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Creative Financing
If there is one positive feature in the Amaila Falls Hydro Electric Project (AFHEP) debate that has played out in the last two years, it is the gradual enlightenment of the public about previously sequestered details of what it takes to ensure that such projects are brought to fruition. But even as Sithe Global, the key investor (and developer) of the project has withdrawn there are still some issues that appear hazy in the minds of even experienced individuals with exposure to the financial sector. One of these is the question as to “who owns the debt of AFHEP?”
The answer lies in one of the creative financing innovations that have flourished in the last few decades – off-balance sheet financing. In the normal course of things, when firms fund an activity or project as equity (using its own funds) it will appear on the firm’s balance sheet as “owners equity”. Conversely, if the funding is debt (borrowed) it appears on the balance sheet as “debt”. This is “on-balance sheet financing”.
For a variety of reasons, but mainly to avoid debt showing up on its balance sheet – either because the cost of acquiring the debt (interest rates) might be too high, and/or its debt-income ratio might become too high, it might be useful to avoid placing owners’ equity, liabilities or assets on a firm’s balance sheet. This is generally accomplished by placing those items on some other entity’s balance sheet. This is the “off balance sheet financing approach”.
Usually, a special purpose vehicle (SPV) – a new and separate corporation – is formed and the assets and liabilities are placed on its balance sheet. The SPV is usually established to perform some specifically-defined or temporary purpose. In the case of AFHEP, the SPV formed was Amaila Falls Hydro Inc. (AFHI), with Nigel Hughes as its company secretary. If the sponsoring entity (firm or government, in this case) wholly owns the SPV, the latter’s assets and liabilities are placed on its balance sheet which defeats the purpose of the SPV. Typically, to enjoy the advantages of the SVP, the originating party takes a minority ownership as the government of Guyana (GoG) did with AFHI. So the answer to the question as to who owns the debt on the AFHEP, it that it is the SPV, AFHI.
Off-balance sheet financing also affords a numbering in securing financing. An SPV technically doesn’t utilise the sponsoring firm’s credit lines or other financing channels. It is presented to financiers as a stand-alone entity with its own risk-reward characteristics. For instance, Guyana’s sovereign credit rating was destroyed after we could not service our debt back in the 1970’s and 1980’s and even though we have been brought our debt to manageable proportions, direct borrowing costs would have been prohibitive. With Sithe Global as the majority equity shareholder, potential lenders would have had more confidence in the project and offered lower rates.
To ensure those lower lending rates, or cost of equity participation the initiating firm often overcapitalises the SPV or enhances its credit profile. In this way, the SPV may have a higher credit rating than the sponsoring firm. In the case of Guyana and AFHEP, the requested government guarantee of GPL’s pass through payments on the Power Purchase Agreement (PPA) should have been used to negotiate much lower interests on the loans from China Development Bank and the Inter-American Development Bank
(IDB). Not inconsequentially, if a new equity partner is to be approached, and we are willing to guarantee GPL’s payments, their rates of return should be lower that Sithe’s 19%.
Finally we have to point out that while SPVs and off-balance sheet financing have many legitimate purposes, they can also be used to misrepresent a firm’s financial condition – in this case, our government’s ultimate debt burden. Enron’s bankruptcy is an object lesson in the misuse of SPV’s. We believe that while the SPV is the way to go with AFHEP, we do recommend that we have an expert panel oversee its structure.
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