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Project Finance Professor Pierre Hillion * Bank

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Title: Project Finance Professor Pierre Hillion * Bank


1
Project Finance
  • Professor Pierre Hillion

2
Project 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

3
Outline 
  • 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

4
INTRODUCTION
  • Definition Project Finance

5
Definition of Project Finance 
  • 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.

6
PART 1
  • Overview of Project Finance

7
Overview 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.

8
Overview of Project Finance Main Characteristics 
  • 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.

9
Overview  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.

10
Overview 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

11
Overview 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.

12
Overview 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.

13
Overview of Project Finance Risk Management
Matrix
14
Overview of Project Finance Risk Management
Matrix
15
Overview of Project Finance Comparison with
Other Forms of Financing  
16
PART 2
  • Statistics

17
Project 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.

18
Project Finance Statistics 
  • 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

19
Project Finance Statistics
Overall 5-Year CAGR of 19 for private sector
investment. Project Lending 5-Year CAGR of 21.
20
Project Finance Statistics
21
Project Finance Statistics
22
Project Finance Statistics
  • 34 of overall lending in Power Projects, 21 in
    Transportation.

23
Project Finance Statistics
  • 5-Year CAGR for Power Projects 30, Oil
    Gas30, Mining 59 and Leisure Property 36.

24
Project 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

25
PART 3
  • Project Finance (PF) versus Corporate Finance (CF)

26
PF 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.

27
PF 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.

28
PF 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.

29
PF 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.

30
PF 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.

31
Project Finance versus Corporate Finance
  • Resolution of Agency Conflicts between Ownership
    and Control

32
Agency 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.

33
Agency 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.

34
Agency 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.

35
Agency 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.

36
Project Finance versus Corporate Finance
  • Resolution of Agency Conflicts between Ownership
    and Related Parties

37
Agency 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.

38
Agency 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.

39
Agency 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.

40
Project Finance versus Corporate Finance
  • Resolution of Agency Conflicts between Ownership
    and Debtholders

41
Agency 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.

42
Project Finance versus Corporate Finance
  • Decrease in Asymmetric Information Costs

43
Decrease 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

44
Project Finance versus Corporate Finance
  • Resolution of Under-Investment problem

45
Resolution 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.

46
Project Finance versus Corporate Finance
  • Project Finance as an Organizational Risk
    Management Tool

47
Project 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.

48
Project 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

49
Project 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.

50
Project 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).
51
Project 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

52
Project 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)

53
Project 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
54
Project 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
55
Project 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.

56
Project 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

57
Project 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.

58
Project Finance Versus Corporate Finance
  • Project Finance as Insurance

59
Project 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.

60
Project 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
61
Project 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.

62
Project Finance versus Corporate Finance
  • Tax and Other Benefits of project Finance

63
Taxes, 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.

64
Part 4
  • Leverage and Financing Issues

65
Leverage 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).

66
Leverage 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.

67
Leverage 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

68
Leverage 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.

69
Leverage 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)

70
Conclusion
71
Conclusion 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.

72
Conclusion 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.

73
APPENDIX
  • Project Finance versus Corporate Finance An
    example

74
Example 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
75
ExampleBP 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
76
Alternative Sources of Risk Mitigation
77
Alternative Approach to Risk Mitigation
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