Title: Project Finance
1Project Finance
- A General Introduction1
- One Example of Off Balance Sheet Financing
Techniques
2Project 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
3Project Finance
- The project is
- Not consolidated as not controlled by the
reporting entity - Liabilities remain within ring fenced entity
- or
- Special Purpose Vehicle (SPV)
4Source 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.
5Project 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
6Project 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
7Project 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
8Project FinanceCharacteristics of PF
- A variety of funding sources
- - export credits
- - development funds
- - specialised asset finance
- - conventional debt and
- - equity finance
9Project 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
10Project FinanceBOT
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
11Project Finance
12Project 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
13Project FinanceWhy? continued
- What risks for oil?
- Exploration
- - geological interpretation
- - harsh environments
- - political risks
14Project 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
15Project 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
16Project 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
17Project 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
18Project 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
19Project 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
20Project 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
21Project 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
22Project 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
23Project 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
24Project 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
25Project 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)
26PF 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".
27PF 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.
28PFSenior 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.
29PF 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
30PF 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).
31PF 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
32PF 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.
33Project 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
34Project 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
35Project FinanceThe Funding Package 3
- Long and short term asset finance e.g. leasing
- Conventional trade finance
- Bond issues
- Conventional senior debt
-
36Project FinanceThe Funding Package 4
- Design and Monitoring
- - Debt service ratios
- - Based on free cash flows
- Economic test
37Project 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
38Project 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