Project Finance

Special Report

Analysts
Doug Harvin
+1 312 368-3120
doug.harvin@fitchratings.com
Michael Hermans
+61 7 3222-8615
michael.hermans@fitchratings.com
Mike McDermott
+1 212 908-0605
michael.mcdermott@fitchratings.com
Laurence Monnier
+44 20 7417-3546
laurence.monnier@fitchratings.com

Tailored Debt Structures: a

Better Fit for Uncertain Cash
Flows
Overview
Although project finance techniques have been applied across a broad
spectrum of assets operating under a variety of business arrangements,
there is typically a common thesis to these transactions: operating cash
flows are reasonably predictable. Based on this belief, a schedule for
amortizing principal can be established that achieves the necessary
credit metrics over the life of the loan. Clearly, projects producing
relatively stable cash flows are ideally suited for project finance
techniques. However, projects with significant cash flow volatility
have increasingly become project finance candidates.
Traditionally, the primary mitigant to cash flow volatility is to decrease
the annual debt service and, accordingly, the projects leverage.
Recently, some new approaches to repaying principal are being applied
to projects in which cash flow is expected to be volatile or even
acknowledged to be unpredictable. Repayment schemes are being
tailored to the actual receipt, rather than the projected receipt, of cash
flow. In some cases, amortization is simply being postponed until a
later refinancing. If properly structured, the reduction in leverage can
be minimized without a significant sacrifice of credit quality.
As the realm of project finance techniques is stretched to include these
new repayment structures, the methods and criteria used to analyze the
credit quality of project debt must grow in step. The credit metrics
traditionally used may not be as meaningful in the newer financing
structures. As a result, Fitchs approach to rating such structures will
be as equally tailored to the transaction as is the debt structure. As
appropriate, Fitch will incorporate debt-service coverage ratios
(DSCR), loan life coverage ratios (LLCR) and project life coverage
ratios (PLCR). In addition, Fitch may consider a projects ability to
recover from temporary interruptions in debt-service payments, as well
as the projects credit metrics under a hypothetical refinancing. The
newer structures essentially require a greater appreciation of an
ultimate recovery analysis within a set time frame as a supplement to
the traditional full and timely payment analysis.
Evolution of Analytic Methods
The traditional project finance paradigm is a well-structured
contractual framework that promotes cash flow stability. In privatesector projects, such as industrial production and natural resources,
long-term contracts with third parties supplying the raw materials
and/or buying the output provide a stable, fixed margin. In publicsector projects, such as toll roads and public infrastructure, stability
was promoted through rate covenants that obligated the governing

March 22, 2006

www.fitchratings.com

Project Finance
credit quality. However, actual traffic volume on
these facilities has been significantly below base-case
projections by as much as 50% in some cases. As a
result, many projects initially rated investment grade
quickly slid to non investment grade after a few years
of operation, leaving all market participants looking
for a better way to evaluate and finance these assets,
given the inability to forecast traffic and revenue with
a reasonable degree of certainty.

authority to generate adequate revenue to pay

operating costs and scheduled debt service.
With contractual arrangements or rate covenants
expected to mitigate the primary sources of
uncertainty, cash flow volatility remained but usually
with only a limited effect. Depending on the unique
circumstances of each transaction, factors such as
increased maintenance costs, decreased efficiency or
throughput, outages and the implementation of rate
covenants can each affect cash flows. However, the
deviation from predicted levels was generally within
known tolerance margins. Accordingly, the
traditional financial analysis of early investmentgrade projects (and, to some extent, current wellstructured projects) was oriented toward providing a
reasonable level of debt-service coverage in the basecase financial projections.

Whereas the traditional philosophy, and inevitable

challenge, of project finance is to measure the
sufficiency of uncertain cash flows in relation to the
certainty of a fixed amortization schedule, a new
philosophy is being introduced of tailoring a flexible
repayment plan to fit the uncertainty of the cash
flows. Several different structures have been used
that provide varying levels of flexibility. A few of the
more common structures are as follows:

As project finance became a proven source of

funding for private-sector projects, the techniques
started to be applied to projects with heightened
exposure to competitive markets. A notable example
is the financing of merchant power projects that
lacked long-term contractual arrangements. The
greater uncertainty in operating cash flow is offset by
lower senior leverage and, therefore, greater basecase debt-service coverage for the rating category.
However, rather than rely on base-case financial
performance, Fitch places greater emphasis on the
financial performance projected in sensitivity
scenarios that stress the effects of merchant exposure.
A properly constructed merchant stress replicates the
market conditions at the low end of the market cycle.
In such a scenario, the remaining sources of cash
flow uncertainty are similar to those in the traditional
project finance paradigm of a well-structured
contractual framework. Accordingly, the relative
credit quality among projects in the same sector can
be identified by comparing the stress-case financial
performance of projects that have a merchant
framework with the base-case financial performance
of projects that have a contractual framework.

