FINANCIAL SERVICES RESEARCH REPORTGet smart or get out:Structured finance
ContentsSummary3What is structured finance?5Market context: Size and trends7Product economics19Business models and strategic implications29Conclusion38Originally published in July 2006 by Mercer Oliver WymanOliver Wyman1 Neal StreetLondon WC2H 9QLUnited Kingdomwww.oliverwyman.com
SummaryStructured finance is an apparently attractive business. From its troughin 2002, the market has grown rapidly. In 2005, global origination ofstructured finance loans reached an all time high of 1 TN, generating 60 BN in revenues for the financial services industry.Beneath these impressive figures, however, lies significant variation ineconomic return to financial institutions. Arrangers capture 40% oftotal revenues and typically enjoy a return on economic risk capital inthe range of 20 to 30%. Yet competition for the arranger role is stiff, anda low success rate can spoil the average return of those few deals thatare won. Nor is participation uniformly profitable. Because structuredfinance deals are complex and often lack public ratings, their risk canbe difficult to measure. Unsophisticated participants frequently underestimate and therefore under-price the risk.In structured finance, the best do much better then the rest: a fact thatcurrent market trends will only reinforce. For although demand forstructured finance is growing – driven by an M&A boom, increasingglobal trade and infrastructure investment – supply is growing faster,with large institutional investors entering the market in search ofyield and diversification. As margins decline and deals get riskier, sounsophisticated players will increasingly participate in under-priceddeals. And growing competition for the profitable arranger role willdrive down the success rate and average returns of all but the mostskillful.We have identified four structured finance business models that webelieve to be viable: Smart participant – Highly selective participation based onsophisticated cash flow simulation-based risk measurement toolsSmart arranger – As above, plus a focussed arrangement strategywith a high conversion rate, strong distribution capabilities and tightcost managementCross-sell focused arranger – As above, plus systematic capture ofcross-sell revenuesIntegrated arranger – As above, plus structured finance functionallyintegrated with the broader financing and capital markets business tocapture the ‘profitability multipliers’ inherent in an end-to-end creditbusinessCopyright 2006-2007 Oliver Wyman
These smart business models are not the industry norm. Moststructured finance players exemplify one of the following unsustainablemodels: Typical arranger – Targets lead arranger role but insufficient focusresults in a low conversion rate, heavy participation and inflatedcosts designed for a larger businessTypical participant – Views structured finance as more profitabledeployment of capital than vanilla credit, but lacks the riskmeasurement capabilities to select the most profitable dealsWith competition increasing, even players with smart models will needto invest in retaining and developing talent to sustain profitability.Typical participants will need to undertake a dramatic transformationof their business. For many, the task will be too hard. They should exitthe market, since the risks from adverse deal selection are great. Themessage is harsh but simple: get smart or get out. Copyright 2006-2007 Oliver Wyman
What is structured finance?Throughout this report we have categorised structured finance into fourproduct categories: Acquisition finance, including corporate M&A finance, LBO financeand recapitalisation finance Project finance, including PPP/PFI finance Export finance, structured ECA (Export Credit Agency) backed only Asset finance, large ticket only, including aircraft, shipping and railfinanceThese structured finance products have the following distinctivecharacteristics: Maturity: Structured finance deals are long term (maturity greaterthan one year)Use of funds: Funds are provided for a specific purpose (e.g. tofinance a project or the acquisition of specific assets, with revenuesfrom the project or asset legally tied to loan interest and capitalrepayments)Deal structure: The loan is tailor-made to specific client needs,in terms of repayment profile, risk mitigation structures, interestrates, legal structure (e.g. in several cases the borrower is an SPVestablished specifically for the transaction)Payments and recourse: Most structured finance loans are nonrecourse. Payments are funded by the cash flows linked to the specialpurpose vehicle (SPV), project or asset being financed and the lenderhas recourse only to the linked assets or project in case of default.This disconnects the risk of the loan from the borrower’s creditratingThe table below contrasts structured finance products with vanillafinance (e.g. corporate revolvers, general purpose loans).Vanilla financeNon-specific and not legallyUse of funds bindingDealstructureSimple, sometimescollateralised, with limitedtailoringPaid by borrower, withrecourse to entire borrowerPaymentsasset base (subject toand recourse seniority)Copyright 2006-2007 Oliver WymanStructured financeLegally linked to a specific assetor projectComplex and often highlytailored to suit specific needsand cash flowsPaid directly by linked cashflows, with no (or limited)recourse to the borrower’s otherassets
