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LE S SON S OF EXP E RI EN CE

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LESSONS OF EXPERI ENCE

6.4-^XlINANCEIN DEVELOPINGCOUNTRIESr. 0 , ,

International Finance CorporationWashington, D.C.

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CONTENTS

K ~~~~~~~~~~Preface vAbbreviations ix

I The Importance of Project FinanceI

2 Globalization and the Rapid Growth of Project Finance 133 IFC's Role in Project Finance 254 Mitigating Major Project Risks 385 Strengthening Project Security 596 Summary and Conclusions 71

Appendix A:Greenfield Projects Supported by IFC throughLimited-Recourse Project Financing, Fiscal 1989-98 78Appendix B:A SampleIFC Project Appraisal 86Glossary 91Bibliography 101

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PREFACE

Project finance to developing countries surged in the decade before the Asian crisis-supported by a growing reliance on market economics in many countries during thisperiod, as well as the increasing integration of global financial markets. Project financestructuring techniques were used to attract international financing for many large-scaleprojects, helping to meet investment needs in infrastructure and other sectors. Thefinancial crisis that began in East Asia in mid-1997, however, has brought a dramaticslowdown in this trend. The crisis has created stresses and strains for many projects,raising concerns about the viability of some and highlighting the importance of carefulstructuring and risk mitigation.

IFC's mission is to contribute to the World Bank Group's overall purpose of reducingpoverty and improving living standards by playing a leading role in the development of asustainable private sector. As part of this mission, IFC was one of the early pioneers ofproject finance in developing countries 40 years ago, and project finance remains animportant core of IFC's activities today.In just the past decade IFC, which has a com-mitted portfolio exceeding $11 billion in loan and equity investments in more than1,100 companies, has supported over 230 greenfield projects in 69 developing countrieswith limited-recourse project finance.

Three important principles guide IFC's work: the business principle, the catalytic princi-ple, and the principle of special contribution. Following the business principle, IFC focuseson promoting competitive and dynamic private enterprises by taking a partnership roleand by accepting the same market risk as project sponsors. The catalytic principle focuseson the demonstration effect of individual transactions, a key to extending theCorporation's real development role.The special contribution principle directs IFC tocomplement the market and hence focus on projects and places where it can add specialvalue. IFC's involvementwith project finance shows how these principles interact to helpbring projects to completion. IFC and other development agencies can play a significantrole in support of project finance in countries that have a fundamentally sound framework

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but where access to financialmarkets is limited. Project finance structuring can be particu-larly important to help mitigate risk and restore confidence in difficult circumstances.

This volume describes IFC's greenfield project finance activities over the past decade,initially against the background of rapid growth in capital flows and project financeactivities in developing markets and then in light of their subsequent recent slowdown.It describes the essentials and some of the complexities of project structuring, for thebenefit of a wider audience, to help explain the importance of "getting it right."Although it is still too early to tell the final outcome for most projects affected by thecrisis, this analysis highlights those features of structuring which in IFC's experiencecontribute to more durable projects over the long term. A primary message is theimportance of clearly identifying and addressing project risks up-front and the poten-tial costs of complacency in dealing with critical issues such as foreign exchange ormarket demand risks. In addition to strong fundamentals, projects that are conserva-tively structured in financial terms and that carry strong sponsor support in terms oftechnical and management strength and financial commitment are those projects mostlikely to be successful.

Although the report focuses on transactions, underlying the discussion is the impor-tance of good policies. Particularly important is the need for governments to provide asupportive legal and regulatory framework. Project finance, which is essentially contract-based financing, can be successful in the long term only against a background of solidrules, regulations, and policies. If, for example, udicial processes are not seen as fair ortransparent, sponsors and investors will be wary of investing even under the most care-fully crafted contractual structure. In a supportive environment, however,project financestructuring can offer a relatively ransparent and efficient means for countries seeking toincrease the level of private participation in economic activity and investment. Anotherimportant policy message running through this discussion, and reinforced by the lessonsof the financial crisis that began in 1997 in developing countries, is the priority govern-ments need to give to strengthening local financial markets. Many of the project diffi-culties suffered in the wake of the financial crisis would perhaps have been more man-ageable if a greater share of project financing had been sourced locally. Local marketsneed to be able to provide long-term debt and equity financing on a reasonably compet-itive basis, so that projects without a natural foreign exchange risk hedge do not need toresort heavily to foreign currency financing and can therefore reduce potentially signifi-cant foreign exchange risk.


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P R E F A C E vii

ProjectFinance in DevelopingCountrieswas written by a team from IFC's CorporatePlanning and Financial Policy Department, led by Anita Ahmed with Xinghai Fang andTracy Rahn, under the overall direction of Dileep Wagle and Nissim Ezekiel. Valuablesupport was also provided by Maybelle Pacis and Donna Raimondi. This book, like oth-ers in the Lessons of Experience series, has drawn upon a full range of operational expe-rience with project finance transactions from across the Corporation. It has also benefit-ed from comments and contributions of staff from the World Bank. Data used in thereport reflect IFC's operational position through June 30, 1998.

PeterL. WoickeExecutive Vice PresidentInternational Finance Corporation

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ABBREVIATIONS

AIU American International UnderwritersBIS Bank for International SettlementsBOO build-own-operateBOT build-operate-transferCAMENA Central Asia/Middle East/North AfricaCITI Citicorp International Trade IndemnityCoface Compagnie Francaise d'Assurance pour le Commerce ExterieurCUP Cooperative Underwriting ProgramD/E debt/equityEAP environmental action planEBRD European Bank for Reconstruction and DevelopmentECA Export Credit AgencyECGD Export Credits Guarantee DepartmentEIA environmental impact assessmentEID/MITI Export-Import Insurance Department/Ministry of International Tradeand Industry (Japan)FDI foreign direct investmentGDP gross domestic productIBRD International Bank for Reconstruction and DevelopmentIDB Inter-American Development BankIDFC Infrastructure Development Finance CompanyIFC International Finance CorporationIMF International Monetary FundIPP independent power projectkwh kilowatt-hourLAC Latin America/CaribbeanL/C letter of creditLibor London interbank offer rateMDB multilateral development bankMIGA Multilateral Investment Guarantee AgencyNGOs nongovernmental organizationsOECD Organisation for Economic Co-operation and DevelopmentOPIC OverseasPrivate Investment CorporationPFA project funds agreementPFC project financial completionPPA power purchase agreementPURPA Public Utility Regulatory Policy ActQIB qualified institutional buyerSEC Securities and Exchange Commission (U.S.)Note: All dollars are U.S. dollars unless otherwise indicated.

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THE IMPORTANCEOF PROJECTFINANCE

In the past twenty years there has been a new wave of globalinterest in project finance as a tool for economic investment.Project finance helps finance new investment by structuring thefinancing around the project's own operating cash flow andassets,without additional sponsor guarantees. Thus the tech-nique is able to alleviate investment risk and raise finance at arelatively low cost, to the benefit of sponsor and investor alike.Though project finance has been in use for hundreds of years,primarily in mining and natural resource projects, its other pos-sible applications-especialy for financing large greenfield projects(new projects without any prior track record or operating history)-have only recently received serious attention. This is particu-larly so in developing markets, but here its application is alsobroadening, as illustrated by the following examples of IFC-supported projects:. In Argentina, in 1993, project finance structuring helped raise

$329 million to finance investment in the rehabilitation andexpansion of Buenos Aires' water and sewerage services basedon a new 30-year concession awarded to Aguas Argentinas.1The investment, financed with IFC support, has helpedimprove water quality and service to a city of more than 6mirion people. At that time, private sector participation in awater concession in a developing country was an untested idea,and there was virtually no precedent for a private company,

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operating in such an envirnet,riig substantial resourcesin international capital markets.

_ In Hungary, in 1994, project finance structuring helpedfinance a 15-year concession to develop, install, and operate a


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nationwide digital cellular network. The S185 million joint venture project was animportant part of the government's privatization and liberalization program. Because ofdifficulty attractingcommercial financing at that time, the project relied heavily on$109 million in debt and equity financing from IFC and the U.S. OverseasPrivateInvestment Corporation (OPIC).

* In China, in 1997, Plantation Timber Products (Hubei) Ltd. launched a $57 milliongreenfield project to install modern medium-density fiberboard plants in interiorChina, using timber plantations developed over the past decade, to support China'sfast-growing construction industry. As part of the limited-recourse financing for theproject, IFC helped arrange $26 million in syndicated loans, at a time when foreigncommercial banks remained cautious about project financing in China's interiorprovinces.

In Mozambique, in 1998, project finance structuring helped establish a $1.3 billiongreenfield aluminum smelter. MOZAL, the largest private sector project in thecountry to date, is expected to generate significant benefits in employment, exportearnings, and infrastructure development. IFC fostered the project by serving aslegal coordinator and preparing an independent, detailed analysis of economicresults and environmental and developmental impacts. IFC also supported theproject with $120 million in senior and subordinated loans for its own account.

