INTRODUCTION TO PROJECT FINANCE

1
INTRODUCTION TO PROJECT FINANCE
2
OUTLINE

1. What is Project Finance?
2. How does project finance create value?
3. Project valuation
4. Case analyses
5. Recap

3
What Is Project Finance?

• Definition
• Major characteristics
• Schematic example of a project structure
• Major project contracts

4
Definition

Project Finance involves one or more corporate
sponsors investing in and owning a single
purpose, industrial asset through a legally
independent project company financed with
limited or non-recourse debt.
A relevant question to investigate
Finance separately with non-recourse debt?
(Project Finance)
SPONSOR PROJECT?
Finance jointly with corporate funds? (Corporate
Finance)
5
Major characteristics

• Economically and legally independent project
  company
• Founded extensively on a series of legal
  contracts that unite parties from input suppliers
  to output purchaser
• Project assets/liabilities, cash flows, and
  contracts are separated from those of the
  sponsors, conditional on what accounting rules
  permit
• Investors and creditors have a clear claim on
  project assets and cash flows, independent from
  sponsors financial condition
• Debt is either limited (via completion
  guarantees) or non-recourse to the sponsors

6
Major characteristics

• Highly leveraged project company with
  concentrated equity ownership
• Partly due to firms need for flexibility and
  excess debt capacity to invest in attractive
  opportunities whenever they arise
• Syndicate of banks and/or financial institutions
  provide debt
• Typical D/V ratio as high as 70 and above
• Debt has higher spreads than corporate debt
• One to three equity sponsors
• Sponsors provide capital in the form of equity or
  quasi-equity (subordinated debt)
• Governing Board comprises of mainly affiliated
  directors from sponsors

7
Major characteristics

• Historically formed to finance large-scale
  projects
• Industrial projects mines, pipelines, oil fields
  
• Infrastructure projects toll roads, power
  plants, telecommunications systems
• Significant financial, developmental, and social
  returns
• Examples of project-financed investments
• 4bn Chad-Cameroon pipeline project
• 6bn Iridium global satellite project
• 1.4bn aluminum smelter in Mozambique
• 900m A2 Road project in Poland

8
Major characteristics

• Statistics as of year 2002
• 135bn of capital expenditure globally using
  project finance
• 19bn of capital expenditure in the US
• Smaller than the 612bn corporate bonds market,
  397bn asset backed securities market and 205bn
  leasing market approximately same size with the
  27bn IPO and 26bn venture capital market

9
A simplified project structure example

A nexus of contracts that aids the sharing of
risks, returns, and control
Source Esty, B., An Overview of Project Finance
2002 Update Typical project structure for an
independent power producer
10
Major project contracts

• The Offtake Contract
• A framework under which Project Company obtains
  revenues
• Provides the offtaker (purchaser) with a secure
  supply of project output, and the Project Company
  with the ability to sell the output on a
  pre-agreed basis
• Can take various forms, such as Take or Pay
  Contract
• Power Purchase Agreement (PPA)

• Input Supply Contract
• The Offtake Contract for the input supplier
• Provides the Project Company the security of
  input supplies on a pre-agreed pricing basis
• The terms of the Input Supply Contract are
  usually crafted to match those of the Offtake
  Contract (such as input volume, length of
  contract, force majeure, etc.)

11
Major project contracts

• Construction Contract
• A contract defining the turnkey responsibility
  to deliver a complete project ready for operation
  (a.k.a. Engineering, Procurement, Construction
  (EPC) Contract)
• Operation and Maintenance Contracts
• Ensures that the operating and maintenance costs
  stay within budget, and project operates as
  planned.

• Permits
• Contracts that ensure permits and other rights
  for construction and operation of the project, as
  well as for investing in and financing of the
  Project Company
• May be provided by central governments and/or
  local authorities
• Government Support Agreements
• Provisions may include guarantees on usage of
  public utilities, compensation for expropriation,
  tax exemptions, and litigation of disputes in an
  agreed jurisdiction

12
OUTLINE

1. What is Project Finance?
2. How does project finance create value?
3. Project valuation
4. Case analyses
5. Recap

13
How Does It Create Value?

• Drawbacks of using Project Finance
• Value creation by Project Finance
• Organizational structure
• Agency costs, debt overhang, risk contamination,
  risk mitigation
• Contractual structure
• Structuring the project contracts to allocate
  risk, return, and control
• Governance structure
• Benefits of debt-based governance
• Case examples to value creation

14
Drawbacks of Using Project Finance Structure

• Takes longer to structure and execute than
  equivalent size corporate finance
• Higher transaction costs due to creation of an
  independent entity and complex contractual
  structure
• Non-recourse project debt is more expensive due
  to greater risk and high leverage
• High leverage and extensive contracting restricts
  managerial flexibility
• Project finance requires greater disclosure of
  proprietary information to lenders

Still, the combination of organizational,
financial, and contractual features may offer an
opportunity to reduce net cost of financing and
improve performance
Structure matters, contrary to MM Proposition!
15
Why does structure matter?

Structural decisions may affect the existence and
magnitude of costs due to market perfections
Agency conflicts Financial distress
Structuring and executing transactions
Asymmetric information between parties
involved Taxes
Value Creation
Governance Structure
Organizational Structure
Contractual Structure
16
How Does It Create Value?

