Professor Gorelick has been working in development finance for the past 17 years, first on Wall Street and later for charitable foundations, bilateral aid agencies, multilateral aid agencies and development finance institutions. He has been responsible for leading a wide variety of transactions, totaling over US $1.3 billion. His primary area of interest is assisting sub-national governments to source financing for urban infrastructure projects. He is currently supporting several bilateral and multilateral organizations – DFID, IFC, AFD – in their efforts to mobilize finance for large-scale development projects. Previously, he was the Senior Infrastructure Finance Advisor for the USAID-financed WASH-FIN program designed to help utilities and municipalities across Africa and Asia raise money for water and sanitation projects. Prof. Gorelick served as the Lead Technical and Financial Advisor for the City of Dakar’s Municipal Finance Program to launch a USD 40 million municipal bond.
Part 1 of 4: Required Steps for Municipal Finance
For utilities and municipalities needing external financing, what are the key steps they should follow?
I want to reframe the question, or at least clarify the vocabulary that we’re using. The use of the word “need” implies that that everybody has come to the consensus that the need exists, and the way to answer that need is through external financing. We should take a step back and question the need for finance and on what this need for finance is predicated. Does it result from an expectation that external sources are the last hope for a utility? Is it that external financing is more attractive than other options? Or is it because there’s a way to match the useful life of an asset to the financing which is available? Or is it a misunderstanding that external finance is easier to access? And, easier to put in place than internal resources?
When discussing external sources, we need to ask a few questions. Is it repayable market finance or repayable concessionary finance? Are we talking about grants, which can be used as subsidies to reduce the interest rate on repayable finance? Are we talking about some other mix? The word finance can be somewhat difficult to grasp. Especially with a commodity like water, which is often not viewed as a commodity, but instead, is viewed as a basic human right.
The reality for most seekers of finance, whether municipalities or utilities or, in all honesty, any entity without sufficient funds to deliver on its long-term strategic goals, is that there needs to be an honest assessment of whether an investor, or source of finance, is likely to believe that the seeker will be able to honour its obligations over the lifetime of the financing. This comes down to an appreciation of a range of factors, from questions of political economy and governance to willingness to pay by consumers, and many other things in between.
But the key steps, at least based on my previous experiences, are fairly straightforward:
a) Establishment of creditworthiness for the municipality, achieved through capacity building on financial management, corporate leadership, institutional relationships between the entity and other related stakeholders in both public and private sectors
b) Completion of comprehensive project preparation to ensure technical and financial sustainability of proposed investment opportunities, including a cost-benefit analysis for the introduction of pioneering or non-traditional investments
c) Finalisation of an city-wide capital investment plan that matches the suite of projects with entity-wide growth for the project sponsor, holistically balancing proposed infrastructure investments with their financial needs and confirming an anticipation of project timing
d) Prioritisation of projects (identified in step 2) in harmony with capital investment plan (completed in step 3) on the basis of financial and technical merit
e) Identification of appropriate financial tools and mechanisms to deliver prioritised projects in capital investment plan, particularly when looking at tenor, investment appetites of funders, and other key considerations
f) Introduction of projects, preferably with associated credit enhancements to investors/lenders likely to be interested based on alignment of investment objectives, pricing, repayment period, and other conditions
g) Negotiation of financial terms with investors/lenders to ensure that the city is able to achieve its targets for delivery while still maintaining financial sustainability
How important is it to develop relationships with financial institutions?
I see that as being one of the challenges that the system faces at large. It’s a question of the interface between the people who are seeking finance and those that are providing it. With any utility or municipality, it’s going to be the financial side of the organization rather than the technical that engages with the financial institutions, even though the money raised often goes towards technical projects. Don’t get me wrong, the technical side has its challenges, but I don’t see that as being the most significant obstacle for municipalities looking for external sources of finance for their urban infrastructure projects. Because, eventually, cities need to be prepared to approach the financial institutions. Other than the Development Finance Institutions (DFIs), which have a mandate that looks at a mix of ability to repay and social/developmental outcomes, these are commercial entities. And, they are rarely aware of the project/technical details. So, putting a commercial financier in the room with a municipal CFO, when there is no basis of the relationship and, often limited understanding of the projects themselves, is not likely to yield the best outcome.
Talking to a concessionary financier, for example, one of the DFIs, is different. They will have a pretty good idea of what the projects are going to look like and what they might be able to finance.
I see this as a common challenge, but one that manifests itself differently depending on the nature of the seeker and source of capital. The universality of the question of relationship management varies pretty significantly based on the sophistication/ creditworthiness of the municipality and the level of appreciation of infrastructure investment by the financial institution.
