PROJECT FINANCE COLLATERALIZED DEBT OBLIGATIONS:

AN EMPIRICAL ANALYSIS ON SPREAD DETERMINANTS*

Valerio Buscaino
Merrill Lynch London

Stefano Caselli
Bocconi University – Department of Finance
CAREFIN

Francesco Corielli
Bocconi University – Department of Finance

Stefano Gatti
Bocconi University – Department of Finance
CAREFIN

Current Draft: May 18, 2009

* The authors would like to thank John Doukas (the editor) and two anonymous referees for comments
and suggestions on an earlier draft of the paper. The responsibility for the contents remains that of the
authors alone. Furthermore, the authors acknowledge the generous financial support provided by Carefin,
Centre for Applied Research in Finance at Bocconi University

Please address all correspondence to:

Stefano Gatti
Dept. of Finance
Bocconi University – Dept. Of Finance
Via Sarfatti 25,
20136 – Milan (Italy)
Tel: 0039-02-5836-6106
Fax: 0039-02-5836-5920
e-mail: stefano.gatti@unibocconi.it

Electronic copy available at: http://ssrn.com/abstract=1590335

 PROJECT FINANCE COLLATERALIZED DEBT OBLIGATIONS:
AN EMPIRICAL ANALYSIS ON SPREAD DETERMINANTS

Valerio Buscaino
Merrill Lynch London

Stefano Caselli
Bocconi University – Department of Finance
CAREFIN

Francesco Corielli
Bocconi University – Department of Finance

Stefano Gatti
Bocconi University – Department of Finance
CAREFIN

Current Draft: May 18, 2009

ABSTRACT

We investigate the determinants of spread on structured finance issues backed by project

finance (PF) loans. We find that credit rating is the most important variable in determining
tranche spread at issue. We also document how factors that are important for pricing in the case
of corporate bonds, such as market liquidity and weighted average maturity, are also relevant for
determining spreads on project Collateralized Debt Obligations (CDOs). Furthermore, we find
that the nature of the underlying assets has a substantial impact on CDO pricing, indicating that
primary market spread is significantly higher when the underlying PF loans bear a higher level
of market risk as compared to issues backed by projects with low market risk exposure. The
larger proportion of projects still under construction in the securitized portfolio is another
feature that explains the level of at-issue spread.

JEL Classification: G12, G15

Keywords: Collateralized Debt Obligations, Project Finance

Electronic copy available at: http://ssrn.com/abstract=1590335

 PROJECT FINANCE COLLATERALIZED DEBT OBLIGATIONS:
AN EMPIRICAL ANALYSIS ON SPREAD DETERMINANTS

Introduction

Project finance (PF) is a structured finance technique extensively used for the financing of

single-purpose, capital-intensive projects in developed and developing countries. Esty and Sesia

(2007, pg. 213) define PF as “the creation of a legally independent project company financed

with equity from one or more sponsoring firms and non-recourse debt for the purpose of

investing in a capital asset.” PF deals are financed with a limited amount of private equity

capital provided by project sponsors and with a larger fraction of non-recourse syndicated loans

or, less frequently, project bonds. The loans granted to the project find repayment in the ability

of the initiative to generate cash flows. In addition, project assets are pledged as collateral to

reinforce creditors’ rights.

Essentially, the success of a project finance deal for sponsoring firms and lenders is based on a

careful analysis of all the possible risks that could arise during either the construction or the

operational phase of the project. Risk analysis leads to an intense risk management process

based on the stipulation of insurance contracts and on the design of construction, sale, purchase,

operation and maintenance (O&M) agreements which effectively transfer risks to the Special

Purpose Vehicle (SPV) counterpart best able to manage them (Tung et al., 2008; Gatti et al.,

2008(a); Yescombe, 2002). Sponsors, lenders and legal advisors work intensively to structure

the deal in order to make it bankable. Given the high specificity of each single transaction, this

process is often based on a case-by-case approach (Gatti, 2007, ch. 3).

Although PF has long been associated with syndicated bank loans (Gatti et al., 2008(b); Esty,

and Sesia, 2007), the implementation of Basel II rules (Ambrose et al., 2004) has had several

repercussions on the PF business for banks. These rules have placed greater emphasis on risk

and credit analysis of PF loans than has historically been the case in the normal course of

prudent banking practice. In particular, the New Capital Accord (NCA) states that unless a bank

qualifies for the internal rating based (IRB) approach, from 1 January 2008 the capital reserve

3
requirements for project loans must be increased, especially for transactions that fall in the

highest rating classes (Gatti, 2007, p.298-304).

In this changed regulatory environment, developing alternative methods for offsetting the

impact of NCA rules on PF loans has become a relevant issue. One option that has emerged is to

structure collateralized loan/debt obligations (CLOs/CDOs) based on portfolios of PF loans.

Table 1 reports all the CLO deals structured so far.1

*** Insert Table 1 about here ***

A CDO is a transaction which involves repackaging the risk of a portfolio of financial assets

(Fender and Kiff, 2004, Vink and Thibeault, 2008). This risk is transferred to an SPV, either by

transferring the portfolio to the SPV or using credit derivative techniques. The risk is then sold

to the capital markets by way of the issuance of securities by the SPV, whereby investors in

those securities bear the risk of losses suffered by the portfolio. Thus, under a CDO structure,

capital market notes are paid by cash flows generated from a pool of PF loans or bonds. The

whole transaction benefits from this scheme because the credit strength of the notes will

generally be stronger than the credit strength of any individual project loan, due to the fact that

pooled cash flows diversify default risk. Compared to an ordinary CDO deal where collateral

consists of a mix of loans, bonds, and other types of securities, in this paper we analyze CDOs

that are associated to PF loans only.

This kind of structured approach to PF is a particularly new field of study as few operations

have been closed since Credit Suisse First Boston (CSFB) finalized the first CLO transaction

backed by PF loans in March 1998 (Project Funding Corp. I). Notes were backed by assigned

interest in a pool of 41 fully-funded amortizing PF loans purchased from CSFB’s loan portfolio.

Each of the loans was a floating rate, USD denominated term loan secured by a US domestic

project (with the exception of one Chilean project).