• Drawbacks of using Project Finance
• Value creation by Project Finance
• Organizational structure
• Agency costs, debt overhang, risk contamination,
  risk mitigation
• Contractual structure
• Structuring the project contracts to allocate
  risk, return, and control
• Governance structure
• Benefits of debt-based governance
• Case examples to value creation

17
Value creation by organizational structure
Agency Costs
Problems
Structural Solutions

• Concentrated equity ownership and single cash
  flow stream provides critical monitoring
• Strong debt covenants allow both sponsors and
  creditors to better monitor management
• High debt service reduces the free cash flow
  exposed to discretion
• Extensive contracting reduces managerial
  discretion
• Cash Flow Waterfall mechanism facilitates the
  management and allocation of cash flows, reducing
  managerial discretion. Covers capex, debt
  service, reserve accounts, and distribution of
  residual income to shareholders
• Given the projects are defined within narrow
  boundaries with limited investment opportunities,
  moral hazard (risk shifting, debt shifting,
  reluctance to invest) is minimized

• Agency conflicts between sponsors (owners) and
  management (control)
• High levels of free cash flow leading to
  overinvestment in negative NPV projects
• Risk shifting/debt shifting by managers to invest
  in high risk, negative NPV projects to recoup
  past losses
• Refusal to make additional investment

18
Value creation by organizational structure
Agency Costs
Problems
Structural Solutions

• Agency conflicts between sponsors and creditors
• Distribution of cash flows, re-investment, and
  restructuring during distress
• Moral hazard (such as risk shifting and debt
  shifting) encouraged by full recourse nature of
  debt to sponsor

• Cash Flow Waterfall mechanism reduces potential
  conflicts in distribution and re-investment of
  project revenues
• Legally/economically separate project company
  eliminates potential for risk shifting and debt
  shifting
• Concentrated debt ownership is preferred (i.e.
  bank loans vs. bonds) to facilitate the
  restructuring and speedy resolutions
• Usually subordinated debt (quasi equity) is
  provided by sponsors
• Strong debt covenants allow better monitoring
• Single cash flow stream and separate ownership
  provides easier monitoring

19
Value creation by organizational structure
Agency Costs
Problems
Structural Solutions

• Conflicts between sponsors and other parties
  (purchasers, suppliers, etc.)

• Vertical integration is effective in precluding
  opportunistic behavior but not at sharing risk.
  Also, opportunities for vertical integration may
  be absent.
• Long term contracts such as supply and off take
  contracts these are more effective mechanisms
  than spot market transactions and long term
  relationships.
• Joint ownership with related parties to share
  asset control and cash flow rights. This way
  counterparty incentives are aligned.

20
Value creation by organizational structure
Agency Costs
Problems
Structural Solutions

• Since project is large scale and the company is
  stand alone, acts of expropriation are highly
  visible in the international arena which detracts
  future investors
• High leverage leaves less on the table to be
  expropriated
• Multilateral lenders involvement detracts
  governments from expropriation since these
  agencies are development lenders and lenders of
  last resort. However these agencies only lend to
  stand alone projects.
• High leverage also reduces accounting profits
  thereby reducing the potential of local
  opposition to the company.

• Conflicts between sponsors and government
  Expropriation through either asset seizure,
  diversion, or creeping

21
Value creation by organizational structure Debt
Overhang
Problems
Structural Solutions

• Sponsors under-investment in positive NPV
  projects when sponsor has
• limited corporate debt capacity
• agency or tax reasons that exclude equity as a
  valid option
• pre-existing debt covenants that limit
  possibility of new debt

• Non-recourse debt in an independent entity
  allocates returns to capital providers without
  any claim on the sponsors balance sheet.
  Preserves corporate debt capacity.
• The fact that non-recourse debt is backed by
  project assets/cash flows and not by the
  sponsors balance sheet increases the chances of
  an already highly leveraged sponsor to separately
  finance a viable project

22
Value creation by organizational structure Risk
Contamination
Problems
Structural Solutions

• A high risk project may potentially drag a
  healthy sponsor into distress, by increasing cash
  flow volatility and reducing firm value.
• Conversely, a failing sponsor can drag a healthy
  project along with itself.
• Very large projects can potentially destroy the
  sponsors balance sheet and lead to managerial
  risk aversion
• Benefit from portfolio diversification is
  negative (risk is higher) when sponsor and
  project cash flows are strongly positively
  correlated.

• Project financed investment exposes the sponsor
  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.
• Separate incorporation eliminates potential
  increase in risk when financing a project
  strongly correlated to sponsors existing asset
  portfolio.

23
Value creation by organizational structure
Other motivations
Problems
Structural Solutions

• Joint venture projects with heterogeneous
  partners Financially weaker partner cannot
  finance its share of investment through corporate
  borrowings, and needs project finance to
  participate
• Location Large projects in emerging markets
  usually cannot be financed by local equity due to
  supply constraints. Investment specific equity
  from foreign investors is either hard to get or
  expensive.

• The stronger partner is better equipped to
  negotiate terms with banks than the weaker
  partner and hence participates in project finance
  even if it can finance its share via corporate
  financing
• Debt may be the only option and project finance
  the optimal structure.
• Besides, host government may grant the project
  tax holiday, which provides sponsors exemptions
  from taxation

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How Does It Create Value?