As a result of these factors, many municipalities in the global South can only consider development finance – the expectations for commercial financiers can be too difficult to overcome. That, added to the unsustainably high interest rates charged by the commercial financial institutions, which is driven by the macroeconomic environments in which they operate, and the lack of decentralization common in so many countries in Africa and Asia, makes any diversification of financial instruments and institutions increasingly unlikely in the short term for cities.
Can you discuss a successful municipal finance effort and the tactics/approaches that yielded success?
I would cite cases in India. There have been many municipal financial transactions where sub-national governments have been able to access money from a diversity of investors and financial institutions. In particular, municipal bond issuances have worked well. The Indian example is one that’s strengthened by a commitment at the national level: to have cities access finance not only from lending but also from capital markets’ issuance. These will be far more appropriate for municipalities looking to finance urban infrastructure over a long period of time. Note that you can replace municipalities with utilities. But, whatever entity is looking for long term financing, it must match its repayment with the useful life from an asset. There are four countries that I would point to, although there are others that have seen success. India, South Africa, Vietnam and Peru all have demonstrated that municipal bonds work.
One reason for success is their ability to show financial strength of the municipality. Another reason is showing a convincing link between a general master plan and the capital investment plan (CIP) that prioritizes investments that make the most sense. And showing how those investments will flow and tie to specific projects. As for bonds, some will be general obligation bonds and others tied to specific projects. At least, we assume that they are general obligation bonds. In most countries of the global South, bonds need to align with revenue expectations. That is, sufficient revenue generated from the investments.
A good practice when issuing bonds is not to use them for general operating expenses. Instead, use them for capital investments. Some counties (such as South Africa) require this in their constitution. That is, bond issuances need to be for long-term capital investments and not items such as salaries or operational expenses for municipalities.
Success is also dependent on the enabling environment. For example, does the enabling environment encourage diversification of financial tools and instruments? Does it include municipal bonds as a desired instrument at the national level and then encourage its implementation down at the sub-national level? This almost ensures going in the direction that we’re hoping it would go in. Otherwise, we end up with a lot of the effort not making sense. For example, let’s say municipalities in India are ambivalent about municipal bonds. Number one, they might not be able to find a transaction size that is attractive to investors. Investors might want the transaction cost not to exceed their desired (proportionate) share of a larger bond issue that is syndicated among several financial institutions. The transaction might not be large enough to make it worthwhile to perform due diligence. A small transaction might result in the issuer’s transaction costs being too high to make it worthwhile. Most municipal bond transactions have fixed costs. These end up being the same, whether we’re talking a $10 million or a billion-dollar bond issuance. These need to be factored. They are on the technical side. Another challenge is if the municipality believes that investors want a larger transaction, larger than what they want to issue. For example, a municipality might need $100 million. This could result in $3 million worth of interest. Some municipalities might actually look for a larger investment – say $300 million. But, they don’t actually have the projects to back up that amount – they only need the $100 million. If they got the $300 million, they would immediately have to start paying interest on the larger amount. And so, a short-term success in the initial transaction could potentially result in default down the road.
Have you seen cases where a municipality went after more financing than it required?
It’s typically not the way that a transaction is initially structured, but nonetheless can happen when institutional investors have strong appetite for participating in a unique or pioneering transaction, or where the offering is mispriced and the municipality is overpaying on nominal interest or the credit enhancements reduce the risk to a point lower than the functional interest rate. Municipal bonds are pretty carefully governed. The US Securities and Exchange Commission (SEC), or the equivalent of the SEC in other countries, has the mandate to be a regulator, a regulator for the market. As such, they would review the prospectus before it’s floated to investors. In some instances, the regulator would state that they don’t want to see an issuer exceed a certain size, which is in effect acting as more than a regulator and starting to be a market-maker. In other cases they would be silent on the investment, in essence, accepting it. The investor will announce that there is a call open for a certain subscription period. And some investors will join in with that issuer. The order book that the arranger of the transaction sees might total to $300 million. But only $100 million was requested. In that instance, there could be more money available on the table.
The municipality might accept this full amount. So, yes, I’ve seen that happen. And, I would say that in almost all cases it works out well. But where it doesn’t work out well, there needs to be a renegotiation with the investors through a trustee who acts on their behalf. The renegotiation usually happens when the municipality recognizes that it lacks the ability to service its debt. However, sometimes that doesn’t work well. That’s not exactly what happened in Argentina. Argentina defaulted for other reasons. But, examples like Argentina that default on their outstanding bond debt, should be instructive for others, whether they are at the national or sub-national level. Remember the 80s across Latin America? There was sovereign level default from most of the countries. The renegotiation, for turning them into Brady bonds, is the only way to avoid large-scale default contagion into the US again. Dollar-denominated bonds, issued mostly by Latin American countries