1
In a traditional CDO structure, banks create an SPV which purchases a pool of loans and issues floating
rate securities collateralized by the same loans. At the end of the 1990s, due to the development of the
credit default swaps (CDSs) market, synthetic unfunded and partially funded CDOs based on credit
exposures due to writing CDSs started to become more popular.

4
Between 1999 and 2001 there were two other cash CLOs backed by project loans originated by

Citigroup and CSFB.

In August 2001, the TCW Group, majority-owned by Société Générale Asset Management,

launched Global Project Fund I. This fund, with a three-year lifespan, pooled investments in 14

projects including a Gas-to-Liquid (GTL) methanol project financing in Western Australia and a

power project in the Dominican Republic. Three years later, TCW recapitalized its original

$500 million Global Project Fund and increased equity and debt investment limit in the new

fund to $700 million. The new fund, called Global Project Fund II, first bought out the assets of

the original fund; then the remaining proceeds were used to acquire additional emerging-

markets power assets over a five-year investment period.

It wasn’t until November 2004 that the first synthetic deal appeared in Europe, when Depfa

Bank launched Essential Public Infrastructure Capital (EPIC). This deal achieved capital relief

via a £392 million synthetic securitization of a portfolio of UK Private Finance Initiative (PFI)-

Public Private Partnerships (PPPs) loans, in an offering led by Merrill Lynch (Manley and

Guadagnolo, 2006).2

In the summer of 2005, Depfa Bank was back with a second EPIC deal, this time backed by a

€900 million global portfolio of PFI loans and bonds, once again managed by Merrill Lynch.

In August 2005, TCW closed its $1.5 billion Global Project Fund III. At close, funded proceeds

from GPF III were used to purchase 15 PF loans and credit-linked notes whose underlying

obligations constituted PF loans. During the five-year investment period of TCW GPF III, the

remaining commitments were to be used to fund additional PF loans under a revolving-note

tranche and equity. Interestingly, assets were not completely known at closing, leaving a

2
PFI/PPPs refer to a range of initiatives designed to engage private sector expertise in the provision of
public services and in the construction and management of related infrastructure (Archer, 2005;
Hammami et al., 2006). A PFI project finance involves a contractual arrangement pursuant to which a
public sector entity enters into a long term contract with an SPV for the provision of construction works
as well as associated operational services. In return for these services, the public sector entity pays an
agreed fee to the SPV. This contractual scheme fits well with two ideal characteristics of PF CDOs,
namely high cash flow stability and low counterparty default risk (Guadagnolo, 2006). This explains why
six out of eight pools of assets were made up of projects referring to publicly-regulated contexts. Also the
Project Funding I deal, though US based, actually referred to regulated power production industries.

5
significant level of risk on investors. However, since investment criteria included limitations on

exposure to obligor, country, region and industry, each PF loan was required to have a

minimum credit rating of BB from Standard and Poor’s. Unlike its two predecessors, GPF III’s

notes were listed as asset-backed debt securities on the Irish Stock Exchange.

In November 2005, the £383-million Stichting PROFILE Securitization I, which was also

driven by regulatory capital considerations, came to market. The deal was a partnership between

Sumitomo Mitsui Banking Corporation (SMBC) and NIB Capital (who acted as lead arranger

on the deal). Late in 2006, Dexia entered the market with its WISE transaction, backed by a

portfolio of wrapped bonds. Finally, in March 2007 SMBC launched the SMART PFI 2007

deal.3

Empirical studies on both securitization and the syndicated loan market for PF are very limited,

but some do exist. However, a completely new field of analysis is the empirical investigation of

price determinants for PF CDOs.

Structuring such deals is more complex than traditional CDOs for many reasons.

The first is that in traditional CDOs, issuer-specific factors that influence spreads are less

important because the underlying assets included in the pool are usually more homogeneous

than in project CDOs. In the latter, in fact, every single project is characterized by deal-specific

features that makes it unique compared to the other projects included in the securitized pool.

The second reason is that reaching an appropriate size for the pool of assets is not as easy as for

traditional CDOs. In fact, it is not very common for a single bank alone to own an adequate PF

loan portfolio suitable for a securitization (unless it is highly involved in the project finance

business).4 In addition, deals closed so far have been limited by jurisdiction (UK and US) and

by sector group. (Satellite, cable, telecom, air transport, defence equipment, primary education

instruction and war zone assets have all been specifically excluded from existing deals and from

3
Both the Stichting PROFILE and SMART PFI deals involved Kfw as a zero-weighted swap
counterparty within the structure. Kfw is a German bank owned by the federal government with a mission
of supporting small and medium enterprises in Germany and promoting investments abroad.
4
Gatti et al. (2008(b)) show that the market shares of the most prestigious arrangers in the project finance
market are not as high as in other investment banking business areas and are also more volatile.

6
top – up criteria.) To manage this issue, one solution is to package loans granted by different

banks, causing the operation to become even more complex. This was one of the reasons why

NIB Capital Bank and Sumitomo Mitsui Banking Corporation pooled their loan assets in the

Stichting deal.

Another reason can be found in the intrinsic complexity of PF operations. The most difficult

task in evaluating PF transactions, in fact, is to find out whether the contractual structure is

properly designed in order to generate sufficient cash flow to service the debt and pay dividends

to sponsors (Gatti et al., 2008(a)). It is easy to see how this process becomes more complex if

applied to a pool of projects in a specific transaction structured on forecasted cash flow

dynamics.

The fourth reason for increased complexity is that defining credit events for PF loans can be

problematic, given the different nature of the projects in the pool. This was one reason why the

EPIC I and Stichting deals were limited to UK PFI/PPP projects, which had a higher degree of

homogeneity than multi – jurisdictional deals.

To the best of our knowledge, ours is the only paper that analyzes these particular kinds of

CDOs and their special features. More precisely, we investigate the relation between the spread

at launch of these CDOs, the characteristics of the deals, and the nature of underlying assets.

Our purpose is twofold. First we want to examine whether risks, specifically those affecting

securitized assets, have a significant impact on the primary market spread. Second, we intend to

analyze the other pricing characteristics that are thought to be important measures for the

primary market spread of a project finance CDO issue.

