by Majid Hasan and Frederic Blanc-Brude
Large infrastructure projects are often financed through limited-recourse project finance (PF) vehicles with a high proportion of senior debt. PF is a unique form of corporate governance that creates extensive creditor rights when certain covenants are broken, most notably the option to ”step-in” upon a credit event, and to restructure the firm to maximise either expected recovery or expected payoff, depending on the nature of the credit event. These options significantly impact the outcome of credit events, and credit rating agencies report anecdotal evidence of very high recovery rates in project finance debt compared to comparable corporate debt.
However, data paucity forbids robust reduced-form modelling of expected recovery rates. In this paper, we extend the structural credit risk model of illiquid debt developed by Blanc-Brude and Hasan (2016) (BBH) to incorporate the step-in option of senior creditors in PF and model its impact on the valuation and risk profile of senior unsecured project debt, taking into account the bargaining power of creditors and borrowers in investment projects that are relationship specific. Step-in options can also be understood as trading-off credit risk and duration, depending on creditor risk preferences.