Abstract:
According to some embodiments, a method includes establishing a special purpose entity in which a first party has made an equity investment. The method further includes establishing a first sales agreement between the special purpose entity and a second party for the special purpose entity to supply a physical commodity to the second party. The method further includes applying a prepayment amount received under the first sales agreement to acquire a guaranteed investment contract from an insurance company. The method further includes establishing a second sales agreement between the special purpose entity and a supplier for the supplier to supply the physical commodity to the special purpose entity.

Description:
CROSS-REFERENCE TO RELATED APPLICATION  
       [0001]     This application claims benefit from provisional patent application No. 60/627,540, filed Nov. 12, 2004, which is incorporated herein by reference. 
     
    
     FIELD  
       [0002]     The present invention relates to municipal finance. In some embodiments, the present invention relates to methods for financing long-term energy purchases by municipal utility companies.  
       BACKGROUND  
       [0003]     Long-term prepaid energy purchases by municipalities and/or municipal energy utilities present opportunities for interest rate arbitrage, since such purchases may be financed by relatively low-interest-rate tax-exempt borrowing on the part of the municipality and may accrue the benefit of (higher) discounting rates, which reflect interest rates accrued by taxable markets, when the present value of future energy deliveries is taken into account. However, lump-sum prepayment to a prospective long-term energy supplier may entail substantial credit risk and adverse accounting implications.  
       SUMMARY  
       [0004]     In light of the foregoing, embodiments of the present invention concern a method to establish a special purpose entity in which a first party has made an equity investment, to establish a first sales agreement between the special purpose entity and a second party for the special purpose entity to supply a physical commodity to the second party, to apply a prepayment amount received under the first sales agreement to acquire a guaranteed investment contract from an insurance company, and to establish a second sales agreement between the special purpose entity and a supplier for the supplier to supply the physical commodity to the special purpose entity.  
         [0005]     In some aspects, the second party may enter into an interest rate swap transaction to pay a fixed rate and to receive a variable rate payment. In some aspects, a first commodity swap transaction may be established between the special purpose entity and a third party for the special purpose entity to pay to the third party a fixed price for the physical commodity and for the special purpose entity to receive from the third party an index price for the physical commodity. The second party may enter into a second commodity swap transaction with the third party for the third party to pay to the second party the fixed price for the physical commodity and for the second party to pay to the third party the index price for the physical commodity. The equity investment by the first party in the special purpose entity may be a contingent investment such as a contingent funding agreement. The physical commodity may be natural gas or electricity.  
         [0006]     In another aspect, a method of achieving interest-rate arbitrage with reduced exposure to credit risks includes a municipal entity issuing tax-exempt bonds to fund a prepayment, where the bonds have a maturity period. The method further includes transferring the prepayment to a special purpose entity in return for the special purpose entity&#39;s obligation to provide natural gas or electricity to the municipal entity over a fixed term that matches the maturity period of the bonds. The method further includes the special purpose entity using the prepayment to obtain a guaranteed investment contract from an insurance company, where the guaranteed investment contract has a contract term that matches the fixed term and the guaranteed investment contract provides a fixed return funding flow to the special purpose entity during the contract term. The method further includes the special purpose entity entering into a supply agreement with a supplier to make periodic payments to the supplier in return for the supplier supplying fixed quantities of natural gas or electricity to the special purpose entity during a supply agreement term that matches the contract term.  
         [0007]     As used herein and in the appended claims a “municipal entity” refers to any of the 50 states of the United States or of any territory or district of the United States or any entity that is or is controlled by a subdivision of an agency of a state, territory or district of the United States.  
         [0008]     In another aspect, a method includes establishing a special purpose entity, receiving a prepayment from a municipal entity, obligating the special purpose entity to supply natural gas or electricity to the municipal entity, investing the prepayment to obtain a fixed return, and entering the special purpose entity into an agreement with a supplier to obtain a fixed supply of natural gas or electricity.  
