FINANCING I

FINANCING TEAM

Who will put the deal together and sell it to investors?

Once a capital need has been identified and a decision made to pursue bond financing, the next step is to assemble a team of financial professionals.  The team will include one or more investment banks responsible for selling the bonds (underwriter), and a law firm that will issue an opinion on the legality and tax status of the bonds (bond counsel).  The team will also include a bank that holds the proceeds of the bond sale, authorizes expenditure of bond funds and represents bondholders in the event of a default (trustee).

The lead underwriter not only sells the bonds but may also serve as a financial advisor by helping the issuer explore financing alternatives.  However some issuers opt to employ an independent financial advisor prior to the selection of an underwriter, or to provide a second opinion once the underwriter has been selected.  The underwriter will retain counsel and the issuer may also choose to retain counsel apart from bond counsel. 

RECOMMENDATION: Find out how the financial team was selected and investigate the players’ past performance

The selection of the financial players in a bond deal may not fall under the laws and regulations governing public procurement, since they are not typically paid directly by public agencies.  Some issuers use a bidding process to select the underwriter while others retain the first underwriter that approaches them with a proposed deal. 

Public officials should be encouraged to solicit bids from multiple investment banks and law firms – if only one bid appears, it may be a sign that the deal is too risky.  Residents can also research past deals managed by the underwriter and reviewed by bond counsel, to determine whether any are at risk of default or have produced other negative consequences.

RECOMMENDATION: Clarify the relationship between bond counsel, issuer and underwriter

Public officials may assume that bond counsel represents the public and will protect its interests, but this is not always the case.  Bond counsel may represent the underwriter or the client relationship may never have been clearly defined.  Even when the issuer is the client, its interests may not coincide with the public’s interests, especially if the issuer is a pass-through bonding authority rather than a sovereign government. 

Further, the scope of bond counsel’s work is limited to issuing an opinion regarding the enforceability of bonds and their taxability.  Bond counsel is not responsible for advising the client whether a deal is prudent.  Finally, bond counsel may have a longstanding relationship with the underwriter that outweighs the legal obligation to protect the issuer’s interests.

The relationship between bond counsel and the issuer should be explained in a public meeting and clarified in writing.  Bond counsel’s track record and relationship to the underwriter should also be examined by looking at past deals and reviewing the financial press.

RECOMMENDATION: Push for second opinions on proposed financial and legal arrangements

Underwriters and bond counsel generally have a financial incentive to see bonds issued, since their fees come out of the borrowed funds.  Large agencies that frequently issue bonds may have sufficient financial and legal expertise in-house to do their own analysis, but where this is not the case, public officials should also seek a second opinion from a financial advisor and/or law firm that has no financial interest in the project.

CAPITAL REQUIREMENTS

How much money will be required to complete the project and get it off the ground?

Before a project is financed, the borrower must know how much capital is required to complete the work.  The issuer must take into account the cost of construction and equipment (fixed capital); start-up expenses such as hiring and training project staff (working capital); bond payments that come due before the project begins generating revenue (debt service); money the issuer is required to set aside to deal with contingencies (reserve funds); and fees and other expenses associated with issuing the bonds such as the underwriter’s discount and the bond counsel fee (cost of issuance).  All of this information will be included in the Official Statement under the heading “Proposed use of funds.”

RECOMMENDATION: Examine proposed use of funds to determine whether amounts are insufficient or excessive

When an issuer allocates too little for construction and start-up, it can end up running out of money before the project is complete and able to generate revenue.  The issuer (or sponsoring agency) may then be forced to dip into its funds and/or issue more bonds to cover the shortfall.  Either way, the result may be costly and harmful to the issuer’s credit rating.  Contributing factors may include unanticipated expenses and cost overruns; delays in construction or start-up that increase costs while exhausting the debt service fund; and weaker than expected revenues in the first years of project operation

On the other hand, the issuer may allocate too much for certain items, unnecessarily increasing the debt load.  If public officials are not watching closely or acting responsibly, the underwriters, bond counsel and other consultants who put the deal together may award themselves large fees.  Excessive borrowing for startup costs or initial bond payments can also be a way to siphon money out of a bond deal.  For example, a one-time development fee paid to a city or county government out of bond funds can temporarily conceal an operating deficit while giving officials an incentive to sign off on bad deals.  Only after the borrowed funds are spent, a year or two down the line, will it become clear whether the project was viable in the long run.