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Project Finance

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Title: Project Finance


1
Project Finance
  • A General Introduction1
  • One Example of Off Balance Sheet Financing
    Techniques

2
Project Finance
  • A Definition from the Association of Corporate
    Treasurers
  • A financing of a particular economic unit in
    which a lender looks initially to the cash flows
    and earnings of that economic unit as the source
    of funds from which a loan will be repaid and to
    the assets of the economic unit as collateral for
    the loan
  • author, FSMD

3
Project Finance
  • The project is
  • Not consolidated as not controlled by the
    reporting entity
  • Liabilities remain within ring fenced entity
  • or
  • Special Purpose Vehicle (SPV)

4
Source Wikipedia
  • A special purpose entity (SPE) (sometimes,
    especially in Europe, "special purpose vehicle"
    or simply SPV) is a legal entity (usually a
    limited company of some type or, sometimes, a
    limited partnership) created to fulfill narrow,
    specific or temporary objectives. SPE's are
    typically used by companies to isolate the firm
    from financial risk. A company will transfer
    assets to the SPE for management or use the SPE
    to finance a large project thereby achieving a
    narrow set of goals without putting the entire
    firm at risk.
  • A special purpose entity may be owned by one or
    more other entities and certain jurisdictions may
    require ownership by certain parties in specific
    percentages. Often it is important that the SPE
    not be owned by the entity on whose behalf the
    SPE is being set up (the sponsor). For example,
    in the context of a loan securitisation, if the
    SPE securitisation vehicle were owned or
    controlled by the bank whose loans were to be
    secured, the SPE would be consolidated with the
    rest of the bank's group for regulatory,
    accounting, and bankruptcy purposes, which would
    defeat the point of the securitisation. Therefore
    many SPEs are set up as 'orphan' companies with
    their shares settled on charitable trust and with
    professional directors provided by an
    administration company to ensure there is no
    connection with the sponsor.

5
Project Finance
  • Two important principles in relation to Recourse
  • Has the legal structure succeeded in taking the
    obligations, risks and returns of the project,
    off the balance sheet of the Sponsors?
  • Accounting standards are constantly tightened
    (due to Enron, Worldcom etc) so substance becomes
    more important than form

6
Project Finance
  • A Project usually defined as a major productive
    capital investment e.g. in
  • - oil or mineral development
  • - heavy industry (aluminium smelters etc)
  • - forestry, agriculture
  • - power generation, transportation, (toll
  • roads, bridges)
  • - telecoms

7
Project FinanceCharacteristics of PF
  • Project cash flows
  • Normally higher levels of debt ( which may lead
    to the need for additional support)
  • Variety of contractual obligations and
    undertakings to manage and reduce risk
  • - Bank Guarantees
  • - Letters of Credit
  • to cover greater risk during construction
    period

8
Project FinanceCharacteristics of PF
  • A variety of funding sources
  • - export credits
  • - development funds
  • - specialised asset finance
  • - conventional debt and
  • - equity finance

9
Project Finance
  • Project finance is a
  • classic example of fundamental principles of
    credit and corporate finance (ACT/FSMD)
  • i.e. managing risk and return for the
  • different parties from a stream of future
  • cash flows

10
Project FinanceBOT
  • Build Operate Transfer

Sponsors project and supplies equity
JV
Supply and Construction Consortium
License to operate and purchase of shares
Supply and Construction
Project
Host Government
Provide Finance
Power purchase agreement
Banks
Electricity Authority
11
Project Finance
12
Project Finance
  • Why use Project Finance
  • Amount too large for company Balance Sheet
  • Too much risk for one company to bear
  • - share different risks with those better able
    to assess and manage
  • e.g. Oil exploration, development and
    production

13
Project FinanceWhy? continued
  • What risks for oil?
  • Exploration
  • - geological interpretation
  • - harsh environments
  • - political risks

14
Project FinanceWhy? continued
  • Once found then, Development/Production
  • - reservoir risk
  • - recovery risk
  • - technology risk
  • - production risk
  • - transportation risk
  • Still have market risk, environmental risk
    de- commissioning and so on

15
Project FinanceWhy? continued
  • Company policy for off balance sheet with or
    without recourse
  • Political risks
  • - e.g. local regulations ref foreign
    shareholdings
  • Existing covenants
  • Project development time
  • Ring fence also helps protect the project from
    sponsor failure

16
Project Finance
  • Recourse
  • from full to zero
  • Determined by the contract
  • - provide extra cost
  • - take a particular risk
  • - agree to take (off-take) product
  • Recourse may also vary in kind (type)
  • as well as degree
  • - Legal obligations
  • - Moral obligations

