Using Credit Enhancements
All investments are subject to real and/or perceived risks that may impede access to finance or increase finance costs, resulting in higher operational costs for the project owners and the public. As a result, to achieve the SDGs and Climate Goals we must devise optimal ways to use credit enhancements to mitigate risks and increase access to affordable finance.
Credit enhancements include all techniques and instruments that improve the creditworthiness of an investment. To optimize the ability to access finance, project owners need to systematically assess the benefits and costs of the full menu of proven credit enhancement solutions. Key concepts underlying the successful use of credit enhancement techniques include:
1) Special Purpose Vehicles (SPVs): Infrastructure services are often provided by SPVs as their legal status as separate companies can result in bankability based on an analysis of whether its cash flow enables timely debt service payments. The SPV independent legal structure can make its obligations secure even if the project owner defaults. In fact, the annual Moody’s bank default study for infrastructure loans states the cumulative default rates for infrastructure projects are consistent with low investment-grade corporate loans (Baa3-rated), even in low-income developing countries. To access the summary of the 2021 Moody’s default study, click here.
2) Structured Finance: Bankability can be achieved by creating structures that ensure the payment of debt principal and interest. A key mechanism is ringfencing specific funds and/or collateral for debt payments.
3) Project Finance: Infrastructure projects usually use project finance techniques as they have been the foundation for bankability, using both SPVs and structured financing. First, project finance involves the creation of a Special Purpose Vehicle (SPV) created by the sponsors. Second, project finance uses structured finance as the lender considers the cash flow generated from this entity as the major source of debt service, usually ringfencing revenues.
4) Risk Mitigation Instruments: There are many types of risk mitigation instruments. For example, many highly rated Development Financial Institutions (DFIs) issue credit guarantees that leverage their limited resources and credit ratings to attract private sector financing for development projects. These products can be used to guarantee a portion of the public sector borrower’s debt service to lenders or bond holders. The objective is to help countries access capital markets or open up new sources of financing. The DFI’s participation as guarantor not only makes commercial financing possible by enhancing the credit profile of projects and borrowers, but also improves the terms of the financing by extending debt tenors and lowering spreads. New issuers benefit by establishing a track record in the capital markets.
Details on Solution
To optimize the use of credit enhancements, governments and project owners will need to engage professionals with extensive experience in using risk mitigation approaches and instruments. Support can be provided through Development Finance Institutions (DFIs) and providers of risk mitigation.
For Africa, a key resource is the Africa Co-Guarantee Platform whose partners collectively support about $10 billion annually in trade and investment through guarantees and insurance. For details and contact information, click here.
Invitation to Partner
GlobalDF invites interested parties to increase the capacity of governments and project owners to optimize the use of credit enhancements, implementing a Toolkit for Using Credit Enhancements and related training. Please contact us by clicking here.