The change in attitude toward project finance can be attributed to a number of fac-tors, a prime one being that most countries today rely on market mechanisms to guidetheir economic activity and on the private sector to supply investment. Greater focuson the private sector has necessitated major regulatory reforms, which in turn havecreated new markets in areas previously the preserve of government activity. In oneillustration, for example, provided by John D. Finnerty in Project Financing: Asset-BasedFinancial Engineering, when the United States passed the Public UtilityRegulatory Policy Act (PURPA) in 1978 and established a private market for electricpower, it provided a strong model for the growth of project financing in many otherindustrial countries.2 Similarly, recent large-scale privatizations in developing countriesaimed at strengthening economic growth and stimulating private sector investment havegiven fuirther impetus to project finance structuring. Governments have also been will-ing to provide incentives to encourage private investors into new sectors. The surge inproject finance was particularly strong in 1996 and 1997, stimulated by large flows ofinternational capital. In 1997 the number of project finance deals worldwide (green-field and expansion projects) exceeded 600, many of them in developing countries, andtheir value topped $236 billion (table 1.1), although this dropped back to about $111billion in 1998.


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Table1.1. ProjectFinance ransactionsy Region,1997-98AmountRegion Numberof projects (millionsf U.S.dollars)

1997 1998 1997 1998Europe 207 104 81,703 26,173Asia 191 63 58,405 27,477LatinAmerica 105 49 41,610 33,554NorthAmerica 75 33 28,400 15,033MiddleEastandNorth Africa 35 14 22,876 7,169Sub-Saharanfrica 11 8 3,429 2,114Total 624 271 236,423 111,520Share f developing ountries 380 140 123,169 60,069

Source:CapitalDATAPrqjectFinanceWare. igned ransactions.Although he scopeof transactionsncluded s projectfinance s broader han hat used n this report, hese dataprovide goodoverview f market rendsand developments.

Some market observers are questioning the prudence of this expanded use of projectfinance, especially in the wake of the East Asia financial crisis that began in mid-1997and the dramatic deterioration that ensued in a number of the major developing mar-kets. In short order, many large projects undertaken in the previous few years were nolonger economically or financially feasible. Contractual arrangements proved to beshaky-in some cases, unenforceable-and many projects, with hindsight, had failedadequately to address potential risks (including foreign exchange risks). Private lendersand investors were much less willing to support projects facing a deteriorating policy ormarket environment than public sector promoters would have been. In a few countriesthese problems were exacerbated by public criticism of government support given to proj-ects, and by allegations of corruption in the awarding of initial contracts.

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, projectfinance offers a means for investors, creditors, and other unrelated parties to cometogether to share the costs, risks, and benefits of new investment in an economicallyefficient and fair manner. As the emphasis on corporate governance increases, the con-tractually based approach of project finance can also help ensure greater transparency.


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Despite the financial crisis that began in mid-1997, the investment needs in manydeveloping markets remain enormous. Meeting these needs is essential to development,not only in the more traditional sectors such as energy but also in nontraditional areassuch as school and hospital construction. For most countries, this will mean a continu-ing reliance on private sector expertise and finance to meet demand. Once growth andinvestment resume, project finance techniques are likely to be an even more importantmeans of sharing risks and of helping these projects get off the ground-particularly insome markets and sectors that may be considered more risky for some time to come. Asthe experience of the crisis has demonstrated, individual projects are not a substitutefor economy-wide regulatory reform designed to improve competitiveness and effi-ciency, or for the development of local financial markets in support of local invest-ment. But in the appropriate framework, project finance can provide a strong and trans-parent structure for projects, and through careful attention to potential risks it can helpincrease new investment and improve economic growth.BASICS F PROJECTINANCINGAs already noted, project finance is tailored to meet the needs of a specific project.Repayment of the financing relies on the cash flow and the assets of the project itself.The risks (and returns) are borne not by the sponsor alone but by different types ofinvestors (equity holders, debt providers, quasi-equity investors). Because risks areshared, one criterion of a project's suitability for financing is whether it is able tostand alone as a distinct legal and economic entity. Project assets, project-related con-tracts, and project cash flows need to be separated from those of the sponsor. Thereare two basic types of project finance: nonrecourse project finance and limited-recourse project finance.

Nonrecourseprojectfinances an arrangement under which investors and creditorsfinancing the project do not have any direct recourse to the sponsors, as might tradition-ally be expected (for example, through loan guarantees). Although creditors' security willinclude the assets being financed, lenders rely on the operating cash flow generated fromthose assets for repayment. Before it can attract financing, then, the project must be care-fully structured and provide comfort to its financiers that it is economically, echnically,and environmentally feasible, and that it is capable of servicing debt and generatingfinancial returns commensurate with its risk profile.

Limited-recourse rojectfinancepermits creditors and investors some recourse to thesponsors.This frequently takes the form of a precompletion guarantee during a project'sconstruction period, or other assurances of some form of support for the project.Creditors and investors, however, still look to the success of the project as their primary


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source of repayment. In most developing market projects and in other projects with sig-nificant construction risk, project finance is generally of the limited-recourse type.Difference from corporate ending. Traditional finance is corporate finance, where theprimary source of repayment for investors and creditors is the sponsoring company,backed by its entire balance sheet, not the project alone. Although creditorswill usuallystill seek to assure themselves of the economic viability of the project being financed, sothat it is not a drain on the corporate sponsor's existing pool of assets, an importantinfluence on their credit decision is the overall strength of the sponsor's balance sheet aswell as business reputation. Depending on this strength, creditors will still retain a sig-nificant level of comfort in being repaid even if the individual project fails. In corporatefinance, if a project fails, its lenders do not necessarily suffer, as long as the companyowning the project remains financially viable. In project finance, if the project fails,investors and creditors can expect significant losses.

Project finance benefits primarily sectors or industries in which projects can be struc-tured as a separate entity, apart from their sponsors. A case in point would be a stand-alone production plant, which can be assessed in accounting and financial terms sepa-rately from the sponsor's other activities. Generally,such projects tend to be relativelylarge, because of the time and other transaction costs involved in structuring, and toinclude considerable capital equipment that needs long-term financing. In the financialsector, by contrast, the large volume of finance that flows directly to developing coun-tries' financial institutions has continued to be of the corporate lending kind.

Traditionally, in developing countries at least, project finance techniques have shownup mainly in the mining and oil and gas sectors. Projects there depend on large-scaleforeign currency financing and are particularly suited to project finance because theiroutput has a global market and is priced in hard currency. Since market risk greatlyaffects the potential outcome of most projects, project finance tends to be moreapplicable in industries where the revenue streams can be defined and fairly easilysecured. In recent years, private sector infrastructure projects under long-term govern-ment concession agreements with power purchase agreements (PPAs) that assure apurchaser of the project's output have also been able to attract major project financeflows. Regulatory reform and a growing body of project finance experience continue toexpand the situations in which project finance structuring makes sense, for example,for merchant power plants that have no PPA but sell into a national power grid atprevailing market prices.

In IFC's experience, project finance is applicable over a fairly broad range of non-financial sectors, including manufacturing and service projects such as privately


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financed hospitals (wherever projects can stand on their own and where the risks canbe clearly identified up front). Although the risk-sharing attributes of a projectfinance arrangement make it particularly suitable for large projects requiring hun-dreds of millions of dollars in financing, IFC's experience-including textile, shrimpfarming, and hotel projects-also shows that the approach can be employed success-fully in smaller projects in a variety of industries. Indeed, that experience suggestsproject finance could help attract private funding to a wider range of activities inmany developing markets.BRINGINGPRIVATEFLOWSTO DEVELOPINGMARKETSMost project finance deals of the past two decades have been concluded in industrialcountries, but the technique has also played a significant role in some developing mar-kets. In 1997 and 1998 combined flows of this kind to developing country projectstotaled about $183 billion, or slightly more than half the total project finance flowsrecorded worldwide (figure 1.1).

For developing markets, project finance holds out the hope that a well-structured,economically viable project will attract long-term financing even if the project dwarfsits sponsors' own resources or entails risks they are unable to bear alone. With such amechanism for sharing the costs, risks, and rewards of a project among a number ofunrelated parties, a privatization or infrastructure improvement program will have agreater chance of raising the volume of funds it requires.

Figure 1.1. Volume of Project Finance Transactions,1994-98(millionsof U.S.dollars)

250,000 -

200,000-

o 150,000 _

100,000 _ Allcountries5o,oao Developingmarkets

01994 1995 1996 1997 1998

Source: Capital DATA ProjectFinanceWare.


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As a result, it is now standard practice for large and complex projects in the majordeveloping markets to employ project finance techniques. The total volume of projectfinance transactions concluded in 1996 and 1997 before the financial crisis (an esti-mated 954 projects costing $215 billion) would have been hard to imagine a decadeago. The number of active participants in these markets also increased as many inter-national institutions (investment banks, commercial banks, institutional investors, andothers) moved quickly to build up their project finance expertise.

The financial and economic crisis that began in mid-1997 in East Asia, the site ofmuch recent growth, and spread to other countries since then has dramatically slowedmarket evolution.The estimated number of projects in developing markets fell in 1998 to140 for an amount of $60 billion. The financial capacity and willingness of many banksin these countries and of other potential investors to support large projects have also beeneroded. As a result, sponsors in crisis countries, both private and public, have canceled ordeferred numerous major projects.The ones still under implementation, particularly thosefinanced during the past few years, have come under increased stress in the face ofreduced market demand for their output or related sponsor problems.

