Title: Project Finance Professor Pierre Hillion * Bank
1 Project Finance
2Project Finance
-
- A project company is like a leveraged buyout
(LBO), except that an LBO is a financing decision
involving existing assets, whereas project
finance is an investment and a financing decision
involving new assets - B. Esty
3OutlineÂ
- Introduction
- Part 1 Overview of Project Finance
- Part 2 Statistics
- Part 3 Project Finance versus Corporate Finance
- Part 4 Leverage and Financing Issues
- Conclusion
- Appendices
4INTRODUCTION
- Definition Project Finance
5Definition of Project FinanceÂ
- Project Finance (PF) involves
- the creation of a legally independent project
company - financed with
- -non-recourse debt
- -equity from one or more sponsoring firms
- for the purpose of financing an investment in a
single-purpose capital asset - usually with a limited life.
6PART 1
- Overview of Project Finance
7Overview of Project Finance Parties Involved
- Sponsors and investors they are generally
involved in the construction and the management
of the project. Other equity-holders may be
companies with commercial ties to the project,
i.e., customers, suppliers - Lenders The needed finance is generally raised
in the form of debt from a syndicate of lenders
such as banks and less frequently from the bond
market. - Government project company need to obtain a
concession from the host government. - Role of type of contract Build-own-operate (BOO)
or Build-transfer-operate (BOT). - Control on revenues such as for example
Eurostar, British Jail, - Suppliers and Contractors Role of turnkey
contracts to make sure that construction is
completed within costs and on schedule. Turnkey
contracts specify a fixed price and penalties for
delays. - Customers Depending on the contract, multiple or
a single customer.
8Overview of Project Finance Main CharacteristicsÂ
- Organizational Structure
- - Project companies involve separate legal
incorporation. -
- Capital Structure
- - Project companies employ very high leverage
compared to public firms. - Ownership Structure
- - Project companies have highly concentrated
debt and equity ownership structures. - Board Structure
- - Project boards are comprised primarily of
affiliated directors from the sponsoring firms. - Contractual Structure
- - Project finance is referred to as contract
finance because a typical transaction involves
numerous contractual agreements from input
suppliers to output buyers.
9Overview of Project Finance Main
Characteristics
- Independent, single purpose company formed to
build and operate the project. - Extensive contracting
- As many as 15 parties and up to 1000 contracts.
- Contracts govern inputs, construction, operation,
outputs. - Government contracts/concessions one off or
operate-transfer. - Ancillary contracts include financial hedges,
insurance for Force Majeure, etc. - Highly concentrated equity and debt ownership
- One to three equity sponsors.
- Syndicate of banks and/or financial institutions
provide credit. - Governing Board comprised of mainly affiliated
directors from sponsoring firms. - Extremely high debt levels
- Mean debt of 70 and as high as nearly 100.
- Balance of capital provided by sponsors in the
form of equity or quasi equity (subordinated
debt). - Debt is non-recourse to the sponsors.
- Debt service depends exclusively on project
revenues. - Has higher spreads than corporate debt.
10Overview of Project Finance Contractual
Agreements
- Contractual and financing arrangements between
the various parties are essential in project
finance - Concession agreement with a government
- Engineering, Procurement and Construction (EPC)
Contract - between the Project Company the Engineering
Firm - Operations and Maintenance (O M) Agreement
- between the Operations Contractor and the Project
Company, obligates the Operator to operate and
maintain the project - Shareholders Agreement
- governs the business relationship of the equity
partners - Inter-creditor Agreement
- an agreement between lenders or class of lenders
that describes the rights and obligations in the
event of default. - Supply Agreement
- agreement between the supplier of a critical key
input and the Project Company (e.g. agreement
between a coal supplier and a power station) - Purchase Agreement
- agreement between the major user of the project
output and the Project Company - agreement between a metropolitan council and a
power station
11Overview of Project Finance Return Distribution
- Capital providers earn an appropriate
risk-adjusted rate of return on a portfolio of
investments by earning, either high rates of
return on just a few investments, or low rates of
return on many projects. The former corresponds
to the venture capital (VC) industry, and the
latter to PF. - VC is used for intangible assets with significant
return uncertainty and little residual value in
the event of failure. Equity has an effective
payoff structure because it allows investors to
capture unlimited upside. In contrast, debt does
not work for these high risk investments with
positively skewed returns. In VC, managers are
responsible for managing growth options and
transforming a small amount of capital into large
companies. - In PF, managers are responsible for transforming
a large amount of capital into something worth a
little more. Project returns have a limited
upside. This means that a large fraction of
projects must be successful and generate positive
returns for capital providers to earn proper
returns.
