Future Flow Securitizations and Synthetic Commodity-Based Project Finance
Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1
This is the second half of Chapter 21, and it’s where the book gets really interesting. We move from straightforward project loan securitizations to something more creative: securitizing future cash flows that don’t exist yet. And then we go even further into synthetic project finance using prepaid commodity derivatives. This section also includes one of the book’s most dramatic case studies: the Enron/Mahonia prepaid saga.
Future Flow Securitizations: Development Finance
A future flow securitization takes the expected revenue from a project and converts it into cash today. The future revenue stream gets conveyed to an SPE, which issues notes backed by those expected flows. In many cases, the cash raised finances the same project that will later produce the revenue.
This started with secured export notes (SENs) in the mid-1980s. These were bonds secured by future export receivables, issued directly by the originator. No SPE needed. But they were full recourse to the sponsor, so investors still bore the general credit risk of the issuing company.
The Met-Mex Penoles deal from 1993 is a classic SEN. Met-Mex, the world’s largest refined silver mining operation (a subsidiary of Mexico’s Industrias Penoles), needed to expand smelting operations. Bank loans were available but expensive on an unsecured basis. So Met-Mex issued $100 million in five-year bonds backed by future silver sales to Sumitomo. The silver price risk was handled through a combination of take-or-pay contracts and at-the-money put options written by Sumitomo. This allowed Met-Mex to borrow at a much lower cost, and Sumitomo’s AA credit rating filtered down to bondholders.
By the late 1990s, SENs declined because investors didn’t love having full recourse to often shaky project sponsors. The fix was obvious: use a proper SPE. Qatar General Petroleum Corp. did this in 2000, raising $400 million by conveying LNG sales receivables to an SPE called QGPC Finance. The SPE issued certificates backed by those receivables and hedged LNG price risk with a pay-floating commodity swap. Ambac provided a monoline wrap to AAA.
Mexico and Brazil accounted for over half of all development finance future flow securitizations through 2003. These deals have expanded beyond commodity exports to include airline ticket receivables (LAN Chile, Avianca, Korean Air), electronic remittances, credit card receivables, toll road revenues, and even uncollected taxes.
Future Flow Securitizations: Principal Finance
The same concept works outside development finance. Three creative examples stand out.
Turning Beer into Cash
This is my favorite section heading in the entire book. In 1989, the U.K. Beer Orders Act forced breweries to sell off excess pubs. Large pub companies (PubCos) sprung up to buy them but often lacked financing. Solution: securitize future pub revenues.
A typical pub securitization ring-fences the pub assets from the sponsor and creates an SPE issuer that raises funds by issuing notes backed by future income from tenanted leases. That income comes from three sources: rental income (43 percent in the Punch Taverns example), beer margins (47 percent), and gaming machine revenue.
The Punch Taverns Finance deal from November 2003 involved a 1.825 billion pound issue in four classes of notes, backed by future cash flows from 4,183 pubs. Maturities ranged from 6 to 27 years. Royal Bank of Scotland provided the interest rate swap, Barclays and Lloyds TSB provided liquidity, and Ambac wrapped a portion. These pub securitizations are a type of whole business securitization, which has been popular mainly in Europe for water companies, health care businesses, and other operations with stable, predictable revenue streams.
Intellectual Property Securitizations
Starting with the famous Bowie Bond in 1997, the idea of securitizing intellectual property took off. David Bowie securitized the publishing and recording rights on up to 300 previously recorded songs, raising $55 million. The bonds were 15-year notes with a 7.9 percent coupon. The SPE also owned a put option on the IP, struck at-the-money, so a decline in the popularity of Bowie’s earlier work wouldn’t destroy the note payments.
The same concept has been applied to film royalties (see the Hollywood Funding case from earlier in the book) and discussed for pharmaceutical patents, though rarely attempted. Each IP securitization looks a bit different, but the core logic is always the same: convert future licensing revenue into current cash.
Synthetic Commodity-Based Project Finance
Now for the really interesting part. Commodity businesses can do project finance synthetically using derivatives. Specifically, prepaid forwards and swaps.
The idea is ancient. Culp notes it goes back to the Assyrians. Imagine a farmer with a viable wheat field who can’t get a traditional loan. Instead of finding a money lender, the farmer sells the crop using a prepaid forward: the buyer pays cash now for delivery of wheat later. The farmer uses that cash to finance planting and harvesting. Project finance by another name.
