project finance concents and applications

Padmalatha Suresh holds a post-graduate diploma in Management from the IndianInstitute of Management, Ahmedabad, as well as a degree in Law. She is a CertifiedAssociate of the Indian Institute of Bankers. She has more than two decades ofwork experience at senior levels in the Banking and IT industries. At present, she isa consultant in the areas of Banking and Finance. A visiting faculty of Finance atthe Indian Institutes of Management at Kozhikode and Indore, she also teaches atGreat Lakes Institute of Management, Goa Institute of Management and the IcfaiBusiness School. Apart from post-graduate programs, she has also taught atExecutive Education programs and Management Development Programs of reputedBusiness Schools, including corporate in-house training programs. She haspresented papers in the areas of Banking and Infrastructure financing and herworks have been published in reputed business dailies and magazines.

ICFAI Books

An Introduction

ICFAI BOOKS is the initiative of the ICFAI University Press to publish a series of

books in the areas of finance, management and allied areas with a special focus on

emerging and frontier areas. These books seek to provide, at one place, a

retrospective as well as prospective view of the contemporary developments in the

environment, with emphasis on general and specialized branches of knowledge

and applications.

The books in this series are based on relevant, authoritative and thought-provoking

articles written by experts and published in leading professional magazines and

research journals. The articles are organized in a sequential and logical way that

makes reading continuous and helps the reader acquire a holistic view of the subject.

This helps in strengthening the understanding of the subject better and also enables

the readers stretch their thoughts beyond the content of the book. The series is

designed to meet the requirements of executives, research scholars, academicians

and students of professional programs. The ICFAI University Press has published

over 600 books in this series. For full details, readers are invited to visit our

website: www.icfaipress.org/books.

Project FinanceConcepts and Applications

Edited by

Padmalatha Suresh

ICFAI BOOKS

The ICFAI University Press

Project Finance – Concept and Applications

Editor: Padmalatha Suresh

© 2005 The ICFAI University Press. All rights reserved.

Although every care has been taken to avoid errors and omissions, this publication isbeing sold on the condition and understanding that the information given in thisbook is merely for reference and must not be taken as having authority of or bindingin any way on the authors, editor, publisher or sellers.

Neither this book nor any part of it may be reproduced or transmitted in any form orby any means, electronic or mechanical, including photocopying, microfilming andrecording or by any information storage or retrieval system, without prior permissionin writing from the copyright holder.

Trademark notice: Product or corporate names may be trademarks or registeredtrademarks, and are used only for identification and explanation without intent toinfringe.

Only the publishers can export this book from India. Infringement of this condition ofsale will lead to civil and criminal prosecution.First Edition: 2005Printed in India

Published by

The ICFAI University Press52, Nagarjuna Hills, PunjaguttaHyderabad, India–500 082Phone: (+91) (040) 23430 – 368, 369, 370, 372, 373, 374

Fax: (+91) (040) 23352521, 23435386

E-mail: info@ icfaibooks.com, [email protected], [email protected]

Website: www.icfaipress.org/books

ISBN: 81-7881-xxx-x

ICFAI Editorial Team: P Sivarajadhanavel, Parul Sinha and R KalyaniDesigners: Ch Yugandhar Rao and M Vijay Kumar

Contents

Overview I

Section I

The Project Finance Market – An Overview

1. Project Finance: The Need to Treat Large 3Projects DifferentlyPadmalatha Suresh

2. Project Finance in Developing Countries – 14The Importance of Using Project FinancePadmalatha Suresh

3. Public-Private Partnerships: The Next 25Generation of Infrastructure Financewww.fitchratings.com

Section II

How Project Structures Create Value

4. Budget: Overcoming Roadblocks to Growth 51Padmalatha Suresh

5. Structure Matters in Project Finance 57Padmalatha Suresh

6. Assessing the Economic Impact of 70Infrastructure Projects – The ERRPadmalatha Suresh

7. Complexities in Valuing Large Projects 81Prof. R Subramanian

Section III

Managing Project Risks

8. The Nature of Credit Risk in Project Finance 93Marco Sorge

9. Refinancing Risk – Permutations of 107Project Finance Structureswww.fitchratings.com

10. Exchange Rate Risk 124Philip Gray and Timothy Irwin

11. Contingent Liabilities for Infrastructure 131Projects: Implementing a Risk ManagementFramework for GovernmentsChristopher M Lewis and Ashoka Mody

Section IV

Financing Projects

12. The Syndicated Loan Market: Structure, 141Development and ImplicationsBlaise Gadanecz

13. Equator Principles – Why Indian Banks 158Too Should be Guided by ThemPratap Ravindran

14. Synthetic Leasing 164www.fitchratings.com

15. Project Finance: Debt Rating Criteria 172Peter Rigby and James Penrose, Esq.,

16. Pension Funds In Infrastructure Project 197Finance: Regulations and Instrument DesignAntonio Vives

Section V

Applications and Cases

17. Private Power Financing – From Project 225Finance to Corporate FinanceKarl G Jechoutek and Ranjit Lamech

18. Pooling Water Projects to Move 232Beyond Project FinanceDavid Haarmeyer and Ashoka Mody

19. Financing Water and Sanitation 239Projects – The Unique RisksDavid Haarmeyer and Ashoka Mody

20. Successful Project Financing – HUB Power Project 246World Bank Project Finance Group

21. Insurance Funds to Flow into Road 254Projects-lic Finalising Loan Pact with NhdpP Manoj

• Index 257

I

Overview

“Project Finance is like a chameleon: It always finds a way to takeadvantage of changes in the Business”1

The last two decades have witnessed the emergence of a new,important method of financing large-scale, high-risk projects, bothdomestic and international. The distinguishing features of this methodare that the creditors share much of the business risk in the projects,and the funding is obtained, based on the strength of the viability ofthe project itself, rather than on the creditworthiness of the projectsponsors. The method, called “project finance” is typically defined aslimited or non-recourse financing of a new project through separateincorporation of a vehicle or project company.

Project finance is not a new financing technique. The earliest knownproject finance transaction took place in 1299, when the English Crownnegotiated a loan from a leading Italian merchant bank of that periodto develop the Devon silver mines. Under the loan contract, the lender1 Esty Benjamin C, “Overview of the Project Finance Market”, Harvard Business School, 2000.

II

would be able to control the operations of the mines for one year. Hewas entitled to all the unrefined ore extracted during the contract period,but had to pay all the operating costs associated with the extraction.There was no provision for interest, nor did the Crown guarantee thequantity or quality of silver that could be extracted. In current parlance,this transaction would be known as a “production payment loan”.

Since the 1970s, when Project finance was used on a large scale todevelop the North Sea Oil fields, this financing technique has beenextensively associated with several financial and operating successstories in developing natural resources, electric power, transport andtelecommunication projects. Equally spectacular have been somerecent financial failures—the Dabhol Power project (India), theEurotunnel, EuroDisney (Paris), and Iridium (the USA). In spite ofthese failures, which have attracted considerable public attention, themarket for project finance has been growing worldwide.

Project financing has been increasingly emerging as the preferredalternative to conventional methods of financing infrastructureworldwide. New financing structures, access to private equity andinnovative credit enhancements make project finance the preferredalternative in large-scale infrastructure projects.

According to World Bank estimates, the demand for infrastructureinvestment is staggering. Asian countries alone, which historicallyhave accounted for about only 15% of the Project Finance market,need to invest USD 2 trillion in infrastructure in this decade tomaintain their current rate of development. Most studies on economicdevelopment find that large-scale infrastructure investment isassociated with one-for-one growth in the country’s GDP. Similarcountry studies of economic development find that inadequate orabsent infrastructure severely impede economic growth.

The intricacies of large scale project financing are formidable andcall for skills that are different from other financial applications.Consequently, these intricacies can be misunderstood, and evenmisused. Although project financing structures share certain common

III

features, every project is unique and requires tailoring of the financialpackage to the particular circumstances and features of the project.Here lie both the benefits and the challenges.

India, too, will be witnessing a boom in the infrastructure sectorin the years to come.

Infrastructure has been recognized as a national priority in India.It is preferable that long-term Infrastructure finance in emergingmarkets like India, is based on project financing arrangements, thusattempting to mitigate the extreme risks of operating very largeprojects. Large infrastructure projects—customarily implemented bythe government— now being implemented with private participationand management, reflect the new trend. All these projects use someform of “Project Finance”, a term currently being used synonymouslywith “Contractual Finance”.

Due to its increasing importance and use as a funding vehicle forlarge projects, Project Finance has been attracting a great deal of academicinterest. The innovative deals being crafted in project finance revolvearound financial packages that offer rich opportunities for testing corefinancial theories. The large number of financial contracts thatcharacterize project finance must be able not only to allocate risks tovarious parties who can best bear them, but also should be able to solvebasic agency problems between sponsors and creditors. Recent researcheshave achieved theoretical breakthroughs in the analysis of separateincorporation (a distinctive feature of project finance), secured debtfinancing, the maturity structure of debt contracts, the choice betweenprivate debt (bank loans) and public debt (bonds and notes), the roleof covenants and collateral in debt contracts, the optimal design ofsecurities, and the monitoring role of financial intermediaries, and haveyielded important insights into project finance structures.

Drawing on existing finance theory, detailed case studies, andextensive field research, Benjamin Esty2 mentions three primarymotivations for using project finance: (1) reduced agency costs and

2 Esty Benjamin C, “The Economic Motivations for using Project Finance”, 2003, Harvard BusinessSchool.

IV

conflicts, (2) reduced debt overhang problem and (3) enhanced riskmanagement. The motivations explain why financing assets separatelywith debt creates value, and why it can create more value thanfinancing assets jointly with corporate debt, the traditional and mostpopular financing alternative.

The research on project finance, though limited, collectively helpsreinforce the practice of project financing techniques. Practitioners3

assert that Project finance will most commonly be used for capital-intensive projects, with relatively transparent cash flows, in “riskierthan average” countries, using relatively long-term financing, andemploying far more detailed loan covenants and allocating risks farbetter to those parties best able to manage them, than to those whowill manage conventionally-financed projects.

In the above context, an understanding of the basic conceptsunderlying project finance is necessary. This book, presented in fivedistinct sections, presents insights into the concepts and applications ofproject finance through articles by experts. The first section definesProject finance, and provides an overview of the Project finance market,the second section elaborates the unique value that project financingstructures generate, the third section is devoted to risk managementand the fourth to innovative financing instruments. The last sectionoutlines some applications of project finance, by sectors and projects.

Section I provides an overview of the Project finance Market.

The opening article “Project Finance: The Need to Treat LargeProjects Differently”, by Padmalatha Suresh describes the origin andgrowth of project finance. It explains the features of project financing,how it differs from corporate finance, and the advantages anddisadvantages of using project finance for large infrastructure projects.

The second paper, “Project Finance in Developing Countries –The Importance of Using Project Finance” sourced from the3 Kensinger and Martin (1988), Smith and Walter (1990), and Brealey, Cooper and Habib (1996) from

Kleimeier, Stefanie, and Megginson, William L, “An Empirical Analysis of Limited Recourse ProjectFinance”, July 2001.

V

International Finance Corporation (IFC), features the growingimportance of Project Finance as a tool for economic investmentand describes non recourse and limited recourse project financeconcepts. Some examples of IFC supported projects and theirdevelopmental impact on the economy, along with data on the projectfinance market have been provided. Differentiating project financefrom traditional balance sheet financing, the paper outlines theadvantages that project finance has for private sponsors, and concludesthat in spite of all the advantages, the rigorous requirements ensurethat there are no ‘free lunches’ in project finance.

Analysts from the pre-eminent rating company, Fitch Ratings, havecontributed the third article, a special report titled “Public PrivatePartnerships: The Next Generation of Infrastructure Finance”.The report looks at the larger roles PPP models would play in emergingand other economies, for funding the infrastructure requirements farin excess of the currently available financing resources. The privatesector can play an active role as project sponsor or a passive role as aninstitutional bond investor. The report identifies the pre-requisitesfor a receptive PPP debt market as a relatively stable macro economicenvironment, a sound legal framework for concessions, contractenforcement and bankruptcy remedies, a stable regulatory frameworkand a developing domestic debt market. With more and moreinnovations coming into PPPs, the article expresses confidence thatthe PPP market is all set for growth. Some of the “next-generation”developments relate to (a) pooling of credit risks (b) the US SRFmodel, and (c) enhancing Pooled credit risk. The report in conclusion,quotes the successful experiment with such credit enhancements inthe case of USAID support of the Water and Sanitation Pooled Fund(WSPF) in Tamil Nadu, India.

Section two of the book is titled ‘How project structures createvalue’. The section elaborates the uniqueness of project structuresthat enable them to take on the inherent risks of long-term projects.

The first article in this section is published by Padmalatha Suresh inthe Business Line, titled “Budget: Overcoming Road Blocks to Growth”.

VI

Taking the cue from the remarks on FDI flows made by India’s FinanceMinister in his 2005 Budget Speech, the article outlines the role ofthe banking system and the government in building world classinfrastructure in India, with particular reference to transport. Drawingextensive references to the remarkable transformation of the Chineseeconomy, the article underscores the need for innovative projectfinancing and active involvement of the banking system, capitalmarkets and legal system in this process.

The next article “Structure Matters in Project Finance” byPadmalatha Suresh, summarizes the rationale for various types ofcontracts and models that form the backbone of project financingtransactions. In doing so, the article tries to seek answers to thefollowing questions—What are the structural attributes of projectcompanies that enable them to find the financial and other resourcesfor very large projects? Having found the resources, how do the projectcompanies structure the project organization to take care of its long-term needs? How do project companies take care of the risks involvedin constructing, financing and operating very large projects? Whatare the structural features of project companies that enable lendersand equity holders to invest substantial funds?

In the next article in this section, “Assessing the Economic Impactof Infrastructure Projects – The ERR”, Padmalatha Suresh avers thatan infrastructure project has to generate social returns as well, apartfrom private returns. While the Financial Rate of Return measures theprivate returns, the Economic Rate of Return [ERR] measures the socialreturns from the project. Since the ERR is the basic criterion forgovernments, multilateral agencies and development banks to lend foran infrastructure project, the article discusses the issues involved incalculating the ERR. Traditional capital budgeting techniques may notbe able to measure the value of long term, risky projects effectively.

In the last article of this section, titled “Complexities in ValuingLarge Projects”, R Subramanian outlines the shortcomings oftraditional methods while valuing large projects, and describes someprevalent methodologies for valuing such projects. Most of the

VII

methodologies being used now, do not take into account the embeddedoptions in investments in large projects. Real options methodologiesare now being preferred for valuing long-term infrastructure projects.

Section three has been devoted to the vital issue of “Managingproject risks”.

Project financing structures are designed to allocate risks throughcontracts to the parties who can best bear the risks. In the first articlein this section, Marco Sorge from the Bank of International Settlements(BIS) describes “The Nature of Credit Risks in Project Finance”.This paper aims to establish that in project finance, credit risk tendsto be relatively high at project inception and to diminish over the lifeof the project. Hence, longer-maturity loans would be cheaper thanshorter-term credits. In order to cope with the asset specificity ofcredit risk in project finance, lenders are making increasing use ofinnovative risk-sharing structures, alternative sources of creditprotection and new capital market instruments to broaden theinvestors' base. Hybrid structures between project and corporatefinance are being developed, where lenders do not have recourse tothe sponsors. Two main findings have emerged, based on the analysisof some key trends and characteristics of this market. First, unlikeother forms of debt, project finance loans appear to exhibit a hump-shaped term structure of credit spreads. Second, political risk andpolitical risk guarantees have a significant impact on credit spreadsfor project finance loans in emerging economies This is particularlyrelevant, given the predominant role of internationally active banksin project finance and the fundamental contribution of project financeto economic growth, especially in emerging economies.

The second article is a report from analysts from Fitch Ratings,elaborating on “Refinancing Risk – Permutations in Project FinanceStructures”. Fitch observes that, refinancing risk is increasingly creepinginto the financing of single revenue-generating assets. Refinancing risk,in some instances, has arisen from financings that aim to avoid someof the restrictions commonly imposed by the terms of projectfinancings, such as stringent limits on additional debt or from the

VIII

implementation of a debt structure that finances a project that is changingin design or scope (expansion of a toll road or pipeline network). Morefrequently, refinancing risk has resulted from the limited term or tenoravailable in a particular debt market. Assets and projects with strongeconomics that are financed subject to covenants or structural elementshave been observed to mitigate refinancing risk adequately. In Fitch’sviewpoint, acceptable flexibility in the repayment structure can have abeneficial effect on project credit quality.

In the third article of this section, a World Bank Group note, PhilipGray and Timothy Irwin discuss an important risk in large projects—“Exchange Rate Risk”. Private foreign investment in the infrastructureof developing countries seems to hold great promise. But foreign investorsmust cope with volatile developing country currencies. This note proposesthat investors take on all financing-related exchange rate risk, even thoughthis may mean higher tariffs for consumers as a premium for bearingthat risk. Reducing reliance on foreign debt may mean that the volumesof private finance and privatizations in developing countries will not beforthcoming; and that the initial costs of finance will be higher. But thebenefits may be long-lived and quite robust.

The fourth article in this section “Contingent Liabilities forInfrastructure Projects: Implementing A Risk ManagementFramework for Governments” is also drawn from a World Bankpublication. This article is relevant to India, where the government isgetting involved in PPP projects in a big way. The authors, ChristopherM Lewis and Ashoka Mody propose that to manage their exposurearising from guarantees to infrastructure projects, governments needto adopt modern risk management techniques. Because guaranteescome due only if particular events occur, and involve no immediatecost to the government, they rarely appear in the government accountsor have funds budgeted to cover them. The note introduces anintegrated risk management system that draws on recent advances inthe private sector. The approach to risk management suggested inthis note also provides a mechanism for governments to criticallyassess the distribution of risks within a loan guarantee or insurance

IX

program and come up with better-designed contracts and fewer andsmaller calls on guarantees. And as risks change over time, theframework provides a basis for easy re-estimation and quickadjustments to the budgetary and reserve system.

Project financing has been characterized by innovative dealstructures and financing instruments. Section four takes a look atsome “New sources of Project financing”.

Syndicated loans are credits granted by a group of banks to aborrower. They are hybrid instruments combining features ofrelationship lending and publicly traded debt. They allow the sharingof credit risk between various financial institutions without thedisclosure and marketing burden that bond issuers face. BlaiseGadanecz, in the BIS Quarterly Review, describes “The SyndicatedLoan Market: Structure, Development and Implications”.Syndicated credits are a significant source of international financing,with signings of international syndicated loan facilities accountingfor no less than a third of all international financing, including bond,commercial paper and equity issues. The paper presents a historicalreview of the development of this increasingly global market anddescribes its functioning, focusing on participants, pricingmechanisms, primary origination and secondary trading.

In the second article titled “Equator Principles – Why IndianBanks Too Should Be Guided By Them?”, Pratap Ravindran,writing in The Hindu, describes the equator principles adopted byleading banks for financing infrastructure projects around the world,at the behest of IFC. The article impresses that Indian banks tooshould be guided by these principles, since most large projects needenvironmental clearance.

The synthetic lease has emerged as a popular financing structuresince it provides off balance sheet treatment for book purposes, whileallowing a company to retain the tax benefits associated with assetownership. Energy firms, to finance the acquisition of new assets orto refinance existing assets, frequently use this structure. In the third

X

article in this section, analysts from Fitch Ratings have described"Synthetic Leasing" as a viable alternative structure that can be readilyapplied to various types of energy-based assets, including electricturbines and other generating assets or natural gas and liquids pipelines.The synthetic lease moves the asset off the balance sheet whilemaintaining ownership for tax purposes. The vast majority of thefinancing for the asset purchase is achieved through a combination ofsenior and subordinated notes issued by the special purpose entity(SPE) created for this purpose.

The next article, excerpted from the Standard & Poor's Yearbook,describes in detail the “Debt Rating Criteria” for project financingtransactions. This article summarizes an analytic framework that canbe used to systematically assess cash flows based on project-level risksand then to analyze risks external to the project. Standard & Poor'sproject ratings address default probability. Project ratings do notdistinguish between the debt issue rating and the issuer credit rating, asis the case with corporate credit ratings. Five levels of analysis formingStandard & Poor's framework of project analysis are: (a) project levelrisks (b) sovereign risk (c) business and legal institutional development(d) force majeure risk and (e) credit enhancements. Standard & Poor'sexpects that as infrastructure investment needs increase, project debtwill remain a key source of long-term financings, and nonrecourse debtwill most likely continue to help fund these changes.

The last paper in this section is “Pension Funds in InfrastructureProject Finance: Regulations and Instrument Design” by AntonioVives for Inter American Development Bank. The article discusses indetail the experiences of the Latin American economies, which arebuilding a pool of individual savings to be invested in attractiveinvestment opportunities, and the applicability of these experiences toother emerging economies. On the other hand, infrastructure projectsare providing needed services that promote economic growth and socialwell-being and require long-term local financing. The time is now rightto enact the necessary measures that will bring the pension funds andinfrastructure investment together. This paper describes what it takes

XI

to achieve such a union. Fortunately, there has been an almostsimultaneous trend toward pension fund reform, including the creationof privately managed pension fund accounts. The paper suggests waysto structure projects to make them more attractive to pension funds,and describes needed regulatory changes to permit pension funds toinvest in them.

Section five describes Applications of project finance conceptsin various infrastructure projects the world over.

Karl Jechoutek and Ranjit Lamech, in their World Bank publication“Private Power Sector Financing – From Project Finance to CorporateFinance”, argue that to achieve substantive progress in Independent PowerProducer (IPP) financing, limited recourse project financing will have toevolve toward structures with greater balance sheet support. The IPPexperience in the United States offers useful insights, and indicates newevidence that variants of corporate financing are being used for financingelectric utilities. Developers are pooling projects into entities that arethen able to raise capital on the strength of a combined balance sheetcomprising the "pooled" assets of different projects. Providers of equityand debt then finance the business of building and operating privategeneration facilities rather than an individual power plant. Pooling spreadsproject risk. Industry consolidation has become a steady trend in the IPPbusiness. Greater corporate finance support will make it possible to raiseprivate capital for independent power financing from wider, deeper, andcheaper sources. But innovative strategies will be required fromgovernments, lenders, investors, and power sector enterprises alike.

The second article in this section is a study of water projects,“Pooling Water Projects to Move beyond Project Finance”. Thispaper reviews the new trends in financing water projects. Manycommercial banks have had little interest in water and sanitationprojects not only because of noncommercial, political and regulatoryrisks, but also the small size, weak local government credit, and hightransactions costs. The move from project to corporate (balance sheet)financing, is occurring in stages. Designed in part to shield a company’s

XII

balance sheet and improve a project's credit strength, innovativestructures and financial instruments are emerging. Ultimately, thegoal is for water utilities to raise debt and equity from capital marketson the basis of their own balance sheets, strengthened by a diversifiedand stable rate-paying customer base.

Carrying this vital subject further, the next article titled “FinancingWater and Sanitation Projects – The Unique Risks” by DavidHaarmeyer and Ashoka Mody (World Bank publications), reviews somerecent innovative projects, and shows that private participation on alimited recourse or no recourse basis has required support frommultilaterals and federal government agencies to absorbnoncommercial risks. In industrial countries the credit strength ofoff-taking municipal governments and the sector's traditionalmonopoly structure expose lenders to potentially significant credit,regulatory, and political risks. These risks, combined with the sunk,highly specific, and non-redeployable nature of water investments,mean that lenders and investors are vulnerable to governmentopportunism and expropriation.

The challenge for the future is in mitigating the noncommercialrisks that characterize the sector. Pakistan’s “HUB Power Project”, isone of the success stories of recent times. This World Bank publicationdescribes how the Project marks the first use of a World Bank guaranteefor a private sector project and is a major step forward in the Bank’seffort to increase private sector investment in infrastructure.

The last article in this section explores another potential avenuefor financing long-term projects—Insurance funds. Titled “InsuranceFunds to Flow into Road Projects”, and authored by P Manoj (inthe Business Line), this note describes the use of LIC funds in financingroad projects in India.

Project finance is fast emerging as the most preferred alternative forfinancing infrastructure projects all over the world. In India, projectfinance models have been used recently in the NOIDA toll bridge and

XIII

the Bangalore Airport projects. In this book, an attempt has been madeto elaborate upon the key financial concepts underlying project financeand illustrate a few applications. This book, therefore, would serve asan introduction to the exciting and growing field of project finance.

There are several changes in the project finance market that areeither under way or likely to emerge in the near future. Co-financingstructures —conventional corporate finance with project finance, orIslamic financing structures in combination with project finance, havealready been implemented successfully in infrastructure projects inother parts of the world. In the coming years, in India, the bankingsystem and the capital markets will have to gear themselves up tohandle the demand for funds. Similarly, more private players willenter infrastructure development either with the government inpublic-private-partnerships (PPPs) or with government guarantees,or even without government guarantees. The biggest changes wouldoccur in the capital markets, and more specifically, bond markets.From the issuer's perspective, project bonds are attractive becausethey have longer maturities, fewer covenants, and represent a deepermarket. As the supply of bonds increases, there will be moreparticipation from institutional investors such as Insurance funds andPension funds. Project bonds would appeal to these investors sincetheir tenure would match the long-term liabilities of the investors.As the project debt market develops, securitization of project loanswill occur with greater frequency. The derivative market and secondaryproject debt markets would also have to develop alongside. Therewill have to be simultaneous innovations in the equity markets aswell. Already sponsors and financial advisors in developed countriesare forming dedicated pools of capital, to invest in infrastructure andother long-term projects.

To take advantage of the growth and deepening of the projectfinance market for development of its infrastructure, India will haveto institute several reforms—financial, regulatory, legal and social.

In conclusion, the Project Finance market will continue to growwell into the future, in tandem with increasing globalization,

XIV

deregulation and economic development. As markets integrate andfirms globalize, the scale of projects is likely to increase. These newmarkets will contain opportunities to appraise and finance not onlylarger projects, but also different kinds of projects. Many countriesthat have not used Project Finance techniques historically, for financingtheir large-scale investments, are likely to do so in the coming years.

1Project Finance: The Need to Treat Large Projects Differently

Section I

The Project Finance Market: An Overview

2 PROJECT FINANCE – CONCEPTS AND APPLICATIONS


1

© The ICFAI University Press. All rights reserved.

Project Finance: The Needto Treat Large Projects Differently

Padmalatha Suresh

Large infrastructure projects are unique. Typically, they take fiveto seven years to structure, require huge upfront capital, compriseof mostly large, tangible assets, and have a very long life. Therisks of such projects are different from those of capital investmentsfor shorter time frames. Traditionally, the government wasfinancing infrastructure projects. However, government financesare increasingly under pressure, necessitating greater privateparticipation in financing such projects. What are the capitalproviders� incentives to participate in infrastructure development?Would they be willing to bear the construction and completion risksof the project and the operating, financial and political risks oncethe project is completed? Would they be able to bring in thephenomenal amounts of equity and debt needed? Would they beprepared for the financial risk, which could, in bad times, lead tofinancial distress? Project finance provides satisfactory answersto these questions, and is increasingly being used to finance verylarge projects. The article outlines the evolution of modern projectfinance and the global project finance market, contrasts it withconventional corporate financing, and concludes that projectfinance is relevant for India�s infrastructure development.


Rationale for Project Finance

What is a large project? Benjamin Esty1 defines large projects as those costingUSD 500 million or more, accounting for 25% of the world’s projects by numberand 75% by value. Typically, these large investments take five to seven years tostructure, require huge doses of capital upfront, comprise of mostly large, tangibleassets, and have a life of 15 to 25 years or more. Such projects are mostly in thenature of necessary social infrastructure in a country, or a large investment thatfills a need of economic development.

Most studies on economic development find that infrastructure investment isassociated with one to one percentage increases in the country’s Gross DomesticProduct (GDP). Similar country specific studies find that absent or inadequateinfrastructure severely impedes economic growth. A study by the InternationalFinance Corporation2 has shown that insufficient or irregular power supply reducesGDP by one to two percent in India, Pakistan and Columbia.

Traditionally, the public sector or the government financed large infrastructureprojects in a country. However, finances of governments are increasingly underpressure, leading to greater use of the private sector in financing such projects. Insome cases, use of private financing for infrastructure has enabled the governmentsto invest in more developmental projects. In other cases, private sector financingof large projects has aided the governments in reducing their public borrowings,thus rejuvenating the flagging financials of the governments.

However, given the nature of such projects as described above, it is evidentthat the risks of such long term projects will be quite different from the risks ofcapital investments for shorter time frames. While the returns of a viable projectwill have to be commensurate with the risks in the long run, the private investorsand the government should be able to sustain the upfront investment of enormouscapital and the gestation period till positive cash flows are generated. In someinfrastructure projects such as toll roads, the mindset and number of users of thefacility will largely determine how profitable the project would be.

1 Esty Benjamin C, “Why Study Large Projects? An Introduction to Research on Project Finance”, EuropeanFinancial Management, vol 10, no 2, 2004, 213-224.

2 1996, “Lessons of Experience #4: Financing Private Infrastructure”, World Bank, Washington DC, pp 43-44.


What then are the incentives for capital providers to participate in infrastructuredevelopment? Would the private investors or lenders be willing to bear theconstruction and completion risks of the project and the operating, financial andpolitical risks once the project is completed? Would they have the financial muscleto wait patiently for cash flows that may happen only over a very long period oftime, with no certainty that these cash flows would sustain over the life of theproject? Would they be able to bring in the phenomenal amounts of equity anddebt needed to finance these projects? And having decided to borrow, would theproject sponsors be able to service the debt from the project cash flows, or wouldthey have to intermingle the cash flows from their other operations in order toservice the debt? Would they be prepared for the financial risk to be undertaken,which could, in bad times, lead to a financial distress situation?

Project finance provides satisfactory answers to most of the questions raised above.Project finance is increasingly being used to finance very large projects during thelast decade, due to the advantages it offers over the conventional corporate finance.

Defining Project Finance

Simply put, Project finance involves the creation of a legally independent projectcompany, with equity from one or more sponsoring firms, and non- or limitedrecourse debt, for the purpose of investing in a single purpose, industrial asset.3

Other working definitions of project finance include the following:

1. “The raising of funds to finance an economically separable capital investment,in which the providers of funds look primarily to the cash flows from theproject as source of funds to service their loans and provide the return of,and a return on their equity invested in the project.”4

A project is further defined as ‘a set of legally and economically independentassets with a single industrial use.’

2. “Limited or non-recourse finance of a newly to-be-developed project throughthe establishment of a vehicle company.”5

3 Esty Benjamin C, “Why Study Large Projects? An Introduction to Research on Project Finance”, EuropeanFinancial Management, vol 10, no 2, 2004, 213-224.

4 Finnerty John D, “Project Finance: Asset Based Financial Engineering”, 1996, John Wiley and Sons, p 2.5 Kleimeier Stefanie and Megginson William I, “An Empirical Analysis of Limited Recourse Project Finance”,

working draft, 2001.


3. “Financing of a particular economic unit in which the lender is satisfied to lookat the cash flows of earnings of that economic unit as a source of funds, fromwhich the loan will be repaid and at the assets as collateral for the loan.”6

Evolution Of Project Finance

Contrary to the general impression that it is a recent phenomenon, Project financehas a history that dates back to about 700 years. The earliest recorded Project financingtransaction was in 1299, when the English Crown asked a Florentine MerchantBank to develop the Devon silver mines. The agreement was in the form of a year’slease of the total output of the mines to the Bank, in exchange for bearing theoperating costs. This implied that the bank was entitled to all the output, whethermore or less than the expected level; and in case the value or volume of output fellbelow the bank’s expectations, the bank would have no recourse to the Crown. Incurrent parlance, this is known as a ‘Production payment loan’.

A similar concept was used in some of the earliest applications (1930s) ofProject finance in the US, in natural resources and real estate. For instance, ‘wildcat’explorers in places like Texas and Oklahoma used production payment loans tofinance oilfield explorations. In the case of commercial development of real estate,developers used loans whose repayment depended on project cash flows only.

6 Hewitt, 1983

Figure 1: How Project Finance Works

Sponsor Lender

MinimumRecourse

SufficientCredit Support

Project

Credit/Contract Support

Third Party Participants


However, Project finance in its modern form, started evolving only in the 1970s.Several natural resource discoveries and spiraling demand for energy were the ‘triggers’that set off this development. Some of the applications during this period were:

• British Petroleum raised USD 945 million from the market on a projectbasis, to finance the development of the oil reserves in the North Sea.

• The Erstberg copper mines in Indonesia were project financed by FreeportMinerals.

• Conzinc Riotionto of Australia project financed the Bougainville coppermines in Papua New Guinea.

The 1980s saw a spurt in project financing of power projects in the US and otherdeveloped countries. In the US, the ‘Power Utilities Regulatory Policy Act’ (PURPA)aided the growth of project finance by necessitating financing of new power plantswith long-term purchase agreements. In this period, project finance was seen as beingsynonymous with ‘power finance’ in developed markets like the US.

Since the 1990s, project finance applications have widened, both geographicallyand sectorally. A wide array of asset types has been project financed around theworld in developing and under-developed economies.

Guarantees

Revenues Construction,Ownership,Operation

Figure 2: Non-Recourse Project Finance Structure

Equity Equity

Vehicle Company

Contracts

Loan Repayment

Loan

3rd Parties Project Assets

Collateral

Lenders


The use of Municipal bonds by the government and municipalities in manycountries, has also contributed to the growth in modern project finance.As government finances got scarce, municipalities and the public sector startedfloating bonds secured only by the revenues to be generated by the public utilityprojects. To create confidence in investors, private sector participation in publicprojects was solicited. The entry of the private sector into typical public sectorprojects, brought with it the necessary funds, managerial expertise and risk sharing.

Public Private Partnerships (PPPs) have now been given a formal structure inmany countries. In the UK and some other countries, this acronym takes theform of PFI—Private Finance Initiative.

Features of Project Finance

• A specially incorporated project company is formed to build and operatethe project. The project company enters into a concession agreement withthe host government.

• The project company enters into extensive contracting

– with several parties—there could be up to 1000 contracts in very largeprojects.

– contracts govern inputs, offtake, construction and operations.

– ancillary contracts include financial hedges, insurance contracts etc.

• Project companies are distinguished by their highly concentrated equityand debt ownership, with frequently more than one equity sponsors, asyndicate of banks and other financial institutions providing credit, andthe governing board comprising primarily of affiliated directors drawn fromsponsoring firms and lending institutions.

• Project companies are characterized by their highly leveraged structureswith mean debts as high as 70%, and the remaining equity contributed bythe group of sponsoring firms in the form of either equity or quasi-equity(subordinated debt), debt being non-recourse to the sponsors. The debt isalso termed ‘project recourse’ since debt service depends exclusively onproject cash flows. Typically, debts to project companies have higher spreadsthan corporate debt, though this scenario has been changing as lendersdevelop more experience in lending to large projects.


• Structuring a project finance deal entails substantial transaction costs inthe nature of fees to lawyers, consultants, and financial advisors, apart fromobtaining necessary permits, environmental clearances, etc. A deal couldtypically take five to seven years to structure, since it also involves identifyingand entering into suitable contracts with construction companies, suppliersof equipment and inputs, purchasers of output, operating companies andtying up the financing with various capital providers.

Comparison of Project Finance With Other Financing Vehicles

1. Secured debt is collateralized by a specific asset or assets. To that extent it issimilar to project finance. However, secured debt almost always has recourse toother assets of the firm as well. Herein lies the dissimilarity with project finance.

2. Asset-backed securities can often be mistaken for project finance, since theyappear to have all the features of the latter—collateralized by asset cashflows, and non-recourse to the originator. However, the major differencelies in the fact that asset-backed securities hold single-purpose ‘financial’assets, not single-purpose ‘industrial’ assets, the latter being mostly illiquid.One of the latest developments in project finance is the ‘securitization’ ofproject finance loans.

3. Leveraged buy outs/management buy outs may seem similar to projectfinance due to their high debt levels. However, LBOs/MBOs are dissimilarin that, they do not have separate corporate/government sponsors and maynot consist of single purpose industrial assets.

4. Privatizations: Those that involve single purpose, industrial assets could becategorized as project finance, provided the debt is non-recourse to theprivate sponsors. Privatization of airports or large telecom facilities couldfall under this category. However, privatization of banks or administrativebodies would not be termed project finance, since they do not satisfy the‘single-purpose industrial asset’ criterion.

5. Venture-backed Companies display concentrated equity ownership likeproject companies. However, debt levels are much lower than projectcompanies, and in most cases, the managers themselves are equity holders.


Comparison of Project Finance With Conventional CorporateFinance

Project finance and conventional corporate finance can be compared on severalparameters to bring out the relative advantages and disadvantages of the two formsof financing.

1. Organization: Project companies can be structured as independent entities;hence project cash flows and assets can be segregated from the sponsor’sother assets and cash flows. If conventional corporate financing is used,there will be no such distinction between the new project’s and the sponsor’scash flows and assets. Hence, project companies can insulate sponsors fromfailure of risky projects.

2. Control and Monitoring: In project finance, closer control is possible sincethe assets and cash flows are segregated, and project specific contracts andcovenants lead to closer monitoring and accountability to investors. Suchclose monitoring would not be possible in the conventional financing model.

3. Risk Allocation: This is one of the most important advantages of Project financing.Project structures add value since they effectively allocate risks to parties, whocan best bear them through contractual arrangements. Under conventionalfinancing, however, the project risks are spread over the entire asset portfolio ofthe sponsor firm, and creditors have full recourse to project sponsor.

4. Financing Arrangements: Financial closure can be achieved under projectfinancing after substantial structuring, which could be time consumingand costly. Structuring and obtaining finance under the conventionalfinancing mode are relatively easier, quicker and less costly.

5. Free Cash Flow and Agency Costs: This is another important advantage ofProject finance. Free cash flows arising out of conventional financingstructures can be allocated according to corporate policy, implying thatmanagers of these firms have discretion over allocation of cash flows. Suchdiscretion sometimes leads to the ‘underinvestment’ problem, wherebymanagers of highly leveraged firms pass up positive Net Present Value (NPV)projects, because the additional cash flows would go towards debt service.These are agency costs attributed to conventional corporate financing. Onthe other hand, in project financing structures, managers have limited


discretion in allocating free cash flows due to the ‘cash waterfall’ mechanisminherent in most projects. Further, by contract, residual cash flows have tobe distributed to equity holders. Closer monitoring by investors is possibledue to segregation of assets and cash flows. Hence, the agency costs arisingout of underinvestment are greatly reduced.

6. Debt Contracts and Debt Capacity: In conventional corporate financing,the lender looks to the entire asset portfolio of the sponsor for debt service.In some cases, the credit granted by the lender could also be unsecured.Further, the amount of debt depends largely on the sponsor’s capacity foradditional debt on the balance sheet. However, in project finance, the lenderlooks solely at the project’s cash flows for debt service, and to the assets forcollateral. A unique advantage of project finance is its ability to expand thedebt capacity of the sponsors by being ‘off-balance-sheet’—even sponsorswith weak balance sheets can look at project finance as a viable alternativefor their projects. In fact, in spite of the risks of funding long-term projects,high leverages are achieved in project finance, which provides valuable taxshields to the project company. Supplemental credit supports are alsoavailable in project financed structures.

7. Financial Distress: A significant advantage of project financing structures isthe lower cost of financial distress or bankruptcy. The fact that the projectand the sponsor are two different entities, isolates the project from thesponsor’s possible bankruptcy and vice versa. The creditors cannot claimtheir dues from unrelated projects. This scenario can be contrasted withthe conventional corporate financing alternative, where the lenders haveaccess to the sponsor’s entire asset portfolio in case of project failure. Underthis scenario, difficulties in one key line of business could drain off cashfrom good projects, with the converse holding good too. Such complicationsmake financial distress costly and time consuming in the traditional corporatelending option.

The Flip Side of Project Finance

• Project finance takes longer to structure than an equivalent size of corporatefinance.


• Transaction costs are higher in project finance due to the complexity oftransactions involved.

• Project debt could be more expensive (50 to 400 basis points over thecomparable rate under corporate finance) due to its non-recourse nature.However, research shows that the average cost of project finance is not muchmore than corporate finance, because of the superior risk managementtechniques employed in project finance.

• Extensive contracting could impose constraints on managerialdecision-making in the case of project finance.

• Project finance requires more transparent disclosure of proprietary and strategicinformation. This is both an advantage and disadvantage—advantage sinceasymmetric information and the associated costs would be lower, anddisadvantage since revealing more and more information leads to higher costs.

The Global Project Finance Market7

Recent statistics show that, globally,

• Project finance investment has grown steeply between 1994 and 2001,with a major portion of the investment in the form of bank loans.

• Compared to bank loans, the growth in project finance equity has beenlower; even lower than the equity growth, has been the growth in projectfinance bonds.

• However, the proportion of project bonds in project debt is increasing.

• Leverage of projects is increasing substantially. Most project companieshave debt to value ratios of more than 70%, with less than 10% of projectcompanies having leverage ratios of less than 50%—in any case, these leverageratios are well above those of the typical firm.

• Investment in electric utilities, telecommunications and transport havegrown substantially during the period 1999-2002, as compared to the twodecade period up to 1999.

• The syndicated loan market for project finance has shown sizeable growthin the four years up to 2001.

7 Esty Benjamin C, “An Overview of the Project Finance Market”, Harvard Business School, 2002.


Conclusion

It is evident that the dynamic nature of globalization and economic developmentwould necessitate innovative financing structures and instruments. Project financingstructures, with their innate flexibility and risk management capabilities, willcontinue to adapt to future requirements of large investments.

Project financing concepts and structures are of great interest and relevance inthe Indian context. There is no gainsaying the fact, that the primary impedimentto India’s fast track growth is the lack of quality infrastructure. It is also obviousthat the government cannot fund the enormous requirements, which accordingto one estimate, is a staggering Rs.2000 billion in the next three years. If theprivate sector has to take the initiative in partnering the government in infrastructuredevelopment, sweeping changes will be required in the mindsets and frameworkof regulators, investors, markets and financing agencies.

(Padmalatha Suresh is a post graduate in Management from IIM-A, holding LLBand CAIIB. She has two decades of banking and IT sector experience. She is currentlyrunning a financial consultancy, she is visiting faculty at IIMs and other reputedB-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached [email protected]).

References

1. Finnerty John D, “Project Finance: Asset-Based Financial Engineering” John Wiley and

Sons, 1996.

2. Kleimeier Stefanie and Megginson William L, “An Empirical Analysis of Limited Recourse

Project Finance”, working draft, 2001.

3. Esty Benjamin C, “Why Study Large Projects? An Introduction to Research on Project

Finance”, European Financial Management, vol 10, no 2, 2004, 213-224.

4. Esty Benjamin C, “An Overview of the Project Finance Market”, Harvard Business School,

2002.


© The ICFAI University Press. All rights reserved. This article is a summary of Chapter I from “Project Finance inDeveloping Countries – The Importance of Project Finance” by International Finance Corporation, April 1999.

2

Project Finance in Developing Countries –The Importance of Using Project Finance

Padmalatha Suresh

Project Finance is growing in importance as a tool for economicinvestment, by structuring the financing around the project�s ownoperating cash flow and assets, without additional sponsorguarantees, thus alleviating risks and raising finance at a relativelylow cost. Non-recourse and limited recourse project financeconcepts are discussed citing examples of IFC supported projects,and their developmental impact on the economy. Governmentwillingness in emerging markets, to fund large-scale infrastructureinvestments through private participation, has given the impetusfor the growth of project finance. The report differentiates projectfinance from traditional balance sheet financing, and outlines theadvantages that project finance has for private sponsors. The reportconcludes that in spite of all the advantages described, there arerigorous requirements and hence no �free lunches� in projectfinance.

15Project Finance in Developing...

The settings are different; the industries are different; the needs of the countries are different. Yet a common thread runs through the following examples:

• Argentina, 1993: Project finance structuring helped raise USD329 millionto finance the rehabilitation and expansion of Buenos Aires’ water andsewerage services. The concession of 30 years had been awarded to AguasArgentina.

• Hungary, 1994: Project finance structuring helped finance a 15-yearconcession to develop, install and operate a nation-wide digital cellularnetwork at a cost of USD185 million.

• China, 1997: Limited recourse project financing helped launch a $57million greenfield project to install modern medium-density fiberboardplants in interior China, using timber plantations developed over theprevious decade.

• Mozambique, 1998: Project finance structuring helped establish a $1.3 billiongreenfield aluminum smelter.

All the projects cited above used project finance to fund the huge investmentsrequired to develop the facilities in these developing countries. All these investmentswere financed with International Finance Corporation’s (IFC) support. All theseinvestments were made with private sector participation for creating publicinfrastructure. Above all, these investments helped improve the quality of life ofpeople in these countries, generated employment, increased export earnings andfostered more infrastructure development and thus, tangible economic growth.

What is project finance, and what has caused this new wave of interest inproject finance as a tool for economic development? The Report elaborates, “Projectfinance helps finance new investment by structuring the financing around theproject’s own operating cash flow and assets, without additional sponsor guarantees.Thus, the technique is able to alleviate investment risk and raise finance at a relativelylow cost, to the benefit of sponsor and investor alike.” (p.1)

Project finance is not a new concept. It has been used for hundreds of years,primarily in mining and natural resource projects. Its other possible applicationsin developing markets, especially for financing large greenfield projects


(new projects without any prior track record or operating history) have beenreceiving serious attention of late. The shift in focus to the private sector to supplythe investment required for large scale investments have necessitated regulatoryreforms, which in turn have created new markets in spheres of activity previouslyconsidered to be the exclusive domain of governments. For example, in the UnitedStates, the Public Utility Regulatory Policy Act (PURPA), passed by the governmentin 1978, not only encouraged a private market for electric power, but was also seenas a precursor to the growth of project financing models in many other industrialcountries. More recently, in the late 1990s, large-scale privatizations in developingcountries were embarked upon to bolster economic growth and stimulate privatesector investment. These developments and the governments’ willingness to provideincentives for attracting private investors into new sectors have given further fillipto the growth of project finance.

The surge in the use of project finance was temporarily halted in the wake ofthe East Asian financial crisis in mid 1997, since many large projects that werebeing implemented at that time, suddenly turned economically and financiallyunviable. Contractual arrangements, the backbone of project finance structures,were all of a sudden unenforceable; though, in hindsight, many projects hadfailed to adequately mitigate potential risks, including currency risks. Analystsstarted questioning the prudence of continued use of project finance.

“In IFC’s experience, however, project finance remains a valuable tool. Althoughmany projects are under serious strain in the aftermath of the East Asia crisis,project finance offers a means for investors, creditors, and other unrelated partiesto come together to share the costs, risks, and benefits of new investment in aneconomically efficient and fair manner. As the emphasis on corporate governanceincreases, the contractually based approach of project finance can also help ensuregreater transparency.” (p.3)

Despite the setbacks of the past, project finance techniques are likely to growin importance, as developmental investment in emerging markets needs enormouscapital, which cannot be met through government finances alone. Moreover, theability of project finance structures to allocate and mitigate risks will be valuablefor getting several projects with private investment off the ground. The crisis hasalso demonstrated that individual projects have to be adequately supported by


far reaching regulatory reform designed to enhance competitiveness and efficiency,and to develop domestic financial markets to support local investment.

IFC is certain that in the appropriate framework, project finance can providea strong and transparent structure for projects and through careful attention topotential risks, it can help increase new investments and improve economic growth.

The Report then goes on to outline the basic concepts and features of project finance:

• Every project finance deal is tailored to meet the needs of a specific project.

• Repayment to capital providers depends solely on the cash flows and theproject assets.

• Along with the sponsors, the risks and returns are borne by variousinvestors—equity holders, debt providers, or quasi-equity investors.

• The important criterion to decide if an investment can be project financedis the project’s ability to stand alone as a distinct legal and economic entity.

• Project assets, project related contracts and project cash flows are segregatedfrom those of the sponsor.

• Project finance can be ‘non-recourse’ or ‘limited recourse’.

• Non-recourse project finance is an arrangement under which investors andcreditors financing the project, do not have any direct recourse to thesponsors, as is the conventional practice. Although creditors’ security willinclude the assets being financed, lenders rely solely on the operating cashflow generated from those assets for repayment. The project must thereforebe carefully structured to satisfy its financiers about its economic, technical,and environmental feasibility, its debt servicing capacity and its ability togenerate financial returns commensurate with its risk profile.

• Limited-recourse project finance permits creditors and investors some recourseto the sponsors. This frequently takes the form of a pre-completionguarantee during a project’s construction period, or other assurances ofsome form of support for the project. Creditors and investors, however,still look to the success of the project as their primary source of repayment.In most developing market projects and in other projects with significantconstruction risk, project finance is generally of the limited-recourse type.


Project Finance vs. Corporate Lending

Project finance differs in many respects from conventional corporate lending.The most striking point of difference is that in traditional corporate financing,the primary source of repayment for investors and creditors is the sponsoringcompany itself, its reputation, and the strength of its balance sheet, apart fromthe project economics. The sponsor’s financial standing is a hedge against projectfailure for the lenders. On the other hand, in project finance, the primary sourceof repayment is the project cash flows alone.

In corporate finance, if the project fails, lenders do not necessarily suffer, aslong as the sponsoring company remains financially viable and solvent. However,in project finance, since the lenders look primarily to the project cash flows fortheir repayment and have little or no recourse to the sponsors’ balance sheets,project failure may entail significant losses to lenders and other investors.

Therefore, all types of assets may not benefit from being project financed.IFC believes that project finance benefits primarily those sectors or industries inwhich projects can be structured as separate entities, distinct from the otheractivities of the project sponsors. A stand-alone production facility, which couldbe isolated from the project sponsor’s other assets and separately assessed inaccounting and financial terms, would therefore benefit from project finance.Typically, these projects tend to be relatively large, take a long time and, are costlyto structure and absorb huge doses of debt.

Since market risk greatly affects the potential outcome of most projects, projectfinance tends to be more applicable in industries where the revenue streams canbe defined and fairly easily secured. In recent years, private sector infrastructureprojects under long-term government concession agreements, have been able toattract major project finance flows. Though, in developing countries, projectfinance techniques were traditionally used in the natural resource sectors—mining,oil and gas and such others, regulatory reform and a growing body of projectfinance experience continue to expand the situations in which project financestructuring makes sense. For example, project finance is used for building merchantpower plants that have no Power Purchase Agreements (PPA), but sell into anational power grid at prevailing market prices.


In IFC’s experience, “project finance is applicable over a fairly broad range ofnonfinancial sectors, including manufacturing and service projects such as privatelyfinanced hospitals (wherever projects can stand on their own and where the riskscan be clearly identified upfront). Although the risk-sharing attributes of a projectfinance arrangement make it particularly suitable for large projects requiringhundreds of millions of dollars in financing, IFC’s experience—including textile,shrimp farming, and hotel projects—also shows that the approach can be employedsuccessfully in smaller projects in a variety of industries.” (p.4) Thus, IFC’s vastexperience suggests that project finance could help attract private funding to awider range of activities in many developing markets.

IFC’s experience also shows that of late, increasing proportions of projectfinance flows go into developing markets. Since project finance allocates costs,risks and rewards of a project effectively among a number of unrelated parties, aneconomically viable privatization or infrastructure improvement program indeveloping markets now has wider opportunities and sources to raise funds.

As a result, it is now standard practice for large and complex projects indeveloping markets to employ project finance techniques. The total volume ofproject finance transactions concluded in 1996 and 1997 before the financialcrisis (an estimated 954 projects costing $215 billion), would have been hard toimagine a decade ago. The number of active participants in these markets alsoincreased as many international institutions (investment banks, commercial banks,institutional investors, and others) started to quickly build up their project financeexpertise. Most of this dramatic growth had taken place in East Asia. However,the financial and economic crisis that began in mid-1997, and spread to othercountries since then, had temporarily slowed market evolution. The estimatednumber of projects in developing markets fell in 1998. IFC opines, “When thegrowth of new productive investment picks up again, however, project financingis likely to increase, particularly in countries where perceptions of risk remainhigh, and investors could be expected to turn to structuring techniques to helpalleviate these risks.”1

1 Note: The article was published in 1999, hence developments after this period have been surmised by IFC. Recentstatistics show that project finance transactions are on the rise again, especially in developing countries.


Advantages of Project Finance

In situations where project finance is the most suitable, it scores over traditionalcorporate finance on two major counts—(a) it increases the availability of finance,and (b) it reduces the overall risk for major project participants to an acceptablelevel. As already stated in an earlier paragraph, corporate sponsors of risky projectsprefer project finance since the risks of the new project would be isolated fromthe sponsor’s existing business, and project failure would not contaminate thesponsor’s balance sheet or its core businesses. Since the project debt is also isolated,a properly structured project finance transaction would protect the sponsor’scapital base and debt capacity, and would also allow the new project to be financedwithout the high doses of equity investment that traditional corporate financewould demand for a similar project. Thus, the technique enables sponsors toincrease leverage to high levels and simultaneously expand their business, withoutbeing tainted by the project’s risks. Since project finance structures typicallyinvolve multiple sponsors, it would be possible for interested sponsors to take onlarger projects with greater risks. By allocating risks effectively among a group ofinterested parties, project finance enables effective risk management.

This was the case in 1995, when IFC helped structure financing for a $1.4 billionpower project in the Philippines during a time of considerable economic uncertaintythere. Sharing the risks among many investors was an important factor in gettingthe project launched.

The Report remarks in this context, “To raise adequate funding, project sponsorsmust settle on a financial package that both meets the needs of the project—inthe context of its particular risks and the available security at various phases ofdevelopment—and is attractive to potential creditors and investors. By tappingvarious sources (for example, equity investors, banks, and the capital markets),each of which demands a different risk/return profile for its investments, a largeproject can raise these funds at a relatively low cost. Also working to its advantageis the globalization of financial markets, which has helped create a broader spectrumof financial instruments and new classes of investors. By contrast, project sponsorstraditionally would have relied on their own resources for equity, and on commercialbanks for debt financing.” (p. 5)


Private equity investors, who are willing to take more risk, are becomingincreasingly important players in the project finance market. They are willing toextend long-term subordinated debt in anticipation of higher returns, whichcould be in the form of equity or income sharing. Such investors, who tend totake a long-term view of their investments, are being increasingly attracted intoprojects to supplement or even substitute for bank lending.

