On 16 October 2024, the Republic of El Salvador ("El Salvador") announced the financial close of a US$1 billion debt-for-nature ("DFN") swap, which was both the world's largest conservation-focused operation of this kind to date and the world's largest DFN conversion for river conservation. The historical breadth of this transaction shows that DFNs continue to offer a promising alternative to traditional financing sources, which can allow sovereigns to refinance existing debt on favourable terms and fund robust and impactful conservation programs.
1. Debt-for-nature swaps
Broadly speaking, DFNs represent financial transactions aimed at refinancing a country's debt at lower relative interest rates in return for a commitment to spend a portion of savings on nature conservation. The concept was introduced in the 1980s for conversion of debt owed to creditors by developing countries that were unable to service their external debt. Notably, one of these early examples involved a 1993 agreement between El Salvador and the United States, which reduced El Salvador's external debt in exchange of establishing a fund for the conservation of natural resources in the country to be managed, among others, by officials of both countries.
More recent and modern examples of DFNs include the ones conducted by Belize, the Seychelles, Barbados, Ecuador, and Gabon (Debt-for-nature swaps: A viable alternative for vulnerable economies amid global challenges). As elaborated below, El Salvador's US$ 1 billion DFN is ground-breaking precedent of the new wave of DFNs and evidence that operations of this nature are getting traction and are becoming more appealing to sovereigns and SOEs in emerging markets. This article thus generally describes El Salvador's DFN with a focus on highlighting its pioneering and highly innovative features.
2. Structure of El Salvador's DFN
New Money and Debt Management
The transaction comprises El Salvador's issuance of US$1 billion 20-year impact notes ("Impact Notes") and the concurrent tender offer of a portion of its outstanding notes using the proceeds of the new Impact Notes. The new Impact Notes, in turn, were purchased by a special purpose vehicle ("SPV") using the proceeds from a loan extended by J.P. Morgan, as an original lender.
The conversion allowed El Salvador to successfully refinance more than US$ 1 billion of its outstanding notes and generate an expected US$ 352 million in lifetime savings through immediate notional debt savings and a material reduction in debt service costs. Critically, as noted below, nearly all these savings (US$ 350 million) will be applied to a program called the Rio Lempa Conservation and Restoration Program (the "Program"), representing the largest funding commitment a country has ever made for conservation in a DFN transaction.
Credit Enhancement
The transaction benefitted from two key credit enhancement products, which enabled a lower coupon on the loan advanced by the original lender and consequently, a lower coupon on the Impact Notes for El Salvador (compared to prevailing commercial lending conditions that would have applied in the market). Specifically:
- PRI: The U.S. International Development Finance Corporation ("DFC") provided political risk insurance ("PRI") in favour of the SPV. The PRI coverage —which is largely limited to the principal amount under the Impact Note—can be triggered if an arbitral tribunal were to recognize that El Salvador has defaulted on the Impact Notes; and
- Letters of Credit: The Development Bank of Latin America and the Caribbean ("CAF") issued standby letters of credit to provide additional liquidity to cover coupon and other periodic payments. These letters of credit provide such coverage in the event that El Salvador is alleged to have defaulted under the Impact Notes and until an arbitral tribunal issues an award resolving whether El Salvador is indeed liable for such default (which as noted above, would unlock the DFC PRI).
This credit enhancement not only improved the transaction's commercial terms but helped catalyse additional investments for 'the conservation of the Rio Lempa watershed.
3. Historical Allocation and Innovative Conservation Structure
'The Rio Lempa watershed is one of the longest rivers in Central America and the only navigable river in El Salvador. The Rio Lempa basin covers 49% of the country's territory and is in close proximity to 80% of the country's population, including the capital city of San Salvador. The Rio Lempa thus, plays a critical role in the well-being of Salvadorans by providing drinking water, in addition to supporting industry and hydropower generation, irrigation, and diverse ecosystems.
As noted above, nearly all savings of the conversion (US$ 350 million) will be applied to the Rio Lempa Program over the next 20 years. This US$ 350 million allocation is the largest funding commitment a country has ever made for conservation in a DFN transaction. By way of comparison, the Republic of Ecuador achieved US$ 323 million in savings in its May 2023 DFN and all prior DFN operations had been of smaller scale.