A full synthetic project financing structure has five pieces:
- Prepaid leg. The SPE pays cash upfront to the project borrower for future commodity deliveries.
- Credit enhancement leg. The buyer needs protection against delivery default. Letters of credit, surety bonds, or trade credit insurance.
- Offtake leg. The SPE sells the commodity when it’s delivered.
- Hedge leg. If the offtake price is variable, the SPE hedges with a forward or swap.
- Financing leg. The SPE borrows the money to fund the prepaid, using the hedged future deliveries as collateral.
Enron’s Volumetric Production Payments (VPP) program was a textbook example of how this works well. Enron targeted struggling natural gas companies with undeveloped but proven gas fields. Each company ring-fenced its gas assets in a bankruptcy-remote SPE. Enron prepurchased production using prepaid swaps. Then Enron securitized the future flows through the Cactus Funds SPE, which sold physical gas on the spot market, hedged with pay-fixed swaps, and issued two classes of securities backed by the hedged revenue stream.
This was legitimate project finance. It gave capital to companies that couldn’t borrow conventionally, using their actual gas reserves as the economic backing.
The Enron/Mahonia Mess
And then things got complicated. When Enron failed in December 2002, it had about $15 billion in prepaid deals with JPMorgan Chase and Citigroup. Between 1993 and 2001, JPMC, an SPE called Mahonia Limited, and Enron had done at least 12 prepaid deals.
Culp presents a representative late deal structure. Mahonia makes a prepaid payment to Enron for future gas deliveries. JPMC makes a mirroring prepaid with Mahonia. Then JPMC does a regular (not prepaid) commodity swap with Enron. If you trace all the flows, the gas goes from Enron to Mahonia to JPMC and then back to Enron through the commodity swap. The gas legs cancel out. What’s left is fixed cash flows: money from JPMC to Enron upfront, and money from Enron back to JPMC later. Critics said this was just a bank loan in disguise.
The credit enhancement controversy makes this even juicier. Early deals used letters of credit. Later, Enron convinced JPMC to accept advance payment supply bonds (APSBs) from multiline insurance companies like Liberty Mutual, Travelers, and St. Paul Fire and Marine. APSBs are supposed to guarantee physical commodity delivery. They’re sureties, not financial guarantees.
When Enron went bankrupt, JPMC tried to collect nearly $1 billion under the APSBs. The insurance companies refused. They argued the deals were really bank loans, making the APSBs financial guarantees, which multiline insurers can’t legally issue under New York law. JPMC eventually settled for about $655 million, or 51 percent.
A separate drama unfolded around Mahonia XII, the last deal, which was entirely cash-settled (no commodity delivery was even intended). That deal used a letter of credit from West Landesbank (WestLB). WestLB also refused to pay, claiming fraud. But a U.K. court ruled against WestLB, finding that the three swaps were independent transactions and Mahonia was genuinely independent of JPMC.
The Lessons
Culp doesn’t try to resolve who was right in the Enron disputes. But he pulls out an important takeaway: you have to take legal and regulatory issues seriously when mixing insurance products with derivatives and structured finance. The financial economics may have converged, meaning insurance, derivatives, and loans can all do similar things economically. But the regulation, case law, accounting, and tax treatment haven’t converged at all. Standing on that gap can get very slippery.
There is no single “this product is better” conclusion. LOCs weren’t automatically safer than APSBs. The lesson is to expect the unexpected, pay for good legal advice, and when in doubt, don’t do it.
My Take
This chapter is a wild ride. You go from Qatari LNG exports to English pub securitizations to the Bowie Bond to Enron’s natural gas prepaid empire and its spectacular collapse. The connecting thread is that future cash flows, no matter where they come from, can be the foundation for structured financing.
The Enron/Mahonia section is worth the price of admission alone. It’s a perfect case study in what happens when financial engineering gets too clever. The VPP program was genuinely useful. Helping struggling gas companies develop their reserves through prepaid financing made real economic sense. But somewhere along the line, the prepaid structure got repurposed from genuine commodity finance into something that looked a lot more like disguised borrowing. And the credit enhancement piece, substituting insurance sureties for bank LOCs, created a legal minefield that exploded when the music stopped.
The pub securitizations are a nice palate cleanser. Straightforward, useful, and frankly kind of charming. Who knew that the revenue from 4,183 English pubs could be packaged into investment-grade bonds?