Deferral of amortization.
Bullets with refinancing.
Cash sweeps

Deferral of Amortization
Certain private-sector projects can deliver relatively
stable cash flows over the long term but are
vulnerable to an occasional year in which cash flow
will be severely depressed. For example, a major
retrofit or overhaul can result in both considerable
capital expenditures and a loss of revenue during
implementation. At best, a rough time frame for these
events can be projected, allowing only a limited
ability to sculpt the debt service accordingly.
Similarly, significant maintenance and repairs are
anticipated at some point over the life of the debt, but
the occurrence is unpredictable. Ideally, these
activities will be performed when necessary instead
of when the debt-service schedule makes it more
tolerable. Another example is a structure that relies
on equity distributions from a separately financed
project. Prohibitions on distributions governed by the
project-level indenture, ranging from insufficient
cash flow to technical events of default, can interrupt
the cash available for structurally subordinated debt
at the parent level.

The evolution of project finance in the public sector

was driven by a greater awareness of the inherent
risks in the sector. In the United States, many
greenfield toll roads were financed in the mid- to
late-1990s with a more traditional 30-year fixed
amortization profile. At that time, the analytical view
was that the financial performance under a properly
constructed stress test in conjunction with a strong
rate covenant would be sufficient to ascertain the
feasibility of the financing structure and associated

Public infrastructure projects, especially greenfield

toll roads, provide a fair amount of uncertainty
regarding near-term utilization due to the difficulty in
forecasting usage, which is dependent upon value of
time assumptions, economic development and other
human behavior. However, the longer term revenue

Tailored Debt Structures: a Better Fit for Uncertain Cash Flows

2

Project Finance
meaningful stress scenarios, it is important to
consider any covenants that limit the frequency or
duration of permitted deferrals. The circumstances of
the project must lend credence that the payment
deferral will be temporary and deferred funds can be
repaid within a short period of time, certainly before
legal maturity of the debt.

profile associated with these facilities is fairly stable

and predictable, especially once the asset has been
operating for a number of years.
Fitch rates several transactions in which scheduled
debt service may be deferred during periods of low
cash flow. The deferral is not at the discretion of the
borrower but is limited to the unavailability of
adequate funds for timely debt service. Prior to the
sponsor receiving future equity distributions the
deferred principal, interest and penalty interest must
be fully paid. The deferral rights apply for only a
limited duration. Upon a protracted payment default,
the typical remedies apply, including the right to
accelerate the debt and foreclose on the assets.

Fitch incorporates LLCRs into the analysis of

projects with longer deferral rights as too much
deferral in the near term can result in the inability of
the project to meet obligations on the back-end, given
accretion of debt. The analysis will also focus on the
legal covenants that protect against unsustainable
deferral, such as a rate covenant step-up provision
that incorporates the scheduled payments and, thus,
forces the project to raise revenues sufficient to avoid
a default on legal maturity, or a forward-looking
distribution test that locks up cash and forces
prepayment should the forward-looking LLCR fall
below a set floor.

Fitch has also rated several toll road transactions that

utilize other structural features to accomplish the
same effect. In these cases, long-dated callable
capital appreciation bonds were utilized with
significantly back-ended legal maturities. To
facilitate prepayment, a planned maturity schedule
was established that mirrored a typical fixed
amortization profile. The expectation is that the
planned payments will be made, but a default will not
be triggered unless the back-ended legal maturities
cannot be achieved. In this approach, the deferral is
not limited to one year. However, rate covenant and
cash distribution tests are tied to the planned payment
schedule, not the legal payment. In this construct, a
default is avoided if the planned payment is not met,
but cash is trapped until the planned principal balance
is restored. Rate covenant step-up provisions that
include an LLCR protect against a growing unpaid
principal balance.