12Overview of Project Finance Return Distribution
- Projects are exposed to three types of risk
- - Symmetric risks including market risk
(quantity), market risk (price), input or supply
risk, exchange, interest and inflation rate
risks, reserve risk, throughput risk. Exposures
to symmetric risks causes larger positive and
negative deviations from the expected outcome. - - Asymmetric risks including environmental
risk, expropriation risk. These risks cause only
negative deviations in the expected outcome. - - Binary risks including technology failure,
full expropriation, counterparty failure,
regulatory risk, force majeureThese risks
increase the probability that an asset ends up
worthless. -
- In practice, projects have relatively low asset
risk allowing a high debt capacity. The use of
leverage introduces financial risk which allow
equity-holders to capture unlimited upside once
debt claims have been satisfied.
13Overview of Project Finance Risk Management
Matrix
14Overview of Project Finance Risk Management
Matrix
15Overview of Project Finance Comparison with
Other Forms of Financing Â
16PART 2
17Project Finance Statistics
- Historically project finance was used by private
sector for industrial projects, such as mines,
pipes, oil fields. In the early 70s, BP raised
945 million to develop the Forties Field in
the North Sea. - The beginning of modern project finance starts
with the passage of the Public Utility Regulator
Act in 1978 in the US to encourage investment in
alternative non-fossil fuel energy generators. - From early 1990s, private firms start financing a
wide range of assets such as toll roads, power
plants, telecommunications systems located in a
wider range of countries. - Project sponsors have been pushing the boundaries
of project finance for most of the last 15 years
by increasing sovereign, market and technology
risks. - World Bank study global investment in new
infrastructure assets 369 billion per year from
2005-2010 with 63 in developing nations, e.g.
Asia, Africa.
18Project Finance StatisticsÂ
- Outstanding Statistics
- Over 408bn of capital expenditure using project
finance in 2008. - US67bn in US capital expenditures which is
- smaller than the US 645 billion investment grade
corporate bonds market, 187 billion
mortgage-backed security market, 160 billion
asset-backed security market, and 387 billion
tax-free municipal bond market (NB these markets
shrank significantly in 2008 from 2006 levels due
to subprime crisis). - but larger than the 26bn IPO market and the
45bn venture capital market. - Some major deals
- US10.65bn 2005 Qatargas 2 project (LNG
production) involved 57 lenders - US3.8bn 2006 Peru LNG plant
- US3.7bn 2007 Madagascar Nickel-Cobalt Mining and
Processing Project - In Singapore, US1.4bn Singapore Sports Hub
19Project Finance Statistics
Overall 5-Year CAGR of 19 for private sector
investment. Project Lending 5-Year CAGR of 21.
20Project Finance Statistics
21Project Finance Statistics
22Project Finance Statistics
- 34 of overall lending in Power Projects, 21 in
Transportation.
23Project Finance Statistics
- 5-Year CAGR for Power Projects 30, Oil
Gas30, Mining 59 and Leisure Property 36.