With the prospects for economic growth slowing worldwide, sponsors in other coun-tries and regions are also structuring projects more conservatively. t is not yet clear howprolonged these difficulties will be. When the growth of new productive investment picksup again, however,project financing is likely o increase, particularly in countries whereperceptions of risk remain high and investors could be expected to turn to structuringtechniques to help alleviate these risks.ADVANTAGESOF PROJECT INANCEIn the appropriate circumstances,project finance has two important advantages over tra-ditional corporate finance: it can (1) increase the availability of finance; and (2) reducethe overall risk for major project participants, bringing it down to an acceptable level.

For a sponsor, a compelling reason to consider using project finance is that the risksof the new project will remain separate from its existing business. Then if the project,large or small, were to fail, this would not jeopardize the financial integrity of the corpo-rate sponsor's core businesses. Proper structuring will also protect the sponsor's capitalbase and debt capacity and usually allow the new project to be financed without requir-ing as much sponsor equity as in traditional corporate finance. Thus the techniqueenables a sponsor to increase leverage and expand its overall business.3

By allocating the risks and the financing needs of the project among a group of inter-ested parties or sponsors, project finance makes it possible to undertake projects that


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would be too large or would pose too great a risk for one party on its own. This was thecase in 1995 when IFC helped structure financing for a $1.4 billion power project in thePhilippines during a time of considerable economic uncertainty there. Sharing the risksamong many investors was an important factor in getting the project launched.

To raise adequate funding, project sponsors must settle on a financial package thatboth meets the needs of the project-in the context of its particular risks and the avail-able security at various phases of development-and is attractive to potential creditorsand investors. By tapping various sources (for example, equity investors, banks, and thecapital markets), each of which demands a different risk/return profile for its invest-ments, a large project can raise these funds at a relatively ow cost. Also working to itsadvantage is the globalization of financial markets, which has helped create a broaderspectrum of financial instruments and new classes of investors. By contrast, projectsponsors traditionally would have relied on their own resources for equity and on com-mercial banks for debt financing. Particularly significant is the increasing importance ofprivate equity investors, who tend to take a long-term view of their investments. Theseinvestors are often willing to take more risk (for example, by extending subordinateddebt) in anticipation of higher returns (through equity or income sharing) than lenders.A project that can be structured to attract these investors-to supplement or even tosubstitute for bank lending-may be able to raise longer-term finance more easily.Further details on the main financial instruments and sources of financing for projectfinance appear in box 1.1.NO FREELUNCHFor all its advantages, project finance cannot be said to offer a "free lunch." On the con-trary, it has rigorous requirements. To attract such finance, a project needs to be carefullystructured to ensure that all the parties' obligations are negotiated and are contractuallybinding. Financial and legal advisers and other experts may have to spend considerabletime and effort on this structuring and on a detailed appraisal of the project. These stepswill add to the cost of setting up the project and may delay its implementation.Moreover, he sharing of risks and benefits brings unrelated parties into a close and longrelationship.A sponsor must consider he implications of its actions on the other partiesassociatedwith the project (and must treat them fairly) f the relationship is to remain har-monious over the long term.

Since project finance structuring hinges on the strength of the project itself, thetechnical, financial, environmental, and economic viability of the project is a paramountconcern. Anything that could weaken the project is also likely to weaken the financialreturns of investors and creditors. Therefore an essential step of the procedure is to iden-tify and analyze the project's risks, then to allocate and mitigate them. Potential risks aremany and varied. Some may relate to a specificsubsector,others to the country and policyenvironment, and still others to more general factors. As the crisis that began in mid-


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Box1.1. ProjectFinancingnstruments, ources, nd Risk-Return rofilesCommercialoans.undsentprimarily y commercialanks ndother inancialnstitutions,generallyecuritizedy he project's nderlying ssets.enderseek:1)projected ashlowsthat can inance ebt epaymentith a safetymargin;2)enough f anequity take romsponsorso demonstrateommitment;3) imited ecourseo sponsorsn the eventof speci-fied problems,uch scostoverruns;nd 4)covenantso ensure pproved sage f fundsand managementf the projects.Equity. ong-term apital rovidedn exchangeor shares,epresentingartownership fthe company r project.Providedrimarily y sponsorsnd minoritynvestors. quity old-ers eceive ividends ndcapitalgains or osses), hicharebased n net earnings. quityholdersake isks dividendsrenot paid f the companymakesosses),ut in return harein profits.Subordinatedoans.oansinanced ith repaymentriority verequity apital ut not overcommercialank oans r other enior ebt n he event f default r bankruptcy.suallyro-videdby sponsors.ubordinatedebtcontains scheduleor payment f interest ndprinci-palbut mayalso llowparticipationn the upside otential imilaro equity.Supplier redit. ong-termoansprovided y project quipmentupplierso cover urchaseof theirequipment y he project ompany. articularlymportantn projects ith significantcapital quipment.Bonds. ong-termebtsecuritiesenerallyurchasedy nstitutionalnvestorshrough ublicmarkets, lthoughhe private lacementf bondssbecoming ore ommon.nstitutionalinvestorsreusuallyisk-averse,referringrojects ith an ndependentredit ating.Purchasersequire high evel f confidencen he project forexample,trong ponsors,contractualrrangements,ndcountry nvironment);his s stilla relativelyewmarketndevelopingountries.Internally eneratedash.Funds vailableo a companyromcash low romoperations(that s,profitafter axplusnoncash harges inus oncasheceipts)hat are retained ndavailableor reinvestmentna project.na financial lan, einvestedrofits re reated sequity, lthoughheywill begeneratednly f operationsresuccessful.ExportCreditAgencyECA) acility.oan, uarantee,r nsuranceacilityprovided yanECA.Traditionally,CAsasked ostgovernmentso counterguaranteeomeproject isks,suchasexpropriation.n he past ive years, owever, anyhave egun o provide rojectdebt on a limited-recourseasis.Multilateral or BilateralAgencyCreditFacilityLoan,guarantee,or insurance politicalorcommercial)acility rovidedhrougha multilateral evelopmentank MDB) r bilateralagency. enor suallyong erm.Loansmay nclude syndicatedoan acilityromotherinstitutions,arallelinghe MDB's wn directending.


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1997 has demonstrated, currency mismatches and government-related risks can have dev-astating consequences if overlooked.Though it may be costly and time-consuming,detailed risk appraisal is absolutely necessary to assure other parties, including passivelenders and investors, that the project makes sound economic and commercial sense.Similarly, lenders and investors must be kept abreast of the project's operational per-formance as it progresses.

The largest share of project finance normally consists of debt, which is usually provid-ed by creditors with no direct control over managing the project. They try to protecttheir investment through collateral and contracts, broadly known as a security package,to help ensure that their loans will be repaid. The quality of the securitypackage isclosely linked to the effectiveness of the project's risk mitigation. Because project financ-ing relies on the project's cash flows and the contractual arrangements that support andensure those flows, it is essential to identify the securityavailable in a project and tostructure the security package to alleviate the risks perceived by participants (see box1.2). Some projects may need additional support-in the form of sponsor assurancesorgovernment guarantees-to bring credit risk to a level that can attract private financing.

The overall financial costs of a project finance transaction may not be as high as undercorporate finance if the project is carefully structured, if it identifies and mitigates eachrisk to the extent possible, and if it sources financing appropriately from different cate-

Box 1.2. A TypicalSecurityPackageThe security package will include all the contracts and documentation provided by var-iousparties involved n the project to assure lenders that their funds will be used tosupport the project in the way intended. The packagealso provides hat if things gowrong, lenders will still have some likelihoodof being repaid.

A typicalsecuritypackage will include a mortgage on available and and fixed assets;sponsor commitments of project support, includinga share retention agreement and aproject funds agreement; assignmentof major project agreements, including construc-tion and supply contracts and offtake agreements; financialcovenantsensuring prudentand professionalprojectmanagement; and assignmentof insurance proceeds in theevent of project calamity.The qualityof the package is particularly mportant to passiveinvestors,since they normallyprovide he bulkof the financing,yet have no say in theoperations of a project and therefore do not want to bear significantoperating risks.The strength of the package, as judged by the type and qualityof security available,governsthe creditworthinessof the project, effectively ncreasing he share of projectcosts that can be funded through borrowings.Significant dditional expense mayaccrue in identifyingand providing he securityarrangements, which will also requiredetailed legal documentation to ensure their effectiveness.


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gories of investor.The seniordebt componentmaybe more expensive, owever, ecausedebt repayment elieson the cash flow of the project ather han on the strength of thesponsors' ntirebalance sheet.The project sponsorswill need o carefullyweigh headvantages f raising arge-scale inancingagainst he relative inancialand administra-tive costs(both up-front and ongoing)of different ourcesof finance.IFC'SPERSPECTIVEThis report explores he changing ace of project inance n developingmarkets. IFCand, more recently, ther multilateral, ilateral, nd exportcredit nstitutionshave playeda strong supportive ole in bringingproject finance o its currentvolumes.This rolewashighlighted n 1998,when these institutions ustained lowsof an estimated$25 billionat a time when there was an abrupt decline n some ypes of private lows. FC, in par-ticular,was a pioneerof project inance n developing ountriesand has a unique depthof experience n this field,which spans more than 40 years n the practical mplementa-tion of some2,000 projects,many of them on a limited-recourse asis. Particularly ntoday'smarketplace, FC's ability o mobilize inance both loan andequity for its ownaccountand syndicated oans under its B-loan program), he strengthof its projectappraisal apabilities, nd its experience n structuringcomplex ransactions n difficultenvironments ave been reassuringo other participantsand important o the success-ful financingof many projects.The report drawson IFC's experience n more than 230greenfieldprojectscosting upwardof $30 billion hat reliedon project inanceon alimited-recourse asis(appendixA). It opens with a brief descriptionof the majorinternational rends n project financeover the past two decadesand then turns to theessential ngredientsof successful roject inancing.

