In this blog tutorial the Video Financial Modelling team dives into the world of mini-perms. And no we are talking about those 80’s hairstyles.
What are Mini-Perms?
Mini-perms are lending instruments which are intended to be refinanced out after a short timeframe usually 5-7 years. A number of project finance and PFI deals have been done using a mini-perm financing structure given the lack of liquidity in the long term lending market post the GFC. In this tutorial we will look at why mini-perms are being taken up, the different types of mini-perms and the issues related to these instruments.
Why are mini-perms being taken up?
Mini-perms have been promoted by banks, in a large number of financial markets, including in the UK PFI market. The main reasons for their use include:
i. concerns over long-term liquidity – an example of this is the introduction of Basel III outlining a global regulatory standard for capital requirements;
ii. the banks’ inability to underwrite and syndicate deals, with the resultant dependence on bank clubs for funding. i.e. banks are being forced to lend and hold; and
iii. a certain degree of opportunism among those banks still in the market.
Where there is limited liquidity for deals, banks prefer mini-perms given the short term over which they can amortise their arrangement fees. In addition there are fewer active lending banks in the post GFC world (i.e. less competition), hence there where a process isn’t competitive or there is limited appetite banks can dictate there terms.
Types of mini perms
There are typically two types of mini-perms a hard mini-perm and a soft mini-perm. We will look at each in turn.
Hard Mini-Perm
A hard mini-perm is a short term loan that mimics a longer term amortisation profile, but with a bullet repayment at the end of the tenor. Legal maturity of this instrument is typically around 5-7 years, forcing the borrower to refinance before maturity or face default. The main disadvantage is the default and refinancing risk for all stakeholders (funders, borrower and Government), which in a PFI deal may mean the termination of the Concession. Soft Mini-Perm
A soft mini-perm is a long term loan with a mechanism to incentivise the borrower to refinance after an initial short period usually 5-7 years. Two methods for incentivising the borrower include:
1) ratcheting up margins post the initial period; and
2) using a cash sweep post the initial tenor
A soft mini-perm is a structure without the default risk of a hard mini-perm, where the loan maturity remains long-term. The soft mini-perm has been used in UK PFI and continues to be promoted by banks on a number of projects. Mini-Perm Financial Modelling
Let’s look at some examples of mini-perms assuming the following inputs. You can follow along by downloading the spreadsheets and youtube video. Also note that this analysis assumes that there are no refinancing fees etc.
For all scenario below we use LIBOR of 400bps, and an ongoing CFADS of 1,300 per month.
Hard mini-perm: 5 year initial tenor, bullet at maturity, amortisation profile mimics 20 year tenor, margins 250bps and a credit foncier repayment profile. Note that a credit foncier repayment profile is like a home loan mortgage with fixed instalments. See our tutorial, CFADS and DSCR sculpting, which goes into the credit foncier repayment profile in depth.
Using the actual margins for the hard mini-perm we get the following.
As mentioned the hard mini-perm is only short term debt and hence has no margins post the initial tenor. Borrowers usually have to estimate the margins post this short term debt tenor. Note that given the short legal tenor of the facility, the borrower must refinance the loan at the end of the initial tenor.
If the borrowers were to assume that the margins continue at 250bps we would get a normal credit foncier profile as per the below. Given the constant CFADS we would get a DSCR that is constant.
Soft mini-perm: 20 years, margins 250bps then ratcheting up to 500bps post 5 years
As you can see in the below the rachet up in margins after the initial tenor of 5 years causes the debt service to increase in mid 2016. With a constant CFADS this margin rachet would decrease the DSCR and eat into potential equity distributions.
Given the high debt service post margin rachet (and the likelihood of these rates occurring) borrowers usually assume different margins post the margin rachet. If we assume that the margins continued at 250bps then we would have the exact same profile as in the hard mini-perm assumed rates case.
As you can see from the above although the dynamics of soft and hard mini-perms are quite different it could be that borrowers could assume the same financial forecasts, particularly with respect to debt service modelling. One should note however, that the hard mini-perm is inherently more risky given the refinance/default risk. Now let’s look at a number of issues which occur with both hard and soft mini-perms.
Issues with mini-perm structures
There are a number of issues which borrowers face with mini-perm structures. These include:
i) Hedging: do you put a short term swap in or long term swap? Short term swaps will face refinancing risk on the underlying rate, usually LIBOR. Long term swaps assume a certain repayment profile which may change over time;
ii) Affordability: what assumptions do the stakeholder (predominantly the borrower and the Concession grantor) make about margins, underlying interest rates, tenor and amortisation profile;
iii) Sharing of risks: who takes the risk on margins, underlying interest rates, tenor and amortisation profile?
The above issues are resolved on a project by project basis.
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