24Project Finance Statistics
- Size distribution of projects
- - 41 lt 100 million, (7 of the total value
of the PF market) - - 19 gt 500 million, (70 of the total value)
- - 8 gt 1.0 billion, (55 of the total
value) - - mean size 435 million, median size 139
million - Project duration
- - Mean (median) construction years 2.1 (2.0)
years - - Mean (median) concession contract 28 (25)
years - - Mean (median) length of off-take agreements
19 (20) years - Project leverage Mean (median)
debt-to-capitalization ratios 71 (76) - Maturity of debt instruments
- -Median maturity of bank loans 9.8 years
- - Median maturity of bonds 11.6 years
-
25PART 3
- Project Finance (PF) versus Corporate Finance (CF)
26PF versus CF Rationale for Project Finance
- Project finance allows firms
- to minimize the net costs associated with market
imperfections such as - - incentive conflicts,
- - asymmetric information,
- - financial distress,
- - transaction costs,
- - taxes.
- to manage risks more effectively and more
efficiently.
27PF versus CF Rationale for Project Finance
- Corporate Finance
- A company invests in many projects
simultaneously. - The investment is financed as part of the
companys existing balance sheet. The lenders can
rely on the cash flows and assets of the sponsor
company apart from the project itself. Lenders
have a larger pool of cash flows from which to
get paid. Cash flows and assets are
cross-collateralized. - Publicly traded firms have typical leverage
ratios of 20 to 30.
- Project Finance
- Purpose a single purpose capital asset, usually
a long-term illiquid asset. The project company
is dissolved once the project is completed. No
growth opportunities. - A legally independent project The project
company does not have access to the
internally-generated cash flows of the sponsoring
firm and vice versa. - The investment is financed with non-recourse
debt. All the interest and loan repayments come
from the cash flows generated from the project. -
- Project companies have very high leverage ratios,
with the majority of debt coming from bank loans.
28PF versus CF Rationale for Project Finance
- Modigliani and Miller show that corporate
financing decisions do not affect firm value
under perfect and efficient markets. The rise of
project finance provides strong evidence that
financing structures do matter. - it is not clear why firms use project finance
given that - - It takes longer and it costs more to structure
a legally independent project company than to
finance a similar asset as part of a corporate
balance sheet. - - Project debt is often more expensive (50 to
400 bps) than corporate debt due to its
non-recourse nature (no benefit of
co-insurance). - - The combination of high leverage and extensive
contracting restricts managerial discretion and
managerial flexibility. - - Project finance requires greater disclosure of
proprietary information which can be costly from
a competitive perspective. - - It is harder to obtain operating synergies as
the project is independent. - - The likelihood of using interest tax shields
and net operating losses is lower.
29PF versus CF Rationale for Project Finance
- Financing decisions matter under
imperfect/inefficient markets. Firms bear
deadweight costs (DWC) when they invest in and
finance new assets. - DWCs result from market imperfections. They
include - - agency costs and incentive conflicts
- - asymmetric information costs
- - financial distress costs
- - transaction costs
- - taxes
- DWCs change under alternative financing
structures, i.e., corporate finance versus
project finance. - Sponsors should use project finance whenever the
DWC are lower than their corporate finance
counterparts.
30PF versus CF Rationale for Project Finance
- Project finance reduces costly agency conflicts
- - Conflicts between ownership and control
- - Conflicts between ownership and related
parties - - Conflicts between ownership and debtholders
- Project finance reduces information costs
(asymmetric information). - Project finance reduces costly underinvestment,
in particular leverage-Induced underinvestment. -
- Project finance, as a organizational risk
management tool, reduces the potential collateral
damage that a high risk project can impose on a
sponsoring firm, i.e., risk contamination. It
also reduces the costs of financial distress and
solves a potential underinvestment problem.
31Project Finance versus Corporate Finance
- Resolution of Agency Conflicts between Ownership
and Control
32Agency Conflicts between Ownership and Control
- Costly agency conflicts arise when managers who
control investment decisions and cash flows have
different incentives from capital providers. - Certain asset characteristics make assets prone
to costly agency conflicts Tangible assets that
generate high operating margins and significant
amounts of cash flow can lead to - - inefficient investment
- - excessive perquisite consumption
- - value destruction
- Ex The agency costs of free cash flows are
higher in cement than in drugs. - Solving the problem of ownership and control is
important in project companies where few of the
traditional sources of discipline are present or
effective.
