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Project Finance

Session on Finance

Sidharth SinhaIndian Institute of Management, Ahmedabad

The views expressed here are those of the presenter and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they

represent.

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itProject Finance

• Objective Financing a single purpose capital asset usually with a

limited life

• Project vehicle Legally independent project company

• Financing (debt and equity definition) Equity from one or more project sponsors Non recourse (to sponsors) debt Equity at the minimum level to issue debt at reasonable

cost

• Comparison with traditional or corporate finance

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• Standard & Poor’s defines a project company as a group of agreements and contracts between lenders, project sponsors, and other interested parties that creates a form of business organization -

that will issue a given amount of debt at start; will operate in a focused line of business; lenders look only to a specific asset to generate cash

flow as the sole source of principal and interest payments and collateral.

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• Project debt is not a permanent part of the capital structure, but is repaid in most projects according to a schedule based on the project’s useful life.

• Projects by design do not build up equity, but instead, use up cash quickly -

First as operating expenses, then as debt service (often the most significant

expense), and finally as dividends.

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• Project finance is suitable for large projects Takes a longer period of time to structure, negotiate and

document a project financing than a traditional financing The legal fees and related costs associated with project

financing can be very high It limits the risk of the sponsor to its equity investment -

not the total project investment.

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itMain Parties in a Project Financing

VehicleSuppliers Purchasers

Operator

Lenders

Contractor

Shareholders

Loan Agreement

Concession Agreement

Off-take Agreement

Equity Subscription Agreement

Supply Agreement

Operation & Maintenance Agreement

Construction Agreement

Shareholders Agreement

Special Purpose Suppliers Purchasers

Authority

Operator

Lenders

Contractor

Shareholders

Loan Agreement

Concession Agreement

Off-take Agreement

Equity Subscription Agreement

Supply Agreement

Operation & Maintenance Agreement

Construction Agreement

Shareholders Agreement

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itProject Financing Participants

• Sponsor/Developer. The sponsor(s) or developer(s) of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in the project company.

• Additional Equity Investors. In addition to the sponsor(s), there frequently are additional equity investors in the project company.

These include government, sponsors, contractors, insurers, suppliers, off-takers, etc, giving them a vested interest in the success of the project

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itProject Financing Participants (continued)

• Lender. The lender in a project financing is a financial institution or group of financial institutions that provide a loan to the project company to develop and construct the project and that take a security interest in all of the project assets. Lenders can also include bond investors in capital markets

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itRisk Analysis

• Since lenders provide bulk of the financing, risk is usually analyzed from the lenders’ perspective

Project-level risks - agreements Default by counterparties

Country risk - stability of economic, political, and regulatory environment

Business and legal institutions risk - enforceability of agreements

• Force majeure risk - ‘acts of god/nature’ Insurance

• Credit enhancements• The objective is to assess the risk of cash flows available for

debt servicing Loan and security agreements

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itProject Level Risks

• Quality of sponsors Experience, commitment (equity investment) Strategic importance of the project Financial strength to meet future obligations such as

contingent equity• Construction risk

Construction agreements Quality of contractors (could be a sponsor) Related investment requirements

• Operations risk Quality of operator Operations and maintenance contract

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itProject Level Risks

• Supply risk Availability Agreements for variability of input prices

• Offtake, demand & market risk Offtake agreement May not offer adequate protection against unfavourable

market situation because of problems of enforceability of contracts

Competitive position Cost of production relative to competitors Availability of substitutes Better competitive position implies lower demand risk

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itConstruction Contract

• Price. Most project financing construction contracts are fixed-price contracts although some projects may be built on a cost-plus basis. If the contract is not fixed-price, additional debt or equity contributions may be necessary to complete the project, and the project agreements should clearly indicate the party or parties responsible for such contributions.

• Completion Date. If construction is not finished by the completion date, the contractor typically is required to pay liquidated damages to cover debt service for each day until the project is completed. If construction is completed early, the contractor frequently is entitled to an early completion bonus.

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itConstruction Contract (continued)

• Performance Guarantees. Such guarantees are measured by performance tests conducted by the contractor at the end of construction. If the project does not meet the guaranteed levels of performance, the contractor typically is required to make liquidated damages payments to the sponsor. If project performance exceeds the guaranteed minimum levels, the contractor may be entitled to bonus payments

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itOperations and Maintenance Agreement

• Long-term agreement for the day-to-day operation and maintenance of the project facilities

• With a company having the technical and financial expertise to operate the project in accordance with the cost and production specifications for the project.