Our findings indicate that – together with rating – the nature of the underlying assets has a

substantial impact on CDO pricing, showing that primary market spread is significantly higher

when the underlying PF loans bear a higher level of market risk as compared to issues backed

by projects with low market risk exposure. The larger proportion of projects still under

construction in the securitized portfolio is another feature that explains the level of the at-issue

spread.

7
The implications of our study for the finance profession are many.

First, despite the recent crisis in the international credit market (Carlson et al. 2008; Demyanyk

and Van Hemert, 2008), PF CDOs remain a valuable means to respond to the unmet need for

infrastructural development funds. Securitization techniques could be useful instruments for

banks in order to comply with regulatory capital requirements and to increase funds available to

finance infrastructure and development projects. This is all the more true if we consider how PF

CDOs might allow subjects other than traditional financial intermediaries to contribute as

indirect lenders to the public or private infrastructural market.

Second, for institutional investors, PF CDOs represent an efficient way of gaining exposure to

the infrastructure market, and diversifying risks inherent to individual PF loans. In addition,

CDOs may offer substantially greater liquidity than single-asset project investments, attracting

investors who otherwise would not have an inclination for this type of lending. This is

particularly relevant as interest is rapidly rising in the infrastructure market creating significant

emphasis on this kind of investments.5

The rest of the paper is organized as follows. Section 1 reviews the available literature on

project finance and securitization pricing. Section 2 presents the data and methodology. Section

3 includes the results of the regressions of the pricing determinants of PF CDOs. Section 4 tests

different specifications of the model in order to provide robustness checks. Section 5 concludes.

1. Literature review

For the purpose of our paper, two different streams of empirical research are useful. The first

one refers to empirical studies on pricing of syndicated PF loans and PF bonds, the second to

empirical studies on securitization pricing.

Only a few large studies have been developed on pricing of syndicated project finance loans.

While Dennis and Mullineaux (2000) were the first to analyze the pricing determinants of

5
Deutsche Börse has developed a new Infrastructure Index (INFRAX®) in cooperation with Berenberg
Private Capital GmbH and Goldman Sachs. In fact, as rapid growth is expected in this industrial sector,
this index aims at offering to market players the opportunity to participate in this trend.

8
syndicated loans, Kleimeier and Megginson (2000) found that PF loans have lower spreads than

many other types of syndicated credits. The authors argue that spreads are lower because the

default risk of the SPV is strongly mitigated by the contractual obligations of the SPV

counterparties and by intense risk fencing. In their paper, they show that project finance loan

spreads are directly related to borrower country risk, the use of covenants in the loan contract,

and project leverage. Therefore, a third-party guarantee significantly reduces project finance

loans spreads, while loan size and maturity generally do not influence loan pricing. These

findings are confirmed by Sorge and Gadanecz (2005) who detect no significant linear

relationship between spread and maturity. Further evidence is provided by Gatti et al. (2008(a))

who demonstrate that effective ring fencing causes a drop of 19 bps in the spread charged to PF

SPVs. Blanc-Brude and Strange (2007) examine whether project risk characteristics drive the ex

ante debt pricing for PPPs. They show that where project risks are not allocated to third parties,

debt spreads reflect the unallocated portion of risk. Gatti et al. (2008(b)) explain the level of

spread on project finance loans on the basis of tranche and project characteristics and of the

prestige of the arranging bank, though they do not reveal statistical significance for the

relationship between project risks and loan spread.

Dailami and Leipziger (1997) explore the determination of credit risk premium on infrastructure

projects in developing countries. They demonstrate how the market imposes a higher risk

premium on loans in countries with high inflation and for projects in the road sector. Dailami

and Hauswald (2007) studied the impact of three key contracts stipulated by the SPV with its

counterparties on the credit spreads of actively-traded PF global bonds. They showed that

market risk perception is a function of the SPV’s contractual structure. In particular, according

to their findings the reception that a project bond will receive in global capital markets depends

on the SPV’s ability to address investors’ concerns about residual risks. When this is done,

well-designed projects can achieve significant financial gains through lower borrowing costs

and longer debt maturities. In another paper, Dailami and Hauswald (2003) also investigate the

emerging project bond market in order to study the relationship between covenant provisions

9
and the determination of bond prices. Their econometric analysis confirms that when legal and

institutional frameworks governing contract formation and enforcement are not well developed,

the link between bond pricing and the legal framework becomes important. These results are in

line with the findings of Tung et al. (2008).

Empirical studies on securitization and CDOs are numerous and have dealt mainly with

analyzing the pricing of this asset class (Fender and Kiff, 2004; Jobst, 2002; Torresetti et al,

2006 and 2007; Andersen and Sidenius, 2005). Yet, much less numerous are the empirical

studies on PF CDOs, most of which are descriptive (Archer and Guadagnuolo, 2005;

Guadagnuolo, 2006; De Vries and Jan, 2006; Tanna and Choudry, 2004) or focused on legal

aspects (Forrester et al., 1994). Firla-Cuchra (2005) examines the importance of credit ratings

and other pricing factors in determining prices of securitized debt at issue. He documents the

critical importance of credit ratings as the most significant pricing factor for structured finance

securities at launch. Vink and Thibeault (2007) demonstrate a relationship between the nature of

the assets and the primary market spread. These authors base their work on the fact that little is

known about how and why spreads of asset-backed securities (ABS) are influenced by loan

tranche characteristics. Moving from this premise, they find that default and recovery risk

characteristics represent the most important variables explaining loan spread variability. Among

these variables (and consistently with Firla-Cuchra’s findings), they identify credit rating as the

most significant in determining loan spread at issue. Pelizzon, Rettore and Sottana (2002)

compare credit spread on Residential Mortgage Backed Securities (RMBS) and Commercial

Asset Backed Securities (CABS) to credit spreads on corporate bonds and reveal that the market

only requires the same remuneration when the rating is low.

Maris and Segal (2002) analyze yield spreads on Commercial Mortgage – Backed Securities

(CMBS). The purpose of their work is to estimate the relationship between CMBS yield spreads

and other variables in order to understand the extent to which the decline in CMBS yield

spreads in the late 1990s could be explained by changes in other observable variables. They

10
eventually demonstrate that the decrease in yield spread was not directly dependent on

observable factors.