Commercial Loans: Funds lent primarily by commercial banks and other financial institutions,generally securitized by the project�s underlying assets. Lenders seek: (1) projected cash flowsthat can finance debt repayment with a safety margin; (2) enough of an equity stake from sponsorsto demonstrate commitment; (3) limited recourse to sponsors in the event of specified problems,such as cost overruns; and (4) covenants to ensure approved usage of funds and management of theprojects.

Equity: Long-term capital provided in exchange for shares, representing part ownership of thecompany or project. Provided primarily by sponsors and minority investors. Equity holders receivedividends and capital gains (or losses), which are based on net earnings. Equity holders take risks(dividends are not paid if the company makes losses), but in return, share in profits.

Subordinated Loans: Loans financed with repayment priority over equity capital, but not overcommercial bank loans or other senior debt in the event of default or bankruptcy. Usually providedby sponsors. Subordinated debt contains a schedule for payment of interest and principal but mayalso allow participation in the upside potential similar to equity.

Supplier Credit: Long-term loans provided by project equipment suppliers to cover purchase oftheir equipment by the project company. Particularly important in projects with significant capitalequipment.

Bonds: Long-term debt securities generally purchased by institutional investors through publicmarkets, although the private placement of bonds is becoming more common. Institutionalinvestors are usually risk-averse, preferring projects with an independent credit rating. Purchasersrequire a high level of confidence in the project (for example, strong sponsors, contractualarrangements, and country environment); this is still a relatively new market in developingcountries.

Internally Generated Cash: Funds available to a company from cash flow from operations (that is,profit after tax plus noncash charges, minus noncash receipts) that are retained and available forreinvestment in a project. In a financial plan, reinvested profits are treated as equity, although theywill be generated only if operations are successful.

Box 1: Project Financing Instruments, Sources, and Risk-Return Profiles

Contd...


No Free Lunch

For all its advantages, project finance cannot be said to offer a “free lunch”. Onthe contrary, it has rigorous requirements. To render a project suitable for projectfinance, the following aspects need to be taken care of :

• The project has to be carefully structured to ensure that all the parties’obligations are negotiated and are contractually binding.

• Considerable time and effort on the part of financial and legal advisers andother experts may have to be expended to do a detailed appraisal of theproject’s technical, financial, environmental and economic viability, andstructure the project in the most optimal manner.

• Identification and analysis of the project’s risks, and allocation and mitigationof these risks, are extremely important steps. Though it may be costly andtime-consuming, detailed risk appraisal is absolutely necessary to assureother parties, including passive lenders and investors, that the project makessound economic and commercial sense.

These preliminary steps imply that transaction costs could be much largerthan for conventionally financed projects. Framing the detailed contracts willadd to the cost of setting up the project and may delay its implementation.Moreover, the sharing of risks and benefits brings unrelated parties into a closeand long relationship. A sponsor must consider the implications of its actions onthe other parties associated with the project (and must treat them fairly) if thelong-term relationship is to remain harmonious.

Export Credit Agency (ECA) Facility: Loan, guarantee, or insurance facility provided by an ECA.Traditionally, ECAs asked host governments to counterguarantee some project risks, such asexpropriation. In the past five years, however, many have begun to provide project debt on alimited-recourse basis.

Multilateral or Bilateral Agency Credit Facility: Loan, guarantee, or insurance (political orcommercial) facility provided through a multilateral development bank (MDB) or bilateral agency,usually long term. Loans may include a syndicated loan facility from other institutions, parallelingthe MDB�s own direct lending.

Source: IFC: Project Finance in Developing Countries: The Importance of Using Project Finance.

Contd...


Lenders and investors must be kept abreast of the project’s operationalperformance as it progresses. The largest share of project finance normally consistsof debt, which is usually provided by creditors who have no direct control overmanaging the project. They try to protect their investment through collateraland contracts, broadly known as a security package, to help ensure that theirloans will be repaid. The quality of the security package is closely linked to theeffectiveness of the project’s risk management. It is therefore, essential to identifythe security available in a project and to structure the security package to mitigatethe risks identified (see Box 2).

The security package will include all the contracts and documentation provided by various partiesinvolved in the project, to assure lenders that their funds will be used to support the project in theway intended. The package also provides that if things go wrong, lenders will still have somelikelihood of being repaid.

A typical security package will include a mortgage on available land and fixed assets; sponsorcommitments of project support, including a share retention agreement and a project fundsagreement; assignment of major project agreements, including construction and supply contractsand offtake agreements; financial covenants ensuring prudent and professional projectmanagement; and assignment of insurance proceeds in the event of project calamity. The quality ofthe package is particularly important to passive investors, since they normally provide the bulk ofthe financing, yet have no say in the operations of a project and, therefore do not want to bearsignificant operating risks.

The strength of the package, as judged by the type and quality of security available, governs thecreditworthiness of the project, effectively increasing the share of project costs that can be fundedthrough borrowings. Significant additional expense may accrue in identifying and providing thesecurity arrangements, which will also require detailed legal documentation to ensure theireffectiveness.

Source: IFC: Project Finance in Developing Countries: The Importance of Using Project Finance

Box 2: A Typical Security Package

The IFC report further clarifies, “Some projects may need additional support—in the form of sponsor assurances or government guarantees—to bring credit riskto a level that can attract private financing. The overall financial costs of a projectfinance transaction may not be as high as under corporate finance if the project iscarefully structured, risks are identified and mitigated to the extent possible, andappropriate financing is sourced from different categories of investors. The seniordebt component may be more expensive, however, because debt repayment relies


on the cash flow of the project rather than on the strength of the sponsors’ entirebalance sheet. The project sponsors will need to carefully weigh the advantages ofraising large-scale financing against the relative financial and administrative costs(both upfront and ongoing) of different sources of finance.” (p 7)

Conclusion

The report has drawn on IFC’s experience in more than 230 greenfield projectscosting upward of USD30 billion. All these projects had relied on project financeon a limited recourse basis. IFC and other multilateral, bilateral and export creditinstitutions have been playing major roles in making project finance moreattractive in developing markets.

IFC, in particular, was a pioneer of project finance in developing countriesand has a unique depth of experience in this field, which spans more than 40years in the practical implementation of some 2,000 projects, many of them ona limited-recourse basis. IFC’s ability to mobilize finance (both loan and equityfor its own account and syndicated loans under its B-loan program), the strengthof its project appraisal capabilities, and its experience in structuring complextransactions in difficult environments have been reassuring to other participantsand important to the successful financing of many projects.


25Public-Private Partnerships: the Next Generation...

Source: http://www.fitchratings.com.au/projresearchlist.asp © 2004 Fitch Ratings, Ltd. Reprinted by permission ofFitch, Inc.

3

Public-Private Partnerships: The NextGeneration of Infrastructure Finance

www.fitchratings.com

The private sector can play an active or passive role ininfrastructure investment as project sponsor or an institutionalbond investor. PPP models have larger roles to play in emergingand other economies for funding infrastructure requirements farin excess of currently available financing. The pre-requisites fora receptive PPP debt market are a relatively stable macroeconomicenvironment, a sound legal framework for concessions, contractenforcement, and bankruptcy remedies, a stable regulatoryframework and a developing domestic debt market. The blurringof the thin line between structured financing and PPPs has givenrise to some myths regarding PPPs, which are listed out andexplored. With more and more innovation, the PPP market is allset for growth. Some of the �next-generation� developments relateto (a) pooling of credit risks (b) the US SRF model, and(c) enhancing Pooled credit risk The successful experiment withsuch credit enhancements in the case of USAID support of theWater and Sanitation Pooled Fund (WSPF) in Tamil Nadu, India,has also been highlighted.


Summary

The scope of global demographic, public health and safety needs, as well aseconomic development goals, translates into infrastructure requirements, far inexcess of currently available financing resources. While the degree of this fundingbacklog differs from country to country, it extends from the poorest to the richestof nations. This is true even in the United States, which enjoys the full benefits ofdecentralized governmental responsibility and an extensive domestic debt market.

Recognition of this funding gap has resulted in a nearly universal acceptancethat the private sector can and should play a larger role in the financing ofinfrastructure in partnership with the public sector, whether actively as a projectsponsor or passively as an institutional bond investor. The latter role carries greaterpromise for enhancing the supply of capital for infrastructure, provided thatstructural elements meaningfully enhance the credit quality of proposed debtinstruments so as to engage a country’s domestic debt market. Sustainableinfrastructure financing can be achieved from the traditional lending roles ofnational and international development banks, although not in meaningfulamounts. Dependence on existing project sponsor companies is even less reliable,given the ongoing contraction within that industry.

In developed countries, these funding partnerships arise regularly throughvarying combinations of bond and commercial (or government-owned) bank loantransactions issued directly by local governments, government-owned enterprisesand private companies contracted by government authorities to provide a publicservice. In the 1990s, private sector participation in the financing of infrastructureneeds outside of the Organization for Economic Cooperation and Development(OECD) countries was defined actively by privatizations and concessions. Passively,it occurred through private debt placements with a select group of foreigninstitutional investors or loan syndications sponsored by a few multilateral banks.

These efforts yielded some positive results but failed to resolve the globalinfrastructure funding gap outside the OECD countries. In emerging markets,the public and private sectors jousted over sovereign control versus investor rightsand remedies, as well as expectations over public access to infrastructure versus areasonable rate of return on capital. Market expectations were further battered by


macroeconomic volatility, the political expense of privatization without publicinvolvement at the local level, and the incompatibility of financing documentswith the host country’s legal practices and customs. Finally, private sector projectequity relied largely on a collapsing field of financially extended constructioncompanies and showed little capacity for sustained investment. After considerableexpectations and a thorough education concerning the various iterations ofdesigning, building, operating and transferring, the global infrastructure fundinggap grew.

For a number of countries, a new and more interesting generation of public-private partnerships (PPPs) is now emerging, which Fitch Ratings believes willcenter on a more efficient and sustainable allocation of capital. Local governments,in partnership with development banks, and international aid agencies are slowlydiscovering that, by pooling project credit risk through infrastructure banks andadding layers of credit enhancement (initial payment of project debt by local userfees or taxes, followed by the ability to intercept intergovernmental aid, reservefunds and partial credit risk guarantees from external sources), they can engagedomestic private capital. By providing an enhancement role with its capital, thispublic sector coalition will be able to leverage its funds much further, while domesticinvestors will benefit from the gradual diversification of their investment portfolios.The remaining construction conglomerates are still on the scene, but their role is lessfor equity and more for their expertise in designing, constructing and operatingprojects. Privately financed infrastructure banks that pool project risk are not farbehind. In this new generation of PPPs, the private sector role shifts to the financialengineers who work in conjunction with government authorities, as well as developmentand multilateral banking partners, to create enhanced investment vehicles thatare attractive to domestic capital.

Stabilized revenue streams and a strong ultimate recovery value of infrastructureassets open the door for progressively longer debt tenures, correcting an age-oldmismatch between the term of debt and the useful life of an infrastructure asset.While a state-owned highway or municipal water system may default on its debt,these are assets with long useful lives that will not be “wound up”, as in a bankruptcyof a corporate entity. The ultimate test for these developing domestic debt marketsis whether this more efficient allocation of risk between the public and privatesectors will also translate into more realistic (i.e., achievable) rates of return on


private investment. If it does, then for these countries the allocation of capital willnot only be efficient, but it will also be sustainable.

For this new generation of PPPs to flourish, the host countries must nurturesome important prerequisites. These include promoting a relatively stablemacroeconomic environment, developing a legal and regulatory framework forinfrastructure projects and nurturing the development of a domestic debt market.Unfortunately, these prerequisites do not exist in most parts of the world, whichmeans that some of the traditional roles of the multilateral and developmentbanks will remain necessary over the long term. In countries where theseprerequisites are taking shape, however, there are real opportunities to expand theavailability of capital by using pooled financings and credit enhancements toharness a developing domestic debt market.

Stimulating the efficient use of capital is not the only challenge facing the nextgeneration of PPPs. These partnerships must also expel a set of myths that havedeveloped along with PPPs. This includes a careful evaluation of partnershipstructures that utilize private sector expertise and efficiency without also embracingcorporate bankruptcy and consolidation risk. (Consolidation risk, in particular, isnot widely understood or anticipated in many non-common law countries, partlydue to codified provisions on the nature of trusts and other legal entities thatpresumably guarantee their assets are separated and, therefore, protected fromthird-party claims).

Due to their nature, PPPs will be affected legally by both administrative lawand commercial or corporate laws. Consequently, a court might dictate againstthe rights of the private partners on the reasoning that the public interest must beelevated above the interests of the private entity. This decision may be based onthe essentiality of services derived from the infrastructure project and their functionwith respect to maintaining social order and safety, as well as public health.

Evidently, public partners can and will change their minds, so that structureddebt transactions will never achieve the level of securitization (security) expectedof credit card or residential mortgage receivable transactions. Trustee relationships,while greatly enhancing the credit quality of PPP debt transactions, will nevermitigate credit risk fully.


Finally, a more sophisticated approach to understanding the true enhancementvalue of government project support, which is too often overinterpreted as a directgovernment guarantee, is required. Does this support promote the full and timelypayment of debt service or enhance a transaction’s ultimate recovery value? Is it ageneral obligation of the government or a contingent obligation subject tobudgetary appropriation? The shades of gray concerning government guaranteesform a broader spectrum than most market participants acknowledge, even indeveloped countries. The perpetuation of these myths impedes the participationand pace of development of domestic capital for infrastructure. Nevertheless, thenext generation of PPPs, armed with pooled project risk and supplemented bymultiple layers of credit enhancement, is perhaps the best chance for a sustainablesupply of capital to meet global infrastructure needs.

Prerequisites for a Receptive PPP Debt Market

• A relatively stable macroeconomic environment.

• A developing legal framework for concessions, contract enforcement,bankruptcy and lender remedies.

• A relatively stable regulatory framework that recognizes the lifecycle needsof the project.

• A developing domestic debt market.

The traditional alternatives to infrastructure finance in most countries are centralgovernment deficits and debt and multilateral bank lending, as well as the foregoneeconomic opportunities of simply not investing in infrastructure. A greater capacityof infrastructure investment is present in the developed countries due to theparticipation of the private sector, both passively as institutional and retail investorsin infrastructure bonds and actively through companies that sponsor projects ascontractors, operators or equity investors.

However, private sector participation requires some structural prerequisites(i.e., a stable playing field) that lessen a country’s susceptibility to economic andfinancial contagions and create an orderly legal and regulatory environment inwhich to invest and operate. Unfortunately, a quick perusal of these investorprerequisites reveals how few countries fit all of these categories. Nevertheless,


private investors (both domestic and international) have shown interest in countriesthat are at least moving toward these structural prerequisites. This allows Fitch todistinguish certain countries, such as Mexico, Korea, Chile and Poland, as moreripe for private sector investment than others.

Relatively Stable Macroeconomic Environment

Only a few countries have truly stable macroeconomic environments, and mostare susceptible to the contagion effect of a financial and economic crisis.Nevertheless, countries that have taken steps to control inflation and externaldebt, increase official international reserves and utilize trading partnerships oftenprovide fertile ground for domestic and foreign private investment. For aninfrastructure project, a national and economic crisis creates not only risk for thefinancial performance of the infrastructure transaction (i.e., its ability to generatesufficient revenues to cover operating and debt service costs) but also addeduncertainty as to the range of political responses that might affect its operationsduring a crisis.

Developing Legal Framework

The private sector requires clear and stable rules of engagement as provided througha country’s legal framework. If a country’s public policy wants to encourage privatesector participation in the financing of infrastructure, its laws should supportthat policy. This includes laws governing concessions and/or privatizations, a clearprocess for dispute resolution and the ability to enforce contracts, as well as lenderremedies under bankruptcy and insolvency.

A number of countries, including Chile, Panama and Korea, have developedcomprehensive and transparent concession laws, where public sector goals andobjectives in private participation are clear. Equally clear is the process by whichthe private sector is to bid on an infrastructure project or system, operate afterwinning a concession contract and recover a return on its investment. Nevertheless,dispute resolution systems in many countries look good on paper but do notwork well in practice. The rules of negotiation continue to prevail over rules forcontract enforcement, in most legal documentation. Finally, legal precedents (suchas in the state of Parana, Brazil) where a court upheld a contested concessionprovision (in this case, a scheduled rate increase) are rare.


Bankruptcy laws also have been amended in many countries, as borrowingmigrates from commercial bank loans to the capital markets. Still, as lender rightsbecome codified, their application in the real world is often untested due to thecontinuing propensity to negotiate financial arrangements outside the courts. Forthese reasons, the ongoing practice of diluting, rather than eliminating, the equityparticipation of construction and project sponsor firms that are in or nearbankruptcy, as in Korea, may unnecessarily expose an otherwise economicallyviable project to bankruptcy and consolidation risk. Of equal concern is the belief,as in Mexico, that a future flow securitization can sidestep the ongoing bankruptcyproceedings of a private project partner. With new and untested legal regimes, itis dangerous to rely solely on the integrity of financial structuring techniques,especially during a financial and economic crisis.

For the private partners, the range of compensation mechanisms for political riskis still developing. Public sector partners can and will change their minds, therebyaffecting the project’s operating environment. Compensation is usually expressed asextraordinary rate relief or as an extension of the term of the concession. In the caseof termination of a concession, provisions that provide compensation based on somemeasure of the net present value of revenues over the remaining life of the concessionbut for no less than the amount of debt outstanding, are increasingly present.

Relatively Stable Regulatory Framework

A country’s regulatory framework is simply the reflective implementation of itslegal and public policy framework. The base set of regulations should be developedin tandem with the legal framework for concessions and privatizations. This processtakes time, but it allows the host government to gain its own comfort level withthe classic trade offs between access to private capital and the dilution of its ownsovereignty. Regulations should focus on the lifecycle of the project (i.e., fromdesign, to construction, to operation and to its eventual return to the publicsector). In Korea, the project selection process involves representatives of all thegovernmental ministries that will be involved with that project over its lifespan.This mitigates much of the regulatory risk upfront, since the concession agreementcan reflect the concerns and agendas of the various government ministries thatwill be involved with the project. The private sector operator can choose to adaptits concession expectations to an onerous regulatory environment. However, projecteconomics often lack the flexibility to adapt to a shifting regulatory environment.


Developing a Domestic Debt Market

Development of a domestic capital market is key to creating a sustainable supplyof capital for infrastructure. For infrastructure finance, the domestic debt marketshould be the “cake”, while the foreign capital markets should be the “icing”, sincein most cases the source of repayment will be generated in the host country’scurrency. Local investors also are in a better position to assess the concession’sservice area and political risk. Infrastructure transactions with either a US dollarrevenue stream or with construction or acquisition costs that exceed the financingcapability of the local debt market make better candidates for foreign capital butnot without structural enhancements, such as offshore reserves and multilateralrisk guarantees.

A growing number of emerging-market countries are developing domestic debtmarkets. The development process requires financial sector reforms, including theability to invest funds in more than direct government debt. It also necessitates asavings plan. Typically, these markets are shallow in that investments are usuallylimited to the bonds of the central government and a handful of other governmentalor privatized entities. Investments also are limited to short- and medium-termmaturities. The ability to issue the long-term debt maturities needed byinfrastructure projects simply does not exist throughout most of the world. Evenin countries that have robust domestic debt markets, like Korea and Mexico, theaverage life of a corporate bond is still approximately 3–7 years; a notable exceptionis Chile, where to date nine projects have been financed in the national bondmarket at terms of 20 years. Generally, the remarketing of these medium-termdebt maturities is a big risk for infrastructure projects, where revenue growth andfinancial margins may not be able to accommodate interest rate volatility. Finally,infrastructure bonds often represent a new form of asset class for domestic investors.Until these userbased revenue streams prove themselves, many domestic investorswill continue to require other forms of government support.

Critique of Traditional PPPs

The drive toward privatization and concession-based project financing in the mid-1990s was seen by many governments as a way to jump start infrastructureinvestments. The belief was project finance could infuse new capital and bettermanagement practices into poorly maintained and overutilized infrastructure


systems. The initial efforts of the 1990s were promising, but they souredthroughout the emerging-market countries with the contagion effect of the Asianfinancial crisis of 1997. While this explains the sudden interruption of new capital,it does not fully explain why infrastructure finance never really recovered. Evidencefrom the past decade points to difficulties caused by the government sector’s rushto privatize basic public services, in most cases without a proper transition period.This resulted in an inevitable clash between public policy goals, public expectationsand the private sector’s desire for a reasonable rate of return on capital.

While the project finance community enjoyed creating a new vocabulary for themany iterations of these partnerships (e.g., build-operate-transfer, build-transfer-operate, build-own-operate, buy-build-operate and design-build-operate, amongothers), most of these transactions did not have the transitional underpinnings tooperate as independent enterprises, or the credit enhancements necessary to withstandmacroeconomic volatility. The developed world pushed its construction and financingcontractual frameworks onto the developing world, external financing was seen assynonymous with external expertise and both sides misinterpreted the consequences.

Public-Sector Risk in Traditional PPPs

It is important for the private and public sectors to understand the risks oftransacting with each other. The key risks that the private sector faces in dealingwith the public sector are described below, followed by the key risks of dealingwith the private sector. In all cases, this is not intended to discourage interactionbut to point out areas where proper structuring can enhance the survivability ofan infrastructure transaction.

Determining Service Ownership

In many countries, ownership disputes over certain public services continuebetween state and municipal governments. While some governments, like Mexicoand Brazil, slant resources and regulation at state-owned water utilities, actualtitle to the water services remains unresolved. It will be difficult to engage privatecapital until the ownership issue is legally addressed. In many cases, state-ownedutilities have contracts with neighboring municipalities, but these are oftenshort-term contracts, and the utilities desire longer term debt. Ownership disputeslend uncertainty to the continuity of utility revenue streams.


Creating Dependable Project Revenue Streams

Capital markets count on dependable revenue streams to make full and timelypayment of debt service. State and local revenues (including infrastructure userfees), outside of central government transfers, rarely make a dependable revenuestream for infrastructure debt in emerging markets. This is partly because localgovernments in many parts of the world depend on central government transfersas their main source of revenues. The relative newness of decentralized governmentalservices is another factor. Local enterprises, such as water authorities, are oftenplagued with poor revenue collections, reflecting relative inexperience and feebleadministrative capacity to operate their enterprises as a business. These challengesare coupled with a still weak public acceptance for user fees and, equally, hikes inuser fees after an improvement in service.

The opportunity for a public enterprise to operate as a publicly owned business,including productivity gains and rate increases for capital improvements, canfacilitate its transition to the private sector. Corporatization, whereby the publiclyowned enterprise is organized and run as an independently financed and operatedbusiness, can prepare users for the consequences of improved and reliable services.Along this line, the state of São Paulo, Brazil, operated the Anchieta-Imigrantestoll road as a public enterprise, first implementing tolls along this importantroute and then increasing rates commensurate with capital improvements or withinflationary cycles. When the private consortium Ecovias won concession over thetoll road, its customers had already adjusted their behavior to paying for serviceenhancements. Similarly, the National Water Commission in Mexico has targetedcertain service-level and administrative efficiencies as prerequisites, beforestate-owned water utilities can borrow for additional water or sewer capacity.

Protecting Against Political Risk

Many governments, until recently, were caught up in the rush to privatize nowand worry about the consequences later, causing a general public backlash againstprivatization. This is especially the case in Latin America, where project contractualcovenants, government budgetary capabilities and public expectations are at oddswith one another. The absence of corporatization, as mentioned, and the lack ofpublic participation at the local level resulted in an escalation of political risk forboth privatizations and concessions. For countries where the prerequisites attract


private sector investment and the legal system supports compensation, effectiveways to mitigate political risk are as follows:

• Select projects that best fit the national, state or local priorities for economicdevelopment.

• Choose projects with sound economic value.

• Seek project partners with strong levels of commitment and expertise withinfrastructure assets.

• Provide an adequate period of corporatization prior to privatization to ensureinterim improvements in the efficient delivery of public services.

• Endow projects with sufficient financial protections to mitigate risk, such asliquidity to offset completion risk, operating ramp-up risk and economic cycles.

• Clarify the relationship between the subnational entity and its public-servicecompanies; the flows of capital and the administrative control betweenparent government and enterprise should be well understood.

Private Sector Risk in Traditional PPPs

Host governments want the expertise, efficiency and capital that the private sectorcan bring to infrastructure and local government services. They should avoidexposure to the corporate sector’s bankruptcy and consolidation risk. PPP structuresare improving upon their ability to isolate voluntary bankruptcy risk (via startingwith an economically viable project). However, the relative newness of revisions tobankruptcy codes contributes to a lesser understanding of the risk of involuntarybankruptcy in countries where this legal concept applies. Evaluating bankruptcyrisk requires a full understanding of who the project’s partners are and their roleswith respect to ultimate ownership of the project’s land, facilities, equipmentand cash.

Mitigating Voluntary Bankruptcy

For mitigating voluntary bankruptcy, the foremost rating consideration is theeconomic value of the infrastructure project or system. If it has strong economicvalue, there is less reason to worry about testing the host country’s legalenvironment, which in most cases is either underdeveloped or untested. After


that, credit quality can be enhanced by the structure of the project’s financialtransaction. “Governing by covenants” provides investors with minimum legalparameters for an infrastructure transaction’s financial margin and limits the eventsof default that could lead a project into bankruptcy. Typical infrastructure projectcovenants include the following:

• A revenue covenant with minimum required debt-service coverage levels.

• Lowest required funding levels for various debtservice and operating reserves.

• Minimum financial tests for the issuance of additional debt.

• An order of priority for the payment of operations, debt service and thereplenishment of reserves, as well as certain tests prior to making equitydistributions.

• Requirements to re-engage financial consultants if the performance of aproject does not meet the minimum covenant levels.

Conditions that cause an infrastructure transaction to default should besufficiently limited to promote its survival. Typical defaults are for nonpayment ofdebt service and a continuing breach of other covenant requirements beyond aprescribed cure period. The latter provides some latitude for reaching compliancewithout placing the project into immediate default.

Mitigating Involuntary Bankruptcy

More difficult to detect is the involuntary bankruptcy risk of a private sectorpartner. This partly reflects shortcomings in corporate sector accounting, as wellas the market volatility of certain corporate activities. Involuntary bankruptcyexposure of infrastructure projects to which these corporate entities are counterpartyassumes the project is functioning fine, but its ability to meet financial obligationsis interrupted externally by investor claims on the corporate parent or subsidiaryto the company associated with the project. There are a number of ways to mitigatethis involuntary bankruptcy risk.

Structuring the Issuer (Creating a Bankruptcy-Remote Entity)

The type of vehicle employed to issue project debt will depend on the possibilitiesafforded by national laws. Thus, in Mexico trust is the one entity that enjoys legal


person status under Mexican law. In the United States and other countries, trustsand special-purpose vehicles are also available, with respect to which bankruptcyrisk mitigation is the most vital characteristic. Chile created a special corporationunder its concession laws. Generally, a nationally incorporated subsidiary orconsortium can be created as a special-purpose, bankruptcy-remote entity. Thefurther this independent entity is removed from the operations of the infrastructureproject or system, the more bankruptcy-remote it becomes. A special-purpose entitycan be a shell, with it being solely responsible for receiving and transferring a givenasset to a trustee. A special-purpose entity also can own an asset, have no ability tovoluntarily file for bankruptcy and contract out for operations. A bankruptcy-remotestructure can be an independent commercial entity and protects against consolidationof the issuer’s assets in a bankruptcy case involving either its parent corporation oranother subsidiary of the parent. Many so-called, special-purpose companies arenot so limited. They may be incorporated under the host country’s law, but theirarticles of incorporation and shareholder documents may not create enough distancefrom the parent company or subsidiaries. In addition, many articles permitengagement into ancillary businesses, creating an additional window for bankruptcyrisk.

Structuring the Transaction (Creating a Trust Estate)

Another approach structures the infrastructure debt transaction. The debt issuersells its rights to the cash flow, securing the debtholder’s obligation to a speciallycreated trust estate. Alternative structures can include a limited liability corporation(LLC) or a limited partnership. Under this “deed of trust”, all of the issuer’s interests,rights and obligations are sold to a trustee on behalf of the bondholders. Whilethe issuer has assigned away its rights, it can still earn returns from the project,although no money is released until the trustee has satisfied all other financingagreement requirements. The trust estate concept is gaining acceptance in suchdomestic debt markets as Mexico through the creation of a master trust agreement.Nevertheless, there are cases in which a trust’s value may be overestimated,particularly where a project trust is created during the ongoing bankruptcy of aparent project sponsor company.

Limiting the Operator’s Interest in the Project

In addition to sponsor companies in a project consortium, project operators are


the other private partners in an infrastructure transaction. Their role is importantsince it is often the operator that holds the cash. Legal structures that limit theoperator’s interest in the project to that of an agent contractually obligated toprovide a specified service for the project (i.e., the operator has no legal rights tothe cash) can eliminate its bankruptcy risk. It is also important to have provisionsin an operating agreement for the potential replacement of an operator undercertain conditions of nonperformance.

Common Myths Concerning Public Infrastructure Finance

Much of the discussion has centered on how structural elements enhance thecredit profile of PPP transactions. The lines between PPPs and structured financehave blurred considerably, which carries both positive and negative consequences.The most positive consequence is that domestic debt markets for infrastructurebonds are now developing in countries like Korea, Mexico and Chile, where untilrecently such projects were financed only by commercial or governmentdevelopment banks. Strong concession laws, revised bankruptcy regimes, thecreation of special-purpose entities and new trustee relationships have set thestage for an exciting evolution in infrastructure finance for both local governmentsthat have large infrastructure financing needs and domestic investors that need todiversify their investment portfolios.

Nevertheless, while PPP transactions have much of the appearance ofsecuritizations, they will never be true securitizations. There are two explanationsfor this. The primary reason is the role of administrative law, not only corporatelaw, in the legal frameworks in which most public infrastructure is developed.Namely, the essentiality of the public service can persuade a court under certaincircumstances to dictate against the interests of the private sector and cut offinvestors from the revenues and assets derived from the project. In addition, apublic-sector partner in the PPP can and will change its mind about public policyobjectives, its regulatory framework and interest in cooperating with private sectorrequirements for return on capital, especially during difficult economic times.

This leads to the secondary reason, which concerns the ratio dynamics thatdrive much of the structured finance world. Collateral and other tests that aredeveloped for the securitization of traditional asset classes, such as residentialmortgages, are based on the collective behavior of thousands of loans observedover a long period. Traditional PPPs are often single-asset facilities instead of a


portfolio of thousands of credit card or mortgage accounts. There are not enoughexisting PPPs from which to derive statistically meaningful default behavioralpatterns or to develop fixed-coverage tests for a given rating category. Add to thisindividuality the constant possibility that a PPP’s operating environment canchange with the policies of a new administration. This diminishes the value oftraditional structured finance ratio-driven analysis.

From this experience, some important misconceptions about PPPs haveemerged. Fitch has categorized four as myths, not because their claims are nevertrue or cannot be made true but because they are frequently misconstrued as true.

Myth 1: Bulletproof Financial Transaction

Experience with PPPs suggests it is not possible to structure the kind of bulletprooftransactions common among more conventional securitization asset classes.Governments from China to Argentina to the United States can and do changethe rules governing PPP transactions.

Every project has multiple agreements, but they generally fall into two broadsets. One set governs the project—concession, construction and operating agreementsfall into this category. The other governs financing—trustee, assignment andintercreditor agreements. While the financial community likes to focus its attentionon the protections afforded by the financing documents, it is important toremember that the concession agreement actually sets the tone for everything todo with the project.

The concession agreement is the government’s grant to a public- or privatesector partner to build, operate and benefit from a project’s revenue stream for aperiod, and under a certain set of conditions, until the project reverts back to thegovernment. This includes the government’s grant to the project partner to chargeand collect user fees, that will recover operating and capital costs of the projectand pay debt service and potential dividends to private sector partners. Theconcession agreement can also determine the circumstances and timing of feeincreases (e.g., annual increases tied to inflation, with a maximum allowable rateof return on capital). All the protections afforded by the financing documents shouldbe calibrated to these overriding rights and obligations under the concessionagreement if they are to remain enforceable. Strengths of various Mexican toll


road master trust agreements, are the broad cross-referencing to the underlyingconcession agreement and the enabling legislation for the toll road. Sometimes,the financing documents are not harmonized with the concession document, andthat is where bulletproof turns into bullet-ridden.

Governments can change their regulations for a project, and they can eventerminate a concession agreement through expropriation. When they do, this canseriously impair or cease access to revenues under a financing agreement, renderingit ineffective. That is why many concession agreements contain provisions forextraordinary rate relief, extension of the term of the concession or compensationin case the concession is terminated. For these reasons, PPP financial transactions,with their assignment of rights, covenants and reserves as well as all of the other“bells and whistles”, which provide so much credit enhancement, cannot be viewedas true securitizations.

Myth 2: Financial Transaction Through a Special-Purpose Entity

Every project has internal and external bankruptcy risk unless it has statutoryprotection that prevents a default from leading into bankruptcy. For financialtransactions involving PPPs, sheer economic strength, combined with structuralelements, can act as the best mitigant to voluntary bankruptcy risk.

For involuntary bankruptcy and consolidation risk, the best protection comesfrom a special-purpose entity, as previously discussed. A determination of whetheror not the transaction benefits from a special-purpose entity status requires anopinion from a qualified local counsel or other source (such as a third-partyguarantee), providing a clear description of the powers and obligations of theentity and certainty with respect to the obligation pledged. Only a handful ofcountries require this opinion to be rendered, or even requested, as part of thedocumentation to market such bonds. In most countries, while it is customaryfor Fitch to request this opinion as part of its due diligence for a rating, it issimply not demanded by the market.

Myth 3: Trustee Controls Revenue Flow

Trustee relationships are a critical feature of project and structured finance. Theyprovide passive bond investors with the comfort that project revenues and accountsare assigned to the trustee on their behalf and payments from these accounts will


be made in a prescribed manner and timetable, as determined by the trustindenture. Nevertheless, investors should be aware of when the trustee takes controlof the revenue flow and the full range of circumstances under which the trusteeretains control.

The tightest trustee control over revenues requires frequent (often daily) depositsof project revenues into an account maintained by the trustee. From here, thetrustee can follow the dictates of the financing document with respect to whendeposits are required into predetermined accounts for operations, debt serviceand reserves, among other costs.

The now familiar theme of bankruptcy remoteness plays a role here. Legalcircumstances can limit the value and effectiveness of trustee control. To begin with,the trustee is not the first participant to handle the revenue. The project operatorcollects user fees from the project’s patrons and channels them to the trustee. Asmentioned, it is important to structure around operator bankruptcy risk.

The second consideration is the full range of circumstances under which thetrustee retains control over the revenues; thus it is necessary to return momentarilyto the risks posed under the second myth (the importance of determining whetherthe concessionaire is really a special-purpose entity). If the bankruptcy remotenessof the project entity is not established, the trustee can only have full contractualcontrol over the revenue flow under normal circumstances.

Under an involuntary bankruptcy proceeding, there are a variety of ways thetrustee can lose control over the revenue flow. The shortest period that loss ofcontrol can occur is when the court determines whether to allow project assetsunder the proceeding. If it decides not to allow the project’s assets, trustee controlcan resume under normal operating conditions.

If the court decides to allow project assets as collateral under the proceeding,their fate can take several courses. One is where the court allows the project tocontinue operating but diverts revenues into the ultimate creditor settlement.The other is when the court decides to wind up the project’s assets as part of theultimate creditor settlement. It is important to remember that the court mayconsider not just project revenue as an allowable asset but also amounts held by


the trustee under the reserve. The legal process and interpretations of bankruptcyproceedings vary from country to country, emphasizing the importance of anindependent bankruptcy opinion.

Myth 4: Financial Transaction Debt Is Government Guaranteed

Debt guarantees from host governments are often required by investors, if aninfrastructure asset class is new or unfamiliar to the market or investors do notbelieve the user revenue stream from the project can provide a reliable paymentsource for the debt. This can either be because the project has a publicdevelopmental purpose in a region that needs the infrastructure but cannot paydebt service solely through user fees, or because the organizational andadministrative mechanisms to operate infrastructure on a self-sufficient basis areeither untested or not trusted. While part of the rationale for bringing privatepartners into an infrastructure project is to provide the skills and efficiency to runthe project on a business basis, the high probability of political risk with respectto rate flexibility, among other things, often causes investors to still demand agovernment guarantee.

There is a long-held financial proverb that the government guarantee is as goodas the sovereign’s own credit risk (i.e., equal to its unsecured obligation risk). Asovereign obligation is an unconditional, irrevocable risk, which although it maynot be guaranteed or collateralized is still a high bar for the vast majority of guaranteesprovided to PPP transactions. In fact, investors should question the logic of why agovernment would grant the same pledge to a project with a private sector partneras it does to its own bonds. For an investor to assign a value to the debt guarantee,experience suggests a number of considerations, such as the following:

• It is important to determine whether the guarantee is automatic or subjectto appropriation as part of the government’s budgetary process. A financialobligation that is subject to budgetary appropriation is of lesser credit qualitythan the sovereign’s unsecured debts.

• Investors should know the guarantee’s priority of payment with respect toother government obligations. Pari passu status with respect to generalobligation debt is the strongest. Anything less than pari passu is a subordinateobligation and of lesser credit quality than a general obligation.


• It is important to be familiar with the mechanism that triggers the guarantee.Essentially, there are two types of triggers. A proactive trigger requires a trusteeand/or concessionaire to formally notify the government in advance if thedebt-service account is deficient for an upcoming debt-service payment. Givingthe government prior notice and time to respond by making a deposit of thedeficiency into the debt-service account on or prior to the payment datepreserves the full and timely nature of the payment and is the strongest typeof trigger. A reactive trigger waits for a payment default to occur, then asksthe government to retroactively use its guarantee mechanism to make up thepayment deficiency; this is a weaker guarantee but also the most common.

• The concession agreement should outline the process and timing by whichthe government will evaluate and settle upon the guarantee commitment.The most effective guarantee specifies which government representativesare responsible for evaluating the guarantee request and how many daysthey have to respond. A time-certain review and payment under theguarantee clause is the strongest form of guarantee. An open-ended reviewprocess is the weakest. Of equal concern is whether the responsiblegovernment agency can reach a different conclusion than the trustee orconcessionaire as to the deficiency amount. The concession agreement shouldrestrict the government’s ability to interpret a guarantee request.Nevertheless, governments may exercise their own calculations as to guaranteeamounts regardless of the mathematical debt-service deficiency. Nothing isever simple where PPPs are concerned.

• Investors should be concerned about the financial sustainability of guaranteecommitments, given other financial and service demands on the government.One should not compare the small debt-service commitment of a projectto the largeness of the government’s budget. Instead, the focus should beon the rigidity of the expenditure budget (how much of it is alreadyaccounted for under legally mandated programs). Additionally, contingentliabilities of a growing portfolio of project guarantees as more PPPs areexecuted could cause financial pressures on the government.

• Finally, investors should consider the political risk inherent to every projectfinance transaction. It is reckless to believe that documentation createsequality among projects in the government’s opinion. Some projects will


be successful and politically popular, while others will be economically orpolitically unpopular. Governments will not treat each project equally,especially at election time or during a crisis. For Fitch, this is a ratingconsideration. Project documents can mitigate political risk, but they donot create an impervious barrier.

PPPs: The Next Generation of Infrastructure Finance

After considering the litany of risk considerations described, it easy to understandwhy there has not been a greater proliferation of PPP financial transactions (i.e., astronger response to the infrastructure funding gap), despite much anticipation andeffort. However, Fitch believes this situation is about to change, as explained herein.

Pooling Credit Risk

The greatest concern for lenders to local government enterprises and PPPs in non-OECD countries, is a lack of confidence in the ability of local revenue streams torepay debt service when due. Economic and political factors often lead tounacceptable rates of default on project debt. Over time, public and lender interestwould be best served if these enterprises became self-sufficient, but in mostcountries, this is a long-term goal at best. In the more desperate environments,self-sufficiency may never be attainable.

For this reason, the pooling of new or refinanced infrastructure loans into abank is an important way to mitigate against individual loan loss. This conceptmay be less applicable to the pooling of existing loans that have different debtstructures. Where the ultimate recovery value of the loan portfolio looks promising,the country with multilateral bank grants, if necessary, can capitalize the fundwith reserves against the expected cash flow deficiencies within the loan portfolio.Interest income from the collateral can be used to reduce the borrowing costs ofthe entities within the infrastructure pool. A single debt emission by the bank onbehalf of the pool participants will also create liquidity within the domestic debtmarket on the theory that the market has more appetite for the larger debt issuanceof the bank than for the smaller individual project loans of the bank’s participants.Liquidity in the capital markets also lowers borrowing costs for the participants.This cheaper access to pooled capital greatly increases the resources available tomeet local infrastructure needs.


US SRF Model

The state revolving funds (SRFs) model was used to create the wastewater andwater projects in the United States. Matching capitalization grants from theEnvironmental Protection Agency (EPA) and their respective states evidence aprioritized list of eligible municipal projects. The model includes qualitativeadjustments for a lack of geographic diversity within the pool (in the UnitedStates, SRFs are single-state funds), as well as expected loan default rates.Capitalization grants can be set aside in a debt-service reserve fund and investedin collateralized guaranteed investment contracts (GICs) with highly rated financialinstitutions. They can also be used to make direct loans, the repayment of whichcan be pledged against future leveraging. Many SRFs issue bonds, lending debtproceeds to participating municipal utilities. Loan repayments from themunicipalities are used to repay SRF debt and provide capital for additional lending.

Investment income can subsidize loan interest rates and, of course, investedreserves can act as collateral against the loan portfolio, as can overcollateralizedloans. Key factors supporting a high ratings profile for SRFs include the extent ofovercollateralization and low default rates on this type of loans. Other ratingfactors are the fund’s criteria and managerial expertise as they relate to structuredand municipal finance transactions, the loan pool structure (including expecteddefault rates), loan underwriting and due diligence guidelines, and investmentpractices. Substantial reserves and excess cash flows allow bond payment, evenduring stress scenarios with unprecedented loan defaults.

Enhancing Pooled Credit Risk

Where the default risk of the loan portfolio is expected to be high and its ultimaterecovery prospects are weaker, the initial reserves will not be enough to protectthe bank. In these situations, extra layers of credit enhancement are needed toimprove the cash flow of the loan portfolio. These layers include the initial paymentof project debt service by local user fees or taxes, followed by the ability to tap thefund’s reserves for cash flow purposes and then to intercept intergovernmental aidto replenish the fund’s reserves. These layers could be further supplemented byavailable lines of credit or other partial credit risk guarantees from external sources,such as multilateral banks, international aid agencies or monoline insurers.


Repayment of multilateral lines of credit should be a subordinate obligationto the bank’s debt, but it should not be a grant. In this case, the bank may have todivert interest income from its reserves as a form of repayment for the externallines of credit. The multilateral agencies can determine on a country-by-countrybasis (by a combination of needs assessment and public policy), which pooledrecovery rates they expect for these subordinated lines of credit (e.g., full andtimely basis in one instance, 75% recovery after 10 years in another, 40% recoveryover 10 years in another, and so on).

While unrecovered amounts can be written off as uncollectible by themultilaterals (having the same economic effect as a grant), this system allows themultilaterals to benefit from the possibility of improved recovery rates over time.Since the assets being financed will have a long useful life, entry into the bankshould be accompanied by acceptance of measures to increase the administrativeand service level efficiency of the local government or PPP enterprise. This increasesthe prospects for better financial performance over time. For the borrowing entities,the incentive to improve loan performance is that it progressively frees up thebank’s interest income to provide interest rate subsidies instead of repayment tothe multilaterals for use of their lines of credit.

The pooling of infrastructure loans plus credit enhancements providesmuch-needed stability to project revenue streams, creating an opportunity toengage the domestic capital market as an investor in the infrastructure bank’sdebt. This has the additional benefit of diversifying domestic investment portfolios.Stabilized project revenue streams also allow for progressively longer debt tenures,correcting a long-standing mismatch between the term of debt and the useful lifeof an infrastructure asset. The ultimate test for these developing domestic debtmarkets is whether this more efficient allocation of risk between the public andprivate sectors will also translate into more realistic (achievable) rates of return onprivate investment. If it does, then for these countries, the allocation of capitalwill not only be efficient, it will also be sustainable and regenerative.

Outlook

In this new generation of PPPs, the private sector role shifts to the financialengineers who work in conjunction with government authorities, as well as


development and multilateral banking partners, to create enhanced investmentvehicles that are attractive to domestic capital. Old allies, the remaining constructionconglomerates, will still be involved, but their role is less for equity and more fortheir expertise in designing, constructing and operating projects.

Is this visionary portrait of the future of PPPs in non-OECD countries realistic?Fitch believes that it is close to becoming a reality. The first steps have been taken,with some multilateral banks starting to provide credit enhancement (partial creditrisk guarantees) to project debt in the local markets and in the local currency.This enhancement role allows these banks to allocate their capital further thanthrough direct lending. If they were enhancing pooled project loans, their capitalcould be extended even further.

Enhanced pooled capital is the concept behind the US Agency for InternationalDevelopment’s (USAID) support of the Water and Sanitation Pooled Fund (WSPF)in the state of Tamil Nadu, India. WSPF is a special-purpose vehicle to beincorporated under the Indian Trust Act, with an initial debt-service reservecontribution from the Tamil Nadu government. Tamil Nadu Urban InfrastructureFinancial Services, Ltd. (TNUIFSL) will manage the fund. Loan repayments forcertain municipal users will be made directly by user fees or local taxes, with theability to intercept state aid if there is a deficiency. For other types of municipalusers, the WSPF has the authority to directly intercept state aid for loan repayment.The debt-service reserve fund carries an amount equal to one full year of debtservice. If these layers are insufficient, USAID contractually plans to guarantee anamount equal to 50% of WSPF’s principal. The fund’s debt will be offered todomestic investors.

Private banks are also exploring the creation of infrastructure banks in selectemerging-market countries. These banks would most likely work in conjunctionwith a host country’s development bank to achieve the risk allocation and cost-of-fund advantages of the SRFs. Finally, for certain emerging-market countries withan investment-grade sovereign rating on the international scale, the monolineinsurers are exploring opportunities to provide credit enhancement at the ‘AAA’national scale rating level. All these signs are important for the development ofdomestic capital markets and the creation of a sustainable and regenerative supply


of capital for infrastructure projects. The financial engineers from both the publicand private sectors will create the next generation of PPPs. A more efficient allocationof capital engages a broader set of participants and creates new incentives to enhancethe capacity for infrastructure finance while also promoting a more efficient deliveryof municipal services. The process has already begun.

(Fitch Ratings is a leading global rating agency committed to providing the world’scredit markets with accurate, timely and prospective credit opinions.)

49Budget: Overcoming Roadblocks to Growth

Section II

How Project Structures Create Value


Perhaps one of the most striking pronouncements by the Finance Minister, Mr. P Chidambaram, during his Budget speech was, to quote

Mr. Chidambaram, “At a recent meeting of G-7 finance ministers in London

Source: http://www.thehindubusinessline.com/2005/03/22/stories/2005032200810800.htm, March 2005 © BusinessLine. Reprinted with permission.

Padmalatha Suresh

4

Budget: OvercomingRoadblocks to Growth

Taking a cue from the comparison of FDI flows into China withthat into India in the Indian Finance Minister�s 2005 budget speech,this newspaper article identifies the role of the banking systemand the government, in building world-class infrastructure in India,with particular reference to transport. Building world-classinfrastructure has been the key to the transformation of the Chineseeconomy from planned to market-oriented. According to studies,infrastructure investment is associated with one-for-one growthin GDP, while inadequate infrastructure impedes economicgrowth. With GDP growth expected to be around seven percentthis year, the Plan target is achievable only if GDP growth for thenext two years is ten percent. The article underlines the need forinnovative project financing and proposes active involvement ofthe banking system, capital markets and legal system in thisprocess.


(that India and China attended), China’s finance minister looked in my directionand said China had received $60 billion of foreign direct investment in 2004”.

India’s Foreign Direct Investment (FDI) last year was less than ten percent ofChina’s. Ignoring for the time being the ongoing academic discussion on FDIcomposition anomalies, the comparison with China in the Budget speech isacknowledgement of the increasing international visibility of China’s aggressivegrowth policies.

Building world-class infrastructure has been the key to the transformation ofthe Chinese economy from planned to market-oriented.

According to studies, infrastructure investment is associated with one-for-onegrowth in GDP, while inadequate infrastructure impedes economic growth.

The Tenth Plan targeted an average GDP growth rate of 8.1 percent. Theactual performance was 4.6 percent for 2002-03 and 8.3 percent for 2003-04.

The shortfall is disturbing since the momentum for acceleration, essential toachieve the 8.1 percent target, is absent.

With GDP growth expected to be around seven percent this year, the Plantarget is achievable only if GDP growth for the next two years is ten percent.

A McKinsey study estimates that addressing impediments to economic growthsuch as inadequate infrastructure, bureaucracy, corruption, labour market rigidities,regulatory and foreign investment controls, “reservation” of key products, andhigh fiscal deficits, would enable India’s economy to grow as fast as China’s, atten percent a year, and create some 75 million new jobs.

It was, therefore, expected that infrastructure would occupy the pride of placein the recently announced Budget. But it appears that the ‘dream-budget merchant’has not woven innovative dreams for infrastructure development and financing inthe ensuing year.

Consider India’s road infrastructure—the primary mode of transport—increasingly seen as a major factor influencing economic growth and socialdevelopment.


India has a very large network of poor quality roads. The 58,000 km stretch ofnational highways that carries 45 percent of total traffic, is mostly two-lanes withheavy traffic, low service and slow speeds. Despite the 3.5 million km stretch ofroads (the world’s second largest), 40 percent of India’s villages have no all-weatheraccess.

Government expenditure on roads accounts for 12 percent of capital expenditureand three percent of total expenditure, but road maintenance is grossly under-funded,with only one-third of needs being met. This has led to road deterioration, hightransport costs and accessibility loss.

While highway length has grown 1.26 times over the last five years (2000-04),traffic on these highways has increased 14 times.

Even if the Golden Quadrilateral (GQ) project is completed by mid-2005,and the north south-east west (NS-EW) highway project is completed on scheduleby 2008, India will have reasonably well-surfaced, four-lane national highwaysthat accounts for just 22 percent of the country’s national highways.

India has 3,000 km stretch of four-lane highways, and no inter-state expressways.

In contrast, China has highway network of over 25,000 km stretch of four orsix-lane access-controlled expressways linking major cities, all built during thelast decade.

The Centre plans to spend over Rs.2,25,000 crore on highway improvementsin the next six years, apart from the substantial investment to connect villages.

In addition, annual expenditure of Rs.7,000 crore is essential to maintain the1,70,000 km stretch of national and state highways, and further funding is requiredto maintain urban networks, district and rural roads.

All these expenditures have to be financed within the current fiscal environmentof deficits amounting to 9.5 percent of GDP. In comparison, by 2020, Chinaplans a 35,000 km stretch, $150 billion trunk highway system.

While continuing massive reforms, China’s budget deficit for 2005 is expectedto be hardly two percent of GDP. India, therefore, has to grapple with the serious


issues of financing the development of highways and other infrastructure, and itsstructuring. There are two approaches to highway financing—traditional andcommercial.

The traditional approach treats roads as public goods, and finances constructionfrom general revenue with little connection between road-provision costs androad-user charges.

The commercial approach treats roads as capital assets, and charges road usersdirectly or indirectly.

In India, the traditional approach largely persists, although national and statefuel cesses, tolls and private financing are increasingly being introduced. Notadopting the commercial approach has contributed to under-funding of roadmaintenance, and substantial economic losses.

The need of the hour, therefore, is innovative infrastructure financing.

China has been financing infrastructure growth through private domesticinvestment, multilateral funding and FDI.

The achievement is laudable, when viewed against the backdrop of a relativelyweak banking system.

China also proposes to invite cross-border investments from strong globalplayers.

The Budget has proposed some measures for infrastructure financing. Are thesesustainable?

• Using a portion of India’s foreign exchange reserves for financing infrastructurecarries the potential danger of fuelling money supply and inflation.

• The Inter-Institutional Group (IIG) of Banks can finance infrastructure,provided they source long-term funds on a sustainable basis. Besides, thesecurity aspects need to be worked out.

• The allocation of Rs.10,000 crore for the year to the new financial specialpurpose vehicle seems meagre, given the required infrastructure investment.


It is becoming imperative that India look increasingly at private participation,domestic and international, to fund infrastructure growth.

The most attractive option for these private investors would be to use “projectfinance”—“limited” or “non-recourse” financing of a project through theestablishment of a vehicle company. The project financing structure permitsmultiple equity investors, lenders and long-term contracts with third parties. Therisk-return trade-off of long-term infrastructure projects would be renderedattractive through the project and capital structures and the risk managementtechniques employed. India’s strength is its relatively robust financial system.However, use of project financing structures call for a sound legal system, sinceproject financing is governed by contracts. Financial regulations and laws havebeen upgraded but poor enforcement weakens market discipline and integrity.

Involvement of the Banking System

World over, bank lending plays a key role in project finance due to its discipliningeffect on borrowers’ cash flows. However, project lenders should re-orient theirskills to assess and hedge the risks of non-recourse lending.

• Development of syndicated loan and long-term bond markets to cater tothe enormous funding requirements.

• Presence of strong insurance mechanisms for risk-mitigation.

• Development of innovative financial and hedging instruments tailored fordeal structures—hybrid-financing structures, such as mix of corporate andproject finance, leveraged leasing structures, etc. Investment bankers wouldhave to upgrade deal-structuring skills, and project capital providers, theirnegotiating skills.

• Superior project management capabilities. India’s ongoing portfolioperformance in the World Bank funded projects is less than satisfactory.China’s portfolio performance is the best in the World Bank.

• Fast track government clearances/permits/licences/concession agreementsand minimal government interference in project implementation. Soon,China will adopt innovative private participation models, as is evident bythe infrastructure construction plan for Beijing to be implemented from


October 1. Infrastructure development has been vital for China—in the1990s, breaking infrastructure bottlenecks was critical to the sustaining-high-growth-without-inflation strategy; in recent years, infrastructuredevelopment has been considered the most effective way of promotingmarket integration, poverty reduction, and inland China development.

Past experiences indicate that India has innovated best in the face of externaltriggers. A decade ago, it was the IMF loan that triggered financial reforms. WillChina’s policies trigger innovation in infrastructure development and financing?


