Projects

PROJECT FINANCE IN THEORY AND PRACTICE

CHAPTER 1:

An Introduction to the theory and practice of project finance

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Summary

• What is project finance?

• Why do sponsors use project finance?

• Who are the sponsors of a project finance deal?

• An overview of the features of project finance

• The theory of project finance

Dr. Anirban Ghatak, Christ University

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What is project finance?

• Project finance is financing that as a priority does not depend on the soundness or creditworthiness of the parties proposing the business idea to launch a project.

• Approval of the financing is basically a function of the project's ability to repay the debt contracted and also remunerate capital invested at a rate consistent with the degree of risk inherent to the venture concerned.

• In project finance the point of reference for any valuation is the ability of the project to generate cash flows.

Dr. Anirban Ghatak,

Christ University

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What is project finance?

• The distinctive features of a project finance deal are the following:

– The debtor is a project company set up on an ad hoc basis that is financially and legally independent from the sponsors.

– Lenders have only limited recourse (or in some cases, no recourse at all) toward the sponsors.

– Project risks are allocated equitably among all parties involved in the transaction.

– Cash flow generated by the initiative must be sufficient to cover operating costs, service the debt and pay relative interest.

– Security is granted by the sponsors to lenders to secure debt service (interests + principal repayment) during the operating phase of the project.

Dr. Anirban Ghatak,

Christ University

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Why do sponsors use project finance?

• DISADVANTAGES • High transaction costs as

compared to corporate-based financing because: – The advisor, the arranger, and

the legal and technical consultants need a great deal of time to value the project.

– Negotiating the contract terms to include in project documentation is labor-intensive.

– The cost of monitoring the project in progress is very high.

– Lenders are expected to pay significant costs in exchange for taking on greater risks.

• ADVANTAGES • The return on a project finance deal

is higher, on average, thanks to the utilization of financial leverage.

• The commitments, security interests, and contract terms do not always appear on the balance sheet or in the notes of the Directors.

• Creating an SPV makes it possible to almost completely isolate the sponsors from events involving the project.

• Lenders can always count on security interests, and having an SPV makes evaluation easier.

Professor XXX - Course YYY Dr. Anirban Ghatak,

Christ University

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Who are the sponsors of a project finance deal? (I)

• There are 4 types of sponsors who would have the interest and motivation to launch a project finance initiative:

– Industrial sponsors who see links between the initiative and their core business

– Sponsors who build or run plants

– Public sponsors

– Financial investors


Christ University

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Who are the sponsors of a project finance deal? (II)

• The project rationale of industrial sponsors lies in their view of the project financing as an initiative linked to their core business. – The link can be upstream or downstream of their original core

business.

• Normally these players also act as suppliers or clients as well as lenders of the SPV (or project company).

• Example: Many construction projects involving cogeneration power plants have industrial sponsors who utilize the project finance deal to dispose of materials later used as feedstock for power production.


Christ University

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Who are the sponsors of a project finance deal? (III)

• The plant contractor or operator is motivated to participate in the project finance deal to supply plants, materials, and services to the SPV.

• Usually this type of sponsor is involved in the initial phase of the initiative, handling design and construction of the plant, and in later phases as well, as shareholder of the SPV.

• It’s quite common for the contractor to offer to serve as plant operator once the facility is finished and activated.


Christ University

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Who are the sponsors of a project finance deal? (IV)

• The public sponsor’s interest in participating in a project finance deal comes from the chance to realize public works with private money, while tying up no (or only negligible) public funds PPPs = Public Private Partnerships

• In these cases the “industrial rationale” is: – To supply a satisfactory and efficient service to the community – To realize public works which are economically self-sustaining and

require limited investment of capital by the public body

• Moreover, project finance allows the public sponsor to limit outlay for works carried out with direct labor where there are structural constraints in the government budget and for the local administration.

• The role of the public body in the framework of project finance initiatives is usually based on a concession agreement.


Christ University

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Who are the sponsors of a project finance deal? (V)

• The most common contracts used in project finance and concession systems:

– BOT (build, operate and transfer)

• Public Administration delegates planning and realization of the project to a private party, together with operating management of the facility for a given period of time; the public body retains ownership.

– BOOT (build, operate, own and transfer)

• Similar to the BOT framework, except the private party owns the facility for the entire duration of the concession; when this expires ownership is transferred to the public body.

– BOO (build, operate and own)

• This contract has features in common with the first two. The private party owns the works (as with BOOT), but does not transfer ownership at the end of the concession term.