2. Data and methodology

We use the complete population of 43 separate observations, each representing a single tranche

of eight CDO transactions in Europe and the US from 1998 to 2007. No other transaction of PF

CDOs has been structured until now, so our analysis is the only complete study of this particular

segment of the CDO market.

To perform our analysis, we collected all available data on PF CDOs. The main sources of

information were the new issue and pre-sale reports issued by rating agencies (Moody’s, Fitch

and Standard and Poor’s). When data were not disclosed, we collected the missing information

through interviews with Arranging Banks and rating agency analysts. For notes listed on the

Irish Stock Exchange we also analyzed offering circulars.

We obtained market data from Thomson Datastream, and retrieved data and information on

European and US securitization markets from Deutsche Bank’s Asset – Backed Barometer and

from the online database securitization.net.

While corporate bonds are backed by cash flows from a single issuer, each CDO deal is secured

by a pool of assets which tend to be highly homogeneous, unlike the case of corporate bonds.

Therefore, while structured finance issues might generally be affected by considerably less

originator-bias, they might be critically dependent on the specific type of assets sold to the SPV.

Following the indications of John et al. (2003), Gabbi and Sironi (2005), Firla-Cuchra (2005)

and Wink and Thibeault (2007 and 2008), who all use a similar approach to empirical analysis,

we posit that spreads at launch should reflect: (1) the investors’ perception of the risk of loss

and (2) primary and secondary market efficiency and liquidity conditions (Sarr and Lybek,

2002; Favero et al., 2008).

Following this reasoning, we explain the spread over LIBOR for a tranche s issued as a part of

issue i, comprising a constant and five groups of pricing factors:

11
Spreadi,s = α + β (DEFAULTi,s) + γ (RECOVERYi,s) + δ (LIQUIDITYi) + λ (MARK_CONDSi)

+ η (ASSETS’_CRTSi) + εs,i

where:

Spreadi,s = the primary market spread over 3-month LIBOR on tranche s of

issue i;

DEFAULTi = the default risk of the underlying pool of loans of issue i;

RECOVERYi = the expected recovery rate of the reference obligations

constituting the underlying pool of loans of issue i;

LIQUIDITYi = the expected secondary market liquidity of issue i;

MKT CONDSi = the prevailing economic conditions in financial markets at the

date of issue i;

ASSETS’ CRTSi = the quality, in terms of risks, of the underlying projects’

portfolio of issue i.6

Our paper is based on primary market spread, which represents the price for the risk taken by

the lender on the basis of information at the time of issue. Primary market spread is calculated

as the spread in basis points over the corresponding benchmark for floating rate issues. For

fixed rate issues, the spread is reported in basis points over the closest benchmark of matching

maturity. Even though prices in securitization deals are almost exclusively reported against

6
It is important to note that for many types of PF loans, default and loss severity data are still fairly
limited (Gatti, 2007, ch. 8). This is because the asset class is still relatively new. While there is a track
record of over ten years for UK projects, particularly in the Private Finance Initiative/Public Private
Partnership (PFI/PPP) sectors, there is limited evidence on how public infrastructure projects perform
under stress or in default. Nevertheless, a research completed by Standard & Poor’s Risks Solutions
Group (Standard and Poor’s, 2004), involving 32 participating banks and representing 75 per cent of the
project finance market, found that while 11.7 per cent of these loans defaulted, the average recovery rate
was 72.5 per cent. This rate is higher than for unsecured corporate loans on average, where project loans
are appropriately secured and economic incentives support project debt. This finding corroborates our
data shown in Section 2.5 demonstrating, from another point of view, how PFI/PPP loans are well-suited
for PF CDO securitization.

12
LIBOR, we do not include basis in order to avoid adding a systematic market component to

results. We excluded secondary market spreads because of the relatively poor liquidity of the

secondary market for these issues. Gabbi and Sironi (2005) argue that loan spreads at issuance

reflect actual loan prices rather than estimations derived from pricing matrices or dealers’

quotes. As such, issuance spreads provide a more accurate measure of the actual cost of debt

and of the risk premium demanded by investors. Moreover, using primary market spreads also

allows us to use “fresher” ratings because ratings of new issues reflect the rating agency

assessment near the time of issuance.

Following the same approach, the independent variables used in the empirical analysis can be

grouped according to their ability to proxy one of the above-mentioned factors. Before

presenting the variables, it is essential to note that all the independent variables refer to the

projects included in the CDO issue. For this reason, we use the same value for all the tranches

belonging to the same issue, excluding RATING and CRENH (discussed in Section 2.1), which

are tranche-specific. The list of variables and sources of data are illustrated in Table A at the end

of the paper.

2.1 Default and Recovery Risk

These two factors are examined jointly, as a tranche’s rating is also a function of its expected

recovery rate in case of default (John et al. (2003). The following variables are used as proxies

for CDO default and recovery risk:

RATING Rating dummies. Each dummy variable is equal to 1 if the average rating has

the corresponding numeric grade and zero otherwise. Credit rating should

capture the difference in both the seniority and security structures of tranches.

Given the need for a consistent rating classification, we use the ratings scales in

a similar fashion as Gabbi and Sironi (2005) as shown in Table 2. This

classification scheme consists of six rating scales for the three main rating

agencies: Moody’s, Standard & Poor’s and Fitch.

13
 *** Insert Table 2 about here ***

As part of the process, we collected the credit rating classes at the time of

issuance. We used a set of six CREDIT RATING dummy variables since rating

classifications below B3 are not present. We omitted the B3 credit rating

category so as to avoid collinearity.

CRENH This variable controls for the seniority of the tranche and for the loss percentage

that the portfolio must suffer before a specific tranche is hit. Tranches with a

very high rating will suffer a loss only under very severe stress scenarios. On

the contrary, lower rated tranches with higher levels of subordination will also

be hit at low level of losses and will have a lower expected recovery rate in case

of default than senior tranches. This explains the expected negative sign of the

coefficient. However, it would not be surprising to find poor statistical

significance since subordination is already reflected in the rating of the tranche.