57Structure Matters in Project Finance


Introduction

Project financing structures have been the subject of substantial research duringthe last decade or so. How do standalone project entities with separate legalincorporation, high leverage and concentrated equity ownership manage the risksassociated with long-term infrastructure development and still deliver financial,social and developmental value?

Structure Matters in Project Finance

5

Padmalatha Suresh

What are the structural attributes of project companies, that enablethem to find the financial and other resources for very largeprojects? Having found the resources, how do the projectcompanies structure the project organization to take care of itslong term needs? How do project companies take care of the risksinvolved in constructing, financing and operating very largeprojects? What are the structural features of project companiesthat enable lenders and equity holders to invest substantial funds?This article summarizes the rationale for, and various types ofcontracts and models that form the backbone of project financingtransactions.


Project financing involves innovative techniques to be used in manyhigh-profile large-scale and infrastructure projects. Employing a carefully engineeredfinancing mix, it has been used over the last decade to fund large-scale naturalresource projects, from pipelines and refineries to hydroelectric, telecommunicationand transportation projects and even projects, in the entertainment and socialsectors.

Although project-financing structures share certain common features, everyproject is unique and requires tailoring the financial package to the particularcircumstances and features of the project. Here in lie both the benefits and thechallenges.

India is on the verge of an infrastructure boom. The pressures created by theneed for central and state governments to balance their fragile budgets, have ledto a greater use of the private sector in infrastructure development and financing.Large infrastructure projects—customarily implemented by the government—now being implemented with private participation and management, reflect thenew trend. It is preferable that long-term Infrastructure Finance in emergingmarkets like India is based on project financing arrangements, thus attempting tomitigate the extreme risks of operating very large projects. All these projects usesome form of “project finance”, a term which is currently being used synonymouslywith “Contract” or “Structured Finance”.

Project finance involves the creation of a legally independent project companyfinanced with non-recourse debt for the purpose of investing in a capital asset,usually with a single purpose and a limited life. One of the most important aspectsof this definition is the distinction between the asset (the project) and the financingstructure. In other words, project companies have evolved as institutional structures,that reduce the cost of performing important financial functions such as poolingresources, managing risk, and transferring resources through time and space(Merton and Bodie, 1995).

We are talking here of projects which typically take five to seven years to complete,have a finite life of 20 to 30 years or more, with very large upfront investmentsfollowed by very large expected cash flows. These features are characteristic ofmost large, infrastructure projects. What are the structural attributes of project


companies that enable them to find the financial and other resources for suchprojects? Having found the resources, how do the project companies structure theproject organization to take care of its long-term needs? How do project companiestake care of the risks involved in constructing, financing and operating very largeprojects?

Structural Attributes of Project Finance

The following facts on the structural attributes of project companies haveemerged from research.1

• Organizational Structure: Project companies involve separate legalincorporation. Special-Purpose Vehicles (SPVs), or Special-Purpose Entities,(SPEs), are created to facilitate construction, financing and operation ofvery large projects.

• Capital Structure: Project companies employ very high leverage comparedto public companies. Research shows that the average (median) projectcompany has a book value debt-to-total capitalization ratio of 70% comparedto 33.1% for similar-sized public firms. While only a few project companieshave leverage ratios below 50%, almost 30% of public companies haveleverage ratios less than 5%!

• Ownership Structure: Project companies have highly concentrated debtand equity ownership structures. Most of the debt comes in the form ofsyndicated bank loans, and not bonds, and is non-recourse to the sponsoringfirms (Esty, 2001b). As a result, creditors must look to the project companyitself for debt repayment. In terms of equity ownership, the typical projectcompany has around one to three sponsors, and the equity is almost alwaysprivately held. International research shows that the average (median) projecthas 2.7 sponsors. In the average project company, the largest single sponsorholds 65% of the equity.

• Board Structure: Project boards are comprised primarily of affiliated(or “gray”) directors from the sponsoring firms. Again, international researchshows that 83% of the directors are affiliated with the project company compared

1 Esty Benjamin C, “The Economic Motivations for Using Project Finance”, Harvard Business School, Working draft,2003.


to 37% in reverse LBOs (Gertner and Kaplan, 1996), 25% in IPO firms(Baker and Gompers, 2001), and 10% in large public companies (Yermack, 1996).

• Contractual Structure: Project finance is sometimes referred to as “contractfinance” because a typical transaction can involve a vertical chain of about15 parties from input suppliers to output buyers bound through 40 ormore contractual agreements. In a typical project, four major contracts areprevalent—contracts governing supply of inputs, purchase of outputs(off-take or purchase agreements), construction, and operations. Larger dealscan even have several thousand contracts. According to the AustralianContractors Association, the Melbourne City Link Project, an A$2 billionroad infrastructure project, had over 4,000 contracts and suppliers (see the2002 award finalists at www.constructors.com.au) (Esty, 2002).

How do the above structural attributes contribute to the success and popularityof project financing? There is no magic formula. Success is accomplished by prudentfinancial engineering that combines the various contracts, undertakings andguarantees between parties interested in the project in such a manner, that no oneparty has to assume the full risk of the project. Yet, when all these undertakingsand contracts are viewed as a whole, the result has to be a satisfactory credit riskfor the lenders and minimal equity risk for the sponsors.

The key to successful project financing therefore lies in ‘structuring’ thefinancing of the project with limited recourse to the sponsors, at the same timeproviding sufficient credit support through guarantees or undertakings of a sponsoror a third party, so that lenders will be satisfied with the credit risk.

In other words, capital providers to the project (both equity and debt holders)should be confident of a reasonable return on the capital employed, which iscommensurate with the risks taken by them.

Since project financing is characterized by the plethora of contracts associatedwith the project company, a closer look at the common contractual structures ofprojects is warranted.

Generally, contracts take the form of ‘guarantees’ and ‘undertakings’, so that thecombined guarantees and undertakings of all parties amounts to a credit-worthy


transaction for the lenders. Guarantees also enable project and market risks to beallocated to the parties who can best bear them.

There are generally two types of guarantors who will come forward to bindthemselves to the project outcomes. The first of these are the ‘owner-guarantors’—the obvious choice in any project. Direct guarantees by owners or project sponsorswould appear on their balance sheets under international accounting standards.

The Role Contracts Play

However, the attractiveness of project financing lies in its being ‘non-recourse’—inother words, off balance sheet for the project sponsors. Apart from keeping the newproject’s risks from tainting the balance sheets of the project sponsors, suchnon-recourse financing also preserves the capital and debt capacity of the sponsorsfor other uses. Therefore, project sponsors would prefer to enter into contracts withthe project company, whereby they provide indirect guarantees to the project, andthus enhance the project’s bankability. Apart from the project sponsors, there willbe other third parties willing to guarantee some aspect of the project’s functioning.These third party guarantors would be those, who are eligible to receive direct orindirect benefits from the project’s successful implementation and functioning.Typically, these third party guarantors could be any one of the following:

• Suppliers of raw material and other inputs to the project.

• Sellers of plant and equipment for the project.

• Users or buyers of the project output.

• Contractors who construct the project infrastructure.

• Contractors who operate the infrastructure facility after construction.

• Government agencies interested in getting the project implementedsuccessfully.

• Multilateral agencies such as the World Bank and its arms, particularly indeveloping countries.

• Banks, Insurance, Pension funds and other Institutional Investors.

In project financing, where the typical capital structure is highly leveraged,lenders require security arrangements and contracts that ensure minimal default


risk. This implies that lenders would require assurances that (a) the project willbe completed on time and at the projected cost (b) even if there are cost or timeoverruns, the lenders’ debt would be serviced in full, (c) when completed, theproject cash flows would be sufficient to service interest and principal repaymentobligations, and, (d) if for any reason, force majeure or otherwise, the project isterminated or suspended, the lenders’ dues would be repaid in full.

In the typical non- or limited recourse structure for project financing, theprime security for lenders is the viability of the project itself. However, even agood credit risk has to be supplemented by other security arrangements. In projectfinance, supplemental arrangements take the form of contracts, the benefits ofwhich are assigned to the project lenders.

• Lenders have the first right over the project cash flows. One of thefundamental contracts in every project is the “cash flow waterfall”, whichprioritizes claims on project cash flows. Through the waterfall, parties agreein advance to meet all operating expenses, capital expenditures, maintenanceexpenditures, debt service, and shareholder distributions in that order, fromthe project cash flows. Sometimes, appropriations to an escrow or reservefund (described later) are also included in the cash waterfall. Typically,such cash flow waterfall mechanisms are under the control of a Trust set upspecifically for this purpose, and therefore reduce managerial discretionover free cash flows from the project.

• Lenders would take direct security interest in the project assets/facilities byholding a first mortgage/lien. The lien gives lenders the right to seize projectassets in the event of debt service default, and realize their dues.

• Completion risk is the risk that the project is not completed in time or notcompleted at all. Completion risk in a project would endanger the lenders’chances of debt recovery. Hence the security arrangement to cover completionrisk, typically requires that the sponsors or other creditworthy parties providean unconditional undertaking to bring in additional funds to complete theproject, or repay the debt in full.

• After the project construction is completed, operations commence.Operational risks include input risks (availability of raw material and other


inputs), and output risks (production capability, demand for output, priceof output, and other market risks). Here, contracts are framed to ensurethat the project will receive cash flows sufficient to meet recurring operatingexpenses and meet the debt service obligations.

• Project debt is also normally secured by direct assignment of the projectcompany’s right to receive payments under various contracts, such ascompletion agreements, purchase and sale contracts or financial supportagreements.

• In addition, the sanction of credit to the project company by lenders willalso contain various covenants. These covenants take the form of representationsand warranties, positive covenants and negative covenants. Many of thesecovenants, while disciplining the project company’s operations and its useof cash flows, may also impose limitations on the functioning of the projectcompany.

Some of the typical indirect guarantees provided for project-financedtransactions are:

1. Take-if-offered Contract: Under this contract, the buyer of the project’soutput is obligated to accept delivery and pay for the output that the projectis able to deliver. The buyer need not pay if the project is not able to deliverthe product. This implies that lenders will be protected only when theproject’s operations are adequate for debt service. Under this contract,therefore, lenders may require supplemental credit arrangements tocompensate for the credit risk that may arise if the project is unable tooperate.

2. Take or Pay Contract: Under this contract, the buyer has to pay for theoutput whether or not he takes delivery. Like the take-if-offered contract,the buyer need not pay if the project is unable to produce the requiredoutput. In this case also, lenders will require supplemental creditarrangements to offset the likelihood of a credit risk. For example, in theDabhol power project, according to the Agreement signed with OmanLNG, MSEB was required to pay for a minimum of 90% of the contractedquantity of 1.6 MMTPA. Similarly, an agreement with ADGAS required it


to pay a minimum of 75% of the contracted amount of 0.5 MMTPA. Thismeans that MSEB was obligated to pay for 1.8 MMTPA of LNG, at a CIFprice of US$ 3.35/MMBTU on a take or pay basis, which was the fuelrequirement for 73% Plant Load Factor (PLF). LNG supply contracts areusually contracted on a take or pay basis. However, in this case, being thesole customer, the entire demand side risk had to be borne by MSEB. Onthe supply side too, MSEB was obligated to purchase all the power thatthe project generated, whether or not it took delivery.

3. Hell-or-High Water Contract: Under this contract, there are no ‘outs’ forthe buyer. He is obligated to pay whether or not any output is delivered.Lenders are more protected against force majeure events in this type ofcontract.

4. Throughput Agreement: Such agreements are found typically in oil orpetroleum pipeline financing. Under this contract, the shippers (oil companiesor gas producers) are obligated to ship, through the pipeline, enough outputto provide the cash flow required to pay all operating expenses and meet alldebt service obligations. Typically, such throughput agreements aresupplemented by a ‘cash deficiency agreement’, which obligates the shippingcompanies to advance funds to the pipeline in the event of a cash shortfall.

5. Cost-of-Service Agreement: The contract requires each buyer to pay projectcosts as actually incurred, in return for a proportionate share in the project’soutput. Typically, such contracts require payments to be made whether ornot the output is delivered.

6. Tolling Agreement: The project company levies tolling charges for processingraw material usually owned and delivered by project sponsors.

7. Step-up Provisions: These provisions are included in purchase and salecontracts when multiple buyers are involved. In case one of the buyersdefaults, the provisions obligate the remaining buyers to increase theirparticipation.

8. Raw material Supply Contracts: These are long-term contracts betweenthe suppliers and the project company, for fulfilling the project’s raw materialrequirements. For instance, under a ‘supply or pay contract’, the supplier has


to make payments, sufficient to cover the debt service requirements of theproject company, in the event of failure to supply the contracted amount ofraw material to the project.

Some Common Models In Project Finance

The various well-known models of concession agreements, such as ‘Build-Operate-Transfer’ (BOT), or ‘Build-Own-Operate-Transfer’ (BOOT) models are derivedfrom contracts such as the ‘Take-or-Pay’ contract. The features of a few frequentlyused models of project structure are presented below:

• Build-Operate-Transfer (BOT): This is one of the most popular models,where the project company enters into a long term concession agreementwith the host government for building and operating an infrastructurefacility. After the concession period, which may typically range up to 20years or more, the ownership is reverted to the host government, to continueoperating the facility. In some models, ownership reversion happens onlyafter the vehicle company is able to generate a satisfactory return on theinvested capital. Sometimes, the host government may also be asked tolend limited credit support or guarantee. Common variations of this modelare the Build-Own-Operate-Transfer (BOOT) model, recently used in theNoida Toll Bridge project, or the Build-Own-Operate (BOO) model,recently seen in the Bangalore International Airport project. Several highwayconstruction projects all over the world and in India have been using theBOT models successfully

• Build-Transfer-Operate (BTO): The ownership of the infrastructure to bedeveloped is vested with the project company till construction is completed.Thereafter, the legal title is transferred to the host. The facility issubsequently ‘leased back’ to the vehicle company for a fixed term, duringwhich the company can collect the revenues generated by the completedfacility. At the end of the term of lease, the host will operate the facility byitself or can hire another operating company.

• Buy-Build-Operate (BBO): In this model, the vehicle company buys the(typically underdeveloped) infrastructure from the host, builds on it bymodernizing or expanding, and thereafter operates it.


• Lease-Develop-Operate: The option is attractive when the vehicle companyis unable to raise sufficient resources for the purchase in a BBO. The leasedfacility is then operated for a fixed term, along with the host on a revenuesharing basis. This model signifying public-private risk sharing has beenseen to be beneficial in cases when the project is losing money.

• Wraparound Addition: In this model, the vehicle company undertakes toexpand an existing host facility. The vehicle company acquires legal titleonly to the addition of the facility. Though ownership is shared, the vehiclecompany is excluded from the liability for the debt already incurred by thecore facility.

• Temporary Privatization: This model is workable when the host is unableto transfer legal title. The vehicle company repairs, operates levies and collectsappropriate charges, and bears the financial risk.

• Speculative Development: This model is popular in developed economieslike the US. The private sponsors identify an unmet public need and fulfillit through a financially feasible and economically viable project. The vehiclecompany set up for this purpose undertakes structuring the project andallocates risk to various parties. The host (government) may join the processby financing or issuing guarantees.

A project company can therefore, choose a structure or model that is befittingthe objective, financing pattern and risks associated with the project. The list ofworkable models given above is only illustrative and is by no means exhaustive.

Supplemental Credit Arrangements

In spite of the presence of contracts, several events can happen to disrupt thefunctioning of the project. To guard against these contingencies, ‘Supplementalcredit arrangements’ are woven into the contractual structure of projects. Thesemechanisms are also termed ‘ultimate backstops’, and can take the following forms:

• Financial Support Arrangement: Typically, the arrangement is in the formof guarantees or letters of credit from the project sponsors or the bank. Inthe event that payments are to be made under the guarantee or letter ofcredit, they will be treated as subordinated loans to the project company.


• Cash Deficiency Arrangement: As the name suggests, the arrangement isdesigned to make good the shortfalls in cash flows, that would ultimatelyimpair the debt service capacity of the project company. Cash deficiencyarrangements usually accompany ‘throughput agreements’ and paymentsare made in advance for the output to be delivered in future.

• Capital Subscription Agreement: This is typically structured as purchasefor cash of junior securities (equity or subordinated debt), issued by theproject company.

• Clawback Agreement: In some cases, project sponsors agree to plough backthe equity cash flows arising from the initial period of operation, or cashdividends received from the Project Company, or tax benefits that mayflow in as a result of their investment in the project, back to the projectcompany. In such cases, the investments may be treated as additional equityor subordinated loans to the project company.

• Escrow Fund: In many cases, lenders insist upon creation of an ‘Escrowfund’ (sometimes called a ‘Debt Service Reserve Fund’) out of project cashflows, to cover from 6 to 18 months of debt service requirements. A trusteeadministers this fund, and in case of a shortfall in project cash flows, drawsfrom the fund to ensure debt service.

• Insurance: This is emerging as one of the strong risk mitigating tools inproject financing. Needless to state, appropriate insurance mechanisms area prerequisite for successful project financing. The presence of costlyinsurance, for example, political insurance, may push up project costs, butthe benefits, in many cases, are seen to outweigh the costs.

Motivations For Using Project Finance Structures

Research2 shows that there are three motivations for using project finance structuresto finance large infrastructure projects.

The first is ‘agency cost motivation’. Project structures can reduce costly agencyconflicts between owners and related parties due to the transaction-specific natureof project assets and high leverage.

2 Esty Benjamin C, “The Economic Motivations for Using Project Finance”, Harvard Business School, Working draft,2003.


The second motivation to use project finance is to counter leverage-inducedunderinvestment. Though there may be several reasons for underinvestment inpositive net present value projects by firms, John and John (1991) have identifiedleverage induced underinvestment as one of the major reasons. Managers of highlyleveraged firms are more likely to pass up positive NPV investment opportunities,since the incremental cash flows from the new project would go towards servicingdebt. Project finance structures allow project cash flows to be allocated to newcapital providers, without impacting the sponsor’s debt capacity.

The third motivation is ‘risk management’. By isolating the assets of the riskyproject in a separate standalone vehicle company, project finance reduces thepossibility of ‘risk contamination’—the phenomenon where an otherwise healthyfirm faces financial distress through the project’s failure.

Through the project structure, sponsors are able to share project risks withother sponsors, with related participants (e.g. contractors, customers, suppliers,etc.), and with debt holders. In summary, this combination of structural features(extensive contracting, concentrated debt and equity ownership, separate legalincorporation, and high leverage) effectively manages risks, reduces asymmetricinformation and controls managerial discretion at the project level.

Conclusion

Recently, the BOOT (Build-Own-Operate-Transfer) model was employed in theNOIDA toll Bridge project in India. This USD 100 million project, implementedwith a 30 year concession and an assured post tax rate of return of 20%, is India’sfirst major PPP initiative. The entire funding of the project has been on a non-recoursebasis. Though beset by traffic risks—the risks that typically afflict any retailtransportation project worldwide—the project is a precursor for more such workableinitiatives.

Structuring projects non-recourse to sponsors would therefore, be an incentivefor the private sector to participate in large scale, risky infrastructure projects, sovital to economic development.

(Padmalatha Suresh is a post-graduate in Management from IIM-A, holding LLBand CAIIB. She has two decades of banking and IT sector experience. She is currently


running a financial consultancy, she is visiting faculty at IIMs and other reputedB-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached [email protected]).

References:

1. Esty Benjamin C, “The Economic Motivations for Using Project Finance”, Harvard Business

School, Working draft, 2003.

2. Finnerty John D, “ Project Finance: Asset Based Financial Engineering” John Wiley and

sons, 1996.

3. Nevitt Peter and Fabozzi Frank, Project Financing, 7th edition, Euro money books, 2000.

70 PROJECT FINANCE - CONCEPTS AND APPLICATIONS


Introduction

The decision to go ahead with a social infrastructure project is critical for any hostgovernment. This is because the private sponsors and the government view thevalue of a large project differently. While the private sponsors would be willing to

6

Assessing the Economic Impact ofInfrastructure Projects – The ERR

Padmalatha Suresh

Governments would be interested in supporting an infrastructureproject, only if the �social benefits� exceed its �social costs�. Thisarticle explains why social returns are different from privatereturns, and outlines the difficulties in assessing the economicimpact of very large projects. Some traditional approaches todetermining social cost benefit are described. The focus of thearticle is on the Economic Rate of Return (ERR) used byMultilateral Institutions such as the IFC, to evaluate thedevelopmental impact of large projects. The stakeholder analysisfor calculating ERR has been elaborated, and the related issuesdwelt upon. The article concludes that the ERR can be evolved tobe a useful tool, for assessing the development impact of largeinfrastructure projects in the country.

71Assessing the Economic Impact of Infrastructure Projects – The ERR

implement the project if its return is commensurate with the risks, governmentswould be interested in supporting a project, financially or otherwise, only if the‘social benefits’ outweigh the ‘social costs’.

In financial terms, the private sponsor of a large project would be looking foran attractive Internal Rate of Return (IRR) or Financial Rate of Return (FRR)from the project. However, the government supporting the project would look ata rate of return that would factor in, apart from the risks, the social costs andbenefits as well—such a rate of return is called the Economic Rate of Return(ERR).

Why should the profitability of an investment from the government or society’sperspective differ from the private investor’s perspective?

Factors Influencing Social Returns

In a market where people are free to decide on the transactions they would like toenter into, there are a few primary factors that can explain why and where socialreturns would differ from private returns.

1. Taxes, Tariffs, Subsidies and other Government Interventions: For example,the amount a firm receives from sale of its product, may be less than theamount the customer pays to acquire it. The reason is ‘taxes’. Similarly,tariffs, subsidies and other public sector interventions result in differencesbetween private and government or social returns.

2. Transaction Costs: A private investor may have to construct a road or bridgeto make his new plant accessible to the firm’s employees and otherstakeholders. However, the public living in the vicinity, which is unconnectedwith the firm, also starts using the facility. It may not be feasible for theprivate firm to restrict access of the facility to outsiders, nor collect tollsfor usage since the transaction costs of toll collection may exceed the amountcollected. Hence, the improved facility becomes an unpriced benefit tosociety. High transaction costs and other restrictions may keep the privatefirm away from charging a fee for the services provided to society.


3. Externalities: Not easily quantifiable, non-market related effects fall underthis category. A leather or chemical factory may give rise to environmentalimpacts like pollution. A plant’s location may lead to congestion in thevicinity. Such effects are not captured in private returns. There are twoother types of externalities that may arise—‘Network’ and ‘Demonstration’effects. A firm may train a subcontractor or a supplier in improving thequality of his product. While the consequent improvement in quality wouldbenefit the firm in the short run, the supplier would stand to benefit fromthe training received, since he can supply products of improved quality tooutside firms as well. A ‘demonstration’ effect would occur when a firmdemonstrates the utility or viability of a new business model or technology,which can be replicated by other firms.

4. Imperfect Markets: Laborers or workers with similar skill sets may be paidmore in a modern plant or a multinational firm than in traditional activities.This could be the case especially in developing countries, where marketsare still evolving. In other words, the price paid for a good or service couldbe significantly different from the opportunity cost of that good or service.

Approaches to Assess Social Returns

Some of the difficulties in assessing social returns are:

• Assessing the social impact of educating and training the workforce, notonly on the workforce itself, but also on the local and domestic economy;

• Assessing the developmental impact of construction of schools, hospitals,housing and other facilities that the project could bring with it;

• Assessing the spin-off effects of investment in a particular industry, or localityon the larger goal of economic development; and

• Assessing the multiplier effect of one large project on the community andthe country.

A look at the traditional approaches to social cost benefit analysis is appropriatebefore understanding the Economic Rate of Return (ERR) approach being practicedby multilateral institutions like the International Finance Corporation (IFC).


A. UNIDO Approach1

The UNIDO approach has been structured in the following stages:

1. It calculates financial profitability at market prices.

2. It then shadow prices the resources, to obtain the net benefit at economicprices. Shadow prices reflect the uncontrolled market prices of goods andservices in the economy. Some of the items typically shadow priced are theprimary outputs of a project, the importable material inputs, the majornon-imported material inputs and unskilled labor.

3. The next step is to adjust for the project’s impact on savings and investment.Such adjustments are carried out by determining the amount of income gainedor lost by different income groups due to the project, evaluating the net impactof these gains or losses on savings, based on the marginal propensity to consumeof each of these groups, and finally estimate the additional savings the projectwould induce through the income generation potential of the project.

4. The fourth step involves adjusting for the project’s impact on incomedistribution. The income flows for each group are derived from stage three,and suitable weights are assigned to reflect the relative changes in incomesfor each group.

5. A final adjustment is made for the project’s production or use of goods,whose social values could be less or greater than their economic value. Goodswhose social values exceed their economic value are called ‘merit goods’,and if less, ‘demerit goods’. For example, a country may include tobacco oralcohol in the list of ‘demerit goods’. An upward adjustment is made to thesocial benefit in the case of merit goods, and a downward adjustment ismade in the case of demerit goods.

B. Little Mirrlees Approach (LM)

The seminal work of Little and Mirrlees has developed a theoretical basis for theanalysis and its underlying assumptions, and lays down step-wise procedure forundertaking benefit-cost studies of public projects. The mathematical formulationis identical to the UNIDO method, except for differences in assigning value to

1. UNIDO - United Nations Industrial Development Organisation


discount rates and accounting for imperfections and other market failures andsocial considerations. The five main elements of the LM approach to shadowpricing are in the nature of valuation of traded goods, valuation of non-tradedgoods, the choice of numeraire (the unit of account in which values of inputs andoutputs are to be expressed), the shadow price of labor and the rate of discount.

Little and Mirrlees have also suggested an elaborate methodology for calculatingshadow prices of non-tradables. This methodology entails use of detailedinput-output tables with a view to tracing down the chain of all non-traded andtraded inputs that go into their production. However, in the case of non-availabilityof detailed input/output tables, a conversion factor based on the ratio of domesticcosts of representative items to world prices of these items could be used forapproximation of shadow prices of non-traded resources.

The similarities of this approach to that developed by UNIDO are:

• Both approaches calculate the shadow prices for foreign exchange savingsand unskilled labor.

• They take into account, equity as a factor.

• Both use discounted cash flow analysis.

However, the dissimilarities between the two approaches are in the following areas:

• The LM approach measures costs and benefits in terms of internationalprices, while the UNIDO approach measures these in domestic currency.

• The LM approach measures costs and benefits in terms of net social incomewhile the UNIDO approach concentrates on consumption.

• The LM approach considers efficiency, savings and redistributionsimultaneously, while UNIDO takes a staged approach in measuring all three.

C. Approach Adopted by Indian Financial Institutions

The Indian financial institutions base their assessment of developmental impact ona modified version of the LM approach. The stages in their assessment are as follows:

1. All non-labor inputs and outputs are valued at international prices. The inherentassumption here is that international prices reflect true economic value.


2. In the case of tradable items, for which international prices are readilyavailable, inputs are valued at CIF prices and outputs are valued at FOBprices. Goods are called fully ‘tradable’ if the impact of increasedconsumption will result in more imports or fewer exports, and increase inproduction results in fewer imports and more exports, other things beingequal. It is also to be noted that, goods that are fully tradable, need notnecessarily be freely traded.

3. In the case of tradable items whose international prices are not available, socialconversion factors are used. The rupee values of these tradable goods are multipliedby appropriate social conversion factors to arrive at the social value.

4. The financial institutions also gauge the degree of protection available toan industry through a simple ratio—the ‘Effective Rate of Protection’ (ERP).This ratio is arrived at by reducing the value added at world prices for anindustry from the value added at domestic prices, and dividing the resultby value added at world prices. The degree of protection enjoyed by anindustry shows its vulnerability to overseas competition if the governmentwithdraws the protection. The ERP being zero implies that the industrydoes not enjoy any protection from global competition. If the indicator isgreater than zero, the industry is protected, and if less than zero, thedomestic industry is more competitive.

5. A measure related to the ERP is the Domestic Resource Cost (DRC). Thisis expressed in terms of the relevant exchange rate multiplied by ERP plus1, and indicates the spending of domestic currency required to generatesavings of one unit of the relevant foreign currency. The higher the DRC,the more the domestic currency required to generate foreign currency savings.Hence as the DRC increases, the priority accorded to the project shouldtypically decrease.

D. Approach Adopted By The Indian Planning Commission

The Project appraisal division of India’s Planning Commission appraises publicsector projects on the following parameters:

• Border prices are used to value tradable inputs.

• Non-tradable items such as power or transport are valued at marginal cost.


• The amount of foreign currency involved in inputs or outputs is valued ata predetermined premium.

• Transfer costs such as taxes and duties are ignored.

• Semi-skilled and unskilled labor is valued at shadow wage rate.

The Economic Rate of Return (ERR)-Framework Used by MultilateralInstitutions

Multilateral institutions such as the World Bank and its arms support private andpublic projects in developing countries, with the objectives of reducing povertyand stimulating economic growth. To participate in large projects of these countries,they need to understand and assess the private and social returns of the projects.

In the traditional approaches to social cost benefit analysis described above,the private returns are calculated using actual market prices, and the social returnsusing ‘shadow prices’. The Multilateral institutions calculate the social return intwo stages, also using shadow prices.

In the first step, the Financial Rate of Return (FRR} or private returns, is calculatedusing market prices.

In the second stage, a ‘stakeholder analysis’ is carried out. Stakeholders are thosewho may be affected by the project. The development impact of the project isestimated by aggregating the net impact on each of the stakeholder groups affectedby the project. The additional return to each of the identified stakeholder groups isassessed as the difference between the actual market price and opportunity costs.

The framework for identifying stakeholders is presented in Figure 1.

• Project Financiers, including the owners, are the core organizers of theproject, and the Internal Rate of Return to them is the stream of privatecash flows (net of costs). This is the FRR and has already been calculated inthe first step.

• Another important stakeholder group will be the labor employed by theproject. The labor employed would benefit to the extent that the wagesthey earn as a consequence of being employed on the project, exceed whatthey would have otherwise received, had this project not been built. It is


noteworthy that wages include annual bonuses and benefits such ashealthcare, pensions, food and food allowances, housing and so on. A wageabove the opportunity cost would hence be added to private benefits, as acomponent of the ERR. In addition, upgrading of skills due to training,and the consequent higher wages they can command in the market wouldalso form part of the assessment.

• Customers can benefit in several ways. They can now get products thatwere not available before, or get products with better quality at the sameprice or get products of the same quality, cheaper. While the first two impactsare difficult to quantify, the impact of a fall in price is measurable as anincrease in the consumers’ surplus.

• Producers of complementary products will benefit due to the increaseddemand for their products, if the project succeeds. A complementary productis one whose value increases, as a consequence of increased supply of anotherproduct. An example is the benefits accruing to tour operators, artifactsellers, taxi drivers, airlines operators and so on, as a result of a new hotelresort opened at a popular tourist destination.

Figure 1: Framework for Assessing Development Impact

Rest ofSociety Customers

Producers ofComplementary

Products

Neighbors CompetitorsNew

Entrants

Suppliers

Financiers(FRR)

Employees


• Suppliers will directly witness increased demand, and hence increased salesand profits. Then, there may be increases in wages to the additional labor force,employed to meet the increased demand. If considered important, the chaincan continue to the suppliers’ suppliers and so on. Beyond these quantifiablebenefits, the training given to the suppliers for providing better quality, whichin turn upgrades the suppliers’ transactions with the outside world, and so on,forms an important network effect, that may or may not be quantifiable. Thedevelopment of such backward linkages (forward linkages in the case ofcustomers, who themselves may be producers), has been emphasized as beingamong the more important development impacts a project can have.

• Competitors may lose clientele due to the new project, which may result inlower demand or lower prices for their products. However, this is not a lossfor the society. The lower prices are offset by the benefits derived by theconsumers. The competitors may also benefit if the new project ‘demonstrates’a new technology or an innovative business model, or if the ‘network’ effectslead to supply of better quality raw material for the competitors’ operations.

• New entrants will also benefit from the demonstration and network effectsdescribed above.

• Neighbors to the project encompass the entire surrounding community. Impactson neighbors may be from environmental externalities, better physicalinfrastructure and the community’s social infrastructure. Environmental effectsmay be positive or negative, depending on what would have happened if therehad been no investment. For instance, felling trees to make way for a new plantmay have a negative impact, while replacing an old polluting plant with amodern non-polluting one may have a net positive impact. Physical infrastructuremay cause or ease congestion. Finally, the community’s social infrastructuremay receive a fillip if the project company creates the necessary socialinfrastructure such as healthcare and education for the community. Whereverfeasible, these effects are quantified for calculating the ERR.

• Rest of society would include the impact of taxes, subsidies, tariffs andother government interventions. Profit taxes go to the government, andtherefore can be added to the ERR calculations. However, the free cashflows to private investors will be computed after taxes, and hence might


affect their FRR. The government may recycle the tax revenues into moresocially beneficial projects, in which case there may be second order orthird order effects on the economy. If important and quantifiable, sucheffects can be included in computing the ERR. Other tax revenues such asthose from Value Added Taxes, Sales taxes and Excise duties would beexpected to increase, as sales of the new project increase and have to betreated similarly. However, if the product is an import substitution product,the total sales may remain unchanged in the economy. The cost of providingsubsidies, which would benefit the private sponsors and be reflected in theFRR, would have to be deducted from the ERR calculations. Similarly, forthe goods produced by the project, the social revenue streams should bereduced by that portion of the price accounted for by the tariff.

Thus, the steps to calculate ERR for a project must begin with the FRR.

1. Calculate free cash flow for every year in the project period.

2. Add net (positive/negative) returns to important stakeholder groups as thedifference between the actual market price and the opportunity costs.

3. Add net profit or losses from taxes, tariffs and subsidies where applicable.

4. Calculate social cash flows for every year.

5. Calculate terminal values where appropriate.

6. Adjust cash flows for inflation.

7. Arrive at real social cash flows.

8. Calculate ERR.

Issues to be Considered While Applying the ERR Framework

The framework to some extent measures the efficiency of resource allocation, buttreats all groups equally. For example, the framework does not measure the impactof a project on poverty alleviation in the economy. Similarly, environmental impactsare difficult to value in totality.

Further, not all costs and benefits are quantifiable, and many times it is moreworthwhile to make a qualitative assessment on the direction of the ERR, ratherthan attempt to quantify the demonstration and network effects.


Another issue is the fact that the concept of a ‘social’ discount rate is yet toattain clarity. At present, IFC uses an arbitrary 10% real discount rate for itssocial cost benefit analysis, which is also IFC’s hurdle rate for accepting projectsfor financing.

The framework is static and does not take into account the value of embeddedoptionality in project analysis. If embedded real options such as sponsorsabandoning the project, or deferring the project are quantified, it is possible thatthe calculated ERR may lead to a different decision.

Nevertheless, in spite of these limitations, the ERR is a useful framework forassessing the social impact of infrastructure projects.

Conclusion

In summary, the ERR gives results similar to traditional social cost benefit analysis,but is more scientific in its approach. Being adopted and in the process ofimprovement by IFC, the ERR would be a powerful valuation tool for governmentsand public bodies to make decisions on the economic viability of infrastructureprojects.

(The author is a post graduate in Management from IIM-A, holding LLB andCAIIB. With two decades of banking and IT sector experience. Currently running afinancial consultancy, she is visiting faculty at IIMs and other reputed B-Schools, Adjunctfaculty-Consulting Editor at IBS Chennai. She can be reached [email protected]).

References

1. “Results on the Ground: Assessing Development Impact”, International Finance Corporation,

Washington DC, 2002.

2. Esty Benjamin C, “An Economic Framework for Assessing Development Impact” , Harvard

Business School, 2002.

3. “Social Cost Benefit Analysis” ICFAI Books, Project Management, volume 3.

81Complexities in Valuing Large Projects

Introduction

The economic development and prosperity of a nation depends on the quantumof funding by, and the quality of commitment of the government and privatecompanies. In India there are many structural changes required, in the developmentof power, transportation and telecommunication sectors, and in the national andinternational logistics and distribution network systems. Infrastructuredevelopment, therefore, is the need of the hour.

The structure, nature, size and complexity of financing infrastructure projectscall for huge investments, and hence, enormous sources of capital to fund theseprojects. Such large projects require meticulous planning, a well-organizedadministrative setup, and a careful understanding of risks associated with it. Largeengineering projects are complex in nature, and the degree of multiple risks associatedwith such projects will finally lead to failure of such projects. There are many factors,like technology, innovative engineering methods, financial re-engineering, international

7

Complexities in Valuing Large Projects

Prof. R Subramanian

Traditional capital budgeting techniques exhibit variousshortcomings when employed to value long-term projects. Thisarticle outlines the various methodologies that could be employedwhile valuing large projects.



political changes and similar unpredictable factors, which could totally alter thevery basis of infrastructure projects as they progress. The risks associated withsuch large mega projects therefore, need to be carefully scrutinized with a view tomanaging their risks effectively.

For example, financial risk can arise at the commissioning, implementation anddistribution phase in a power project, and in the case of highway projects, thegeneral risk associated is usage rate. How do we value these projects, which areessentially long-term in nature and whose risks could be severe and dynamic? Arethe typical capital budgeting methods adequately equipped to handle thecomplexities of infrastructure projects?

It is therefore essential to study, at this juncture, the various techniques of CapitalBudgeting which can be used to analyze long-term projects. In this exercise it isworthwhile to highlight the four basic points of view essential for valuing longterm projects, viz.,

• The project sponsor’s point of view.

• The project lenders’ point of view.

• The institutional investors’ point of view.

• The host government’s point of view.

How are their perspectives different? While project sponsors would look to theequity cash flows for their residual returns, lenders would look to the project cashflows to service the debt, and institutional investors would require a competitiverate of return on their investment. The government, however, would look more tothe social costs and benefits of the project. Are the traditional valuation techniquesgeared to meet these requirements?

Techniques Generally Applied in Assessing Long-Term Projects

The common approach that a valuation analyst, must consider are threefold:

• Base year Company Cash Flow.

• The Future Cash Flow (projection).

• Cost of Capital.


In the first step, the sponsor identifies the cash flow for the base year and bifurcatesthe firm’s reported cash flow into three possible sources:

1. Cash flow from operations.

2. Cash flow from passive investments.

3. Ancillary cash flows.

The second step is to make adjustments wherever appropriate, to report the operatingcash flow for the base year according to the Generally Accepted Valuation Standards.The areas where adjustments are to be made for valuation purposes are enumeratedbelow:

• Sponsor’s Compensation.

• The Discretionary Expenses of the long-tem Projects.

• Other Discretionary Projects.

Issues in Valuation

Cost of Capital

The development of a unique Cost of Capital for each long-term project isinevitable, since characteristics of projects differ from country to country. The keyto valuing a corporate investment opportunity as a viable option, is the ability tocarry out an analysis of the project characteristics.

The following are the chief characteristics that have to be taken cognizance of,while applying the capital budgeting techniques:

1. Project Feasibility details need to be worked out.

2. Length of the project.

3. Equity Cash Flow Analysis.

4. Financial leverage.

5. Operating Cash flow.


Deficiencies of IRR in Valuing Long Term Projects

The basic IRR assumption about investment in mega infrastructure projects isthat if two unrelated projects, like construction of ports or a golden quadrilateral,with identical cash flows, risk levels, and duration are identified, then the relevantreinvestment rate for interim cash flows has to be considered. If, for example, aninvestor invests in Project B, then the interim cash flows could be redeployed at atypical 8% cost of capital, while if he invests in Project A, the cash flows could beinvested in an attractive investment, then both the projects are expected to generatea 30 to 40% annual return.

Some analysts feel that mega projects should use a Modified Internal Rate of Return(MIRR), wherein the weaknesses of IRR can be circumvented and greater clarity canbe arrived at, to assess such projects. When the calculated IRR is higher than the trueinvestment rate for interim cash flows, the measure will overestimate the annualequivalent return from the project. Some analysts strongly recommend that managersmust either avoid using IRR entirely or at least make adjustments and rely on MIRR.

Empirical evidence shows that three-fourths of CFOs, generally involved inlarge projects, use IRR for assessing such projects, be it on irrigation, power orother infrastructure projects.

Valuation Threats

The resource-allocation process presents not one, but three basic types of valuationproblems. Managers need to be able to value operations, opportunities andownership claims. The three fundamental factors for evaluating the three types ofvaluation problems, which can be highlighted are timing, cash and risk.

At this stage, to overcome these threats, the three complementary tools, whichcan be brought out are WACC-based DCF, APV and option pricing. Most of thecompanies now use Option Pricing as their workhorse valuation methodology.

Weighted Average Cost of Capital is a tax-adjusted discount rate, intended to pickup the value of interest tax shields by using an operation’s debt capacity. Themore complicated a company’s capital structure, tax position, or fund-raisingstrategy, the more details need to be worked out about the feasibility of theapplication of WACC.


The analyst’s task is, firstly, to forecast expected future cash flow, by period andsecond, to discount the forecast to present value at the opportunity cost of funds.Opportunity cost consists partly of time value, the return on a nominally risk-freeinvestment. This is the return you earn for being patient without bearing any risk.

Today’s better alternative for valuing a business operation, is to apply the basic DCFrelationship to each of a business’s various kinds of cash flow, and then add up thepresent values. This approach is most often called Adjusted Present Value or APV. Itwas first suggested by Stewart Myers of MIT, who focused on two main categoriesof cash flows—real cash flows (such as revenues, cash operating costs and capitalexpenditure) associated with the business operation, and side effects associated withits financing program (such as the values of interest tax shields, subsidized financing,issue cost, and hedges). APV relies on the principle of value additivity.

What are the practical payoffs from switching to APV from WACC? Bothapproaches are skillfully applied in a large project situation.

Long term Projects and Valuation

The issues concerning the valuation methodology of large projects, which need tobe addressed are:

• How much are the expected future cash flows worth, once the companyhas made all the major discretionary investments?

• What are the sources for investing in long term projects?

Regardless of the opportunities, the valuation tool should gear up to strengthenthe corporate capability to allocate and manage resources effectively. Cyclicalcompanies often commit themselves to big capital—spending on projects just whenprices are high, and the cycle is hitting its peak, and retrenching when prices arelow. Some of the companies develop business forecasting models that are quitesimilar to those used by equity analysts for interpolating and extrapolating thedesired outcomes of the projects. Most aggressive managers aspire for trading approachafter attempting at risk analysis, preferably adopting option pricing mechanism.

Distributed generation, has tremendous promise for providing efficient,technologically advanced and environmentally—friendly electricity supplies in theUnited States. There is an increasing interest in developing countries, in contracting


with NGOs and the non-profit private sector to deliver primary healthcare (PHC),including nutrition and family planning services.

There are few bitter experiences in the low-income countries, in the sense thatthe contracting will have high transaction costs, and be difficult for governmentsto implement. When it comes to the provision of major infrastructure in Australia,it seems that there are often alternative ways to deal with these situations, otherthan government provision.

The transaction costs of negotiating such many-sided contracts may be sufficientlylow, and improvements in technology can also resolve these issues. Businessesfrequently solve free-rider problems, by developing means of excluding non-payersfrom enjoying the benefits of a good or service. For example, new tolling technologyhas made it easier to build private roads and charge tolls to road users.

Several major international Grid development projects are underway at present,both within the European Community, and in the USA. All of these projects areworking towards the common goal of providing transparent access to the massivelydistributed computing infrastructure, that is needed to meet the challenges ofmodern data-intensive applications.

International Organization for Standardization (ISO), ISO 9000,Quality Management and Quality Assurance Standards

The ISO 9000 collection is a suite of standards and guidelines, that helporganizations implement effective quality systems for the type of work they do.Two items in the collection are most useful to organizations that design and buildsoftware:

• ISO 9001: Quality Systems Model for Quality Assurance in design,development, production, installation and servicing.

• ISO 9000-3: Guidelines for the Application of ISO 9001 to the development,supply, and maintenance of software.

ISO 9001 covers the requirements for a quality system that supports the full productlife cycle, from initial agreement on a deliverable, through design, development, andsupport of the product. ISO 9000-3 provides specific advice on how to interpret the


standard for developing a quality system of an organization whose product is primarilysoftware. This guideline has been very useful to software organizations, since the originalfocus of ISO 9000 was for managing manufacturing and process control type of activities,and interpreting the standards for software was sometimes difficult.

Standard practices have been developed through field experience, throughplanning analyses, and from legal or regulatory directives. The governmentresponsibility to ensure that good construction practices are used on public lands,and they apply to the ‘surface-disturbing’ activities. Best management practices aredeveloped by the responsive government and federal laws permit such practices asa well-accepted norms of the business enterprise.

• Take up internal studies of an industry or an issue, for purposes of both business developmentand to push the boundaries of knowledge of internal professionals.

• The process of developing the standard, provides a laboratory for professionals committed tofuture marketing of the outputs of the commissioned work. An increasing number ofprofessionals are involved as a methodology progresses from development to implementation.

• Carry out strategic studies, perhaps on a discounted basis, that would establish a firm as anearly leader in a field or as a proponent of a methodology. Learning activity is emphasized inthe first two or three projects in a new field.

• Encourage extracurricular training or professional development �sabbaticals�. Specific initiativesare tied to the results of project reviews that focus on identification of areas for improvement.

Box 1: Best Practices in Large Consulting Companies

Valuing Opportunities: Option Pricing

Companies with new technologies, product development ideas, or access topotential new markets have vistas of valuable opportunities. A common approachis not to value them formally until they mature to the point where an investmentdecision can no longer be deferred. Generally two types of cash flows matter i.e.,cash for investing and cash for operation. R&D is a major factor for exercisingthe option, and time also matters in two ways—the timing of the eventual flowsand how long the decision to invest may be deferred.

Real Options as a Tool for measuring Long-Term Projects

Generally for evaluating long-term projects, the widely accepted techniques areaccounting rate of return, payback period, net present value, modified internal


rate of return and real options. The first four methodologies ignore the value offlexibility and embedded options, inherent in any large project.

Real Option is one of the important tools used for valuing the investmentopportunities under conditions of uncertainty, and to monitor, measure and adjustdecisions according to economic changes. It is a well-accepted simple valuationtechnique under the Net Present Value method and principally the operationtakes place through option valuation.

Real option gives the right but not the obligation to undertake businessdecisions, for venturing into private public partnerships, or for attempting tofund large infrastructural projects. The technique can also be used for starting anew venture, a hotel project in a hill resort, a new factory, an industrial establishmentor a long-term infrastructure project in transport, power or telecommunication.

The sponsors have more flexibility, since they can now scale up or switch a projectGenerally, real options are used for scaling up or switching a project, which is a growthoption, apart from exercising scaling down options, learning options and abandonmentoptions. The concept of Real Option can be better understood from a long termperspective. While assessing a long term project, the real option mechanism will act asan important tool to evaluate, to judge and to bifurcate the projects into two dimensions,i.e., the pilot project and the main project. If the pilot project fails, then the sponsorcan back out from funding such large non-result yielding projects.

Conclusion

Valuing mega projects, particularly, in infrastructure development and funding,where the future is uncertain, problems are complex and the risks are immense,calls for innovative valuation methodologies. In this context, the Real OptionMechanism can be a better tool provided the following points are consideredbefore attempting to apply it:

• Real option mechanism must not be viewed in isolation, but with othertime adjusted techniques preferably APV, MIRR.

• Flexibility and change mechanisms are definite pre-emptive measures beforeadopting a particular tool.


• It should be viewed as one of the tools which will act as a means to a finaldecision and not an end by itself.

(Prof. R Subramanian, is a post graduate in Commerce, in Public Administration,in Business Administration, Master of Philosophy in Commerce, and presently pursuinghis Doctoral Programme in Accounting for Derivatives. He has two decades of industryand academic experience and is presently a faculty in IBS Chennai, in the area ofAccounting and Finance. He can be reached at [email protected]).

Reference

1. Tom Copeland, Timothy Koller, and Jack Murrin, Valuation: Measuring and Managing theValue of Companies, third edition, New York; John Wiley & Sons.

2. Stewart C Myers, “Interactions of Corporate Financing & Investment Decisions—

Implications for Capital Budgeting” Journal of Finance, vol 29, March 1974.

3. Harvard Business Review May-June 1997.

4. Finance & Development, A quarterly magazine of the IMF, March 1999. vol. 36, No. 1.

• There was no competitive bidding for the project�the deal was negotiated exclusivelybetween the Maharashtra government and Enron; ·

• The project costs and power tariffs were higher than other power projects in India, and thecost of electricity from the DPC project would significantly inflate prices in other areas; ·

• The MSEB promised to buy all the high-priced power produced by Enron, whether there wasdemand or not, and even if cheaper power were available from its own generating plants.These contracted annual payments to Enron would amount to half of Maharashtra�s entirebudget expenditure;

• The DPC was assured a post-tax return of 16 percent on capital investment, and there was nolimit on what Enron could make. Indian economists calculated that the after-tax rate of returnwould actually be 32 percent, about three times the average rate in the US;

• There were counter guarantees from the state and central governments for payments whichwould have been due to DPC from the MSEB. However, the contract shields Enron fromIndian jurisdiction, as all disputes must be settled under English law in England;

• An assurance was given that the project would not be nationalized;

• The project authorities carried out no environmental impact assessment; and

• Enron paid $20 million as �educational gifts�. Critics consider these payments as bribes toclear the project.

Box 2: Some of the Accusations that were made againstEnron Dhabol Power Project were:

91The Nature of Credit Risk in Project Finance

Section III

Managing Project Risks


For decades, project finance has been the preferred form of financing for largescale infrastructure projects worldwide. Several studies have emphasised

its critical importance, especially for emerging economies, focusing on the linkbetween infrastructure investment and economic growth. Over the last few years,however, episodes of financial turmoil in emerging markets, the difficultiesencountered by the telecommunications and energy sectors, and the financialfailure of several high-profile projects2 have led many to rethink the risks involvedin project financing.

Source: http://www.bis.org/publ/qtrpdf/r_qt0412h.pdf, Originally published in BIS Quarterly Review, Dec.2004.The full publication is available free of charge on the BIS website. © BIS Quarterly Review. Reprinted with permission.

The Nature of Credit Risk inProject Finance1

8

Marco Sorge

In project finance, credit risk tends to be relatively high at projectinception and to diminish over the life of the project. Hence,longer-maturity loans would be cheaper than shorter-term credits.

1 I would like to thank Claudio Borio, Blaise Gadanecz, Már Gudmundsson, Eli Remolona and Kostas Tsatsaronis fortheir comments, and Angelika Donaubauer and Petra Hofer (Dealogic) for their help with the data. The views expressedin this article are those of the author, and do not necessarily reflect those of the BIS.

2 Three spectacular recent financial failures are the Channel Tunnel linking France and the United Kingdom, theEuroDisney theme park outside Paris, and the Dabhol power project in India.


The question whether longer maturities are a source of risk per se, is crucial tounderstanding the distinctive nature of credit risk in project finance. Large-scalecapital-intensive projects usually require substantial investments upfront, and onlygenerate revenues to cover their costs in the long-term. Therefore, matching thetime profile of debt service and project revenue cash flows implies, that on an average,project finance loans have much longer maturities than other syndicated loans.3

This special feature argues that a number of key characteristics of project finance,including high leverage and non-recourse debt, have direct implications for theterm structure of credit risk for this asset class. In particular, a comparative econometricanalysis of ex ante credit spreads in the international syndicated loan market, suggeststhat longer-maturity project finance loans are not necessarily perceived by lendersas riskier compared to shorter-term credits. This contrasts with other forms of debt,where credit risk is found to increase with maturity ceteris paribus.

Financing high-profile infrastructure projects not only requires lenders to commitfor longer maturities, but also makes them particularly exposed to the risk of politicalinterference by host governments. Therefore, project lenders are making increasinguse of political risk guarantees, especially in emerging economies. This special featurealso provides a cross-country assessment of the role of guarantees against politicalrisk, and finds that commercial lenders are more likely to commit for longer maturitiesin emerging economies, if they obtain explicit or implicit guarantees from multilateraldevelopment banks or export credit agencies. This is shown to further reduce projectfinance spreads observed at the long end of the maturity spectrum.

After a brief review of the history and growth of project finance, the secondsection illustrates the specific challenges involved in financing large-scalecapital-intensive projects, while the third section explains how project financestructures are designed to best address those risks. The core of the analysis, in thefourth and fifth sections, shows how the particular characteristics of credit risk inproject finance are consistent with the hump-shaped term structure of loan spreadsobserved ex ante for this asset class. The conclusion summarises the main findingsand draws some policy implications.

3 The average maturity of project finance loans in the Dealogic Loanware database is 8.6 years, against only 4.8 years forsyndicated loans in general.


Recent Developments in the Project Finance Market

Project finance involves a public or private sector sponsor investing in asingle-purpose asset through a legally independent entity. It typically relies onnon-recourse debt, for which repayment depends primarily on the cash flowsgenerated by the asset being financed.

Since the 1990s, project finance has become an increasingly diversified businessworldwide. Its geographical and sectoral reach has grown considerably, followingwidespread privatization and deregulation of key industrial sectors around the world.

In the years following the East Asian crisis (1998–99), financial turmoil inemerging markets led to a global reallocation of investors’ portfolios from thedeveloping to industrialised countries. New investments, notably in North Americaand western Europe, more than offset the capital flight from emerging economies,such that total global lending for project finance rebounded from a two-yearslump, reaching a record high in 2000 (Graph 1).

Since 2001, the general economic slowdown and industry-specific risks in thetelecoms and power sectors have led to a substantial decline in project financelending worldwide (Graph 2). The power sector has been particularly hurt by

Graph 1: Project Finance Global Lending by Region (US$ bn)

160

120

80

40

0

1997 1998 1999 2000 2001 2002 2003

Note: The amounts shown refer to new bank loan commitments for project finance, by yearand region.

Source: Dealogic ProjectWare database.