33Agency Conflicts between Ownership and Control
- Project Finance
- Project company is dissolved once the project
gets completed. No future growth opportunities. - Cash flows of the project are separated from
cash flows of sponsors. The single discrete
project enable lenders to easily monitor project
cash flows. - The verifiability of CFs is enhanced by the
waterfall contract that specifies how project CFs
are used.
- Corporate Finance
- Company invests in many projects and possesses
many growth opportunities. - Cash flow separation is difficult to accomplish
in corporate finance. Project cash flows are
co-mingled with the cash flows from other assets
making monitoring of cash flows difficult. - The verifiability of cash flows is difficult.
34Agency Conflicts between Ownership and Control
- Project finance
- Monitoring mechanisms include
- Managerial discretion is constrained by extensive
contracting. Claims on cash flows are prioritized
through the CF waterfall. - Concentrated equity ownership provides critical
monitoring, The unique board of directors and
separate legal incorporation makes monitoring
more simple and efficient. - High leverage both the amount and type
(maturity) Bank loans provide credit
monitoring. - Senior bank debt disgorges cash in early years.
- Corporate Finance
- Traditional monitoring mechanisms include
- Takeover market
- Product market
- Reputation
- Staged investment
- Staged financing
- Leverage high debt service forces managers to
disgorge free cash flows. - Creditors rights lenders threat to seize
collateral and threat of liquidation to deter
borrowers opportunism.
35Agency Conflicts between Ownership and Control
- From a sample of 6045 project loans (provided to
project companies and corporations) from 40
countries originated between 1993 and 2003 - PF is much less likely in the US (19) than in
the rest of the world (53) and in English and
Scandinavian legal origin countries than in
French or German legal origins. Why? - PF is more likely in countries with weak
protection against managerial self-dealing. - In countries that provide weak protection to
minority investors against expropriation by
insiders, PF is relatively more likely than CF in
industries where free cash flows to assets is
higher. - In countries that provide stronger protection to
creditors, the effects of weaker protection
against managerial self-dealing in encouraging PF
is lower. - Large deadweight costs incurred in bankruptcy
increase the likelihood of PF as bankruptcy costs
are lower in PF than in CF. PF is less likely
when the bankruptcy process is more efficient.
36Project Finance versus Corporate Finance
- Resolution of Agency Conflicts between Ownership
and Related Parties
37Agency Conflicts between Ownership and Related
Parties
Problem (Hold Up) A second type of agency
conflict is the opportunistic behavior by related
parties, causing ex-ante reduction in expected
returns and ex-ante incentives to invest. The
most common culprits are related parties that
supply critical inputs, buy primary outputs, and
host nations that supply the legal system and
contractual enforcement.
- Standard Approach
- Vertical integration (not always possible or
desirable). - Long term contracts, with contract duration
increasing with asset specificity.
- Project Finance Approach
- Joint ownership that allocate the residual cash
flow rights and asset control rights among the
deal participants. - High debt level. With high leverage, small
attempts to appropriate value will result - In costly default and possibly a change in
control.
38Agency Conflicts between Ownership and Related
Parties
Problem (Expropriation) Opportunistic behavior
by host governments. They provide a critical
input, the legal system and the protection of
property rights. Either direct through asset
seizure or creeping through increased
tax/royalty. This causes an ex-ante increase in
risk and required return.
- Standard Approach
- Visibility/reputation
- High leverage.
- Project Finance Approach
- High leverage to discourage expropriation (excess
cash is disgorged, lower profits and less
visibility). - Multilateral lenders involvement as a deterrent
against expropriation. - Joint ownership.
39Agency Conflicts between Ownership and Related
Parties
- Why corporate finance cannot deter opportunistic
behavior? - Do not allow joint ownership and when they do
(VC), they are susceptible to free cash flow
problems. - Direct expropriation can occur without triggering
default because corporate assets and cash flows
cross-collateralize each debt obligation. - .
