Christian M. Macellari
New Trends in Alternative Lending
Updated: Apr 26, 2019
To many investors in Public Private Partnership projects, the idea of credit enhancement is not a new idea. In fact, prior to the 2009 Real Estate Crisis in the US, it was not uncommon for "Mono Liner" insurance companies to provide credit enhancements to commercial real estate projects as well. So what exactly is a credit enhancement and what shapes can it take? Perhaps, even more importantly, why does it matter to commercial real estate investors.
We'll start with a basic understanding of what credit enhancement is. In its most basic form, a credit enhancement is a form of risk transference, specifically risk transference of project specific risk to some form of credit risk. This can take on many forms including commercial and performance insurance and reinsurance to surety and bank letters of credit. The idea is that by providing an additional level of protection, a lender will be more comfortable extending credit to a borrower. In the case of capital markets transactions, bond investors are often comfortable taking on credit risk but not necessarily construction or operating risk in a project and therefore will welcome the ability for a project to provide certain financial guaranties through some manner of a credit enhancement vehicle.
So what types of enhancements exist, the answer is not so simple as it might seem. In general terms, Reinsurance companies will sometimes "wrap" a group of insurance policies covering individual risks including construction and operational risks and thus act as a quasi financial guarantor. In the past, many large reinsurance groups in the US were able to provide actual financial guaranties against principal and interest defaults on a loan. Post the financial crisis, not so much so. Outside of the public finance market, this type of guaranty no longer exists in the US markets. Another type of enhancement can come in the form of completion bond guaranties provided by surety companies. This type of bond typically requires either the developer or the contractor to show their financial wherewithal to support the surety bond and can be quite costly. In fact many surety companies will also require some form of financial instrument to act as recourse in the event of a contractors inability to meet the demands of its contract. This is yet another expense incurred by the sponsor or contractor and is typically reflected in the cost of the project which can further erode the economic viability of a project. Finally, the completion bond, at least in the sense of how the US insurance markets view them, do not truly act as a financial guaranty in the same sense that they did prior to 2008/2009.
What's interesting is that some European banks are beginning to get comfortable with the idea of using insurance and reinsurance wrappers to credit enhance their facilities allowing them to lend at leverage levels and in geographies that would otherwise not be feasible for the bank portfolio. Furthermore, this type of credit enhancement can also lead to lower cost of capital based on the fact that the lenders seem to view these wrappers as a way to mitigate the risks associated with the project and provide some sort of counter credit risk with the insurance groups issuing the policies. Though these policies are not acting as guaranties specifically to the debt and interest on the loans themselves in cases involving commercial real estate, they are in fact treating the actual problem vs the symptoms in that they are insuring against the things that could go wrong leading to a default by the project sponsor. Some typical types of risks that are being insured are delays in startup, force majeure and political risks.
In conclusion, it seems that European banks and Investors seem to be at the front of the class with respects to finding new and innovative ways to put money to work in their low interest environment. Lets hope that they don't make some of the mistakes we've made here in the US as we head into the next economic cycle.