• Drawbacks of using Project Finance
• Value creation by Project Finance
• Organizational structure
• Agency costs, debt overhang, risk contamination,
  risk mitigation
• Contractual structure
• Structuring the project contracts to allocate
  risk, return, and control
• Governance structure
• Benefits of debt-based governance
• Case examples to value creation

25
Value creation by contractual structure

• An introduction to risk management
• Risk management defined
• Sources of risks
• Who bears risk?
• Mechanisms for reducing cost of risk
• Contractual structure in Project Finance to
  reduce cost of risk and create value

26
Value creation by contractual structureAn
Introduction to Risk Management

• Risk Management
• The process of identification, assessment,
  mitigation, and allocation of risks to reduce
  cost of risk and improve incentives
• Sources of risk
• External
• Markets Availability and quality of products,
  inputs, and services used
• Financial markets
• Government policy
• Natural resource availability and quality
• Natural disasters, politics
• Internal
• Incentive problems during construction and
  operation stages
• Relationships between management, sponsors,
  lenders, workers, suppliers, government
• (some addressed in the previous slides under
  value creation by organizational structure)

27
Value creation by contractual structureAn
Introduction to Risk Management

• Who bears risk?
• Sponsors bear the residual gains and losses, and
  make key investment decisions.
• In simple terms,
• Return to equity Revenues Material /
  service costs Labor costs -
  
  Depreciation Interest expenses Taxes
• Variability in RHS variables lead to changes in
  return to equity
• Other earners of net income (or net value added)
  from investment can also share risk
• Net Value added
• Return to equity Interest expenses Taxes
  Labor costs
• Revenues Material / service
  costs Depreciation
• Profit sharing mechanisms or tax incentives may
  change how variability in income is shared among
  sponsors, lenders, government, and labor
• Output purchasers and input suppliers can also
  share the risks as they experience variability in
  their markets

28
Value creation by contractual structureAn
Introduction to Risk Management

• How are costs of risk reduced?
• Some risks can be reduced by spreading the burden
  across many participants some other risks cannot
  be spread, but can be shifted or reallocated
• Different stakeholders in a project may have
  different preferences, and hence different
  willingness and capacity to bear risks
• Cost of risk is lower to those with greater
  capacity and willingness to bear risk
• Risk-return trade-offs may enable integrative
  (not necessarily competitive) negotiations among
  different stakeholders and may create value in a
  project setting
• Gains in economic efficiency can be achieved if
  overall cost of risk declines through risk
  shifting and reallocating
• The same risk will have a lower cost if born by
  parties better capable and willing to do so

29
Value creation by contractual structureAn
Introduction to Risk Management

• Mechanisms to reduce cost of risk
• Capital, financial, and futures markets
• Mix of debt and equity (capital structure) and
  probability of default
• Risk spreading / pooling
• Risk diversification
• Insurance markets (for residual risks)
• Derivative financial instruments (not available
  for asymmetric risks)
• Futures markets
• Real options Design flexibility into project to
  allow for responses of new information or market
  changes
• Project design itself for risk mitigation
  (elements of production process, technology used,
  etc.)
• Project Finance mechanism complex contractual
  arrangements involving all mechanisms of
  contractual risk allocation and reduction to deal
  with risk in large scale investments

30
Value creation by contractual structureContracti
ng and Project Finance to reduce cost of risk

• Generally well developed capital, financial, and
  futures markets may not always be available
• Special contractual arrangements are often
  required to manage risk to make projects viable
• The aim of extensive contracting is to reduce
  cash flow volatility, increase firm value and
  debt capacity in a cost-effective way
• Guarantees and insurance for those risks that
  cannot be handled through contracting
• Elements of contracting
• General form
• Exchange risk (x) for return (y)
• Additional considerations
• Participation or partial transfer of ownership
• Timing of x and y
• Contingency of x and y (under what circumstances)
• Penalties on non-performance
• Bonus on performance

31
Value creation by contractual structureContracti
ng and Project Finance to reduce cost of risk

• Contracting criteria
• Contract with lowest cost not necessarily best
  contract
• Effective contracts may provide
• Better risk shifting better distributions of
  cost
• Better incentives higher project returns or
  lower total project risk as a result of
  incentives
• Change the incentive structure to change the
  probabilities of different outcomes ?
  stakeholders have incentives to increase
  probability of success and reduce probability of
  failure in project
• Zero Sum (Competitive) versus Positive Sum
  (Integrative) perspectives
• Cost focus is implicitly a zero sum perspective
  one stakeholder gains and the other stakeholder
  loses
• Integrative focus is explicitly a positive sum
  perspective By crafting the right contract, one
  stakeholder can gain without necessarily costing
  to the other one (due to differences between
  perceived values, preferences, and risk bearing
  capacity) ? contracts that create increased value
  through risk sharing and /or improved incentives

32
Value creation by contractual structureContracti
ng and Project Finance to reduce cost of risk

• Sources of contracting benefits
• Stakeholders differing risk preferences
• Differing capability to diversify
• Differing capability to manage risks
• Differing information or predictions regarding
  future
• Differing ability to influence project outcomes
• Risks manageable via contractual structure or
  other mechanisms in
• Project Finance
• Pre-completion risks Resource, technological,
  timing, and completion risks
• Post-completion risks Market risk, supply risk,
  operating cost risk, and force majeure
• Sovereign risks Inflation risk, exchange rate
  volatility, convertibility risk, expropriation
• Financial risks Default risk