         [0009]     Thus, in some aspects, the obligations of the special purpose entity to the municipality are supported by a very low risk investment such as a guaranteed investment contract issued by a highly rated insurance company, and the municipality is insulated from a large part or all of any credit risk involved in dealing with the energy supplier which is the source of supply under contract to the special purpose entity.  
         [0010]     In another aspect, no part of the prepayment is treated as debt of the first party for balance sheet and accounting purposes.  
         [0011]     With these and other advantages and features of the invention that will become hereinafter apparent, the invention may be more clearly understood by reference to the following detailed description of the invention, the appended claims, and the drawings attached hereto. 
     
    
     BRIEF DESCRIPTION OF THE DRAWINGS  
       [0012]      FIG. 1  is a schematic illustration of a financing technique provided according to some embodiments.  
         [0013]      FIG. 2  is a flow chart that illustrates a process performed in accordance with the financing technique of  FIG. 1 . 
     
    
     DETAILED DESCRIPTION  
       [0014]     In general, and for the purposes of introducing concepts of embodiments of the present invention, a special purpose entity is inserted between a municipal agency and a supplier of energy under a long-term financing arrangement. The special purpose entity receives from the municipal entity a prepayment for an energy supply and invests the prepayment in a guaranteed investment contract issued by a highly rated insurance company. The special purpose entity contracts with an energy supplier (supplier of natural gas or electricity) for a supply of energy on a long-term basis. The supply contract is to be financed by funds provided from the guaranteed investment contract. The municipal entity is largely or entirely sheltered by the special purpose entity and the guaranteed investment contract from any risks arising from potential failure of the energy supplier.  
         [0015]     Features of some embodiments of the present invention will now be described by first referring to  FIG. 1 .  FIG. 1  is a diagram that illustrates a sequence of transactions involved, in accordance with the invention, in financing a long-term energy supply arrangement for the benefit of a municipal entity. As illustrated in  FIG. 1 , a municipal entity  102  (e.g., a municipally-owned gas and/or electric utility) issues tax-exempt bonds to bond investors  104 . Net proceeds of the bond issue, as indicated at  106 , are received by the municipal entity  102 . The bonds may pay interest at a rate that varies according to market conditions, in some embodiments. The municipal entity  102  is obligated to provide debt service for the bond issues over the life of the bonds, as indicated at  108 .  
         [0016]     A special purpose entity  110  is established especially for purposes of the financing arrangement indicated in  FIG. 1 . In some embodiments, an entity (not necessarily shown in the drawing) independent of the municipal entity  102  holds an equity interest in the special purpose entity  110 . The equity investment in the special purpose entity  110  may be in the form of a contingent funding agreement. To support equity ownership for tax purposes of the special purpose entity  110  independent of the municipal entity  102 , the contingent funding agreement may be in an amount that corresponds to 3% or more of the assets of the special purpose entity  110 .  
         [0017]     The special purpose entity  110  and the municipal entity  102  enter into a transaction in which the municipal entity  102  makes a prepayment  112  (funded by the bond proceeds  106 ) to the special purpose entity  110 . In return, the special purpose entity  110  is obligated to provide a supply of energy (in this instance, in the form of natural gas  114 ; may alternatively be in the form of electricity) to the municipal entity  102  on a long-term basis (e.g., over a period matching the term of the bonds, such as 10 to 20 years).  
         [0018]     The special purpose entity  110  may invest the prepayment  112  (as indicated at  116 ) in a guaranteed investment contract issued by a highly-rated (e.g., AA to AAA) insurance company  118 . The guaranteed investment contract may provide a return at a fixed rate that corresponds to a return for taxable investments. The fixed funding flow to be provided to the special purpose entity  110  by the guaranteed investment contract is indicated at  120 . The term of the guaranteed investment contract may be the same as that of the bonds issued by the municipal entity  102  and of the contract between the municipal entity  102  and the special purpose entity  110 .  