17
Project FinanceProcess
  • Strategic/commercial evaluation
  • Systematic identification and exploration of
    risks
  • Valuation (NPV of cash flows)
  • Design of risk bearing/sharing package
  • Appropriate funding package
  • Impact of financing package on net cash flows and
    sensitivity analysis

18
Project Finance
  • Risk Analysis
  • Pre construction
  • Construction
  • Operation
  • But many risks may be present at all stages
  • Resource availability- Geological-Infrastructur
    e-Technological-Construction-Operating-Labour
    supply-Material sourcing-Product
    market-Management-FX-Political-Regulatory-Environm
    ental

19
Project Finance
  • Common causes of failure
  • Completion delay-Cost overrun-Technical
    failure-Uninsured casualty losses-Increase
    price/shortage of raw materials-Technical
    obsolescence-Government interference-Loss of
    competitive position-Expropriation-Poor management

20
Project FinanceDesign of Risk SharingContractual
Structure
  • Objective to prevent or limit their effect
  • Concession agreements-Construction and equipment
    contracts-Completion guarantees-Supply
    agreements-Throughput agreements-Cost over run
    insurance-Cash deficiency agreements-Political
    risk insurance-Management contracts

21
Project FinanceDesign of Risk SharingContractual
Structure
  • Banks will use
  • Assignment of proceeds
  • Cash handling procedures
  • Financial guarantees
  • from sponsor, governments, other banks, third
    parties
  • Credit protection
  • Insurance

22
Project FinanceDesign of Risk SharingContractual
Structure
  • What may be an unacceptable risk for one party
    may be perfectly acceptable to another
  • Government permissions
  • Physical completion
  • Cost over runs
  • Delays
  • Costs of inspection
  • Technical performance
  • Prices
  • Supply
  • Throughput or off take agreements

23
Project FinanceDesign of Risk SharingContractual
Structure
Lending Banks
Advisors
Project Sponsors
Financing Agreement
Financial, Legal, Insurance advice
Shareholders Agreement
Offtake/Product Purchase
Offtake/Purchase Contract
Project Company
Insurance Policies
Insurers
Supply contract
Operation and Maintenance Agreement
Raw Material supplier
Construction contract
Operator
Construction
24
Project FinanceThe Funding Package 1
  • The objective is to
  • Create an acceptable
  • Risk/Return
  • relationship for the participants
  • Build in flexibility to cater for variations in
    project outturn
  • Risk hedging
  • - financial by debt
  • - interest rate risk
  • - foreign exchange rate

25
Project FinanceThe Funding Package 2
  • As little straight equity as possible (but some)
  • Quasi equity e.g. subordinated loan stock
  • - more flexible
  • - performs like mezzanine finance
  • (leveraged buyouts)

26
PF Subordinated Debt
  • What Does Subordinated Debt Mean?A loan (or
    security) that ranks below other loans (or
    securities) with regard to claims on assets or
    earnings. Also known as a "junior security" or
    "subordinated loan".

27
PF Junior Security/Debt
  • What Does Junior Security Mean?A security that
    ranks lower than other securities in regards to
    the owner's claims on assets and income in the
    event of the issuer becoming insolvent.
  • Investopedia explains Junior SecurityWhen
    bankruptcy occurs, holders of both preferred
    shares and debt securities have first claim on
    the remaining assets. Only after preferred
    shareholders have been paid back, remaining
    assets (if any) are divided among common
    shareholders.

28
PFSenior Debt
  • What Does Senior Issue Mean?An issue of bonds,
    preferred stock or other securities that
    represents the first priority lien on the
    issuer's assets or earnings. Senior issues have a
    higher priority claim on a firm's dividends,
    interest payments, or in case of a bankruptcy,
    the value salvaged from a liquidation.
  • Investopedia explains Senior IssuePriority
    levels may change in the subordinated debt
    structure. An issue that is considered senior may
    lose that title in certain situations. For
    example, if a firm claims bankruptcy and begins
    acting as a debtor in possession (DIP), it may
    attempt to raise more funds to keep operations
    going. A new lender may require its lien to be
    given top priority, forcing the current senior
    issue of bonds down the claims ladder.

