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Lecture 9:
Financial innovations
Anton Miglo
Fall 2013
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Contents
 Project financing
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What is a Project?
What is Project Finance?
Project Structure
Motivation
Underinvestment and project financing
Real World Cases
 Asset-backed securities
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Securitizable Assets
How Asset Securitization Works
Synthetic IPO
Benefits/Incentives
Examples
Income Trust
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The MM Proposition
“The Capital Structure is irrelevant as long as the
firm’s investment decisions are taken as given”
Then why do corporations:
 Set up independent companies to undertake mega
projects and incur substantial transaction costs
 Finance these companies with over 70% debt even
though the projects typically have substantial risks
and minimal tax shields, e.g. Iridium: very high
technology risk and 15% marginal tax rate.
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What is a Project?
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High operating margins.
Limited Life.
Significant free cash flows.
Few diversification opportunities. Asset specificity.
Projects have unique risks:
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Currency, interest rate, inflation.
Environmental.
Expropriation.
Technology failure.
Counterparty failure
Force majeure
Regulatory risk
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What Does a Project Need?
Customized capital structure/asset specific
governance systems to minimize cash flow
risk and maximize firm value.
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What is Project Finance?
Project Finance involves a corporate
sponsor investing in and owning a single
purpose, industrial asset through a legally
independent entity financed with nonrecourse debt.
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Project Finance – An Overview
 Outstanding Statistics
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Over $220bn of capital expenditure using project finance in 2001
$68bn in US capital expenditure
Smaller than the $434bn corporate bonds market, $354bn asset backed
securities market and $242bn leasing market, but larger than the $38bn
IPO and $38bn Venture capital market
 Some major deals:
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$4bn Chad-Cameroon pipeline project
€ 10bn Eurotunnel
$6bn Iridium global satellite project
$1.4bn aluminum smelter in Mozambique
€900m A2 Road project in Poland
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Total Project Finance Investment
Total Project Finance Investment
$250.00
$200.00
Equity Finance
$150.00
Bonds
Million USD
Bank loans
$100.00
Others
$50.00
$1
2
3
4
5
Years
•Overall 5-Year return of 18% for private sector investment.
•Project Lending 5-Year return of 23%.
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Number of Projects
Number of Projects
700
600
500
Number of 400
Projects 300
Project with Bond Finance
Projects with Bank Loan
Finance
200
100
0
1997 1998 1999 2000 2001
Years
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Project Finance Lending by Sector
Amount of Project Lending by Sector
$120.00
$100.00
$80.00
Amount USD
$60.00
$40.00
$20.00
$1997 1998 1999 2000 2001
Industrial
Leisure
Petrochemical
Mining
Telecom
Oil and Gas
Infrastructure
Power
Years
• 37% of overall lending in Power Projects, 27% in telecom.
• 5-Year return for Power Projects: 25%, Oil & Gas:21% and
Infrastructure: 22%.
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Underinvestment and project financing
 Consider a firm with $5,000 worth of debt due in period 1
 Cash flows in period 1 are stochastic, in the good state they will
be $8,000, in the bad state they will be $3,000; each state has equal
probability (50%)
 The firm has an opportunity to undertake a project costing
$1,500 that will generate cash flows of $2,000 in both states
 Assume risk neutrality and risk-free interest rate equals 0
 Will the firm undertake this positive NPV project?
 The answer depends on how the project is financed
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Motivations: Debt Overhang
Problems:
 Under investment in
Positive NPV projects at the
sponsor firm due to limited
corporate debt capacity.
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Structural Solutions:
 Non recourse debt in an
independent entity
allocates returns to new
capital providers without
any claims on the
sponsor’s balance sheet.
Preserves corporate debt
capacity.
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Motivations: other agency costs
Problems:
 High levels of free
cash flow. