1

Project Finance

A General Introduction1

One Example of Off Balance Sheet Financing Techniques

2

Project Finance

• A Definition from the Association of Corporate Treasurers*

‘A financing of a particular economic unit in which a lender looks initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan’

*author, FSMD

3

Project Finance

• The project is

• Not consolidated as not controlled by the reporting entity

• Liabilities remain within ring fenced entity

or

Special Purpose Vehicle (SPV)

4

Source Wikipedia• A special purpose entity (SPE) (sometimes, especially in Europe, "special

purpose vehicle" or simply SPV) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives. SPE's are typically used by companies to isolate the firm from financial risk. A company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk.

• A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.

5

Project Finance

• Two important principles in relation to Recourse

1. Has the legal structure succeeded in taking the obligations, risks and returns of the project, off the balance sheet of the Sponsors?

2. Accounting standards are constantly tightened (due to Enron, Worldcom etc) so substance becomes more important than form

6

Project Finance

• A Project usually defined as a major productive capital investment e.g. in

- oil or mineral development - heavy industry (aluminium smelters etc) - forestry, agriculture - power generation, transportation, (toll roads, bridges) - telecoms

7

Project FinanceCharacteristics of PF

• Project cash flows• Normally higher levels of debt ( which may

lead to the need for additional support)• Variety of contractual obligations and

undertakings to manage and reduce risk - Bank Guarantees - Letters of Credit to cover greater risk during construction

period

8

Project FinanceCharacteristics of PF

• A variety of funding sources

- export credits

- development funds

- specialised asset finance

- conventional debt and

- equity finance

9

Project Finance

• Project finance is a

‘classic example of fundamental principles of credit and corporate finance’ (ACT/FSMD)

i.e. managing risk and return for the

different parties from a stream of future

cash flows

10

Project FinanceBOT

» Build – Operate – Transfer

JVSupply and Construction Consortium

Sponsors project and supplies equity

Banks

Project

License to operate and purchase of shares

Host Government

Provide Finance

Electricity Authority

Power purchase agreement

Supply and Construction

11

Project Finance

12

Project Finance

Why use Project Finance

• Amount too large for company Balance Sheet

• Too much risk for one company to bear

- share different risks with those better able to assess and manage

e.g. Oil exploration, development and production

13

Project FinanceWhy? continued

• What risks for oil?

• Exploration

- geological interpretation

- harsh environments

- political risks

14

Project FinanceWhy? continued

• Once found then, Development/Production - reservoir risk - recovery risk - technology risk - production risk - transportation risk• Still have market risk, environmental risk

de- commissioning and so on

15

Project FinanceWhy? continued

• Company policy for off balance sheet with or without recourse

• Political risks - e.g. local regulations ref foreign

shareholdings• Existing covenants• Project development time• Ring fence also helps protect the project

from sponsor failure

16

Project Finance

• Recourse from full to zero• Determined by the contract - provide extra cost - take a particular risk - agree to take (off-take) product• Recourse may also vary in kind (type) as well as degree - Legal obligations - Moral obligations

17

Project FinanceProcess

• Strategic/commercial evaluation

• Systematic identification and exploration of risks

• Valuation (NPV of cash flows)

• Design of risk bearing/sharing package

• Appropriate funding package

• Impact of financing package on net cash flows and sensitivity analysis

18

Project Finance

Risk Analysis• Pre construction• Construction• Operation But many risks may be present at all stages Resource availability- Geological-Infrastructure-

Technological-Construction-Operating-Labour supply-Material sourcing-Product market-Management-FX-Political-Regulatory-Environmental

19

Project Finance

• Common causes of failure

Completion delay-Cost overrun-Technical failure-Uninsured casualty losses-Increase price/shortage of raw materials-Technical obsolescence-Government interference-Loss of competitive position-Expropriation-Poor management

20

Project FinanceDesign of Risk Sharing

Contractual Structure Objective to prevent or limit their effect

Concession agreements-Construction and equipment contracts-Completion guarantees-Supply agreements-Throughput agreements-Cost over run insurance-Cash deficiency agreements-Political risk insurance-Management contracts

21

Project FinanceDesign of Risk Sharing

Contractual Structure Banks will use• Assignment of proceeds• Cash handling procedures• Financial guarantees from sponsor, governments, other banks,

third parties• Credit protection• Insurance

22

Project FinanceDesign of Risk Sharing

Contractual Structure• ‘What may be an unacceptable risk for one party may be

perfectly acceptable to another’• Government permissions• Physical completion• Cost over runs• Delays• Costs of inspection• Technical performance• Prices• Supply• Throughput or off take agreements

Project FinanceDesign of Risk Sharing

Contractual Structure

Project Company

Lending Banks Advisors

Offtake/Product Purchase

Raw Material supplier

Construction

Operator

Insurers

Project Sponsors

Shareholders Agreement

Financing Agreement

Financial, Legal, Insurance advice

Offtake/Purchase Contract

Supply contract

Construction contract

Operation and Maintenance Agreement

Insurance Policies

24

Project FinanceThe Funding Package 1

• The objective is to 1. Create an acceptable Risk/Return relationship for the participants2. Build in flexibility to cater for variations in

project outturn3. Risk hedging - financial by debt - interest rate risk - foreign exchange rate

25

Project FinanceThe Funding Package 2

• As little straight equity as possible (but some)

• Quasi equity e.g. subordinated loan stock

- more flexible

- performs like mezzanine finance

(leveraged buyouts)

26

PF: Subordinated Debt

• What Does Subordinated Debt Mean?A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings. Also known as a "junior security" or "subordinated loan".