Fitch does not believe deferral rights solely are an

effective solution for projects with meaningful longterm uncertainties as there is an increased probability
that deferred debt service will not be repaid.
Similarly, Fitch does not believe deferral rights are an
acceptable alternative to a debt-service reserve.
Whereas a debt-service reserve mitigates a sporadic
reduction in cash flow, deferral rights alone do not
mitigate a slow deterioration in cash flow.
Bullet with Refinancing
Single or multitranche bullet maturities with a
refinance assumption have also been used to address
uncertain near- to medium-term cash flow. Bullet
structures have been used extensively to finance toll
road projects in Australia and Spain and are now
being employed to finance the private acquisition of
mature public infrastructure in the United States. In
addition to providing flexibility to deal with short- to
medium-term cash flow uncertainty, this structure
also lends itself to debt markets with limited appetite
for longer term debt consistent with the useful life of
the asset. For toll road projects, domestic debt
markets prefer a maximum maturity of 10 years in
Australia, while 50-year maturities have been
achieved in the United States. In contrast, U.S. toll
road privatizations have received 99-year concession
periods, an indication of the perceived useful life.
The bullet structure is well-suited to solve this type of
financing problem in that it provides flexibility to
deal with some level of cash flow uncertainty and

The flexibility provided by the deferral of

amortization, in essence, is a form of prepackaged
restructuring that preserves the project as an ongoing
concern during temporary cash flow interruptions
that are difficult to predict. At the same time,
exceeding the deferral conditions in the event of
significant problems allows for a tailored
restructuring.
Fitch believes projects with limited deferral rights
require a similar analysis as projects with an
inflexible amortization schedule. Specifically, the
focus should be the full and timely payment of the
projects
scheduled debt-service
obligations.
However, in consideration of the deferral rights, Fitch
places less significance on the financial performance
in stress scenarios that typically result in only a
temporary reduction in coverage. When identifying

Tailored Debt Structures: a Better Fit for Uncertain Cash Flows

3

Project Finance
and growing coverage ratios over the assumed
amortizing period. For a detailed discussion on
refinancing risk, see Fitchs special report, Refinancing
Risk Permutations of Project Finance Structures,
dated Oct. 20, 2004, and available on Fitchs Web site at
www.fitchratings.com.

also allows the debt to be placed, given that these

assets have proven to have a stable or increasing
economic value over time.
Similar to deferred amortization structures, bullet
structures essentially allow for a reduction in nearterm debt-servicing commitments but with minimal
scheduled amortization, if any, prior to maturity. The
lower debt-service burden allows the project to
withstand the initial years of uncertainty with a
higher level of coverage and, hence, a lower
probability of default. Once the project has a
demonstrated operating history, the bullets can then
be refinanced at terms and rates more consistent with
the projects cash flow potential, which can be better
or worse than originally projected. However, unlike
the deferral structures, bullet structures introduce
many forms of refinance risk. Longer term changes in
the economic profile may affect the ability of a
project to ultimately repay debt within a defined
concession or project life. In essence, debt is
subordinated to equity, as cash is distributed to equity
in the near term at the expense of debtholders, who
will face a growing probability of not being paid if
the economic value deteriorates. Accordingly, Fitch
places a high degree of importance on the structural
aspects of the transaction that ensure cash will be
trapped for the benefit of the debtholders when the
longer term economic profile appears to be
deteriorating.

For projects or concessions with lives of

approximately 2040 years, Fitch expects a tail of
usually between 2 and 5 years for most conventional
structures. Other things being equal, the longer the
transaction the longer the tail required, given the
higher degree of uncertainty of the longer dated cash
flows. Fitch envisages that significantly longer tails
would be required for projects with lives in excess of
50 years due to the inherent uncertainty associated
with ultra long-term projections and the significant
effect small deviations can have when compounded
over the long term. A proper sensitivity analysis will
identify a weakness of this nature.
The inclusion of equity or cash lock-up provisions is
also a necessary feature for bullet repayment
structures. These provisions need to be linked to
historical and projected coverage ratios to ensure that
any surplus cash is retained for the benefit of lenders
in the event of diminishing financial performance.
The preservation of cash allows for the project to
delever on a net-debt basis, reduces the refinancing
requirement of a scheduled bullet and, in turn, helps
to mitigate refinancing risks.

Given the unique nature of this approach, Fitch

believes the following asset characteristics are
necessary to utilize a structure with either minimal or
no scheduled amortization over an initial financing
term:

Fitch also believes other characteristics of the

transaction can mitigate refinancing risk. Issuing debt
under multiple tranches of varying maturities and
limiting the bullet to an amount that can customarily
be refinanced in the relevant debt market can reduce
excessive refinancing risk in any one year.
Affirmative covenants requiring timely refinancing
efforts and the use of soft bullet maturities (i.e.,
scheduled maturity prior to legal maturity) lend
comfort that the refinancing will be completed prior
to maturity. Furthermore, initially issuing the debt
into a market that is expected to remain liquid during
times of uncertainty increases the likelihood that a
market will exist for the refinanced debt.

