A Project Financing transaction often requires a large initial capital investment in order to create tangible assets and long term, predictable cash flows. This combination of substantial capital requirements, tangible collateral, and reliable cash flows makes Project Financing a natural candidate to rely on debt for the majority of its capital structure. As a result, much of the financial modelling for these transactions focuses on determining the amount of leverage that can be supported while still creating a capital structure that is acceptable to lenders.
Solving for the optimal capital structure and obtaining the requisite amount of debt in a conventional Project Finance transaction focusses on the calculating the Debt Service Coverage Ratio (“DSCR”) of the underlying assets. Most lenders rely primarily upon satisfactory stress testing of the DSCR (which is the ratio of Cash Flow Available for Debt Service, “CFADS” to payments owed to lenders under the debt financing). The DSCR is used as a critical measure when determining the credit quality of a given transaction. The maximum amount of debt that would typically be available is solved by ensuring there is sufficient CFADS after stress testing the financial metrics to scenarios with deteriorated future revenues and expenses.
The concept is similarly applicable in an M&A situation where a requisite amount of debt needs to be raised to support the purchase (or bid) price of a project. Any deterioration in the project’s DSCR would translate into a lower debt capacity and hence require additional equity to support the bid price, which in turn is likely to be dilutive to the project’s realized Internal Rate of Return (“IRR”).
One of the ways in which equity sponsors look to stabilize the DSCR of a given project, is to enter into hedge contracts to de-risk the project’s interest rate exposure. In this article, we explore techniques utilized to transfer or monetize existing interest rate hedges in an M&A context.
Equity sponsors interested in bidding on a target project in an M&A transaction are sometimes faced with restructuring of existing hedge contracts.
Equity sponsors interested in bidding on a target project in an M&A transaction are sometimes faced with restructuring of existing hedge contracts. These hedges will have a Mark-to-Market (“MTM”) value which can at times be ‘out-of-the-money’ (“OTM”). Under this scenario, the sponsor may elect to either:
(a) Terminate the OTM value or re-coupon the hedge and incur the cost as part of the acquisition process. The sponsor would then execute a new hedge which is optimized to the pro-forma leverage profile and would have an ‘at-market’ (“ATM”) interest rate. Re-couponing in this way would lower the fixed interest coupons and increase future operating cash flows (accretive to IRR). At the same time, it requires an upfront cash payment in-line with the acquisition closing timeline (dilutive to IRR). The upfront cash payment may be funded via raising additional project debt. Recall that a lower ‘at-market’ interest expense improves DSCRs and increases debt capacity.
(b) Transfer the OTM value into a newly executed hedge contract and defer the cash payment associated with the MTM. To transfer, the sponsor would execute a new hedge which is optimized to the pro-forma leverage profile and would have an ‘off-market’ (“OTM”) interest rate. The new OTM hedge, however, would carry a higher fixed rate and a higher credit charge associated with the financing of the MTM. This alternative would require no upfront cash payment and hence no need to raise additional project debt.
In conclusion, equity sponsors dealing with existing hedge contracts can select to make an upfront cash payment versus deferring the payment by financing it via additional project debt or a newly executed OTM hedge. It is important to perform an assessment of the available alternatives and select one which offers the lowest cost of capital, attractive liquidity requirements, and accretion of projected IRR.
For hedges that are ‘in-the-money’ (“ITM”), similar analysis would help determine the impact on DSCRs, Debt Capacity, and IRR of the project. In this case, an upfront cash payment is received by the equity sponsor upon termination or re-couponing of the contracts which is seen as additional source of liquidity and can be invested at the project’s hurdle rate or IRR to enhance the equity return profile.
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