The operator may be an independent company, or it may be one of the sponsors.

The operator typically will be paid a fixed compensation May be entitled to bonus payments for extraordinary

project performance and, Be required to pay liquidated damages for project

performance below specified levels.

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itInput Supply Agreements

• Agreements for the supply of raw materials, energy or other resources over the life of the project.

Frequently, supply agreements are structured on a "put-or-pay" basis -

This means that the supplier must either supply the input or pay the project company the difference in costs incurred in obtaining the input from another source.

Fixed or spot price

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itProduct Offtake Agreements

• The product offtake agreements represent the source of revenue for the project.

Frequently, offtake agreements are structured on a "take-or-pay" basis,

The offtaker is obligated to pay for product on a regular basis whether or not the offtaker actually takes the product unless the product is unavailable due to a default by the project company.

Price Fixed Scheduled changes Pass through of fluctuating input prices

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itCountry Risk

• Stability and predictability Economic environment Political and regulatory environment

Expropriation or creeping expropriation Currency risk

Exchange rate volatility, transfer and convertibility risk Currency of revenue, expenses, debt servicing and

shareholder return

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itLoan and Security Agreement

• Security. The project loan typically will be secured by multiple forms of collateral

Mortgage on the project facilities and real property. Assignment of operating revenues. Assignment of any letters of credit or performance or

completion bonds relating to the project under which borrower is the beneficiary.

Assignment of insurance proceeds.  Assignment of all project agreements

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itLoan and Security Agreement (continued)

• Disbursement Controls. These frequently take the form of conditions precedent to each drawdown, requiring the borrower to present invoices, builders' certificates or other evidence as to the need for and use of the funds.

• Progress Reports. The lender may require periodic reports certified by an independent consultant on the status of construction progress.

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itLoan and Security Agreement (continued)

• Covenants Not to Amend. The borrower will covenant not to amend or waive any of its rights under the construction, feedstock, offtake, operations and maintenance, or other principal agreements without the consent of the lender.

• Completion Covenants. These require the borrower to complete the project in accordance with project plans and specifications and prohibit the borrower from materially altering the project plans without the consent of the lender.  

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itLoan and Security Agreement (continued)

• Dividend Restrictions. These covenants place restrictions on the payment of dividends or other distributions by the borrower until debt service obligations are satisfied.

• Debt and Guarantee Restrictions. The borrower may be prohibited from incurring additional debt or from guaranteeing other obligations.

• Financial Covenants. Such covenants require the maintenance of working capital and liquidity ratios, debt service coverage ratios, debt service reserves and other financial ratios to protect the credit of the borrower.

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itCredit Enhancement

• Some third parties offer various credit enhancement products designed to mitigate project level risks, sovereign risks, and currency risks, among others.

Multilateral agencies, such as the Multilateral Investment Guarantee Agency, the International Finance Corp., and ADB offer various insurance programs to cover both political and commercial risks.

Project sponsors can themselves provide some type of support in mitigation of some risks - a commitment that tends to convert a non-recourse financing into a limited recourse financing.

These enhancement packages cover only specified risks.

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itFinancial Modeling

• The most important decision making instrument in the financing of a project is its financial model.

• The model ties up the revenue model, capex, opex, capital structure and other inputs

• It provides projected multi-year financials, e.g. income statement, balance sheet and cash flow statement

• The model can also be programmed to do scenario testing, sensitivity analysis and stochastic analyses of performance measures.

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itPerformance Measures

• Valuation measures Internal Rate of Return (IRR) and Net Present Value (NPV)

• Debt-service coverage ratios (DSCRs) as the primary quantitative measure of a project’s financial credit strength.

The DSCR is the ratio of cash from operations (CFO) to principal and interest obligations.

CFO is calculated strictly by taking cash revenues and subtracting expenses and taxes, but excluding interest and principal, needed to maintain ongoing operations.

The ratio calculation also excludes any cash balances that a project could draw on to service debt, such as the debt service reserve fund or maintenance reserve fund.