Political risk insurance has been around since the 1960s but until now there was little investors could do to protect themselves against currency devaluation. Political instability is less of a problem than it was 40 years ago, but currencies have become more volatile. Brazil’s real lost 30% of its value during the January 1999 financial crisis when the government could no longer defend the currency and had to allow it to float.
Overseas Private Investment Corporation (OPIC), a US government organization, and Bank of America have developed a product to address this problem. In May, they arranged the first bond issue to cover currency devaluation for a Latin American company. The deal was also the longest-dated Brazilian corporate deal ever and the only investment-grade power project in a non-investment grade country, says Bob Sheppard, managing director in project finance at Bank of America.
The $300 million bond issue for Companhia de Geração de Energia Elétrica Tietê, a privatized hydroelectric plant, could open the way for more foreign investment in Brazil’s struggling energy sector. This month the country decreed power rationing to cope with shortages.
Robert Drumheller, vice president of finance at OPIC, says the bond’s devaluation insurance coverage attracted strong support from private investors and is good news for other projects in the region. “We can participate in more projects if we can use a small amount of OPIC coverage to attract large amounts of private capital into a transaction,” he says. Jay Buth, chief financial officer for the São Paulo subsidiary of AES, the US energy company that has a controlling interest in Tietê says, “We hope to replicate this structure for other investments in generation development in Brazil.”
Brazil needs to invest more in generating and transmission capacity. Drought has reduced water levels at hydroelectric reservoirs, which in the southeast are at a third of their normal capacity (see MarketWatch). Nearly all Brazil’s energy comes from hydroelectric dams but the country has attracted minimal investment into thermal plants, in spite of the government encouragement. This is because Brazilian law requires prices to be set in reais while most power projects are financed with dollar-denominated loans. This currency mismatch exposes companies to escalating debt service payments in local currency terms following a devaluation. “Currency devaluation from exogenous shocks is a pretty big deterrent and makes obtaining finance for projects more difficult,” says Drumheller.
AES acquired its 38% stake in Tietê from CESP, a state-owned utility, in a privatization in October 1999 for $486 million. It paid for this with a $186 million loan from Brazil’s national development bank, BNDES and $300 million in equity provided by AES. The new bond will repay the BNDES loan.
The offering will repay the $130 million bilateral BNDES loan and a $53 million BNDES-backed loan provided by a syndicate of Brazilian banks. “We refinanced acquisition indebtedness and took a three-year average life and turned it into a 11-year average life,” says Buth. “The 15-year maturity is the first for a Latin American borrower.”
Drumheller says AES and Bank of America approached the agency late last year. “They wanted to access the capital markets but needed to address this devaluation issue and asked us if we would work with them on developing the product,” he says.
The result was a $300 million, 15-year bond with a coupon of 11.5%, covered by $30 million in devaluation risk insurance in the form of a standby liquidity guarantee facility plus $85 million in inconvertibility insurance. OPIC will cover debt service payments for Tietê if a devaluation of the real makes it impossible for the company to service its debt or transfer funds offshore.
The 15-year notes are structured as a securitization of a local currency dividend that flows upstream from Tietê through two Brazilian holding companies, AES Tietê Empreendimentos Ltda and Tietê Participações, to AES Tietê Holdings Ltd, a Cayman Islands company wholly owned by AES. The notes are backed by full recourse to the Brazilian holding companies and a pledge of shares in Tietê, but there is no recourse to either Tietê or AES. They have further security in a six-month offshore debt service reserve account. In exchange for the proceeds from the offering, the AES holding company will issue the $300 million IHB note to Tietê Certificates Grantor Trust, a New York trust.
Drumheller says in order to develop a devaluation risk product OPIC needed a project with strong operations, predictable cash flows in a country with a free floating exchange rate.It also needed a project that would clearly differentiate between operational and devaluation risks. Tietê fulfilled all these requirements.
The company’s operations are located in the state of São Paulo where it has 10 generating plants with an installed capacity of 2,651 megawatts, representing less than 5% of Brazil’s installed capacity. The location of the plants in three separate river basins reduces the company’s vulnerability to low rainfall. Brazilian law requires generation plants to cover one another when there is a shortfall of energy, which should ensure that Tietê has power to sell when rainfall is low and it can draw on capacity from other hydroelectric or thermoelectric plants. “Tietê can produce energy even in severe drought conditions,” says Sam Fox, director in international structured finance at Fitch, the rating agency, which rated the bond BBB-. Moody’s rated the bond Baa3.
Steady Revenues Key
Tietê also has a consistent revenue stream, which appealed to OPIC. Tietê’s contracts with six electricity distributors will be phased out between 2003 and 2006 and replaced with a 15-year power purchase agreement (PPA) with the São Paulo distribution company Eletropaulo, which is also owned by AES. The PPA should ensure stable revenues for Tietê throughout the life of the bond.
Tietê’s power purchase agreements are secured by the Brazilian wholesale market’s assured energy policy, intended to assure generators buyers for their energy. Tietê also has potential for additional revenues when it sells surplus power into the wholesale energy market after 2003 at negotiated rates.
OPIC conducted internal studies and Tietê commissioned C. C. Pace, an econometrics consultancy, to analyze a range of possible devaluation events and compared that to the robustness of cash flows in hydroelectric projects. Drumheller says the study concluded that the likelihood of an external shock causing a major devaluation of the Brazilian real “was a very low probability.”
However in order to minimize the probability of it drawing on the $30 million liquidity guarantee facility, Tietê’s six-month offshore debt service account stipulates that the company must have minimum cash reserves of 1.4 times the amount of debt service. If Tietê’s available cash in US dollars falls below the minimum, that would constitute a devaluation event and the policy pays out to Tietê to make a debt service payment.
“The devaluation insurance deal works well for the mitigated hydrology risk in the Tietê transaction but is not a blanket solution to the currency mismatch that companies with revenues in local currencies and liabilities in dollars have,” says Fitch’s Fox. However both AES and Bank of America would like to see a similar product developed for thermoelectric generation projects in Brazil. Says AES’s Buth, “Brazil is a long-term play for AES and we are looking for most attractive products to help us achieve our investment goal.”