29
PF Senior Security
  • Notwithstanding the senior status of a loan or
    other debt instrument, another debt instrument
    (whether senior or otherwise) may benefit from
    security that effectively renders that other
    instrument more likely to be repaid in an
    insolvency than unsecured senior debt. Lenders of
    a secured debt instrument (regardless of ranking)
    receive the benefit of the security for that
    instrument until they are repaid in full, without
    having to share the benefit of that security with
    any other lenders. If the value of the security
    is insufficient to repay the secured debt, the
    residual unpaid claim will rank according to its
    documentation (whether senior or otherwise), and
    will receive pro rata treatment with other
    unsecured debts of such rank.
  • Source Investopedia and Wikipedia

30
PF Mezzanine Finance
  • What Does Mezzanine Financing Mean?A hybrid of
    debt and equity financing that is is typically
    used to finance the expansion of existing
    companies. Mezzanine financing is basically debt
    capital that gives the lender the rights to
    convert to an ownership or equity interest in the
    company if the loan is not paid back in time and
    in full. It is generally subordinated to debt
    provided by senior lenders such as banks and
    venture capital companies. Since mezzanine
    financing is usually provided to the borrower
    very quickly with little due diligence on the
    part of the lender and little or no collateral on
    the part of the borrower, this type of financing
    is aggressively priced with the lender seeking a
    return in the 20-30 range. 
  • Investopedia explains Mezzanine
    FinancingMezzanine financing is
    advantageous because it is treated like equity on
    a company's balance sheet and may make it easier
    to obtain standard bank financing. To attract
    mezzanine financing, a company usually must
    demonstrate a track record in the industry with
    an established reputation and product, a history
    of profitability and a viable expansion plan for
    the business (e.g. expansions, acquisitions,
    IPO).

31
PF Mezzanine Finance
  • Mezzanine capital, in finance, refers to a
    subordinated debt or preferred equity instrument
    that represents a claim on company's assets,
    which is senior only to that of the common
    shares. Mezzanine financings can be structured
    either as debt (typically an unsecured and
    subordinated note) or preferred stock.
  • Mezzanine capital often is a more expensive
    financing source for a company than secured debt
    or senior debt. The higher cost of capital
    associated with mezzanine financings is the
    result of its location as an unsecured,
    subordinated (or junior) obligation in a
    company's capital structure (i.e., in the event
    of default, the mezzanine financing is less
    likely to be repaid in full after all senior
    obligations have been satisfied). Additionally,
    mezzanine financings, which are usually private
    placements are also often used by smaller
    companies and may also involve greater overall
    leverage levels than issuers in the High Yield
    market and as such involve additional risk. In
    compensation for the increased risk, mezzanine
    debt holders will require a higher return for
    their investment than secured or other more
    senior lenders.
  • Source Wikipedia

32
PF Mezzanine Finance
  • Leveraged buyouts
  • In a leveraged buyouts, mezzanine capital is used
    in conjunction with other securities to fund the
    purchase price of the company being acquired.
    Typically, mezzanine capital will be used to fill
    a financing gap between less expensive forms of
    financing (e.g., senior loans, second lien loan,
    high yield financings) and equity. Often, a
    financial sponsor will exhaust other sources of
    capital before turning to mezzanine capital.
  • Financial sponsors will seek to use mezzanine
    capital in a leveraged buyout in order to reduce
    the amount of the capital invested by the private
    equity firm. Because mezzanine lenders typically
    have a lower target cost of capital than the
    private equity investor, using mezzanine capital
    can potentially enhance the private equity firm's
    investment returns. Additionally, middle market
    companies may be unable to access the high yield
    market due to high minimum size requirements,
    creating a need for flexible, private mezzanine
    capital.

33
Project FinanceFunding Package 2
  • Back to Subordinated Loan
  • Gives advantages such as
  • - higher return than senior debt
  • - can carry low and flexible coupon
  • - tax deductible
  • - can be regarded as equity by senior
  • lenders

34
Project FinanceThe Funding Package 3
  • Debt will be sourced from a variety of providers
  • Export Credit Agencies e.g. ECGD, COFACE, HERMES,
    Eximbank, SACE
  • Buyer and Supplier credits
  • Non commercial finance e.g. development loans
    from regional national or international
    development agencies e.g. EIB, EBRD, Asian
    Development Bank

35
Project FinanceThe Funding Package 3
  • Long and short term asset finance e.g. leasing
  • Conventional trade finance
  • Bond issues
  • Conventional senior debt

36
Project FinanceThe Funding Package 4
  • Design and Monitoring
  • - Debt service ratios
  • - Based on free cash flows
  • Economic test

37
Project FinanceThe Funding Package 5
  • Annual Debt Service Cover Ratio
  • (ADSCR)
  • Period project cash flows before interest
    payable and debt repayment
  • Divided by
  • Period interest payable and debt repayments
  • Calculated for each period
  • Minimum ratios between 1.25 to 2.00

38
Project FinanceThe Funding Package 6
  • Multi period ratios
  • Loan Life Cover Ratio (LLCR)
  • NPV of free cash flows over loan life
  • Outstanding Debt
  • Project Life Cover Ratio (PLCR)
  • NPV of free cash flows over project life
  • Outstanding Debt
  • Note Discount used is the average interest cost
    so relates to PV of the project to the bank
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