Long-dated project or concession life with

sufficient remaining term after the refinance date
to repay debt under various downside scenarios;
Relatively predictable and growing level of cash
flows over the long term (not necessary in the
short term); and
Growing economic value with discounted
present value of future cash flows increasing or
at least maintained over the nonamortizing
period (see Appendix 1 on page 7).

Cash Sweeps
Because of the commercial practices in many market
sectors, it is difficult to mitigate long-term price
exposure, which invariably leads to cash flow
volatility. In the oil and gas sectors, contractual
arrangements primarily address volumetric concerns.

When analyzing these structures Fitch will undertake

an extensive analysis to ensure the ability of a project
to be refinanced into an amortizing debt structure that
can withstand multiple downside scenarios, including
a sizable interest rate stress, and still maintain stable
Tailored Debt Structures: a Better Fit for Uncertain Cash Flows
4

Project Finance
maturity. The structure incorporates neither planned
nor scheduled amortization. Rather, a cash sweep
dictated by LLCR provisions in the rate covenant
ensure that sufficient revenue will be raised to retire
the debt fully prior to the legal maturity date.

Pricing under these agreements is typically based on

a market index. The use of uncorrelated indices in the
different markets where raw materials are purchased
and finished products are sold, which is common in
ethanol and biodiesel industries, compounds the
projects market price exposure. Although it is
possible to hedge market prices for many of these
commodities, current forward contracts have short
terms. A growing practice in natural gas storage and,
to a lesser extent, electrical power sectors is to
execute 35 year fixed price contracts.

When evaluating a loan that relies on a cash sweep to

reduce outstanding principal, Fitch assesses both the
probability of default prior to maturity and the
refinance risk at maturity, if applicable. Evaluating
the probability of default involves the same stresses
of debt-service coverage as used in the analysis of a
conventionally amortizing loan. However, assessing
the refinance risk requires developing appropriate
scenarios to approximate the outstanding principal at
maturity. In addition to the magnitude of the stress
scenario, the timing and duration of the stress are
important, as it is unlikely that the stress conditions
will occur during all years of the tenor.

Term B loans are an increasingly popular structure

for projects that have considerable price exposure.
The classic B loan structure is similar to a bullet loan.
However, a cash sweep mechanism reduces the
outstanding balance of the loan and, therefore, the
associated refinance risk. Scheduled debt service is
primarily interest expense, as scheduled amortization
is typically minimal if not nonexistent. Prior to
making equity distributions, a defined percentage of
the available funds must be applied to prepay the
principal balance. Accordingly, the debt-service
burden is manageable during periods when market
conditions are unfavorable, while principal
repayment will be significant during a favorable
market environment. In theory, the outstanding
balance of a B loan will be similar to that of a
conventional amortizing loan after a complete market
cycle, though the duress of annual debt service will
be lower. However, mirroring the unpredictability of
market cycles, there is little assurance of the principal
amount remaining at maturity and the corresponding
refinance risk. Accordingly, cash sweep dominated
structures are a trade off between the risk of timely
payment prior to maturity and ultimate payment by
maturity.

It is worth noting that cash sweeps are likely to be

inadequate for a project with meaningful technology
risk or with diminished long-term prospects. The
potential for a sustained period of depressed cash
flows increases the probability that the principal will
not be fully amortized by final maturity and suggests
that refinancing the outstanding balance will be
difficult. In such cases, reduced leverage is likely the
most appropriate solution.
Conclusion
The various structures discussed provide project
sponsors with the flexibility needed to finance
projects with some degree of revenue uncertainty.
With the benefit of a flexible amortization comes a
new risk that Fitch needs to evaluate: does the asset
financed have a long-term economic value sufficient
to pay off a financial obligation that could potentially
grow faster than the value of the asset.

Fitch rates several transactions in which alternate

applications of the cash sweep concept are used. In
one variation, cash sweep mechanisms used in
conjunction with a fixed amortization structure can
be effective for projects with near-term revenue
stability but longer term uncertainty. A pattern of
diminished cash flow will trigger the cash sweep
provision in order to expedite the full repayment
prior to maturity. In addition, some projects facing
cyclic market exposure incorporate a partial cash
sweep during favorable conditions to legally defease,
rather than prepay, the projects debt. Meaningful
defeasance, if achieved, will enhance the projects
credit metrics during a subsequent downturn. A
variation of the B loan was used to finance a public
infrastructure project with debt having a 35-year

