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MBF1223 | Financial Management Prepared by Dr Khairul Anuar

L3 – Project Financing

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Objectives

To understand what project financing is and whatsteps are involved in securing and managing it.

Part 1 – Introduction

• For whom is it important to understand project financing?• Why is it important to understand project financing?• What is a project?• Types of projects.• What is project financing?• Key characteristics of project financing.• Advantages of project financing.• Disadvantages of project financing.

Introduction – For whom is it important to understand project finance?

• Financial managers• Sponsors• Lenders• Consultants and practitioners• Project managers• Builders• Suppliers• Engineers.• Researchers• Students.

Introduction – Why is it important to understand project finance?

• The people involved in a project are used to find financing dealfor major construction projects such as mining, transportationand public utility industries, that may result such risks andcompensation for repayment of loan, insurance and assets inprocess.

• That’s why they need to learn about project finance in order tomanage project cash flow for ensuring profits so it can bedistributed among multiple parties, such as investors, lendersand other parties.

Introduction – What is a Project?

In our context of Project Finance, a Project is normally a long-term infrastructure, industrial or public services scheme, development or undertaking having:

Large size. Capital Intensive - Intensive capital requirement. Finite Long Life. Few diversification opportunities i.e. assets specific. Stand alone entity. High operating margins. Significant free cash flows.

Such projects are usually government regulated and monitored which are allowed to an entity on B.O.O or B.O.T basis.

Introduction – Types of Project

• Motorway and expressway.• Metro, subway and other mass transit systems.• Dams.• Railway network and service – both passenger and cargo.• Power plants and other charged utilities.• Port and terminals.• Airports and terminals.• Mines and natural resource explorations.• Large new industrial undertakings – [new expansion and

extensions.• Large residential and commercial buildings.

Introduction – What is Project Financing?

International Project Finance Association (IPFA) defined projectfinancing as:

“The financing of long-term infrastructure, industrial projects andpublic services based upon a non-recourse or limited recoursefinancial structure where project debt and equity used to finance theproject are paid back from the cash flows generated by the project.”

Project finance is especially attractive to the private sector becausethey can fund major projects off balance sheet.

Introduction – Common features of project financetransactions

1. Capital-intensive – Project financings tend to be large-scale projects thatrequire a great deal of debt and equity capital, from hundreds of millions tobillions of dollars. Infrastructure projects tend to fill this category.

2. Highly leveraged – These transactions tend to be highly leveraged with debt accounting for usually 65% to 80% of capital in relatively normal cases.

3. Long term – The tenor for project financings can easily reach 15 to 20 years.

4. Independent entity with a finite life – Project financings frequently rely on a newly established legal entity, known as the project company, which has the sole purpose of executing the project and which has a finite life “so it cannot outlive its original purpose.” In many cases the clearly defined conclusion of the project is the transfer of the project assets. For example, in a build-operate-transfer (BOT) project, the project company ceases toexist after the project assets are transferred to the local company.

Introduction – Common features of project financetransactions5. Non-recourse or limited recourse financing – The project company is the

borrower. Since these newly formed entities do not have their own credit or operating histories, it is necessary for lenders to focus on the specific project’s cash flows.

That is, “the financing is not primarily dependent on the credit support of the sponsors or the value of the physical assets involved.” Thus, it takes an entirely different credit evaluation or investment decision process to determine the potential risks and rewards of a project financing as opposed to a corporate financing. As a result, they will concern themselves closely with the feasibility of the project and its sensitivity to the impact of potentially adverse factors.”

6. Controlled dividend policy – To support a borrower without a credit history in a highly-leveraged project with significant debt service obligations, lenders demand receiving cash flows from the project as they are generated. In project financing, the project has a strictly controlled dividend policy, though there are exceptions because the dividends are subordinated to the loan payments. The project’s income goes to servicing the debt, covering operating expenses and generating a return on the investors’ equity. This arrangement is usually contractually binding. Thus, the reinvestment decision is removed from management’s hands.


7. Many participants – These transactions frequently demand the participation of numerous international participants. It is not rare to find over ten parties playing major roles in implementing the project.

8. Allocated risk – Because many risks are present in such transactions, often the crucial element required to make the project go forward is the proper allocation of risk. This allocation is achieved and codified in the contractual arrangements

between the project company and the other participants. The goal of this process is to match risks and corresponding returns to

the parties most capable of successfully managing them. For example, fixed-price, turnkey contracts for construction which typically include severe penalties for delays put the construction risk on the contractor instead on the project


9. Costly –Raising capital through project finance is generally more costly than through typical corporate finance avenues. The greater need for information, monitoring and contractual

agreements increases the transaction costs. Furthermore, the highly-specific nature of the financial structures also

entails higher costs and can reduce the liquidity of the project’s debt. Margins for project financings also often include premiums for country

and political risks since so many of the projects are in relatively high risk countries.