33
Value creation by contractual structurePre-comp
letion risks
Risk Solution
Site acquisition and access, permits A government support agreement
Risks related to contractor Is it competent to do the work? Reputation, references for similar projects and technology being used Experience with the country, good relationships with local subcontractors Similar references for the subcontractors
Is it also one of projects sponsors? (Conflict of interest) Contract supervision by the project companys other personnel not directly related to the contractor
The contractors credit standing? If the contractors wider business gets into difficulty, the project is likely to suffer Careful review of contractors credit standing Careful review of the project scale in relation to the size of contractors overall business If project too big for the contractor to handle alone, a joint venture approach with a larger contractor Guarantees of obligations by the contractor's parent company
34
Value creation by contractual structurePre-compl
etion risks
Risk Solution
Construction cost overruns reduce equity returns, and DSCR Pre-agreed overrun funding (contingency finding) Fixed (real) price contract, as the EPC contract is normally the largest cost item in budget (60-70) Contractor takes junior debt and/or equity stake in operations (BOT or BOO)
Delay in completion failure to meet the milestones increase costs, reduce equity returns, and reduce DSCR Financing costs, especially as debt will be outstanding longer Revenues from operating the project will be lost or deferred (significant risk also especially if part of financing depends on early revenues) Penalties may be payable under contract to input suppliers or off-taker Completion guarantees, date-certain EPC contract Performance bonds Completion bonuses/penalties Reputable contractor Close monitoring / testing of project execution (operational, financial, etc.) for early detection of problems Careful definition of completion in all the contracts (EPC contract, input supplier contracts, off-taker contract, etc) so that it is acceptable and manageable by all parties involved
Process failures Process / Equipment warranties Tested technology
35
Value creation by contractual structurePre-compl
etion risks
Risk Solution
Nonperformance on completion due to poor design, inadequate technology Debt recourse to sponsors (from lenders perspective) Performance LDs (liquidated damages) Pre-agreed level of loss to be born by the contractor. Covers the NPV of loss due to nonperformance over the life of the project The Project Company should be aware of the uncertainty regarding the LDs and should allow a margin when negotiating the calculations with the contractor
Natural resource risk Independent reserve certification
36
Value creation by contractual structurePre-compl
etion risks
Risk Solution
Third party risks The contractor may be dependent on third parties such as suppliers of utilities to complete the project The project may be dependent on completion of another project worst type of third party risk especially when the project financing is dependent on it. If the third party is not otherwise involved in the project, incentive mechanisms to keep the timetable If the third party is involved with a project contract, the contract should include terms such that the third party should be held responsible for the delay losses Contractors good relationships and experience with the third parties may be a plus Financing the projects as one package may be examined as a potential solution, as long as the sponsors interests on both sides can be aligned
Sponsor-related risks (Lenders perspective) Sponsor commitment to the project Financially weak sponsor Require lower D/E ratio Starting with equity eliminate risk shifting, debt overhang and probability of distress (lenders requirement). Add insider debt (Quasi equity) before debt reduces cost of information asymmetry. Attain third party credit support for weak sponsor (letter of credit) Cross default to other sponsors
37
Value creation by contractual structurePost-comp
letion risks
Risk Solution
Market risk Uncertainty regarding the future price and demand for the output Volume risk cannot sell entire output Price cannot sell output at profit Long term off-take contract with creditworthy buyers take and pay, take or pay, take if delivered contracts Price floors A fixed price growth path An undertaking to pay a long-run average price Specific price escalator clauses that would maintain the competitiveness of the product, such as indexing price to the price of a close substitute or cost of major input Hedging contracts
Operating cost risk Uncertainty regarding the changes in the operating cost throughout the life of the project Risk sharing contracts to increase correlation between revenue and some cost items If there is an off-take contract, linking input supply price to it Basing the product price under the off-take contract on the cost of the input supplies (more likely if input supply is a widely traded commodity like oil) Basing the input supply price to product price under the off-take contract (more likely if the input is a specialized commodity, or if there is no off-take contract and risk is passed to the input supplier) Price ceilings Profit sharing contract with labor Output or cost target related pay
38
Value creation by contractual structurePost-comp
letion risks
Risk Solution
Input supply risk Uncertainty regarding the availability of the input supplies throughout the life of the project If there is an off-take contract, linking the terms of the output contract with input supply contracts such as the length of contract, volume, or force majeure If there is no off-take contract, making the input supply contract run for at least the term of debt An input supply contract is off-take contract for the supplier
Organizational risks Incentive problems relating to management or workers Profit sharing / stock options Output or cost target related pay for workers
Operating risk operating difficulties due to technology (being degraded or obsolescent), processes used, or incapacity of operator team leads to inefficiencies and insufficient cash flow Performance warranties on equipment Expert evaluation and retention accounts Proven technology Experienced operator/management team Operating/maintenance contracts to ensure operational efficiency Allowances for service / upgrade built into equipment supply contracts Insurance to guarantee minimum operating cash
Force majeure risk Likelihood of occurrence of events like wars, labor strikes, terrorism, or nonpolitical events such as earthquakes, etc. Insurance for natural disasters
39
Value creation by contractual structureSovereign
risks
Risk Solution
Exchange rate changes Uncertainty regarding the changes in the exchange rate throughout the life of the project Implications of a sudden major local currency devaluation in cases where the project revenue is in local currency and debt in foreign currency Revenues, costs, and debt in same currency (indexing if they are not in the same currency) Market-based hedging of currency risks (though not widely used) For protection from a sudden major devaluation, a revolving liquidity facility can be utilized to cover the time lapse between the devaluation and the subsequent increase in inflation that should compensate the project company for debt payments
Currency convertibility / transferability risk As it is often not possible to raise funding in local currency in developing countries, revenues earned in local currencies need to be converted into foreign currency amounts needed by offshore investors/lenders, and then need to be transferred outside the country to pay for them. Additionally, foreign currency may be needed to import materials, equipment, etc. Government Support Agreement Government guarantee of foreign exchange availability However, if the host country gets into financial difficulty and runs out of foreign currency reserves, then the government may forbid either the conversion of local currency amounts to foreign currency, or the transmission of these amounts abroad ? The support agreement may become invalid Enclave projects If the project revenues are paid from a source outside the host country, the project can be insulated from foreign exchange and transfer risks (Example sales of oil, gas across borders) Offshore debt service reserve accounts
40
Value creation by contractual structureSovereign
risks
Risk Solution
Hyperinflation risk Relative changes in the price of inputs and output may adversely affect the project Indexing the output price (in the long term sales contract) against the CPI and or industry price indices in the host country where the relevant costs are incurred (Indexing means increasing over time against agreed, published economic indices)
Expropriation Direct, diversion, creeping Governments breach of contract and court decisions Government guarantees or regulatory undertakings to cover taxes, royalites, prices, monopolies, etc. Involvement of multilateral/bilateral agencies Offshore accounts for proceeds Governments equity ownership Using external law or jurisdiction
Legal system Unclear and/or inconsistent legal/regulatory framework for projects operations Insufficient protection of private investment and private ownership/control of project Bureaucratic hurdles Changes in law, such as imposition of new environmental/health/safety requirements, price controls, import duties/controls, increase in taxes, royalties, deregulation, amendment or withdrawal of projects permits, changing the control of company Government support agreement Using external law or jurisdiction Involvement of multilateral/bilateral agencies A general principle is that the party who is paying for the output under a project contract should pay for the losses incurred due to changes in law specific to the industry, because such change is reflected in the entire industry and any extra costs will normally be passed on to end users therefore an offtaker who does not bear this risk would earn extra profits at the expense of the project company
41
Value creation by contractual structureSovereign
risks
Risk Solution
Political risks Likelihood of occurrence of political events like wars, labor strikes, terrorism, etc. Political risk insurance Involvement of multilateral agencies (WB/IFC) (structuring legal/financial documents, mediation in negotiations, sovereign deterrence, halo effect) Bilateral agencies Export credits from ECAs (who provide PRI) The private insurance market Contractual sharing of political risks between sponsors and lenders
42
Value creation by contractual structureFinancial
risks
Risk Solution
Default risk Ensure sufficient debt service coverage Decrease debt/equity ratio Match term of loan to productive life of assets Match repayment schedule to expected cash flows Bonds with interest rates indexed to product sales price Match currency of loans to currency of revenues
Interest rate risk Interest rate swaps and hedging Interest rate caps
43
How Does It Create Value?

