well as political uncertainties have meant that emerging market sponsors have had to go above and beyond to convince financiers that any potential financing would pass internal credit and risk reviews. The riskier the project, the more diluted the pool of financiers became, eventually paving the way for development finance institutions to step in and provide much needed capital, especially into more volatile industries such as agriculture. However, debt from development finance institutions comes with nuances that are not always easy for sponsors to swallow. For instance, finance documents are policy heavy, which is understandable considering the special status of development finance institutions and the reputational risks involved in high-risk jurisdictions. Timelines for deals can be cumbersome, and debt is usually more expensive both in terms of pricing and under reporting requirements under information covenant packages.
By effluxion of time, the more deals concluded in a specific industry or jurisdiction changes the perception and demographics of financiers available to sponsors. New private sector debt has become available at opposite ends of the risk spectrum. Firstly, there are private sector financiers who approach transactions in a pragmatic fashion, adopting internal protocols copy pasted from development finance institutions, and secondly, there are private sector financiers who have an unsavoury risk appetite who prefer covenant light deals and fast lead times. The issue with the latter is that the market realised that the end game for these financiers was to control the asset forming the basis of the deal in question. Throughout Africa there are examples of sponsors losing assets to aggressive financiers, who then take over assets and operate them as their own. An unscrupulous, by highly successful strategy.
So where does the market sit now? The answer lies in the emergence of the ESG emphasis on transactions. Emerging markets offer lucrative opportunities for financiers to achieve their sustainable finance metrics, which in turn satiates stakeholder pressure on these financiers. Sponsors have an even greater choice of potential financiers, including more risk averse financiers that are enticed by the prospect of growing their ESG portfolio. Unfortunately, though, the traction that was predicted has not materialised in the way that the market expected. Without getting themselves into a precarious situation with aggressive financiers, sponsors are faced with risk averse financiers who would like to do ESG deals but at an acceptable credit limit. This then leads to the issue that has plagued sustainable finance from the onset, which is scalability. Timid private sector capital inevitably reaches a ceiling making it difficult for the “whale deals” to be concluded. The solution once again lies in development finance institutions, just not in the way we would usually expect.
By no means are de-risking structures new. Their history extends all the way back to the first private public partnerships which have proven very successful. However, in this market climate development finance institutions have the ability to crowd in private capital by guaranteeing the obligations of sponsors under financing agreements within the ESG sphere. De-risking in itself can form the basis of an article, however for purposes of this article we will focus on the practical implications sponsors should consider when embarking on this financing route.
The first port of call for sponsor is to identify the development finance institution that they would like to partner with. Ideally sponsors would want a development finance institution that has a proven track record in a particular jurisdiction or industry which would make marketing a proposed transaction easier when approaching financiers. The parameters of the de-risking would then need to be agreed upon as the development finance institution would conduct its own due diligence on the sponsor and the project in question. Once agreed the sponsor would open discussions with the private sector, and it is at this point that the sponsor finds themselves as the go between the de-risker and the financier. Financing terms will be discussed with the financier, with the de-risking instrument forming part of the credit decision, however the sponsor will not have to navigate through overlapping issues between all parties, a few of which are briefly discussed below.
Firstly, ideological and policy concerns for both the de-risker and the financier need to be navigated through. Each entity will have its own approach to lending and to ESG, which sometimes are not complimentary to each other. It is worth noting that there will be two sets of documents, with overlap in very limited circumstances. The de-risking instrument is a product sold by a development finance institution and will not form part of the composition of the finance documents under the financing. As such there could be policy points that a development finance institution has that must be referenced in the financing which is benefitting from its product. The difficulty being that there is usually limited interaction between the de-risker and the financier, so the sponsor is placed in a position whereby it needs to raise points for each party while also trying to negotiate their own position. Major policy points would include sell down restrictions for the financier, excluded activities in respect of sensitive industries, and more relevant than ever, sanctions.
Secondly, there is the covenant package that must be agreed upon, and, in particular, the information covenant package. As discussed, there will be two sets of documents that the sponsor will need to negotiate. Sponsors would want to ensure that the covenant packages mirror each other as far as possible across the two sets of documents, so as to avoid having to prepare two sets of reporting documents for both the financier and the de-risker. This is harder in practice than in theory, as internal environmental risk management teams will have differing internal protocols and requirements which feed into their ESG reporting matrix. Unfortunately, there is no silver bullet to mitigate this. Sponsors can however try to match development finance institutions and financiers who have worked together previously, or that have matching ideologies when it comes to risk and ESG reporting. Practically, sponsors should use the covenant package offered to the de-risker as a baseline when negotiating with financiers. As far as possible these should be replicated into the financing structure, but in reality there will be two sets of covenants to adhere to, and sponsors should rather focus on the timing of these so as to avoid back office burden or duplication of work.
Lastly, given that there are two sets of documents, there could be two sets of security documents as well. De-risking instruments are usually backed by a counter indemnity of sorts, which would need to be bolstered by hard security. Development finance institutions usually favour cash collateral structures (for example debt service reserve accounts or cash sweeps), however share and other hard asset security may be explored. The issue is that the sponsor and the de-risker would have agreed upfront on a security package as part of the de-risking instrument, which in turn means that there must be a separate pool of assets available to a financier. One way to mitigate this situation, would be to ensure that project related assets are ring fenced for the financier, while sponsor specific assets or cashflows are ring fenced for the development finance institution. There may still be some creative packages created, however that is part and parcel of running essentially two separate deals, under the umbrella of one.
These are some of the considerations that sponsors will need to bear in mind when approaching ESG deals through de-risking. Being in the middle is never easy, and playing the go-between between two separate parties can prove tiresome and frustrating. Especially so if some issues could be dealt with by those parties simply speaking directly. However, this rarely happens as the sponsor offers both de-riskers and financiers a buffer as between each other, where each can still hide behind the guise of policy and internal protocols, while leaving things to the sponsor to settle. But, the pros certainly outweigh the cons, if sponsors can get through being in the middle, they would have unlocked more capital through crowding in the private sector which addresses the fundamental issue of scalability. More so, if the structure works, it opens up the possibility of replicating the structure between the same parties with just commercial terms needing to be refreshed from tranche to tranche. Perhaps we are looking at this incorrectly, as instead of being the middle man, sponsors can actually be seen as the bridge between public and private sector in the context of ESG, or maybe something in the middle.
Marc Naidoo is a finance partner specialising in sustainable finance in the London office of international law firm, McGuireWoods. He can be reached at firstname.lastname@example.org