Project Finance
A General Introduction1
One Example of Off Balance Sheet
Financing Techniques
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Project Finance
• A Definition from the Association of
Corporate Treasurers*
‘A financing of a particular economic unit in
which a lender looks initially to the cash
flows and earnings of that economic unit
as the source of funds from which a loan
will be repaid and to the assets of the
economic unit as collateral for the loan’
*author, FSMD
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Project Finance
• The project is
• Not consolidated as not controlled by the
reporting entity
• Liabilities remain within ring fenced entity
or
Special Purpose Vehicle (SPV)
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Source Wikipedia
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•
A special purpose entity (SPE) (sometimes, especially in Europe, "special
purpose vehicle" or simply SPV) is a legal entity (usually a limited
company of some type or, sometimes, a limited partnership) created to fulfill
narrow, specific or temporary objectives. SPE's are typically used by
companies to isolate the firm from financial risk. A company will transfer
assets to the SPE for management or use the SPE to finance a large
project thereby achieving a narrow set of goals without putting the entire
firm at risk.
A special purpose entity may be owned by one or more other entities and
certain jurisdictions may require ownership by certain parties in specific
percentages. Often it is important that the SPE not be owned by the entity
on whose behalf the SPE is being set up (the sponsor). For example, in the
context of a loan securitisation, if the SPE securitisation vehicle were owned
or controlled by the bank whose loans were to be secured, the SPE would
be consolidated with the rest of the bank's group for regulatory, accounting,
and bankruptcy purposes, which would defeat the point of the securitisation.
Therefore many SPEs are set up as 'orphan' companies with their shares
settled on charitable trust and with professional directors provided by an
administration company to ensure there is no connection with the sponsor.
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Project Finance
•
Two important principles in relation to
Recourse
1. Has the legal structure succeeded in taking the
obligations, risks and returns of the project, off
the balance sheet of the Sponsors?
2. Accounting standards are constantly tightened
(due to Enron, Worldcom etc) so substance
becomes more important than form
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Project Finance
• A Project usually defined as a major
productive capital investment e.g. in
- oil or mineral development
- heavy industry (aluminium smelters etc)
- forestry, agriculture
- power generation, transportation, (toll
roads, bridges)
- telecoms
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Project Finance
Characteristics of PF
• Project cash flows
• Normally higher levels of debt ( which may
lead to the need for additional support)
• Variety of contractual obligations and
undertakings to manage and reduce risk
- Bank Guarantees
- Letters of Credit
to cover greater risk during construction
period
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Project Finance
Characteristics of PF
• A variety of funding sources
- export credits
- development funds
- specialised asset finance
- conventional debt and
- equity finance
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Project Finance
• Project finance is a
‘classic example of fundamental principles
of credit and corporate finance’
(ACT/FSMD)
i.e. managing risk and return for the
different parties from a stream of future
cash flows
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Project Finance
BOT
» Build – Operate – Transfer
JV
License to operate and
purchase of shares
Host Government
Sponsors project and
supplies equity
Supply and Construction
Consortium
Supply and Construction
Project
Provide Finance
Power purchase agreement
Banks
Electricity Authority
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Project Finance
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Project Finance
Why use Project Finance
• Amount too large for company Balance
Sheet
• Too much risk for one company to bear
- share different risks with those better
able to assess and manage
e.g. Oil exploration, development and
production
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Project Finance
Why? continued
• What risks for oil?