- Multi lateral lenders which help mitigate
sovereign risk lend only to project companies. - Non-recourse debt had tougher covenants than
corporate debt and enforces greater discipline. - In the presence of a corporate safety net, the
incentive to generate free cash is lower.
40Project Finance versus Corporate Finance
- Resolution of Agency Conflicts between Ownership
and Debtholders
41Agency Conflicts between Ownership and
Debtholders
- Standard Approach
- Strong debt covenants allow both equity/debt
holders to better monitor management.
- Problem
- Debt/Equity holder conflict in distribution of
cash flows, re-investment and restructuring
during distress. High leverage can lead to risk
shifting and underinvestment.
- Project Finance Approach
- Cash flow waterfall reduces managerial discretion
and thus potential conflicts - Concentrated ownership ensures close monitoring
and adherence to the prescribed rules. - To facilitate restructuring, concentrated debt
ownership, less classes of debtors, and bank
debt, are preferred. Bank debt is much easier to
restructure than bonds. - With few growth options, the opportunity cost of
underinvestment due to leverage is negligible in
project companies. - Opportunities for risk shifting do not exist
because the cash flow waterfall restrict
investment decisions.
42Project Finance versus Corporate Finance
- Decrease in Asymmetric Information Costs
43Decrease in Asymmetric Information Costs
- Standard Approach
- Disclosure.
- Analyst-relationship.
- Institutional shareholder, activist game.
- Signaling
- Problem
- .Insiders know more about the value of assets in
place and growth opportunities than outsiders.
Asymmetric information increases monitoring
costs and increases cost of capital (equity is
more costly than debt).
- Project Finance Approach
- Segregated cash flows enhance transparency, which
decreases monitoring costs. - Segregation eliminates the need to analyze other
corporate assets or cash flows. Creditors can
analyze the project on a stand-alone basis. - Project structure reserves the sponsors debt
capacity/ flexibility to fund higher risk
projects internally
44Project Finance versus Corporate Finance
- Resolution of Under-Investment problem
45Resolution of Under-Investment Problem
- Debt Overhang Firms with high leverage, risk
averse managers and asymmetric information have
trouble financing attractive investment
opportunities. This leads to under investment in
positive NPV projects due to limited corporate
debt capacity as new debt is limited by
covenants. - Standard Approach Use of secured debt, senior
bank debt, new equity (raised at a discount). - Project Finance Approach
- - Non recourse debt in an independent entity
allocates returns to new capital providers
without any claims on the sponsors balance
sheet. This preserves scarce corporate debt
capacity and allows the firm to borrow more
cheaply than it otherwise would. - - Project finance is more effective than secured
debt because it eliminates recourse back to the
sponsoring firm.
46Project Finance versus Corporate Finance
- Project Finance as an Organizational Risk
Management Tool
47Project Finance as an Organizational Risk
Management Tool
- Standard Approach
- Hedging, or foregoing the project
(under-investment)
- Problem
- A high risk project can potentially drag a
healthy corporation into distress. Short of
actual failure, the risky project can increase
cash flow volatility, the expected costs of
financial distress, and reduce firm value.
Conversely, a failing corporation can drag a
healthy project along with it.
- Project Finance Approach
- Project financed investment exposes the
corporation to losses only to the extent of its
equity commitment, thereby reducing its distress
costs. - Through project financing, sponsors can share
project risk with other sponsors. Pooling of
capital reduces each providers distress cost due
to the relatively smaller size of the investment
and therefore the overall distress costs are
reduced. - PF adds value by reducing the probability of
distress at the sponsor level and by reducing the
costs of distress at the project level. This
facilitates the use of high leverage.
48Project Finance as an Organizational Risk
Management Tool
- Risky projects impose deadweight costs on
sponsors. Costs of financial distress represent a
low of 3 up to 10-20 of firm value. They
include both direct costs, such as legal
expenses, bankers fees and indirect costs such
as - - Underinvestment by the sponsor.