Structured finance products provide several benefits to both borrowersand lenders, as shown below.Borrower benefits Lender benefits Larger and longer facilities available:access to international pools ofliquidity Higher profitability due to higherfees and higher margins comparedto vanilla lending Lower cost of credit for lower-ratedborrowers Reduced risk due to collateralisationand legally binding use of funds Loans are often off-balance sheetand so do not affect key ratios andindicators Access to larger deals which wouldotherwise have been beyond thereach of smaller participants Higher leverage ratios can beachieved, without any riskcontamination in case of failure Extensive due-diligence reducespotential for unexpected risks Flexibility around terms of the loan:structuring of loan to match asset orprojectCopyright 2006-2007 Oliver Wyman
Market context: Size and trendsGlobal origination of structured finance loans reached an all time highin 2005 of 1 TN across acquisition, project, asset and export finance.This is more than double the levels of the recent trough in 2002 andequivalent to a 40% 3-year CAGR (Compound Annual Growth Rate).Figure 1: Global structured finance new loan volumes by product typeDeal volume BN1,2001,000800600400200020002001Acquisition finance2002Project finance2003Asset finance20042005Export financeSource: Thomson Financial, Project Finance International, Oliver WymanStructured finance volumes experienced rapid growth in the late 1990sas booming M&A markets fuelling acquisition and project financedeals. However, the telecommunications and energy crashes, the M&Aslowdown and global airline crisis over 2001 and 2002 drove originationvolumes down by more than 40%. Increased default rates createduncertainty around all products.The market returned to growth in 2003 with renewed interest across allproducts on both the demand and supply sides. We expect this growthto continue, albeit with different trajectories across products: Acquisition finance: Sustained growth driven by the continued high,but unpredictable, level of M&A activity. LBO Finance will grow asfunds continue to flow into the Private Equity business. Institutionalinvestors will be a growing source of funds as they search for yieldand diversificationProject finance: Pockets of growth, particularly infrastructurefinance in both developing countries (driven by goodmacroeconomic indicators and high commodity prices) and PPP/PFI in developed countries (as governments look for alternative waysto fund infrastructure development)Asset finance: Continued growth, with shipping driven byincreasing export volumes and a recovery in the US aviationindustry adding to activity in Europe and AsiaCopyright 2006-2007 Oliver Wyman
Export finance: Continued growth driven by world trade and exportvolumes, although at a slightly slower rate, as the improved creditenvironment allows importers to access local credit without ECAguarantees Acquisition financeAcquisition finance is the largest product category in structured finance,contributing 68% of total volumes across corporate M&A finance, LBOfinance and recapitalisation finance. Origination reached 725 BN in2005, after growing at 47% CAGR since 2002.The technology and internet boom of the late 1990s generated stronggrowth in both the M&A and acquisition finance markets, particularlyin the telecom sector. After the bubble burst, acquisition financevolumes fell to less than 250 BN in 2002, 50% down on the 2000 peak.Figure 2: Acquisition finance volumes by region and type of dealM&A dealvolume TNDeal volume BN8001270010600Deal volume 01US20022003Europe20042005ROWM&A activity1000200020012002200320042005Corporate acquisitionsLeveraged buyoutsRecapitalisationSource: Thomson Financial, Oliver WymanVolumes have rebounded strongly since 2003. Private equity has seena substantial inflow of capital as investors turn to alternative assetclasses targeting higher returns which triggered a wave of LBO activity.This demand for finance has found a willing supply of funding frominstitutional investors and hedge funds seeking higher returns on debtinvestments. Indeed, supply has been stronger than demand in theUS, due to the lack of M&A activity in the region and the maturity ofthe institutional investor market. Recapitalisations are also growing,following a lagging trend to LBO finance, as financial sponsors look tore-leverage their investments and realise returns by extracting cash.Acquisition finance net interest margins have been stable over the lastfive years, with LBO and recapitalisation loans hovering around 250bps and corporate M&A lending around 100 bps. Up-front fees arelow for corporate M&A, at around 50 bps for arrangers (and 25 bps forparticipants), while LBOs and recapitalisations can generate 150 to 200bps for arrangers (and half that for participants). Copyright 2006-2007 Oliver Wyman