         [0019]     The funding flow  120  at least indirectly supports a long-term supply contract entered into by the special purpose entity  110  with an energy supplier  122 . According to that supply contract, the special purpose entity agrees to make payments (indicated at  124 ) indexed to the price, from time to time, or at a fixed price of the energy to be supplied, in return for a commitment from the supplier  122  to provide energy (in this instance in the form of natural gas  126 ) to the special purpose entity  110 . The gas supplied by the supplier  122  may be passed through the special purpose entity  110  to the municipal entity  102  to satisfy the special purpose entity&#39;s supply obligation  114 . The payments to the supplier are expected to be made from the cash flow received by the special purpose entity from the guaranteed investment contract.  
         [0020]     Two commodity swap transactions may be arranged with a commodity swap counterparty  128  to allow the municipal entity  102  to effectively pay current (indexed) prices for the energy over the course of the financing/supply arrangement. The commodity swap counterparty  128  may be independent of the municipal entity  102  and the special purpose entity  110 . In the first commodity swap transaction (indicated at  130 ), which is between the special purpose entity  110  and the commodity swap counterparty  128 , the special purpose entity  110  effectively agrees to pay to the commodity swap counterparty  128  a fixed price  131  for the gas supplied by the supplier  122  and to receive from the commodity swap counterparty an index price  132  for the gas. In the second commodity swap transaction (indicated at  134 ), which is between the municipal entity  102  and the commodity swap counterparty  128 , the municipal entity  102  effectively agrees to pay to the commodity swap counterparty  128  an index price  136  for the gas and to be paid a fixed price  138  for the gas.  
         [0021]     The municipal entity  102  may also enter into an interest rate swap transaction  140  with an interest rate swap counterparty  142  to hedge the interest rate risk assumed by the municipal entity  102  in issuing variable rate bonds. In the interest rate swap transaction  140 , the municipal entity  102  effectively agrees to make payments at a fixed rate  144  to the interest rate swap counterparty  142  and to receive payment at a synthetic variable rate  146  from the interest rate swap counterparty  142 .  
         [0022]     In some embodiments, the synthetic variable rate  146  provided by the interest rate swap counterparty  142  may be derived from a London Interbank Offered Rate (LIBOR). For example, the synthetic rate may be defined as:  
         [0023]     When the 1 month LIBOR is 1.00% or less, equal to the 1 month LIBOR;  
         [0024]     when the 1 month LIBOR is between 1.00% and 4.89%, equal to 0.56 times the 1 month LIBOR plus 44 basis points; and  
         [0025]     when the 1 month LIBOR is 4.89% or higher, equal to 0.65 times the 1 month LIBOR.  
         [0026]     With a synthetic rate defined in this manner, the municipal entity  102  would receive a higher percentage of LIBOR when interest rates are relatively low. Consequently, this type of synthetic rate provides the municipal entity  102  with hedging against rate compression. (By “rate compression” is meant a reduction in the spread between tax-exempt and taxable returns.)  
         [0027]     Also indicated in  FIG. 1  are utility customers  148  of the municipal entity  102 . The customers  148  receive natural gas deliveries  150  (in this example) and make payments  152  to municipal entity  102  that vary with the market price of gas.  
         [0028]     In some embodiments, the supplier  122  may be the holder of equity in the special purpose entity  110  for tax purposes (via, e.g., the above-mentioned conditional finding agreement). In some embodiments, the supplier  122  may be affiliated with an investment bank (not separately indicated) which underwrites issuance of the tax-exempt bonds issued by the municipal entity  102 . In some embodiments, the supplier  122  may not be the equity owner of the special purpose entity  110 , which rather may be owned for tax purposes by the underwriting investment bank. In some embodiments, the supplier  122  may be unaffiliated with the underwriting investment bank. In some embodiments, the interest rate swap counterparty  142  may be, or may be an affiliate of, the underwriting investment bank.  