In viewof IFC's considerable xperience nd the attention now being given o proj-ect financing,especially mong developingmarket participants hemselves, he timeseems ripe to let others benefit from that experience. he discussion n the pages hatfollowshouldbe of particular nterest o privatesectorcommercial anks and investmentbanks n developingmarkets hat are giving hought to financingprojects, rivate sectorcorporations onsidering new project n a developing ountry,other financial nstitu-tions, and governmentsn developingmarkets seeking better understanding f howproject inancecan help promote new investment.

Notes1. Note that for some projects the date may differ from the project's fiscal year commitment date, because ofthe time lag between project preparation and commitment date of financing.2. John D. Finnerty, ProjectFinancing.:Asset-Based inancialEngineering (New York: John Wiley and SonsInc., 1996).


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3. In some cases, project finance structured with minority participation may also confer tax or financial dis-closure benefits on the sponsor.4. The report concentrates on project finance for private sector projects. Although some national and localgovernments seek to attract private financing to public sector projects through project finance structuring,and the techniques are similar, the project is under the explicit or implicit umbrella of government support.5. Since its founding in 1956, IFC has committed more than $23.9 billion of its own funds and has arranged$17 billion in syndications and underwriting for 2,067 companies in 134 developing countries. IFC's totalcommitted portfolio outstanding atJune 30,1998, was $11.4 billion and included financing to 1,138 com-panies in 111 countries.


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GLOBALIZATION ANDTHE RAPID GROWTHOF PROJECT FINANCE

As the financial literature describes in detail, globalization hasbrought a rapid increase in international capital flows, a widerrange of financial products, and a new and diverse group offinanciers and investors.1 Between 1990 and 1997 long-termflows to private sector borrowers in developing countries rosefrom about $44 billion to $322 billion (figure 2.1). Although cap-ital flows slowed dramatically from mid-1997 following thefinancial and economic crisis in East Asia and elsewhere, global-ization is expected to continue to spur financial integration aseconomic growth picks up again.

Globalization has greatly benefited project finance, just as ithas benefited foreign direct investment and portfolio flows. Atthe same time, project finance has itself helped strengthen the

Figure 2.1. Long-TermPrivate Sector and ProjectFinanceFlows to Developing Countries,1990-98(billions f U.S.dollars)600-

.,, --: -ff O4 X3S,~~5001990 1991 1992 1993 1994 1995 1996 1997 1998

.Total flows Pnivateectorlows Project financelows

Note: Debt on a gross basis; equity on a net basis. Project finance flows datae< s. availableonly from 1994.Source: World Bank, GlobalDevelopmentFinance,1999, Capital DATAProjectFinanceWare.13


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14 PRO j E CT F [NA NC E

effects of globalization. The liberalization of financial markets, combined withadvances in information technology, has given rise to new financial instruments, mostnotably a broader spectrum of debt and equity products and a wider range of riskmanagement techniques. Project finance, which relies heavily on the mitigation ofproject risks, has been able to build on these financial products, making projectfinancing possible even in the face of commercial, interest rate, foreign exchange, andcommodity risks. Until the 1997 crisis, this mutually reinforcing relationship was fos-tering a rapid growth in project finance, in industrial countries, and also in developingmarkets, although the availability of new techniques in the developing marketsremained much more limited.

As noted in chapter 1, project finance flows to emerging markets reached an estimat-ed $123 billion in 1997 before the financial crisis, representing more than a 25-foldincrease over the previous decade. The growth in the number of transactions-manyinvolving larger and larger projects-was also impressive, rising from less than 50 in1994 to more than 400 in 1996 and 380 in 1997, before declining significantly in 1998.

Project finance also supported economicgrowth as many developing countriesstrengthened their macroeconomicmanagement and liberalizedtheir economic struc-tures; this led to increased investment and a strong demand for financing, which wasreinforced by the transfer of project finance techniques to those countries and sectorshaving the appropriate regulatory and business framework. The willingnessof govern-ments to create the regulatory framework to attract private investment (and in some casesto provide additional support) alsocreated many new opportunities in developing mar-kets, particularly in areas that were previouslythe preserve of state enterprise. As a result,public-private partnerships have been a fertile area for project financing. The increasingacceptance of international accounting standards and the resulting improvement in cor-porate accountability and transparency have also improved the business and regulatoryframework in many countries, thereby facilitating contract-bound transactions. This lastpoint is important for project finance, which usually brings together a number of unrelat-ed parties to complete a project. Project finance relies on a system that can ensure thatagreed obligations and responsibilitiesbetween its different parties will be met.MILESTONES N PROJECT INANCINGProject finance has not flowed to all countries and all geographic regions, ust as all regionshave not benefited equally from the dramatic increase in private capital flows.The growthand spread of the project finance market can be seen in some of the major policy changesand innovative projects structured over the past two decades (box 2.1). For the most part,project finance to developing countries has increased wherever sponsors have found notonly a relatively stable macroeconomic environment but also the followingfavorable con-


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G LO BALI ZAT IO N AND G ROWT H 15

ditions: regulatory reforms opening marketsto competition and private investment; iber-alized foreign investment regulations;privatization programs that have increased nvest-ment opportunities; liberalized financialmarkets promoting the deepeningand broadeningof local markets; wider use of risk management and other financial products; improvedlegal frameworks (particularly or contract enforcement); and improved accounting stan-dards, which have increased corporate accountabilityand transparency.

Through 1997 the lion's share of project finance volumes went to Asia, although itsrelative share declined in 1997 and more significantly in 1998 (figure 2.2). Between1994 and 1998 developing markets in Asia received 41 percent of the estimated flowsto developing countries, followed by Latin America and the Caribbean with a share of31 percent. Asia's dominance until the latter part of 1997, and Latin America's sincethen (with about 56 percent of flows in 1998), was due to high levels of domesticinvestment and growth, macroeconomic stability (which increased the ability to attractlong-term financing essential to project finance), and a regulatory framework relativelysupportive of contract-based finance. Countries in other regions, however, can and doattract large flows. The ability to sustain future growth in project finance flows toindividual developing countries will depend on continued improvements in the frame-work supporting these flows.The sectoral distribution of project finance transactionsin developing markets over the same period is illustrated in figure 2.3. The importanceof infrastructure is clear, with 51 percent of flows over the period 1994-98, includingan increased share of 58 percent in 1998.

Figure 2.2. Project FinanceTransactions n Developing Markets, 1994-98(billionsf U.S.dollars)

150 -120

Latin mericandt90 5 theCaribbean60 ~ ~ ~~ ~ ~~~~~~~~*Europe

_ X Centralsia/Middleast/North frica30 30 _ - _ ~~~~~~~~~~~~~~~~~~~~~~A

O __ _ Sub-Saharanfrica1994 1995 1996 1997 1998



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Box 2.1. Milestones in Project Financing1970s 1980s 1990-93 199495Foundationsor project inancing Continuedegulatoryeform n Expansionf sectoraloverage. Expansionf regional overage.laid n the powersector. industrializedountries. Accesso capitalmarkets nd Securitizationf project quity,Previouslyonfinedmainly o Macroeconomicolicy hanges securitization. investmentradessues.natural esourceector. and egulatoryeforms lsopavedhe way or project inanc-

ing n developingmarkets.

NorthAmerica,WesternEurope, apanU.K.:British etroleumaised U.S.:AT&T, hich or much f its U.S.:COSO eoThermal roject, U.S.:ndiantownCogeneration$945m roma syndicatef 66 history ad unctioned sa egally $560million.First rojectinanc- Project, 505 million;publiclybankso developts Fortiesield n sanctioned,overnment-regulatedng arrangedn thequasi-public registered apitalmarketsproj-the NorthSea 1972). monopoly, as ormally equired Rule144A ecurities arket. First ect inancing.First o receiveU.S.:PublicUtilityRegulatory to divesttselfof itsBelloperating project-relatedinancingo investment-gradeatingduringPolicy ct, equiringocalutilities companies,hichprovidedhe achievenvestment-gradetatus. construction eriod.to buy heoutputof qualified bulkof telecommunicationsn the U.K.:Privateinancenitiative. U.S.:GlobalPower ndPipelines,independentowerproducers U.S. hus hecompetitiverame- Launchf program f publicpart- capitalizedt $165million, stab-under ong-term ontract t he work or a majorexpansionn nership ith privatendustry,o lished sa listed ompany yutility'smarginal ostof generat- telecommunicationservices as bringprivatenvestorsnto inanc- Enrono pool tsdeveloping ar-ing electricity. URPAhusprovid- established1984). inga wide angeof traditionally kets nfrastructurerojects,ellinged he foundation nwhichnon- governmentctivitiesinduding 50 percent f equity o privaterecourseending ould akeplace schools,ospitals, rsons),hus investors.in thepower ndustry1978). opening ewareaso project Japan.Electric owerUtility awfinance. amendedo allowcreation findependentower roducers.