Figure 3: Net interest margins on acquisition finance loansAverage margin (bps)300250200150100500199920002001Corporate ce: Thomson Financial, Oliver WymanWhile margins have been flat, risk taking has increased. Leverageratios (the ratio of debt to EBITDA – Earnings Before Interest, Taxes,Depreciation and Amortisation) have risen and the risk mitigatingterms and conditions attached to these leveraged loans have becomeweaker. Many banks over-estimate the risk adjusted profitability of dealsbecause their risk methodologies cannot reflect the impact of changesto terms and conditions. Default rates remain low and the impact onrecovery rates has not yet been tested. However, the concerns indicatedby several players could lead to a future increase in margins or slowergrowth in the supply of funds.The acquisition finance market is concentrated, with the top five playersarranging more than 33% of volumes. Banks with a strong presence inthe M&A market are ideally positioned to provide acquisition finance, asthey are already involved in deals. This is true of banks advising sellersas well as buyers. ‘Stapled financing’ – where an adviser for the seller ofa business provides financing for the buyer – is now a common featureof leveraged deals. This can encourage interest from financial sponsors,who know that at least one funding package is on offer, but it can alsolead to conflicts of interest.We expect continued strong growth in acquisition finance in the shortterm. The M&A boom looks set to continue through 2006 and will bringwith it the need for financing. Asia and Europe are likely to be the areasof highest growth. Further out, however, volumes are difficult to predictand several market participants have expressed concern over a slowingof the M&A pipeline. Nevertheless, we expect continued growth in theprivate equity market to provide a sustained pipeline for LBO finance.Copyright 2006-2007 Oliver Wyman
Project financeProject finance contributes approximately 17% of total structuredfinance volume. Origination reached 175 BN globally in 2005(including loans and bonds), growing at a 35% CAGR since 2002.Figure 4: Historical project finance volumes (loans and bonds) by regionDeal volume ope20042005ROWSource: Thomson Financial, Project Finance International, Oliver WymanProject finance grew rapidly in the late 1990s, particularly in the UStelecoms and energy sectors, and in the UK PPP/PFI sector. The USenergy crisis and the bursting of the telecoms bubble caused a sharpdecline in 2002 and changed expectations of the projects being financed,with a deterioration in credit grades and a substantial increase inprovisioning by many lenders.The emerging markets led the recovery in 2004, with volumes growingto 44% of global origination in 2005. Asia, the Middle East and LatinAmerica all experienced growth rates over 100%, with South Korea,Qatar and Mexico each generating volumes over 5 BN in 2005. Strongeconomic development in these countries has generated both thelocal pressure as well as the funding required to develop better localinfrastructure. The rise of oil prices has also provided some developingcountries with large cash flows, and improved the attractiveness of oilrelated projects such as extraction and refineries.We expect project finance to continue growing strongly in bothdeveloped and developing markets. A joint study by the ADB, JBIC andthe World Bank released in 2005 reported that emerging countries inEast Asia alone need an estimated 200 BN in annual investments until2010 to develop their local roads, water, communications, power andother infrastructure.The sector breakdown of project finance volumes varies considerablybetween regions and has changed markedly over time. Telecoms wasthe second largest global sector in 2000 after power, representing25% of global volumes, as companies invested in third generationinfrastructure. Volumes have since dropped significantly to 7% of globalorigination.10Copyright 2006-2007 Oliver Wyman