Latin America and CaribbeanAsiaEastern Europe, Middle East, AfricaAustralia and PacificNorth AmericaWestern Europe

11111212

121211123123123

123451234512345 12345

1234512345

123451234512345

1234512345

123451234512345 12345

12345

1234512345

12345123451234512345

123456789123456789123456789123456789123456789123456789

123456789123456789123456789123456789

123456789123456789123456789

123456789123456789123456789123456789

123456123456

12345671234567

1234567

123456123456123456

1234512345

123451234512345

12345123451234512345

12345123451234512345

12345678901234567890123456789012345678901234567890123456789012345678901234567890

1234567890123456789012345678901234567890123456789012345678901234567890

123456789012345678901234567890123456789012345678901234567890

12345678901234567890123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890

123451234512345

1234512345

1234512345

12345

1234512345

1234512345

123456789123456789123456789

123456789123456789123456789

123456789123456789123456789123456789

12345671234567

12345671234567

123456123456

1234512345

1234512345

123451234567890112345678901123456789011234567890112345678901123456789011234567890112345678901

12345678901234567890123456789012345678901234567890

123456789012345678901234567890123456789012345678901234567890


accounting irregularities and high volatility in energy prices—the debt ratings often of the leading power companies fell from an average of BBB+ in 2001 to B– in2003. Telecoms firms have been penalised for sustaining onerous investments innew technologies (like fibre-optic transmission or third-generation mobile licencesin Europe), that have not yet generated the expected returns. Over 60 telecomscompanies filed for bankruptcy between 2001 and 2002, as overcapacity led toprice wars and customer volumes failed to live up to over-optimistic projections.

Despite the recent downturn, the long-term need for infrastructure financingin both industrialized and developing countries remains very high. In the UnitedStates alone, between 1,300 and 1,900 new electricity generating plants need tobe built in order to meet growing demand over the next two decades (NationalEnergy Policy Development Group (2001)). For developing countries, an annualinvestment of $120 billion would be required in the electricity sector until 2010(International Energy Agency (2003)).

The Main Challenges of Financing Large-scale Projects

Projects like power plants, toll roads or airports share a number of characteristicsthat make their financing particularly challenging.

160

120

80

40

01997 1998 1999 2000 2001 2002 2003

Note: The amounts shown refer to new bank loan commitments for project finance by year andsector.


Graph 2: Project Finance Global Lending by Sector (US$ bn)121212

123123

12121212121212

Mining and natural resourcesOtherPetrochemical/chemical plantInfrastructureTelecomsPower

12345123451234512345

123451234512345

1234512345

1234512345

12345123451234567891234567891234567891234561234561234561234561234512345123451234512345123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890

1234512345123451234512345123456789123456789123456712345671234567123456712345123451234512345678901123456789011234567890112345678901123456789011234567890112345678901123456789011234567890112345678901

1234512345678912345678912345671234567123456712345123451234512345123451234567890123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890

1234512345123456789123456712345671234567123456712345123451234512345123451234512345123451234512345678901234567890123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890

1234512345123451234567891234567891234567123456712345671234512345123451234512345678901234567890123456789012345678901234567890123456789012345678901234567890

123456789123456789123456712345671234567123451234512345678901234567890123456789012345678901234567890

12345123451234512345678912345678912345678912345671234567123456712345671234567123451234567890123456789012345678901234567890123456789012345678901234567890


First, they require large indivisible investments in a single-purpose asset. Inmost industrial sectors where project finance is used, such as oil and gas andpetrochemicals, over 50% of the total value of projects consist of investmentsexceeding $1 billion.

Second, projects usually undergo two main phases (construction and operation)characterised by quite different risks and cash flow patterns. Construction primarilyinvolves technological and environmental risks, whereas operation is exposed tomarket risk (fluctuations in the prices of inputs or outputs) and political risk,among other factors.4 Most of the capital expenditures are concentrated in theinitial construction phase, with revenues instead starting to accrue only after theproject has begun operation.

Third, the success of large projects depends on the joint effort of several relatedparties (from the construction company to the input supplier, from the hostgovernment to the offtaker5) so that coordination failures, conflicts of interest andfree-riding of any project participant can have significant costs. Moreover, managershave substantial discretion in allocating the usually large free cash flows generatedby the project operation, which can potentially lead to opportunistic behaviorand inefficient investments.

The Key Characteristics of Project Financing Structures

A number of typical characteristics of project financing structures are designed tohandle the risks illustrated above.

In project finance, several long-term contracts such as construction, supply,offtake and concession agreements, along with a variety of joint-ownershipstructures, are used to align incentives and deter opportunistic behavior by anyparty involved in the project. The project company operates at the centre of anextensive network of contractual relationships, which attempt to allocate a varietyof project risks to those parties best suited to appraise and control them. For

4 Hainz and Kleimeier (2003) identify three broad categories of “political risk”. The first category includes the risks ofexpropriation, currency convertibility and transferability, and political violence, including war, sabotage or terrorism.The second category covers risks of unanticipated changes in regulations or failure by the government to implement tariffadjustments because of political considerations. The third category includes quasi-commercial risks arising when theproject is facing state-owned suppliers or customers, whose ability or willingness to fulfil their contractual obligationstowards the project is questionable.

5 The offtaker commits to purchase the project output under a long-term purchase (or offtake) agreement.


example, construction risk is borne by the contractor and the risk of insufficientdemand for the project output by the offtaker (Figure 1).

Figure 1: Typical Project Finance Structure

International organisationsor export credit agencies

Banksyndicate

SponsorA

SponsorB

SponsorC

Non-recourse debtInter-creditor agreement

EquityShareholder agreement

Labor

Input(eg. gas)

Supply contract

Output(eg. power supply)Offtake agreement

Project company(eg. power plant)

Constructionequipment, operating

and maintenancecontracts

Host governmentLegal system, property

rights, regulation, permits,concession agreements

70% 30%

Note: A typical project company is financed with limited or non-recourse debt (70%) and sponsors�equity (30%). It buys labor, equipment and other inputs in order to produce a tangible output(energy, infrastructure, etc). The host government provides the legal framework necessary for theproject to operate.

Source: Adapted from Esty (2003).

Project finance aims to strike a balance between the need for sharing the risk ofsizeable investments among multiple investors and, at the same time, theimportance of effectively monitoring managerial actions and ensuring a coordinatedeffort by all project-related parties.

Large-scale projects might be too big for any single company to finance on itsown. On the other hand, widely fragmented equity or debt financing in thecapital markets would help to diversify risks among a larger investors’ base, but


might make it difficult to control managerial discretion in the allocation of freecash flows, avoiding wasteful expenditures. In project finance, instead, equity isheld by a small number of “sponsors” and debt is usually provided by a syndicateof a limited number of banks. Concentrated debt and equity ownership enhancesproject monitoring by capital providers and makes it easier to enforce projectspecificgovernance rules for the purpose of avoiding conflicts of interest or suboptimalinvestments.

The use of non-recourse debt in project finance further contributes to limitingmanagerial discretion by tying project revenues to large debt repayments, whichreduces the amount of free cash flows.

Moreover, non-recourse debt and separate incorporation of the project company,make it possible to achieve much higher leverage ratios than sponsors couldotherwise sustain on their own balance sheets. In fact, despite some variabilityacross sectors, the mean and median debt-to-total capitalization ratios for allproject-financed investments in the 1990s were around 70%. Nonrecourse debtcan generally be deconsolidated, and therefore does not increase the sponsors’on-balance sheet leverage or cost of funding. From the perspective of the sponsors,non-recourse debt can also reduce the potential for risk contamination. In fact,even if the project were to fail, this would not jeopardise the financial integrity ofthe sponsors’ core businesses.

One drawback of non-recourse debt, however, is that it exposes lenders toproject-specific risks that are difficult to diversify. In order to cope with the assetspecificity of credit risk in project finance, lenders are making increasing use ofinnovative risk-sharing structures, alternative sources of credit protection and newcapital market instruments to broaden the investors’ base.

Hybrid structures between project and corporate finance are being developed,where lenders do not have recourse to the sponsors, but the idiosyncratic risksspecific to individual projects are digressed by financing a portfolio of assets asopposed to single ventures. Public-private partnerships are becoming more andmore common as hybrid structures, with private financiers taking on constructionand operating risks, while host governments cover market risks.


There is also increasing interest in various forms of credit protection. Theseinclude explicit or implicit political risk guarantees,6 credit derivatives and newinsurance products against macroeconomic risks such as currency devaluations.Likewise, the use of real options in project finance has been growing across variousindustries.7 Examples include refineries changing the mix of outputs among heatingoil, diesel, unleaded gasoline and petrochemicals depending on their individualsale prices; real estate developers focusing on multipurpose buildings, that can beeasily reconfigured to benefit from changes in real estate prices.

Finally, in order to share the risk of project financing among a larger pool ofparticipants, banks have recently started to securitize project loans, thereby creatinga new asset class for institutional investors. Collateralized debt obligations as well asopen-ended funds have been launched to attract higher liquidity to project finance.8

The Term Structure of Credit Spreads in Project Finance

The specific risks involved in funding large-scale projects and the key characteristicsof project financing structures, illustrated in the previous sections, (in particular,high leverage and non-recourse debt) have important implications for the termstructure of credit spreads for this asset class.

First, based on the widely used framework for pricing risky debt originallyproposed by Merton (1974), we should expect to observe a hump-shaped termstructure of credit spreads for highly leveraged obligors (Graph 3). In this approach,the default risk underlying credit spreads is primarily driven by two components:(1) the degree of firm indebtedness or leverage, and (2) the uncertainty about thevalue of the firm’s assets at maturity. Given Merton’s assumption of decreasing leverage

6 The explicit guarantee is a formal insurance contract against specific political risk events (transfer and convertibility,expropriation, host government changing regulation, war, etc) provided by some commercial insurers. The “implicitguarantee” instead works as follows. The financing is typically divided into tranches, one of which is underwritten bythe agency. The borrower cannot default on any tranche without defaulting on the agency tranche as well. The agencyrepresents a G10 government or supranational development bank with a recognised preferred creditor status. Defaultingon the agency has additional political and financial costs that the host country would not want to incur, since agenciesare usually lenders of last resort for host countries in financial distress.

7 Analogous to financial options, i.e., derivative securities which give the holder the right but not the obligation to tradein an underlying security, real options provide management with the flexibility to take a certain course of action orstrategy, without the “obligation” to take it (in both cases options are exercised only if deemed convenient ex post).

8 Among the new capital market instruments used for project financing, revenue bonds and future-flow securitizations aredebt securities, backed by an identifiable future stream of revenues generated by an asset; compartment funds offer shareswith different levels of subordination, to different types of investors, and, are dedicated to make equity investments.


ratios over time, postponing the maturity date reduces the probability that thevalue of the assets will be below the default boundary when repayment is due. Onthe other hand, a longer maturity also increases the uncertainty about the futurevalue of the firm’s assets. For obligors that already start with low leverage levels, thissecond component dominates, so that the observed term structure is monotonicallyupward-sloping. For highly leveraged obligors, instead, the increase in default riskdue to higher asset volatility will be strongly felt by debt holders at short maturities,but as maturity further increases, the first component will rapidly take over, thanksto the greater margin for risk reduction due to declining leverage. This leads to ahump-shaped term structure of credit spreads for highly leveraged obligors.9

Second, despite the extensive network of security arrangements illustrated inFigure 1, the credit risk of non-recourse debt remains ultimately tied to the timingof project cash flows. In fact, projects which are financially viable in the long runmight face cash shortages in the short term. Ceteris paribus, obtaining credit atlonger maturities implies smaller amortizing debt repayments due in the earlystages of the project. This would help to relax the project company’s liquidityconstraints, thus reducing the risk of default. As a consequence, long-term projectfinance loans should be perceived as being less risky than shorter term credits.

Third, the credit risk of non-recourse debt might be affected not only by thetiming, but also by the uncertainty of project cash flows and how the latter evolvesover the project’s advancement stages. In fact, successful completion of theconstruction and setup phases can significantly reduce residual sources ofuncertainty for a project’s financial viability. Arguably, extending loan maturitiesfor any additional year after the scheduled time for the project to be completelyoperational, might drive up ex ante risk premia but, only at a decreasing rate.10

Finally, the term structure of credit spreads observed in project finance, islikely to be affected by the higher exposure of large infrastructure projects topolitical risk and by the availability of political risk insurance for long-term projectfinance loans. While long maturities and political risk represent in principle separatesources of uncertainty, commercial lenders are often willing to commit for longer

9 With leverage ratios approaching 100%, the second component completely dominates and the term structure becomesdownward-sloping.

10 This is consistent with the hypothesis of sequential resolution of uncertainty in Wilson (1982)


maturities in emerging economies, only if they obtain explicit or implicit guaranteesfrom multilateral development banks or export credit agencies. As political riskguarantees are most often associated with longer maturities,11 lenders should notnecessarily perceive political-risk-insured long-term loans as being riskier thanuninsured short-term loans, ceteris paribus.

11 For example, the World Bank has launched a programme of partial credit guarantees, that cover only against defaultevents occurring in the later years of a loan. This encourages private lenders to lengthen the maturity of their loans.

A Comparative Analysis of Credit Spreads in the InternationalSyndicated Loan Market

As argued above, several peculiar characteristics of project finance would implythat the term structure of credit spreads for this asset class, need not be monotonicallyincreasing as observed for other forms of financing. This section will attempt tosubstantiate this claim empirically.

Graph 4 illustrates the pricing of a few representative loans for projects both inindustrialised and in emerging economies, which have received funding in tranches

Graph 3: Term Structure of Credit Spreads

In basis points

20% leverage50% leverage

2 5 10 25

400

300

200

100

0

Note: Volatility of firm�s asset value is set at 20% per unit of time. Leverage is defined as theratio of debt to the current market value of the assets, where debt is valued at the risklessrate.

Source: Merton (1974).

Maturity (years)


with different maturities. The general pattern shown in the graph suggests thatthe term structure of loan spreads in project finance may be hump-shaped.

In order to test this hypothesis, the ex ante credit spreads over Libor for a largesample of loans12 are extracted from the Loanware database compiled by Dealogic,a primary market information provider on syndicated credit facilities.

They are regressed on several micro characteristics of the loans (such as amount,maturity, third-party guarantees, borrower business sectors, etc) along with severalcontrol variables including the macroeconomic conditions (eg real GDP growth,inflation and current account balance) prevailing in the country of the borrowerat the time of signing the loan, plus global macroeconomic factors (such as worldinterest rates and the EMBI index).

12 International syndicated bank loans accounted for about 80% of total project finance debt flows over the period1997–2003 (source: Thomson Financial).

Graph 4: Term Structure of Loan Spreads in Project Finance

Spread over Libor, in basis points

United KingdomUnited States

Industrial countries Emerging markets

3 4 5 7 16.5 20 5 7 8 10 12 16

500

400

300

200

100

0

250

200

150

100

50

0

Note: The connected diamonds represent different loans to the same project. Five representativeprojects are illustrated from both industrial and emerging economies. The shaded points indicatecoverage by political risk guarantee.


Maturity (years)

CroatiaPhilippinesIndia


Estimated coefficients for loan maturity and its logarithmic transformationreported in Table 1, suggest that the relationship between ex ante spread andmaturity for project finance loans is indeed hump-shaped,13 while for all otherloans it appears instead monotonically increasing.14 This result applies toindustrialised as well as emerging economies and is found to be robust to a largenumber of sensitivity tests.15

The regressions in Table 1 also control the impact on loan spreads of politicalrisk and political risk guarantees. Political risk is proxied by the corruption indexprovided by Transparency International.16 Results suggest that while corruptionis not a significant problem for project finance in industrialised countries, lendersfinancing projects in emerging markets, systematically charge a higher premiumon borrowers from countries characterised by a higher political risk. However,this risk appears to be effectively mitigated by the involvement of multilateral

13 At short maturities, the positive logarithmic term prevails and accounts for the upward-sloping part of the termstructure. As maturity increases, the negative linear term dominates and explains the downward-sloping section of theterm structure.

14 The corresponding estimated coefficient on “log maturity” in Table 1 is not statistically significant. The same result isfound using alternative non-linear functions of maturity (eg. quadratic or square root).

15 Including tests for endogeneity and sample selection as well as robustness checks for the range of maturities analysed, repaymentschedules, bond ratings, loan covenants and fixed vs floating rates. See Sorge and Gadanecz (2004) for more details.

16 In the reported regression, a higher score on the index indicates a higher degree of corruption in the political system ofthe host country.

Table 1: Microeconomic Determinants of Loan Spreads

Dependent Variable: SpreadProject finance loans

Industrializedcountries Emerging markets

Other loans

Maturity �5.258** �5.039* 7.066**

Log maturity 52.426** 33.184** �0.761

Corruption index �0.792 19.340** 13.339**

Agency guarantees 11.872 �58.324** �48.147**

Number of observations 331 687 12,393

Adjusted R2 0.259 0.337 0.329

Note: Only regressors of interest are shown. * and ** indicate statistical significance at the 5%and 1% confidence levels, respectively.

Source: Sorge and Gadanecz (2004).


development banks or export credit agencies. In fact, Table 1 shows that loanswith political risk guarantees from these agencies are priced on average about50 basis points cheaper, ceteris paribus.

The evidence also suggests that the availability of agency guarantees effectivelylengthens maturities of project finance loans in emerging markets. However, eventaking this effect into account through the inclusion in the regressions in Table 1of an interaction term between maturity and agency guarantees, the estimatedrelationship between spread and maturity for project finance loans remainshump-shaped.17 This is consistent with the hypothesis that, while it is true thatlenders especially use political risk guarantees for longer-term loans, the observedhump-shaped term structure of credit spreads may be due to more fundamentalcharacteristics of project finance.

Conclusion

This special feature has analysed the peculiar nature of credit risk in project finance.Two main findings have emerged, based on the analysis of some key trends andcharacteristics of this market. First, unlike other forms of debt, project financeloans appear to exhibit a hump-shaped term structure of credit spreads. Second,political risk and political risk guarantees have a significant impact on credit spreadsfor project finance loans in emerging economies.

These results need to be taken with some caution. In the absence of project-specific ratings, the analysis relies on a number of micro- and macroeconomic riskcharacteristics that are admittedly imperfect proxies for the credit quality ofindividual projects. Moreover, loan spreads at origination are only ex ante measuresof credit risk. In the future, the development of a secondary market for projectfinance loans would allow more light to be shed on the time profile of credit riskfor this asset class.

A deeper understanding of the risks involved in project finance and theirevolution over time is important for both practitioners and policymakers. Inparticular, further research in this area might help in the implementation ofrisk-sensitive capital requirements providing market participants with the incentives

17 See Sorge and Gadanecz (2004) for more details.


for a prudent and, at the same time, efficient allocation of resources across assetclasses. This is particularly relevant, given the predominant role of internationallyactive banks in project finance and the fundamental contribution of project financeto economic growth, especially in emerging economies.

(Marco Sorge is Economist at Bank of International Settlement. The author can bereached at [email protected]).

References

1. Esty B (2003): “The Economic Motivations for Using Project Finance”, mimeo, Harvard

Business School.

2. Hainz C and S Kleimeier (2003): “Political Risk in Syndicated Lending: Theory and EmpiricalEvidence Regarding the Use of Project Finance”, LIFE working paper 03–014, June.

3. International Energy Agency (2003): “World Energy Investment Outlook”, Paris.

4. Merton R C (1974): “On the Pricing of Corporate Debt: The Risk Structure of Interest

Rates”, Journal of Finance, 29(2), pp 449–70.

5. National Energy Policy Development Group (2001): “US National Energy Policy”,

Washington DC.

6. Sorge M and B Gadanecz (2004): “The Term Structure of Credit Spreads in Project finance”,

BIS Working Papers, no 159.

7. Wilson R (1982): “Risk Measurement of Public Projects”, in Discounting for time and risk inenergy policy, Resources for the Future, Washington DC.

107Refinancing Risk – Permutations of Project Finance Structures

Source: http://www.fitchratings.com.au/projresearchlist.asp 21 Oct, 2004. © 2004 Fitch Ratings, Ltd. Reprinted bypermission of Fitch Inc.

Increasingly, refinancing risk is creeping into the financing ofsingle revenue-generating assets, often with debt structures morecommonly associated with corporate and structured finance thantraditional or classic project finance. Refinancing risk, in someinstances, has arisen from financings that aim to avoid some ofthe restrictions commonly imposed by the terms of projectfinancings, such as stringent limits on additional debt or from theimplementation of a debt structure that finances a project that ischanging in design or scope. More frequently, refinancing riskhas resulted from the limited term or tenor available in a particulardebt market. The sources of refinancing risk and some of themitigating tools that can be employed in single-asset financing arediscussed sequentially in this report. Assets and projects with strongeconomics, that are financed subject to covenants or structuralelements have been observed to mitigate refinancing riskadequately.

9

Refinancing Risk – Permutations ofProject Finance Structures



Refinancing Risk Creeps Into Project Finance

A wide diversity of assets in a variety of economic sectors and industries worldwide—including mining, oil and gas, power, transport and public infrastructure—benefitfrom project finance techniques. Project finance structures have been successfullyemployed in the construction of facilities, the refinancing of assets in operation,the acquisition of assets through a combination of leverage and equity, or the financingof portfolios of assets. The legal structure supporting the financing of projects typicallyaims to achieve a few of the following common goals:

• Mitigate construction risk (if applicable).

• Restrict the activity of the borrower (usually, but not always, through aspecial-purpose vehicle (SPV)) to avoid diversion of funds for uses unrelatedto the functioning of the financed facility, and to protect the project againstcorporate bankruptcy and consolidation risk.

• Provide some form of security or collateral for the benefit of the lenders.

• Safeguard the project’s cash flow and liquidity, usually the only sources ofdebt repayment.

• Fully repay the debt by its final maturity, which is usually within a term thatis consistent with the useful life of the project. The project’s term of debt iscommonly constrained either by the physical characteristics of the project(power plants, upstream oil, and gas, and mining), by contractual terms(concessions, public private partnerships (PPPs), offtake agreements, etc.) orby a combination of these factors. In this respect, project finance, unlikecorporate finance, traditionally is viewed as having quite limited room toaccommodate refinancing risk, particularly at investment-grade levels.

Nevertheless, Fitch observes that, increasingly, refinancing risk is creeping intothe financing of single revenue-generating assets, often with debt structures morecommonly associated with corporate and structured finance than traditional orclassic project finance. Given the wide variety of asset types and circumstancesassociated with refinancing risk, it is impossible to generalize on the credit implicationsof these trends. Refinancing risk, in some instances, has arisen from financingsthat aim to avoid some of the restrictions commonly imposed by the terms ofproject financings, such as stringent limits on additional debt. In other instances,


refinancing risk arises from the implementation of a debt structure that financesa project that is changing in design or scope (expansion of a toll road or pipelinenetwork). More frequently, refinancing risk has resulted from the limited term ortenor available in a particular debt market.

Instead of generalizing a credit approach to refinancing risk and sentencing allprojects subject to it to either unrateable or non investment-grade status, Fitchanalyzes the effect on a project’s risk profile and determines the extent to which itwill diminish credit quality on a case-by-case basis. In some cases, refinancingrisk can be mitigated by an asset’s quality and specifications, low probability oftechnical obsolescence, strong economics and long useful life, as well as its abilityto reduce leverage prior to a needed refinancing. It can also be mitigated by certainelements adopted in the financing structure. The sources of refinancing risk andsome of the mitigating tools that can be employed in single-asset financing arediscussed sequentially in this report.

Traditional Project Finance: Monolithic?

Traditionally, projects are financed on a non-recourse basis (i.e., relying only onthe cash flows generated by the asset to meet debt-service payments without thebenefit of support from a corporate or government entity). The financing structureshave either mitigated or completely eliminated refinancing risk. In fact, afundamental characteristic of such non-recourse financing has been the avoidanceof refinancing risk altogether. Traditional project finance is, however, characterizedby certain rigidities. Due to the considerable risks inherent in the asset and thereliance solely on the asset’s cash flows for debt repayment, as well as theusual existence of substantial leverage, especially during construction or at thepoint of acquisition of an asset, traditional project finance will impose a varietyof constraints. These constraints include limits on activity, additional indebtednessand distribution of cash to the project’s owners. Dilution of some of these rigiditiesis among the factors engendering refinancing risk.

Limit on Activity, Acquisitions, Disposals and Ownership

In conventional project finance, the borrower usually undertakes to limit its activityto the construction and operation of the specific asset being financed. In addition,acquisition and disposal of assets by the borrower, or engaging in ancillary or


unrelated businesses, are usually restricted. The motivation underpinning theseconventional limitations is to safeguard the project’s cash flows, which if usedfor unrelated purposes, could erode the project’s capacity to repay its debt.

However, in some cases, expansion of activity will be permitted or even encouraged,which in turn may contribute to higher refinancing risk. This can include, for instance,additions to an existing oil pipeline or, particularly, changes in the design of governmentconcessions for public infrastructure. With more private-sector participation inthe development of public infrastructure worldwide, some of the traditional limitationsof project finance could change to fit more adequately, the characteristics of the asset,ownership or management model, as well as government concerns. To illustrate, inrecent years Chile’s public toll road concessions have evolved from fixed to variableterms, and have instituted minimum revenue-guarantee mechanisms to encouragesponsors to undertake additional capital programs for road expansions beyond theinitially specified scope. In this sense, the projects are no longer static or rigid butinstead are assets with physical characteristics that change and conform to a varyingservice scope or design. The variable nature of the projects is then reflected in thestructure of the financings, with longer amortization periods but also the option oftaking on additional debt to finance the new capital programs demanded by theconcession agreement or to refinance existing debts originally used to fund the initialconstruction. Without a strong project that benefits from access to fresh liquidityin the capital or bank markets as needed, holders of the original debt could assumeconsiderable refinancing and credit risk.

Ownership limitations tend to impede the sale or transfer of project-financedfacilities, reflecting the concerns of creditors who typically demand securityor collateral against an asset. In some cases, particularly in the oil and gas sector,the original owners must hold the asset until at least the end of theconstruction period and sometimes until the debt is fully repaid. A recent projectfinancing for Qatargas II, a new liquefied natural gas (LNG) terminal developedby a joint venture between ExxonMobil and Qatar Petroleum, was structuredwith this limitation. Although consistent with tradition and at the same time abit unusual in form, the Qatargas II limitations run contrary to the strong trendamong institutional investors toward project debt and equity investments, as wellas acquisitions, divestitures and consolidation of the physical projects or portfoliosof projects, especially in the US power sector.


Contrary to convention, specialized investment funds and other investors inexisting assets with successful operating histories, such as profitable pipelines, power plants or other projects in the United States, are designing capital structuresthat address a number of competing concerns. These concerns include complyingwith regulatory capital requirements for certain assets in the power market, enablingthe acquisition of various projects in investment portfolios under one holding entity(groups of power plants), accommodating debtholder concerns and maximizingleverage to the fullest degree possible for a targeted rating level.

In some of these cases, refinancing risk may arise. Equity investors may leveragethe asset to fund the acquisition and minimize the required cash orequity contribution to no more than 25%–30% of the acquisition cost. Thetransaction might comprise a holding company (Holdco)/operating company (Opco)capital structure so that the operating asset or project (pipeline or power plant) isowned by the Opco, a subsidiary of a special- or sole-purpose Holdco. Dependingon the amount of leverage required or desired to fund the acquisition and the effectof debt-service coverage on sustainable cash flow, tranches or classes of debt will beallocated to the Holdco and others to the Opco. Debt of the Opco will rank senior,with debtholders benefiting from a security pledge, as well as first position on cashflows from the project. However, the Opco debt might not fully amortize by thefinal maturity date, particularly when the project is regarded by the equity investors assufficiently strong, economically, to stand on its own for a relatively long period.Opco debtholders will have assumed refinancing risk, or stated another way, theywill assume that the useful life of the asset and its economic viability will enable theproject to meet financial obligations indefinitely into the future. Holdco obligations,which are structurally subordinated to the Opco debt, will usually be structured toamortize, completely or almost completely, by the maturity dates and are usuallyof shorter life than the Opco debt.

Limit on Indebtedness

In most project finance transactions, the ability of the borrower to raise additionaldebt beyond the original financing is controlled more tightly than forcorporate loans—Most projects are of a certain economic value, which will not beincreased by additional leverage (unless this debt is incurred to fund value-enhancinginvestments). At the most stringent end of the spectrum, the imposed additional debt


test or limit will impede any other indebtedness above a certain minimal amountassociated with mandated expenditures (legal or regulatory requirements)or expenditures necessary to maintain the integrity and the satisfactory operationsof the asset.

However, to facilitate additional financing, in some cases, the indebtednesslimitations will permit the borrower to raise additional pari passu senior debt,if certain financial covenants are satisfied or specific minimum ratings are achievedafter taking into account the additional debt. In other cases possessing less favorablefinancial and economic profiles, senior debt investors may not have an appetitefor the implied refinancing risk. In such cases, subordinated debt may be employedto lessen senior debt refinancing risk, thus potentially benefiting, or at least notdegrading, the credit quality at the senior level. To the extent that a default ofsubordinated debt can cause a default of the senior debt, or if the subordinateddebt is not subject to payment restrictions similar to those applicable toequity distributions (as discussed later), additional subordinated debt couldjeopardize the rating of the senior debt. Thus, proper structuring ofemployed subordinated debt is critical. (For more information on Fitch’s approachto subordinated project debt, please refer to the criteria report, “Layer It On —The Essentials of Rating Project Subordinated Debt,” dated Sept. 9, 2002, andavailable on Fitch’s Website at www.fitchratings.com).

Consistent with project finance conventions, Express Pipeline, a Canadian-USproject, is subject to a comprehensive set of restrictive covenants, which limitmanagement’s options to fund anticipated expansions to the pipeline network(Graph 1). The project’s owners (one operating sponsor and two financial investors)view the pipeline as a strong asset capable of standing on its own and requiring noadditional equity support; the ultimate financing decision for the pipeline’sexpansion thus resulted in the issuance of Holdco-level, structurally subordinateddebt. These new notes carry the option to convert into senior project-level debtranking pari passu to the original senior notes upon completion of the expansionby the end of 2005. Like the existing notes, the new notes rely on the project’scash flow (in the form of equity distribution payments from the pipeline’sOpco owner) to service debt interest. Principal is due as a bullet in 15 years. Thelegally inspired use of Holdco-level debt with a bullet maturity (unrated) satisfiedthe restrictive covenants, as the bullet repayment structure allows the project to


maintain debt-service coverage margins consistent with the ‘A–’ rating on the Opconotes and withstand periods of significant stress. The risk of refinancing thebullet maturity is expected to be modest, as it is due after the full repayment ofexisting Opco senior and subordinated notes (the latter rated ‘BBB–’). If properlymaintained, the pipeline should enjoy a long useful life, and strong demand forCanadian oil throughout North America further mitigates Holdco refinancingrisk. In sum, in Express Pipeline’s case, a traditional project finance limitation onadditional debt was successfully and sensibly overcome with a viable project andlegal structure that mitigated the refinancing risk incorporated in theexpansion’s financing.

Restricted Payments

While project finance aims to restrict diversion of cash, it usually allows paymentof equity distributions if certain tests are met. This restriction differentiates projectfinance from, for example, leverage finance, where all cash generated by the assetis often used completely for the benefit of lenders. This difference stems from thefact that equity investors in project-financed assets usually demand currentcash returns once a project achieves a steady state of operations.

Customarily, project finance transactions include restricted payment provisionscontrolling whether equity distributions (or subordinated debt payments) can bepaid. These payments are normally more tightly defined than those for corporate

Graph 1: Express Pipeline Debt-Service Schedule

Principal Payment Interest Expense($ Mil.)

120

100

80

60

40

20

0

Source: Terasen.

20032004

20052006

20072008

20092010

20112012

20132014

20152016

20172018

2019


finance and are of key interest to Fitch, especially in project acquisitions. As statedpreviously, in their quest for returns, equity investors are increasingly resortingto leverage in ways that substantially heighten the debtrefinancing risk oflong-lived projects. Therefore, Fitch pays special attention to restrictedpayment provisions, which typically include the following:

• Maintenance of certain minimum dedicated cash balances (in particular, thedebt-service reserve account (DSRA) and the maintenance reserve account(MRA)), which may not be distributed, is a standard structural element inmost project financings.

• Payment of dividends or principal and interest on subordinated debt is normallysubject to compliance with certain financial covenants, usually a minimumDSCR or a bond life coverage ratio (BLCR, also known as a “lock up”). To be ofvalue, these covenants will usually be forward looking, preventingthe distribution of dividends unless the project’s covenant threshold is reached.This was the case for AES Drax Holding, Ltd., a UK power project rated byFitch, which could not meet its subordinated debt payment from cash flowin February 2002 because, based on the market consultant’s price forecast, thecompany would be below its DSCR covenant level in future periods. This cashretention occurred 10 months before the borrower defaulted on its senior debt asa result of the default of its power offtaker, TXU Europe.

Repayment Structure as Source of Refinancing Risk

Refinancing risk can arise from the need to surpass stringent constraints in projectfinance or from the design of the project’s debt repayment structure (Graph 2).A wide variety of repayment modes can be employed in the financing of assets,including fixed amortization, indexed-linked bonds, and bullets and balloons,as well as, increasingly, debt deferral and flexible amortization structures, whichsometimes incorporate cash-sweep mechanisms. The choice of structure is drivenby the need to address competing concerns of sponsors and debtholders, as wellas the inherent nature and characteristics of the asset.

Fixed or Sculpted Amortization

Project finance assets usually have a limited life and are, therefore, generally lesscapable than corporates of withstanding refinancing risk. For this reason, many


project finance loans amortize fully according to a fixed amortization schedule inconformity with the indenture maturity date.

Typically, mining and oil projects, as well as other projects affected bycommodity-price risk, will be structured such that debt principal is fullyrepaid within the term of the debt. Lenders are keen to be repaid in full and willensure that the debt will mature well in advance of the tail end of themine’s recoverable reserves. Therefore, in properly structured mining transactions,the debt’s amortization will be front loaded, of relatively short duration and notsubjected to refinancing risk. A trade off does materialize, however, as frontloading can significantly burden a mining project’s cash flows and hinder debtrepayment capacity when substantial development or construction isrequired before revenues reach steady state. Therefore, the debt repayment profilewill often be sculpted to match the expected output production andcash generation of the project, while leaving a sufficient tail reserve after debtmaturity to cover contingencies. (Graph 3)

Indexed-Linked Bonds

The market for indexed-linked bonds has been growing rapidly in Europe in thepast few years, fueled by the growth of the PPP sector. These bonds are suitableinvestments for asset-liability matching, particularly long-dated pensionobligations. The bonds’ repayment tends to be back ended, which increases theaverage life of the bond, especially in high inflation periods. Nevertheless, this isnot necessarily a source of concern, especially when the net cash flow generated

Graph 2: Classic Repayment Debt Schedule

Outstanding Debt BalanceAnnual Principal Payment($ Mn.)

120

100

80

60

40

20

02003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017


by the project follows the bond’s amortization repayment pattern. Inaddition, indexed-linked bonds issued for PPP projects are typically fullyamortizing within the legal maturity term and are thus not significantly exposedto refinancing risk.

Bullet or Balloon Repayments

Shorter term, bullet maturity loans might be taken, with the expectation thatthe financed asset’s life will extend sufficiently beyond the maturity of thebullet loan to support a refinancing. During the 1990s, this type of financing(sometimes nicknamed “miniperm”) was popular in the US power sector. However,the ensuing deterioration of this market in the latter half of the decade highlightedthe pitfalls associated with refinancing risk. These structures are, however, backin favor in the infrastructure sector. In Spain, recent toll roads were financed bybanks with miniperm-like financing that included relatively short maturitiesbut were underpinned by long-term concessions.

Generally, a bullet1 or balloon2 structure arouses concern, as it exposes theproject to refinancing risk. Bullets or balloons can, therefore, sometimes be expected

1 Bullet - 100% of initial amount is due at maturity2 Balloon - The credit is only partially repaid during its term and presents a lumpy repayment at maturity.

Graph 3: Derby Healthcare PLC Amortization Schedule

Principal Payment Interest Expense(GBP 000)

60,000

50,000

40,000

30,000

20,000

10,000

0

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76

GBP � British pound.

Source: Derby Healthcare PLC.

Payment Periods


to have a negative effect on credit quality. However, this type of repayment structurecan achieve an investment-grade or near investment grade rating if the financedasset has a long, useful life and strong economics. This has been the case for certainAustralian and New Zealand transportation and infrastructure transactions, whichhave been backed by strong assets generating cash flows that allow for debt to bepaid or refinanced within the concession’s term while maintaining robust coveragelevels. A common characteristic of these transactions is the relatively modest sizeof the refinancing requirement or leverage relative to the availability of credit fromeither banks or bond investors in these markets; therefore, the bullet maturitiesare likely to be refinanced successfully at or prior to their due dates. Alternatively,as illustrated by the Coleto Creek project, a cash-sweep mechanism, whereby excessproject cash flows beyond what is required to satisfy certain fixed costs, are appliedto debt principal prepayments prior to the bullet payment date, can assure thatthe refinancing will be accomplished with less risk than relying simply on thetimely access to credit.

Fitch notes that recent infrastructure and PPP transactions in the UK havefully amortizing loans or bonds. However, these loans and bonds amortize over avery long period and effectively do not repay much more than a shorter bulletloan during the first 8–10 years. For instance, Derby Healthcare PLC, a UK hospitalunder a PPP, rated ‘BBB’ (unenhanced) by Fitch, pays down only 0.3% of thebond debt during the first ten years after financial close. This project benefitsfrom a 40-year concession and a predictable cash flow stream, which enables theback-ended amortization. In this respect, Fitch notes that with the smallrepayments during the first ten years, the amortization profile of the bond is notmaterially different from that of a bullet loan. Unlike a bullet structure, the projectis in fact not exposed to refinancing risk, with debt serviced from the start.

Flexible Repayment and Debt Deferral

In between the two ends of the repayment-risk spectrum (scheduled amortizationfully within the maturity term and bullet or no periodic amortization), the rangeof possible repayment structures is quite wide, limited only by the imagination ofbankers, sponsors and investors.


One example would be debt with a target and a minimum repayment profile.In this instance, flexibility is provided in the repayment structure withoutadverse consequences, as long as the project meets the minimum repaymentschedule. Such flexible repayment structures are more commonly seen in projectfinance bank loans than in bonds, as the majority of projects financed with bondstypically incorporate fixed-amortization terms, although, as noted, this is changing.

Coleto Creek WLE, LP

An illustrative case of an unorthodox repayment structure affected by refinancing risk is ColetoCreek WLE, LP (Coleto Creek). Fitch assigned a rating of �BB� to a $205 million secured term loandue 2011 (first-lien B loan) and �BB�� to a $150 million secured loan due 2012 (second-lien C loan).Coleto Creek, a project domiciled inTexas, consists of a net 632-MW generating facility comprisinga coal-fired boiler, a steam turbine with a nameplate capacity of 570 MW and ancillary facilities.Due to the design of the loan repayment structure, Coleto Creek faces refinancing risk, asscheduled principal payments are insufficient to repay the loans fully upon their respective legalmaturity dates. In fact, no principal payments are scheduled for the C loan, and payments on the Bloan are minimal, amounting to a mere $1 million annually (2005�2011). In its analysis, Fitchassumed that a realistic refinancing scenario would include the aggregate amounts due, underboth the B and C loans.

To mitigate the risk, a cash-sweep mechanism in the credit agreement provides for theprepayment, or additional principal payment, of the loans, above the scheduled amounts. Thisannual cash sweep captures 75% of excess project cash flow, which is defined as cash availableafter operating expenses, capital expenditures, interest and scheduled principal, replenishmentof a debt-service reserve and reimbursement of sponsors� income tax payments. Swept cash isfirst used to prepay the outstanding balance of the B loan. Once the B loan is fully repaid, sweptcash is applied against the principal balance of the C loan. Implicit in the Fitch base case, all ofthe scheduled and swept cash will be applied to the amortization of the B loan. The cash-sweepmechanism substantially increases the amount of actual debt repayment relative to the scheduledamounts, thus improving the credit quality of the project, as well as refinancing prospects.The outstanding balance subject to refinancing by the legal maturity date of the B loan in 2011will constitute approximately 57% of the combined issue. The non investment-grade ratingsassigned to the loans consider both the credit strengths of the project (reliable operations, lowfuel supply risk and highly competitive cost structure) and the credit concerns (refinancingrisk, merchant price risk and interest rate risk). The �BB�� rating of the C loan reflects the loan�sbalance at maturity in 2012 (original full amount, unamortized) and priority position in the cashsweep relative to the B loan. A more detailed analysis is summarized in the new issue report onColeto Creek that is dated Oct. 20, 2004, and available on Fitch�s Web site at www.fitchratings.com.Fitch anticipates that the Coleto Creek repayment structure will be employed with increasingregularity for certain power projects in the United States.


Another source of flexibility is the capacity, whether limited or not, to defersome principal repayment. The deferred principal repayment, also known as a“soft bullet”, is commonly employed in structured finance. Assets monetized inthis manner can vary widely in terms of their nature and characteristics, butmainly include financial assets (mortgages, loan portfolios and future paymentson export receivables). It is still rare to see such structures employed in the financingof projects, although the use of soft bullets has become increasingly popular tomitigate refinancing risk.

In cases where debt repayment deferral is permitted, the rating still addressesprobability of default, though not of timely payments but whether they are madeby the legal maturity date. A structure allowing for partial or full deferral of principal,will sometimes have the effect of lowering the probability of default. Consequently,such flexibility can potentially permit the project to achieve a higher rating thanwould have been achieved without the deferral feature, but only to the extent thatlenders retain adequate control over the cash generated by the asset and refinancingrisk is minimized. To illustrate, Fitch rated the various tranches of the refinancing ofTube Lines (Finance) PLC (Tube Lines), a company managing one-third of theLondon Underground infrastructure under a PPP contract with Transport for London.In all of the 20 sensitivity tests prepared, the investment-grade rated tranches willbe fully repaid before final maturity. In the most severe case, however, the DSCRwill fall below 1.0 times (x) on the ‘BBB–’ tranche in two periods. This suggeststhat the SPV would have to draw on cash reserves (which are expected to be morethan adequate due to the implementation of the cash lock-up provision) or defer apayment during those periods. In these circumstances, the capacity to defer apayment reduces the risk of default on that tranche.

A key consideration in the Tube Lines case, which is consistent with Fitch’sapproach to US toll roads and other long-lived projects (for example, the PocahontasParkway in Virginia), is the availability of an amply funded reserve. FromFitch’s perspective, draws on a liquidity and debt-service reserve for short-termneeds do not necessarily preclude an investment-grade rating, provided that fulldepletion of the reserves at any time during the debt’s life is highly improbableand the ability to replenish the reserves in a timely manner can be demonstrated.In fact, the reverse might be the case—a reserve for liquidity can shield againstnot only downgrades but also refinancing risk.


While a flexible amortization profile can lower the probability of default, itcan negatively affect debt recovery to the extent that lenders do notretain appropriate control. To mitigate this, such flexibility is more suitable whenaccompanied by cash lock-up provisions, and the ability to accelerate amortization ifforward-looking DSCRs fall below certain levels. In Fitch’s opinion, investment-grade transactions are likely to have only limited deferral capacity. If there is nolimit in the number of times that the deferral can take place (or in the cumulativedeferral amount), then the amortizing structure, if misused, can effectively becomea bullet structure, exposing the project to unmitigated refinancing risk.

Graph 4: Coleto Creek Debt-Repayment Profile

Cash-Sweep AmortizationTerm Loan C1212Term Loan B

($ Mil.)400350300350200150100

500

20042005

20062007

20082009

2010

Source: Coleto Creek WLE, LP.

2011

12341234123412341234123412341234

12341234123412341234123412341234

1234123412341234123412341234

123412341234123412341234

1234512345123451234512345

1234123412341234

123412341234

123412341234

Benefits of Traditional Project Finance Structures

As outlined in this report, the risk of refinancing project obligations may arisefrom a variety of sources, including the structural limitations imposed by traditionalproject finance, as well as debt repayment profiles adopted for assetswith characteristics that may or may not be in conflict with them. Fitch continuesto look favorably upon restrictive covenants that traditionally conform to projectfinance. Assets and projects with strong economics that are financed subject tocovenants or structural elements, such as the following, have been observed tomitigate refinancing risk adequately:

• A cash flow lock up, which effectively causes cash to be retained in theproject’s SPV for the benefit of lenders, is obviously positive.


• Fitch’s ratings, especially at the lower ‘BBB’ level and below, reflect an assessmentof the probability of default and, sometimes, take into account the potentialfor loss upon default. Fitch views tight covenants as providing early warningsfor the lenders of any deterioration in the project’s creditworthiness, therebyallowing for corrective actions (including retention of cash) at an earlier stage.In this respect, tighter covenants can enhance recovery prospects.

Lane Cove Tunnel Finance Pty Ltd.

The Lane Cove Tunnel project (the project) illustrates a repayment structure affected by refinancingrisk, which is more commonly assumed by investors in Australia and New Zealand than in NorthAmerica or other highly developed project finance markets. Fitch assigned a �BBB�� rating to thestandalone credit quality of the bonds (and �AAA� with the guarantee provided by MBIA InsuranceCorp.). Lane Cove Tunnel Finance Pty Ltd. (LCTF), the issuer, is a special-purpose finance company of aconsortium contracted by the New South Wales Roads and Traffic Authority to design, build, operateand maintain the project. The tunnel is an integral link in Sydney�s orbital motorway network.

The project�s debt comprises senior secured bonds issued, to date, in four tranches rangingin terms from 10�25 years for a total of AUD690.83 million. A fifth tranche for AUD451.2 millionis expected to be issued by December 2004. The LCTF financing structure incorporates theexpectation of a significant degree of refinancing, with bullet repayments on all bonds (exceptbond 1 for AUD126.83 million).

The risk of refinancing these bullet payments is partly mitigated by the reasonablywell-spread maturity profile of the bonds and also by a soft bullet structure, which provides for atwo-year extension to the final maturity. On bond 3 (for AUD191.76 million) and bond 4 (forAUD259.44 million), a call option also provides a four-year period of flexibility to refinance amajor portion of the debt due. Further, the LCTF consortium is obligated to commence therefinancing arrangements of maturing obligations at least 12 months prior to scheduledmaturity, and penalties are imposed on the consortium for refinancing after scheduled maturity.

In its analysis, Fitch undertook a wide variety of sensitivity tests to determine the project�sability to withstand the effect of certain stresses. Important structural elements supporting thefinancing are reserve accounts for liquidity that are to be drawn upon under stress. A cash-trap orlock-up provision also helps to ensure that the project maintains liquidity and the ability toeffectively deliver (on a net basis) in periods of lower debt-service margins. Therefore, in spite ofthe refinancing risk, Fitch concludes that the project�s financing structure possesses adequatecapacity for timely payment of interest and principal on the bonds.

Fitch�s �BBB�� rating balances the project�s credit strengths and concerns. Among the strengthsare the characteristics of the transport corridor served by the tunnel and its effect on timesavings; low traffic risk, as the existing road link is well known; strong counterparties; and thestructural enhancements in the financing, including cash reserves and cash-trap provisions. Amongthe credit concerns are refinancing risk (mitigated by the soft bullet maturity structure), highleverage and construction risk. A more detailed analysis is summarized in the credit analysis onthis project dated Jan. 30, 2004, and available on Fitch�s Website at www.fitchratings.com.


In Fitch’s view, traditional covenants that may seem severely restrictive in certainsituations provide valuable signals and control for creditors. However, it is notnecessarily the case, that tight covenants will automatically improve the rating.The documentation should be carefully tailored to each specific situation.

Fitch acknowledges the trade offs and tensions generated by sponsor or projectowner motivations and interests, commodity market conditions, changes in assetspecifications or scope, economic environment and availability of long-termfinancing at reasonable cost, among other variables. In addressing thesewide-ranging concerns, which may engender refinancing risk, a variety ofrepayment and other structural elements, may be considered such as the following:

• Front-loading amortization in the early years, increasing default probabilitybut also improving recovery prospects—This is a sensible approach for miningand other resourcerelated projects, as well as power plants. Alternatively, acash sweep can be used to ensure timely repayment of the debt withoutincreasing probability of default.

• Back-loading amortization, decreasing default probability versus increasingdebt costs—Toll roads, which are affected by the uncertainties of trafficflows in the early years but have long economic lives and a growing revenuestream, might benefit from this repayment structure.

• Providing for soft bullet maturities—This approach is analogous to therepayment models of structured finance. Limited deferral of debt principal canbe an effective tool to providing financial flexibility withoutexacerbating refinancing risk, as was the case of Tube Lines with the lowestrated tranche, rated ‘BBB–’. In some cases, Fitch might require the availability ofa fully funded cash reserve in order to achieve investment-grade ratings targets.

• Tranching bullet payments—Instead of one large bullet maturity, smallerpayments fall under various maturity buckets, limiting refinancing risk inany one year. In Australia’s Transurban and Lane Cove Tunnel projects, thiselement is employed, making refinancing risk more manageable.

• Diversifying source of financing—Refinancing risk, especially inmarkets vulnerable to a credit crunch or in which longterm maturities are notavailable, a combination of bank loans, bonds fully enhanced orwrapped, unenhanced bonds, and domestic and international credit, among


other sources, can mitigate credit and refinancing risk. For Chile’s 30-year tollroad projects, a combination of financing sources is relied upon tolimit refinancing and credit risk.

• Providing for mandatory prepayment and forward-looking cash lock upThese mechanisms, if implemented properly, can effectively deliver a projecton a net-debt basis (especially where performance is below the base), andthe build up of cash can be used to reduce the level of debt to be refinancedand, hence, reduce refinancing risks.

• Providing for a cash-sweep mechanism—The likelihood that a bullet orsubstantial principal payment is due before the project’s cash flow has fullyamortized the debt, constitutes a refinancing risk. A viable mitigating mechanismis a cash sweep, through which excess project cash flow is applied periodicallyto the prepayment, or more rapid amortization of principal than provided for inthe credit agreement schedule (as with the Coleto Creek project).

• Employing callable debt—At the issuer’s option, the project’s debt would becalled, allowing for a refinancing at a date favorable to the project. Callablebonds and bank loans are commonly employed for Australian projects.

• Limiting the size of the bullet payment—Express Pipeline is expected tosuccessfully refinance the Holdco bullet debt, as the bullet payment is dueafter the initial project debt is fully repaid. The pipeline also enjoys along economic life and access to both the Canadian and US debt markets.

Ostensibly, finding the most suitable repayment structure remains somewhat ofa trial-and-error and evolutionary process. The choice of financing mode for a specificproject is often as much driven by investors’ concerns and preferences andmarket conventions as it is by the project’s intrinsic risk profile. From Fitch’s viewpoint,acceptable flexibility in the repayment structure can have a beneficial effect on projectcredit quality, assuming that creditors, as provided for by indentures, remainin control of the asset and the cash flow it generates.

(Fitch Ratings is a leading global rating agency committed to providing the world’scredit markets with accurate, timely and prospective credit opinions.)


The standard advice on allocating risk—to assign it to the party best able tomanage it—has controversial implications for the allocation of exchange rate

risk in a private infrastructure project. Three parties can bear the risk of exchangerate movements in the first instance—the private investors (whether foreign orlocal equity-holders or creditors), the host country government (ultimately, itstaxpayers), and customers of the service. Some argue that investors—or at leasttheir ultimate shareholders—should bear the risk because they can diversify awaycountry-specific exchange rate risk. Others argue that the government should bear

Source: http://rru.worldbank.org/PublicPolicyJournal/Summary.aspx?id=262. © 2003, World Bank publication.Reprinted with permission

Exchange Rate Risk

Philip Gray and Timothy Irwin

10

Each year developing countries seek billions of dollars ofinvestment in their infrastructure, and private investors, mostlyin rich countries, seek places to invest trillions of dollars of newsavings. Private foreign investment in the infrastructure ofdeveloping countries would seem to hold great promise. But foreigninvestors must cope with volatile developing country currencies.Many attempts to do so have created as many problems as theyhave solved. This Note proposes that investors take on allfinancing-related exchange rate risk, even though this may meanhigher tariffs for consumers as a premium for bearing that risk.

125Exchange Rate Risk

the risk because it is responsible for macroeconomic policies that strongly influencethe exchange rate. Still others argue that customers should bear it because theymust ultimately pay for the cost of the service and the risk can be shared widelyto lessen the impact.

The allocation of exchange rate risk is often done through tariff adjustmentformulas that implicitly share risk through the way they adjust the tariff overtime. If indexation is allowed, tariffs can reflect the exchange rate in several ways:

• Allowed prices or revenue can be fully or partially indexed to the exchange rate.

• Input costs that depend on the exchange rate can be treated as a pass-through,so that customers pay the actual costs of the inputs.

• The contract can provide for a renegotiation of allowed prices or revenue ifthe exchange rate moves outside a specified band.

At one extreme of the risk sharing spectrum, Argentina effectively indexed100 percent of costs to the dollar. The implications of this are now being foughtout by the investors and the Argentine government, which has prevented significanttariff increases since the devaluation of the Argentine peso. Most countries usea hybrid approach to tariff adjustment. Part of the tariff is indexed to local inflation,part is indexed to dollar inflation, and some costs are straight pass-throughs. Butthere is still much debate about what share of the cost base should be indexed tolocal inflation and what share to international costs. And tariff adjustmentmechanisms are not the only approach—governments sometimes provide exchangerate guarantees to cover repayment of foreign currency debt.

Nature and Sources of Exchange Rate Risk

To shed more light on the debate requires first looking more closely at the natureand sources of the risk. Exchange rate risk, as defined here, is variability in thevalue of a project, or of an interest in the project, that results fromunpredictable variation in the exchange rate.

There are two types of exchange rate risk—project and financing related. Projectexchange rate risk arises when the value of a project’s inputs or outputs dependson the exchange rate. Typical infrastructure projects sell their outputs domestically,


so, valued in local currency, revenues usually are not subject to exchange rate risk.But any input that is tradable, even if it is not imported, will have a world price,so its cost, measured in local currency, will vary inversely with the exchange rate.The cost of fuel, for example, creates exchange rate risk for a thermal electricitygenerator.

Financing choices affect the amount of exchange rate risk borne by differentparticipants in the project (shareholders, creditors, customers, taxpayers). In particular,loans requiring repayment in foreign currency expose shareholders to exchange raterisk. As a result, shareholders may seek to shape the contractual arrangements to passon some or all of the risk to the government or customers (through exchange rateguarantees or indexation of the tariff to the exchange rate).

Optimal Allocation of Exchange Rate Risk

Parties can manage exchange rate risk in three ways:

• They can influence the underlying source of the risk. Governments, forexample, can reduce the rate of depreciation and the volatility of the exchangerate by keeping budget deficits small and inflation low.

• They can influence the sensitivity of the value of a project or of their interestin it to the risk. Project sponsors, for example, can reduce the sensitivity ofthe value of their shareholding to the exchange rate by reducing the project’sreliance on foreign currency debt.