• Drawbacks of using Project Finance
• Value creation by Project Finance
• Organizational structure
• Agency costs, debt overhang, risk contamination,
  risk mitigation
• Contractual structure
• Structuring the project contracts to allocate
  risk, return, and control
• Governance structure
• Benefits of debt-based governance
• Case examples to value creation

44
Value creation by governance structure

• Benefits of debt-based governance
• Tighter covenants limit managerial discretion and
  enforces greater discipline via better monitoring
• High leverage reduces free cash flow exposed to
  discretion
• High leverage reduces expropriation risk
• High leverage also reduces accounting profits
  thereby reducing the potential of local
  opposition to the company
• Tax shields

45
2. How Does It Create Value?

• Drawbacks of using Project Finance
• Value creation by Project Finance
• Organizational structure
• Agency costs, debt overhang, risk contamination,
  risk mitigation
• Contractual structure
• Structuring the project contracts to allocate
  risk, return, and control
• Governance structure
• Costs and benefits of debt-based governance
• Case examples to value creation

46
Case examples to value creation
Australia-Japan Cable Structuring a Project
Company

• Background
• The project included a 12,500 km submarine
  telecommunications system between Australia and
  Japan via Guam at a cost of 520M. The project
  would use Telstras two landing stations at
  Australia. In Japan, it needed to either obtain
  permit from the government for building new
  stations, or contract or partner with other
  companies to obtain access to the existing ones.
  Japanese Government seemed not likely to approve
  building of a new landing station. Most
  significant risks were market and completion
  risks.
• The lead sponsor, Telstra, has to structure the
  project company, selecting an ownership,
  financial, and governance structure.