         [0029]     In some embodiments, terms of the interest rate swap transaction  140  may call for automatic termination, without any mark-to-market settlement payment, of the interest rate swap transaction  140  upon occurrence of any one of a number of “automatic termination events”. Such automatic termination events may be defined to include (a) termination of the prepaid energy delivery contract between the municipal entity  102  and the special purpose entity  110  due to default by the special purpose entity  110 ; (b) reduction in the credit rating of the interest rate swap counterparty  142  below a specified level or levels; (c) bankruptcy or insolvency of the interest rate swap counterparty  142 . Similar automatic termination events may apply to extinguish, without any mark-to-market settlement payment, the commodity swap transactions  130 ,  134 .  
         [0030]     In addition or alternatively, in some embodiments, the special purpose entity  110  may be obligated, at the option of the municipal entity  102 , to remarket (instead of delivery to the municipal entity  102 ) for the account of the municipal entity  102  at least a portion of the gas supply, in the manner and to the extent permitted under applicable tax regulations.  
         [0031]     In some embodiments, the bonds issued by the municipal entity  102  may pay a fixed interest rate rather than a variable rate. In some embodiments, the interest rate swap  140  may be dispensed with. In some embodiments, the interest on the bonds may be taxable rather than tax-exempt. In some embodiments, the funding for the prepayment  112  by the municipal entity  102  may become available other than via a bond issue.  
         [0032]     In some embodiments, the “fixed for floating” interest rate swap  140  may feature a variable rate directly tied to an index (e.g., a straight percentage of LIBOR) rather than a synthetic variable rate. Alternatively, a synthetic variable rate other than the synthetic rate described above may be employed.  
         [0033]     In some embodiments, the gas supply arrangement between the special purpose entity  110  and the supplier  122  may call for payment by the special purpose entity  110  of a fixed price for the natural gas rather than a variable price. In some embodiments, one or both of the commodity swaps  130 ,  134  may be dispensed with. In some embodiments, the swap transaction  134  may remain in place and the swap transaction  130  may be entered into by the supplier  122  rather than by the special purpose entity  110 .  
         [0034]     The financing techniques described above may be applied to prepayment of long-term electricity supply contracts in addition to or instead of financing gas supply contracts.  
         [0035]     For accounting purposes, the special purpose entity  110  may be consolidated with the municipal entity  102  pursuant to relevant guidelines of the GASB (Government Accounting Standards Board) and would not be consolidated with its tax owner.  
         [0036]     The above financing structure allows for market arbitrage that accrues to the benefit of the municipal entity  102 . Further, the risk to the municipal entity  102  of failure of the supplier  122  is mitigated by the presence of the special purpose entity  110 , which is backed up by the guaranteed investment contract. In the event of failure of the supplier  122 , the continuing funding flow from the guaranteed investment contract allows the supplier to be replaced and will fund a replacement supply agreement with the new supplier.  
         [0037]      FIG. 2  is a flow chart that illustrates a process that may be performed in accordance with the financing technique of  FIG. 1 .  
         [0038]     At  202  in  FIG. 2 , the special purpose entity  110  is established. At  204 , the special purpose entity  110  receives the prepayment  112  from the municipal entity  102 . At  206 , the special purpose entity  110  undertakes a contractual obligation  114  to supply natural gas to the municipal entity  102 . At  208 , the special purpose entity  110  invests the prepayment in a guaranteed investment contract issued by the insurance company  118 . At  210 , the special purpose entity  110  enters into a gas supply agreement with the supplier  122 . At  212 , the commodity swap transactions  130 ,  134  are established. At  214 , the interest rate swap  140  is established.  
         [0039]      FIG. 2  and the above description thereof are not meant to imply a fixed order of steps. Rather, the steps may be performed in any order that is practicable. At least some of the steps may be performed simultaneously with one or more of the other steps illustrated in  FIG. 2 . For example, most if not all of the steps illustrated in  FIG. 2  may be accomplished substantially simultaneously at a closing for the financing transaction.  
         [0040]     The present invention has been described in terms of several embodiments solely for the purpose of illustration. Persons skilled in the art will recognize from this description that the invention is not limited to the embodiments described, but may be practiced with modifications and alterations limited only by the spirit and scope of the appended claims.