Introduction – Corporate Finance-Project Finance Continuum

Introduction – Key characteristics of Project Financing

The key characteristics of project financing are:• Financing of long term infrastructure and/or industrial projects

using debt and equity.• Debt is typically repaid using cash flows generated from the

operations of the project.• Limited recourse to project sponsors.• Debt is typically secured by project’s assets, including revenue

producing contracts. First priority on project cash flows is given to the Lender. Consent of the Lender is required to disburse any surplus cash

flows to project sponsorsHigher risk projects may require the surety/guarantees of the

project sponsors.

Introduction - Advantages of Project Financing

• Eliminate or reduce the lender’s recourse to the sponsors.

• Permit an off-balance sheet treatment of the debt financing.

• Maximize the leverage of a project.

• Avoid any restrictions or covenants binding the sponsors under theirrespective financial obligations.

• Avoid any negative impact of a project on the credit standing of thesponsors.

• Obtain better financial conditions when the credit risk of the projectis better than the credit standing of the sponsors.

• Allow the lenders to appraise the project on a segregated and stand-alone basis.

• Obtain a better tax treatment for the benefit of the project, thesponsors or both.

Introduction – Disadvantages of Project Financing.

• Often takes longer to structure than equivalent size corporatefinance.

• Higher transaction costs due to creation of an independent entity.Can be up to 60 basis points (bp)

• Project debt is substantially more expensive (50-400 bp) due to itsnon-recourse nature.

• Extensive contracting restricts managerial decision making.• Project finance requires greater disclosure of proprietary

information and strategic deals.

• One basis point is equal to 1/100th of 1%, or 0.01% (0.0001)

Part 2 – Stages in Project Financing

• Project identification• Risk identification & controls Pre Financing Stage• Technical and financial feasibility

• Equity arrangement• Negotiation and syndication Financing Stage• Commitments and documentation• Disbursement.

• Monitoring and review Post Financing• Financial Closure / Project Closure Stage• Repayments & Subsequent monitoring.

Stages in Project Financing – Project IdentificationPre Financing Stage.

• Identification of the Project Government announcedSelf conceived / initiated

• Identification of market Product of the project Users of the product Marketability of the product Marketing Plan

Stages in Project Financing – Risk Identification and Minimizing

Pre Financing Stage

Risk Solution

Completion Risk Contractual guarantees from contractors, manufacturer, selecting vendors of repute.

Price Risk hedging

Resource Risk Keeping adequate cushion in assessment.

Operating Risk Making provisions, insurance.

Environmental Risk Insurance

Technology Risk Expert evaluation and retention accounts.

Interest Rate Risk Swaps and Hedging

Insolvency Risk Credit Strength of Sponsor, Competence of management, good corporate governance

Currency Risk Hedging

Political and Sovereign Risk

• Externalizing the project company by forming it abroad or using external law or jurisdiction

• External accounts for proceeds

• Political risk insurance (Expensive)

• Export Credit Guarantees

• Contractual sharing of political risk between lenders and external project sponsors

• Government or regulatory undertaking to cover policies on taxes, royalties, prices, monopolies, etc

• External guarantees or quasi guarantees

Stages in Project Financing – Risk Identification and Minimizing

Post Financing Stage

• Technical feasibility Location Design Equipment Operations / Processes.

• Financial feasibility Business plan / model Projected financial statements with assumptions Financing structure Pay-back, IRR, NPV etc.

Stages in Project Financing – Technical and Financial Feasibility

Pre Financing Stage

.

Stages in Project Financing – Equity arrangementFinancing Stage

• Sponsors Lead sponsors Co – sponsors

• Private equity participation Angel investors – Private equity funding Financial institutions Non-financial institutions.

Stages in Project Financing – Negotiation and syndicationFinancing Stage

• Lenders Banks. Non- banking financial institutions. International lending institutions.

• Syndication Lead arranger. Co-arrangers.

• Negotiation Pricing. Documentation. Disbursement.

Stages in Project Financing – Negotiation and syndicationFinancing Stage

• Commitment letters / MOUs Commitment letters from sponsors and investors MOU signing with financiers.

• Documents Offer Letters Lending agreements Security documents Disbursement plan

• Contracts Management/shareholder agency relationship Inter corporate agency relationship Government/corporate agency relationship Bondholder stockholder relationship

Stages in Project Financing – DisbursementFinancing Stage

• Equity Disbursement Shares application. Shares proceeds. Share certificates.

• Loan Disbursement Sponsor loans Advance payments Progress Payment

Stages in Project Financing – Monitoring and ReviewPost Financing Stage

• Why? Project is running on schedule Project is running within planned costs. Project is receiving adequate costs.

• How? First hand information. Project completion status reports. Project schedule chart. Project financial status report. Project summary report. Informal reports.

Stages in Project Financing – Financial Closure / Project Closure


• Financial closure is the process of completing all project-related financial transactions, finalizing and closing the project financial accounts, disposing of project assets and releasing the work site.