47
Case examples to value creation

• Issues
• Selection of strategic sponsors who would bring
  the most value to the project
• Mitigation of market risk Growing demand and
  capacity shortfall that triggers competition,
  rapid improvements in cable technology and
  resulting price decline necessitates moving very
  quickly
• Completion risk Potential delays due to
  environmental approvals and other permits
• Management of possible agency conflicts between
• sponsors and management
• sponsors and other parties (capacity buyers
  (purchasers), suppliers, etc.)
• sponsors and creditors - decision of how many
  and which banks to invite to participate

48
Case examples to value creation
How project structure may help

• Telstra partnered with Japan Telecom (who would
  bring its landing station in Japan and was
  interested in buying capacity) and Teleglobe (a
  major carrier who would bring significant volume)
  as sponsors (?reducing cash flow variability)
• Other equity investors to be selected would be
  high rated sponsors who were also capacity
  buyers. They would be made to sign presale
  capacity agreements (? reducing variability).
• Capacity agreements with high rated sponsors
  would also be instrumental in raising debt with
  favorable conditions

49
Case examples to value creation
How project structure may help

• Contemplated on concentrated equity ownership to
  maintain more effective management and monitoring
  
• As for an interim management team, sponsors would
  also be made equal partners in control,
  regardless of individual ownership shares
• A permanent management team was discussed, that
  would work exclusively for the project
• Management compensation package was easier to
  craft, since it was a single purpose company with
  limited and well-defined growth opportunities
• Single cash flow easier to monitor

50
Case examples to value creation
How project structure may help

• Decided on high leverage and project finance
  structure to help
• limit the amount of equity they needed to invest
  to an acceptable size
• share the project risk with debt holders
• enforce management discipline by reduced free
  cash flow and contractual agreements
• Bank debt with a small banking group was
  preferred rather than project bonds to have
  flexibility
• The initial tranche of bank debt would be secured
  and repaid in 5 years with presale commitments
• The second tranche would also be repaid in 5
  years, but from future sales, acting as trip
  wires for the management team

51
Case examples to value creation
Calpine Corporation

• Background
• Calpine, a small power generator with high
  leverage (80), sub-investment grade rating, and
  little debt capacity, has to decide how to
  finance its aggressive growth strategy, facing
  increasing pressure for speed, efficiency, and
  flexibility in a soon-to-be competitive commodity
  market.
• The growth strategy includes building and
  operating a power system consisting of multiple
  power plants. Project financing and corporate
  financing alternatives are considered.

52
Case examples to value creation

• Issues
• Speed was very important to gain first mover
  advantage
• Necessity to be a low-cost producer in a
  commodity market
• Operating a system of power plants to gain scale
  economies and also the flexibility to switch
  between the plants to offer uninterrupted service

53
Case examples to value creation

• Issues
• 4. Using corporate finance as the financing
  method
• Benefits
• Issuing high yield bonds would not require
  collateral and reduce legal fees
• Bonds would leave Calpine free to switch between
  plants in the power system
• Costs
• The high-yield market was thinner and more
  volatile compared to investment grade market,
  creating pricing and availability risk
• As a firm with high leverage and sub-investment
  grade rating, the high cost of corporate
  financing might lead Calpine to miss the
  opportunity to invest in a positive NPV growth
  project (Debt Overhang)
• A large debt issue might further jeopardize
  Calpines debt rating

54
Case examples to value creation

• Issues
• 5. Using project finance as the financing method
  
• Benefits
• Opportunity to finance the growth strategy even
  if Calpine had low investment ratings and limited
  debt capacity
• Costs
• Time consuming and expensive to set-up and
  execute individual deals
• Limited size and absorption capacity of the
  project finance market
• Possible restrictions to flexibly switch between
  the plants in the power system if each plant
  would be collateralized separately

55
Case examples to value creation
How project structure may help

• A hybrid structure was crafted that combined
  elements of both project and corporate finance
• Project Finance
• Calpine project financed a portfolio of plants
  rather than a single plant. This reduced legal
  and other fees, transaction costs, and saved
  time.
• Project finance allowed raising a large amount of
  debt on a non-recourse basis, which was
  impossible at the parent level
• Corporate Finance
• The structure gave Calpine flexibility to build
  the plants using equity, and manage them flexibly
  as part of a power system (which would be
  impossible with separately project financing the
  individual plants)

56
Case examples to value creation
BP Amoco

• Background
• A large and well-capitalized company, BP Amoco
  tries to decide on the best way to finance its
  share in the 8 billion development project of
  Caspian oil fields, undertaken by a consortium of
  11 companies.
• Each of the partners had a choice in how to
  finance its share of the total investment. Of
  these companies, 5 formed a Mutual Interest Group
  (MIG) to obtain project loan with assistance of
  IFC and EBRD. The alternatives BP Amoco
  considered for its share were corporate
  financing, project financing, or a hybrid
  structure.

