Recovery Ratings for Structured and Project Finance Transactions: Opportunities for PRI

Recovery ratings provided by agencies such as Standard & Poor’s (S&P) and Fitch can help lenders and borrowers assess the prospects of recovery once a default has occurred, open access to particular investors and lenders, as well as to calculate capital requirements, and to price issues. We believe that political risk insurance (PRI) can prove to be an increasingly important factor in recovery ratings for structured and project finance

 Both S&P and Fitch have recently established recovery ratings and methodologies for rating the recovery prospects of project or structured financed instruments.

S&P first looks at possible circumstances of default and then at post-default recovery prospects. Its recovery ratings take into account both legal structure and collateral. S&P does a project value analysis, but if viability is doubtful, it performs a liquidation analysis. S&P then ranks the issue numerically from 1+ to 5, based on descending levels of likely recovery of principal (see Table 1 below).

PRI could be viewed as an element of either a going concern or a liquidation analysis. In post-default circumstances, PRI may keep the project performing by keeping the cash flowing, for example with convertibility and transfer coverage, or, as a form of collateral, may yield values for lenders in the form of insurance proceeds.

Fitch’s recovery ratings are based on a relative scale measuring potential recoveries in bankruptcy, liquidation, or some other form of restructuring. It notches down and up from the issuer rating (see Table 2 below). For its corporate analysis, Fitch will focus primarily on ultimate recoveries, although the recovery analysis will use stressed cash flow scenarios and realistic enterprise valuations. For structured finance, Fitch concludes from market feedback that prospective users concur with Fitch’s view that cash flow streams are more predictable and easier to model, making a present value approach more appropriate for some, if not all, asset classes and structures. Sector-specific recovery methodologies will be published in concert with the incorporation of this methodology and recovery scale.

Fitch believes that the adoption of recovery ratings and issuer default ratings (IDRs) globally will enhance the informational content of Fitch’s ratings by separating the two main components of credit risk: probability of default and loss given default (LGD). This type of information is increasingly valuable in a post Basel-II world of sophisticated credit risk management. They see an overwhelmingly positive response from the market to Fitch’s rollout of recovery ratings and IDRs, which reinforces this view.

A case in point is the recent assignment by Fitch of a “B” rating to an Autopistas del Nordeste (AdN) issue of $163 million senior notes due in 2026, to finance a toll road project in the Dominican Republic. A very significant factor in the rating was a “partial political risk guarantee” (PPRG) provided by the Multilateral Investment Guarantee Agency (MIGA) that encompassed expropriation, inconvertibility, war and civil disturbance, and most significantly, breach of contract coverage that underpins a minimum revenue guarantee from the Government of the Dominican Republic. The PPRG covers 51% of the loss attributable to the covered risks, and in the event of a breach of contract claim, noteholders could receive a single accelerated payment rather than awaiting scheduled installment-by-installment compensation. In Fitch’s view, MIGA’s PPRG enhanced recovery prospects enabled the issue’s rating to be notched up from “B-“ to “B”.

Recovery ratings may not, as a matter of course, take political risk insurance into consideration, but in the right situations, the existence of PRI coverage with terms appropriate to the circumstances of default would deserve investigation and considerable weight in recovery calculations for project financings. For example, in 2004, the Overseas Private Investment Corporation (OPIC) made payments to Bank of America (as trustee for debt holders) in response to an expropriation claim involving the Dabhol project in India. The payments included defaulted installments and the outstanding loan principal.

PRI could be a factor in recovery rating analysis on a going concern basis if, for example, a project payment is in default on account of currency inconvertibility. That default and future defaults similarly caused could be redeemed or prevented by currency inconvertibility coverage. Further, PRI lender policies typically provide that if an expropriation or political violence claim is found to be valid, there is a presumption that subsequent consecutive defaults will be similarly caused. In either case, the existence of the PRI coverage could determine whether lenders will receive payments down the road.

On the other hand, the failure of a sovereign off-taker to meet its payment obligations, for example, might cause sponsors and lenders to discontinue normal project operations and fall back on contractual rights to arbitrate the matter against the sovereign or its agent, in effect liquidating the project. In the interval between the commencement of default and the arbitration’s outcome, coverage against non-payment of the award and sovereign thwarting of the arbitration process would be a factor in assessing the prospect of recovering sums that would ultimately offset the lenders’ loss.

In later editions, this Newsletter will explore further how PRI might play a role in recovery ratings for debt in project financings and in other cross-border lending situations. ■

Table 1: Standard & Poor’s

Table 2: Fitch