WAM The weighted average maturity (in years) of the issue. We preferred WAM over

nominal maturity because the latter is not a meaningful factor in structured

finance issues (Fabozzi and Goodman, 2001). A positive coefficient is expected

as longer maturity tranches require a higher spread.

2.2. Liquidity

Similarly to Firla-Cuchra (2005), in order to proxy for the expected secondary market liquidity,

we use only one variable:

LN(SIZE) The natural log of the US dollar equivalent of the total issue. In general issue

size is believed to improve secondary market liquidity. A negative coefficient

sign is therefore expected for this variable.

2.3 Market conditions

14
None of the previous studies investigating pricing for structured securities include any market

condition controls, as we do. To fill this gap we include the following variable:7

AAACLO The mid-market spreads level for an AAA-rated CLO tranche (in bps). Since

this variable proxies for the prevailing economic conditions in financial markets

at the date of issue, we expect a positive relationship with spreads.

2.4 Asset characteristics

The characteristics of the PF deals pooled in a PF CDO are particularly important for our

analysis. As we explained in the introduction, PF deals show very specific features that make

them less homogeneous than the loans used in traditional CDOs; this should be reflected in the

tranche pricing. Given the numerous idiosyncrasies of a PF transaction, we selected the

following variables as proxies for portfolio quality of underlying projects in terms of risk.

MKTRISK This is the percentage of projects included in the CDO pool with no long-term

or offtaking contracts. Some PF deals (for example in the oil and gas, power and

energy or mining industries) are based on long-term selling agreements (also

known as offtaking agreements) that shield the SPV from market risk by

obliging the long-term purchaser to buy 100% of the SPV’s output. In most

PPP/PFI, the Public Administration pays a fee to the SPV, thereby shielding the

project from market risk. Other PF initiatives, particularly in transportation

infrastructure or in the hotel and leisure industry, cannot benefit from these kind

of agreements. MKTRISK is used to account for the level of market risk to

which the pool of projects is exposed. We expect a positive coefficient although

the statistical significance of this variable could be poor because rating could

already account for market risk.

7
Although for different purposes than ours, Carlson et al. (2008) control for general market conditions
using corporate credit spreads.

15
PRJUNDCO This measures the percentage of projects included in the CDO transaction that

are still under construction. In a PF CDO, the originator can include projects

that are currently in the completion phase; this phase could be particularly long,

especially in the infrastructure industry. A larger fraction of projects under

construction could – all other factors being equal – expose investors to higher

risks of default than CDOs including only projects already in the operational

phase. As above, the expected effect is positive even though statistical

significance could be poor since most construction contracts require general

contractors to liquidate damages in case of performance deficiencies or delays

in delivering the facilities (Gatti, 2007; Yescombe, 2002).

INDCONC This measures the Herfindahl-Hirschman index referred to the industrial

concentration of the portfolio. A positive coefficient sign is therefore expected

for this variable given the lower level of diversification offered to investors.

COUCONC This measures the Herfindahl-Hirschman index referred to the geographical

concentration of the portfolio. As above, a positive coefficient sign is therefore

expected for this variable.

2.5 Descriptive statistics

In order to analyze issuance spreads, Table 3 shows the breakdown of tranches by credit rating.

*** Insert Table 3 about here ***

Average spreads per rating category monotonically increase with rating values; this clearly

indicates that spreads increase as ratings worsen. Earning a (BBB – B1) investment grade

represents a critical threshold for pricing as the average B2 tranche spread is twice that of B1.

This finding will be subsequently confirmed by the multivariate analysis.

Table 4 concentrates on the whole sample providing means, medians, standard deviations, and

maximum and minimum values for key variables.

*** Insert Table 4 about here ***

16
Table 5 presents the breakdown of variables among the different transactions in the sample.

*** Insert Table 5 about here ***

The average securitized amount is $909 million, and the mean spread is 171.30 bps above the

base lending rate, which is typically LIBOR. There is great variability in both market conditions

and weighted average maturity, with the mid-market spread of an AAA CLO tranche ranging

from 13 bps (Dec 2006) to 50 bps (Mar 1998), and WAM between 5.5 and 32 years, varying

significantly across transactions.

Of securitized PF loans, 55.03% referred to initiatives still under construction. Instead, projects

bearing market risk represented, on average, 30.52% of those constituting the underlying

portfolios.

Table 5 shows strong industrial diversification across the board, as only one transaction (Project

Funding I) almost entirely refers to projects operating in the same industry (Herfindal index

close to 10,000). The average Herfindal index for Industrial concentration (INDCON) is 4,261.

Education, health infrastructure and transportation are the main sectors of activity involved in

transactions closed to date. These industries are clearly related to public administration

investments which, in the special case of the UK, are often included in the PPP/PFI (see Figure

1).

*** Insert Figure 1 about here ***

In observing the geographical concentration of underlying portfolios (see Figure 2), it is quite

normal to find the high levels of Herfindal Indices (COUCON) reported in Table 5 because

deals are limited by jurisdictions. Almost six out of eight transactions, in fact, involve projects

operating in the same country (HHI=10,000).

*** Insert Figure 2 about here ***

17
The predominance of the PFI scheme results in industrial concentration focused on selected

sectors. At the same time, this program relies on favorable legislation, implying a high

geographical concentration in the UK.

Table 6 provides the breakdown by rating of tranche-specific variables.

*** Insert Table 6 about here ***

In keeping with our expectations, top-rated tranches (A1) report the lowest level of

subordination. We would expected, then, to observe the CRENH mean value to decrease

monotonically and significantly as the credit rating worsens. This trend seems to be confirmed,

although A3 rated tranches present a higher level of enhancement on average than A2. We have

two possible explanations. First, since both classes are above investment grade, it is reasonable

that slight differences in subordination level lose importance as far as the quality of underlying

assets is concerned. Second, the average values could be biased by contingent features related to

observed transactions.

According to the data presented above, top-rated tranches are larger than low-rated ones. The

average size for an A1 rated tranche is $75.71 million, approximately five times the value of a

B3 tranche. This finding clearly reflects the approach commonly used by originators in

securitization deals. In structured finance transactions, in fact, an issue is structured in order to

obtain a given credit rating. In light of asset characteristics, the rating agency specifies certain

conditions needed to achieve the target credit rating. Obviously, lead managers concentrate their

efforts on making the AAA tranche as large as possible in order to reduce costs and improve

transaction attractiveness for investors. This justifies the considerable size of top-rated tranches.