57
Case examples to value creation

• Issues
• Project Risks The project had considerable
  political, financial, industrial (price and
  reserve volatility), and transportation related
  risks largely due to the unique region it was
  located.
• Risk management Protection of BP Amocos balance
  sheet from risk contamination or distress costs
  from investing in a risky asset
• Involvement of multilateral organizations
  Increased capacity to raise capital

58
Case examples to value creation
How project structure may help

• Using corporate finance as the financing method
• Benefits
• Financially strong enough to support a corporate
  funding strategy with favorable terms
• Easier to set up and less costly
• Costs
• Project might create additional risks in BP
  Amocos current asset portfolio ? Risk
  contamination
• BP Amocos absence in the IFC/EBRD finance deal
  for the MIG would make it harder for the weaker
  partners to negotiate good terms, reducing
  flexibility in operations and management
• BP Amocos using corporate funding while at least
  some of the other partners using the IF/EBRD
  deal might potentially create disagreements
• Other partners might accuse BP Amoco as free
  rider, since BP Amoco would benefit at no cost
  from the political risk protection IFC/EBRD deal
  would have provided
• How they funded the initial phase would change
  possibilities of financing for the coming stages
  

59
Case examples to value creation
How project structure may help

• Using project finance as the financing method
• Benefits
• Reducing projects potential negative impact on
  the balance sheet The project was very large and
  posed too many risks which BP Amoco could not
  bear alone, meaning a potentially huge negative
  impact on the balance sheet if financed solely by
  internal funding
• More protection from the many project risks due
  to risk sharing
• Accommodating the financially weaker partners in
  the consortium to negotiate better deals with
  creditors for the sake of future managerial and
  operational flexibility
• Benefiting from IFC/EBRDs existence to shield
  from possible conflicts with the host governments
  
• Costs
• Harder, costlier, and more time consuming to set
  up
• Less flexibility compared to corporate finance
  alternative

60
OUTLINE

• What is Project Finance?
• How does project finance create value?
• Project valuation
• Case analyses
• Recap

61
Project Valuation

• Background
• Approaches to calculating the Cost of Capital in
  Emerging Markets
• Country Risk Rating Model (Erb, Harvey and
  Viskanta)

62
Background

• Projects are characterized by
• unique risks
• high and rapidly changing leverage
• imbedded flexibility to respond to changing
  conditions (real options)
• changing tax rates
• early, certain and large negative cash flows
  followed by uncertain positive cash flows
• Traditional DCF method is inaccurate
• Single discount rate does not account for
  changing leverage
• Ignores imbedded options
• Idiosyncratic risks are usually incorporated in
  the discount rate as a fudge factor
• Traditional CAPM method is inaccurate
• Many mega projects are in emerging markets
• Many of these markets do not have mature equity
  markets. It is very difficult to estimate Beta
  with the World portfolio.
• The Beta with the World portfolio is not
  indicative of the sovereign risk of the country
  (asymmetric downside risks). E.g. Pakistan has a
  beta of 0.
• Most assumptions of CAPM fail in this environment
• More appropriate approaches to project valuation
  may include

63
Approaches to calculating the Cost of Capital in
Emerging Markets

• World CAPM or Multifactor Model (Sharpe-Ross)
• Segmented/Integrated (Bekaert-Harvey)
• Bayesian (Ibbotson Associates)
• CAPM with Skewness (Harvey-Siddique)
• Goldman-integrated sovereign yield spread model
• Goldman-segmented
• Goldman-EHV hybrid
• CSFB volatility ratio model
• CSFB-EHV hybrid
• Damodaran

64
Approaches to calculating the Cost of Capital in
Emerging Markets

• Many of these methods suffer problems because
• Method does not incorporate all risks in the
  project
• Assume that the only risk is variance, and fails
  to capture asymmetric downside risks
• Assume markets are integrated and efficient
• Arbitrary adjustments which either over or
  underestimate risk
• Confusing bond and equity risk premia.

65
The Country Risk Rating Model

• Erb, Harvey and Viskanta (1995)
• Country credit rating a good ex ante measure of
  future risk
• Some of the factors that influence a country
  credit rating are
• political and other expropriation risk,
• inflation, exchange-rate volatility and controls,
  
• the nation's industrial portfolio, its economic
  viability, and its sensitivity to global economic
  shocks
• The credit rating may proxy for many of these
  fundamental risks as it is survey based
• Impressive fit to data
• Explains developed and emerging markets

66
The Country Risk Rating Model
67
The Country Risk Rating Model

• Cost of Capital risk free intercept (slope
  x Log(IICCR))
• Log(IICCR) is the natural logarithm of the
  Institutional Investor Country Credit Rating
• Gives the cost of capital of an average project
  in the country in ).
• If cash flows are in local currency, convert into
  US
• Calculate the difference between the multiyear
  forecasts of inflation in the host country and
  those in US
• Use the difference to map out the expected
  exchange rates
• Use calculated expected exchange rates to convert
  cash flows into
• Adjust for industry risk
• Calculate the country risk premium from ICCRC
• Country risk premium
• Country cost of equity capital US cost of
  equity capital
• Calculate US industry cost of capital by using
  industry beta
• Add the country risk premium to US industry cost
  of capital
• Adjust for project specific risks that deviate
  the project from the average level of risk in the
  host country
• Risks incorporated in cash flows or industry
  adjustment
• Pre-completion technology, resource, completion.
  
• Post-completion market, supply/input,
  throughput.
• Risks incorporated in discount rate
• Sovereign risk macroeconomic, legal, political,
  force majeure.