DevelopingMarketsTurkey.FirstBuild-Operate- Philippines.irst ountry n Asia C6ted'lvoire.Ciprel,$70m. irstTransferBOT)aw o attractpri- to enact specialaw or BOT IPPn Africa. FC rovided $14mvate inanceor publicnfrastruc- schemeor infrastructureroject loan or itsown account ndtureprojects. his llowed implementationnd unding, invested 1m in equity.developero buildandoperate whichauthorizedhe inancing, Malaysia. TLPowerGeneration,projectongenougho cover on- constructing,ndmaintenancef $570million quivalentocal ur-struction osts nd urn a profit, infrastructurerojectsy he pri- rency ondoffering. argestebtbefore urningt over o the state vate ector, financingn Malaysianistory.(1987).Subsequentulings y Philippines.ubicBayPower, Landmarkn developmentfTurkey'sighest dministrative $105million.First nvate lace- Asia'socalbondmarkets,courton theapplicabilityf inter- mentbya foreignprojectn the Poland. lectrowinauron. irstnational rbitration ave, owev- U.S. nderSecurbes ule144A. BOT ower-generationlant ner,complicatedhe framework, Regional. cudder atin Poland.delaying number f projects. Americanrustor Independent Oman.Al ManahPower tation,Power,o make ong-termnvest- $155million. FirstBOTn thements, enerallyquity-typeecu- Gulf.The K invested 14millionrities,n private owerprojectsn for itsown account, 4 millionthe egion; nitial losingn June equity, nda further$57million1993 aised 75 million rom in B-loans.threenvestors,ncludingFC. Colombia.entragas,172mil-Colombia. amonal ower, 70 lion.Firstnvestment-graderojectmillion. First ndependentower financessuerom a developingprojectn LatinAmerica n a imit- market.Eurobond/ ule144Aed-recourseasis, ith no govern- issue.mentor sponsor uarantees.OverseasrivatenvestmentCorporationoliticalisk nsur-ance. Projectequired new reg-ulatory,egal,and ecuritiesframework.Mexko.GrupoSerficor/PublicFinancial anagementtructuredthe first ever ollateralizedoanobligation rogramor Mexico.Mexico. oluca ollRd,$200mil-lion.First inancing f a oll roadin nternational arkets.FC ro-videda $13.8million oan.


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G LOB ALI Z AT IO N AN D G ROWT H 17

1996 1997 1998Larger xposures,ongerenors,ess overn- Continuing rowth n regionaloverage,nd Continuednnovationn selectedreas, utment,MDBandECA nvolvement. reater improvedinancingerms hroughmid-year. dramaticlowdownn inanciallows ocapitalmarkets ccess. Foreignurrency risis eginningmid-1 97 developing arkets ffectedroject inanceovertookmany rojects. access. ewer ewprojects;many ancella-tionsanddebt restructuring.electedrojectscontinuedo be inanced, anywithstrongMDB,ECA, r governmentupport.Greateremphasislso n ocal urrencyunding.

North America,Western Europe, JapanU.K.:AESBarry, .K.'sirst merchantower U.S.:Project unding orp.First ollateralizedplant inancingo close; 30 MWgas-fired bondobligation acked y project-inancepowerplant. loans.A pooling f about$600million fU.K.:SuttonBridge.Gas-firedowerplant CreditSuisse irst oston'srojectinanceprojectmarked keydevelopments he first loans. ncludesbout40 $ loans,mostlyEurobond ith a Rule144A lacement, securedn U.S. ower rojects.whichwasLondon-listedndon which OECD: roject inance odifications:investorsore onstructionisk.First nvest- Consensusules overing roject-inancement-gradeating or a plantwith somemer- activitiesor ECAsntroducedor 3-yearrialchantpower isk. period; ermitsenors p to 14 years aver-age ife7.25years); xpectedo expandheparticipationf ECAsn project inance.

Developing MarketsChina. angshanitheCoalFiredPlant, 128 China. nhuiHefei x 350MW $430mil- China.Shandonghonghua ower; ,000million.First imited-recourserojectn China lion. First owerprojectn China orwhich MW plant; 2.2 billionprojectndudes 822without he participationf ECAtMDBnsti- domestic anks rovidedong-termimited- million quivalentocaldebt and$312milliontutions, r sponsorsMsovereignupport ut recourseebt($190million quivalent) ECA-backedranche roviding olitical ndcredit nhancementy PICC, hina'sargest alongside CAs nd nternationalanks. commercialiskcoverage.state-ownednsuranceo. China. aibinB2 x 350MWpowerproject Coted'lvoire.AzitoPower 88 MWpowerThailand. ayong efinery,1.5billion. $616 million. First OT rojectinancingn plant. First DApartial isk oanguaranteeLargest onrecourseeal n Asia. ChinaCoface articipation,300million); issuedor a private ector roject elpedaiseQatar.Ras affaniquified atural asproj- totally inancednternationally. $30million ommercialank inancing.FC-ect. Seta recordor sizeof bond originally Morocco.orfLasfar ower, 1.3billion. supportedroject ith $30million or ownplannedo raise 40mbut ncreasedo $1.2 Country'sirst privatelyinanced owerproj- account ndan additional 30 millionB-loanbillionon strongdemand)nd ength f ect. NorthAfrica's iggest PP nd imited- fromcommercialanks.tenor. recourseinancingo date. India. nfrastructureevelopmentinancePeru.Aguatyiantegratednergy,257mil- SaudiArabia.Yanpet, 2.3 illion. Largest Co. IDFC).FC elped reatehis nnovativelion. Firstong-termimited-recourseinancing financingor a petrochemicalsrojectn the nonbankinancialnstitutonsupportingroj-in the regionor merchant owerplant. 30- world. Largestinancingor a nonsovereign ect inancinghroughakeoutinancinguar-year inancingrombanks nd nstitutional entity n the Middle ast. antees-standbyacilitieso lengthenoaninvestorsith MDBsupport. Chile.LosPelambrosines, 950million. maturities ndhelp reate secondary ar-Longest yndicatedncoveredank oan or ket or projectoans.a Chilean roject, 2 years. Brazil.UsinaHidrelectricauilman-Amorim;Panama. orthern orridor ndMaddenoll first Brazilianowerplant inanced n aproj-roads.First apitalmarket onstruction ect inance asis y he private ector.Onfinancingor a roadprojectn the region July29, 7998, ntered ommercialperation.sinceMexican eso risis f 1994.Contains iFC s nvesting 121million n theproject,constructioniskandno governmentuaran- including B-loan f $91 million.teesof traffic low. First roject inance Mexico.MeridaIl, he first PPn Mexico,transactionn Central merica. 200million leadsponsoredy AESCorporation.projectncluding 131million15-year ule Financingf $173million ed by exim $69144A ond ssue, t 425 basis oints bove million)nd FC up o $104million,ncluding10-year .S.Treasuryecurities. $74millionB-loans). erida ll will sellelec-Venezuela. etrozuata1 billion. argest tricity o the state-ownedlectric tility CFE)projectinancingn he region.Largestevel- under25-year PA. FE ill makemostpay-opingcountriesnvestmentradeproject ments nder he PPAn U.S.$.Mexico'sbond offeringrom a below-investment- Electricityommissionnnouncedlansograde ountry.Longestenorproject ond open idding n a urther10 new projects.worldwide, 5years.

Source: Various ssues of IFR Publishing,ProjectFinance nternational, nd EuromoneyPublicationsLC ProjectFinance.


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18 PROJ E CT F INA NC E

The growth in project finance and in total capital flows to developing markets wasparticularly strong in the period from mid-1995 until the last few months of 1997 (afterthe onset of the Asia crisis), and was accompanied by improved terms for borrowers.The spreads for private sector borrowers and projects in developing markets declineddramatically (figure 2.4); at the same time, available maturities lengthened. There was asharp increase in the demand for bonds issued by private corporations, while a fewbonds were issued for limited-recourse projects. Loan pricing also became more flexible,frequently including grid pricing, or multiple interest rate settings, depending on riskchanges, as defined by certain events over the life of the loan. Typical events for projectsmight include project completion, a change in sovereign or company rating, leverage andother financial ratios, ownership, and debt amount outstanding.2

The tighter spreads and longer maturities seemed tied both to general market liquidi-ty (noted by many who thought that the pricing of some transactions was becomingexcessivelyaggressive) and to improved perceptions of country risk. The success of eco-nomic reform programs dramatically altered the external perceptions of many countries,particularly in Latin America; for example, Uruguay, Panama, and El Salvador joinedChile and Colombia in 1997 in obtaining an investment-grade rating.3 In some cases,corporations themselves obtained a higher rating than did their country.CAPITALMARKETSFINANCINGThe rapid growth of the international securities markets in recent years, as reflected inthe increased volume of finance and sophistication of their instruments, was linked to

Figure 2.3. Project Finance Transactions n Developing Countries bySector, 1994-98Timber, ulp,andpaper2%

Hotels nd ourism3% Food ndagribusiness%Other % _

Chemicals%

Oil,gas,andmining13% -_ Infrastructure1%

Manufacturing0%



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G LOB ALI ZAT IO N AND G ROWT H 19

Figure2.4. DevelopingMarketBondYieldsversus 0-YearTreasuryYields,1994-982520 Emergingarket rady ondndex ield

g 15 - U.S.ighyieldndex105 _ 5 ~~~~~~~~~~~~~~30-Year.S. reasuryield0 _ _ _ _ _-__ _ _-_ _._ _J . - -,__

1994 1995 1996 1997 1998Note: Monthly data, in percentage points.Source: Bank for International Setdements, International Banking and FinancialMarket Developments,November 1998.

this overall improvement and had a significant impact on financing opportunities forborrowers in developing markets.Public financial markets. Traditionally, developing countries' corporate equity and debtwere placed directly with investors and creditors through private placements or syndica-tions. Today, the capital markets play an important role in financing the private sector, asshown earlier in table 2.1. This has enabled many corporate borrowers to gain access tolarge-scale financing.