Christ University

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Who are the sponsors of a project finance deal? (VI) • PPPs as contractual schemes to allocate risks

Professor XXX - Course YYY

Dominant counterparty:

Public Sector

Dominant counterparty:

Private sector

Low or relatively low

Predominantly public

Public

High or very high

Private

Private

RISK INCURRED BY THE PRIVATE PARTNERS

OPERATION &

MAINTENANCE

SERVICES (O&M)

CONCESSION

(PUBLIC OWNERSHIP

OF THE FACILITIES)

CONCESSION

(PRIVATE OWNERSHIP

OF THE FACILITIES)

FULL

PRIVATIZATION

• Management of

public facilities by

private parties

• Leasing agreements

• Rehabilitation of existing

facilities, management and

transfer

• Design, building, management

and transfer (service agreements

with the public administration)

• Design, building, own,

management

and transfer

• Merchant plants

• Asset sales

• Divestitures

• Construction: Public

• Investment: Public

• Commercial: Public

• Operation: Private

• Construction: Public

• Rehabilitation: Private

• Commercial: Public/Private


• Construction: Private

• Commercial: mainly Private


• Investment: Private

• Commercial: Public/Private


TYPES OF CONTRACTUAL STRUCTURES

RESPONSIBILITY FOR FINANCING

PROJECT GOVERNANCE

MAIN RISKS AND RELATIVE ALLOCATION AMONG THE INVOLVED PARTIES

Dr. Anirban Ghatak,

Christ University

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Who are the sponsors of a project finance deal? (VII)

• Financial investors sponsor project finance initiatives with a single goal: to invest capital in a high-profit deals.

• Infrastructure funds: greenfield funds vs brownfield funds

• Clearly, these investors have a high propensity for risk and seek substantial returns on their investments; they’re similar in many ways to venture capitalists (pension funds, insurance firms, infrastructure funds). Expected net IRR: 15% (greenfield funds), 10-12% (brownfield funds)

• For these investors, there is no industrial project rationale like for industrial sponsors


Christ University

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An overview of the features of project finance (I)

• A project finance deal can always be viewed as a contractual network which revolves around the SPV.

• Each counterparty sets up contracts with the SPV which refer to specific phases or parts of the project.

• A deal is successful when all the interests of all the parties involved are satisfied at the same time, even though these interests are not always perfectly compatible.

• The same player can take on several different roles.

• The same players are not found in every project finance deal.


Christ University

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An overview of the features of project finance (II)

PROJECT

SPONSORS

PLANT OPERATOR

FUEL SUPPLIER

HOST

GOVERNMENT

RAW

MATERIAL

PRODUCT PURCHASER

PROJECT COMPANY

LENDING BANKS

bank facilities

security

FSA (1)

Sales Agreement

equity subscription

concessions and permits

PLANT CONSTRUCTOR

RMSA (2)

O&MA (3)

TKCC (4)

comfort letter

comfort letter


Christ University

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An overview of the features of project finance (III) – The contractor

– The contractor is the company (or consortium of companies) that wins the tender for the design and construction of a given plant on the basis of a fixed price turnkey contract.

– Contract obligations are taken on by the main contractor (who commits directly to the SPV) and are later passed on to consortium members.

– The main contractor is normally responsible for damages resulting from delays in completing the facilities.

– The contractor is also required to pay penalty fees if the plant does not pass performance tests.

– By the same token, the contractor may also receive bonuses if the plant performs at higher than contracted levels or if the project is finished ahead of schedule.


Christ University

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An overview of the features of project finance (IV) – The operator

– This is the counterparty who takes over the plant from the contractor after the construction phase is complete, and handles maintenance for a set number of years, guaranteeing the SPV that the plant is run efficiently in keeping with the pre-established output parameters.

– This party plays a key role during the operational phase of the project finance initiative.

– The operator may be an already-in-place company (perhaps even one of the sponsors) or a joint venture created to serve as operator by the shareholders of the SPV.


Christ University

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An overview of the features of project finance (V) – The buyers

– These are the counterparties to whom the SPV sells its output.

– Buyers of goods or services produced by the plant might be generic, which means not defined ex ante (i.e. a retail market), or a single buyer who commits to buying all the project company’s output. In the latter case, these buyers are called offtakers and output is sold wholesale.


Christ University

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An overview of the features of project finance (VI) – The suppliers

– These companies supply input to the SPV to run the plant on the basis of long-term contracts which include arrangements for transporting and stocking raw materials.

• However, in certain project finance structures there may not be a long-term supply contract.

– In practice, there are rarely a large number of suppliers. More often, in fact, the project counterparties prefer a single supplier who is frequently one of the project sponsors.


Christ University

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An overview of the features of project finance (VII) – Risk management

• Project finance is a system for distributing risk among the parties involved in a venture.

• Identifying and allocating risks leads to minimizing the volatility of cash inflows and outflows generated by the project.

• This is advantageous to all participants in the venture, who earn returns on their investments from the flows of the project company.


Christ University

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Risk identification and risk analysis

Total risk

Allocation toSPV counterpartiesthrough operating

contracts(chapter 3)

Allocation toInsurers(insurance policies)

(chapter 4)

Residual riskborne by the

SPV

Final loan/bondpricing

An overview of the features of project finance (VIII) – Risk management


Christ University

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The theory of project finance (I)

• Corporate finance

• An existing firm finances a new venture using its balance sheet as general collateral for creditors.

