by Majid Hasan, Frédéric 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 control rights for creditors to safeguard their share of the investment. The most significant of these control rights is the option to “step-in” upon a credit event, which allows creditors to impose a debt restructuring and to maximise either their expected recovery or their expected payoff, depending on the nature of the credit event. This option significantly impact the outcome of credit events, and credit rating agencies report anecdotal evidence of higher recovery rates in project finance debt compared to standard corporate debt. However, the paucity of available data 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) to incorporate the step-in option found in PF, and examine its impact on the valuation and risk profile of senior infrastructure project debt. In our model, the value of the step-in option is determined by the relative bargaining power of creditors and borrowers, itself the result of what we call creditors’ “exit option” i.e. their option to exit the creditor-borrower relationship and take over the project company. Bargaining power evolves over time in PF and introduces a supplementary dynamic in the risk profile of infrastructure project debt. The option to “step-in” in PF can also be understood as a trade-off between credit risk and duration and the optimal exercise of this option should take into account creditors’ preferences for these risk factors.
Project Financal Valuation with a Renegotiable Debt Threshold (Majid Hasan, Frédéric Blanc-Brude), In Journal of Fixed Income, 2016.