'Projects funded by the savings from the transaction are expected to enhance water quality, quantity, and reliability; strengthen climate resilience; protect the watershed's natural ecosystem; and mitigate water security risk in the region. The Program will be co-managed by Catholic Relief Services ("CRS") and the Environmental Investment Fund of El Salvador ("FIAES"), entities with prior experience managing conservation programs in El Salvador.
Regarding conservation, El Salvador's DFN comprised the following key features and innovations:
- El Salvador will be making periodic payments to: (i) a conservation fund co-managed by FIAES and CRS, which will finance conservation projects in the Rio Lempa to be executed by non-sovereign players and (ii) an endowment account, which is designed to accumulate an endowment fund that will be unlocked upon the repayment of the Impact Notes and will procure further resources for the conservation fund.
- El Salvador made certain conservation and sustainability commitments to assist the Program's development, including: (i) establishing a zonal organization to oversee conservation and restoration of the Rio Lempa watershed; (ii) setting up a water resources data monitoring system for the Rio Lempa watershed; and (iii) declaring 75,000 hectares of protected aquifer recharge zones throughout the watershed by 2044.
- Moreover, El Salvador agreed to various sophisticated mechanisms that incentivise the country's long-term compliance with its conservation commitments. This includes not only monetary payments in case of commitments default but also payments in case of any subsequent abandonment of such commitments. As an added compliance incentive, compliance with certain conservation commitments will lead to a step down in the Impact Notes interest (and subsequent non-compliance will bring the interest to the original level) and the breach of certain conservation commitments might require El Salvador to mandatorily redeem its Impact Notes and a failure to so would be an event of default under its Impact Notes. Nonetheless, El Salvador has retained the ability to set off the monetary payments against future obligations of El Salvador to pay periodic conservation and endowment payments if El Salvador cures the relevant breach.
- Another novelty in this context is a focus on ensuring that the conservation and endowment payments are used for the Program's purposes and objectives in all possible scenarios, including in the case of events of default under the Impact Notes, defaults of the Program's co-managers (FIAES and CRS) or the conservation trust, or conservation trustee defaults.
This transaction thus demonstrates an innovative, comprehensive, sophisticated, and well thought through approach to conservation commitments and fund governance that can be a game changer in this space and a helpful tool for pushing sovereigns' ESG and financial agendas.
4. Other Pioneering and Notable Features of the Transaction
The transaction also involved additional legal and financial complex features. Specifically, due to El Salvadorian constitutional requirements, the provision of CAF's letters of credit had to be structured across multiple transaction documents such that it would not create any legal risks of them being classified as sovereign guarantees. Moreover, this DFN involved hedging elements required to provide a fixed rate borrowing for El Salvador.
In addition to the innovative and complex aspects highlighted above, this operation is a pioneering one in many senses. Specifically, this operation:
- shifted a conservation focus to freshwater conservation being the world's largest DFN for river conservation (all previous DFN conversions had focused on ocean conservation and related goals).
- further stands out for its expedited timeline of its execution. While transactions of this nature have normally required at least two years from inception to closing, El Salvador's DFN deal was completed in just under one year. This shows that, despite their complexity, these transactions can be done on a more accelerated timetable where the circumstances allow so.
5. Conclusion
While there have only been a handful of DFN swap deals executed to date across the world, these transactions are steadily getting more traction and are becoming more appealing to emerging markets sovereigns and SOEs. This is because they can be useful tools for sovereigns that want to meet two objectives at once: (i) refinancing existing debt on favourable terms as part of a sovereign debt strategy management; and (ii) applying savings towards conservation projects and beyond, especially where grants and concessional financings may not be available.
Overall, El Salvador's DFN represented a bespoke structure, which combined capital markets (the Impact Notes), banking (the loan and letters of credit), derivatives (floating to fixed rate hedge), project finance (conservation), and international arbitration (enforcement) products that were carefully designed and aligned to serve the commercial and environmental objectives of the transaction. It sets a precedent for future deals of this type and paves the way for other similarly innovative solutions across the globe.
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.
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