Assets

in place

Share

Capital

Existing

Debt

New

project

New

Debt

New

Share

capital

WACC

Cost of new debt

Cost of new equity

Return on new project

Return on existing

assets


Christ University

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The theory of project finance (II)

• Project finance

• Separate incorporation of the new venture in a specially created SPV.

Assets

in place

Share

Capital

Existing

Debt

New

project

New

Debt

New

Share

capital

WACC

Cost of new debt

Cost of new equity

Return on new project

Return on existing

assets

Existing firm

(sponsor/parent)

SPV


Christ University

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The theory of project finance (III)

• The two financing structures show major differences if the project in question:

– is very large with respect to the current size of the company

– has a higher degree of risk than the average riskiness of the portfolio of existing assets on the left side of the balance sheet

– is linked to the core business (slight diversification effect)


Christ University

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The theory of project finance (IV)

• CONTAMINATION RISK (or the co-insurance effect)

– Possibility that the new project has negative and positive consequences on existing investments

– When effects are negative we refer to contamination risk, while positive effects (in particular for lenders) are called insurance effects.


Christ University

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The theory of project finance (V)

Notice that even with a negative correlation the combination of Projects A and B has resulted in an increase in both risk and return compared to the original existing assets.

Existing assets

(project A)

New assets

(project B)

Market value 1,000 4,000

% on total value 20.0% 80.0%

Expected Return 10% 20%

Standard deviation (+/-) 5% 20%

Correlation Coefficients

-1 0 0.4 0.8 1

Expected return 18.0% 18.0% 18.0% 18.0% 18.0%

Risk (std deviation) 15.0% 16.03% 16.4% 16.8% 17.0%


Christ University

Professor XXX - Course YYY 26

The theory of project finance: co-insurance effect (I)

• Incorporating the new venture in a SPV is the optimal solution for shareholders (avoids contamination risk)

• Incorporating the new venture in a SPV is the optimal solution for creditors:

– Full control over the project cash flow

– Easier monitoring

– Possibility to tie-up management behaviour (covenants and restrictions)

… but loss of co-insurance

Dr. Anirban Ghatak,

Christ University


Project Finance vs Corporate Finance: co-insurance effect (II)

• Consider the following example:

Scenarios

1 2 3 4 5 6

HypothesisDebt Project 1 (assets in

place)100 100 100 100 100 100

Debt Project 2 (new

project)100 100 100 100 100 100

Expected cash flows project

1 (assets in place)50 50 130 130 300 300

Expected cash flows project

2 (new project)50 130 50 130 50 130

Dr. Anirban Ghatak,

Christ University


Project Finance vs Corporate Finance: co-insurance effect (III)

• First option: corporate finance

• The firm defaults in 3 states out of 6

Solution 1: on balance

sheet financing

Total cash flows 1+2 100 180 180 260 350 430

Total debt 1+2 200 200 200 200 200 200

Payoff creditors 100 180 180 200 200 200

Payoff shareholders default default default 60 150 230

Dr. Anirban Ghatak,

Christ University


Project Finance vs Corporate Finance: co-insurance effect (IV)

• Second option: project finance

• The project defaults in 3 states out of 6; the parent firm defaults in 2 states out of 6.

Solution 2: off balance

sheet financing

Total cash flows 2 50 130 50 130 50 130

Total debt 2 100 100 100 100 100 100

Payoff creditors 2 50 100 50 100 50 100

Payoff for shareholders

project 1 (dividends)default 30 default 30 default 30

Dividends from project 2

(A)0 30 0 30 0 30

Total cash flows 1 (B) 50 50 130 130 300 300

Total cash flow (A+B) 50 80 130 160 300 330

Total debt 1 100 100 100 100 100 100

Payoff creditors 50 80 100 100 100 100Payoff shareholders

sponsorsdefault default 30 60 200 230

Dr. Anirban Ghatak,

Christ University


Project Finance vs Corporate Finance: co-insurance effect (V)

• Summary of the results:

• Scenario 2: project finance allow the new venture to survive (parent co. defaults, the SPV doesn’t) – Contamination risk avoided

• Scenario 3: project finance allow the parent co. to survive (project defaults, parent doesn’t) – Contamination risk avoided

• Scenario 5: project finance causes the default of the new venture. If financed on balance, the firm doesn’t get bankrupt (loss of co-insurance) and the project would have survived.

Dr. Anirban Ghatak,

Christ University


Project Finance vs Corporate Finance: co-insurance effect (VI)

• From the point of view of creditors, the separate incorporation is sub-optimal in 2 states:

• Scenario 3: 180 (corporate finance) vs 150 (project finance)

• Scenario 5: 200 (corporate finance) vs 150 (project finance)

• The loss of coinsurance determines a wealth transfer from creditors to shareholders but…

• …reputation is a mitigative effect on the shareholders opportunism.

Dr. Anirban Ghatak,

Christ University

Projects

Documents

project finance deal

project finance initiative

theory of project finance

project financing

practice of project

features of project

project risks

project documentation