- - Underinvestment by related parties as distress
may deter business partners, from making
long-term investments. - - Lost sales as distress may discourage
customers. - -Lost interest tax shield as volatility
increases the probability of generating losses. - - Human capital
-
49Project Finance as an Organizational Risk
Management Tool
- If a firm uses corporate finance, it becomes
vulnerable to risk contamination, the possibility
that a poor outcome for the project causes
financial distress for the parent. This cost is
offset by the benefit of co-insurance whereby
project cash flows prevent the parent from
defaulting. - From the parent corporation perspective,
corporate finance is preferred when the benefits
of co-insurance exceed the risk of contamination
and vice versa. - Project finance is more likely when projects are
large compared to the sponsor, have greater total
risk and have high positively correlated cash
flows.
50Project Finance as an Organizational Risk
Management Tool
- Risk (variance) is a proxy fro distress costs and
the probability of risk - contamination. Combined cash flow variance (of
project and sponsor) with - joint financing increase with
- Relative size of the project.
- Project risk.
- Positive Cash flow correlation between sponsor
and project.
Firm value decreases due to cost of financial
distress which increases with combined variance
Project finance is preferred when joint
financing (corporate finance) results in
increased combined variance.Corporate finance
is preferred when it results in lower combined
variance due to diversification (co-insurance).
51Project Finance as an Organizational Risk
Management Tool
- Corporate-financed investment involves the
combination of 2 risky assets - Sponsor (S) Project (P)
- Total Risk Variance of Combined returns
- Compare Risk with and without investment
Var(RPRS) vs. Var(RS) - Portfolio Theory tells us
- Var(RPRS) wP2Var(RP) wS2Var(RS)
2wPwSCorr(RPRS)sPsS - where
- wP ,wS proportion of value in the
project/sponsor - Var(RP), Var(RS) variance of project/sponsor
returns - sP ,sS standard deviation of project/sponsor
returns
52Project Finance as an Organizational Risk
Management Tool
- Financial Distress is costly
- Expected costs of financial distress
Prob(distress)Cost of Distress - Probability(distress) is related to Total Risk,
leverage and asset/,liability matching - Total Risk is a function of Risk Contamination.
- So what factors matter the most for Risk
Contamination? - Relative Size Project/(Project Sponsor)
- Project Risk Var(RP)
- Return Correlation Corr(RP,RS)
53Project Finance as an Organizational Risk
Management Tool Impact of Project Size on Total
Risk (Project Risk 50)
Return Variance
Big Project (wP 50)
Medium Project (wP 33)
Sponsor Stand-Alone Return Variance 20
20
Small Project (wP 5)
1.0
-1.0
Correlation of Sponsor and Project Returns
54Project Finance as a n Organizational Risk
Management Tool Impact of Project Size on Total
Risk (Project Risk 33)
Return Variance
High Risk (VarP 50)
Sponsor Stand-Alone Return Variance 20
Medium Risk (VarP 20)
20
Low Risk (VarP 10)
1.0
-1.0
Correlation of Sponsor and Project Returns
55Project Finance as an Organizational Risk
Management Tool
- Usually diversification is beneficial. Here,
diversification (corporate finance) can be worth
less than specialization (project finance). - If corporate-financed investment causes total
risk, and hence costs of financial distress to
increase enough, PF may reduces the incremental
costs of financial distress by isolating and
containing project risk. - - For project finance to make sense, the
reduction in the costs of financial distress must
exceed the incremental transaction costs . -
- - Project finance lowers the net costs of
financing certain assets. Large, tangible, risky
assets make the best candidates for project
finance, particularly when they have returns that
are positively correlated with the sponsors
existing assets.