3. The determinants of PF CDO spreads

For all the issues in our study, we face the problem that the observations are not completely

independent, as tranches belonging to the same issue are correlated (Torresetti et al., 2006). To

solve this problem we use the Huber – White robust estimators of variance with specified

clusters, which allow us to relax the independence assumption. Obviously, clusterization is done

18
according to the distribution of tranches among different issues. Regression results are presented

in Table 7.

We start by testing a very basic form of the model including only dummy variables accounting

for tranche ratings. As previously mentioned, credit ratings for a particular tranche are achieved

by a combination of internal and external credit enhancement; hence, we expect rating to have a

critical impact on spreads.

In line with our expectations, almost all credit rating dummies are statistically significant at the

1% level, and the pattern presented by the coefficients indicates that spreads rise when ratings

worsen. Interestingly, it is noticeable how credit rating explains most of the variability, with an

adjusted R2 of 0.84. This finding is reassuringly similar to those documented by Firla-Curcha

(2005), Vink and Tibeault (2007) and Gabbi and Sironi (2005), who also explain launch spread

(albeit with reference to corporate bonds).

*** Insert Table 7 about here ***

The results presented here confirm how credit rating is crucial for pricing in structured finance;

moreover, our findings also offer some evidence to support the prediction that some investors

might base their pricing decisions almost exclusively on rating (Firla-Cuchra, 2005).

Column 3 of Table 7 reports regression results, obtained with the inclusion of all other control

variables. Combining credit rating with other pricing controls explains 94% of the total

variation in launch spread.

CRENH is statistically significant at the 10% level. The coefficient on WAM is positive and

significant, indicating that investors charge a premium for tranches with longer maturities, as

expected. Consistent with our expectations, we find the coefficient of LNSIZE to be negative

and significant, since, in general, the size of the issue is likely to proxy for liquidity.

Quite surprisingly, AAACLO shows no statistical significance. This result could be attributed to

two main factors: (i) the idiosyncrasy of securitized assets, which means that risks inherent to

projects finance CDOs are not comparable with those of traditional collateralized debt

securities, even if equally rated; this is realistic to the extent that we assume investors to be

19
primarily driven by the opportunity to gain exposure to the infrastructure market; (ii) the high

degree of specialization and limited number of project CDO investors, which causes the risk-

reward scheme to follow a tailor-made approach independent from the general conditions of

financial markets.

Finally, moving on to the peculiarities of the underlying projects, MKTRISK has a positive and

significant coefficient, indicating that project finance CDO investors require a higher risk

premium than the one implicit in the downgrading applied by rating agencies. This is true when

(given a certain rating) collateralized PF loans bear market risk and are not based on long-term

selling agreements. This relation holds for PRJUNDCO. The presence of construction risk is

reflected in the pricing of the PF CDOs, although this risk is partially covered by the payment of

liquidated damages against delays and sub-par performance by contractors. This confirms the

criticality of proper risk management of the underlying transactions.

4. Robustness checks

In order to test the robustness of our results, we take into consideration the absolute value of the

LIBOR at launch for each tranche, and with this new data we build two additional variables:

Spreadi,s/LIBOR = The ratio between the primary market spread on tranche s of issue i to

the level of 3-month LIBOR at launch; this dependent variable,

compared to the absolute value of the spread, should account for

prevailing market conditions at launch. (For example, the same 100-bps

spread indicates two different situations if the 3-month LIBOR at

launch is 3% instead of 4%.)

AAACLO/LIBOR The mid-market spreads level for an AAA rated CLO tranche (in bps)

over the level of 3-month LIBOR at launch. The inclusion of this

independent variable is justified for the same reasons as the previous

variable.

20
The inclusion of the above variables allows us to specify different models. We test whether the

prevailing market conditions on the CDO market play an important role in price setting or if

instead idiosyncratic components of risk for every deal are more important to investors when

deciding the price of a tranche. The results are shown in Table 8. Model I is the base model

already discussed in Section 3, included here to make comparisons among the models easier.

Model II substitutes the absolute AAACLO spread for the relative one. Models III and IV use

the relative spread/LIBOR value as a dependent variable.

*** Insert Table 8 about here ***

In observing these data, a general robustness of the results emerges. Also the levels of the

adjusted R2 remain satisfactory and always close to the 90% mark.

The rating coefficients are robust and statistically significant across all the specifications of the

model, except for the B2 rating dummy which is insignificant in Models III and IV. The

negative relation with both absolute and relative spreads is confirmed (given the negative sign,

lower ratings require higher spreads).

CRENH coefficients are robust and statistically significant at the 10% level in all regressions

except Model III. Therefore, the evidence included in Table 7 is corroberated: lower recovery

values are associated with higher spreads. (Put another way, the higher the level of losses on the

portfolio before a tranche starts suffering losses, the higher the credit enhancement for that

tranche and the lower the spread required by investors.)

Our findings confirm the importance of WAM and LN(SIZE) in price setting for PF CDOs.

Smaller sized tranches with longer maturities require higher absolute and relative spreads. Since

size can be considered a proxy for liquidity, this implies that a higher liquidity contributes to

lowering the level of pricing.

It is interesting to note that the coefficients of both the AAACLO and AAACLO/LIBOR

variables are always insignificant in all models. Again, this confirms that investors in PF CDOs

are more concerned about the specific risk profile of the underlying assets than the absolute or

relative spreads prevailing on the market at launch. This argument is confirmed by the sign and

21
the statistical significance of the MKTRISK and PRJUNDCO variables, which are robust across

all the models.

5. Summary and conclusions

The recent financial crisis and the contagion effect that financial markets have had on the real

economy have forced many governments to carry out intense intervention aimed at increasing

the level of private investments in an effort to strengthen respective economies. Part of this

intervention is related to measures for improving and strengthening the infrastructure capital of

the country. Although completely understandable, this goal clashes with severe budget

constraints that many governments are already facing today. The bottom line is the need for

private investment in public infrastructure which in turn calls for a substantial increase of PPP

projects in the future. In this scenario, project finance is destined to remain one of the growing

business areas of structured finance.