Fitch views a flexible debt structure, whether it is in

the form of deferred amortization, a bullet with
refinancing or a cash sweep mechanism, as an
appropriate tool to finance projects with cash flow
uncertainty, either in the long term or short term.
These structures are also suitable for markets in
which long-term debt is not available. While these
structures have slightly different permutations across
the spectrum of assets in the project finance arena,
their specialized nature requires some nontraditional
analytical approaches to assess credit quality. The
degree to which the structure shifts the risk from a
payment default prior to maturity to the loss of
Tailored Debt Structures: a Better Fit for Uncertain Cash Flows
5

Project Finance
principal at maturity must be mirrored in the
analytical methods. Proper balance between a full
and timely payment analysis and an ultimate recovery
analysis is necessary. Not all projects are suitable to
employ such financial structures, all the more so if an
investment-grade credit rating is being contemplated.

of the proposed structure to handle a Fitch-designed

stress case and adequately provide for operations and
maintenance funding and major maintenance reserve
requirements. The legal term of the debt should be
limited to the lesser of the economic life of the asset
or the concession term, if any. If refinance risks exist,
an appropriate tail must also exist. Rate covenants
and/or cash distribution tests need to incorporate
scheduled but not legally required prepayments and
should include forward-looking tests (such as DSCR,
PLCR or LLCR, as appropriate).

Fitchs approach to analyzing flexible structures in

the project finance arena, regardless of the
permutation, will incorporate several principles. Most
importantly, the analysis will be based on the ability

Tailored Debt Structures: a Better Fit for Uncertain Cash Flows

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Project Finance

Appendix 1

Economic Value Over Time Finite Life Asset

40

($ Mil.)

35
30
25
20
15
10
5

50

40

30

20

10

Year

value of the asset (Year 0) amounts to $24 million,

increasing to a maximum of $39 million in year 28.
The example provides a simplified graphical
rationale as to how a nonamortizing term loan can be
refinanced for a period of time without affecting
project life or loan life ratios. However, it should be
noted that the projected discounted asset values can
be sensitive to changes in overall levels of cash flow,
growth rate, discount rate and term. Hence, caution
must be exercised when using such structures and in
undertaking appropriate debt-service coverage
analysis and sensitivity analysis.

The graph is a hypothetical example showing the

economic value over time of an asset with a finite life
(e.g., a toll road with a 50-year concession). In this
example, we have used an annual cash flow
commencing at $1 million, escalating at 4% per
annum (comprising real growth of 2% per annum and
inflation of 2% per annum) for the first 20 years and
then 2% per annum (inflation only) for the following
30 years, for a term of 50 years. The economic value
assumes a discount rate of 7% per annum through the
end of the term. In the example, the initial economic

Tailored Debt Structures: a Better Fit for Uncertain Cash Flows

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Project Finance
Appendix 2
In addition to many projects for which Fitch
maintains private ratings, Fitch referred to the
following publicly rated projects to develop the

examples in this report. See also the Fitch special

report, Refinancing Risk Permutations of Project
Finance Structures, dated Oct. 20, 2004.

Deal List
Project
Airport Motorway Trust
Astoria Energy LLC
Caithness Coso Funding Corp
Coleto Creek WLE, LP
Del Mar Race Track
Dulles Greenway
Flinders Power Partnership
Hospital Car Parking Limited
IndoCoal Exports (Cayman) Limited
Interlink Roads Pty Limited
Juniper Generation LLC
Klamath Cogeneration Project
Lane Cove Tunnel Finance Pty Limited
Miami Intermodal Center
TCW Global Project Fund II
Transurban Finance Company Pty Limited
WSO Finance Pty Limited
Tube Lines (Finance) PLC

Report
Nov. 1, 2004
June 15, 2005
Aug. 11, 2005
Oct. 20, 2004
Aug. 30, 2005
March 4, 2005
May 12, 2004
Aug. 5, 2004
July 7, 2005
June 3, 2005
Aug. 4, 2005
Sept. 29, 2003
Jan. 30 2004
Oct. 17, 2005
April 11, 2005
Nov.23, 2004
Dec. 22, 2005
May 12, 2004

Feature
Bullet with Refinance
Cash Sweep
Deferred Amortization (Subdebt)
Cash Sweep
Cash Sweep
Deferred Amortization
Cash Sweep
Bullet with Refinance
Cash Sweep
Bullet with Refinance
Deferred Amortization (Subdebt)
Cash Sweep (Defeasance)
Bullet with Refinance
Cash Sweep
Various
Bullet with Refinance
Bullet with Refinance
Deferred Amortization

Copyright 2006 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.
Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the
information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the
truth or accuracy of any such information. As a result, the information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the
creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of
any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection
with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort.
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