For the most part, this access has not yet extended to limited-recourse projects indeveloping countries, which continue to rely on commercial loan syndications, althoughthere have been some important exceptions, including AES China Generating's 1994$150 million equity offering for new power projects in China and its 1996 $180 mil-lion public bond offering. Only a few IFC-supported projects in some half-dozencountries (notably Argentina, Brazil, Mexico, and India) have gained access to theinternational bond and equity markets. Almost all of these projects are in countrieswith an investment-grade credit rating, and their sponsors have been able to shift fromcommercial bank, development agency or export credit agency financing to securitiesmarkets transactions to take advantage of both longer-term maturities and more flexi-ble financing requirements.

The main advantages of bond financing over bank loans are that they can reach awider group of investors and therefore usually achieve a lower interest cost margin andlonger maturity. Documentation also usually requires fewer covenants, so there is less


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Table 2.1. Net Long-TermBond and Portfolio Equity Flows toDeveloping Markets, 1990-98(billionsf U.S.dollars)

1990 1995 1996 1997 1998Total net private flows 43.09 201.5 275.9 298.9 227.1

Bonds 1.2 26.6 53.5 42.6 30.2Portfolio equity 3.7 36.1 49.2 30.2 14.1

Source:World Bank,GlobalDevelopmentFinance 1999.

negotiation with lenders and a faster conclusion. Securities laws, however,generallyrequire a high level of public disclosure of all the material contracts relating to a project,together with the details of its financial activities.That may be problematic if informa-tion on materials isof a confidential nature. In addition, considerable legal, accounting,and auditing expense may be incurred in gathering the required financial information,which may offset the lower interest costs. Another drawback is that the traditional bondstructure does not provide the same degree of flexibility,monitoring, or control of acreditor's interests in the project as does bank financing. Bonds are usually held as bearerinstruments (with no central register of names of holders), so the sponsors may find itdifficult to adjust covenantsor financial terms if the project's needs change.

Of more concern for many potential borrowers is the volatility of the public securitiesmarket. The availabilityof senior loans is generally not as market-sensitive as bonds, ashas been confirmed by the difficulties since the Asia crisis erupted. A number of projectsthat before the crisis had hoped to tap the public bond markets have now reverted toloan syndications or private placements, even though these markets have also contractedsignificantly.Figure 2.5 illustrates the decline in bond and short-term note issues sincethe last quarter of 1997.

Over the longer term, however, project-related bond issues are expected to gain andsustain greater accessibility to public markets. To illustrate, it is estimated4 that globalbond issuance for project financing rose 23 percent in 1998 to $9.9 billion, even whilebank lending declined 16 percent. Investors are becoming more familiar with the struc-tured aspects of project debt because of the success of other structured debt programs(for example, mortgage-backed securities). Project bonds are also becoming moreattractive to longer-term fixed-income investors because they are backed by long-termidentifiable cash flows. The expanding use of development agencies through Export


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G LOB ALI ZAT ION AND G ROWT H 21

Credit Agency (ECA) guarantees and insurance as well as their private sector equiva-lents will help reduce perceptions of risk and enhance credit ratings. One illustrationof this was the increase in project ratings assigned by the major rating agencies in1996 and 1997 before the Asia crisis (for example, Standard and Poor's rated $5.5 bil-lion in 1996 and over $10 billion in 1997), although most greenfield projects remainedbelow investment grade. Box 2.2 illustrates one expansion project that obtained aninvestment-grade rating with the help of IFC financing.Private placement market.Although most projects in developing markets will continueto have limited access to the public listed markets for securities, a significant liberaliza-tion of U.S. securities regulations in 1991 opened new opportunities for limited-recoursefinancing through private placements. Previously,some non-U.S. companies avoided theU.S. capital markets because of a concern that the registration requirements of the U.S.

Figure2.5. InternationalBondand Note Issuanceby DevelopingMarket Borrowers, 993-98(billionsf U.S. ollars)

Asiaa LatinAmerica40 - 40 -

20 -20-

c 0 D' 0

-20 -20

.40 -401993 1994 1995 1996 1997 1998 1993 1994 1995 1996 1997 1998 d* Bankinancing * Securitiesssuance

a. Excluding Hong Kong, Japan, and Singapore.b. Exchange rate adjusted in BIS reporting banks' claims vis-a-vis Asian and Latin American countries.c. Net issues of international money market instruments, bonds, and notes.d. Data on bank borrowing not yet available for the third quarter of 1998.Source: Bank for International Settlements (BIS), International Banking and FinancialMarketDevelopments,November 1998.


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22 P RO J E C T F I N A N C E

securities laws (including U.S. generally accepted accounting principles) could apply toofferings and resales of securities. Since 1991, however, a non-U.S. issuer may make aninternational capital markets offering that is similar to a public offering without havingto register and without presenting U.S.-reconciled financial statements. These issues,called Rule 144A/Regulation S issues, may not be made to the general public but maybe made to an unlimited number of qualified institutional buyers (QIBs) in the UnitedStates and to an unlimited number of investors outside the United States. Because thereare more than 4,000 QIBs (mostly investment advisers,pension fund managers, insur-ance companies, and banks), the market is quite broad. As with publicly issued bonds,bonds offered under Rule 144A generally contain fewer financial covenants than eithercommercial bank loans or development agency and ECA financing agreements. Of themore than $110 billion raised in the private placement market in 1996, about 80 percentcame under Rule 144A. Private placement financing costs are usually slightly higherthan those for public securities but still allow developers of international projects to tapinto a deep and liquid market at relatively ow cost.Equity funds. Funds, also known as collective investment vehicles, are financial struc-tures for pooling and managing the money of multiple investors. They offer investors amechanism with which to buy securities they could not otherwise hold because of trans-

Box 2.2. Transportadora de Gas del Norte S.A., Argentina:Lower-Cost, Longer-TermFinancing rom the Capital MarketsIn 1996,an Argentine ompanyTransportadoraeGasdel NorteS.A.,or "TGN") n hebusiness f naturalgas ransmissionnd distribution anted o upgrade nd expandtsfacilities. FC dvisedhe companyo makeuseof the U.S.nstitutionalnvestormarketbymeans f a "singleasset ecuritization," hereby n IFC oan o TGNwould besold o aU.S.-domiciledrust,which n turn would ssuerust certificates acked y he IFC oan.Toaccesshe nstitutionalnvestormarket n the U.S.mostefficiently, n nvestment-gradeat-ing of the trust certificatesrom oneor two leadingntemationalatingagencies asneed-ed. IFC elpedTGN ecure ratingof BBB-rom Standard Poor's nd a BBBrom Duff&Phelps.Theseatingswerehigher han Argentina's overeignatingof BBat he time.

The rust certificatesad a maturity f 12 years nd a fixedcouponof 9.45 percent.U.S.insuranceompanieshowed strong nterestn the trust certificates, ith the originallyplanned 175million ssue eingoversubscribednd ncreasedo $215 million.Themarketconditionshen prevailingndicatedhat if the same mountof moneywas aisedhroughan IFC-syndicatedank oan IFC's -loan rogram),he interest ateon such loanwouldhavebeenon the orderof 100 basis ointshigherand he maximumermattainablewouldhavebeen ess han 12 years.Thus,accessinghe U.S.nstitutionalmarket esultedncheaperinancing nd a longer enor hanwould otherwise avebeenpossible.


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G LO BAL I ZAT IO N AND G ROWT H 23

action costs, legal restrictions, or lack of expertise. They also help investors diversifyassets, achieve better liquidity, and obtain the benefits of professional management andresearch. Domestic companies benefit from funds because they provide greater accessto equity capital. Since 1984, when IFC helped structure one of the first countryfunds (for Korea), the volume of equity funds invested in developing markets hasgrown well beyond $100 billion. Most equity funds are country portfolio funds thatinvest in the listed securities of local companies, but a growing category are privateequity funds geared to investing in large projects, including greenfield and unlistedsecurities. IFC helped promote one of the first such funds, the Scudder LatinAmerican Trust for Independent Power, which was established in 1993 to make long-term investments, generally equity-type securities, in private power projects in LatinAmerica and the Caribbean.