Furthermore, the mounting interest of financial investors for the infrastructure market suggests a

new role for the securitization technique backed by project finance deals.

The analysis of PF CDOs has never been addressed before in academic literature. With this

paper we intend to fill this gap by investigating the price determinants of structured finance

issues backed by project finance loans. In particular, the purpose of this work is to provide

empirical evidence on the relationship between the nature of the collateralized assets and the

primary market spreads of CDO tranches.

We conducted an empirical analysis of launch spreads on eight project finance CDO issues

(representing the full population of all the deals globally closed to date). Our results indicate

that, contrary to what happens in other kinds of securitization deals, the idiosyncratic

components of risk inherent to underlying projects play an important role in defining the spread

of the CDO. Of these components, our analysis clearly shows that the percentage of projects

still under construction at the moment of the CDO launch and the percentage of projects that are

subject to market risk are two characteristics that influence the spread of PF CDOs.

22
We wish to point out that while the rating criteria for infrastructure and public finance have

already been developed by rating agencies (Standard and Poor’s, 2005), the criteria for project

finance CDOs have yet to be unequivocally established. The very limited evidence in this

respect (Fitch 2008) confirms our empirical findings, These results reveal the complexity of

applying methodologies and pricing models used for corporate bonds (see for example Black

and Cox (1976); Longstaff and Schwartz (1995) and Duffie (1998)), or for other more

established CDO/CLO transactions. This complexity can be attributed to the lower granularity

of the portfolio (or conversely the higher industry and geographical concentration) and a lower

level of standardization of the underlying assets in project finance CDOs..

23
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27
 Table 1 – Transactions record
Project Finance CDOs closed in the period between 1998 and 2007. For the three highlighted
transactions, information was collected through interviews since some data were missing (TWC GPF I) or
data were not disclosed at all (Project Funding Corp II and Project Securitisation I).

Transaction Year Size (mil) Risk Transfer Originator Maturity

Project Fund Corp I 1998 $ 617 True sale CSFB 2012

Project Fund Corp II 1999 n.a. True sale CSFB n.a.
Project Securitisation I 2001 n.a. True sale Citigroup n.a.
TCW GPF I 2001 $ 500 True sale TCW Group n.a.
TCW GPF II 2004 $ 700 True sale TCW Group 2016
EPIC I 2004 £ 392 Synthetic Depfa Bank 2038
EPIC II 2005 € 900 Synthetic Depfa Bank 2044
TCW GPF III 2005 $ 1500 True sale TCW Group 2017
Stichting PROFILE 2005 £ 383 Synthetic SMBC-NIBC 2041
WISE 2006 £ 1500 Synthetic Dexia 2041
SMART PFI 2007 £ 400 Synthetic SMBC 2044

Source: Fitch Ratings, Standard and Poor’s and Moody’s pre – sale reports (1998 – 2007)

Table 2 – Rating scales

Rating Agency
Moody’s Standard & Poor’s Fitch

A1 Aaa/Aa1 AAA/AA+ AAA/AA+

A2 Aa2/Aa3 AA/AA- AA/AA-
A3 A1/A2/A3 A+/A/A- A+/A/A-
B1 Baa1/Baa2/Baa3 BBB+/BBB/BBB- BBB+/BBB/BBB-
B2 Ba1/Ba2/Ba3 BB+/BB/BB- BB+/BB/BB-
B3 B1/B2/B3 B+/B/B- B+/B/B-

28
 Table 3 – Spread - breakdown of tranches by rating
Tranche n° Mean Median Std. Dev. Min Max

A1 12 41.42 38 18.47 26 90
A2 8 66.38 57.5 32.09 37 135
A3 8 121.63 107.5 56.65 55 215
B1 7 209.29 200 75.13 100 350
B2 6 470.83 450 149.51 300 725
B3 2 537.50 537.5 53.03 500 575

Source: Fitch Ratings, Standard and Poor’s and Moody’s pre – sale reports (1998 – 2007)

Table 4- Summary statistics for the entire sample

Each tranche is considered as a separate observation. For a definition of the variables see Table A.

Variable Mean Median St Dev Min Max n°

AAACLO 24.84 19.00 11.71 13.00 50.00 43

lnsize 6.81 6.59 0.44 6.43 7.99 43
crenh 8.29% 5.39% 8.90% 0.00% 42.86% 43
wam 13.98 15.00 7.18 5.50 31.70 43
couconc 8062 10000 3225 2303 10000 43
indconc 4261 3467 1894 2529 9072 43
prjundco 55.03% 58.82% 31.68% 4.88% 100.00% 43
mktrisk 30.52% 16.53% 39.55% 0.00% 100.00% 43
spread 171.30 90.00 176.52 26.00 725.00 43

Source: Fitch Ratings, Standard and Poor’s and Moody’s pre – sale reports (1998 – 2007)

29
 Table 5 - Transaction-specific variable
AAACLO Ln(size) Wam Couconc Indconc Prjundco Mktrisk

EPIC1 24 6.59 21.00 10,000 2,529 16.67% 25.00%

EPIC2 18 7.04 14.08 2,303 4,182 53.13% 16.53%
PRJFUN 50 6.43 5.50 9,524 9,072 4.88% 4.88%
SMART 14 6.66 15.00 10,000 3,377 58.82% 0.00%
STICH 19 6.50 16.00 10,000 3,301 61.29% 6.45%
TCW II 38 6.55 6.00 3,050 5,000 100.00% 100.00%
TCW III 25 7.34 7.40 10,000 3,750 100.00% 100.00%
WISE 13 7.99 31.70 10,000 3,467 47.83% 0.00%

Total 24.84 6.81 13.98 8,062 4,261 55.03% 30.52%

Source: Fitch Ratings, Standard and Poor’s and Moody’s pre – sale reports (1998 – 2007)

Table 6 - Tranche-specific variable (Standard deviation in parenthesis)

n° Crenh Tranche size

A1 12 11.73% 75.71
(11.07%) (149.48)

A2 8 8.69% 31.24
(11.35%) (29.95)