• Exploration
- geological interpretation
- harsh environments
- political risks
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Project Finance
Why? continued
• Once found then, Development/Production
- reservoir risk
- recovery risk
- technology risk
- production risk
- transportation risk
• Still have market risk, environmental risk
de- commissioning and so on
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Project Finance
Why? continued
• Company policy for off balance sheet with
or without recourse
• Political risks
- e.g. local regulations ref foreign
shareholdings
• Existing covenants
• Project development time
• Ring fence also helps protect the project
from sponsor failure
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Project Finance
• Recourse
from full to zero
• Determined by the contract
- provide extra cost
- take a particular risk
- agree to take (off-take) product
• Recourse may also vary in kind (type)
as well as degree
- Legal obligations
- Moral obligations
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Project Finance
Process
• Strategic/commercial evaluation
• Systematic identification and exploration of
risks
• Valuation (NPV of cash flows)
• Design of risk bearing/sharing package
• Appropriate funding package
• Impact of financing package on net cash
flows and sensitivity analysis
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Project Finance
Risk Analysis
• Pre construction
• Construction
• Operation
But many risks may be present at all stages
Resource availability- Geological-InfrastructureTechnological-Construction-Operating-Labour
supply-Material sourcing-Product marketManagement-FX-Political-RegulatoryEnvironmental
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Project Finance
• Common causes of failure
Completion delay-Cost overrun-Technical
failure-Uninsured casualty losses-Increase
price/shortage of raw materials-Technical
obsolescence-Government interferenceLoss of competitive position-ExpropriationPoor management
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Project Finance
Design of Risk Sharing
Contractual Structure
Objective to prevent or limit their effect
Concession agreements-Construction and
equipment contracts-Completion
guarantees-Supply agreementsThroughput agreements-Cost over run
insurance-Cash deficiency agreementsPolitical risk insurance-Management
contracts
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Project Finance
Design of Risk Sharing
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•
•
•
•
Contractual Structure
Banks will use
Assignment of proceeds
Cash handling procedures
Financial guarantees
from sponsor, governments, other banks,
third parties
Credit protection
Insurance
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Project Finance
Design of Risk Sharing
Contractual Structure
• ‘What may be an unacceptable risk for one party may be
perfectly acceptable to another’
• Government permissions
• Physical completion
• Cost over runs
• Delays
• Costs of inspection
• Technical performance
• Prices
• Supply
• Throughput or off take agreements
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Project Finance
Design of Risk Sharing
Contractual Structure
Lending
Banks
Project Sponsors
Shareholders Agreement
Insurers
Insurance Policies
Financing
Agreement
Project
Company
Advisors
Financial, Legal, Insurance advice
Offtake/Purchase Offtake/Product
Contract
Purc
Supply contract
Operation and Maintenance
Agreement
Operator
Construction contract
Construction
Raw Material supplier
Project Finance
The Funding Package 1
• The objective is to
1. Create an acceptable
Risk/Return
relationship for the participants
2. Build in flexibility to cater for variations in
project outturn
3. Risk hedging
- financial by debt
- interest rate risk
- foreign exchange rate
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Project Finance
The Funding Package 2
• As little straight equity as possible (but
some)
• Quasi equity e.g. subordinated loan stock
- more flexible
- performs like mezzanine finance
(leveraged buyouts)
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PF: Subordinated Debt
• What Does Subordinated Debt Mean?
A loan (or security) that ranks below other
loans (or securities) with regard to claims
on assets or earnings.
Also known as a "junior security" or
"subordinated loan".
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PF: Junior Security/Debt
• What Does Junior Security Mean?
A security that ranks lower than other securities in
regards to the owner's claims on assets and income in
the event of the issuer becoming insolvent.
•
• Investopedia explains Junior Security
When bankruptcy occurs, holders of both preferred
shares and debt securities have first claim on the
remaining assets. Only after preferred shareholders
have been paid back, remaining assets (if any) are
divided among common shareholders.
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PF:Senior Debt
• What Does Senior Issue Mean?
An issue of bonds, preferred stock or other securities that represents
the first priority lien on the issuer's assets or earnings. Senior issues
have a higher priority claim on a firm's dividends, interest payments,
or in case of a bankruptcy, the value salvaged from a liquidation.
• Investopedia explains Senior Issue
Priority levels may change in the subordinated debt structure. An
issue that is considered senior may lose that title in certain
situations. For example, if a firm claims bankruptcy and begins
acting as a debtor in possession (DIP), it may attempt to raise more
funds to keep operations going. A new lender may require its lien to
be given top priority, forcing the current senior issue of bonds down
the claims ladder.
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PF: Senior Security
• Notwithstanding the senior status of a loan or other debt instrument,
another debt instrument (whether senior or otherwise) may benefit
from security that effectively renders that other instrument more
likely to be repaid in an insolvency than unsecured senior debt.
Lenders of a secured debt instrument (regardless of ranking) receive
the benefit of the security for that instrument until they are repaid in
full, without having to share the benefit of that security with any other
lenders. If the value of the security is insufficient to repay the
secured debt, the residual unpaid claim will rank according to its
documentation (whether senior or otherwise), and will receive pro
rata treatment with other unsecured debts of such rank.
