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.

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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

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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

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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

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Project FinanceCharacteristics of PF

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

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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

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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
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Project Finance
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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

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Project FinanceWhy? continued

• What risks for oil?
• Exploration
• - geological interpretation
• - harsh environments
• - political risks

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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

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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

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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

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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

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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

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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

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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

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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

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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
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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

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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)

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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".

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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.

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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.

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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

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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).

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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

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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.

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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

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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

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Project FinanceThe Funding Package 3

• Long and short term asset finance e.g. leasing
• Conventional trade finance
• Bond issues
• Conventional senior debt

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Project FinanceThe Funding Package 4

• Design and Monitoring
• - Debt service ratios
• - Based on free cash flows
• Economic test

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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

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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