56Project Finance as an Organizational Risk
Management Tool
- Example
- Consider a riskless sponsor. Its assets are worth
100 in all states of the world and it is financed
with 30 of riskless debt. It has the opportunity
to invest in a 0 NPV, risky project worth 200 in
the good state and 0 in the bad state and is
financed with 85 of (junior) debt. Assume that
with the possibility of default, the costs of
financial distressed imposed on the sponsors
existing assets are equal to 5. The managers
job is to decide whether to invest using
corporate finance, invest using project finance,
or not at all. - Assume
- - a one period model
- - the good and the bad states are equally
probable - - the risk-free rate is 0
- - the manager is risk-neutral
- - the organizational form does not affect
operating synergies - - no structuring costs
- - no relation between project structure and
project cash flows
57Project Finance as an Organizational Risk
Management Tool
- Example
- No investment The sponsor is worth 100, the debt
is worth its face value of 30 and the equity is
worth 70. There is no possibility of default. - Corporate financed investment Assets are reduced
by 5 in both states of the world. The new
debt-holders invest only 75 for the project and
equity-holders the remaining 25. Equity is worth
65 (90-25). The equity-holders bear the distress
costs. Managers acting on behalf on existing
shareholders would not make the investment. - Project-financed investment The sponsor raises
42.5 of new project debt and invests 57.5 into
the project. Default is contained at the project
level and there is no collateral damage inflicted
at the sponsor level. The sponsor does not incur
incremental distress costs.
58Project Finance Versus Corporate Finance
- Project Finance as Insurance
59Project Finance as Insurance
- Compare the choice faced by sponsors between
corporate finance and project finance - When sponsors use corporate finance, they expose
themselves to the full range of outcomes (NPVs). -
- When sponsors use project finance, they truncate
the downside. The decision to use project
finance can be thought of as the decision to buy
a walkaway put option on the project. The
combination of holding an underlying asset
(project) and buying a put option on that asset
gives the payoff function of a call option. - The downside protection may be valuable but the
choice between corporate finance and project
finance depends on the put premium and the
willingness of sponsors to exercise the put
option.
60Project Finance as InsurancePayoffs to
Project-Financed vs.Corporate Financed Investment
Sponsor Equity Value
Corporate Finance Payoff
Project Finance Payoff
Project Value
0
Walkaway Put Option
D
61Project Finance as Insurance
- Project Finance provides sponsors with a put
option - The put premium is paid in the form of higher
interest and fees on loans. Lenders who are at an
informational disadvantage are likely to charge a
high price for the option. Sponsors may prefer to
bear the risk rather than to buy an expensive
option. As projects get bigger, distress costs
increase, making the purchase of a put by
sponsors more likely. - The put option is valuable only if sponsors are
able/willing to exercise the option. Sponsors who
cannot walk away from the project because - It is in a pre-completion stage and the sponsor
has provided a completion guarantee, - It has take or pay contracts,
- It is part of a larger development,
- It represents a proprietary asset,
- and for which default would damage the firms
reputation and ability to raise future capital, - cannot exercice the put and are more likely to
use corporate finance than project finance.
62Project Finance versus Corporate Finance
- Tax and Other Benefits of project Finance
63Taxes, Location, Heterogenous Partners
- Location Large projects in emerging markets
cannot be financed by local equity due to supply
constraints. Investment specific equity from
foreign investors is either hard to get or
expensive. Debt is the only option and project
finance is the optimal structure.
- Tax An independent economic entity allows
projects to obtain tax benefits that are not
available to the sponsors. When a project is
located in a high-tax country and the project
company in a lower tax country, it may be
beneficial for the sponsor to locate the debt in
the high tax country.
- Heterogeneous partners
- Financially weak partner needs project finance to
participate. - Financially weak partner if using corporate
finance can be seen as free-riding. - The bigger partner is better equipped to
negotiate terms with banks than the smaller
partner and hence has to participate in project
finance.
64Part 4
- Leverage and Financing Issues
65Leverage and Financing Issues
- Debt offers multiple benefits
- Tax Advantages.
- Helps to solve Free Cash Flow Problem.
- Helps to solve Political Problem (Hold Up)
- There are lower bankruptcy costs than in
corporate finance (large tangible assets).
66Leverage and Financing Issues How to Finance the
Project
- Bank Loans
- Advantages
- Cheaper to issue.
- Concentrated ownership makes it easier for
lending. - Tighter covenants and better monitoring.
- Easier to restructure during distress.