Source: Investopedia and Wikipedia
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PF: Mezzanine Finance
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What Does Mezzanine Financing Mean?
A hybrid of debt and equity financing that is is typically used to finance the expansion
of existing companies. Mezzanine financing is basically debt capital that gives the
lender the rights to convert to an ownership or equity interest in the company if the
loan is not paid back in time and in full. It is generally subordinated to debt provided
by senior lenders such as banks and venture capital companies.
Since mezzanine financing is usually provided to the borrower very quickly with little
due diligence on the part of the lender and little or no collateral on the part of the
borrower, this type of financing is aggressively priced with the lender seeking a return
in the 20-30% range.
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•
Investopedia explains Mezzanine Financing
Mezzanine financing is advantageous because it is treated like equity on a company's
balance sheet and may make it easier to obtain standard bank financing. To attract
mezzanine financing, a company usually must demonstrate a track record in the
industry with an established reputation and product, a history of profitability and a
viable expansion plan for the business (e.g. expansions, acquisitions, IPO).
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PF: Mezzanine Finance
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•
•
Mezzanine capital, in finance, refers to a subordinated debt or preferred
equity instrument that represents a claim on company's assets, which is
senior only to that of the common shares. Mezzanine financings can be
structured either as debt (typically an unsecured and subordinated note) or
preferred stock.
Mezzanine capital often is a more expensive financing source for a
company than secured debt or senior debt. The higher cost of capital
associated with mezzanine financings is the result of its location as an
unsecured, subordinated (or junior) obligation in a company's capital
structure (i.e., in the event of default, the mezzanine financing is less likely
to be repaid in full after all senior obligations have been satisfied).
Additionally, mezzanine financings, which are usually private placements
are also often used by smaller companies and may also involve greater
overall leverage levels than issuers in the High Yield market and as such
involve additional risk. In compensation for the increased risk, mezzanine
debt holders will require a higher return for their investment than secured or
other more senior lenders.
Source: Wikipedia
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PF: Mezzanine Finance
• Leveraged buyouts
• In a leveraged buyouts, mezzanine capital is used in conjunction
with other securities to fund the purchase price of the company
being acquired. Typically, mezzanine capital will be used to fill a
financing gap between less expensive forms of financing (e.g.,
senior loans, second lien loan, high yield financings) and equity.
Often, a financial sponsor will exhaust other sources of capital
before turning to mezzanine capital.
• Financial sponsors will seek to use mezzanine capital in a leveraged
buyout in order to reduce the amount of the capital invested by the
private equity firm. Because mezzanine lenders typically have a
lower target cost of capital than the private equity investor, using
mezzanine capital can potentially enhance the private equity firm's
investment returns. Additionally, middle market companies may be
unable to access the high yield market due to high minimum size
requirements, creating a need for flexible, private mezzanine capital.
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Project Finance
Funding Package 2
• Back to Subordinated Loan
• Gives advantages such as
- higher return than senior debt
- can carry low and flexible coupon
- tax deductible
- can be regarded as equity by senior
lenders
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Project Finance
The Funding Package 3
• Debt will be sourced from a variety of providers
1. Export Credit Agencies e.g. ECGD, COFACE,
HERMES, Eximbank, SACE
2. Buyer and Supplier credits
3. Non commercial finance e.g. development
loans from regional national or international
development agencies e.g. EIB, EBRD, Asian
Development Bank
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Project Finance
The Funding Package 3
4.
Long and short term asset finance e.g. leasing
5.
Conventional trade finance
6.
Bond issues
7.
Conventional senior debt
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Project Finance
The Funding Package 4
• Design and Monitoring
- Debt service ratios
- Based on free cash flows
• Economic test
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Project Finance
The Funding Package 5
• Annual Debt Service Cover Ratio
(ADSCR)
Period project cash flows before interest payable
and debt repayment
Divided by
Period interest payable and debt repayments
Calculated for each period
Minimum ratios between 1.25 to 2.00
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Project Finance
The Funding Package 6
• Multi period ratios
1. Loan Life Cover Ratio (LLCR)
NPV of free cash flows over loan life
Outstanding Debt
2. Project Life Cover Ratio (PLCR)
NPV of free cash flows over project life
Outstanding Debt
Note Discount used is the average interest cost so
relates to PV of the project to the bank
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