• They can hedge or diversify away the risk. Hedging exchange rate risks ispossible in only a few developing countries. But most of the ultimate foreignshareholders of the project company—individuals with savings inmutual funds, pension plans, and life insurance—can diversify their savings,limiting their exposure to any one country’s exchange rate risk (as defined).

The principle of optimal allocation can therefore be restated as follows—Exchange rate risk should be allocated according to the parties’ ability and incentivesto influence the exchange rate, change the sensitivity of the value of the project (orof their interest in it) to the exchange rate, and hedge or diversify away the risk.Since the principle involves three types of management, its implications are notclear cut (Table 1).


The government’s influence over the exchange rate is one factor that, otherthings equal, argues in favor of allocating project and financing-related exchangerate risk to the government. But this argument should not carry too much weight.Allocating the risk to the government is unlikely to improve the quality ofits decisions affecting the exchange rate—both because the relationship betweenthe exchange rate and the government’s financial position is affected in complexways by many factors unrelated to the project and because governments do notrespond to financial incentives in the same way as firms and individuals do.

If the government does not assume the exchange rate risk, the risk must beshared between customers and investors (shareholders). Neither can influence theexchange rate, so the choice turns on the other two factors.

First, consider project exchange rate risk. Customers can sometimes influencethe sensitivity of a project’s value to the exchange rate by changing their consumptionlevels in response to changes in the cost of tradable inputs. When the cost of fuel

Customers Shareholders Government

Project Risk

Influence over exchange rate None None Great

Influence over sensitivity of Limited, but can Limited, but can Little

project to exchange rate change consumption sometimes changein response to changes inputs in responsein the cost of tradable to changes in theinputs cost of tradable

inputs

Ability to cope with risk by Little Great (through Little hedging or diversification diversification)

Financing-related Risk Influence over exchange rate None None Great

Influence over sensitivity of None Great (throughvalue of investors� interest in choice of financial Nonecompany to exchange rate structure)

Ability to cope with risk by Little Great (through Littlehedging or diversification diversification)

Table 1: Ability of Customers, Shareholders,and Government to Manage Exchange Rate Risk


rises as the exchange rate depreciates, customers may be able to mitigate the adverseeffect on a power project’s value by cutting their electricity consumption.In other cases, investors may be better placed to mitigate project exchange rate risk.For example, they may be able to change the mix of inputs (using more hydro andless thermal power) to soften the effect of depreciation. Shareholders are also betterplaced than customers to diversify away or hedge exchange rate risk—because oftheir ability to diversify risk in equity markets and, in a few developing countries, tohedge risk using exchange rate derivatives.

This suggests that project exchange rate risk should be shared between investorsand customers according to their ability to respond in value-enhancing ways tochanges in the exchange rate—erring toward investors, given their greater abilityto hedge or diversify away the risk. For many infrastructure projects, however,project exchange rate risk is small. Financing-related exchange rate risk tends toloom much larger. Should investors or customers bear this risk?

Customers are in a poor position to manage the risk because they have no influenceover the sensitivity of the value of shareholders’ interest in the project, to the exchangerate (they have no control over whether the investors decide to use financing thatcreates exchange rate risk). Moreover, most customers have no good natural hedgesagainst the risk of currency fluctuations—and in most developing countries norealistic opportunities to acquire hedges or diversify away the risk. Indeed, becauseexchange rates tend to fall during macroeconomic crises, their ability to pay highertariffs is likely to be lowest just when the exchange rate has fallen.

Investors, however, choose financing and thus control the extent of financing-related exchange rate risk; and their ultimate shareholders are well placed to diversifyaway much of the risk they choose to take on.

Implications for Prices and Financing

Although investors should generally face some project and all financing-relatedexchange rate risk, they still need to be able to recoup their costs and make areturn that is reasonable, given the risks they take. Not protecting investors fromexchange rate risk may well imply higher tariffs. Moreover, if tariffs are not linkedto the exchange rate, they need to be linked to an index of local inflation, possiblyadjusted to reflect the cost of inputs more closely. For example, an electricity utility’s


tariffs might be linked to an index, in which the price of fuel has greater weightthan in the consumer price index. Over the long-term, the effect on prices will besimilar whether tariffs are linked to local inflation or to the exchange rate (see thecompanion Note). But with a link to local inflation, currency crises will tend notto cause such immediate, politically perilous price increases.

What are the implications for financing if neither the host country governmentnor customers, protect foreign investors from financing-related exchange rate risk?Unless the government provides explicit subsidies in place of the implicit subsidieswhere taxpayers or customers bear the exchange rate risk:

• Projects may be able to raise less financing, with shorter terms and higherinitial rates.

• Traditional project finance deals, with dollar-denominated debt financinga large share of the project cost, may be less feasible, leading to greater useof local currency debt and local and foreign equity and therefore higherinitial rates of return and higher project prices.

• In East Asian and other countries with high savings rates, the prospects forraising more local equity and debt for infrastructure seem promising. Elsewhere,progress will take longer. But governments can help by facilitating thedevelopment of local capital markets and contractual savings institutions, suchas pension funds and insurance companies—by ensuring that tariff formulasdo not implicitly discourage local currency financing.

While foreign debt financing will be scarcer, innovative financing structuresoffer solutions. The Tietê project in Brazil illustrates one approach to mitigatinginvestors’ exposure to financing-related exchange rate risk. To finance the generatingfacilities, AES (the US parent company of the operator, AES Tietê) issued US$300million in US dollar bonds with an average maturity of ten years, at rates less thanthose paid by the Brazilian government for debt of an equivalent maturity. Theproject sells power at prices indexed to local inflation with no provision for changesin the exchange rate. If the exchange rate declines substantially and AES Tietê hasinsufficient cash to pay its debt service, however, it may draw on a US$30 millionliquidity facility (revolving loan) provided by the US Overseas Private InvestmentCorporation. Once local inflation has caught up with the exchange rate reduction,


AES Tietê will repay the advances from cash that would otherwise have gone toshareholders.

Conclusion

Despite the drawbacks of high levels of foreign currency debt, the argument forforeign capital remains. Developing countries need investment in infrastructure,and local debt and equity investors may well be unable to meet all the costs of theinvestment efficiently. The problem with many deals is the mix of foreign capital—many projects have too much dollar-denominated debt, which drives the demandfor allocating exchange rate risk to governments and consumers. While allocatingthe risk this way keeps the initial financing costs low, it risks a blowup in thelonger term. Reducing reliance on foreign debt may mean that the volumes ofprivate finance mobilized in the 1990s for greenfield projects and privatizationsin developing countries will not be forthcoming—and that the initial costs offinance will be higher. But the benefits may be longer-lived, and more robustinvestments that can weather the vagaries of emerging markets.

(Philip Gray ([email protected]) is a senior private sector development specialist,and Timothy Irwin ([email protected]) a senior economist, at the World Bank.)

NoteThis Note is a companion to Philip Gray and Timothy Irwin, “Exchange Rate Risk: Reviewing the Record

for Private Infrastructure Contracts”, Viewpoint 262 (World Bank, Private Sector and Infrastructure

Network, Washington, DC, 2003). For different perspectives on the issue, see Ignacio Mas, ”Managing

Exchange Rate–and Interest Rate–Related Project Exposure: Are Guarantees Worth the Risk?” in Timothy

Irwin, Michael Klein, Guillermo E Perry, and Mateen Thobani, eds., Dealing with Public Risk in

Private Infrastructure, Latin American and Caribbean Studies Viewpoint (Washington, DC: World Bank,

1997); and Joe Wright, Tomoko Matsukawa, and Robert Sheppard, ”Foreign Exchange Risk Mitigation

for Power and Water Projects in Developing Countries,” Energy and Mining and Water and Sanitation

Sector Boards Discussion Paper (World Bank, Washington, DC, 2003).

131Contingent Liabilities for Infrastructure...

Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/148mody.pdf. © World Bank publication. Reprintedwith permission. This Note is based on a longer paper by the authors in Timothy Irwin, Michael Klein, GuillermoE Perry, and Mateen Thobani, eds., Dealing with Public Risk in Private Infrastructure (Latin American andCaribbean Studies, Washington, D.C.: World Bank, 1998).

11

Contingent Liabilities for InfrastructureProjects: Implementing a Risk

Management Framework for Governments

Christopher M Lewis and Ashoka Mody

To manage their exposure arising from guarantees toinfrastructure projects, governments need to adopt modern riskmanagement techniques. As guarantees come due only if particularevents occur and involve no immediate cost to the government,they rarely appear in the government accounts or have fundsbudgeted to cover them. This Note introduces an integrated riskmanagement system that draws on recent advances in the privatesector. The system, adapted for use in the public sector, enablesgovernments to budget for expected losses and to set aside reservesagainst unexpected losses, thus avoiding the budgetary stressassociated with redirecting scarce public resources to cover asudden increase in costs.


Over the past several years many large multinational firms, including Bankers Trust, Chase Manhattan, and Microsoft, have implemented enterprisewide

systems for risk management. For each risk identified as important, these firmsdetermine the best approach for improving their management of exposure, whetherby insuring, transferring, mitigating, or retaining the risk. The goal is not just tohedge a fixed set of risk exposures, but to determine the areas and lines of businessin which a company is willing to retain risks in order to generate target returns.

Adapted to the public sector environment—and customized to reflect thegovernment’s budgetary and regulatory processes, the legislative and legalenvironments, and the risks being evaluated—this approach can be used to managea government’s exposure to risk, particularly contingent liability risk. The modelbroadly involves six steps:

• Identifying the government’s risk exposures.

• Measuring or quantifying expected and unexpected exposures.

• Provisioning for expected costs in the budgetary process.

• Assessing the government’s tolerance for bearing risk.

• Using the government’s risk tolerance as a basis for establishing policiesand procedures for structuring reserves against unexpected losses.

• Implementing risk mitigation and control mechanisms to prevent unintendedlosses on those risks and establishing systems to continually monitor andreassess the government’s risk exposure over time.

As in the private sector, these steps should be applied to four general categoriesof risk—financial, operational, business, and event risk.

Measuring Risk

A government’s exposure to loss can arise from a wide variety of events, and attemptingto account for every source of exposure is not feasible. A better approach, and thatfollowed in the private sector model, is to first examine general categories of risk andthen focus on the areas of highest risk (see Figure 1 for a lattice of generic risks). Thenext step is to value the expected and unexpected losses (see Box 1 for a definition ofexpected and unexpected losses). The valuation techniques used will depend on the


type of risk being analyzed and the data available. Actuarial and econometric modelscan be used to estimate exposures, but both techniques require substantial data onthe performance of a program (or on a comparable program). For project finance,where deals are unique and data records often missing or of low quality, more advancedmodeling approaches are required. The most powerful are those commonly used tovalue options in financial markets; these can be applied to value direct loans, loanguarantees, and insurance contracts granted to support infrastructure liabilities.

Budgeting for Expected Costs

Armed with a measure of risk exposure for expected costs, a government can usethe information as a budgetary control mechanism and work out how to improvethe budgetary process to provide stronger incentives for risk management. Thegovernment could publish its risk exposure in the national budget, use it toestablish exposure limits or credit limits, or use it to develop risk-adjustedperformance measures. (Such measures could be applied to reward programs thatdeliver social benefits with the least risk to the public budget.)

The main impediment to implementing these options is the cash budgetaccounting system used by most governments. While private institutions computevirtually all investment decisions, expenditures, plans, and budget forecasts on apresent value basis, most government bodies account for credit and insuranceproducts using a simple cash-based system of budgeting. Cash-based budgetingmisrepresents and masks the aggregate exposure associated with loan guarantees and

Government Risk Exposure

Financial Risk Business Risk Opurational Risk Event Risk

Market Risk Strategic Risk Production Risk Political Risk

Liquidity Risk Management Risk Legal Risk Exogenous Risk

Credit Risk System Risk

Figure 1: Risk Identification Lattice


government insurance programs, and creates perverse incentives for selecting one formof financing assistance over another. To see how these incentives skewdecision-making, consider the different ways in which a government could helpfinance a US$100 loan to a private infrastructure provider. If the government providesa ten percent loan subsidy, the cash budget cost would be US$10 in year one. Ifit provides the loan directly, the cash budget cost in year one would be US$100—the full face value of the loan. And if it agrees to guarantee a loan by a private bank,the budgetary cost would be zero (or negative if a guarantee fee is collected) in thefirst year. Thus while the economic and financial values of the three forms offinancial assistance are equal, a legislative body would favor the guarantee option.Only by enforcing budgetary controls at the time the financial assistance iscommitted, can the budgetary incentives be realigned to eliminate this effect.

Many governments face significant legal, regulatory, and political hurdles inmoving from current budgetary practices to a full accounting of the risks ofcontingent liabilities. Often governments prefer incremental changes or interimsteps to smooth the transition. Implementing risk-adjusted performance measuresallows governments to manage their exposures to contingent liabilities, even if animmediate change in national budgetary policy is not feasible. Nonbudgetary

Box 1: Defining Expected and Unexpected Losses

Consider a government loan guarantee program Probability Exposure

characterized by the following very simple (Percent) (millions of US dollars)

Probability distribution. While the expected 5 0

costs of the program (the mean of the 5 2

distribution) are US$10, losses 15 5

will exceed this expectation 15 8

35 percent of the time. That means that if the 25 10

government sets reserves only to cover expected 15 12

losses, it will have to request outcomes of the 5 14

guarantee. For a portfolio of thirty similar 5 16

programs and with five-year guarantees, the 5 18

central government would have to go to the 2.5 20

legislature twice a year for additional funds. 2.5 30


control mechanisms for contingent liabilities (publishing information, establishingcredit quotas or exposure limits, and earmarking future funds to cover guaranteecosts) also could be used during a transition to a new budgetary system. Andthey could be used on a permanent basis for liabilities grandfathered during achange in budgetary policy or as a permanent management solution if thegovernment fails to enact a change in the budget law.

Reserving for Unexpected Costs

In addition to budgeting for the full expected present value of costs, governmentsneed to set aside reserves against unexpected losses. For a private firm with multiplelines of business, determining the appropriate level of capital or reserves is a complexprocedure that takes into account both the variability of losses for each product lineand the correlation between product returns and the opportunity cost of capital.

A private firm must also weigh the expectations of shareholders and stakeholders,rating agencies, and business partners in determining the optimal level of capital.The capital or reserves held by an enterprise reflect its relative risk aversion and itsability to withstand a specific level of unexpected losses. Thus, a firm seeking aAAA rating will hold considerably more capital against unexpected losses(say, capital to cover a 99 percentile event over a one-year period), than a firmseeking an A rating (capital to cover a 90 percentile event).

Similar pressures come into play in assessing government tolerance for risk.But the assessment must also consider the unique question of how often theexecutive wants to go to the legislature for funds. Once the proper valuationtools are in place, the government can set reserve policy, based on an assessmentof its aversion to making frequent funding requests. The government’s leverageconsiderations will also be different from those in the private sector. Holding morefunds in reserve increases the liquidity of the guarantees that the reserve supports,increasing their value and allowing the government to leverage more privatefunding in the guarantee program. But, reserving funds in a separateaccount reduces the money available for other public sector projects and services.If the net benefits of additional public spending exceed the liquidity benefits ofadding to the guarantee reserve, the government may want to directadditional funds toward public spending.1


Setting Reserves

Having assessed which risks and what level of loss it is willing to bear, thegovernment can set its reserves against unexpected losses (“risk capital”) in itscredit and insurance programs. But first, it needs to determine whether reserveswill be set based on the additive unexpected loss exposure of each guarantee or ona portfolio value-at-risk approach to account for portfolio diversification, whatthe investment policy of the reserves will be, and where the reserves should reside.

Under an additive reserve standard, the government calculates the unexpectedloss exposure of each of its contingent liabilities independently (that is, examinesthe sensitivity of each guarantee valuation to changes in the underlying factors).Then, for a given confidence level and time interval, it determines the amountof unexpected loss it wishes to cover for each guarantee, taking into considerationthe opportunity cost of capital. It then identifies the average cash reserve requiredto fund these unexpected losses. Finally, it aggregates the individual cash reservebalances to arrive at a total unexpected loss reserve.

The problem with the additive approach is that it fails to account for portfoliodiversification— the fact that pooling imperfectly correlated risks will reduce thevariance in the expected loss of a portfolio. As a result the risk of the overall portfoliowill be overstated, and more protection against unexpected losses providedthan originally sought by the government. The alternative is to calculate the aggregateloss distribution of the government’s portfolio of risks, using a value-at-risk approachthat incorporates cross-correlations between guarantee exposures, and then set reservesto cover unexpected losses based on the unexpected loss profile of the entire portfolio.

Investing Reserves

The objective in investing the reserve funds should be to maximize the value of theassets when the costs to the government increase— that is, to invest the reservefunds in assets that provide the best hedge against the government’s cost for a givenreturn. In doing this, the government may achieve better results by managing itsassets and liabilities at the balance sheet level rather than on a program basis.

The government also needs to decide whether to hold its reserves offshore, ina foreign currency, or domestically, in the domestic currency. If the guarantees


are denominated in dollars, the government should consider investing the reservefund in dollar assets and possibly keep the reserve offshore to circumventconvertibility risk issues. This strategy would greatly enhance the market value ofthe guarantees and provide the government with greater leverage from the guaranteeprogram. However, decisions on the location of the reserves must be made in thecontext of the government’s broader foreign currency risk management program.

Next Step

This approach to risk management also provides a mechanism for governments tocritically assess the distribution of risks within a loan guarantee or insuranceprogram and come up with better designed contracts and fewer and smaller callson guarantees. And as risks change over time, the framework provides a basis foreasy reestimation and quick adjustments to the budgetary and reserve system.

(Christopher M Lewis is Managing Director of Fitch Risk Advisory, a division ofFitch Risk. Ashoka Mody ([email protected]) is Project Finance and GuaranteesDepartment, World Bank.)

Endnote

1 When a private company assesses the tradeoff between holding reserves and investing in other

programs, it usually has a targeted economic return that helps guide its capital policy. For a

government the comparable concept is social return. Calculating social return requires a complete

asset-liability management program that goes beyond the valuation of infrastructure liabilities or

other forms of direct loans, loan guarantees, and insurance. This Note focuses on reserving against

contingent liabilities without considering a broader asset-liability management policy.

139The Syndicated Loan Market: Structure, Development and Implications

Section IV

Financing Projects


Source: http://www.bis.org/publ/qtrpdf/r_qt0412g.pdf. December 2004. © BIS Quarterly Review. Reprinted withpermission. The full publication is available free of cost on the BIS website.

12

The Syndicated Loan Market: Structure,Development and Implications1

Blaise Gadanecz

This special feature has presented a historical review of thedevelopment of the market for syndicated loans, and has shownhow this type of lending, which started essentially as a sovereignbusiness in the 1970s, evolved over the 1990s to become one of themain sources of funding for corporate borrowers. The syndicatedloan market has advantages for junior and senior lenders. Itprovides an opportunity to senior banks to earn fees from theirexpertise in risk origination and manage their balance sheetexposures. It allows junior lenders to acquire new exposures withoutincurring screening costs in countries or sectors where they maynot have the required expertise or established presence. Primaryloan syndications and the associated secondary market thereforeallow a more efficient geographical and institutional sharing ofrisk origination and risk-taking.

1 The views expressed in this article are those of the author and do not necessarily reflect those of the BIS. I would liketo thank Claudio Borio, Már Gudmundsson, Eli Remolona and Kostas Tsatsaronis for their comments, Denis Pêtre forhelp with database programming, and Angelika Donaubauer for excellent research assistance.


The syndicated loan market allows a more efficient geographical and institutional sharing of risk. Large US and European banks originate loans for emerging

market borrowers and allocate them to local banks. Euro area banks have expandedpan-European lending and have found funding outside the euro area.

Syndicated loans are credits granted by a group of banks to a borrower. Theyare hybrid instruments combining features of relationship lending and publiclytraded debt. They allow the sharing of credit risk between various financialinstitutions without the disclosure and marketing burden that bond issuers face.Syndicated credits are a very significant source of international financing, withsignings of international syndicated loan facilities accounting for no less than athird of all international financing, including bond, commercial paper and equityissues (Graph 1).

This special feature presents a historical review of the development of thisincreasingly global market and describes its functioning, focusing on participants,pricing mechanisms, primary origination and secondary trading. It also gauges itsdegree of geographical integration. We find that large US and European bankstend to originate loans for emerging market borrowers and allocate them to localbanks. Euro area banks seem to have expanded pan-European lending and havefound funding outside the euro area.

Development of the Market

The evolution of syndicated lending can be divided into three phases. Creditsyndications first developed in the 1970s as a sovereign business. On the eve ofthe sovereign default by Mexico in 1982, most of developing countries’ debtconsisted of syndicated loans. The payment difficulties experienced by manyemerging market borrowers in the 1980s resulted in the restructuring of Mexicandebt into Brady bonds in 1989. That conversion process catalysed a shift in patternsfor emerging market borrowers towards bond financing, resulting in a contractionin syndicated lending business. Since the early 1990s, however, the market forsyndicated credits has experienced a revival and has progressively become thebiggest corporate finance market in the United States. It was also the largest sourceof underwriting revenue for lenders in the late 1990s (Madan et al., 1999).


The first phase of expansion began in the 1970s. Between 1971 and 1982,medium-term syndicated loans were widely used to channel foreign capital to thedeveloping countries of Africa, Asia and especially Latin America. Syndicationallowed smaller financial institutions to acquire emerging market exposure withouthaving to establish a local presence. Syndicated lending to emerging marketborrowers grew from small amounts in the early 1970s to $46 billion in 1982,steadily displacing bilateral lending.

Graph 1: Syndicated lending since the 1980sGross signings, in billions of US dollars

Total1 International

1212121212

12121212

121212121

12121212121212

1111

111112

1212121212121212

1212121212

121212121212121

11111111111

1212121212

11111111

12121212121212121212

121212121212

12121212121212121

11111111111

1212121212121212

1111111111112

121212121212121212121212121212

12121212121212121212

121212121212121212121212

11

11111111111111

12121212121212121212

11111111111111111

12121212121212121212121212

1212121212121212121212

121212121212121212121212121212

1111111111111

1212121212121212121212121212

1212121212121212121212121212121212121212

1,500

1,000

500

086 90 94 98 02 94 96 98 00 02

3,000

2,000

1,000

0

1 Of international and domestic syndicated credit facilities.

Sources: Dealogic Loanware; Euromoney; BIS.

Syndicated creditsMoney market instrumentsBonds and notesEquities

1212

1212111212

Lending came to an abrupt halt in August 1982, after Mexico suspendedinterest payments on its sovereign debt, soon followed by other countries includingBrazil, Argentina, Venezuela and the Philippines. Lending volumes reached theirlowest point at $9 billion in 1985. In 1987, Citibank wrote down a large proportionof its emerging market loans and several large US banks followed suit. That movecatalysed the negotiation of a plan, initiated by US Treasury Secretary NicholasBrady, which resulted in creditors exchanging their emerging market syndicatedloans for Brady bonds, eponymous debt securities whose interest payments andprincipal benefited from varying degrees of collateralisation on US Treasuries.

The Brady plan provided a new impetus to the syndicated loan market. By thebeginning of the 1990s, banks, which had suffered severe losses in the debt crisis,


started applying more sophisticated risk pricing to syndicated lending (relying inpart on techniques initially developed in the corporate bond market). They alsostarted to make wider use of covenants, triggers which linked pricing explicitly tocorporate events such as changes in ratings and debt servicing. While banks becamemore sophisticated, more data became available on the performance of loans,contributing to the development of a secondary market which gradually attractednon-bank financial firms, such as pension funds and insurance firms. Eventually,guarantees and unfunded2 risk transfer techniques such as synthetic securitisationenabled banks to buy protection against credit risk while keeping the loans on thebalance sheet. The advent of these new risk management techniques enabled awider circle of financial institutions to lend on the market, including those whosecredit limits and lending strategies would not have allowed them to participatebeforehand. Partly, lenders saw syndicated loans as a loss-leader for selling morelucrative investment banking and other services. More importantly, in additionto borrowers from emerging markets, corporations in industrialised countriesdeveloped an appetite for syndicated loans. They saw them as a useful, flexiblesource of funds that could be arranged quickly and relied upon to complementother sources of external financing such as equities or bonds.

As a result of these developments, syndicated lending has grown strongly fromthe beginning of the 1990s to date. Signings of new loans—including domesticfacilities—totalled $1.6 trillion in 2003, more than three times the 1993 amount.Borrowers from emerging markets and industrialised countries alike have beentapping the market, with the former accounting for 16% of business and, for thelatter, an equal split between the United States and western Europe (Graph 2).Syndicated lending in Japan reportedly makes up just a small—albeit growing—fraction of total domestic bank lending, not least because of the traditionalimportance of “main banks” for corporations.

Syndicated credits have thus become a very significant source of financing.The international market3 accounts for about a third of all international financing,including bond, commercial paper and equity issues. The proportion of merger,

2 In an unfunded risk transfer, such as a credit default swap, the risk-taker does not provide upfront funding in thetransaction but is faced with obligations depending on the evolution of the borrower's creditworthiness.

3 An international syndicated loan is defined in the statistics compiled by the BIS as a facility for which there is at leastone lender present in the syndicate whose nationality is different from that of the borrower.


acquisition- and buyout-related loans represented 13% of the total volume in2003, against 7% in 1993. Following a spate of privatisations in emerging markets,banks, utilities, and transportation and mining companies4 have started to displacesovereigns as the major borrowers from these regions (Robinson (1996)).5

4 Syndicated loans are widely used to fund projects in these sectors, in industrial and emerging market countries alike.A feature article on page 91 of this BIS Quarterly Review explores the nature of credit risk in project finance.

5 Interestingly, for most of the 1990s, emerging market borrowers were granted longer-maturity loans, five years onaverage, than industrialised country ones (three-four years).

6 These bank roles, enumerated here in decreasing order of seniority, involve an active role in determining the syndicatecomposition, negotiating the pricing and administering the facility.

A hybrid between relationship lending and disintermediated debt

In a syndicated loan, two or more banks agree jointly to make a loan to a borrower.Every syndicate member has a separate claim on the debtor, although there is asingle loan agreement contract. The creditors can be divided into two groups.The first group consists of senior syndicate members and is led by one or severallenders, typically acting as mandated arrangers, arrangers, lead managers or agents.6

These senior banks are appointed by the borrower to bring together the syndicateof banks prepared to lend money at the terms specified by the loan. The syndicateis formed around the arrangers—often the borrower’s relationship banks—whoretain a portion of the loan and look for junior participants. The junior banks,

Graph 2: Syndicated Lending by Nationality of BorrowerGross signings, in billions of US dollars

Industrial Countries Emerging markets

Source: Dealogic Loanware.

123123

123123

123123

12123123

123123

123123123123

123123123

123123

123123

123123123

12341234

12341234123

12312

123123123123

123123123123

123123

123123123123

123123123

123123

1234123412341234

123123123

1212

123123123123

123123123

123123

123123123123123123

123123

1212

123123

12341234

1234123412341234123412341234

123123123

123123123123123123123123123

123123

123123123123123123123123123123123123

123123123123

123123123123123123123123123123123123123123

123123123123123

123123123123123123123123123123123123123123123123

123123123

123123123123123123

123123123

123123123123123123

123123123123

123123123123123123123123123123123

123123123

123123123123123123123123123

123123123123

123123123123123123123123123

123123123123123

123123123123123123123123123123123

2,000

1,500

1,000

500

093 95 97 99 01 03 93 95 97 99 01 03

200

150

100

50

0

OtherEuro areaJapanUnited KingdomUnited States

Middle East & AfricaEastern EuropeLatin AmericaAsia-Pacific

1212

1212


typically bearing manager or participant titles, form the second group of creditors.Their number and identity may vary according to the size, complexity and pricingof the loan as well as the willingness of the borrower to increase the range of itsbanking relationships.

Thus, syndicated credits lie somewhere between relationship loans anddisintermediated debt (Dennis and Mullineaux, 2000). Box 1 below shows, indecreasing order of seniority, the banks that participated in a simple syndicatestructure to grant a loan to Starwood Hotels & Resorts Worldwide, Inc in 2001.

Senior banks may have several reasons for arranging a syndication. It can be ameans of avoiding excessive single-name exposure, in compliance with regulatorylimits on risk concentration, while maintaining a relationship with the borrower.

Starwood Hotels & Resorts Worldwide, Inc$250 million

Two-year term loan, signed 30 May, 2001Loan purpose: General corporate

Pricing: Margin: Libor + 125.00 bp; commitment fee: 17.50 bp

Mandated arrangerDeutsche Bank AG

BookrunnerDeutsche Bank AG

ParticipantsDeutsche Bank AG

Bank One NACitibank NA

Crédit Lyonnais SAUBS AG

Administrative agentDeutsche Bank AG

Box 1: Example of a Simple Syndicate Structure � Starwood

mandated to originate,structure and syndicate thetransaction

issues invitations to participatein the syndication, disseminatesinformation to banks andinforms the borrower about theprogress of the syndication

banks providing funds

title given to the arranger of asyndicated transaction in the USmarket

Source: Dealogic.


Or it can be a means to earn fees, which helps diversify their income. In essence,arranging a syndicated loan allows them to meet borrowers’ demand for loancommitments without having to bear the market and credit risk alone.

For junior banks, participating in a syndicated loan may be advantageous forseveral reasons. These banks may be motivated by a lack of origination capabilityin certain types of transactions, geographical areas or industrial sectors, or indeeda desire to cut down on origination costs. While junior participating banks typicallyearn just a margin and no fees, they may also hope that in return for theirinvolvement, the client will reward them later with more profitable business,such as treasury, management, corporate finance or advisory work (Allen (1990))7

Pricing Structure: Spreads and Fees

As well as earning a spread over a floating rate benchmark (typically Libor) on theportion of the loan tha is drawn, banks in the syndicate receive various fees (Assen(1990), Table 1). The arranger8 and other members of the lead management teamgenerally earn some form of upfront fee in exchange for putting the deal together.This is often called a praecipium or arrangement fee. The underwriters similarlyearn an underwriting fee for guaranteeing the availability of funds. Other participants(those at least on the “manager” and “co-manager” level) may expect to receive aparticipation fee for agreeing to join the facility, with the actual size of the feegenerally varying with the size of the commitment. The most junior syndicatemembers typically only earn the spread over the reference yield. Once the credit isestablished and as long as it is not drawn, the syndicate members often receive anannual commitment or facility fee proportional to their commitment (largely tocompensate for the cost of regulatory capital that needs to be set aside against thecommitment). As soon as the facility is drawn, the borrower may have to pay a perannum utilisation fee on the drawn portion. The agent bank typically earns an agencyfee, usually payable annually, to cover the costs of administering the loan. Loanssometimes incorporate a penalty clause, whereby the borrower agrees to pay aprepayment fee or otherwise compensate the lenders in the event that it reimburses

7 In practice, though, these rewards fail to materialise in a systematic manner. Indeed, anecdotal evidence for the UnitedStates suggests that, for this reason, smaller players have withdrawn from the market lately and have stopped extendingsyndicated loans as a lossleader.

8 For this discussion, it has to be recalled that the same bank can act in various capacities in a syndicate. For instance, thearranger bank can also act as an underwriter and/or allocate a small portion of the loan to itself and therefore also be ajunior participant.


any drawn amounts prior to the specified term. Box 1 above provides an example ofa simple fee structure under which Starwood Hotels & Resorts Worldwide, Inc hashad to pay a commitment fee in addition to the margin.

At an aggregate level, the relative size of spreads and fees differs systematically inconjunction with a number of factors. Fees are more significant for Euribor-basedthan for Libor-based loans. Moreover, for industrialised market borrowers, the shareof fees in the total loan cost is higher than for emerging market ones. Arguably thiscould be related to the sectoral composition of borrowers in these segments.

Table 1: Structure of Fees in a Syndicated LoanFee Type Remarks

Arrangement fee

Legal fee

Underwriting fee

Participation fee

Facility fee

Commitment fee

Utilisation fee

Agency fee

Conduit fee

Prepayment fee

Front-end

Front-end

Front-end

Front-end

Per annum

Per annum,charged onundrawn part

Per annum,charged ondrawn part

Per annum

Front-end

One-off ifprepayment

Also called praecipium. Received and retained by thelead arrangers in return for putting the deal together.

Remuneration of the legal adviser.

Price of the commitment to obtain financing during thefirst level of syndication.

Received by the senior participants.

Payable to banks in return for providing the facility,whether it is used or not.

Paid as long as the facility is not used, to compensate thelender for tying up the capital corresponding to thecommitment.

Boosts the lender�s yield; enables the borrower toannounce a lower spread to the market than what isactually being paid, as the utilization fee does not alwaysneed to be publicized.

Remuneration of the agent bank�s services

Remuneration of the conduit bank1

Penalty for prepayment

1 The institution through which payments are channelled with a view to avoiding payment ofwithholding tax. One important consideration for borrowers consenting to their loans beingtraded on the secondary market is avoiding withholding tax in the country where the acquirer ofthe loan is domiciled.

Source: Compiled by author.


Non-sovereign entities, more prevalent in industrialised countries, may have a keenerinterest, for tax or market disclosure reasons, in incurring a larger part of the totalloan cost in the form of fees rather than spreads. However, the total cost (spreads,front end and annual fees)9 of loans granted to emerging market borrowers is higherthan that of facilities extended to industrialised countries (Graphs 3 and 4). Thereis also more variance in commitment fees on emerging market facilities. In sum,lenders seem to demand additional compensation for the higher and more variablecredit risk in emerging markets, in the form of both spreads and fees.

Spreads and fees are not the only compensation that lenders can demand inreturn for assuming risk. Guarantees, collateral and loan covenants offer thepossibility of explicitly linking pricing to corporate events (rating changes, debtservicing). Collateralisation and guarantees are more often used for emerging marketborrowers (Table 2), while covenants are much more widely used for borrowers inindustrialised countries (possibly because such terms are easier to enforce there).

9 One should note that the fees shown in Graphs 3 and 4 are not directly comparable. In Graph 3, for the purposes ofcomparability with spreads, annual and front-end fees are added together by annualising the latter over the wholematurity of the facility, assuming full and immediate drawdown. Graph 4, on the other hand, shows annual and front-end fees separately without annualising the latter.

Graph 3: Spreads and Fees1

(In basis points)

1 Quarterly averages weighted by facility amounts. Front-end fees have been annualised overthe lifetime of each facility and added to annual fees.



Primary and Secondary Markets: Sharing Versus Transferring Risk

While commercial banks dominate the primary market, both at the senior arrangerand at the junior funds provider levels, other institutions have made inroads overtime. Globally, there are virtually no non-commercial banks or non-banks amongthe top 200 institutions that have around 90% market share. However, investmentbanks have benefited from the revival of syndicated lending in the 1990s. Theyhave taken advantage of their expertise as bond underwriters and of the increasingintegration of bank lending and disintermediated debt markets10 to arrange loansyndications. Besides the greater involvement of investment banks, there is alsogrowing participation by multilateral agencies such as the International FinanceCorporation or the Inter- American Development Bank.11

Syndicated credits are increasingly traded on secondary markets. Thestandardisation of documentation for loan trading, initiated by professional bodiessuch as the Loan Market Association (in Europe) and the Asia Pacific Loan Market

Graph 4: Breakdown of Fees1

(In basis points)

1 Quarterly averages weighted by facility amounts. 2 Not annualised. 3 Industrialised countryborrowers only.


10 For instance, it is very common nowadays for a medium-term loan provided by a syndicate to be refinanced by a bondat, or before, the loan’s stated maturity. Similarly, US commercial paper programmes are frequently backed by asyndicated letter of credit.

11 This provides an opportunity for risk-sharing between public and private sector investors. It usually takes the form ofsyndicated loans granted by multilateral agencies with tranches reserved for private sector bank lenders.


Association, has contributed to improved liquidity on these markets. A measureof the tradability of loans on the secondary market is the prevalence of transferabilityclauses, which allow the transfer of the claim to another creditor.12 The US markethas generated the highest share of transferable loans (25% of total loans between1993 and 2003), followed by the European marketplace (10%). The secondarymarket is commonly perceived to consist of three segments: par/near par, leveraged(or high-yield) and distressed. Most of the liquidity can be found in the distressedsegment. Loans to large corporate borrowers also tend to be actively traded.

Participants in the secondary market can be divided into three categories:market-makers, active traders and occasional sellers/investors. The marketmakers(or two-way traders) are typically larger commercial and investment banks,committing capital to create liquidity and taking outright positions. Institutionsactively engaged in primary loan origination have an advantage in trading on thesecondary market, not least because of their acquired skill in accessing andunderstanding loan documentation. Active traders are mainly investment andcommercial banks, specialist distressed debt traders and socalled “vulture funds”(institutional investors actively focused on distressed debt). Non-financialcorporations and other institutional investors such as insurance companies alsotrade, but to a lesser extent. As a growing number of financial institutions establishloan portfolio management departments, there appears to be increasing attentionpaid to relative value trades. Discrepancies in yield/return between loans andother instruments such as credit derivatives, equities and bonds are arbitragedaway (Coffey (2000), Pennacchi (2003)). Lastly, occasional participants are presenton the market either as sellers of loans to manage capacity on their balance sheetor as investors which take and hold positions. Sellers of risk can remove loans from12 Transferability is determined by consent of the borrower as stated in the original loan agreement. Some borrowers do

not allow loans to be traded on the secondary market as they want to preserve their banking relationships.

Table 2: Non-price Components in the Remuneration of RiskShare of syndicated loans with covenants, collateral and guarantees, in percent, by nationality of borrower

Covenants Collateral Guarantees

Emerging Industrialised Emerging Industrialised Emerging Industrialised

1993�96 0 16 40 15 31 7

1997�2000 2 24 49 16 22 4

2001�041 3 19 37 13 21 41 First quarter only for 2004.Source: Dealogic Loanware.


their balance sheets in order to meet regulatory constraints, hedge risk, or managetheir exposure and liquidity.13 US banks, whose outstanding syndicated loancommitments are regularly monitored by the Federal Reserve Board, appear tohave been relatively successful in transferring some of their syndicated credits,including up to one quarter of their problem loans, to non-bank investors (Table.3).Buyers of loans on the secondary market can acquire exposure to sectors or countries,especially when they do not have the critical size to do so on the primary market.14

13 The seller banks often enhance their fee income by arranging new loans to roll over facilities they had previously grantedto borrowers. They may sell old facilities on the secondary market to manage capacity on their balance sheet, which isrequired to hold some of the new loans.

14 For example, minimum participation amounts on the primary market may exceed the bank's credit limits.

Table 3: US syndicated credits1

2000 48 45 7 1,951 2.8 2.6 10.2 3.2

2001 46 46 8 2,050 5.1 4.7 14.6 5.7

2002 45 45 10 1,871 6.4 7.3 23.0 8.4

2003 45 44 11 1,644 5.8 9.0 24.4 9.3

Share of total credits 2 Percentage classified3

Total credits($ bn)US

banksForeignbanking

Non-banks

Totalcredits

USbanks

Foreignbanking

Non-banks

1 Includes both outstanding loans and undrawn commitments.2 Dollar volume of credits held by each group of institutions as a percentage of the total dollar

volume of credits.3 Dollar volume of credits classified �substandard�, �doubtful� or �loss� by examiners as a percentage

of the total dollar volume of credits.

Source: Board of Governors of the Federal Reserve System.

While growing, secondary trading volumes remain relatively modest comparedto the total volume of syndicated credits arranged on the primary market. Thebiggest secondary market for loan trading is the United States, where the volumeof such trading amounted to $145 billion in 2003. This is equivalent to 19% ofnew originations on the primary market that year and to 9% of outstandingsyndicated loan commitments. In Europe, trading amounted to $46 billion in2003 (or 11% of primary market volume), soaring by more than 50% comparedto the previous year (Graph 5).

Distressed loans continued to represent a sizeable fraction of total secondary tradingin the United States, and gained in importance in Europe. Admittedly, this to someextent reflects higher levels of corporate distress in Europe. But as the investment


grade segment matures, it is also indicative of sustained investor appetite and of themarket’s improved ability to absorb a larger share of below par loans (BIS (2004)).

In the Asia-Pacific region, secondary volumes are still a tiny fraction of those inthe United States and Europe, with only six or seven banks running dedicateddesks in Hong Kong SAR, and no non-bank participants. In 1998, the Asiansecondary market was exceptionally active. That year, large blocks of loan portfolioschanged hands as Japanese banks restructured their distressed loan portfolios.15

Trading was more subdued in subsequent years,16 although banks’ interest appearsto have recently been rekindled by the secondary prices of loans, which havedecreased less than those of collateralised debt obligations and bonds.17

Geographical integration of the market

As financial markets are becoming more integrated geographically, a question ishow this process manifests itself in syndicated lending in the form of crossborder

15 Banks tend to trade blocks of loans when they restructure whole portfolios. In normal times, loan by loan trading is morecommon.

16 Nonetheless, Japanese banks have recently been very active in transferring loans on the Japanese secondary market.According to a quarterly survey conducted by the Bank of Japan, for the financial year April 2003-March 2004, suchtransfers totalled ¥11 trillion, 38% of which were non-performing loans. This was followed in the second quarter of2004 by unusually weak secondary market activity by historical standards.

17 According to practitioners, major international banks with an Asian presence are among the main sellers of loans, whiledemand comes from Taiwanese and Chinese banks.

Graph 5: US and European Secondary Markets for Syndicated Credits

1 In billions of US dollars. 2 As a percentage of total loan trading. For Europe, distressed andleveraged. 3 From non-LMA members.

Sources: Loan Market Association (LMA); Loan Pricing Corporation.

United States, by loan quality Europe, by loan quality Europe, by counterparty1

21,3


deals. To answer this question, we examine the nationality composition of syndicateson the primary market, where information is readily available about institutionalinvestors. We first perform this exercise at a global level and then within the euroarea, in order to assess any impact from the introduction of the single currency.

Table 4 shows the degree of international integration of syndicated loan markets,measured by the share of loans arranged or provided by banks of the same countryor region as the borrower. At the senior arranger level, the nationality compositionis calculated based on the number of deals, and at a junior participant level basedon the dollar amounts provided by individual financial institutions. A number offindings stand out.

First, unsurprisingly, there appears to be relatively little penetration by foreignlenders in the market for loans to Japanese, euro area and US borrowers. Thesenior arranger and junior funds provider banks in loan facilities set up for theseborrowers are often from the borrowers’ own country, with the share of dealsarranged or of funds provided by foreign institutions rarely exceeding 30%.18

Second, foreign banks appear more present (with shares often in excess of 60%)in syndicates set up for European borrowers from outside the euro area and, inparticular, the United Kingdom. It is interesting to note that Japanese borrowerstend to pay higher fees on average than UK borrowers, whose market is characterisedby more foreign bank penetration. This may suggest that the market is morecontestable in the United Kingdom.

Third, with the possible exception of Asia, syndicates put together for emergingmarket borrowers tend to be dominated by foreign lenders. Interestingly, for allemerging market borrowers, but especially in the Middle East and Africa andAsia-Pacific regions, “domestic” banks (ie from the same geographical area as theborrower) are more present as junior funds providers than as senior arrangers. Itwould appear typical for a major international bank to arrange the syndicationand then allocate the credit to regional lenders.19 Given that the presence of areputable major foreign arranger has a “certification effect” for banks which are

18 For US borrowers, the statement about low foreign penetration should be balanced by the relatively high share—approximately 45% since 2000—of total syndicated credits held by foreign banking organisations, after allowing fortransfers on the secondary market (Table 3).

19 For more background and an extension of the analysis to bond markets, see McCauley et al (2002).


ranked lower in the syndicate, this makes cross-border investment in a juniorfunds provider capacity easier than the provision of screening and monitoringservices as a senior arranger.

Finally, the advent of the euro appears to have led to some integration in thepan-European syndicated loan market, especially at the arranger level. The firsttwo columns of Table 4 show that within the euro area, the percentage of loansarranged by banks from the same country as the borrower is about the same

Table 4: International Integration of the Market

By Borrower Nationality

Main countries and regions

United States 74 70 61 62Euro area4 59 72 71 67United Kingdom 58 43 35 42Other western Europe 37 26 36 25Japan 62 84 63 87Other industrialised economies 67 65 61 57Asia-Pacific 29 37 34 51Eastern Europe 9 12 10 13Latin America/Caribbean 5 7 6 8Middle East & Africa 15 20 22 28Offshore 54 36 44 31

Euro area countries

Austria 5 42 33 42Belgium 17 22 31 16Finland 26 13 16 9France 48 50 45 46Germany 43 46 57 44Greece 7 29 8 24Ireland 20 18 16 14Italy 34 53 39 48Luxembourg 10 8 30 7Netherlands 24 29 28 25Portugal 31 27 30 23Spain 64 51 64 49

Euro area5 39 42 43 38

% of deals1 where the arrangeris of the same nationality2 as

the borrower (based onnumber of deals)

% of funds1 provided by banksof the same nationality2 as the

borrower (based on USDamounts)

1993�98 1999�20043 1993�98 1999�20043

1 Calculated also including purely domestic deals. 2 From the same region, where regions are shown.3 For 2004, first quarter only. 4 Borrower from any euro area country, arranger/provider from anyeuro area country. 5 Borrower from same euro area country as arranger/provider, euro area average.

Sources: Dealogic Loanware; author’s calculations.


before and after 1999 (39% versus 42%).20 Meanwhile, the overall share of euroarea arrangers rose from 59% to 72%, suggesting that euro area banks have beenarranging a higher share of loans for borrowers from euro area countries otherthan their own.21 At the same time, the additional credits arranged at apan-European level seem to have been funded largely by banks from outside theeuro area, since the share of euro area banks among junior funds providers hasremained relatively stable (last two columns of Table 4). This could reflect a greaterbalance sheet capacity outside the euro area.

Conclusion

This special feature has presented a historical review of the development of themarket for syndicated loans, and has shown how this type of lending, whichstarted essentially as a sovereign business in the 1970s, evolved over the 1990s tobecome one of the main sources of funding for corporate borrowers.

The syndicated loan market has advantages for junior and senior lenders. Itprovides an opportunity to senior banks to earn fees from their expertise in riskorigination and manage their balance sheet exposures. It allows junior lenders toacquire new exposures without incurring screening costs in countries or sectorswhere they may not have the required expertise or established presence. Primaryloan syndications and the associated secondary market therefore allow a moreefficient geographical and institutional sharing of risk origination and risk-taking.For instance, loan syndications for emerging market borrowers tend to be originatedby large US and European banks, which subsequently allocate the risk to localbanks. Euro area banks have strengthened their pan-European loan originationactivities since the advent of the single currency and have found funding for theresulting risk outside the euro area.

However, we find that the geographical integration of the market appears tovary among regions, as reflected in varying degrees of international penetration.

20 While the euro is widely used as a currency of denomination for European (including eastern European) borrowers, the USdollar is still the currency of choice for syndicated lending worldwide (US dollar facilities represented 62% of totalsyndicated lending in 2003, while the euro accounted for 21%, and the pound sterling and the Japanese yen for 6% each).

21 In a study of the bond underwriting market, Santos and Tsatsaronis (2003) show that the elimination of marketsegmentation associated with the single European currency failed to result in an intensification of the business linksbetween borrowers and bond underwriters from the euro area. It must be stressed, though, that bond underwriting andsyndicated loan markets are quite different, as bonds are sold to institutional investors and loans mainly to other banks.


While these differences could also be related to disparities in the sizes of nationalmarkets, further research is needed to improve our understanding of marketcontestability by assessing whether they are systematically related to differencesin loan pricing, especially fees.

(Dr.Blaise Gadanecz, Monetary and Economic Department, BIS. The author canbe reached at [email protected]).

References

1. Allen T (1990): “Developments in the International Syndicated Loan Market in the 1980s”,

Quarterly Bulletin, Bank of England, February.

2. Bank for International Settlements (2004): 74th Annual Report, Chapter 7, pp 133-4.

3. Coffey M (2000): “The US Leveraged Loan Market: From Relationship to Return”, in

T Rhodes (ed), Syndicated Lending, Practice and Documentation, Euromoney Books.

4. Dennis S and D Mullineaux (2000): “Syndicated Loans”, Journal of Financial Intermediation,

vol 9, October, pp 404-26.

5. Madan R, R Sobhani and K Horowitz (1999): “The Biggest Secret of Wall Street”, Paine

Webber Equity Research.

6. McCauley R N, S Fung and B Gadanecz (2002): “Integrating the Finances of East Asia”,

BIS Quarterly Review, December.

7. Pennacchi G (2003): “Who Needs a Bank, Anyway?”, Wall Street Journal, 17 December.

8. Robinson M (1996): “Syndicated Lending: A Stabilizing Element in the Latin Markets”,Corporate Finance Guide to Latin American Treasury & Finance.

9. Santos A C and K Tsatsaronis (2003): “The Cost of Barriers to Entry: Evidence from theMarket for Corporate Euro Bond Underwriting”, BIS Working Papers, no 134.


Source: http://www.equator-principles.com/hindu1.shtml. July 2003. © The Hindu. Reprinted with permission.

13

Equator Principles – Why Indian BanksToo Should be Guided by Them

Pratap Ravindran

What, exactly, does the adoption of the Equator Principles involve?The banks, to begin with, agree upon a common terminology incategorising projects into high, medium and low environmentaland social risk, based on the IFC�s categorisation process. Theyapply this to projects globally and to all industry sectors so as toensure consistent approaches in their dealings with high andmedium-risk projects. Second, the banks ask their customers todemonstrate in their environmental and social reviews, and in theirenvironmental and social management plans, the extent to whichthey have met the applicable World Bank and IFC sector-specificpollution abatement guidelines and IFC safeguard policies, or tojustify exceptions to them. Recent reports on the decision byten leading banks from seven countries to adopt the EquatorPrinciples make for encouraging reading. However, it must besaid that the conspicuous absence of Indian banks from the list isdistinctly depressing.

159Equator Principles – Why Indian Banks...

The Equator Principles—a voluntary set of guidelines developed for managing social and environmental issues, related to the financing development

projects—apply only to projects which cost $50 million or more, as those costingless represent only three percent of the market.

Recent reports on the decision by ten leading banks from seven countries toadopt the so-called Equator Principles make for encouraging reading. However, itmust be said that the conspicuous absence of Indian banks from the list is distinctlydepressing. While Indian financial institutions (including banks) can hardly bedescribed as major players in the funding of infrastructure projects at a globallevel, the fact remains that their adoption of the Equator Principles or other similarones to guide their lending within the country, would have given a major fillip toIndia’s environmental initiative, such as it is. They may argue that they see noneed to adopt such principles as their lending to infrastructure projects is restricted,to those that have secured the environmental clearances mandated by statute.As these clearances can be purchased for a pittance, this argument is not particularlyconvincing.

Unfortunately, the truth is that Indian financial institutions are concerned—to the exclusion of all other considerations—about the ecology of their balance-sheets and, therefore, focused on ever-greening their assets.

Banks adopting the Equator Principles undertake to provide loans only to projects,whose sponsors can demonstrate their ability and willingness to comply withcomprehensive processes, aimed at ensuring that projects are developed in a sociallyresponsible manner and according to sound environmental management practices.The banks which have taken the initiative—ABN AMRO Bank, N V, Barclays PLC,Citigroup, Inc., Credit Lyonnais, Credit Suisse Group, HVB Group, Rabobank,Royal Bank of Scotland, WestLB AG, and Westpac Banking Corporation—will,henceforth, apply the principles globally and to project financings in all industrysectors, including mining, oil and gas and forestry.

Their adoption of the Equator Principles is significant in that these banks,between them, underwrote approximately $14.5 billion of project loans in 2002,representing a whopping 30 percent of the project loan syndication market globally.


According to a prepared statement of the International Finance Corporation(IFC) Executive Vice-President, Mr Peter Woicke, presented at the EquatorPrinciples press conference in Washington DC on June 4, the adopting bankshave done something that financial institutions rarely do—Step forward to take aleadership role on global environmental and social issues. “The adoption of theEquator Principles confirms that the role of global financial institutions is changing.More than ever, people at the local level know that the environmental and socialaspects of an investment can have profound consequences on their lives andcommunities, particularly in the emerging markets where regulatory regimes areoften weak. And if financial institutions want to operate in these markets, there isa bottom line value in having clear, understandable, and responsible standards forinvesting.”

It is possible that Indian financial institutions are under no pressure to factorenvironmental considerations into their lending activities, because most peopleare not aware of the Equator Principles.

They were evolved when the IFC convened a meeting of banks, in London inOctober, 2002 to discuss environmental and social issues in project finance.At that meeting, the banks present decided to try and develop a banking industryframework for addressing environmental and social risks in project financing.This exercise culminated in the drafting of the Equator Principles which, in essence,represented an industry approach for financial institutions in determining, assessingand managing environmental and social risks in project financing.

The preamble to the principles, states that project financing plays an importantrole in financing development throughout the world. In providing financing,particularly in emerging markets, project financiers often encounter environmentaland social policy issues.

“We recognise that our role as financiers affords us significant opportunities topromote responsible environmental stewardship and socially responsibledevelopment.”

The preamble goes on to add, “In adopting these principles, we seek to ensurethat the projects we finance, are developed in a manner that is socially responsibleand reflect sound environmental management practices. We believe that adoption


of, and adherence to, these principles offers significant benefits to ourselves, ourcustomers and other stakeholders. These principles will foster our ability todocument and manage our risk exposures to environmental and social mattersassociated with the projects we finance, thereby allowing us to engage proactivelywith our stakeholders on environmental and social policy issues. Adherence tothese principles will allow us to work with our customers in their management ofenvironmental and social policy issues relating to their investments in the emergingmarkets.”

What, exactly, does the adoption of the Equator Principles involve? To beginwith, it is important to understand that the term “adopt” does not mean that thebanks sign an agreement of some kind. They do not. Instead, each bank thatadopts the principles individually declares that it has or will put in place, internalpolicies and processes that are consistent with the Equator Principles.

The banks, to begin with, agree upon a common terminology in categorisingprojects into high, medium and low environmental and social risk, based on theIFC’s categorization process. They apply this to projects globally and to all industrysectors, so as to ensure consistent approaches in their dealings with high andmedium-risk projects.