- Lower duration forces managers to disgorge cash
early. - Bond market may be fickle.
- Draw on credit line as needed.
- Disadvantages
- Short maturity.
- Restrictive Covenants.
- Variable interest rates.
- Limited size.
67Leverage and Financing Issues How to Finance the
Project
- Project Bonds (144A Market)
- Advantages
- Private placement does not through SEC
registration procedure. - Lower interest rates (given good credit rating).
- Less and flexible covenants.
- Long Maturity.
- Fixed rates.
- Size, (US 100-200 million).
- Secondary trading.
- Disadvantages
- Disperse ownership
- less monitoring
- less efficient negotiations
- New market
- Lump sum nature
68Leverage and Financing Issues How to Finance
the Project
- Project Bonds
- Project bonds have negotiated ratings sponsors
adjust leverage, covenants and deal structure
until the projects achieve an investment-grade
rating. - The largest advantage in pricing and liquidity
occurs above the BBB- cutoff due to institutional
restrictions against investment in sub-investment
grade securities. Bonds must have an investment
grade to sell in the market. - Since 1998, the percentage of project bonds with
an investment grade (BBB- or higher) has ranged
from 63 to 67.
69Leverage and Financing Issues How to finance the
project
- Agency Loans
- Advantages
- Reduce expropriation risk.
- Validate social aspects of the project.
- Reduce political risk
- countries less likely to want to injure
multilateral agency. -
- Provide political risk insurance
- Overseas Private Investment Corporation (OPIC) in
U.S. - Multilateral Investment Guarantee Agency (MIGA)
of World Bank - provide insurance against political risks for up
to 20 years. - Disadvantages
- Cost (300 bp)
- Time (12-18 months to arrange)
70Conclusion
71Conclusion Future of Project Finance
- The future of PF will be shaped by many factors
- Financing structure There are four specific
financing trends - - hybrid project-corporate financings (corporate
debt structure with project-finance-like
covenants, with recourse to the sponsors in the
event of default unless default is due to
political risk) portfolio financing, i.e., the
bundling of multiple projects into a single
transaction. - - use of Term B loans, a bond with back-end
amortization with bank-type covenants, heavily
collateralized and carrying high interest rates. - - use of monoline bonds, bonds that wrap the
credit rating of the insurer around the debt
issue to raise the credit rating to AAA. - - participation of private equity, purchasing
both non-distressed and distressed assets.
72Conclusion Future of Project Finance
- Regulatory and environmental policy
- - new international capital standards (Basel
II), risk-weighting of project loans. - - management of environmental and social risks
(Equator Principles) whose focus is to assess and
minimize the social risks of large projects. - Expropriation risk has risen especially in
developing countries sponsors are increasingly
challenged to design and implement sustainable
long-term contracts and agreements with
governments or face the risk of expropriation. - Valuation of infrastructure assets with the
infrastructure sector in danger of suffering from
the dual curse of over-valuation and excessive
leverage, the classic symptoms of an asset
bubble.
73APPENDIX
- Project Finance versus Corporate Finance An
example
74Example BP AMOCO The Corporate Finance Model
- Long-term Financing
- Bonds
- Equity
BP Amoco
- Short-term Financing
- Commercial paper
- Bank loans
Business Units
Treasury Group
Cash Management and Money Market Instruments
Operating Cash Flow
400m
40 of Cash Flow
Project Cost 1 billion
Partner A 25 share
Partner B 35 share
250m
350m
25 of Cash Flow
35 of Cash Flow
75ExampleBP AMOCO The Project Finance Model
BP Amoco
Partner B 35 share
Partner A 25 share
Business Units
Treasury Group (40 share)
140 million equity
160 million equity
40 of operating cash flow
100 million equity
300 million secured loan
Project Cost 1 billion Equity 400
million Debt 600 million
300 million secured loan
144A Bond Market
Banks
payback Interest
paybackinterest
International Org.
Government
Suppliers
Contractors
76Alternative Sources of Risk Mitigation
77Alternative Approach to Risk Mitigation