A3 8 9.50% 22.56
(7.39%) (20.82)

B1 7 6.29% 20.36
(5.45%) (19.93)

B2 6 4.09% 13.68
(4.75%) (8.55)

B3 2 0.85% 15.92
(1.20%) (10.67)

Total 43 8.29% 37.10

(8.90%) (82.23)

Source: Fitch Ratings, Standard and Poor’s

and Moody’s pre – sale reports (1998 – 2007)

30
 Table 7 – Linear regressions of spread

The regression for spread is estimated with OLS and both R2 and adjusted R2 are reported as goodness-
of-fit measures. ***, **, and * indicate that the coefficients are significantly different from zero at the
1%, 5% or 10% level, respectively. Robust Huber – White standard errors are reported in parentheses
Regressions (I) test a very basic form of the model including only dummy variables accounting for rating
of tranches. Regression (II) reports results obtained with the inclusion of all other control variables. For
a definition of the variables see Table A.

Coefficients (standard errors)

I II

A1 (0/1) -496.083 -507.185

(15.52)*** (32.29)***
A2 (0/1) -471.125 -507.031
(13.59)*** (26.32)***
A3 (0/1) -415.875 -463.275
(11.81)*** (23.69)***
B1 (0/1) -328.214 -379.357
(9.15)*** (19.37)***
B2 (0/1) -66.667 -114.405
(1.01) (37.22)***
CRENH -403.064
(225.85)*
WAM 7.331
(2.57)***
LN(SIZE) -84.742
(28.05)***
AAACLO 2.870
(1.307)
MKTRISK 136.602
(28.45)***
PRJUNDCO 178.579
(88.16)**
Constant 537.500 868.099
(17.80)*** (96.00)***

Observations 43 43

R-squared 0.8610 0.9578

Adj R-squared 0.8422 0.9428

31
 Table 8 – Robustness checks of the determinants of CDO spreads

This table reports robustness checks for the base complete model included in Table 7, column II. Model I
is the complete model with the absolute spread as dependent variable and is reported in this table for
convenience of comparison. Model II uses the absolute spread as dependent variable but the relative
value of the AACLO spread/LIBOR as a regressor. Models III and IV use the relative spread/LIBOR as
dependent variable. The absolute AACLO spread and the relative AACLO spread/LIBOR are used as
independent variables respectively. All regressions are estimated with OLS and both R2 and adjusted R2
are reported as goodness-of-fit measures. ***, **, and * indicate that the coefficients are significantly
different from zero at the 1%, 5% or 10% level, respectively. Robust Huber – White standard errors are
reported in parentheses For a definition of the variables see Table A.

Coefficients (standard errors in parenthesis)

Model I Model II Model III Model IV

(spread) (spread) (Spread/LIBOR) (Spread/LIBOR)

A1 (0/1) -507.185 -515.628 -0.825 -0.830

(32.29)*** (32.04)*** (0.103)*** (0.110)***
A2 (0/1) -507.031 -514.625 -0,834 -0,842
(26.32)*** (27.35)*** (0.09)*** (0.101)***
A3 (0/1) -463.275 -469.995 -0.735 -0.741
(23.69)*** (25.94)*** (0.09)*** (0.104)***
B1 (0/1) -379.357 -386.27 -0.566 -0.576
(19.37)*** (20.69)*** (0.085)*** (0.096)***
B2 (0/1) -114.405 -121.889 -0.04 -0.055
(37.22)*** (34.47)*** (0.127) (0.126)
CRENH -403.064 -387.954 -0.878 -0.942
(225.85)* (210.76)* (0.546) (0.482)*
WAM 7.331 5.824 0.017 0.015
(2.57)*** (1.67)*** (0.006)*** (0.004)***
LN(SIZE) -84.742 -62.169 -0.206 -0.166
(28.05)*** (19.03)*** (0.067)*** (0.054)***
AAACLO 2.870 0.004
(1.307) (0.005)
AAACLO/LIBOR 23.007 0.045
(10.20) (0.033)
MKTRISK 136.602 83.86 0.346 0.227
(28.45)*** (45.60)* (0.081)*** (0.120)*
PRJUNDCO 178.579 164.899 0.404 0.428
(88.16)** (72.76)** (0.204)* (0.158)**
Constant 868.099 727.58 1.759 1.433
(96.00)*** (168.42)*** (0.246)*** (0.288)***

Observations 43 43 43 43

R-squared 0.9578 0.959 0.919 0.923

Adj R-squared 0.9428 0.945 0.890 0.896

32
 100%
Other
90%
80%
Public accomodation
70% (Offices, prisons, courts)
60%
Education
50%
40% Transport
30%
20% Hospitals
10%
0% Water
SMART EPIC I EPIC II STICH PRJFUN WISE

Figure 1. Breakdown of transactions by industry

100%
90% Other EU Australia
80%
70% Japan Spain
60%
50%
Canada Portugal
40%
30%
Chile USA
20%
10%
0% UK
SMART EPIC I EPIC II STICH PRJFUN WISE

Figure 2. Breakdown of transactions by country

33
 Table A – Definition of variables

Variable Description Source Variable type

spread Spread over 3-month LIBOR (in bps) of Pre-sale reports Dependent

tranches variable

wam Weighted average maturity (in years) of Pre-sale reports control variable

the issue

AAACLO Mid market spreads level for a AAA rated Datastream, control variable

CLO tranche (in bps) Asset backed

barometer –

Deutsche Bank*

lnsize Natural log of the total issue US dollar Pre-sale reports control variable

equivalent amount

crenh Percentage of tranche’s seniority Pre-sale reports control variable

couconc Herfindahl-Hirschman index measuring Pre-sale reports control variable

geographical concentration of the portfolio

indconc Herfindahl-Hirschman index measuring Pre-sale reports control variable

industrial concentration of the portfolio

prjundco Percentage of projects still under Pre-sale reports control variable

construction at issue.

mktrisk Percentage of projects with no long-term Pre-sale reports control variable

or off-taking contracts at issue.

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rating Rating dummies. Each dummy variable is Pre-sale reports control variable

equal to 1 if the average rating has the

corresponding numeric grade and zero

otherwise

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