Looking forward. With the onset of the East Asia crisis in mid-1997, financial mar-kets changed drastically. Project finance, having its biggest market in Asia, was particu-larly hard hit. Many borrowers and projects in the region saw interest rate spreadsjump, as did less creditworthy borrowers outside. Liquidity in the bond markets, whichare traditionally more volatile, declined dramatically; in many countries access disap-peared altogether. Activity in the lending markets also declined, exacerbated by thepullback of Japanese financial institutions (major players in the area) for domestic rea-sons. In the wake of these changes, the volume of new market transactions fell frommonthly averages of $18 billion in January-October 1997 to $12 billion in Novemberand December.5 Concern over the impact of the currency crisis on longer-term eco-nomic growth prospects in Asia and elsewhere has also slowed activity considerably. Asa result, many projects have been canceled or are on hold pending stabilization of eco-nomic and financial markets. Of the projects going ahead, some that had not reachedfinancial closure before the crisis are having to resort to more conservative financingpackages (at a higher cost; see table 2.2), or must seek other means to help mitigate theperceived increase in risks.

How soon East Asia and other developing markets affected by the crisis will be able torecover is as yet unclear. Forecasts for the longer term are generally optimistic: institutionsspecializing n project finance expect pre-1997 trends in this area to resume once eco-nomic growth returns to the major developing markets. Much will depend, however, on areturn of a willingness of banks in Japan, Korea, and Taiwan, major suppliers of capitalbefore the crisis, to resume lending activities. In the interim, projects will continue to besponsored, particularly in the more creditworthy countries, but structuring will be muchmore conservative,and sponsors are likely to rely more frequently on support from officialagencies to complete their financing packages.These trends are discussed next.


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Table2.2. Confidencendicatorsn SelectedAsianCountries,Early1998Political isk Interest ateCountry Crisis Tenora cover spread%)

Indonesia Pre 15 No -1.30Indonesia Post 10 Yes n.a.Thailand Pre 16 No >1.00Thailand Post 10 Yes n.a.Philippines Pre 10 Yes 1.375Philippines Post 7 Yes >2.50China Pre 12 Yes >1.50China Post 12 Yes >2.00India Pre 8-1/2 No 2.00-2.50India Post 10-12 Yes 1.00 bn.a. Not available.a. Maximum tenor on an uncovered basis.b. With full insurance cover.Source:IFR Publishing, ProjectFinance nternational,Asia PacificReview, March 1998.

Notes1. See, for example,World Bank, GlobalDevelopmentFinance1998,March 1998, and Private CapitalFlows oDevelopingCountries:The Road to Financial ntegration,1998.2. Adjustable features helplenders lengthen loan maturities, as they can adjust pricing for changes in the futurecredit standing of the borrower.3. As of October 1, 1998, more than 50 developing countries had sovereign credit ratings (compared with just18 in 1994); of these, 22 were considered investment grade, as rated by Moody's Investors Service.4. IFR Publishing, ProjectFinance nternational,February 1999.5. World Bank, GlobalEconomicProspects nd the Developing Countries, anuary 1998.


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IFC'S ROLE INPROJECT FINANCE

The rapid growth in project finance to developing countries overthe past decade was facilitated in part by direct support (in theform of finance, guarantees, or insurance) from multilateral insti-tutions like IFC, from export credit agencies, and from otherofficial institutions. During the period 1994-97, a major share ofall project finance transactions involved at least one officialagency. Many projects also received support in the form of polit-ical assurances, implicit or explicit, from host governments thatindirectly facilitated their financing. The share of official supportvaried depending on the sector and country of the project (figure3.1 and table 3.1), and during the 1996-97 heyday of capitalflows, the need for official support seemed to diminish in a num-ber of countries. Since the mid-1997 crisis, its role has againincreased significantly as private investors have become morecautious, and it is expected to remain essential to the financing ofmany projects until full confidence is restored.

Figure 3.1. Finance from Development FinanceInstitutions and ECAsas a Percentage of InternationalFlows to the Private Sector,1994-9830-25-20-

- . '1050Sub-Saharan Asia Europe LatinAmericalCentralAsial Total

Afrka Caribbean MiddleEast/NorthAfricaSource: Internal IFC Study: The Private SectorFinancingActivities of theInternational FinancialInstitutions: 1991-1997, and staffupdates.

25. .


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26 P RO J EC T F INA NC E

Table 3.1. Involvement of Development Finance nstitutions and ECAs nDeveloping Countries' Project Finance, 1994-97(percent)Country isk grade

Sector 80-60 60-40 40-20 20-0Waterand sewerage 0 29 89 100Roadand rail 11 11 78 0Agriculture 0 0 60 100Oil and gas/upstream 0 25 40 60Mining 0 26 30 71Property 0 3 56 50Power 22 27 51 38Oiland gas/downstream 6 22 35 20Telecommunications 0 21 29 25Manufacturing 6 10 17 29Transport/shipping 0 0 30 21

Note: Percentage of transactions in which a multilateral or bilateral agency or an export creditagency participated. Country risk ratings are Institutional Investor atings.Source: Oliver Wyman and Company, based on Capital DATA ProjectFinanceWare.

MULTILATERAL, ILATERAL, ND REGIONALDEVELOPMENTAGENCIESIn response to the growing belief that private enterprise can be an engine for growth,many development agencieshave switched the focus of their financial support from gov-ernment to private sector transactions and programs. Their willingness to invest in high-risk countries and sectors has helped spread the growth of project financing. In particu-lar, their ability to extend long-term financing and to directly guarantee or insure againstcertain project risks has enabled some large and complexprojects to proceed, especiallythose involving public-private partnerships. When development agencies participate inthe financing package, even without explicit guarantees, the project often has a higherprofile, which helps protect it against certain political risks.

IFC is the largest multilateral source of loan and equity financing for private sector proj-ects in the developingworld; it is also a leading agency supporting project finance for theprivate sector. Its experiencespans more than 40 years and reaches into 134 countries. Asof June 30, 1998, IFC's total financing portfolio covered 1,138 companies in 111 coun-tries. Over the past five years, other development agencies-including the European Bankfor Reconstruction and Development, the Inter-American Development Bank (IDB), theAsian Development Bank, and the African Development Bank-have all increased heirlending to the private sector (figure3.2). In 1998, their total finance to the private sector


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I C S R 0 L E 27

Figure 3.2 Commitments f DevelopmentAgenciesor PrivateSectorFinancingn DevelopingCountries, 991-98(millions f U.S.dollars)

12,000

e 8,00- f_tC.M

4,000- Bilateralevelopmientnstitutios

01991 1995 1996 1997 19a

a. Estimate.Source: Internal IFC Study: The Private SectorFinancingActivities of International Financial nstitutions:1991-1997, nd staffupdates.

is estimated at $10.2 billion, of which IFC represents about $2.8 billion. Although figuresfor their project finance activitiesare not available, hey are estimated to represent at least25 percent of these agencies' otal private sector lending. The syndicated oan programs(known as B-loans) offered by some MDBs are also an important means of mobilizingfinance. Total B-loan syndications in 1997 were about $4 billion. IFC has by far thelargest B-loan program (box 3.1): it completed$2.4 billion in syndications during fiscal1998 and $9.8 billion between fiscal 1995 and 1998.IFC'SROLE N PROJECTINANCEN DEVELOPING ARKETSProject finance has been part of the central core of IFC's activities since it began opera-tions in 1956, and IFC remains the leading multilateral institution supporting privatesector project finance.1 IFC supports project finance in three principal ways:* By sharing the risks ofprojects with private investors. IFC equity and long-term debt

financing alongside that of other partners can help projects go forward. This is par-ticularly important in countries having weak local financial markets or having diffi-culty attracting foreign investment.

* By helping reduceproject risk through appraisal and structuring skills. IFC's emphasis oncareful appraisal and its broad experience in difficult environments can help sponsorsstructure a financially, echnically, and environmentally sound project. The agency'sknowledge and understanding of different business environments may also facilitatethe actual investment process by helping to secure administrative or regulatoryapprovals.


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28 P RO JE CT F INA NC E

Box 3.1. IFC'sSyndicatedLoan ProgramThesyndication f participationsn IFCoanshasbeen he cornerstone f IFC'smobiliza-tion efforts. Under his structure, nown as he B-loanprogram,FCs the sole enderofrecord o the project,actingon behalfof both itselfand participating anks. Participantsshareully in the commercial redit isksof IFC rojects, ut alsoenjoy he advantagesthat IFCderivesrom its statusas a multilateral evelopment ank, ncluding:* Likely ccesso foreignexchange: FC oesnot haveguaranteed ccesso foreignexchangeor debt service, ut to date t has eceivedriorityaccessncountries xperi-encing oreign exchangehortages.No FCoan, ncluding he portion undedby par-ticipants,hasbeen ncludedn the general eschedulingf aborrowing ountry'sor-eign debt. Also, FC asneverbeen equestedo participaten new money oans odebt-reschedulingountries ased n its existingexposure.* A stronghistoricalperformanceecord:Despitenvestingn someverydifficult

countryenvironments,FC's rojects avedemonstrated strong epaymentecord,with few loan write-offs.Whenprojects o experienceifficulties,FCworkswith thesponsorsnd other enderso helpdevelop uitable estructuring lans.* Regulatory enefits:Bank egulatorsn mostOECD ountries xemptB-loanpartici-pations rom heir normal ountry isk provisioningequirements.IFC s always substantialender or itsown accountwhen t syndicates loan,sharingherisksalongsideheparticipants. s lenderof record,FCnormally dministershe B-loan,with responsibilityor payment rrangements.articipantsurrentlynclude ome280commercial anksand other inancialnstitutions. xport reditagenciesnd domesticlenders re not ncludedn the B-loanprogram ut finance n a parallel asiswith IFC.