27

PF: Junior Security/Debt

• What Does Junior Security Mean?A security that ranks lower than other securities in regards to the owner's claims on assets and income in the event of the issuer becoming insolvent.

• • Investopedia explains Junior Security

When bankruptcy occurs, holders of both preferred shares and debt securities have first claim on the remaining assets. Only after preferred shareholders have been paid back, remaining assets (if any) are divided among common shareholders.

28

PF:Senior Debt• What Does Senior Issue Mean?

An issue of bonds, preferred stock or other securities that represents the first priority lien on the issuer's assets or earnings. Senior issues have a higher priority claim on a firm's dividends, interest payments, or in case of a bankruptcy, the value salvaged from a liquidation.

• Investopedia explains Senior IssuePriority levels may change in the subordinated debt structure. An issue that is considered senior may lose that title in certain situations. For example, if a firm claims bankruptcy and begins acting as a debtor in possession (DIP), it may attempt to raise more funds to keep operations going. A new lender may require its lien to be given top priority, forcing the current senior issue of bonds down the claims ladder.

29

PF: Senior Security

• Notwithstanding the senior status of a loan or other debt instrument, another debt instrument (whether senior or otherwise) may benefit from security that effectively renders that other instrument more likely to be repaid in an insolvency than unsecured senior debt. Lenders of a secured debt instrument (regardless of ranking) receive the benefit of the security for that instrument until they are repaid in full, without having to share the benefit of that security with any other lenders. If the value of the security is insufficient to repay the secured debt, the residual unpaid claim will rank according to its documentation (whether senior or otherwise), and will receive pro rata treatment with other unsecured debts of such rank.

Source: Investopedia and Wikipedia

30

PF: Mezzanine Finance• What Does Mezzanine Financing Mean?

A hybrid of debt and equity financing that is is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies.

Since mezzanine financing is usually provided to the borrower very quickly with little due diligence on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender seeking a return in the 20-30% range. 

• • Investopedia explains Mezzanine Financing

Mezzanine financing is advantageous because it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing. To attract mezzanine financing, a company usually must demonstrate a track record in the industry with an established reputation and product, a history of profitability and a viable expansion plan for the business (e.g. expansions, acquisitions, IPO).

31

PF: Mezzanine Finance• Mezzanine capital, in finance, refers to a subordinated debt or

preferred equity instrument that represents a claim on company's assets, which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.

• Mezzanine capital often is a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a company's capital structure (i.e., in the event of default, the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements are also often used by smaller companies and may also involve greater overall leverage levels than issuers in the High Yield market and as such involve additional risk. In compensation for the increased risk, mezzanine debt holders will require a higher return for their investment than secured or other more senior lenders.

• Source: Wikipedia

32

PF: Mezzanine Finance• Leveraged buyouts• In a leveraged buyouts, mezzanine capital is used in conjunction

with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior loans, second lien loan, high yield financings) and equity. Often, a financial sponsor will exhaust other sources of capital before turning to mezzanine capital.

• Financial sponsors will seek to use mezzanine capital in a leveraged buyout in order to reduce the amount of the capital invested by the private equity firm. Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firm's investment returns. Additionally, middle market companies may be unable to access the high yield market due to high minimum size requirements, creating a need for flexible, private mezzanine capital.

33

Project FinanceFunding Package 2

• Back to Subordinated Loan

• Gives advantages such as

- higher return than senior debt

- can carry low and flexible coupon

- tax deductible

- can be regarded as equity by senior

lenders

34

Project FinanceThe Funding Package 3

• Debt will be sourced from a variety of providers

1. Export Credit Agencies e.g. ECGD, COFACE, HERMES, Eximbank, SACE

2. Buyer and Supplier credits

3. Non commercial finance e.g. development loans from regional national or international development agencies e.g. EIB, EBRD, Asian Development Bank

35

Project FinanceThe Funding Package 3

4. Long and short term asset finance e.g. leasing

5. Conventional trade finance

6. Bond issues

7. Conventional senior debt

36

Project FinanceThe Funding Package 4

• Design and Monitoring

- Debt service ratios

- Based on free cash flows

• Economic test

37

Project FinanceThe Funding Package 5

• Annual Debt Service Cover Ratio

(ADSCR)

Period project cash flows before interest payable and debt repayment

Divided by

Period interest payable and debt repayments

Calculated for each period

Minimum ratios between 1.25 to 2.00

38

Project FinanceThe Funding Package 6

• Multi period ratios1. Loan Life Cover Ratio (LLCR) NPV of free cash flows over loan life Outstanding Debt

2. Project Life Cover Ratio (PLCR) NPV of free cash flows over project life Outstanding DebtNote Discount used is the average interest cost so

relates to PV of the project to the bank