Second, the banks ask their customers to demonstrate in their environmentaland social reviews, and in their environmental and social management plans, theextent to which they have met the applicable World Bank and IFC sector-specificpollution abatement guidelines and IFC safeguard policies, or to justify exceptionsto them. This practice allows them to secure information of the quality requiredfor them to make judgments. And then again, the banks insert into the loandocumentation for high- and medium-risk projects covenants for borrowers tocomply with their environmental and social management plans. If those plans arenot followed and deficiencies not corrected, the banks reserve the right to declarethe project loan in default.

What are the IFC safeguard policies and how do they differ from the WorldBank safeguard policies? Basically, the IFC’s set of environmental and social policiesare based on the set used by the World Bank. However, some policies have beenadapted to better reflect their applicability to the IFC’s private sector client base


while others have been retained in the World Bank format and, as such require,careful interpretation for private sector projects. The safeguard policies provideguidance on matters relevant to the IFC’s operations, including environmentalassessment, natural habitats, involuntary resettlement and indigenous peoples.

The environmental assessment policy is a key umbrella policy for the IFC, andvarious requirements—environmental and social—flow from it. In addition, toreflect the fact that the IFC works with employers, it has adopted the PolicyStatement on Harmful Child and Forced Labour. The Bank’s safeguard policiesare geared to its public sector activities.

And what is the relationship between the IFC safeguard policies and the WorldBank and IFC guidelines? The safeguard policies generally represent an approachto critical issues that cut across industry sectors, such as the protection of naturalhabitats or the physical or economic displacement of people (resettlement), whereit is important to apply a consistent set of environmental and social principles.The guidelines, on the other hand, are sector-specific environmental standardsthat are applicable to the processes, technology, and issues that apply in specificindustries, and represent good practice within that sector. As such, the policiesand guidelines are mutually supportive of each another.

The Equator Principles apply to only projects which cost $50 million or more.The question now arises: How many projects fall below $50 million and whatabout them?

According to the IFC, a cut off point and some level of materiality are necessary.Most of the sensitive project developments involve much larger sums. While theleague tables for project loans do not necessarily record all small project loans,they indicate that projects costing less than $50 million represent only threepercent of the market.

Its proponents point out that a risk management rationale exists for banks toadopt the Equator Principles in that they will be able to better assess, mitigate,document and monitor the credit risk and reputation risk associated with financingdevelopment projects. In any case, they say, the principles will not hurt banks’business as they have been championed by the project finance business heads of


banks. They believe that having a framework for the industry will lead to greaterlearning among project finance banks on environmental and social issues, andthat having greater expertise in these areas will better enable them to advise clientsand control risks. Quite simply, they observe, the principles are good for business.


Overview

The synthetic lease has emerged as a popular financing structure since it providesoff balance sheet treatment for book purposes, while allowing a company to retainthe tax benefits associated with asset ownership. This structure is frequently usedby energy firms to finance the acquisition of new assets or to refinance existingassets. It provides an interim take-out to construction financing (usually five to

Source: http://www.fitchratings.com.au/projresearchlist.asp March 7, 2002. © 2004 Fitch Ratings, Ltd. Reprinted bypermission of Fitch Inc.

14

Synthetic Leasing


While originally structured for real estate transactions, the syntheticlease can be readily applied to various types of energy-based assets,including electric turbines and other generating assets or naturalgas and liquids pipelines. The synthetic lease has emerged as apopular financing structure since it provides off balance sheettreatment for book purposes, while allowing a company to retain thetax benefits associated with asset ownership. When rating companiesthat use synthetic leases, Fitch Ratings will effectively add thefinancing back to the balance sheet and income statement byadjusting leverage and other key credit ratios. In addition, Fitchmay also assign a rating to the lease debt, based on the credit ratingof the lessee and/or the value of the underlying asset(s).

165Synthetic Leasing

seven years), and, like any interim financing, exposes the company to refinancingrisk at the end of the lease term.

When rating companies that use synthetic leases, Fitch Ratings will effectivelyadd the financing back to the balance sheet and income statement by adjustingleverage and other key credit ratios. In addition, Fitch may also assign a rating tothe lease debt, based on the credit rating of the lessee and/or the value of theunderlying asset(s).

The Characteristics of Synthetic Leasing

While originally structured for real estate transactions, the synthetic lease can bereadily applied to various types of energy-based assets, including electric turbinesand other generating assets or natural gas and liquids pipelines. The syntheticlease moves the asset off the balance sheet, while maintaining ownership for taxpurposes through the following steps:

• The energy company (the lessee) isolates the asset by having a special purposeentity (SPE) buy the asset or enter into the appropriate equipment andconstruction contracts on a build-tosuit basis, with the lessee acting asconstruction agent.

• To finance the asset purchase, the SPE raises debt and equity. The debt isgenerally tranched and issued in the bank and debt capital markets. Theequity is a requirement to ensure the independence of the SPE and is privatelyplaced.

• At the time of completion, the lessee can either purchase the asset from theSPE or lease the asset from the SPE.

Under the typical structure, a synthetic lease is treated as an operating lease underGenerally Accepted Accounting Principles (GAAP), and a financing for tax purposes.The legal ownership of the asset resides with the lessee, so the lessee retains allrights and obligations of ownership, including legal liability, market risk, andownership in bankruptcy. In addition, the lessee will assume all maintenanceand insurance requirements associated with ownership as in a “triple-net lease.”To qualify as an operating lease for GAAP purposes, the lease must be structuredto meet the following requirements for operating leases detailed in the Statementof Financial Accounting Standards Number 13 (SFAS 13):


• No automatic transfer of the asset to the lessee at the end of the lease term.

• No “bargain” purchase option at the end of the lease term.

• The lease term cannot be 75%, or more, of the economic useful life of theleased property.

• The present value of the minimum lease payments cannot be 90%, or more,of the fair market value of the property at the inception of the lease term.

It is important to note that a synthetic lease does not result in any transfer ofoperating risk from the energy company to the SPE or the noteholders. In caseswhere the underlying asset is a generating plant, the lessee continues to bear allfuel supply risk, market off-take risk, and operating risk of the plant. Consequently,when assessing the impact of a synthetic lease on the rating of the lessee, Fitchwill incorporate the energy company’s risk management and hedging strategy ona qualitative basis. When assigning a rating to the lease debt, Fitch will look to theunderlying credit quality of the lessee and its ability to satisfy the obligationsunder the lease.

Treatment in Bankruptcy: While actual case law regarding synthetic leases in thearea of bankruptcy is limited, the parties to the transaction generally representand intend that the debt of the SPE would be treated as a secured financing of thelessee in the case of the lessee’s Chapter 11 filing. However, investors should beaware of the possibility that the bankruptcy court may take the opposite view

The Synthetic Lease � Basic Scheme

Tax Ownership

Plant

SyntheticLease

Accounting Ownership

Residual ValueGuaranty

SPE

3% Investment

85%

12%

Certificates

�A� SeniorNotes

�B�Subordinated

Notes

SPE � Special purpose entity.

Lessee


and treat the structure as a lease. In this case, the lessee would have the option ofaffirming or rejecting the lease as part of its reorganization plan. If thelessee concludes that the underlying asset(s) is integral to its ongoing operationsand decides to affirm the lease, it must continue to perform under the leasethrough the timely payment of scheduled interest and principal. If the lease isrejected, the lessee would effectively concede control of the asset, returning it tothe lessor. In addition, the lessee would become subject to liabilities for breachingthe lease, which would be an unsecured claim in a bankruptcy situation.

Financing Structure

Special Purpose Entity (SPE): The SPE can be a trust, a limited liability company,or any other passthrough entity that is separate and distinct from the operationsof the lessee. It will have a very limited purpose, usually to construct, purchase,and/or own the asset, to raise funds to finance the purchase or refinancing, and tolease the asset back to the lessee. The SPE must be capitalized with a minimalamount of equity to classify as a separate subsidiary of the lessee. The minimumequity required under GAAP is currently 3% of the total project cost. Equity maybe invested by independent, third parties or by parties related to the debt holders;however, affiliates of the lessee cannot supply the equity to the SPE. Equity holderswill generally have a first loss position in the waterfall and are fully exposed to theresidual value of the underlying asset. Equity raised by the SPE will be part of theoverall financing of the asset. The remainder will be raised through the issuanceof senior and subordinate notes.

Debt Portion: The vast majority of the financing for the asset purchase is achievedthrough a combination of senior and subordinated notes issued by the SPE. Inmost instances, the debt portion represents up to 97% of project cost and istypically comprised of two tranches—the senior note “A” tranche, equal to 85% ofproject cost; and the junior note “B” tranche, equal to 12%. The “A” notes willhave a first claim on cash flows and on the residual value of the asset.The subordinated “B” notes will have second claim on cash flows followed byequity holders.

Synthetic leases are usually structured in a manner that exposes the “A”noteholders solely to the underlying corporate credit risk of the lessee. In particular,if the lessee elects to return the assets to the lessor at the end of the lease term, the


lessee is generally required to make a residual value payment equal to approximately80%–85% of the original cost (the residual value guarantee). This payment is appliedfirst to the “A” notes with any remaining proceeds to the “B” notes and certificates.

When providing ratings for synthetic lease transactions, Fitch will assess thecredit quality of the lessee as well as the value of the underlying asset. Given theresidual value guarantee, the “A” note portion is clearly recourse to the lessee andtherefore will be assigned the senior credit rating of the lessee in most cases. Thisanalysis assumes that the lease debt would be considered secured debt of thelessee in bankruptcy. However, if the credit rating of the lessee were to decline,Fitch may incorporate asset value into the analysis, on a secondary basis.

With respect to the “B” note, Fitch will rate this tranche one or more notchesbelow that of the “A” note to account for the return scenario risk (as describedbelow) and potential residual value shortfall. The level of notching will be assessedon a case by case basis and could vary based on Fitch’s assessment of the returnrisk, including the strategic importance of the asset to the lessee, potentialfair market value, and replacement value.

Lease Term and Residual Value

To abide by GAAP requirements, the lease is structured with a periodic leasepayment and a residual. The lease payments will generally be sized to cover interestpayments on the debt and some minimal principal amortization. Although theterm of the lease cannot exceed 75% of the useful economic life of the asset, whichcan range as high as 60 years for a generating facility, the initial term under asynthetic lease is relatively short, with most ranging from five to seven years.

At the end of the initial lease term, the lessee will have three primary options tochoose from—purchase the asset (for book purposes, effectively buying out the lease);renew the lease (extending the financing for tax purposes); or return the asset to thelessor and arrange for its sale. The credit implications surrounding the first twooptions are relatively straightforward. Under a purchase scenario, all debt and equityholders are effectively made whole as the lessee must buy the assets at a price equalto the entire outstanding lease balance. If a renewal is sought, the lessee can simplyextend the lease term after receiving approval of the extension from the lenders orcash proceeds from refinancing in the case of a capital markets debt issuance.


Under a return scenario, the ‘A’ notes are, in most instances, fully protected bythe residual value guarantee and are thus exposed only to the corporate credit riskof the lessee. On the other hand, the “B” note and certificate holders are exposedto a potential principal loss if the asset deteriorates significantly in value sinceaccounting rules state that the guaranteed residual value cannot exceed 90% ofthe fair market value. However, Fitch believes that the return option is the leastlikely to be pursued by an energy company given the strategic importance of theunderlying assets subject to the lease. In addition, lease terms often contain fairlyonerous return provisions, which can discourage a sale.

Credit Implications for Lessee

As with any type of interim financing, a synthetic lease poses refinancing risk tothe lessee at the end of the lease term. However, as described above, it also providessome intrinsic refinancing options. Under the purchase option, the lessee wouldbe responsible for raising sufficient capital to repay the lease and purchasing theasset for book purposes (it would already own the asset for legal and taxpurposes). Under the renewal option, the lessee would be responsible for arrangingthe extension terms with the lease debt holders and the lessor. Under thereturn option, the lessee would be responsible for the payment of the residualvalue guarantee and for arranging the sale of the asset. It is important to note that,as legal owner of the asset, the lessee had retained all risks of ownership (includingmarket value risk) throughout the term of the lease. If, during this term, themarket value of the asset had fallen, the lessee would suffer a loss if the residualvalue guarantee exceeded the market value of the asset.

When assessing the impact of a synthetic lease on the credit of the lessee, Fitchwill analyze the relationship of the synthetic lease debt to the company’sexisting corporate debt and loans. Some companies have very tight restrictions intheir existing indentures or bank agreements regarding the ability to enter intosecured financing such as synthetic leases. Other companies’ corporate debtcovenants may include broad “carve outs” that allow for the creation of a significantor unlimited amount of secured debt to be incurred as synthetic leases or othertypes of contracts. If a corporation creates a material amount ofadditional obligations that have an equal or superior claim on cashflow to that ofunsecured senior creditors, it may reduce the rating of the company’s seniorunsecured obligations.


Fitch will recalculate key interest coverage and balance sheet ratios, effectivelyconsolidating the SPE back onto the balance sheet. Specifically, the followingadjustments will be made:

• Earnings before interest, taxes, depreciation, and amortization (EBITDA)is adjusted by adding back the annual synthetic lease payment(principal and interest) to calculate EBITDA earnings before interest, taxes,depreciation, amortization, and lease rental expense (EBITDAR).

• The interest component of the synthetic lease payment is stripped out andincluded as additional interest expense. As previously stated, theinterest component represents the vast majority of the annual rental paymentunder a synthetic lease.

�Scenario 1� �Scenario 2� �Scenario 3�with $300 Million With $300 Million

Base Case Synthetic Lease Additional Debt.

Income Statement ($000)EBITDA (GAAP Basis) 195.00 170.50 195.00Gross Synthetic Lease Rent 0.00 24.50 0.00

Adjusted EBITDAR 195.00 195.00 195.00

Reported Interest Expense 70.00 70.00 91.20Interest Portion of Synthetic Lease 0.00 21.20 0.00Total 70.00 91.20 91.20

Balance Sheet ($000)Reported Debt 707.00 707.00 1007.00Synthetic Lease Residual Value Gurantee 0.00 270.00 0.00Synthetic Lease Uncovered Debt 0.00 21.00 0.00Total Adjusted Debt 707.00 998.00 1,007.00Shareholders� Equity 900.00 900.00 900.00Plus: SPE Equity (3%) 0.00 9.00 0.00Total Adjusted Capitalization 1,607.00 1,907.00 1,907.00

Unadjusted RatiosEBITDA/Interest 2.79 2.44 2.14Debt/EBITDA (x) 3.63 4.15 5.16Debt/Capital (%) 44.00 44.00 52.80

Adjusted RatiosEBITDAR/Lease Adjusted Interest 2.79 2.14 2.14Lease Adjusted Debt/EBITDAR 3.63 5.12 5.16Lease Adjusted Debt/Capital (%) 44.00 52.30 52.80

EBITDA � Earnings before interest, taxes, depreciation, and amortization, GAAP � Generally accepted accounting principles.EBITDAR � Earnings before interest, taxes, depreciation, amortization, and rent. SPE � Special Purpose Entity.

Hypothetical Credit Impact of Synthetic Lease with 90%Residual Value Guarantee


• Balance sheet debt is modified to treat a portion of the lease balance ason-balance sheet debt. Specifically, Fitch will adjust reported debt levels toinclude a portion of the original lease balance, equivalent to the residualvalue guarantee as senior debt. This represents the maximum potentialprincipal payout for which the lessee would be responsible under a return/sale scenario. The remaining ‘B’ tranche would be treated as subordinateddebt. SPE equity will be given credit as equity (in effect, treating the SPEequity as a minority).

The table above provides a hypothetical illustration of the credit impact of financingan acquisition using a synthetic lease as opposed to senior debt. The first scenarioshows the base case, with no additional financing. Scenario two shows the samebalance sheet with an additional $300 million synthetic lease. The third scenarioshows the balance sheet with $300 million of additional debt. As mentioned previously, Fitch will treat the SPE as though it were consolidated on the company’sbalance sheet. Before adjustments, in scenario two, the company seems to carrymuch lower leverage than in scenario three, and has a higher coverage ratio. Afteradjustments, scenario two and scenario three have the same coverage ratios, whilescenario two has a slightly lower leverage ratio due to the treatment of the equity inthe SPE. Note that the EBITDA in scenario two is lower than in the base caseand in the debt case. This is due to the fact that under GAAP accounting rules,the lease payments would be classified as an operating expense, a difference thatis eliminated by the use of ratios based on EBITDAR. For simplicity, thetable assumes that the implied interest rate on the synthetic lease is the same asthe actual interest rate on the debt.

(Fitch Ratings is a leading global rating agency committed to providing the world'scredit markets with accurate, timely and prospective credit opinions.)


Source: http://www2.standardandpoors.com/spf/pdf/fixedincome/030502IFcriteria.pdf. November 2004 © Standard& Poor’s Global Project Finance Yearbook. Standard & Poor’s Rating Services, a division of The McGraw-HillCompanies, Inc. Reprinted with permission.

Project Finance: Debt Rating Criteria

15

Peter Rigby and James Penrose, Esq.,

To address the challenge in analyzing project finance risk, Standard& Poor�s uses a framework of analysis that extends well beyondits traditional approach that grew out of rating US independentpower projects. The approach begins with the assumption that aproject is a collection of contracts and agreements among variousparties, including lenders, that collectively serves two primaryfunctions: The first is to create a company that will act on behalfof its sponsors, to bring together several unique factors ofproduction to produce a single product or service. The secondfunction is to provide lenders with the security of payment ofinterest and principal from a single operating entity. Standard &Poor�s analytic framework then focuses primarily on determininghow competitive the project will be in its market segment, andwhich risks might undermine its competitiveness and hence, theassurance of repayment to lenders.

173Project Finance: Debt Rating Criteria

As project finance has adjusted to the increasingly diverse needs of project sponsors and their lenders, the analysis of risk has become more complicated.

The increasing variety of project finance applications and locations suggests thatperhaps project finance, despite weaker numbers recently, continues to be theviable means of raising capital. Yet, projects have departed from their traditionallong-term revenue contract bases. Contract-based revenues are increasingly rare.Fewer projects are able to secure the highly desirable fixed-price, turnkey, date-certainconstruction contracts that protect lenders from construction and completionrisk. Commodity price and market risk now complicate the analysis of projectfinance. Term B loan structures with minimal amortizations and risky bulletmaturities have made inroads in project finance. Transactions span such industriesas meatpacking, power generation, oil and gas, entertainment, transport andmilitary housing, to name a few. For lenders and other investors, identifying,comparing, and contrasting project risk systematically can indeed be adaunting task.

To address the challenge in analyzing project finance risk, Standard & Poor’suses a framework of analysis that extends well beyond its traditional approachthat grew out of rating US independent power projects. The approach beginswith the assumption that a project is a collection of contracts and agreementsamong various parties, including lenders, that collectively serves two primaryfunctions. The first is to create a company that will act on behalf of its sponsors tobring together several unique factors of production to produce a single productor service.

The second function is to provide lenders with the security of payment ofinterest and principal from a single operating entity. Standard & Poor’s analyticframework then focuses primarily on determining how competitive the projectwill be in its market segment and which risks might undermine its competitivenessand hence, the assurance of repayment to lenders.

Project Finance Defined

Standard & Poor’s defines a project company as a group of agreements and contractsbetween lenders, project sponsors, and other interested parties that creates a formof business organization that will issue a finite amount of debt on inception; will


operate in a focused line of business; and will ask that lenders look only to aspecific asset to generate cash flow as the sole source of principal and interestpayments and collateral.

What the rating means: Standard & Poor’s project ratings address defaultprobability, or put differently, the level of certainty with which lenders can expectto receive timely payment of principal and interest according to the terms of thebond or note. Project ratings do not distinguish between the debt issue ratingand the issuer credit rating, as is the case with corporate credit ratings, for anumber of reasons. First, project documentation generally allows a project toissue debt at its inception to operate with a single business focus and typically tomaintain a constant risk profile. Second, project debt does not become a permanentpart of the capital structure, but rather amortizes in most projects according to aschedule based on the project’s useful life. Finally, projects do not by design buildup equity, but instead, use up cash quickly, first as operating expenses, then asdebt service (often the most significant expense), and finally as dividends. (For amore comprehensive discussion of project finance risk and for clarification of specifictopics, see “Debt Rating Criteria for Energy, Industrial, and Infrastructure ProjectFinance,” March 19, 2001).

Framework for Project Finance Criteria

This article summarizes an analytic framework that can be used to systematicallyassess cash flows based on project-level risks and then to analyze risks external tothe project. External risks, many of which are often country specific, include lackof host country institutional development needed to support the project, forcemajeure, and sovereign risk.

Five levels of analysis form Standard & Poor’s framework of project analysis: (Chart 1)

• Project-level risks,

• Sovereign risk,

• Business and legal institutional development,

• Force majeure risk, and

• Credit enhancements.


The analysis begins with identifying and assessing project-level risks. Theserisks generally define most of the risks associated with the choice of businessbecause if a project cannot reasonably forecast commercially ongoing operations,other concerns such as the viability of guarantees or credit enhancements willcount for little.

Project-level risk consists of the following categories:

• Contractual foundation;

• Technology, construction, and operations;

• Competitive market exposure;

• Legal structure;

• Counterparty exposure; and

• Financial strength.

A project debt rating involves a marshaling of the various heads of risk, analyzingtheir respective magnitude and likelihood of occurrence, and assessing the effectthereof on the project to operate and to pay debt service on the rated obligations.Surprisingly, even though project finance is supposed to be non-recourse to the

Chart 1: Framework of Project Analysis

Credit Enhancement

Force Majeure Risk

Institutional Risk

Sovereign Risk

Project Level Risks


sponsor, some lender credit assessments are often based on the sponsor’s reputation,its creditworthiness, or both—the implication being that the sponsor will supportthe project in difficult times. When the sponsor is rated higher than the project,such an approach flies in the face of evidence that sponsors have walked awaywhen the projects became uneconomical. Sponsor reputation and experience arecertainly considered in the assessment of project completion and operations. Butin the absence of an independent determination that, despite its non-recoursestatus, the project is strategically essential to the sponsor, the rating will reflectprimarily the project’s standalone economic viability.

Project Level Risks

The analysis of project finance risk begins with identifying and assessing project-levelrisks. Standard & Poor’s defines these risks as those intrinsic to the project’s businessand the industry in which it operates (e.g., a merchant power plant selling powerto the UK electricity sector). The first objective of the analysis is to determinehow well a project can sustain ongoing commercial operations throughout theterm of the rated debt and, as a consequence, how well the project will be able toservice its obligations (financial and operational) on time and in full.

Assessing project-level risk takes six broad steps:

1. Evaluate project operational and financing contracts that, along with theproject’s physical plant, serve as the basis of the enterprise;

2. Assess the technology, construction, and operations of the enterprise;

3. Analyze the competitive position of the project against the market in whichit will operate;

4. Determine the risk that counterparties, such as suppliers and customers,present to the enterprise;

5. Appraise the project’s legal structure; and

6. Evaluate the cash flow and financial risks that may affect forecasted results.

Contractual foundation. The primary objective of analyzing project contractsis to determine the level of protection from market and operating conditions eachagreement provides. The secondary objective is to determine how well the various


contract obligations address the project’s operating risk characteristics and meshwith other project contracts.

The project structure should protect stakeholders’ interests through contractsthat encourage the parties to complete project construction satisfactorily and tooperate it competently. The project’s structure should also give stakeholders aright to a portion of the project’s cash flow to service debt and, in appropriatecircumstances, to release free cash to the equity in the form of dividends. Moreover,higher rated projects generally give lenders the assurance that project managementwill align their interests with lenders’ interests; project management should havelimited discretion in changing the project’s business or financing activities. Finally,the stronger projects distinguish themselves by agreeing to give lenders a first-perfected security interest (or fixed charge, depending on the legal jurisdiction)in all of the project’s assets, contracts, permits, licenses, accounts, and othercollateral so the project can be disposed of in its entirety, should the need arise.

Score Characteristics

1 Project has a credit lease, hell-or-high-water contract; even if the project is a technological/operational failure, it receives full revenue payments sufficient to cover debt service.

Indenture creates a first-perfected security interest in all project assets, contracts, permits,and accounts necessary to run the project.

Strict controls on cash flows and distributions.

Trustee (offshore for cross-border debt).

2 Project has a credit lease, hell-or-high-water contract; even if the project is a technological/operational failure, it receives full revenue payments.

Indenture creates a first-perfected security interest in all project assets, contracts, permits,and accounts necessary to run the project. Strict controls on cash flow.


3 Project has excellent long-term concession or other offtake agreement, that providespredictable revenues that cover fixed payments and variable costs.

Virtually no conditions that could reduce revenue payments.

Revenues are protected from foreign exchange, inflation, and market risks.

Solid supply contracts; minimal cost/revenue mismatch.

Table 1: Contractual Foundation Benchmark Scores

Contd...


Business interruption and casualty insurance policies in place.

No regulatory outs or easy termination provisions.


Strict controls on cash flow.


5 Project has good long-term concession or offtake agreement, but does not fully protectlenders from market, inflation, or foreign exchange risks.

Project could be a merchant project, but is secured by licenses, permits, sites, andcontractual access to markets.

Contract outs for offtaker or government.

Adequate supply contracts; potential for cost/revenue mismatch.

Business interruption and casualty insurance policies in place.


Strict controls on cash flow.


7 Project has fair long-term concession or offtake agreement, but exposes lenders tomarket, inflation, or foreign exchange risks.

Contract outs or termination easily achieved.

No contractual requirements to perform while disputes are being resolved.

Contracts contain poorly defined provisions and ambiguous requirements.

No provisions for international arbitration.

Weak insurance program.

Indenture provides little security or collateral for lenders.

Few controls on cash flow. No trustee.

10 No contracts support revenue or supply.

No contractual requirements to perform while disputes are being resolved.

Contracts contain poorly defined provisions and ambiguous requirements.

No provisions for international arbitration.

Little or no insurance.

Indenture provides virtually no security for project.

Virtually no controls on cash flow.

No trustee.

Contd...


Contract analysis focuses on the terms and conditions of each agreement. Theanalysis also considers the adequacy and strength of each contract in the contextof a project’s technology, counterparty credit risk, and the market, among otherproject characteristics. Project contract analysis falls into two broad categories—commercial agreements and collateral arrangements. Examples of key commercialproject agreements and contracts include the following:

• Power purchase agreements,

• Gas and coal supply contracts,

• Steam sales agreements,

• Concession agreements, and

• Airport landing-fee agreements.

Collateral agreements include an analysis of the following:

• Project completion guarantees;

• Assignments to lenders of project assets, accounts, and contracts;

• Credit facilities or lending agreement;

• Equity contribution agreement;

• Indenture;

• Mortgage, deed of trust, or similar instrument that grants lenders a first-mortgage lien on real estate and plant;

• Security agreement or similar instrument that grants lenders a first mortgagelien on various types of personal property;

• Depositary agreements;

• Collateral and intercreditor agreements; and

• Liquidity support agreements, such as letters of credit (LOCs), surety bonds,and targeted insurance policies.

Technology, construction, and operations. A project’s rating rests, in part, onthe dependability of a project’s design, construction, and operation; if a projectfails to achieve completion or to perform as designed, many contractual and otherlegal remedies may fail to keep lenders economically whole.



1 Project is a credit lease, hell-or-high-water contract; even if the project is a technological/operational failure, it receives full revenue payments.

2 Project has fixed-price, date-certain, turnkey contract; one-year-plus guarantees; superiorliquidated performance/delay damages; highly rated by Standard & Poor�s, EPC contractor,credible sponsor, completion guarantee, or LOC-backed construction; installed costs at orbelow market; contracts executed.

Independent engineer (IE) oversight through completion, including completion certificate.

Commercially proven technology used.

Rated O&M contract with performance damages.

Budget and schedule are credible, not aggressive.

Thorough and credible IE report.

3 Project has fixed-price, date-certain, turnkey contract; one-year guarantees for adequateliquidated performance/delay damages; reputable EPC contractor or LOC-backedconstruction; installed costs at market rate; mostly permitted and well-sited.

IE oversight through completion.


O&M contract with performance damages.

Budget and schedule are credible, possibly aggressive.

Thorough IE report, but missing key conclusions.

5 Project has fixed-price, date-certain, turnkey contract; less than one-year guarantees;some liquidated performance/delay damages; known EPC contractor or surety bond-backedconstruction; installed costs at premium rate; many permits and well-sited; possible localpolitical/regulatory problems.

Limited IE oversight.


O&M contract with performance damages.

Budget and schedule are credible, possibly aggressive.

Mostly complete IE report; conclusions are weak.

7 Project has partial fixed-price, date-certain, turnkey contract and cost-plus features; weakguarantees, if any; minor liquidated performance/delay damages; questionable EPC contractoror weak performance bond-backed construction; installed costs at premium rate or notcredible; permits lacking and siting issues; possible local political/regulatory problems.

No IE oversight.

Technology issues exist.

Aggressive budget and schedule.

IE report leaves many issues open.

Table 2: Technology, Construction, and Operations Benchmark Scores

Contd...


The technical assessment of project risk falls into two categories—preconstructionand postconstruction.

Preconstruction risk consists of:

• Engineering and design,

• Site plans and permits,

• Construction, and

• Testing and commissioning.

Postconstruction risk is made up of:

• Operations and maintenance (O&M), and

• Historical operating record, if any.

Project lenders frequently rely on the reputation of the engineering,procurement, and construction (EPC) contractor or the project sponsor as a proxyfor technical risk, particularly when lending to unrated transactions. The recordsuggests that such confidence may be misplaced. Standard & Poor’s experiencewith technology, construction, and operations risk on more than 300 projectfinance ratings indicates that technical risk is pervasive during the pre- andpostconstruction phases, while the possibility of sponsors coming to the aid of atroubled project is uncertain. Moreover, many lenders do not adequately evaluatethe risk when making investment decisions. Thus, Standard & Poor’s placesconsiderable importance on the technical evaluation of project-financedtransactions.

10 Project has cost-plus contracts, no cap; weak guarantees, if any; minor liquidatedperformance/delay damages; questionable EPC contractor.

Costly budget.

Permits lacking; siting issues exist.

Possible local political/regulatory problems.

No IE oversight.

No IE report.

Technology issues exist.

Aggressive budget and schedule.

Contd...


Standard & Poor’s relies on several assessments for its technical analysis,including a review of the independent engineer’s (IE) project evaluation. Thisreview assesses whether the scope and depth of the engineer’s investigation supportthe sponsor’s and EPC contractor’s conclusions. Standard & Poor’s supplementsits review of the independent expert’s report with meetings with the authors andvisits to the site to inspect the project and hold discussions with the project’smanagement and EPC contractor. Without an IE review, Standard & Poor’s willmost likely assign a speculative-grade debt rating, regardless of whether the projectis in the pre- or postconstruction phase.

Competitive market exposure. A project’s competitive position within its peergroup is a principal credit determinant. Analysis of the competitive market positionfocuses on the following factors:

• Industry fundamentals,

• Commodity price risk,

• Supply and cost risk,

• Outlook for demand,

• Foreign exchange exposure,

• The project’s source of competitive advantage, and

• Potential for new entrants or disruptive technologies.

Given that most projects produce a commodity, such as electricity, ore, oil orgas, or some form of transport, low-cost production relative to the market characterizesmany investment-grade ratings (Table 3). High costs relative to an average marketprice, in the absence of mitigating circumstances, will almost always place lendersat risk. But competitive position is only one element of market risk. The demand fora project’s output can change over time, sometimes dramatically, resulting in lowclearing prices. The reasons for demand change are many and usually hard to predict.Any of the following can make a project more or less competitive:

• New products,

• Changing customer priorities,

• Cheaper substitutes, or

• Technological change.


Experience has shown, however, that offtake contracts providing stable revenuesor that limit cost risk, or both, may not be enough to mitigate adverse marketsituations. Hence, market risk can potentially take on greater importance thanthe legal profile of, and security underlying, a project. Conversely, if a projectprovides a strategic input that has few, if any, substitutes, economic incentiveswill be stronger for the purchaser to maintain a viable relationship with the project.



2 Project sells a commodity sold widely on the world market.

Project is in first cost quartile of producers.

Solid competitive advantage in location, technology, and know-how.

Demand is excellent for product/service.

Long-term market outlook is excellent.

For non-commodity products/services, project is in first cost quartile of producers andenjoys defensible price premium.

Revenue and supply contracts will likely keep project economical.

3 Project sells a commodity sold widely in regional markets.

Project is in first cost quartile of producers.

Solid competitive advantage in location, technology, and know-how.

Demand is excellent for product/service.

For non-commodity products/services, project is in second cost quartile of producers andenjoys defensible price premium.

Revenue and supply contracts will likely keep project economical.

5 Project sells a commodity widely sold on the market.

Project is in the second cost quartile of producers.

Demand for product/service should be adequate through debt.

Competitive advantage in location, technology, and know-how, but may be hard to defendlong term.

For non-commodity products/services, project is in second cost quartile of producers;does not have a premium product.

Pricing controlled/influenced by a regulator.

Project could be uneconomical to primary offtaker.

Table 3: Competitive Market Risk Benchmark Scores

Contd...


Legal structure. Standard & Poor’s assesses whether the project is charteredsolely to engage in the business and activities being rated. It will also determinethat the insolvency of entities connected to the project (sponsors, affiliates thereof,suppliers, etc.), which are unrated or are rated lower than the rating sought forthe project, should not affect project cash flow. Standard & Poor’s also analyzesother structural features to assess their potential to manage cash flow and preventa change in the project’s risk profile. These may include:

• Choice of legal jurisdiction,

• Documentation risk,

• Trustee arrangements, or

• Intercreditor arrangements.

Standard & Poor’s generally will not rate a project higher than the lowest ratedentity (i.e., the offtaker) that is crucial to project performance, unless the entitymay be easily replaced, notwithstanding its insolvency or failure to perform, orunless it is a special purpose entity (SPE). Moreover, the transaction rating mayalso be constrained by a project sponsor’s rating if the project is in a jurisdictionwhere the sponsor’s insolvency may lead to the insolvency of the project, particularlyif the sponsor is the sole parent of the project. (Table 4)

7 Project sells a commodity, but sold in limited markets.

Project is in the third cost quartile of producers Few competitive advantages.

For non-commodity projects/services, project is in third cost quartile of producersproducers; does not have a premium product.

Demand for product/service is limited and decreasing.

Project is out of market or soon will be.

Project is uneconomical to primary offtaker.

10 Project sells a commodity, but sold only in a few markets.

Project is one of the most expensive producers.

Virtually no competitive advantage in any aspect of its business.

For non-commodity projects, project is in fourth quartile of low-cost producers and doesnot have a premium product.

Little demand for product/service.

Project is uneconomical to any/all parties associated with it.

Contd...


A project finance SPE, as defined by Standard & Poor’s, is a limited purposeoperating entity whose business purposes are limited to:

• Owning the project assets,

• Entering into the project documents (e.g., construction, operating, supply,input and output contracts, etc.),

• Entering into the financing documents (e.g., the bonds; indenture; deedsof mortgage; and security, guarantee, intercreditor, common terms,depositary, and collateral agreements, etc.), and

• Operating the defined project business.

The thrust of this single-purpose restriction is that the rating on the bondsrepresents, in part, an assessment of the creditworthiness of specific businessactivities.

One requirement of a project finance SPE is that it is restricted from issuing anysubsequent debt rated lower than its existing debt, unless such debt is subordinatedin payment and security to the existing debt and does not constitute a claim on the

Table 4: Legal Risk BenchmarksScore Characteristics

1 Project is a credit lease, hell-or-high-water contract; even if the project is a technological/operational failure, it receives full revenue payments sufficient to service fixed obligations.

Project is a bankruptcy-remote SPE.

Virtually no ability to issue additional debt.

New York or London financing jurisdiction.

Adequate legal opinions support project documentation, collateral, and relevant tax matters.

Documents provide for superior ongoing disclosure and monitoring.

2 Project is a bankruptcy-remote SPE.New York or London financing jurisdiction.Adequate legal opinions support project documentation, collateral, and relevant taxmatters.Superior financing documentation.Extremely limited ability to issue additional debt.Collateral and security strongly enforceable.Documents provide for superior ongoing disclosure and monitoring.

Contd...


project. A second requirement is that the project should not be permitted to mergeor consolidate with any entity rated lower than the rating on the project debt.A third requirement is that the project (as well as the issuer, if different) continue inexistence for as long as the rated debt remains outstanding. The final requirement isthat the SPE must have an antifiling mechanism in place to hinder an insolventparent from bringing the project into bankruptcy. In the US, this can be achievedby the independent director mechanism whereby the SPE provides in its charter

3 Project is a bankruptcy-remote SPE.


Adequate legal opinions support project documentation, collateral, and relevant taxmatters.

Excellent financing documentation.

Mostly limited ability to issue additional debt.

Collateral and security strongly enforceable.

Documents provide for superior ongoing disclosure and monitoring.

5 Project is reasonably bankruptcy-remote and strong SPE.


Adequate legal opinions support project documentation, collateral, and relevant tax matters.

Adequate financing documentation.

Project can issue additional debt with some controls.

Collateral and security adequately enforceable.

Documentation provides for adequate ongoing disclosure and monitoring.

7 Project is neither bankruptcy-remote nor an SPE.

Financing jurisdiction is questionable.

Legal opinions weak or unavailable.

Marginal financing documentation.

Project can issue unlimited additional debt.

Collateral and security probably not enforceable.

Ongoing disclosure and monitoring will probably be difficult.

10 Project is neither bankruptcy-remote nor an SPE.

Financing jurisdiction is questionable.

Legal opinions unavailable.

Weak financing documentation.

Project can issue unlimited additional debt.

Questionable enforceability of collateral and security.

Documentation does not provide for ongoing disclosure or monitoring.

Contd...


documents that a voluntary bankruptcy filing by the SPE requires the consentingvote of the designated independent member of the board of directors (the boardgenerally owing its fiduciary duty to the equity shareholder(s)). The independentdirector’s fiduciary duty, which is to the lenders, would be to vote against the filing.In other jurisdictions, the same result is achieved by the “golden share” structure, inwhich the project issues a special class of shares to some independent entity (such asthe bond trustee), whose vote is required for a voluntary filing.

The antifiling mechanism is not designed to allow an insolvent project tocontinue operating when it should otherwise be seeking bankruptcy protection.In certain jurisdictions, antifiling covenants have been held to be enforceable, inwhich case such a covenant (and an enforceability opinion with no bankruptcyqualification) would suffice. In the UK and Australia, where a first “fixed andfloating” charge may be granted to the collateral trustee as security for the bonds,the collateral trustee can appoint a receiver to foreclose on and liquidate the collateralwithout a stay or moratorium, notwithstanding the insolvency of the project debtissuer. In such circumstances, the requirement for an independent director maybe waived.

The SPE criteria will apply to the project (and to the issuer if a bifurcatedstructure is considered) and is designed to ensure that the project remainsnonrecourse in both directions: by accepting the bonds, investors agree that theywill not look to the credit of the sponsors, but only to project revenues and collateralfor reimbursement. Investors, on the other hand, should not be concerned aboutthe credit quality of other entities (whose risk profile was not factored into therating) affecting project cash flows.

Counterparty exposure. The strength of a project financing rests on the project’sability to generate cash, as well as on its general contractual framework, but muchof the project’s strength comes from contractual participation of outside parties inthe establishment and operation of the project structure. This participation raisesquestions about the strength and reliability of such participants. The traditionalcounterparties to projects have included raw material suppliers, principal offtakepurchasers, and EPC contractors. Even a sponsor becomes a source of counterpartyrisk if it provides the equity during construction or after the project has exhaustedits debt funding. (Table 5)


Important offtake counterparties to a project can include:

• Providers of LOCs and surety bonds,

• Parties to interest rate and currency swaps,

• Buyers and sellers of hedging agreements and other derivative products,

• Marketing agents,

• Political risk guarantors, and

• Government entities.

Because projects have taken on increasingly complex structures, a counterparty’sfailure can put a project’s viability at risk.

Financial strength. Projects must withstand numerous financial threats to theirability to generate revenues sufficient to cover O&M expenses, nonrecurring items,

Table 5: Counterparty Benchmark ScoresScore Characteristics


Rated offtake counterparty with exceptional credit rating.

Counterparty guarantees debt payment.


Rated offtake counterparty with excellent credit rating.

Counterparty guarantees revenue payments.

3 Supply and offtake contract counterparties have good credit ratings.

Sponsor counterparty obligations are backed by good ratings or LOCs.

Government counterparties, if any, have good credit ratings.

Financial counterparties have good credit ratings.

5 Supply and offtake contract counterparties have adequate credit ratings.

Sponsor counterparty obligations are backed by adequate ratings or LOCs.

Government counterparties, if any, have adequate credit ratings.

Financial counterparties have adequate credit ratings.

Contd...


capital replacement expenditures, taxes, and annual fixed charges of principal andinterest, among other expenses. Projects must contend with such risks as interestrate and foreign currency volatility, inflation risk, liquidity risk, and funding risk.Standard & Poor’s considers a project’s capital structure a source of financial risk.Too much debt places a project at risk of volatile currencies, interest rates, andmarket liquidity. (Table 6)

Investment-grade project debt should be amortizing debt. Few projects,particularly power projects, can adequately assume the refinancing risk of thebullet maturities characteristic of corporate or public financings. Unlike a corporateentity, a single-asset power generation facility is more likely to have a finite usefullife. Because of this depreciating characteristic, a fixed obligation payable by anaging project near the end of the project’s life is necessarily more risky and speculative,than an obligation payable from cash sourced in diverse assets.

Standard & Poor’s relies on debt-service coverage ratios (DSCRs) as the primaryquantitative measure of a project’s financial credit strength. The DSCR is theratio of cash from operations (CFO) to principal and interest obligations. CFO iscalculated 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 onto service debt, such as the debt service reserve fund or maintenance reserve fund.To the extent that a project has tax obligations, such as host country income tax,withholding taxes on dividends and interest paid overseas, etc., Standard & Poor’s

7 Supply and offtake contract counterparties have doubtful creditworthiness.

Sponsor counterparty obligations are uncertain.

Government counterparties, if any, have adequate credit ratings.

Financial counterparties have weak credit ratings.

Service counterparties have weak credit ratings.

10 Supply and offtake contract counterparties have poor creditworthiness.

Sponsor counterparty obligations are weak.

Government counterparties, if any, have poor credit ratings.

Financial counterparties have poor credit ratings.

Service counterparties have poor credit ratings.

Contd...


treats these taxes as ongoing expenses needed to keep a project operating (see “TaxEffects on Debt Service Coverage Ratios”, July 27, 2000).

Note that some projects have been using subordinated debt recently in theircapital structures to help mitigate commodity price risk. Although such structurescan be helpful, subordinated debt is just that-inferior to senior lenders’ rights tocash flow or collateral until after the project has met senior lenders’ obligations.Moreover, in calculating the DSCR, and ultimately the rating, on subordinateddebt, Standard & Poor’s divides total CFO by the sum of senior debt-serviceobligations plus the subordinated obligations. Such a formula more accurately

Table 6: Financial Risk Benchmark Scores



Financial flexibility not needed.

Amortizing debt payments.

No subordinated debt allowed.

2 Financial model strongly reflects project documentation.

Minimum DSCR exceeds 4.0x.

Average DSCR exceeds 6.0x.

Project insensitive to interest, inflation, and foreign exchange risks.

Distress scenario analyses show less than 50 basis point coverage deterioration.

Excellent financial flexibility protection.


No subordinated debt allowed.

3 Financial model reflects project documentation.


Average DSCR exceeds 5.0x.

Project slightly sensitive to interest, inflation, and foreign exchange risks.


Good financial flexibility.


Subordinated debt allowed, but rights against senior debt are unenforceable.

5 Financial model adequately reflects project documentation.


Contd...


measures the subordinated payment risk than using CFO after senior debt serviceobligations and dividing it by subordinated obligations.

Sovereign Risk

As a general rule, the foreign currency rating of the country in which the projectis located will constrain the project debt rating. A sovereign foreign currencyrating indicates the sovereign government’s willingness and ability to service itsforeign currency denominated debt on time and in full. The sovereign foreigncurrency rating acts as a constraint because the project’s ability to acquire thehard currency needed to service its foreign currency debt may be affected by actsor policies of the government. For example, in times of economic or politicalstress, or both, the government may intervene in the settlement process byimpeding commercial conversion or transfer mechanisms, or by implementing

Average DSCRs range from 2.0x to 3.0x.Project sensitive to interest, inflation, and foreign exchange risks.Distress scenario analyses show less than 80 basis point coverage deterioration.Good financial flexibility.Mostly amortizing debt, but may have limited bullet payment(s).Subordinated debt allowed, but rights against senior debt are limited.

7 Financial model conflicts with project documentation.Minimum DSCR exceeds 1.2x.Average DSCR ranges from 1.5x to 2.5x.Interest, inflation, and/or foreign exchange changes significantly affect DSCRs.Distress scenario analyses show less than 80 basis point coverage deterioration.Limited financial flexibility.Bullet maturities likely.Subordinated debt allowed; distress may affect senior debt.

10 Financial model conflicts with project documentation.


Average DSCRs range from 1.1x to 1.5x.

Interest, inflation, and/or foreign exchange changes significantly affect DSCRs.


No financial flexibility.

Bullet maturities likely.

Subordinated debt likely to have enforceable rights.

Contd...


exchange controls. In some rare instances, a project rating may exceed the sovereignforeign currency rating if the project has foreign ownership that is key to itsoperations, if the project can earn hard currency by exporting a commodity withminimal domestic demand, or if other risk-mitigating structures exist.

Institutional Risk

Even though a project’s sponsors and its legal and financial advisors may havestructured a project to protect against readily foreseeable contingencies, risks fromcertain country-specific factors may unavoidably place lenders at risk. Specifically,these factors involve the business and legal institutions needed to enable the projectto operate as intended. Experience suggests that in some emerging markets, vitalbusiness and legal institutions may not exist or may exist only in nascent form.Standard & Poor’s sovereign foreign currency ratings do not necessarily measureinstitutional risk. In some cases, institutional risk may prevent a project’s ratingfrom reaching the host country’s foreign currency rating, notwithstanding otherstrengths of the project. That many infrastructure projects do not directly generateforeign currency earnings, and may not be individually important for the host’seconomy may further underscore the risk. (Table 7)

In certain emerging markets, the concepts of property rights and commerciallaw may be at odds with investors’ experience. In particular, the notion of contract-

Table 7: Institution Risk Exposure Benchmark ScoresScore Characteristics1 Well-developed legal system; significant precedent exists.

Well-developed financial system.Significant history of transparency in financial reporting.

3 Developed legal system; reasonable precedent exists.Developed financial system; enforcement culture still developing.Transparency in financial reporting may raise concerns.

5 Developed legal system; limited precedent exists.Financial system beginning to develop.Contract culture developing.Transparency just taking hold.

10 No legal statutes for project finance.Bankruptcy code not developed or not enforced.Banking sector poorly monitored and/or poorly supervised.Little contract culture.


supported debt is often a novel one. There may, for example, be little or no legalbasis for the effective assignment of power purchase agreements to lenders ascollateral, let alone the pledge of a physical plant. Overall, it is not unusual forlegal systems in developing countries to fail to provide the rights and remediesthat a project or its creditors typically require for the enforcement of their interests.

Force Majeure Risk

Project-financed transactions distinguish themselves from corporate or structuredfinance assets by their vulnerability to potential force majeure risks. Force majeurecan excuse performance by parties when they are confronted by unanticipatedevents outside their control. A careful analysis of force majeure events is critical inproject financing because such events, if not properly recompensed, can severelydisrupt the careful allocation of risk on which the financing depends. Floods andearthquakes, civil disturbances, strikes, or changes of law can disrupt a project’soperations and devastate its cash flow. In addition, catastrophic mechanical failure,due to human error or material failure, can be a form of force majeure that mayexcuse a project from its contractual obligations. Despite excusing a project fromits supply obligations, the force majeure event may still lead to a default dependingon the severity of the mishap.

The risk of force majeure events, if unallocated away from the project, willlimit most projects to the ‘BBB’ category or below. Occasionally, some types ofproject, such as pipelines and toll roads, can achieve ratings that are less affectedby force majeure risk because of the improbability of such an event materiallydisrupting operations. Thus, pipeline and road projects can more easily return tooperations, compared with a mechanically complex, site-concentrated project suchas a refinery or liquefied natural gas plant. In addition, some rating increase maybe possible to the extent that a project can mitigate force majeure risk with businessinterruption and property casualty insurance. (Table 8)

Credit Enhancement

Some third parties offer various credit enhancement products designed to mitigateproject-level risks, sovereign risks, and currency risks, among others. Multilateralagencies, such as the Multilateral Investment Guarantee Agency, the InternationalFinance Corp., and the Overseas Private Investment Corp., to name a few, offer various


insurance programs to cover both political and commercial risks. Project sponsors canthemselves provide some type of support in mitigation of some risks-a commitmentthat tends to convert a non-recourse financing into a limited recourse financing.

Unlike financial guarantees provided by monoline insurers, enhancementpackages provided by multilateral agencies and others are generally notcomprehensive for reasons of cost or because such providers are not chartered toprovide comprehensive coverage. These enhancement packages cover only specifiedrisks and may not pay a claim until after the project sustains a loss; they are notguarantees of full and timely payment on the bonds or notes. Although thesepackages may enhance ultimate postdefault recovery, they may not prevent adefault. On a project default, the delays and litigation intrinsic in the insuranceclaims process may result in lenders waiting years before receiving an insurancepayment. Even if a project has a debt-service reserve fund of six to 12 months, theeffect of the reserve would be limited in preventing the default; the insurancepayment could come well after the reserve funds have been exhausted.

For Standard & Poor’s to give credit value to insurers, the insurer must have ademonstrated history of paying claims on a timely basis. Standard & Poor’s financialenhancement rating (FER) for insurers addresses this issue in the case of privateinsurers (see “Surety Policies as Mechanisms for Timely Credit Support in Project

Table 8: Force Majeure Risk Exposure Benchmark ScoresScore Characteristics Examples

1 Highly linear, simple operations. Toll roads,Loose linkages. Pipelines,Geographically spread out. Hydro-electric power plants

5 Greater complexity in operations. Coal-fired power plants,Specialized equipment used Natural gas-fired power plants,(compressors, generators, heat exchange,high pressure, high temperature).

Tighter linkages of sequential operations. Mines

10 Highly complex operations. Petrochemical plants,Extremely tight linkages amongsystem operations. Refineries,

Highly specialized equipment used. Liquefied natural gas,

Operating accidents can be costly. Nuclear power plants.


Finance Transactions”, published on RatingsDirect, June 28, 2000), but it shouldbe stressed that such policies or guarantees tend to be limited in scope and that asa result, ratings enhancement may be limited.

Outlook for Project Finance

For single-asset-based transactions and as an asset class for investors, project financehas seen a remarkable growth during the past 20 years This growth will likelycontinue. Hundreds of billions of dollars of debt have financed thousands of projectsacross many industries throughout the world. Currency crises tested many projectstructures and ultimately the financial viability of many projects, especially inAsia and Latin America. Some survived, while others folded. In the US and theUK, the massive buildout in gas-fired generation followed by the collapse inoperating margins has underscored project vulnerability to commodity price riskas projects failed. Despite the failure of some projects, project sponsors willcontinue to use project finance to raise capital. It is a proven financing technique.Yet, political and country risks will persist, as will market risks. And clearly, therisk profile for project finance is as complex as it has ever been.

Standard & Poor’s expects that project sponsors and their advisors will continueto develop new project structures and techniques to mitigate the growing list ofrisks and financing challenges. As investors and sponsors return to emergingmarkets, particularly as infrastructure investment needs increase, project debtwill remain a key source of long-term financings. Moreover, as the march towardprivatization and deregulation continues in all markets, nonrecourse debt willlikely continue to help fund these changes. Standard & Poor’s framework of projectrisk analysis anticipates the problems of analyzing these new opportunities, inboth capital debt and bank loan markets. The framework draws on Standard &Poor’s experience in developed and emerging markets and in many sectors of theeconomy. Hence, the framework is broad enough to address the risks in mostsectors that expect to use project finance debt, and to provide investors with abasis with which to compare and contrast project risk.

Project Risk Benchmarks-Appendix

The analysis of project finance relies on many subjective judgments, althoughmany quantitative techniques are available to assess comparative financial and


competitive project attributes, such as sales price or cost of production. To facilitatecomparing and contrasting key project risks across the spectrum of rated projects,Standard & Poor’s uses a series of benchmark scoring criteria for project-level andexternal risks (e.g., institutional, and force majeure).

Benchmark scores, expressed as integers, range from one to 10, with one beingthe least risky. Higher numbers represent exponentially higher risk. The scoresand their criteria represent only guidelines; they are not prescriptive but are flexible,given the specifics of a particular transaction.

The different benchmark scores are not additive, as they might be in a scoring-driven rating model. As project finance is a form of structured finance, a deficiencyin one small part of a transaction, such as the lack of a debt-service reserve fund, oran unsecured lending structure that prevents lenders from taking control of theproject, could be cause for a speculative-grade rating. In such an example, a projectcould conceivably have relatively high benchmark scores in all categories but oneand still achieve only a speculative-grade rating. Nonetheless, in general, scores ofone to five will typically point to investment grade characteristics.

(Standard & Poor’s is the world’s foremost provider of independent credit ratings,indices, risk evaluation, investment research, data, and valuations.)

197Pension Funds In Infrastructure Project Finance: Regulations...

Source: http://www.iadb.org/sds/doc/IFM-110-E-Rev2002.pdf. May 1999. © Inter-American Development Bank,Washington, DC. Reprinted with permission.

16

Pension Funds In InfrastructureProject Finance: Regulations and

Instrument Design

Antonio Vives

Private pension funds benefit from the opportunity to enhance therisk-return combination offered to the affiliates, hopefullyenhancing the value of their savings and pensions. Privateinvestments in infrastructure benefit from the possibility of tappinglong-term resources in local currency and reducing financingcosts. In the process, there is the opportunity to promote thedevelopment of the country in areas that can have a multipliereffect in terms of competitiveness and quality of living. To achievethis relationship, pension fund regulations must be restructuredso that the goal of safeguarding the value of pensions does nothinder investments in viable and profitable infrastructure projects.On the other hand, infrastructure needs to tailor the instrumentsto satisfy the needs of pension funds. The discussion presentedshows how this can be achieved for the benefit of all parties. Thisrelationship is a positive sum game.