* By helpingreduce erceived isk through tspresencen a project.Because IFC is an inter-national organization owned by its member countries, its participation in a projectprovides some comfort in the faceof political risk. This gives it a strong catalytic rolein many projects, especially n mobilizing loans from other financial institutionsthrough syndications (B-loans). IFC, the lender of record, extends the advantages itderives as a multilateral institution to other participants in the syndicated loan, whichmay enable IFC's clients to obtain financing on better terms and allows financialinstitutions to finance at lower perceived risk.


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I F C S R O L E 29

Table3.2. IFCProjectFinance or GreenfieldProjects, 989-98(millionsf U.S.dollars)

Instrument Maximumamounta AverageamountaSenior oan 100 16Syndicatedoan 350 35Quasi-equity 65 7Equity 20 3

a. Maximum mountand average mountcommitted o an individual roject.Source: FC.

To illustrate IFC's role, this chapter examines its greenfield project financing overthe past decade. The discussion also provides a useful backdrop to chapters 4 and 5,which describe the central features of successful project structuring.IFC's greenfield project financing. The projects reviewed for this report constitutethe greenfield projects for which IFC has committed project financing on a limited-recourse basis during the past 10 years (fiscal 1989_98).2 The sample consists of 291project finance transactions (including additional investments and risk managementfacilities) for 233 greenfield projects approved and committed by IFC. The total cost ofthese projects was $30.5 billion, and IFC's total committed financing about $8 billionincluding B-loans. These projects represent only part of IFC's total limited-recoursefinancing during the period, which also included more than 400 expansion or otherfinancings arranged for existing companies or projects. Although project finance is fre-quently used to support the expansion of an existing project, this review focuses ongreenfield projects because these endeavors, with their new plant construction and newoperations, pose the greatest challenge to structuring and risk sharing.IFC's investment. IFC invests in projects through a mixture of debt, equity, and quasi-equity. In almost all (95 percent) of the greenfield projects reviewed, IFC agreed to pro-vide long-term loans, and in half of the projects it also helped raise additional debtfinancing through its syndications (B-loans) to commercial banks and other financialinstitutions. Unlike many other development agencies, IFC has also traditionally been amajor provider of equity funding to the private sector in developing markets; in morethan half (54 percent) of the greenfield projects, it invested equity, and in more than a


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Figure3.3. IFCs Financingof Greenfield Projects, 1989-98(percent)

10080

%4 60a)a.4020

0Total ommittedrojectost100% $30.5bn) IFC ommittedinancing100% $8.Obn)

IK committedinancing * Equity * Otherinancing* Senioroans 3 Syndicatedoam ",Quasi-equity

Source: IFC.

quarter (27 percent), it also provided quasi-equity in the form of subordinated debt orconvertible loans. Table 3.2 indicates the maximum and average amount of IFC's sup-port through different financial instruments in these projects.

IFC and IFC-arranged financing usually covers a significant share of total projectcost, although the agency itself is never the major investor and does not take an activerole in project management. The relative importance of IFC's overall financing togreenfield projects and of its different instruments is shown in figure 3.3. On average,IFC's own lending represented 11 percent of total project costs, while B-loans repre-sented 13 percent, although they averaged 21 percent of the financing in projects wherethey were used. IFC's equity represented 2 percent of the total cost of the projects inwhich IFC made equity investments, and accounted for 7 percent of the equity in thoseprojects. Quasi-equity averaged 1 percent of total project cost and 5 percent of the costin projects with quasi-equity.

IFC support for individual greenfield projects has varied, as illustrated in figure 3.4,depending on the type of project and alternative financing available. Overall, it hasaveraged 27 percent of project cost, and in 52 percent of the projects it ranged between20 percent and 30 percent. In 17 percent of the projects, IFC's support represented 30percent or more of project cost. When syndicated loans arranged by IFC are included,the picture is rather different. For 36 percent of the projects, IFC support (includingB-loans) was 20 percent to 30 percent of project cost, but it reached 40 percent or moreof total project cost in 35 percent of the projects.


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I F C ' S RO L E 31

Figure3.4. IFCShareof Total ProjectCosts orGreenfieldProjects, 989-98150

* ExcludingyndicatedB-) oanstn120. 120 * U IncludingyndicatedB-)oans

oL 90.4-0 ~60E

30

00-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80

Note:Share f IFCsupportn totalproject ost percent).Source:FC.

IFC's long-term financing is considerably longer than that usually offered in privatemarkets. About 81 percent of IFC's greenfield loans have a tenor of 8 years or more, buta few have stretched even to 20 years. Syndicated B-loans generally cover slightly short-er periods. Projects are usually provided grace periods of 2 to 3 years before principalrepayments start. Interest rates are determined according to prevailing market rates,depending on the country, project risk, and tenor of the loan. Interest margins on theB-loans of the projects reviewed range from 0.5 to 4.0 percent above Libor, mostly atvariable rates. Interest margins on IFC's own loans are slightly higher, reflecting theirlonger tenor. About 25 percent of IFC's loans were provided at fixed rates of interest.Countrydistribution. IFC has financed greenfield projects in 69 countries (of which18 are in Sub-Saharan Africa) over the past decade and in a wide range of sectors. Ofthe 233 projects, 67 are in Asia, 61 are in Latin America and the Caribbean, and theremainder are spread among Europe (43), Sub-Saharan Africa (26), and Central Asia,the Middle East, and North Africa (36) (see figure 3.5).

IFC has relied on project finance techniques for a large number of projects in difficultcountry environments. Of the 233 greenfield projects, 77 percent were in countries withan Institutional Investor rating of less than 45 at the time the project was approved, and27 percent were in high-risk countries with a rating of less than 25.3 By comparison,only about 10 percent of the total international project financing in developing marketsover the period 1994-98 was in countries with a risk rating of less than 25.4


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Figure 3.5. IFCProject Finance or Greenfield Projects,RegionalDistribution by Volume and Number, 1989-98100% = 233 projects 100% $30.5 billion

Sub-Saharan frica 10% Asia 38% Sub-Saharan frica 11% Aia29%CentralAsia/Europe 1 1 % ~Middleast/North Africa 15%Central Asia/Middle EastENorth Africa 12% LaiLatin America/Caribbean26%

Latin America/ Europe 18%Caribbean29%Source: FC.

Figure 3.6. SectoratDistribution of IFC-SupportedGreenfieldProjects,1989-98Infrastnicture1%

Oilandgas 2%other ervices%Textiles%

Food nd gribusiness% Manufacturing%Hotelsnd ourism%Constructionaterials%

Timberulp, aper % Mining and xtractionf metals%Chemicals%Note: Total project cost = $30.5billion.Source: FC.

Figure 3.7. IFC-SupportedGreenfieldProjects,Shareof Major Sectorsby Region,1989-98(billionsof U.S. ollars)12 . Infrastructure

8 ~~~~~~~~~~~~~~~~~~~~Oilnd as6 6 Manufacuring

4 Mining nd xtractionf metals2 OtherO -Sub-Saliam, Eume cee Aski La[mAMnnekalrb

Source: IFC. Nwraldk Earic Cari.bea


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IF C ' S R O LE 33Sector distribution. Over the period 1989-98, infrastructure accounted for the largestshare of IFC greenfield finance (27percent of the projects, or 41 percent in terms of projectcost)(figure3.6). Project finance techniques have enabled investment in this sector toundergo rapid growth during the past five years. FC's support for infrastructure projects isparticularly mportant in Latin America and Asia, where it accounts for nearly half of allIFC's greenfield project finance activity (figure3.7).5 Other sectors receivingsubstantialsupport have been oil and gas, manufacturing, mining, and chemicals. n general, the pat-tern of IFC's participation in individual sectors n each region reflects both the investmentactivity n that sector, nfluenced by the pace of regulatory reform, and the ability of the sec-tor and the country to attract international capital flows without MDB or ECA support.Projectsize. IFC's greenfield experiencedemonstrates that relatively mall projects can befinanced successfully sing project finance techniques. Over the past decade IFC has helpedfinance projects ranging in size from $5 million (the cutoff for the sample) for an agribusi-ness project in Europe to $1.7 billion for an oil refining and petrochemicals project in Asia.Five projects (2 percent of the total) had an initial cost of more than $1 billion; three werein Asia, one in Latin America and the Caribbean, and one in Sub-Saharan Africa.However, 46 percent of IFC-supported greenfield projects cost less than $50 million (20percent less than $20 million), and 67 percent less than $100 million. Overall, IFC's green-field project finance activityreflects its mandate to finance projects hat do not have easyaccess o international markets.EXPORTCREDITAGENCIESExport credit agencies are more recent participants in the project finance market, but theirvolume of financing has quicklybecome very significant.The willingness of many ECAs tosupport complex private sector projects has greatly boosted the growth of project financingin developing countries (table 3.3). The primary objective of most ECAs, which are usuallygovernment agencies, s to promote their home-country exports.Traditionally, his has beendone through credit insurance and loan guarantee facilities hat protect exporters againstthe commercialand political risks of exporting, as well as through direct medium- andlong-term loans to foreign buyers. n the past five years a number of ECAs (notably inJapan, France, Germany, he United Kingdom, and the United States) have extended theirsupport to limited-recourse projects n developingmarkets. The driving force behind thismove

proyect finance

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