• Financial closure is a prerequisite to project closure and the Post Implementation Review (PIR). A project cannot be closed until all financial transactions are complete, otherwise there may not be funds or authority to pay outstanding invoices and charges. Financial closure establishes final project costs for comparison against budgeted costs as part of the PIR. Financial closure also ensures that there is a proper disposition of all project assets including the work site.

• Project closure and commencement take place after financial closure.

Stages in Project Financing – Repayment & Subsequent Monitoring


• Repayments Grace period. Monthly installment. Quarterly installments. Dividends

• Monitoring? Appointment of directors and managers. Management meetings. Board meetings.

Part 3 – Project financing structure

• A typical project financing structure.• Highlights of project financing structure.

Part 3 – Project financing structure• A typical project financing structure.• Highlights of project financing structure.

Part 3 – Project financing structureA Typical Project Finance Structure.


Project sponsors or owners - The sponsors are the generally the project owners with an equity stake in the project. Typical sponsors include foreign multinationals, local companies, contractors, operators, suppliers or other participants. The World Bank estimates that the equity stake of sponsors is typically about 30% of project costs.

Because project financings use the project company as the financing vehicle and raise nonrecourse debt, the project sponsors do not put their corporate balance sheets directly at risk in these often high-risk projects. However, some project sponsors incur indirect risk by financing their equity or debt contributions through their corporate balance sheets.

Project company - The project company is a single-purpose entity created solely for the purpose of executing the project. Controlled by project sponsors, it is the center of the project through its contractual arrangements with operators, contractors, suppliers and customers.

Typically, the only source of income for the project company is the tariff or throughput charge from the project. The amount of the tariff or charge is generally extensively detailed in the off-take agreement. Thus, this agreement is the project company’s sole means of servicing its debt. The creation of the project company and its role as borrower represent the limited recourse characteristic of project finance. However, this does not have to be the case. It is possible for the project sponsors to borrow funds independently based on their own balance sheets or rights to the project.


Contractor - The contractor is responsible for constructing the project to the technical specifications outlined in the contract with the project company. These primary contractors will then sub-contract with local firms for components of the construction. Contractors also own stakes in projects. For example, Asea Brown Boveri“created a fund, ABB Funding Partners, to purchase stakes in projects where ABB is a contractor.Chase Manhattan Bank - much of the infrastructure development “is being driven by the contractors which may ultimately view equity investment as a cost of doing business.”

Operator - Operators are responsible for maintaining the quality of the project’s assets and operating the power plant, pipeline, etc. at maximum efficiency. It is not uncommon for operators to also hold an equity stake in a project. Depending on the technological sophistication required to run the project, the operator might be a multinational, a local company or a joint-venture.


Supplier. The supplier provides the critical input to the project. For a power plant, the supplier would be the fuel supplier. But the supplier does not necessarily have to supply a tangible commodity. In the case of a mine, the supplier might be the government through a mining concession. For toll roads or pipeline, the critical input is the right-of-way for construction which is granted by the local or federal government.

Customer. The customer is the party who is willing to purchase the project’s output, whether the output be a product (electrical power, extracted minerals, etc.) or a service (electrical power transmission or pipeline distribution). The goal for the project company is to engage customers who are willing to sign long-term, offtake agreements.

Commercial banks. Commercial banks represent a primary source of funds for project financings. In arranging these large loans, the banks often form syndicates to sell-down their interests. The syndicate is important not only for raising the large amounts of capital required, but also for de facto political insurance. Even though commercial banks are not generally very comfortable with taking long term project finance risk in emerging markets, they are very comfortable with financing projects through the construction period. In addition, a project might be better served by having commercial banks finance the construction phase because banks have expertise in loan monitoring on a month-to-month basis, and because the bank group has the flexibility to renegotiate the construction loan.

Part 3 – Project financing structureCapital markets - Capital markets has become the instrument of choice for financing emerging markets transactions. The capital market route can be cheaper and quicker than arranging a bank loan. In addition, the credit agreement under a capital market is often less restrictive than that in a bank loan. Furthermore, these financings might be for longer periods than commercial bank lending; might offer fixed interest rates; and can access wider pool of available capital and investors such as pension funds.

Direct equity investment funds - Private infrastructure funds represent another source of equity capital for project financings. Examples of these funds include AIG Asian Infrastructure Fund ($1.1 billion), Peregrine’s Asian Infrastructure Fund ($500 million), Global Power Investments23 ($500 million) and the Scudder Latin America Infrastructure Fund ($100 million, with target of $600 million). The funds typically take minority stakes of the infrastructure projects in which they invest.

Multilateral agencies. The World Bank, International Finance Corporation and regional development banks often act as lenders or co-financers to important infrastructure projects in developing countries.


• Independent, single purpose company formed to build and operatethe project.

• Extensive contracting

As many as 15 parties in up to 1000 contracts.

Contracts govern inputs, off take, construction and operation.

Government contracts/concessions: one off or operate-transfer.

Ancillary contracts include financial hedges, insurance for ForceMajeure, 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.