Introduction

In the nineties, two major reforms were undertaken with intensity by LatinAmerican countries; namely, private participation in pension fund managementand in infrastructure investment. Many countries in other parts of the world haveundertaken one or another of these reforms, but not both at the same time(with the exception of the United Kingdom, which closely resembles the case ofmany countries in Latin America and pioneered private participation ininfrastructure). These dual reforms have created a sizable, mostly domestic sourceof long-term funds, while at the same creating a sizable need for domesticinvestment funds. Nevertheless, in spite of the potential benefits of a happymarriage, a relationship has not yet been developed.

The liberalization of many emerging market economies and the attendantrealization of the many benefits of private participation in infrastructure, haveresulted in a considerable need for private capital. This liberalization, occurringin the context of relatively underdeveloped financial markets, has meant relianceon foreign capital to finance growing needs, with the concomitant risk for theeconomies of unexpected devaluations and/or sudden reversals of those flows. Eventhough foreign capital flows into infrastructure projects are more resilient thanportfolio investment, recent crises have reduced the willingness of investors toprovide capital for emerging markets. As a result, projects have been subjected tosevere foreign exchange risks.

This situation underscores the importance of developing domestic sources oflong-term capital. The major, and sometimes only sources of domestic long-termcapital are local pension fund resources, which, in addition, can contribute to thedevelopment of local financial markets. It is imperative that these resources betapped by infrastructure projects. If they are to tap their resources successfully,project developers and the international project finance industry must be awareof the special needs of local pension funds. Even though the discussion isconcentrated on Latin America, it has implications for most countries with privatelymanaged pension funds and private infrastructure.

The purpose of this paper is to promote this symbiotic relationship, outliningthe conditions under which sources and uses of long-term resources can meet, andfocusing the attention of both parties to the benefits of a properly structured


relationship. There are benefits for both parties that can be exploited through abetter mutual understanding of the needs of the other party. We do not proposethat special subsidies, guarantees or tax benefits be granted to infrastructure worksto make them attractive to private pension fund managers. Nor do we proposethat public pension fund resources be directed or forced into infrastructureinvestments on account of their positive externalities or social benefits. Privateinfrastructure investment instruments must be structured so that they fit into theinvestment strategies of private pension funds, while appropriate changes in thepension fund regulatory framework should be encouraged. We propose a strictlyvoluntary private-to-private relationship, albeit with the participation of the publicsector as grantor and regulator of private activities. The public sector has theimportant role of facilitator; it controls most of the rules of the game and itsactions in either sector can make or break the relationship.

Before embarking on the purpose of this paper, the discussion of the structureof infrastructure financial instruments needed to capture pension fund investmentsand the consequent policy and regulatory reforms needed in most developingcountries, we briefly review the potential sources and needs for investment, thecharacteristics of the funds and of the projects, the current limitations to therelationship and the benefits for both parties. The article concludes with adiscussion of the implications this can have for developed countries, like the UnitedStates and most of Europe, that lag in private participation in both areas, mandatorypensions and infrastructure.

Private Pension Fund Investments in Latin America

Since the pioneering effort of Chile, which took place in 1981, many Latin Americancountries have undertaken pension fund reform, including the introduction ofprivate management of mandatory pension savings along with or as a replacementfor the public pension system.

These pension funds have accumulated a significant amount of resources.1

Table 1 shows that Chile has the largest pension funds relative to the size of itseconomy. At the end of 1998, accumulated assets exceeded US$31 billion,

1 Even though Brazil’s public system has not been reformed, the assets under administration under corporate pensions areso large that they are of considerable interest for financing infrastructure and as such are included in the discussion.


representing 40% of GDP. Other regulated systems (mandatory and voluntary)are relatively recent, and more are added every year (the most recent one beingthat of El Salvador, which was established in 1998; a private pension fund systemis slated to start in Venezuela in late 1999). While most systems are relativelyincipient, they are growing rapidly, both as a result of the profitability ofinvestments and the number of new entrants. Chile's private pension fund systemhas been in operation for almost 20 years, and in that period resources have grownat an annualized rate of 29.4% (in local currency). Most recent systems haveposted very high growth rates. For example, in Argentina, pensions increased at arate of 29% a year over three years; in Colombia the rate of increase was 39% overtwo and a half years; in Mexico it reached 168% over two years; and in Peru, 22%over three years. Nevertheless, they are still small when compared with theirpotential and relative to the size of the respective economies. If the countries thathave started private pension funds were to reach the levels attained in Chile, LatinAmerica would have over US$560 billion. This is a significant amount that theunderdeveloped and thin capital markets would not be able to absorb, forcinginvestments in government paper or bank instruments (Table 7 gives an indicationof capital market depth). There is a need to develop those markets and to introducenew instruments, which the pension funds are in a position to support.

Investment Regulations2

In order to protect the interests of the affiliates, all the countries of Latin Americain which private pension funds operate, regulate the composition of portfolios. Asthese portfolios are expected to provide or supplement the pensions that were previouslyprovided by the state, they tend to place strict limits on allowable investments andthe performance of the portfolio.

These regulations tend to favor stability and uniformity of investment portfolioperformance, which tends (however unwittingly) to exclude worthwhile, andeconomically and socially desirable investments like the provision of newinfrastructure. A few regulations that further exacerbate this difficulty must beovercome, if infrastructure investments are to be a part of pension fund portfolios.

2 This section benefits from the paper by Shah (1996), which criticizes the regulation for their effect on managementexpenses and sub-optimal portfolio choice, and Vittas (1998), which moderates the criticisms, for lesser developedcountries, on account of under-developed financial markets and institutions.


The regulations cover the range of allowable investments, their liquidity,valuation and risk characteristics and other regulations on the portfolios themselves,such as minimum return. They also govern the management, allowing freedom toswitch administrators, the number of portfolios per affiliate, portfolios peradministrator and allowable managers. Still other regulations set limits on theliquidity and valuation of investments and limit investments to rated instruments.Some of these regulations make it almost impossible to invest in infrastructureassets or at least tend to discourage such investments. Appendix II presents asummary of the most relevant regulations in the countries listed in Table 1.

Regulations That Hinder

Ratings: In order to account for the risk of the allowable assets and the rules set byregulators, pension fund administrators tend to require that non-government paperbe rated by an independent agency and have a local investment grade. Thosepension schemes that allow investments in foreign assets require an investmentgrade for such assets, rated by internationally recognized credit rating companies.Even equity investments are sometimes limited to rated firms.

Table 1: Comparative Size of Private Pension Funds

Total Pension GDP 1998 Population Pension/ Pension AssetsFund System(a) (millions of US$) Projected 1998 GDP (%) per Capita

(millions of US$) (millions) (US$)

Argentina 11,526 337,615 36.1 3.4 319Brazil 75,068 776,900 165.5 9.4 454Chile 31,146 77,417 14.8 42.7 2,101Colombia 2,110 87,474 37.7 2.4 56Mexico 5,801 379,126 95.8 1.5 61Peru 1,739 60,480 24.8 2.9 70Germany 294,379 2,142,100 82.0 13.7 3,591Netherlands 457,807 378,300 15.6 121.0 29,259Spain 31,831 569,000 39.3 5.6 810UK 991,951 1,362,300 58.3 72.8 17,027USA(corporate) 4,400,000 8,508,900 269.8 51.7 16,310(a) Pension Fund Data at Dec. 1998, Except Germany, Netherlands and UK at Dec. 1997

Sources: GDP data: IMF (1999). Latin America Pension data: FIAP, Boletin #5; Europe Pension data:Mercer W./Inverco. USA Pension data: Pensions and Investments (1999)


Liquidity: To minimize problems with the valuation of security assets, mostregulations prohibit, or in the best of cases, limit the holding of assets that are nottraded or do not have a high degree of liquidity in major organized exchanges. Forthe purpose of identifying the level of liquidity, some regulations use liquidityindexes.

Valuation Rules: Most regulations require mark-to market valuation, whichby itself tends to favor investments whose prices are frequently quoted. This,again, would make investments in new infrastructure less likely to occur, becausethe instruments backing those assets would tend to be traded infrequently.

Regulations That Discourage

Allowable Investments: As of 1999, the most restrictive private pension fundregulation is that of Mexico, where the only allowable instruments are debt securitiesissued or guaranteed by the federal government or the central bank. The onlyexception is the investment of up to 35% of the assets of the fund, in debt securitiesissued or guaranteed by private companies and financial institutions with highcredit rankings. Also, at least 65% of the portfolio should be invested in paperwith maturities and/or review of interest rates not higher than 183 days, some ofwhich must be invested in securities issued by the government or central bankwith maturities of less than 90 days. At the end of 1998, the portfolio compositionof all pension fund administrators in Mexico included 97% government or centralbank paper. In addition to being conservative, these rules, which are expected tobe temporary, aim to ensure financing for the government liability created by thetransition from the old pays-you-go (PAYG) public pension system to the privatesystem. The most liberal and oldest of the pension fund regulations are those ofChile, which allow investments in stocks, foreign securities, real estate, infrastructureand most negotiable instruments with an investment grade rating. These regulationshave been progressively liberalized, as capital markets became more developedand confidence in the operation of the system increased.

These investment regulations discourage investment managers from investingin infrastructure assets, as most (with the exception of Chile’s) make the rules ofliquidity, valuation and ratings applicable to all investments. This, in effect, limitsdirect investment in projects and, only in some cases, allows indirect investments


through the purchase of stocks of well established infrastructure corporations ormutual funds. Furthermore, investments in non-recourse or limited recoursegreenfield projects (i.e., investments that depend on the cash flows of newlyconstructed or under-construction projects) are even more restricted. These projectsdo not have an established track record, are rather risky, illiquid, and in mostcases lack a rating (let alone an investment grade rating).

Performance Regulations: In order to protect the value of the affiliate's pensionsagainst overaggressive behavior by the administrators and to minimize the needfor supplementary public pensions, most countries regulate the performance ofportfolios. In many cases, they are required to earn minimum returns, measuredin either absolute (nominal or real) terms or relative to the performance of otherpension funds. In the case of Chile, administrators are required to earn a minimum,which is the lesser of 200 basis points below the average system return or half theaverage return. Those that do not meet this criteria are required to compensatethe portfolio with resources from a fluctuation reserve, established with priorearnings exceeding the minimum, and/or the administrator's own capital. In thecase of Argentina, minimum returns are measured as 30% below the system average.

In order to avoid under-performance at a given point in time, pension fundmanagers tend to avoid volatility (inherent in infrastructure) and to invest insimilar portfolios, reducing incentives for taking greater risks, while diversifyingthe portfolio within the limits allowed by local financial markets thereby precludinglarger returns. Quantitative evidence from the Chilean system presented by Shah(1997), show that there are minimal variations in portfolio composition.

This herding behavior is not exclusive of regulated funds. It can also be foundin the management of private corporate pension funds, where managers oftencompare their performance with the industry average or with a standard benchmarkand, in an attempt not to report under-performance relative to the average, tendto imitate each other’s portfolio. This tendency is obviously not as prevalent asthat forced by regulation.

Switching: Most regulations allow affiliates to switch accounts, between pensionfund administrators, once or more in a given year. In addition to the obviousimpact on marketing expenses, when combined with restrictions on portfolio


composition and minimum performance requirements, this option tends toreinforce herding behavior since administrators do not want to lose customers onaccount of reporting volatility, arising out of infrastructure investments.

One Portfolio Per Affiliate: All Latin American countries require that all pensionassets of the affiliate be invested in the same portfolio, although several areconsidering a change. This precludes the existence of portfolios with differentrisk-return characteristics, that could adapt to the risk tolerance of the affiliateand his/her life-cycle. Again, this restriction conspires against the incorporationof illiquid assets. The model of the individual retirement accounts sponsored byprivate US corporations is a good one. In this case, the affiliate can opt to divideinvestments among several portfolios offered by the fund manager in order totailor the combined portfolio based on age, risk tolerance or to take account ofother investments he/she may have. Obviously in this case, there is no bailout ofpensioners by the government, as is the case in some Latin American countries,which guarantee a minimum pension. Moreover, the level of development of thecapital markets and the investment sophistication of the affiliates in Latin America,make it more difficult to allow this freedom.

A better solution would be to allow flexibility in the choice of portfolio withina given pension administrator, after the pensioner has a part of his/her savings inone that guarantees a minimum pension.

One Portfolio Per Administrator: Pension fund managers can only offer oneportfolio to their clients. Combined with the restrictions described above, thisone also reinforces the convergence to the mean portfolio and precludes theincorporation of riskier assets. In the case of Mexico, for example, the law establishesthat pension fund administrators could manage several pension fund companieswith different portfolio composition and risk levels, although the current, verystrict investment and minimum return rules restrict the viability of this option.

Monopoly of Pension Asset Management: Almost all Latin American countriescurrently restrict the management of pension assets to institutions exclusivelydevoted to this end, often regulated by a special regulator (in the case of Colombia,the Bank Superintendency regulates pension fund administrators). Competitionfrom banks, insurers and other financial institutions is not permitted. While this


allows for easier oversight of the industry, it also precludes the offer of alternativeinvestment vehicles, which in general have had better returns than pension fundportfolios, albeit with greater risk. This choice, which should become available asthe system matures, would allow for greater competition, portfolios which aremore along the risk-return frontier, and a stronger interest in infrastructure assets,particularly as financial institutions gain experience in infrastructure finance. Thisis not to suggest that oversight be eliminated. As investment and pensionmanagement services become specialized, the industry will continue to needregulation to protect the interests of affiliates. But, as the system and financialmarkets mature, it will become more obvious that there are significant similaritiesbetween the pension fund and the banking and insurance industries, and that allcan operate in the same markets with common regulations.

Portfolio Composition

Given the foregoing, the portfolio composition of pension funds tends to be ratherconservative. The least conservative system is that of Chile because that country'ssystem is more mature. (Table 2)

Table 2: Portfolio Composition by Sector (End of 1998)

Bonds StocksReal

Foreign Other TotalEstate

Argentina 70.9% 25.0% 0.3% 0.3% 3.5% 100.0%

Brazil 47.0% 36.5% 14.5% 0.0% 2.0% 100.0%

Chile 76.4% 16.1% 1.7% 5.7% 0.1% 100.0%

Colombia 84.0% 3.2% 2.5% 0.0% 10.3% 100.0%

Mexico 100.0% 0.0% 0.0% 0.0% 0.0% 100.0%

Peru 65.8% 33.5% 0.0% 0.0% 0.7% 100.0%

Germany 71.0% 6.0% 13.0% 7.0% 3.0% 100.0%

Netherlands 47.0% 15.0% 7.0% 29.0% 2.0% 100.0%

Spain 62.4% 13.7% 0.0% 16.7% 7.2% 100.0%

UK 8.0% 54.0% 2.0% 29.0% 7.0% 100.0%

USA (a) 28.9% 51.9% 3.0% 10.5% 5.7% 100.0%

(a) Top 1,000 Funds aggregate asset mix.

Source: Latin America: FIAP (1999); USA: Pensions and Investments (1999); Europe: Mercer.


The case of Chile, with its longer history, is illustrative of the possible evolutionas funds mature and tend toward riskier portfolios, even within the very conservativelimits set by regulations. At the beginning, most assets were invested in essentiallyriskfree securities, as is the current case in Mexico (although in this case, pensionassets are also used to finance the deficit of the transition form the old to the newsystem). As time went by and capital markets developed, funds started to investin mortgage bonds and corporate securities, to the point that in 1994 theserepresented a proportion similar to public securities. This changed in 1998, whenthe stock market was hit by uncertainties associated with the Asian crisis andfunds moved into bank deposits and international diversification.

Moreover, in 1990, pension funds were authorized to invest in foreign securitiessubject to a very low and slowly increasing limit (currently set at 12%). Foreigninvestments started in 1993, increasing by 38% in 1998, reaching US$1,785 million.Investments in venture capital and infrastructure funds were permitted in 1993; in1995 the limit on equity holdings was raised to 37% (Vittas, 1996). (Table 3)

Given their relatively large size, Chile’s pension funds have also contributed to thedevelopment of the market. They have been instrumental in developing credit ratingagencies (clasificadoras de riesgo), giving depth to the markets, stabilizing prices (becausethey are long-term investors), developing new products to attract them and thepossibility of investing in infrastructure funds as we are exploring in this paper.

Table 3: Evolution of Chile�s Pension Fund InvestmentsType of asset(percentage of total assets) 1981 1985 1990 1994 1998

Government Securities 28 43 44 40 41

Bank Deposits 62 21 17 5 14

Mortgage Bonds 9 35 16 14 17

Corporate Bonds 1 1 11 6 5

Corporate Equities 0 0 11 32 15

Other 0 0 1 3 3

Foreign Securities 0 0 0 0 6

Total 100 100 100 100 100

Source: Vittas (1996), data for 1998 form Boletin #5, FIAP (1999).


As can be seen, when private pension funds mature and capital markets develop,the range of investments tends to widen and move away from concentration ingovernment securities. The current, very restrictive regulations can be expected tobe liberalized as the systems gain the confidence of regulators and self-regulationis developed. Eventually those systems will adopt the “prudent man rule” (i.e., norestrictions, just common sense), that governs the pension programs of privatecorporations or the most advanced systems in Europe, like the Netherlands andthe United Kingdom. This trend needs to develop for the inclusion of infrastructureas an allowable investment.

Infrastructure Investments

The only Latin American countries that now explicitly allow investments ininfrastructure (even greenfield projects) are Argentina, Colombia and Chile. Pensionfund managers in those countries are able to participate in infrastructuredevelopment programs and public services only indirectly by purchasing paperissued by specialized infrastructure investment funds or (titulos securitization),which spread the risks involved. Obviously, those systems that allow investmentsin private securities allow, indirectly, investments in infrastructure assets, throughthe purchase of mutual funds or stocks and/or bonds of the corporations owningthose assets. Nevertheless, some of these assets may not have the required ratingand/or liquidity necessary to comply with other regulations, and, as such, mayhave to be exempted if project finance investments are desired. Furthermore, mostmanagers would have to acquire the capabilities to perform due diligence on theseinvestments.

The case of investment in established corporations that have a significant portionof their assets in infrastructure, falls within the categories of investments in stocksor bonds of traded corporations and is rather straightforward. As a result, we willnot address it here. We are more concerned with investments in new infrastructureprojects (project finance). Although no precise figures exist, in the case of Chilethe private pension system has invested in several road and airport concessions byinvesting in the concession partners. In all cases, it was investment in alreadyexisting assets, not greenfield projects. In the case of Argentina as of the end of1998, approximately 0.6% and 5.8% of total pension assets were invested inbonds and shares respectively, of infrastructure related projects or companies.


The newly created pension funds should hope to emulate U.S. corporate pensionfunds, which operate in a very well-developed financial market. As of the end of1998, the defined benefit corporate pension funds, in the top 1000 funds in theUnited States, have an average of 5.1% of their assets in private equity and realestate (these assets are the most similar to infrastructure projects) and 11.8% ininternational equity.3

Investment Needs of Private Pension Funds

The regulations described above determine, in most cases rather narrowly, thepotential investments of pension funds. If these regulations were relaxed, pensionfunds would probably invest in other instruments. In particular, they are likely tobe interested in instruments that:

• Provide higher returns.

• Provide opportunities to reduce risk through diversification.

• Provide inflation protection.

• Do not enhance volatility of reported returns.

• Do not add undiversifiable risks (like foreign exchange exposure).

• Have liquidity.

• Provide short-term and mid-term cash flows.

Unfortunately, most financial markets in the developing countries do not havethe instruments needed, even if the regulations were relaxed. Therefore, instrumentswill have to be created, as financial markets develop. If properly structured,infrastructure financial instruments can meet some of those needs and, as a result,should be attractive to those pension funds. Nevertheless, infrastructure investmentis an activity which is inherently risky, both because of its strategic inflexibility(it cannot be moved or used for other purposes) and the fact that it provides basicpublic services subject to political interference (which could be reduced as aconsequence of private pension fund participation). In this regard, it is importantto distinguish between investments in well-established firms that provide

3 Even though private pension funds in Latin America are defined contribution, the management of the portfolios is inthe hands of independent managers with a single portfolio and as such, the resulting portfolio is more comparable to theUS-defined benefit case.


infrastructure services (which should be treated as regular investments) andinvestments in new projects, which require special consideration in terms of theregulatory environment and financial instrument design.

In terms of the latter, we propose that private pension funds invest between1% and 5% in infrastructure project finance assets. Needless to say, thisrecommendation is not based on a comprehensive analysis of the risk returncharacteristics of infrastructure investments or the efficiency frontier of the allowableassets of pension fund portfolios. Nor does it incorporate the risk preferences ofaffiliates (the research required goes beyond the scope of this paper). This is merelya rule of thumb, based on the preceding analysis, in particular by looking at theevolution of the Chilean case and the practices of pension funds administeredunder the “prudent man rule”.

Potential Private Pension Fund Investment in Infrastructure

Based on the expected rates of growth in pension fund assets4 and assuming that 3%of those assets are invested in infrastructure, Table 4 gives an indication of the availabilityof resources in selected countries. The third column gives the stock of potential assetsin the portfolio if the full 3% were invested. The fourth column gives the availabilityof resources for new investments during the year, assuming that investment of 3% ofthe new assets flow into the pension funds portfolio (growth).

4 Assumes the following rates of growth: Argentina and Brazil, 20%; Chile, 12%; Colombia, Mexico and Peru, 30%.These rates are not critical for the point we want to show and are merely indicative.

Table 4: Availability of Resources for Infrastructure in the Year 2000Country Pension Fund Potential investments in Potential new yearly

Assets year end infrastructure projects investments in(billion US$) (portfolio) (million US$) infrastructure

projects (million US$)

Argentina 20 600 120

Brazil 117 3,900 780

Chile 49 1,470 180

Colombia 3 90 30

Mexico 20 600 180

Peru 3 90 30


The investment of pension funds assets in infrastructure provides importantbenefits to those projects in which:

• Foreign exchange risk exposure is reduced, as most projects generate localcurrency revenues, but have traditionally depended on foreign exchangefinancing to cover long-term needs.

• Financing (refinance) risk is reduced because pension funds are able to providelonger tenors than those currently available in the local financial markets.

• The cost of capital is potentially reduced because these resources tend to beless expensive on a risk-adjusted basis than most of the alternatives (importedcapital or short-term local finance).

• There would be less interference in decision-making because pension fundstend to be less involved in day-to-day management than the alternativesources (this must be compensated with proper governance system to ensurethat pension funds are not “taken for a ride”).

• Political risk is reduced because the participation of resources representingthe pensions of local workers should induce closer adherence and fairnessin the application of infrastructure regulatory principles. Pension fundscan be honest brokers, as affiliates are affected both by the returns of theprojects and the rates charged by the services provided.

These benefits are important enough for infrastructure projects to be very interestedin pension fund resources and to take the necessary measures to capture them.

Private Participation In Infrastructure

The current decade has seen a significant transformation in the modalities ofprovision of infrastructure services concurrent with pension reform. There hasbeen a major increase in private sector participation in the provision of infrastructureservices. This is particularly the case in the countries that undertook pensionreform, that also liberalized their economies, but it is not limited to them. In thecase of Latin America, the main reasons for the increase in private participationhas been the need to modernize and expand the services which the state can nolonger finance and to redirect resources used to finance the deficits of publicutilities to more pressing social needs. This has led most countries to privatize


public utilities and to concession in transportation services, leaving the financingof the rehabilitation and expansion in the hands of the private sector. Theseinvestment needs, as will be seen below, are rather large and are well beyond thecurrent capacities of domestic financial and capital markets, both in terms ofvolume and in terms of tenor. This forces the private sector to resort to internationalsources to finance investments that generate revenues mostly in domestic currencies.

Financing Needs

It has been estimated that for each 1% in GDP, investment in the traditionalinfrastructure sectors (telecommunications, energy, transportation and water andsewage) would need to increase by 1% of GDP (World Development Report,1995). A reasonable goal for governments would be to make sure that infrastructurecan support a long-term annual growth rate of 5%. Given the size of the LatinAmerican economy, this would require investments of US$70 billion (in year2000 dollars) per year. It is estimated that the telecommunications sector wouldrequire roughly $25 billion a year; energy, $28 billion; transportation, $10 billion;and water, $7 billion. Telecommunications can be considered a relatively safe anddeveloped sector that should be part of the regular portfolio of investments ofpension fund assets in publicly traded stocks and bonds. It should hence beexcluded from the special “project finance” allocation we are suggesting. Also, aportion of the energy sector that includes well established utilities in countries

Table 5: Investment in Infrastructure Projects with Private Participation,1990-1997 Latin America and the Caribbean (million US$)

Year Electricity Water Gas Telecom Transport Total

1990 645.70 - - 4,443.30 5,311.00 10,400.00

1991 - 75.00 - 9,213.80 395.50 9,684.30

1992 2,130.06 - 2,930.00 11,112.00 2667.50 18,839.56

1993 2,925.74 4,153.00 142.80 5,804.40 835.80 13,861.74

1994 3,019.57 434.00 1,342.90 9,109.90 1,517.10 15,423.47

1995 5,380.48 1,178.80 796.50 6,910.30 1,600.70 15,866.78

1996 9,012.51 153.90 915.80 9,710.40 2,785.40 22,578.01

1997 20,514.80 1,625.20 2,490.88 11,273.40 3,658.50 39,562.78

43,628.86 7,619.90 8,618.88 67,577.5 18,771.80 146,216.94

Source: World Bank (1999).


with mature reforms could also be seen in this light. Nevertheless, as this is still asmall segment of the overall Latin American market (although it represents a largepart in Chile and Argentina), we will assume that the energy sector is in need ofrisk capital and include the estimates in our proposal. As a result, total annualneeds that could potentially be covered by the risky portion of pension fundsassets could amount to almost $50 billion in the year 2000. These large needscontinue to be met mostly by the public sector and it is estimated that privatesources only cover 15% (World Bank, 1997a).

Table 6 shows the percentage of private investment covered assuming that theprivate sector finances around 15% of the infrastructure needs of those countries(15% of 5% of GDP).5 Obviously every country would be different, and thenumbers shown only attempt to provide orders of magnitude to assess the overallfeasibility of pension fund financing. They are more valid in the aggregate thanon an individual country basis.

Even though the potential contribution by pension funds appear to be smallcompared with the needs, they do represent an important contribution to thefinancing, particularly in terms of the very scarce local currency finance. Whenconsidered in the context of the financing package of any project, these figures, evenexcluding the special case of Chile, represent a large contribution from a singlesource of financing and surely would be the largest of the local financing sources.

5 If the telecommunications sector is excluded from these estimates, under the assumption that they represent traditionalinvestments, then the figures could, as a rough estimate, be multiplied by 1.5, as telecommunications account for about30% of the estimated financing needs.

Table 6: Coverage of Infrastructure Needs in the Year 2000Country Private financing New investments in Percent of yearly

of needs (15%) infrastructure projects needs satisfiedper year (million US$).

Exhibit 7.

Argentina 1,900 120 6.3

Brazil 4,200 780 18.6

Chile 435 180 41.4

Colombia 525 30 5.7

Mexico 2,700 180 6.7

Peru 435 30 6.9


What Do Infrastructure Investments Offer

Based on the discussion above, it should be clear that private infrastructure couldand should tap into pension fund assets. Yet, this can only happen if thoseinvestments bring something which is of value to the pension funds. Indeed,infrastructure investments do have some valuable features:

• They tend to provide a higher return than the one obtained by pensionfund portfolios.

• Although infrastructure projects are riskier, they provide diversificationbenefits given that their returns are less than perfectly correlated with existingpension fund portfolios. For risk averse investors, investments ininfrastructure may move the overall return to a more desirable risk returncombination.

• These investments could increase the volatility of returns, but given thatthe proportion would be very small, the impact should be negligible.

• These investments contribute to overall economic growth, including thecreation of new jobs, thereby generating even more resources for the pensionfunds and benefiting their stakeholders.

Nevertheless, these investments also have some undesirable features that mustbe overcome before pension funds undertake them:

• Higher expected returns are achieved over the long run. Even though pensionfunds can afford to wait for returns because their liabilities are long-term,current regulations lead them to prefer short-term, steady returns.

• These investments may not comply with some of the regulations describedabove, in particular with respect to ratings, valuation and liquidity.

• Given that these investments carry a higher (although mostly diversifiable)risk, they bring the nondiversifiable risk of having to report a failure in aninvestment, with the potential for increased switching by affiliates to anotherpension fund administrator. This is an agency problem, because even thoughthe investment may benefit the affiliate in the long run, it poses a short-term risk to the administrator.


Compatibility Between Infrastructure Investments and PensionFund Portfolios

At the end of the previous two sections, we analyzed the investment needs of theprivate pension fund portfolios. Based on the previous discussion, it is apparentthat the incompatibilities outweigh the synergies. Nevertheless, it is important toemphasize that these incompatibilities are more the consequence of the lack ofappropriate instruments and regulations, than of the fundamentals. We furtherdiscuss the ideal regulatory environment to foster the investments and make somepolicy recommendations. We also discuss the design of financial instruments neededto take advantage of that pool of resources.

Changes In The Regulatory Environment

Based on the discussion on pension fund regulation and the characteristics ofinfrastructure investment, it is no wonder that there has been so little participation.The regulations on ratings, liquidity, switching, minimum return, one portfolioper affiliate, one portfolio per administrator, monopoly by pension fundadministrators, and valuation rules make these investments almost impossible.The ideal regulatory framework will use the “prudent person rule”, whereby decisionson investments are left to the administrators exercising their fiduciary responsibility,as is the case of corporate pension funds in the United States and pension funds inthe Netherlands and the United Kingdom. However, the government continuesto have a financial interest because, in many cases, it guarantees the minimumpension. Furthermore, in the case of developing countries, this relaxation must beaccompanied by the corresponding enhancement of the capabilities of thesupervisory agencies. Thus, regulations should allow affiliates to have severalportfolios—a properly regulated one for the minimum pension, and several forsupplementary pensions that are basically deregulated and operate under the“prudent person rule”. Minimum pension portfolios would be regulated undercurrent rules, and gradually relaxed as the system matures.

This ideal regulatory framework cannot be achieved in the short run, butshould be the benchmark to be achieved as pension funds and financial marketsmature. In the meantime, the regulations could be progressively relaxed and, movefrom regulating investment to measures that regulate overall portfolio risk. Theperformance of supplementary pension portfolios would be assessed based on


measures of risk-adjusted returns. Each administrator should be allowed to manageseveral portfolios with different risk-return characteristics (with the number beingcompatible with the development of the local capital markets). Each portfoliowould advertise the risk tolerance and net-of-expenses performance benchmarkand under-performance (say 20% below benchmark return) would be coveredthrough reserves or the administrator’s capital. Switching would still be allowed,but it would be less of an issue, because comparison is relative to net-of expensesbenchmark and not to other “competing” portfolios (not comparable, unless theyare of the same risk and same expenses). Ideally, all financial institutions would beable to manage pension funds and, would fall under a consolidated regulatorybody, with specialized units (banking, securities, insurance, pensions).

Regulations on ratings, liquidity and valuation should be handled throughthe proper design of infrastructure financial instruments. Nevertheless, it wouldhelp if these regulations were relaxed, not eliminated, for a small percentage ofassets, say 5%. For instance, valuation and rating rules could be substituted byperiodic independent assessments of the investment value.

The Ideal Regulatory Framework:

� Prudent person rule for supplementary pensions

� Progressive liberalization for minimum

Design of Financial Instruments

Based on the discussion above, it is clear that if these instruments are to beattractive to pension funds, without been forced, they need to be, to the extentpossible:

• More liquid

• Less risky (lower probability of failure)

• Less volatile.

The instruments can have either direct or indirect claims on the cash flows. Inthe case of direct claims, the instruments can be securities (the need to be marketableis a sine qua non condition) like general project bonds, securitization of specificcash flows or shares of the special purpose vehicles. In any case, to comply with


these conditions, the securities would have to have claims on special cash flows.For instance, they should have a senior claim on revenues, be based on projectswith track records (operation stage) or have some form of enhancement throughthe participation of the government, multilateral agencies and/or political or creditinsurance. The above-mentioned conditions can be further enhanced if the securitiesare based on indirect claims on the cash flows through some form of investmentpools. This would allow investment in the securities of several projects, over severalsectors and even over several countries. The resulting securities would alreadyconstitute a well-diversified portfolio and, as such, would be more liquid, lessrisky and less volatile, and may even be rated. In all cases, the underlying projectsmust be well structured and backed by solid sponsors. Even though this is theideal, barely achievable in practice, it is the benchmark that those seeking pensionfund financing should strive for.

In the United States and other developed capital markets, there are endless optionsfor the private pension fund administrator to invest the portfolio assets, and toconfigure the desired risk-return profile. In the case of countries with lesser developedmarkets the options are rather limited, sometimes limited to government paper andthe negotiable certificates of deposit or liquid deposits of financial institutions. Thecase of most countries of Latin America is paradoxical. The private pension fundindustry generates long-term, domestic, investable resources, and it needs to enhanceprofitability and minimize risk. Unfortunately, it does not have a well-developedcapital market capable of providing the necessary instruments, either because it isunderdeveloped, or as the case of Chile, its size is rather small when compared withthe size of the funds. On the other hand, there are large unsatisfied needs of legitimatelong-term domestic investments waiting to tap into the pool of those resources.There is a real gap between the potential of the funds, the needs of infrastructureand the development of the capital markets that must be closed through thedevelopment of the proper instruments, regulations, and institutions.

Pension Fund Investments in Infrastructure Assets

As discussed above, changes in the pension fund regulations are needed, but thesealone will not be enough. Changes in the design of infrastructure finance instrumentsare also needed. These regulatory changes, if any, will occur over prolonged periodsof time. In the meantime, for pension funds to invest in project finance infrastructure


assets, the instruments will have to adapt to the existing regulations and the proposalindicated in the box below requires minimal changes in regulations, and in somecountries none at all. The ideal instrument proposed is the most conservative thatcan be designed, short of one guaranteed by AAA-rated institutions or governments.It should have ample liquidity, very low risk (obviously with a correspondinglylower return) and would be properly valued. Even though it would capture fundsfor infrastructure, pension funds could do better in the risk-return tradeoff withmore direct investments. As regulations are relaxed, the instruments will not have tobe as complex as implied by the recommendation and some funds may be able toacquire simpler instruments, including direct investments or the purchase ofnegotiable debt instruments of specific projects.

The application of the prudent man rule most likely would not imply a dramaticchange in the portfolios of pension funds, evidenced by the portfolio compositionof countries that use this rule. Administrators would probably still insist on liquidity,ratings and valuation rules, but most likely, they would be willing to “exempt” aportion of the portfolio from these self-imposed rules and allow investment in illiquid,non-rated and subjectively valued assets. This would favor direct investment in therelatively riskier (diversifiable), but return-enhancing infrastructure assets.

The ideal financial instrument: Securities of a fund, invested in many carefully selected projects, withsome form of credit enhancement (e.g. multilateral participation, credit guarantees, political riskinsurance), over several sectors (heavy on energy, light on water, with a mix of transportation subsectors),covering several countries, mostly in operational stage, with shares quoted in some exchange.

Table 7: Indicators of Capital Depth1996 Market Domestic 1996 1998

Capitalization Credit (a) Turnover Fund Size

Argentina 18 26 50 3.4

Brazil 32 37 86 9.4

Chile 93 60 10 42.7

Colombia 25 46 10 2.4

Peru 27 12 26 1.5

USA 105 138 93 51.7

Percent of GDP, except turnover.

Sources: IMF, Financial Statistics, March 1999; Word Bank, World Development Indicators, 1998; (a)Provided by banking sector in 1996.


Implications for Other Countries and Other Investments

Even though we have been mainly discussing Latin America, the conclusions haveimplications for all countries, taking into account the differences in financial marketsdevelopment. This is particularly the case because pension fund reforms in manydeveloping countries are following the Chilean model (with the needed variations).Also, many developed countries (particularly in Europe) are under pressure to reducetheir fiscal deficits and, to do so, are considering the private provision of infrastructureservices. Given that these countries already have corporate or private pension fundsin place, the implications of our discussion are also valid for them. Obviously, as thediscussion refers to a private-private relation, it is valid if both infrastructure andpension funds are in private hands. The discussion can also be applied in the case ofother private investments, different from infrastructure, that share some of theproblems of inflexibility and size, as would be the case of housing.

In the United States, there was a proposal in the early nineties to utilize thevast resources of private corporate funds to finance public infrastructure (see USDepartment of Transportation, 1993). In this case, the proposal was to use resourcesunder private management to finance public sector works. The proposal involvedthe creation of a public financial institution that would issue securities, insuredby a separate insurance company and with the implicit guarantee of the USgovernment and tax benefits for purchasers. These securities were to be purchasedby institutional investors, including private pension funds, and the proceeds wouldbe used to finance public infrastructure, leveraging the capital paid in thecorporation by the federal government. Even though the idea was very wellstructured, the private sector was not enthusiastic about it, as it appeared to be aform of forced investment. The problem was that even though the corporationmay have been managed along private criteria, the activities financed were publicworks without an underlying cash flow and the tax exempt pension funds weremore interested in taxable securities (for a comprehensive analysis of the proposal,see US General Accounting Office, 1995). Given that corporate pension funds inthe United States have very few investment restrictions, the problem of insufficientinfrastructure finance could be solved by privatizing some of the infrastructureand issuing securities along the lines proposed in this paper.


Concluding Remarks

If regulations of private pension funds were to be relaxed to allow investments inprivate infrastructure projects and, in turn, these projects adapted their financialinstruments to the needs of those pension funds, both parties would be able toreap significant tangible and intangible benefits. Private pension funds benefitfrom the opportunity to enhance the risk-return combination offered to theaffiliates, hopefully enhancing the value of their savings and pensions. Privateinvestments in infrastructure benefit from the possibility of tapping long-termresources in local currency and reducing financing costs. In the process, there isthe opportunity to promote the development of the country in areas that canhave a multiplier effect in terms of competitiveness and quality of living.

To achieve this relationship, pension fund regulations must be restructured sothat the goal of safeguarding the value of pensions does not hinder investments inviable and profitable infrastructure projects. On the other hand, infrastructureneeds to tailor the instruments to satisfy the needs of pension funds. The discussionpresented shows how this can be achieved for the benefit of all parties. Thisrelationship is a positive sum game.

(Antonio Vives is Deputy Manager, Infrastructure, Financial Markets and PrivateEnterprise, of the Sustainable Development Department and Vice-Chairman of thePension Fund Investment Committee at the Inter-American Development Bank inWashington, DC.)

References

1 Bustamante J Quince años después: Una mirada la sistema privado de pensiones, Santiago,Chile, 1997.

2 Federación Internacional de Administradoras de Fondos de Pensiones. Semi-annual Bulletinsfor the years 1996,1997, and 1998, Santiago de Chile.

3 Financial Times. “Pension Fund Investment, Financial Times Survey”, Financial Times,May 14, 1998.

4 International Monetary Fund. International Financial Statistics, International MonetaryFund, Washington DC, March 1999.

5 Kilby P “The Rising Tide of Local Capital Markets”, Latin Finance, Number 92, October 1997.

6 Latin Trade “Growing Older: Latin America’s Pension Funds Come of Age”, Latin Trade,December 1998.


7 “Mercer European Pension Fund Managers Guide”, Investment and Pensions Europe, March1998, W.H. Mercer Companies, Inc., 1998.

8 Ministerio de Obras Publicas, Ministerio de Hacienda. Bonos de Infraestructura, Santiago,Chile, 1997.

9 Pension and Investments: The International Newspaper of Money Management. January 25,1999.Crain Communications Inc.

10 Queisser M The Second-Generation Pension Reform in Latin America, Organization forEconomic Cooperation and Development, Paris, 1998.

11 Riesen H “Liberalising Foreign Investments by Pension Funds: Positive and NormativeAspects”. Technical Paper No.120, Organization for Economic Cooperation and Development,Paris, January 1997.

12 Shah H “Toward Better Regulation of Private Pension Funds”, Policy Research WorkingPaper No. 1791, World Bank, Washington DC, March 1998.

13 US Department of Transportation. Financing the Future, Report of the Commission toPromote Investment in Infrastructure, US Department of Transportation , Washington DC,February 1993.

14 US General Accounting Office. Private Pension Plans: Efforts to Encourage InfrastructureInvestment, US General Accounting Office, Washington DC, September 1995.

15 Vittas D “Pension Funds and Capital Markets, Public Policy for the Private Sector”, NoteNo. 71, World Bank, Washington DC, February 1996

16 Vittas D “Regulatory Controversies of Pension Funds”, Policy Research Working PaperNo. 1893, World Bank, Washington DC, March 1998.

17 World Bank, Infrastructure for Development, World Development Report 1994, World Bank,Washington DC, 1994.

18 World Bank “Facilitating Private Involvement in Infrastructure: An Action Program”, WorldBank, Washington DC, 1997.

19 World Bank “Mobilizing Domestic Capital Markets for Infrastructure Financing”, WorldBank Discussion Paper No. 377, World Bank, Washington DC, 1997.

20 World Bank. World Development Indicators, World Bank, Washington DC, 1998.

21 World Bank. “Private Sector Development Department, Private Participation in InfrastructureDatabase”, World Bank, Washington DC, April 1999.

221Pension Funds In Infrastructure Project Finance: R

egulations...

Chile Peru Colombia Argentina Mexico Bolivia Brazil

Start of operations 1981 1993 1994 1994 1997 1997 1977Public PAYGO system closed remains remains remains closed closed remainsPrivately-funded systemAffiliation of new workers mandatory voluntary voluntary voluntary mandatory mandatory corporateFund management companies (a) AFP AFP AFP AFJP AFORES AFP EFPPContribution rate for savings(% of wage) 10 8 (d) 10 7.5 6.5+subsidy 10 variableCommissions + insurance(% of wage) 2.94 3.72 3.49 3.45 4.42 3.00 variableContribution collection decentralized decentralized decentralized centralized decentralized decentralized corporatePast contributions (b) RB RB RB CP life-time switch CP N/ADisability/survivors insurance private private private private public private N/ASupervision specialized specialized integrated specialized specialized integrated integratedAccount transfers (c) 2 x p.a. 2 x p.a. 2 x p.a. 2 x p.a. 1 x p.a. 1 x p.a. N/AMinimum rate of return relative unregulated relative relative no no (e) N/AMinimum pension yes no yes yes yes no N/A

Notes: (a) AFP = Administradoras de Fondos be Pensioners; AFJP = Administradoras de Fondos de Jubilacioness Pensiones;AFORE = Administradoras de Fondos de Ahorro para el Retiro; EFPP = Entidades Fechadas de Previdencia Privada.

(b) RB = Recognition Bond; CP = Compensatory Pension;(c) Due to administrative delays, transfer may be more limited.(d) Contribution rate will be increased gradually to 10%.(e) Guarantees are required from the fund management companies.

Source: Queisser (1998) and own data.

Characteristics of Latin American Private Pension Funds

APPENDIX 1

222PR

OJE

CT

FINA

NC

E - C

ON

CE

PTS A

ND

APPLIC

ATIO

NS

Comparison of Investment Regulations (Percentages are of the Total Assets of the Pension Fund)

APPENDIX 2

Securities issued Debt Securities Stocks Mutual Funds Foreign Investments Othersguranteed by Government (non Government)

and/or Central BanksArgentina Max. 65% Max. 100% Max. 35% Max. 14% Max. 17% Max. 2%

� In any case no more than 7% in securities issued or guaranteed by the same entity� Max. 1% of the fund in a mutual fund and/or 10% of the capital of the mutual fund. If mutual fund ivests in the real estate sector,

max. 5% of capital of the fund per real estate mutual fund or 20% of the issue.

Brazil Max. 100% Max. 80% Max. 50% Max. 15% - Max. 35%� Max. 5%of the fund in the capital of a company or max. 20% of its capital� Max. 10% of the fund in a company and/or group and max. 20% of the fund in a financial institution and/or group� Max. 20% of the capital of a real state mutual fund

Chile Max. 50% Max. 100% Max. 37% Max. 15% Max. 16% Max. 10%� Max. 7% of the fund in one entity or max. 15% of the fund in a group� Max. 5% per diversification factor on mutual funds that invest in real state, development of enterprises and securitization;

and/or 20% of its capital� Max. 3% in debt of new companies (could include public infrastructure by private companies); and/or 20% of the issue� Max. 5% in real estate companies (could include investments in public concession projects); and/or 20% of the capital of the company� Max. 1% of the fund per foreign investment fund

Colombia Max. 50% Max. 100% Max.30% - Max. 10% -� Max. 5% of the fund per issuer, including group. If the issue is supervised by the bank superintendency, the limit is 10%� Max. 10% of the capital of a company and max. 20% of an issue, including securitization, except government or central bank paper.

Mexico Max. 100% Max. 35% - - - -� Max. 10% issued or guaranteed by an entity, and max. 15% for a group� Max. 15% for a serie or same issue

Peru Max. 40% - - Max. 100% Max. 35% Max. 15%Max. 10%Max. 10%

� In any case no more than 15% in one company or 25% in an economic group

Germany Max 30% Max. 20% Max. 25%; Real Estate� Equities: EU, equities, including Germany: max 30%; Non EU equities: max. 6%

Netherlands � Prudent person rule� Self Investment: max. 5%

Spain � Min. 90% invested in listed assets, real estate and bank deposits; Bank Deposits: max. 15%.� Max. 5% (max. 10%) in securities issued or guaranteed by one entity (group). This limit doesn�t apply to foreign estates/

international organizationUnited Kingdom � Prudent person rule

Source: Websites of Associations of Pension Fund Administrators, law and regulations.

223Private Power Financing – From Project Finance to Corporate Finance

Section V

Applications and Cases


Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/056lamech.pdf. October 1995 ©World Bank Publica-tion. Reprinted with permission

17

Private Power Financing – From ProjectFinance to Corporate Finance

Karl G Jechoutek and Ranjit Lamech

To achieve substantive progress in IPP financing, limited recourseproject financing will have to evolve toward structures with greaterbalance sheet support. The IPP experience in the United Statesoffers useful insights, and indicates new evidence that variants ofcorporate financing are being used for financing electric utilities.Developers are pooling projects into entities, that are then able toraise capital on the strength of a combined balance sheet comprisingthe �pooled� assets of the different projects. Providers of equityand debt then finance the business of building and operating privategeneration facilities rather than an individual power plant. Poolingspreads project risk. Industry consolidation has become a steadytrend in the IPP business. It has been argued that the increasingsize and scope of projects is the main factor driving this change.Although these mergers and acquisitions could be driven by anumber of strategic objectives, increased balance sheet support inproject development is clearly one of them.


Limited recourse project financing of power generation projects has been widely promoted, as a solution to the intractable problem of getting private credit to

a sector dominated by non-creditworthy borrowers and public agencies—fromthe point of view of both those supplying capital and those needing it. When thelights are going out, incumbent power enterprises are financially unviable, andthe public purse is nearly empty, project financing of independent power producers(IPPs) may seem the only way to get new capacity fast. In the developing world,however, the public-private partnership in project-financed IPP ventures has beendisappointingly slow to produce results.

This Note argues that, to achieve substantive progress in IPP financing, limitedrecourse project financing will have to evolve toward structures with greater balancesheet support. The need for corporate balance sheet support for private power sectorinvestments is gradually being recognized, and the benefits of this shift in financingstructure are worth reflecting upon. First, balance sheet support by the mainpartnersin an IPP financing offers greater security to lenders and provides easier (and perhapscheaper) access to long-term debt—critical to sustainable power sector financing giventhat IPPs typically depend on debt for 60 to 75 percent of their financing requirements.Second, while equity in limited recourse project finance is almost exclusively private,balance sheet support by IPP sponsors can open access to public equity markets,which are deeper and generally cheaper. Third, increased corporate balance sheet supportis a corollary to the restructuring in the world’s power sectors. As sector unbundlingand self-generation expand choice for wholesale and (potentially) retail consumers,and thus increase demand uncertainty, balance sheet support by IPPs will play animportant role in sharing demand risk among key participants.

Project Finance is More Expensive for an IPP

Project finance implies that the lenders to a project have recourse (or claim) onlyto the project’s cash flows and assets. In effect, then, the project is financed “offthe balance sheet” of the project sponsors. Such project finance is termed nonrecourseand is at one extreme of the project finance–corporate finance continuum offinancing possibilities. In practice, project finance in developing countries is backedby sponsor or government guarantees provided to give lenders extra comfort. Thisis limited recourse project financing, involving at least a small degree of corporate orbalance sheet support.


In traditional corporate financing, at the other extreme of the financingcontinuum, lenders rely on the overall creditworthiness of the enterprise financinga new project to provide them security. If the enterprise is publicly held,information on its performance and viability is usually available through stockmarkets, rating agencies, and other market-making institutions. This combinationof security, liquidity, and information availability allows debt to be issued at alower cost than through project finance. Further, because the enterprise’s overallrisk is diversified over all the activities that it is engaged in, the cost of equity isalso usually lower. The financing advantage for both debt and equity makes theoverall cost of capital lower for corporate finance.

Systematic empirical evidence specific to the power sector in the developingworld is lacking, but anecdotal evidence suggests that corporate finance is indeedcheaper than project finance. Corporate financing also has significant transactioncost advantages because it avoids the high cost of negotiating the web of carefullystructured legal contracts with purchasers and commercial lenders necessary underproject financing.1

The IPP experience in the United States offers useful insights, and indicatesthat the projectfinanced independent generation model may not necessarily bethe most efficient mode for capital formation in generation. Nor is it the dominantmode in other countries. The United States pioneered generation by independentoperators on a merchant basis, and it is where the now ubiquitous term independentpower producer, or IPP, originated. Project-financed independent generators havethrived in the United States, contributing more than half the additions togeneration capacity in recent years. It has been shown that the cost of capital fora purchasing US utility may be higher if it chooses to build its own generationcapacity rather than purchase power from an IPP.2 But much of the advantage isdue to the adversarial regulatory environment in the United States, which favorsIPPs. Purchasing utilities weigh the risk that state regulators will disallow investmentcosts against the perceived lower risk (and lower profits) of purchasing electricityfrom an IPP, an arrangement in which all costs can be passed through or expensed.The preference for purchasing power from IPPs is easily rationalized when one1 See Anthony A Churchill, “Beyond Project Finance,” Electricity Journal 8(5): 36–44, 1995.2 For the only systematic presentation of information on this issue, see Edward Kahn, Steven Stoft, and Timothy Belden,

“Impact of Power Purchased from Non-Utilities on the Utility Cost of Capital”, Utilities Policy 5(1): 3–11, 1995.


notes how many utilities and their bondholders were hurt in the 1970s and1980s, when regulators disallowed cost recovery for large investments in capacity.

Increasing Balance Sheet Support for IPPs—The Evidence

Project developers operate in a fiercely competitive market for international projects.Assuming competitive bidding, the primary source of competitive advantage liesin the ability to find financing at the lowest cost, as differences in technical andoperating abilities become virtually indistinguishable among the frontrunners.(Other attributes may, however, predominate in negotiated, noncompetitive IPPdeals.) In the competitive international IPP market, several trends indicate thatbalance sheet support is the preferred means for achieving this cost-of-capitaladvantage.

Raising Capital Using a Parent’s Balance Sheet

Project developers are putting their own balance sheets at risk—or those of theirparent companies—to raise cheaper debt for projects and to finance their equitycontribution. Projects in which sponsors have used their own balance sheets toraise finance include the Puerto Quetzal project in Guatemala (Enron), the PuertoPlata project in the Dominican Republic (Enron), and the Upper Mahaiao andMahanagdong projects in the Philippines (California Energy). Chinese IPPdevelopers, such as Huaneng Power and Xinli (Sunburst Energy), an affiliate ofCITIC, have also used this strategy. California Energy pioneered the largestcorporate financing in the independent power business, raising US$530 millionthrough ten year securitized bonds in March 1994.

Creating Consolidated Balance Sheets

Developers are pooling projects into entities that are then able to raise capital onthe strength of a combined balance sheet comprising the “pooled” assets of thedifferent projects. Providers of equity and debt then finance the business of buildingand operating private generation facilities rather than an individual power plant.Pooling spreads project risk. For a multinational developer, it also reduces country-specific risk. And for a developer with a few projects already under commercialoperation, pooling offers the advantage of an immediate revenue stream for repayingdebt and paying dividends.


Pooling has two other benefits. First, it enables project developers to tap publicequity markets—most private project developers finance the equity component ofa project privately. Second, it enables developers to raise cheaper debt on a corporatefinance basis. IPP sponsors that have used this approach include ConsolidatedElectric Power Asia (CEPA), the San Francisco–based Bicoastal Energy InvestorsFund (EIF), and Huaneng Power International (HPI) of China. CEPA raised debtand equity in the capital markets on the basis of its corporate strategy of buildingmultiple power plants in Asia. EIF securitized its equity interests in sixteenindependent power projects in the United States, creating a synthetic balancesheet and issuing US$125 million of seventeen-year bonds. And HPI, which owns2,900 megawatts of capacity under commercial operation and has another 5,900megawatts under construction, raised US$332 million by listing its IPP businesson the New York Stock Exchange in October 1994.3

Pursuing Mergers and Acquisitions

Industry consolidation has become a steady trend in the IPP business. Notabletransactions among international players include the purchase of CMS Generationby HYDRA-CO Enterprises, the purchase of Magma Energy by California EnergyInc. (creating an enterprise with annual revenues exceeding US$400 million),and the acquisition of J Makowski Co. Ltd. by PG&E Enterprises and BechtelEnterprises to form International Generating Co. Ltd. It has been argued that theincreasing size and scope of projects is the main factor driving this change. Smallercompanies are at an important disadvantage in international capital marketscompared with larger players, with their greater experience, capitalization, andtrack records. Although these mergers and acquisitions could be driven by a numberof strategic objectives, increased balance sheet support in project development isclearly one of them.

The IPP Financing Challenge

Private financing needs to be tailored to the changing structural relationships inthe sector. Core generation, transmission, and distribution functions are beingseparated, competition is being introduced in wholesale and retail markets, andtechnological progress is rapidly increasing the number of cost-effective options

3 The proclaimed success of this transaction is controversial, as the share price of Huaneng dropped from US$14.25 atlisting (October 1994) to about US$9 in mid-1995.


for decentralized self-generation or cooperative generation. This restructuring willrequire a redefinition of the underlying assumptions in power sector financing.