68
OUTLINE

1. What is Project Finance?
2. How does project finance create value?
3. Project Valuation
4. Case analyses
5. Recap

69
Case analyses

• Chad-Cameroon Petroleum Development and Pipeline
  Project
• Petrozuata and Oil Field Development Project
• Financing the Mozal Project

70
Chad-Cameroon Petroleum Development and Pipeline
Project

• Background
• Corporate finance vs. project finance
• Why is there a difference between financing of
  field and export systems?
• The role of World Bank
• Assessment of project risks and returns
• Real options
• Project update

71
Background

• ExxonMobil, Chevron, and Petronas undertake a 4
  Billion petroleum development and pipeline
  project in Chad, which presented a unique
  opportunity to stimulate Chads economic
  development, and yet entailed environmental and
  social risks.
• Corporate finance for the development of the
  field system and project finance for the
  pipelines
• Debate on unstable political structure and how
  Chad would use its share of project revenues
• WBs introduction of Revenue Management Plan to
  target Chad Governments returns from the project
  for developmental purposes, and debate on the
  likelihood of effectiveness of such a plan

72
Corporate financing for the field system

• The lead sponsor, ExxonMobil had AAA debt rating,
  very strong balance sheet (145M assets) and 16M
  cash flow ? Could afford the field investment in
  a less costly way relative to project financing
• ExxonMobil was actually a huge portfolio of
  upstream businesses (exploration, development,
  production of crude oil and natural gas),
  downstream businesses (transportation, marketing,
  and sales), as well as chemical byproducts and
  operations in mining. With less than perfect
  correlation among its assets, ExxonMobil might
  actually have been able to eliminate the
  idiosyncratic risks via adding a field
  development project to its portfolio. Corporate
  financing as opposed to project financing helped
  ExxonMobil keep the project as part of its
  portfolio and reduce the risks.
• Besides, the vertically integrated business model
  made it a naturally cost-efficient choice for
  ExxonMobil to hold the assets collectively with
  corporate financing rather than individually with
  project financing
• Corporate financing probably also enabled
  managerial flexibility and discretion over the
  use of oil wells, drilling equipment, etc. that
  constitute the field system

73
Corporate financing for the field system

• Field development was the less risky part of the
  entire project for the sponsors, because upstream
  operations including field development and
  production was one of the core business areas
  where they were very strong at. This reduced the
  cost of bearing these risks themselves since they
  were better equipped than anyone else.
• Project financing for a field development project
  would also not be a viable financing option, as
  the lenders generally would be reluctant to
  finance until after all reserves are proven and
  capable of production.
• The crude oil prices for the last 18 months
  ranged from 9 to 42, averaging 20 per barrel,
  which, even after discounted for the lower grade,
  was considerably higher than the projects 5.20
  exploration and development costs. With a total
  proven plus probable reserves of 917M barrels,
  downside exposure to price and resource risk was
  already mostly eliminated ? No serious need to
  protect from the downside risk (via risk sharing
  )with project finance and incurring higher
  interest rates and loan fees.
• Corporate financing probably also helped save
  both the costly delays at the development stage
  of the project and the structuring costs, which
  would be incurred in project financing

74
Project financing for the export system

• Export system was the riskiest part of the
  project. Project financing for the export system
  mainly enabled the sponsors to spread the
  political risks as much as possible via the
  presence of outside lenders such as WB, IFC,
  ECAs.
• The expectation was that the Chad and Cameroon
  Govts would be less likely to take or tolerate
  adverse actions against the project in fear of
  jeopardizing future funding from the WB and other
  international financing institutions who were
  lenders of last resort
• Additionally, it facilitated alignment of Govts
  interests with the project through equity
  ownership, which would not have been possible
  otherwise as Govts could not afford on their own
• Project financing also created the opportunity
  for the pipeline companies (JV between Govts and
  the sponsors) to issue limited-recourse debt,
  guaranteed by the sponsors through completion
• Project financing enabled external monitoring
  from the lenders
• ExxonMobil also reduced total investment
  commitment to the project under the
  corporate/project finance structure, compared to
  that under a complete corporate finance structure

75
The role of World Bank

• WB involvement assured sponsors the much needed
  protection against the political risk
• Besides direct investment through A loans, it
  mobilized other funding sources like ECA and
  other banks through a syndicated B loan
• WBs extensive lending and policy experience with
  Chad offered the leverage that sponsors did not
  have
• The project with potentially high returns and
  developmental impact for Chad was also aligned
  with WBs policy objectives
• WB facilitated extensive consultation process
  including supporters and opponents The process
  helped sponsors restructuring the project to
  minimize the social and environmental impact
  (such as increasing the benefits to indigenous
  people and changing the pipeline route to protect
  the natural habitat)
• WB also initiated a Revenue Management Plan to
  help prevent probable misuse of Chads revenues
  by the Govt, and target them for developmental
  purposes to increase welfare
• Insisted on an open and transparent project
  planning process
• Established capacity building programs to develop
  the infrastructure for a well-functioning
  petroleum industry and investment climate in both
  Chad and Cameroon

76
The role of World Bank

• WB involvement also ensured that sponsors did not
  abandon the project due to huge political risks
  and looked instead for safer opportunities in
  other countries, leading to a missed opportunity
  for Chad
• Without the WB, the Govt might turn to
  neighboring countries such as Sudan and Libya for
  partnering in oil export. This potentially would
  have adverse consequences in case the project
  revenues were utilized to finance
  non-developmental purposes such as war.
• Such an alternative would mean longer and hence
  more expensive pipelines
• The projects exposure to social risks would
  increase, as the pipelines would inevitably cross
  the northern part of the country with social
  unrest and upheavals.

77
Subjects of opposition

• The environmental and social impacts were claimed
  to be irreversible
• The revenue management plan was claimed to be
  flawed and to lack effective oversight