Infrastructure finance has been the fastest growing sector, more thandoubling from 14% of volumes in 2000 to 34% in 2005. This growth hasbeen driven mainly by upgrading old infrastructure in Europe, (wherethe PPP/PFI structure pioneered in the UK has been adopted by severalother countries) and by new infrastructure investments in emergingeconomies. North America is a relatively small market for infrastructurefinance, because tax efficient municipal bonds provide a cheaper way forthe government to finance investments.Figure 5: Evolution of project finance sector concentration by region% of tructure20002005Natural resourcesIndustry and servicesSource: Project Finance International, Oliver WymanThe competitive landscape in project finance has changed considerablyover the last five years. The market has become more fragmented, withthe arranging share of the top 10 global players falling from 66% in 2000to 30% in 2005. The economic turmoil in the US energy and telecomssectors resulted in a number of high profile project finance defaults.Several players with large exposures to these sectors scaled backsignificantly. This included two of the top five arrangers, who publiclywithdrew from the market completely. Regional and smaller localplayers stepped in to capture share as volumes recovered.Despite the high default rates in 2001/02, actual losses were lessdramatic. In the power sector, for example, recovery rates were upto 90%. Those banks that remained committed to project financethroughout the downturn avoided the level of losses initially feared (andprovisioned for) by managing the restructuring and recovery processeffectively.The complexity of project finance deals allows arrangers to charge upfront fees in the region of 75 to125 bps, and occasionally up to 250 bpson smaller deals. However, significant effort and expense is involved inanalysing the cash flows and structuring deals to align risks and returns.Participants’ lower up-front investment in deal analysis means they tendto receive up-front fees between 40 and 60 bps.Copyright 2006-2007 Oliver Wyman11
Interest margins have been under significant pressure as marketliquidity has outpaced the rapid growth in demand. Average interestmargins across all project finance deals globally have declined steadilyfrom 150 bps in 1999 to 110 bps in 2005. Also driving down overallmargins is the larger portion of lower risk-return infrastructure finance.Many recent PPP/PFI deals have enjoyed ratings of AA and above.PPP/PFIPublic Private Partnerships (PPPs) and Public Finance Initiatives (PFIs)refer to projects in which the public and private sectors work togetherto develop services and infrastructure. A PPP is any alliance betweenpublic bodies, local authorities or central government and privatecompanies. PFI is one of the principal models of PPP, where the publicsector transfers to the private sector responsibility for the provision ofinfrastructure, products and services.PPP/PFI has three main advantages over traditional public investment: Deals may sit outside the public sector’s balance sheet and thereforedo not affect macroeconomic debt indicators By introducing private sector investors who put their own skills andcapital into the project, the public sector benefits from commercialefficiencies and innovations and timely delivery. (On-time and onbudget delivery is typically twice as frequent, and overall costs are 15to 20% cheaper) Risks are allocated between the public and private sector to the partybest able to manage themPPP/PFI structures were originally developed in the UK but haverecently been adopted by other countries across Europe, North Americaand Asia. Future demand is expected to be strong, with over 200 BNof global investment needs already publicly announced as planned forthe next 5 to 10 years by various governments. Legal frameworks andresponsible public bodies are being put into place, development andinvestment plans are being drafted and the potential private participantsare lining up to arrange the finance, building, execution and operationof the projects.12Copyright 2006-2007 Oliver Wyman
Asset financeAsset finance represents 8% of total structured finance volumes, withrecent new loan volumes of 80 BN in 2005. Volatility of asset financevolumes over the past six years has been lower than other categories ofstructured finance, because the different cycle timing of the underlyingproducts (aircraft, ships and rolling stock) provides some diversification.Figure 7: Asset finance volumes over time and aircraft/ship units deliveredDeal volume BNNumber of 03Aircraft deliveries200420050Ship deliveriesSource: Airbus, Boeing, Eurofima, Thomson Financial, UNCTAD, Oliver WymanUntil 2000 the market was dominated by aircraft financing deals,which accounted for 60% of global origination. However, recent eventshave increased the overall importance of ship and rail finance, whichrepresented 40% and 15% of total volumes respectively in 2005. Thisshift was driven by the continuing crisis in the airline industry, theboom of global trade with Asia and the increased pace of railroadprivatisations in Europe.Aircraft financeThe aviation industry has been through turbulent times sin
The table below contrasts structured finance products with vanilla finance (e.g. corporate revolvers, general purpose loans). Vanilla finance Structured finance Use of funds Non-specific and not legally binding Legally linked to a specific asset or project Deal structure Simple, sometimes collateralised, with limited tailoring Complex and often .
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