The financial challenge will be to find ways to provide lenders with adequatelong-term revenue security when the new industry structure might not allowutilities to guarantee demand risk and price risk for the maturities required.Traditional project finance is based on allocating demand risk to the purchaser,whether an integrated utility, a central generator and purchaser, a distributionutility, or a large consumer. This risk allocation works well because purchasershave a monopoly franchise area, which they are obliged to serve. But as directaccess to consumers is encouraged—whether or not the sector is broken up—purchasing utilities will face increased demand risk as the loss of retail customersbecomes a greater possibility.

The key to any debt-based financing is the ability to provide adequate securitythrough a contract or other credible evidence of future revenue streams. Innovativesharing of demand risk between market players—the power seller, the powerpurchaser, and the financier—will become necessary. An IPP developer’s abilityto bear any of the demand risk will depend in part on its willingness to providecorporate assets and revenues as a backstop for lenders.

The view that well-capitalized corporate entities will be the ones able to meetfinancial markets’ requirements in a competitive environment seems to be confirmedby market responses. Most recent additions to generation capacity in the UnitedKingdom—the model of sector unbundling—have been corporatefinanced IPPs.And witness the efforts by industry players in the United States to create highlycapitalized enterprises as competition for final consumers looms on the horizon.The recently announced US$1.26 billion merger of Public Service Co. of Coloradoand Southwestern Public Service Co. is a reaction to the perceived increase indemand risk stemming from plans for wider retail competition—the utilities arenoncontiguous and plan to build a connecting transmission line to share generatingresources.

Conclusion

Greater corporate finance support will make it possible to raise private capital forindependent power financing from wider, deeper, and cheaper sources. But


innovative strategies will be required from governments, lenders, investors, andpower sector enterprises alike. The following strategies are worth considering:

• Encourage the formation of large, well capitalized independent generationcompanies. Purely private and quasi-private variants of the Huanengmerchant generation model in China might be workable in large powersystems. Healthy competition should be engendered through prudentregulatory reviews of the market power of the IPP in a particular system.

• Encourage divestiture of commercially operating (and perhapsunderperforming) generation plants by incumbent utilities to IPPdevelopers. These sales should be conditional on the purchaser’s commitmentto making specified investments. By making positive revenue streamsavailable to IPP developers immediately, such transactions would give themthe financial base to invest in multiple plants.

• In IPP prequalification under competitive bidding, give greater weightingto IPP developers with businesses listed on a stock exchange and to thosewith well-capitalized balance sheets. The strategic goals of publicly heldentities are likely to be more transparent and longer term because of theseentities’ obligations to public shareholders.

• Encourage project sponsors to use balance sheet support for subordinateddebt and quasi-equity portions of the project financing plan in order toincrease corporate financing. This strategy would ease the overall financingcosts of projects and could be a transitional strategy for meeting the hugefinancing needs for IPPs in developing countries.

(Karl G Jechoutek, Division Chief, Power Development, Efficiency, and HouseholdFuels Division (email: [email protected]), and Ranjit Lamech, RestructuringSpecialist (email: [email protected]), Industry and Energy Department.)

(For comments contact Suzanne Smith, editor, Room G8105, The World Bank,1818 H Street, NW, Washington, DC 20433, or E-Mail: [email protected])


Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/152haarm.pdf. September 1998 ©World BankPublication. Reprinted with permission. The Note is based on a longer paper by the auLthors “Tappinig the PrisateSector: Approaches to Maniaging Risk in Vater and Sanitation” (RINC Discussion Paper 122, World Bank. ResourceMobilization and Cofinancing Vice Presidency, Washington, DC, 1998).

18

Pooling Water Projects to MoveBeyond Project Finance

David Haarmeyer and Ashoka Mody

Many commercial banks have had little interest in water andsanitation projects not only because of non-commercial political andregulatory risks, but also the small size, weak local governmentcredit, and high transactions costs (legal, consulting, and financialcosts of structuring). Most projects have been financed on a limitedrecourse basis, that is, with project cash flows and assets as themain security for lenders. The move from project to corporate(balance sheet) financing is occurring in stages. Financing projectdebt from the sponsor company�s balance sheet exposes that companyto significant risk and thus requires a strong and large balance sheet.Designed in part to shield a company�s balance sheet and improve aproject�s credit strength, innovative structures and financialinstruments are emerging. Ultimately, the goal is for water utilitiesto raise debt and equity from capital markets on the basis of theirown balance sheets, strengthened by a diversified and stable rate-paying customer base. This Note reviews the new trends.

233Pooling Water Projects to Move Beyond Project Finance

In the transition from government to private financing, projects in the waterand sanitation sector require a heavy focus on risk allocation and mitigation,

which has often implied drawn-out negotiations before and sometimes after financialclosure. To address non-commercial risk, many projects have required some formof ongoing government or third-party support (see Viewpoint151). To transformthemselves into economically viable enterprises, projects must mitigate commercialrisks and gain credit strength (significant cash for investments and the ability toraise funds from capital markets). Risk pooling structures and in water and assetaggregating instruments may be one way to achieve the funding objectives:

• Financing of project debt on the basis of the sponsor’s balance sheet, orcorporate finance (pooling risks with the corporation’s other activities).

• Equity funds to leverage sponsors’ equity and attract a larger group ofinvestors.

• Bundling of water and sanitation projects to form economically viableentities that can be integrative to lenders.

• Integration of water and sanitation utilities with other utilities (such asnatural gas distribution or power generation and distribution entities) toform holding companies with stronger balance sheets.

Corporate Finance and Capital Markets

Corporate finance can simplify the transition to capital market financing, becausethe risk of a project’s debt is absorbed in part by other corporate activities. As inother sectors, projects in water and sanitation have been financed with some(“limited”) recourse to a sponsor’s balance sheet. This mechanism focuses projectperformance incentives but is generally costly in terms of time and resources.

Increasing balance sheet financing may require significant industry restructuring,such as consolidating the ownership and operation of water utilities in a region orencouraging the integration of different utility sectors (Box 1). Such restructuringis already happening. Malaysia has bundled its entire sewerage system under oneconcession, a case of project pooling. While this project has forgone the benefitsof comparative competition achieved when systems operate side by side, it createsthe potential for securing revenue streams to finance a large number of smallinvestments that would not be commercially viable on their own.


In the long term, however, achieving financial and operational sustainabilitywill require a utility to finance investments from internal cash and long-termbond issues. As the English and Welsh water companies demonstrate, water projectshave the potential to do this. Once established, they can produce stable revenuesthat not only permit internal financing but also allow access to a much broaderclass of investors through bond issues. Among developing country projects, onlyAguas Argentinas has moved significantly in this direction—internal cashgeneration accounted for nine percent of financing in the first three years and wasexpected to rise to 30 percent in the next three.

The use of bond financing by privately financed water projects and utilities isrelatively new. Leading the way, the English and Welsh utilities have used bondfinancing based on their balance sheets. In most developing countries, however,the development both of bond markets and of economically viable water utilitiesis at an incipient stage. The United States has the most mature bond market formunicipal infrastructure; its development has been aided by tax exceptions andcredit enhancements (see the discussion below on state revolving funds). Althoughthe funds are used primarily by utilities owned by local governments, this“municipal” bond market taps private financing.

Equity Funds

Over the past few years infrastructure equity funds have provided a means bywhich developers can raise financing for infrastructure projects and investors canparticipate in this emerging market. Such funds can be attractive to infrastructure

New investments in the water and wastewater sector tend to be much smaller than those in otherinfrastructure sectors because of the market�s fragmentation. Municipalities are in charge ofwater and sanitation, so investments facilities reflect demand only within their jurisdictions. TheMexican wastewater program, for example, will build many small wastewater plants, with anaverage cost of about US$25 million to US$30 million. Even where large investments are expected,they are spread over time, keeping pace with growth in demand. The massive Buenos Airesconcession is expected to make investments worth a few billion dollars over its lifetime but theinitial financing was for less than US$200 million. Similarly, the Manila concessions are expectedto invest about US$5 billion over thirty years, but the initial round of financing probably will notexceed US$350 million. This pattern of small, incremental investments contrasts with that ofpower and transportation projects, which typically require large investments over a short periodand gain the attention, and often the support, of national governments.

Box 1: Project Fragmentation


developers because they allow them to leverage their contributions with those ofother investors and thus to spread their capital. For investors, equity funds mitigateproject and country risk by creating a portfolio of projects under one company.

The French water and sanitation company Lvonnaise des Eaux for example,introduced an infrastructure equity fund in Asia in 1995, a US$ 300 million waterfund. Besides Lyonnaise, contributors to the fund include Allstate Insurance Company,the Employees Provident Fund Board of Malaysia, and the Lend Lease Corporationof Australia. Investors are expected to benefit from the water company’s significantmarket position and deal flow in the region. The fund refinances the equity of theoriginal sponsors. Thus, it conserves sponsor equity for the riskier developmentphase; sponsors apply their expertise in the early phase to get projects started andcan then move on to other projects. Investors in the fund expect to receive steady,utility-like returns and potentially stand to gain significantly if the fund or aportion of it is publicly listed.

Houston-based Enron Corporation used a similar strategy, though the fundtook the form of a publicly listed company. In 1994, Enron packaged its emergingmarket power plants and natural gas pipelines in a new company that it floatedon the New York Stock Exchange. Capitalized at about US$165 million, GlobalPower and Pipelines (GPP) included the assets of two power plants in thePhilippines, a power plant in Guatemala, and a natural gas pipeline system inArgentina. Enron retained a 50 percent share of the company and sold the rest toinvestors. GPP has the right to buy into projects developed by Eriron at favorableprices, providing Enron an ensured exit mechanism to free up capital forhigh-risk, high-return development opportunities.

EBRD’s Private Multiproject Financing Facility

To mobilize private investment in Eastern Europe, the European Bank forReconstruction and Development (EBRD) has developed a multiproject financingfacility (MPF) that provides a framework for financing a series of projects thatmay be too small to be considered individually. The MPF is made available to aprivate company, which uses the facility to make equity investments in, and loansto private water and sanitation projects. Under this arrangement the companylargely takes on the task of due diligence, which helps to reduce the transactionscosts for each project financed.


EBRD signed its first MPF in July, 1995—a US$90 million equity and loanfacility with Lyonnaise des Eaux. The company was recently awarded a projectthat could be the first to access the facility, a US$ 41 million, twenty-five-yearBOT (build-operate-transfer) wastewater treatment project in Maribor, Slovenia(population 150,000). In 1996 the second MPF was signed, with three Austriancompanies. The agreement involves a $700 million (approximately US$140 million)equity and loan facility to support an investment program of $2 billion. TheAustrian companies will also receive financial support in the form of a guaranteefrom the East-West Fund of the Austrian Finanzierungsgarantie GmbH.

State Revolving Funds

In the United States the federal government has supported state and localgovernments in financing the construction of wastewater treatment plants sincethe 1950s. In 1987, in an effort to delegate more responsibility to state and localgovernments, the US Congress replaced the existing grant funding with a programto capitalize state revolving funds (SRFs). States are required to contribute anamount equal to at least 20 percent of the federal capitalization funding. Theprogram is aimed at leveraging federal resources and creating a renewable andperpetual source of financial assistance for wastewater infrastructure. Unlike withgrant funding, the need to repay SRF loans introduces an important element ofaccountability, as well as a basis for new loans.

The structure of each state’s revolving fund program depends primarily on thestate’s needs and circumstances (such as its borrowing limit and ability to repayloans). Some states use program funds to provide direct loans to local governmentsof up to 100 percent of a project’s cost at below-market rates. Others provideexcess reserves or excess debt payment coverage that helps secure bonds backed bythe revenues of a wastewater facility. Program funds may be used as collateral toborrow new resources; because several jurisdictions borrow on the basis of thesame collateral, spreading the risks, the overall costs of borrowing are lowered.

The large, diversified pools of municipal borrowers created under SRF programsare attractive to lenders because they spread the risks of debt payment interruptionor default. Pooling projects for financing on a statewide basis also makes it moreeconomical for credit rating agencies to evaluate credit risks. While a single projectmight not be large enough to justify a credit assessment, a large group of projects


will be attractive. Credit rating agencies provide important information toprospective lenders about the creditworthiness of SRF programs by, for example,assessing and monitoring reserve fund and debt coverage levels and evaluating thesize and composition of the borrower pool. Size and diversity matter. Ratingagencies have found that smaller pools (20-100 borrowers) generally face morestringent credit requirements from lenders than larger pools because the behaviorof individual borrowers has an amplified effect. For pools with fewer than twentyborrowers the weakest borrower tends to determine the credit rating.

The revolving nature of the funds has had a insignificant effect on purchasingpower. According to the US Environmental Protection Agency, funds invested inthe SRFs provide about four times the purchasing power over twenty years thanfunds used to make grants. Even so, the funds represent only a fraction of theinvestment needed to upgrade municipal plants. In 1997, states were expected tomake SRF loans of US$ 3 billion, compared with US$ 11 billion in total capitalinvestment in wastewater infrastructure from all sources (federal, state, and local).

Multi Utilities

Deregulation and increasing competition in industrial countries are creatingpressures for different utility sectors to combine. By combining, utilities hope toachieve not only economies of scope but also larger balance sheets and increasedcredit strength (through diversity) to attract long- term private financing. Thetrend has been most pronounced in the United Kingdom but is growing elsewhere.United Utilities and Scottish Power, two of the three UK provide utility servicesthat run the gamut—principally electricity generation and distribution and waterand sanitatiion, but also gas distribution and telecommunications services.

Multiutilities in developing countries may soon play a growing role. Argentinaand Slovenia have combined gas and water utilities. In Cote d’Ivoire the projectcompany developing the water supply concession went on to develop the electricitydistribution system and a power generation project. This multiutility approach isbeing adopted in the concessions recently awarded in Casablanca and Gabon andis being considered for water and power projects in the Republic of Congo. However,the implications for the concentration of monopoly power are a concern. Chilerecently passed a law prohibiting owners of water utilities from simultaneouslyowning power distribution or telephone service in the same area.


Conclusion

As a utility matures, and its revenues become increasingly predictable and secure,its financing structure can be expected to shift to corporate finance or greaterbalance sheet support. Internally generated revenues are an important source offunding for water projects that have achieved a stable and diversified customerbase. And strong balance sheets permit utilities to obtain external financing byissuing long-term debt to a broader class of investors. However, as a result of highpolitical risk and shallow or nonexistent capital markets, in developing countries,the work of building stronger balance sheets and tapping capital markets generallytakes time.

New financing techniques in other sectors and their early applications in waterand sanitation, suggest that pooling projects may be a way to move beyond projectfinance, particularly for the many small projects that need financing. Multiutilities—entities that deliver multiple infrastructure services such as water and electricity,offer another approach to attracting private capital. These multiutilities can gaincredit strength through a diversified revenue base that enhances the prospects forcorporate finance.

(David Haarmeyer (david.haarmeyer@ stoneweb.com), Stone & Webster Consultants.Boston, and Ashoka Mody ([email protected]), Project Finance and GuaranteesDepartment.

For comments contact Suzanne Smith, editor, Room F6p-188, The World Bank,1818H Street, NW, Washington, DC. 20433, or E-Mail: [email protected]).

239Financing Water and Sanitation Projects - The Unique Risks

Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/151haarm.pdf. September 1998. © World BankPublication. Reprinted with permission.

Financing Water and SanitationProjects – The Unique Risks

David Haarmeyer and Ashoka Mody

19

A project finance structure allows water projects with attractivecash flows and risk profiles to secure long-term private capital.This structure provides a direct link between a project�s cash flowand its funding to give project sponsors, investors, and lendersstrong incentives to ensure that projects are structured andoperated to generate stable revenue streams. But even in industrialcountries, the credit strength of offtaking municipal governmentsand the sector�s traditional monopoly structure expose lenders topotentially significant credit, regulatory, and political risks. Theserisks, combined with the sunk, highly specific, and non-redeployablenature of water investments, mean that lenders and investors arevulnerable to government opportunism and expropriation. Reviewingsome recent innovative projects, this Note shows that privateparticipation on a limited recourse or no recourse basis has requiredsupport from multilaterals and federal government agencies toabsorb non-commercial risks.


Private sector participation in water and sanitation has often taken the form of special purpose build-operate-transfer (BOT) projects following the project

finance or limited recourse model. These are self-contained projects that addressthe need for more water and sanitation. Although these bulk suppliers can alleviateimmediate shortages, they have virtually no effect on systemwide revenue problems(for example, leakage and tax collection) or labor cost problems. These long-termproblems are sometimes tackled incrementally through leases and managementcontracts. An increasing number of countries have gone further by awardingoperating concessions for entire systems, which require investment commitmentsfrom the concessionaire. Beyond such concessions lies full privatization of assets,which facilitates financing by creating collateral.

The promise of steady, if not growing, long-term future cash flows is the basisof the private sector’s interest in financing these ventures. As one of the lastmonopoly utility sectors, water and sanitation can be especially attractive to long-term private investors. But financing water and sanitation projects has been aspecial challenge because of their unique risks:

• Expensive to transport but cheap to store, water is essentially a local serviceand subject to control by local government, which can be more politicizedand have weaker credit than state or federal government.

• With most of the assets underground, their condition is hard to assess.That makes investment planning difficult, posing risks for contractrenegotiations.

• Inadequate provision is associated with health and environmental risks, sogovernment has a strong interest in extending access to service, regardlessof ability to pay.

• Significant currency risk arises because customers pay in domestic currencythat does not match the currency of international debt and equity financing.

• There has so far been little scope to introduce direct competition intreatment, transmission, and distribution.

The risk profile of a project is also influenced by its type and by its stage ofdevelopment. Greenfield projects with a build-operate-transfer or build-own-


operate (BOO) structure, because they involve a period of construction beforerevenues are generated, generally expose lenders to greater credit, political, andregulatory risks than concessions for infrastructure services that are up and running.Similarly, older and more efficiently run systems with longer operating historiestend to have more secure and predictable cash flows and mature investment profiles,and thus expose lenders and investors to fewer risks.

The water and sanitation sector’s exposure to risks that are often difficult andcostly to cover has two important ramifications:

• Fewer projects have been successfully financed with private capital than inother infrastructure sectors, such as power and telecommunications.

• Projects financed with private capital have tended to involve direct financialor credit support from government or third parties such as bilateral,multilateral, and export credit agencies.

Case Studies in Finance

The experience of six water and sanitation projects and one set of utilities inaccessing and structuring private finance illustrates the level of government orthird-party support (Table 1). All the projects follow the standard project financestructure except for the more mature English and Welsh water companies, whichrely on corporate finance.

Only the BOT project in Johor, Malaysia, was financed on a non-recourse basiswith no sponsor or third-party support to cover risk of nonpayment. All otherprojects were financed on a limited recourse basis. The recourse was generallyprovided by payment guarantees to the parties offtaking the service (buying bulkwater or wastewater services), such as a local government entity in a BOT or BOOproject. For the BOT in Chihuahua, Mexico, for example, Banobras, the domesticdevelopment bank, provided credit support to the local government entity. InIzmit, the Turkish government stands behind the local government’s water purchaseagreement. In Sydney, the state government guarantees the payment of the citywater utility (Sydney Water Corp.) to the private project company, even thoughthe utility’s debt is rated AAA by Standard & Poor’s. In Buenos Aires, the Argentinegovernment’s guarantee to pay compensation if the concession is terminated earlyprovides the chief form of security for lenders.

242PR

OJE

CT

FINA

NC

E - C

ON

CE

PTS A

ND

APPLIC

ATIO

NS

Project Site, Type, and Date Project Cost Debt/Equity Countryrating Source and Maturity of Debt

Malaysia US$2.4 billion 75/25 A+ Government soft loans due to Concession (1993) (about US$500 million severe tariff collection problems

in first 2 years)

Buenos Aires, Argentina US$4 billion 60/40 BB� 10-year IFC A-loan, 12-year IFC B-loanConcession (1993) (US$300 million (recourse to Argentine government in

in first 2 years) event of early termination)

Izmit, Turkey US$800 million 85/15 B 13-year export credit agency loans,

BOT (1995) 7-year MITIa loan, 7-year commercial bank loan(recourse to Turkish government)

Chihuahua, Mexico US$17 million 53/15/32b BB 8.5-year commercial bank loanBOT (1994) with limited recourse to Banobras

Johor, Malaysia US$284 million 50/50 A+ 10-year project finance loan BOT (1992) from Public Bank Bhd (non-recourse)

Sydney, Australia A$230 million 80/20 AAA 15-year commercial loans BOO (1993) (State government stands behind

Sydney Water Corp. payment)

England and Wales US$5.24 billion 25/75 AAA Capital markets, corporate finance, Full privatization (1989) European Investment Bank, and other

sources

a. Ministry of International Trade and Industry of Japan.

b. Debt/equity/grant.

Source: Haarmeyer and Mody 1998.

Table 1: Funding for Selected Water and Sanitation Projects


Sources of Debt

In countries with weak sovereign credit ratings, financing has been provided bymultilateral and export credit agencies. These agencies are generally in the bestposition to shoulder political and regulatory risk, and thus provide long-termfinance at reasonable rates. The US$9 million Chase Manhattan Bank loan to theChihuahua BOT project, which received no multilateral or bilateral funding butdid receive grant and credit support from Banobras, is a rare case of commercialbank participation. In a similar BOT project in Puerto Vallarta, Mexico, theInternational Finance Corporation provided debt finance backed by a revolvingand irrevocable letter of credit from Banobras.

In countries with high sovereign credit ratings, projects have been financed bydomestic commercial bank loans. The BOT project in Johor, Malaysia, and theBOO project in Sydney, Australia, were financed by commercial debt. As a resultof the project structure (existing cash flows) and Malaysia’s highly developed capitalmarket and relatively low interest rates, the Johor project was financed entirelywith local debt. The Sydney project had both local and offshore financing.

The limited capital market financing of water and sanitation indicates thatindividual investors are not in a position to accurately evaluate and mitigate therisks. But as the experience of the English and Welsh water companies shows,projects can be expected to access capital markets as their cash flows to supportdebt service become more stable and certain and independent regulatory agenciesare established.

The English and Welsh companies have drawn on a variety of financing sources,including the bond markets. Anglian Water, one of the ten privatized watercompanies, reflects the low risk profile of more mature water utilities. In 1990 thecompany floated a twenty-four-year bond issue priced at just fifty-three basis pointsover UK Treasury gilts due November 2006. Standard & Poor’s based its AA ratingof the £150 million Eurobond on Anglian’s “robust financial profile and stableoperating environment”, which “should provide the company with a fair degree ofinsulation from the impact of key regulatory and political risks going forward”.The English and Welsh companies have also taken advantage of low-cost loans fromthe quasi-governmental European Investment Bank.


Equity Financing

Although debt is generally cheaper than equity, a long-term equity stake by thesponsor (which is sometimes also the operator) ensures that management has along-term interest in the project and that cash flow growth leads to capitalappreciation. Equity also reduces the debt service burden on the cash flow, whichcan be especially important in a project’s early development phase.

Equity has been provided largely by sponsors. For large projects especially,equity, like debt, is often sourced from multiple consortium members, bothinternational developers and local investors. The Buenos Aires concession, forexample, has four international shareholders and four local shareholders (includingthe utility’s employees).

Lenders like to see sponsors achieve a reasonable return on their investment, toensure that sponsors have adequate incentive to maintain support for the project,at least through the life of the loans. Equity holders partially shield lenders, becausethe lower priority of their claims on a project’s revenues means that they willabsorb unexpected shortfalls in revenue. In full concessions and privately ownedutility companies internal cash generation can provide an important source ofequity for financing investment.

Although information on the return on equity for project sponsors is not widelyavailable, the return can be expected to vary with project risk and cash flow profiles.In two of the cases discussed here, returns to investors are regulated:

• The Malaysian government has guaranteed returns of 14 to 18 percent oninvestment in the national sewerage project; actual returns are currently at12 percent because the concessionaire failed to achieve a 90 percent tariffcollection rate.

• For the English and Welsh water companies, the returns on regulatorycapital (the assets of the core business) were 11.5 percent in 1995-96 and12 percent in 1994-95. According to Ofwat, the UK water companyregulator, these returns are expected to fall as the water companies becomemore established and capital expenditures decline.

To compensate for the greater country and political risks, required returns inmost developing country projects are likely to be significantly higher and closer


to those in other infrastructure sectors. For a sample of power projects in Asia andLatin America, Baughman and Buresch (1994) estimated the equity returnat between 18 and 25 percent. And for privately financed toll roads, Fishbein andBabbar (1996) found that investors expect annual returns to range between15 and 30 percent.

Conclusion

The challenge for the future is in mitigating the non-commercial risks thatcharacterize the sector and moving beyond the limited capacity of third parties.Part of the solution lies in generating better information about these risks so thatthey are more transparent and their costs are more fully recognized by parties thatcan mitigate them. Two tracks to achieve this end are independent regulatoryagencies and competition—for the market and for rights to supply individualcustomers, as in England and Wales.

(David Haarmeyer (david.haarmeyer@ stoneweb.com), Stone & Webster Consultants,Boston, and Ashoka Mody (amody@worldbank. org), Project Finance and GuaranteesDepartment.)

(For comments contact Suzanne Smith, editor, Room F6p-188, The World Bank,1818 H Street, NW, Washington, D.C. 20433, or E-Mail: [email protected])

References

1 Baughman David, and Matthew Buresch. (1994). “Mobilizing Private Capital for the

Power Sector: Experience in Asia and Latin America.” US Agency for International

Development and World Bank, Washington, DC.

2 Fishbein Gregory, and Suman Babbar. (1996). “Private Financing of Toll Roads.” RMC

Discussion Paper 117. World Bank, Resource Mobilization and Cofinancing Vice Presidency,

Washington, DC.

3 Haarmeyer David, and Ashoka Mody. (1998). “Tapping the Private Sector: Approaches to

Managing Risk in Water and Sanitation.” RMC Discussion Paper 122. World Bank, ResourceMobilization and Cofinancing Vice Presidency, Washington, DC.


Source: http://siteresources.worldbank.org/INTGUARANTEES/Resources/HubPower_PFG_Note.pdf. Originallypublished as “World Bank Guarantee Sparks Private Power Investment in Pakistan: The Hub Power Project”, June1995. © World Bank Publication. Reprinted with permission.

20Successful Project Financing – HUB

Power Project

World Bank Project Finance Group

Hub Power Company (HubCo), was established by privatedevelopers in Pakistan to own and operate the power station. Thesponsors, which led the development and negotiation process, wereXenel Industries of Saudi Arabia and National Power of the UK.HubCo will build, own and operate the conventional, oil-fired steamplant. The transmission interconnection between the plant and thenational power grid is being handled by the Water and PowerDevelopment Authority (WAPDA), partially financed by a Bankloan. Hub is important to Pakistan for several reasons. In additionto being the largest private sector project in the country, itdemonstrates investor confidence in the expansion of the privatesector�s role in infrastructure development. The project also playeda significant role in the formulation of the Government�slong-tem strategy to attract private investment to the power sectorand the development of model independent power contracts. As aresult, several follow-on projects are expected to be completedrelatively quickly. Finally, the project will expand Pakistan�sgenerating capacity by approximately 20% and ease powershortages that currently constrain economic growth.

247Successful Project Financing – HUB Power Project

The Hub Power Project

The Hub Power Project marks the first use of a World Bank guarantee for a privatesector project, and is a major step forward in the Bank’s effort to increase privatesector investment in infrastructure. In addition, the project sets several milestonesfor the Bank:

• First use of a partial risk guarantee;

• Largest private sector infrastructure project supported by the Bank to date;

• First Bank-financed infrastructure fund to support private sector projects;and

• First co-guarantee with another financial institution, the Japan Export-ImportBank.

Financial closure occurred in January 1995, putting into place nearly US$1.8billion in equity and long-term debt financing, required to refinance constructionbridge loans and complete the project. Construction of the 1,292 megawatt powerplant began in early 1993, and is expected to be completed by 1997. The projectis located about 40 kms outside Karachi.

The Bank’s guarantee, which protects commercial lenders against sovereign risksassociated with the project, establishes a new method of supporting build, own,operate (BOO) projects which are normally financed on a project finance or limited-recourse basis. Prior to Hub, Bank guarantees were utilized as cofinancinginstruments, designed to help mobilize commercial funding for Bank-supportedpublic sector projects. It is expected that the Bank guarantee for the Hub projectwill serve as a model for future guarantees in support of other BOO projects.

What is Project Finance?

Project finance, sometimes referred to as limited-recourse finance, refers to financing structuresunder which lenders look to project cash flows for debt repayment and to project assets forcollateral. In deciding whether or not to lend to a project, a lender bases its decision on anevaluation of a project's-not the sponsors-creditworthiness. In the event of default, the liability ofproject sponsors is limited to their investment in a project.

Project Overview

Bank involvement in the project dates back to the late 1980s, when Pakistan initiatedan energy sector adjustment program with Bank assistance. A key element of the


program was the opening of the power sector to private investment To this end, theBank, along with several bilateral donors, established the Private Sector EnergyDevelopment Fund (PSEDF). PSEDF, a Government-owned facility, provides debtfinancing of up to 30% of the financing needs of private sector energy projects.Project sponsors are expected to mobilize 20-25% equity and raise the remaining45-50% of the funding in domestic and international financial markets.

A special-purpose project company, Hub Power Company (HubCo), wasestablished by private developers in Pakistan to own and operate the power station.The sponsors, which led the development and negotiation process, were XenelIndustries of Saudi Arabia and National Power of the UK. HubCo will build, ownand operate the conventional, oil-fired steam plant. The transmissioninterconnection between the plant and the national power grid is being handledby the Water and Power Development Authority (WAPDA), partially financedby a Bank loan.

Hub is important to Pakistan for several reasons. In addition to being thelargest private sector project in the country, it demonstrates investor confidencein the expansion of the private sector’s role in infrastructure development. Theproject also played a significant role in the formulation of the Government's long-tem strategy to attract private investment to the power sector and the developmentof model independent power contracts. As a result, several follow-on projects areexpected to be completed relatively quickly. Finally, the project will expandPakistan's generating capacity by approximately 20% and ease power shortagesthat currently constrain economic growth.

Financing Structure

The total financing of US$1.8 billion includes US$1.7 billion equivalent in foreignexchange and about US$100 million equivalent in local costs. The capital structureis 20% equity and 80% debt—the debt is mobilized on a project finance basis.Included in the financing plan are costs associated with the turnkey constructioncontract, development costs, interest during construction and other finance relatedcosts, as well as a reserve contingency fund.

The Sponsors contributed a significant portion of the project’s total equity.Other equity sources include Commonwealth Development Corporation (CDC)


of the UK, Entergy, Xenergy and other offshore and local investors. An innovativefeature of the project’s financial structure is the US$ 102 million global depositaryreceipt (GDR) issue underwritten by Morgan Grenfell, UK, the first GDR issuefor an independent power project.

The amount of debt financing required for the project (US$ 1.4 billion)necessitated that it be raised from a variety of sources, including PSEDF, foreigncommercial banks supported by partial risk guarantees from the World Bank andJ-Exim, and political risk insurance from export credit agencies of France, Italyand Japan, local commercial banks, and CDC. Other large private sectorinfrastructure projects will likewise be obliged to obtain debt financing from manydifferent sources, given the exposure limitations of lenders, insurers and guarantors.

Contractual Framework

A key element of project finance is the apportioning and allocation of risks, adifficult and complex process even in developed countries. In a developing countrysuch as Pakistan, the process is substantially more difficult. There is often a lack ofprecedents to build on, and the process is further hampered by an undevelopedlegal regulatory environment.

Funding Structure

World Bank/J-Exim Guarantee

Export CreditAgency Insurance

$360 $335Commercial

Banks

$695

$372$602PSEDF*Subordinated Loan

$163

Hub PowerCompany

(Project Cost:US$1.8bn)

EquityInvestors

Other Localand

Offshore Lenders

* World Bank, J-Exim,France, Italy, Others.


Under Hub’s commercial arrangements, project-specific risks (completion,performance operation and underwriting risks) are assumed by equity investorsand lenders, while sovereign-or political-risks are assumed by the Government(GOP) and its agencies. These risks are identified and allocated via the project’scontractual framework, which comprises the following main agreements:

• Implementation Agreement (IA)

Overall project implementation is being undertaken within the provisionsof this 30- year agreement between HubCo and GOP. The IA grants HubCothe sole right to develop the project and defines each party’s responsibilitiesduring the construction and operation phases of the project.

• Power Purchase Agreement (PPA)

The PPA, which secures the project’s revenue streams, is the most importantcommercial agreement. The 30-year agreement also defines the interfacebetween HubCo and WAPDA.

• Fuel Supply Agreement (FSA)

Fuel supply is secured through this 30-year agreement between theGovernment owned fuel supplier, Pakistan State Oil Company, and HubCo.

• Operation & Maintenance Agreement (OMA)

The OMA between HubCo and National Power International (a subsidiary ofNational Power, UK) has an initial term of 12 years and provides for operationand maintenance of the plant according to agreed terms and technical criteria.

• Construction Contract

A fixed-price, date-certain turnkey construction contract between HubCoand a consortium led by Mitsui 7 Company of Japan was signed in 1991.In addition to Mitsui, the consortium includes Ishikawajima-Harima HeavyIndustries Co., Ltd. of Japan, Ansaldo GIE, S.R.I. of Italy and CampenonBernard SGE-SNC of France.

• Other Agreements

Several other agreements/provisions are integral components of thecontractual arrangements of the project. These include: (i) escrow agreementsfor local and offshore escrow accounts; (ii) foreign exchange risk insurance


provided by the State Bank of Pakistan for a fee included in the projectcost; and (iii) a shareholders’ agreement and related corporate documentation

Bank Guarantee

To match project revenues with debt service, long-term financing is critical to theviability of power (and other infrastructure) projects. However, due to its poorcredit standing, such long-term financing was inaccessible to Pakistan. Commerciallenders needed a creditworthy third party to back commitments made to theproject by the Government of Pakistan to enable them to make long-term loans—hence the need for the World Bank Guarantee.

The Bank is providing a partial risk guarantee to a syndicate of internationalcommercial banks. The guarantee covers, on an accelerable basis, principalrepayments for up to US$240 million in loans. It would be triggered if GOPnoncompliance with one ormore of its obligations, as outlined in project contracts,resulted in a default in the repayment of the loans. Specifically, these obligationsare delineated in the project agreements (IA, PPA, FSA—see above). The US$120million J-Exim co-guarantee is of an identical structure. The 12 year maturity ofthe project’s commercial loan financing is a major achievement, considering thatprior to Hub, Pakistan’s access to international credit markets was limited to short-term trade credit and medium-term aircraft financing.

There are three main categories of risk covered by the Bank and J-Exim guarantees:(i) GOP guarantees of obligations (payment and supply) of state-ownedentities, including WAPDA and PSO; (ii) GOP payment obligations specified inthe Implementation Agreement, including payments resulting from occurrence ofcertain force majeure events ( force majeure events can be political events, such aswar of civil strife, or natural events, such as lightning outside plant boundaries);and (iii) provision and transfer of foreign exchange through the Foreign ExchangeRisk Insurance Scheme provided by the State Bank of Pakistan.

Accelerability and GuaranteesIf a loan is accelerable, lenders can demand payment of the unpaid balance if specified events ofdefault occur. Under an accelerable guarantee, the unpaid balance of guaranteed exposure (whichcould be different than the unpaid balance) would be payable by the Bank upon call of theguarantee. Prior to call of the guarantee, however, all remedies specified in project agreementsmust exhausted. In contrast, under a nonaccelerable guarantee, each individual payment is, ineffect, guaranteed, and the guarantee would be called each time a payment default occurs.


Risks guaranteed by the Bank were translated in GOP payment obligations sothat the exact cause of a debt service default can be determined, and hence, whatconstitutes a legitimate call of the guarantee, is well-defined. The Bank enteredinto Guarantee Agreement with the commercial banks, which outlines the coverageand mechanics of the Bank’s guarantee. In parallel, the Bank entered intoan Indemnity Agreement with GOP which counterguarantees the Bank for anydisbursement made under the terms of the Guarantee Agreement. (A counter-guarantee is a requirement of the Bank’s Articles of Agreement; it takes the formof an indemnity agreement.) The Bank’s US$240 million commitment under theguarantee was counted at 100% in the lending program, i.e., as if the Bank hadmade a loan, because the Bank is providing coverage on the whole loanamount (against certain risks).

The commercial banks, despite the breadth of the Bank’s guarantee, areassuming substantial risks, including those associated with construction andcompletion of the project and on time and efficient plant operation. Constructioncost overruns and delays, depending on their severity, would first erode returns toequity and could also jeopardize debt service. Although the debt-equity ratio grantsdebt providers a cushion of 20% (standby facilities are also available), lenders arestill at risk in the event of a shortfall in project revenue. Cost overruns and/orinefficient management of the project during operation also could lead to debtservice default.

Security Structure

World Bank

Counter-guarantee

Fuel SupplyAgreement

NationalPower Plc

WAPDA

Pakistan StateOil Company

Governmentof Pakistan

Hub PowerProject

State Bankof Pakistan

O&MAgreement

Implementation

AgreementGuaranteeAgreement

Power PurchaseAgreement

ConstructionContract

ConstructionConsortium

Cash Flows

CommercialLenders

Offshore EscrowAccount

Domestic EscrowAccount

FX &Transfer


Bank Guarantees and Private Sector Projects

In order to streamline its appraisal of private sector projects involving Bankguarantees and shorten project development time, the Bank intends to capitalizeon project reviews by other project participants. To this end, the Bankcan incorporate third-party project assessments into its own appraisal. For instance,since commercial lenders will assume construction and performance risks of aproject, they will closely scrutinize the project’s technical and financialcharacteristics. If it finds them satisfactory, the Bank could incorporate the resultsof the analysis into its own appraisal.

The Bank’s partial guarantee covers debt service default caused by nonfulfillmentof government contractual obligation to a project. Therefore, risks covered by aBank guarantee need to be clearly defined in the commercial contracts which setout the risk sharing allocation for a build, own, operate project. To allow theBank’s guarantee to voucher these risks, they must be translated into governmentpayment obligations. In the case of government guarantees of payment obligationsof state-owned entities, this is relatively easy to quantify since payments are relatedto the provision of a service at a specified price. For other government obligationswhich could jeopardize project cash flows, such as the granting of permits,or political force majeure, this quantification becomes more difficult, This maybe handled, as in Hub, by linking government defaults related to these events tothe payment of fixed amount (defined in the Power Purchase Agreement as thecapacity purchase price) which covers fixed costs, including debt service.

In summary, the Bank’s guarantee can act as an important catalyst formobilizing private sector financing for private sector infrastructure projects. Asexemplified by the Hub Power Project, not only does the Bank guarantee providecoverage for a part of the debt financing, but the presence of the Bank in theproject enhances the project’s attractiveness to other providers of capital, both debtand equity.

(For more information on the Hub Power Project and the Bank’s partialrisk guarantee, please contact Suman Babbar, CFSPF (ext. 32029) or Per Ljung, SA1EF(ext. 81933)


According to the terms of the loan agreement to be signed in June, LIC would provide a maximum of Rs.6,000 crore or a minimum of Rs.4,000 crore to

NHAI to be availed of in eight quarters as per a schedule to be drawn up.

The 25-year loan with a moratorium of ten years will be repaid in 30 equalsemi-annual instalments beginning from the second half of the tenth year to theterminal year of the loan.

The LIC loan will carry an interest rate on par with Government of IndiaSecurities (G-Sec) plus 100 basis points. Besides, NHAI will pay a commitment

Source: http://www.blonnet.com/2003/05/25/stories/2003052501630100.htm. May 2003. @ Businessline, Reprintedwith permission.

21

Insurance Funds to Flow into RoadProjects-LIC Finalising Loan Pact

with NHDP

P Manoj

Insurance funds are set to be ploughed into the highways sector forthe first time, with the National Highways Authority of India (NHAI)and Life Insurance Corporation (LIC) finalising the terms for along-term loan agreement of Rs.6,000 crore, to part-fund theRs.58,000-crore National Highways Development Project (NHDP).

255Insurance Funds to Flow into Road Projects-lic Finalising...

fee of 0.10 percent per annum of the funds to be disbursed in a particular financialyear, a penalty fee of 0.25 percent per quarter of the amount undrawn out of theminimum agreed disbursement, for any quarter and expenses relating to listing.

The debt will be drawn by issuance of bonds, which will be listed in thewholesale debt segment of the National Stock Exchange. Each bond carries a facevalue of Rs.1 crore and will be issued in demat form.

The debt servicing obligations of the NHAI will be backed by a contingentGovernment of India guarantee, on an unconditional and irrevocable basis forwhich the highway authority will pay a guarantee fee of 0.25 percent every yearto the Finance Ministry.

“All these elements will translate into a cost of less than 8 percent. Consideringthat such long-term loans are not available in the market, at this maturity, thecost is very competitive”, a senior NHAI official said.

LIC will have pari passu first charge on the funds assigned to NHAI from theCentral Road Fund made up of the cess on petrol and diesel. The cess fundswould be utilised to service the debt obligations of NHAI through an escrowmechanism operated by a suitable trustee, the official said.

The loan agreement also contains a provision to review the G-Sec rates afterseven years.

Apart from ensuring a steady stream of funds to finance the NHDP, the LICloan also fulfils a Government strategy to channelise insurance money to builthighways, port and railway projects.

257Index

A

Active Traders, 151

Adjusted Present Value, 85

Africa, 95, 143, 145, 154, 155

Agency Costs, 10, 11

Agency Fee, 147, 148

Antifiling Mechanism, 186, 187

Argentina, 15, 39, 125, 143, 200, 201,203, 205, 207, 209, 212, 217, 221, 222,234, 235, 237, 242

Arrangers, 145, 148, 154, 156

Asia, 16, 19, 95, 143, 150

Asia-Pacific Region, 153, 154

Asset-Backed Securities, 9

Asymmetric Information, 12, 68

Austria, 155

B

Bond Financing, 142, 234

Bond Market, 32, 55, 144, 154, 234, 243

Brady Plan, 143

Brazil, 30, 33, 34, 129, 143, 199, 201,205, 209, 212, 217, 221, 222

Build-Operate-Transfer (BOT), 65, 240

Build-Own-Operate (BOO), 65

Build-Transfer-Operate (BTO), 65

Bullet or Balloon Repayments, 116

C

Callable Debt, 123

Capital Markets, 20, 31, 32, 34, 44, 47, 51,98, 129, 165, 168, 200, 202, 204, 206,207, 211, 215, 216, 219, 220, 229, 232,233, 238, 242, 243

Casablanca, 237

Cash Deficiency Agreement, 64

Cash-Sweep, 114, 117, 118, 120, 123

Cash-Trap, 121

Chile, 30, 32, 37, 38, 110, 123, 199-203,205-207, 209, 212, 216, 217, 219-222,237

Collateral, 6, 7, 11, 23, 38, 41, 44, 45, 108,110, 149, 151, 174, 177-179, 185-187,190, 193, 236, 240, 247

Collateralized Debt Obligations, 153

Completion Risk, 3, 5, 35, 62, 173

Concession Agreements, 18, 40, 55, 65, 97,98, 179

Concessionaire, 41, 43, 240, 244

Consolidation Risk, 28, 31, 35, 40, 108

Contingent Liabilities, 43, 131, 133-137

Contingent, 29, 43, 131-137, 255

Contract Enforcement, 25, 29, 30

Contract Finance, 60

Cost-of-Service Agreement, 64

Counterparty Exposure, 175, 187

Index


Covenants, 10, 21, 23, 34, 36, 40, 63, 104,107, 112, 114, 120-122, 144, 149, 151,161, 169, 187

Credit Default Swap, 144

Credit Derivatives, 100, 151

Credit Enhancements, 25, 28, 33, 46, 174,175, 234

Credit Lease, 177, 180, 183, 185, 188, 190

Credit Ratings, 174, 188, 189, 196, 243

Credit Risk, 23, 25, 27, 28, 42, 44, 45, 47,60, 62, 63, 93-95, 99, 101, 105, 110,123, 133, 142, 144, 145, 147, 149, 162,167, 169, 179, 236

Cross-Border Debt, 177, 178

Currency Risk, 16, 137, 193, 240

Currency Swaps, 188

D

Debt Market, 25-29, 32, 37, 38, 44, 46,107, 109, 123, 150

Debt Service, 8, 10, 11, 29, 30, 34, 36, 39,41, 42, 44, 45, 47, 62-65, 67, 94, 129,174, 175, 177, 189, 191, 243, 244,251-253

Debt-Service Coverage Ratios (DSCRs), 189

Debt-Service Reserve Fund, 45, 47, 194,196

Debt-Service Reserve Account (DSRA), 114

Design-Build-Operate, 33

Dispute Resolution, 30

Domestic Resource Cost (DRC), 75

Dominican Republic, 228

Due Diligence, 40, 45, 207, 235

E

Economic Rate of Return (ERR), 70-72, 76

Economic Value, 35, 73, 74, 111

Electric Utilities, 12, 225

Emerging-Market, 32, 33, 47

Entertainment, 58, 173

Equator Principles, 158-162

Escrow, 62, 67, 250, 252, 255

Europe, 95, 96, 114, 115, 144, 145, 150,152, 153, 155, 199, 201, 205, 207, 218,220, 235

European Bank for Reconstruction andDevelopment, 235

European Investment Bank, 242, 243

Exchange Rate Risk, 124-130

Expropriation, 22, 40, 97, 100, 239

F

Financial Distress, 3, 5, 11, 68, 100

Financial Risk, 3, 5, 66, 82, 133, 176, 189,190

Financial Sector Reforms, 32

Force Majeure, 62, 64, 174, 175, 193, 194,196, 251, 253

Foreign Direct Investment (FDI), 52

Foreign Exchange Reserves, 54

Foreign Exchange Risk, 130, 178, 190,191, 198, 210, 250, 251

France, 93, 155, 249, 250

Free Cash Flow, 10, 11, 62, 78, 79, 97, 99

Funding Gap, 26, 27, 44

G

Gabon, 237

Generally Accepted Accounting Principles(GAAP), 165

Global Depositary Receipt, 249

Golden Quadrilateral (GQ), 53

Governance, 16, 99, 210

259Index

Government Guarantee, 23, 29, 42, 226,241, 253

Grant Funding, 236

Greenfield Projects, 15, 24, 130, 203, 207,240

Guaranteed Investment Contracts (GICs),45

Guatemala, 228, 235

H

Hedging, 55, 126, 127, 166, 188

Hell-or-High-Water Contract, 177, 180,183, 185, 188, 190

Hong Kong, 153

Hungary, 15

I

Indenture, 41, 115, 123, 169, 177-179,185

India, 3, 4, 13, 25, 47, 51-56, 58, 65, 68,75, 81, 89, 93, 103, 159, 254, 255

Infrastructure, 3-5, 13-15, 18, 19, 25-30,32-38, 42, 44, 46-48, 51, 52, 54-58,60, 61, 65, 67, 68, 70, 71, 78, 80-82,84, 86, 88, 93, 94, 96, 98, 101, 108,110, 116, 117, 119, 124, 125, 128-131,133, 134, 137, 159, 174, 192, 195, 197-222, 234-238, 241, 245-249, 251, 253

Insolvency, 30, 184, 187

Institutional Bond Investor, 25, 26

Institutional Risk, 175, 192

Inter- American Development Bank, 150,197, 219

Interest Rate Risk, 118

Inter-Institutional Group (IIG), 54

International Arbitration, 178

International Development Banks, 26

International Finance Corporation (IFC), 72,160

Involuntary Bankruptcy, 35, 36, 40, 41

IPP, 225-231

Italy, 155, 249, 250

J

Japan, 144, 145, 155, 242, 247, 249, 250

K

Korea, 30-32, 38

L

Latin America, 34, 95, 130, 131, 143, 145,155, 157, 195, 198-201, 204, 205, 207,208, 210-212, 216, 218-221, 245

Lead Managers, 145

Lease Rental Expense, 170

Legal Framework, 25, 29-31, 38, 98

Lender Rights, 31

Leverage Ratios, 12, 59, 99, 101

Life Insurance Corporation (LIC), 254

Limited Liability Corporation, 37

Little Mirrlees Approach (LM), 73

Loan Portfolio, 44, 45, 119, 151, 153

M

Maintenance Reserve Account (MRA), 114

Malaysia, 233, 235, 241-243

Mandated Arrangers, 145

Market Risk, 18, 61, 63, 97, 99, 133, 165,173, 177, 182, 183, 195

Market-Makers, 151

McKinsey, 52

Mexico, 30-34, 36-38, 142, 143, 200-202,204-206, 209, 212, 221, 222, 241-243


Military Housing, 173

Modified Internal Rate of Return, 84

Multilateral Agencies, 46, 61, 150, 193,194, 216

Multilateral Investment Guarantee Agency,193

Multiproject Financing Facility (MPF), 235

Municipal Infrastructure, 234

N

National Highways Authority of India(NHAI), 254

National Stock Exchange, 255

Natural Gas Pipelines, 235

Network Effect, 78, 79

New Zealand, 117, 121

Non-recourse, 5, 7-9, 12, 14, 17, 55, 58,59, 61, 68, 94, 95, 98-101, 109,175,176, 187, 195, 203, 226, 241, 242

O

Offtake Agreement, 23, 97, 98, 108, 177,178

Oil and Gas, 18, 97, 108, 110, 159, 173

Open-Ended Funds, 100

Operating Agreement, 38, 39

Operating Risk, 23, 99, 166, 177

Organization for Economic Cooperation andDevelopment (OECD), 26

Overseas Private Investment Corporation,129

P

Pari Passu, 42, 112, 255

Pension Asset Management, 204

Pension Funds, 61, 129, 144, 197-201,203, 205-221

Petrochemicals, 97, 100Philippines, 20, 103, 143, 228, 235

Political Risk Guarantees, 94, 100, 102, 104,105

Political Risk, 3, 5, 31, 32, 34, 35, 42-44,94, 97, 100-106, 133, 188, 210, 217,238, 239, 243, 244, 249, 250

Pooled Financings, 28

Portfolio Performance, 55, 200

Power Purchase Agreement (PPA), 250

Power Sector, 95, 110, 116, 226, 227, 230,231, 245, 246, 248

Prepayment Fee, 147, 148

Private Pension Funds, 197, 199-201,207-209, 218-221

Private Sector Risk, 35

Privatizations, 9, 16, 26, 30, 31, 34, 130

Project Debt Rating, 175, 191

Project Finance Market, 3, 12, 13, 21, 95,121

Project Financing Structures, 10, 11, 13,55, 57, 58, 97, 100

Project Risks, 10, 22, 68, 97, 196

Project Sponsors, 5, 18, 20, 24, 61, 64, 66,67, 82, 126, 173, 194, 195, 226, 231,239, 244, 247, 248

Public Utility Regulatory Policy Act(PURPA), 7, 16

Public-Private Partnerships, 25, 27, 29, 99

R

Ratings, 25, 27, 45, 48, 96, 104, 105, 112,118, 121-123, 144, 164, 165, 168, 171,174, 181, 182, 188, 189, 192, 193, 195,196, 201, 202, 213-215, 217, 243

Raw Material Supply Contracts, 64, 100

Real Estate, 6, 100, 164, 165, 179, 202,208, 222

261Index

Real Options, 80, 87, 88, 100

Refinancing Risk, 107-123, 169, 189

Refineries, 58, 100, 194

Republic of Congo, 237

Residual Value Guarantee, 168-171

Revolving Loan, 129

Risk Contamination, 68, 99

Risk Identification, 133

Risk Management, 12, 13, 20, 23, 55, 68,131-133, 137, 144, 162, 166

Risk-Return Trade-Off, 55

S

Secondary Market, 105, 141, 144, 148,150-154, 156

Securitization, 9, 28, 31, 38-40, 100, 207,215, 222

Shadow Prices, 73, 74, 76

Slovenia, 236, 237

Sovereign Risk, 174, 175, 191, 193, 247

Spain, 116, 155, 201, 205, 222

Special Purpose Entity (SPE), 165, 167, 184

Special Purpose Vehicles (SPVs), 59, 95

Speculative Development, 66

Stakeholder Analysis, 70, 76

State Revolving Funds (SRFs), 45, 236

Step-up Provisions, 64

Structured Finance, 38-40, 58, 107, 108,119, 122, 193, 196

Subordinated Debt, 8, 21, 67, 112-114,171, 190, 191, 231

Supplemental Credit Arrangements, 63, 66

Supply or Pay Contract, 64

Surety Bonds, 179, 188

Syndicated Loans, 24, 94, 141-145, 147,150, 151, 156, 157

Synthetic Lease, 164-171

T

Take or Pay Contract, 63, 65

Take-if-Offered Contract, 63

Technical Risk, 181

Telecom, 9, 12, 58, 81, 88, 93, 95, 96,211, 212, 237, 241

Throughput Agreement, 64, 67

Toll Road, 4, 34, 40, 96, 109, 110, 116,119, 122, 123, 193, 194, 245

Tolling Agreement, 64

Transport, 12, 51-53, 58, 68, 75, 81, 88,108, 117, 119, 121, 145, 173, 182, 211,217, 218, 220, 234, 240

Trust Estate, 37

Trustee, 28, 37-43, 67, 177, 178, 184, 187,255

U

US Agency for International Development’sUSAID, 25, 47, 245,

Underwriting, 45, 142, 147, 148, 156,157, 250

UNIDO Approach, 73, 74

United Kingdom (UK), 93, 103, 114, 117,130, 145, 154, 155, 176, 187, 195, 198,201, 205, 207, 214, 222, 230, 237, 243,244, 246, 248-250

United States (US), 6, 7, 16, 25, 26, 32, 37,39, 45, 47, 64, 66, 85, 89, 95, 96, 103,106, 110-112, 116, 118, 119, 123, 129,134, 142-147, 150-157, 160, 161, 172,173, 186, 195, 199-201, 204, 206, 208,209, 211, 212, 214, 216, 218, 220, 225,


227-230, 234-237, 242-245, 247-249,251, 252

User Fees, 27, 34, 39, 41, 42, 45, 47

Utilisation Fee, 147, 148

V

Venezuela, 143, 200

Venture Capital, 206

Voluntary Bankruptcy, 35, 40, 187

W

Water and Sanitation Pooled Fund, 25, 47

World Bank, 4, 55, 61, 76, 102, 124, 130,131, 137, 158, 161, 162, 211, 212, 220,225, 231, 232, 238, 239, 245-247, 249,251, 252

Wraparound Addition, 66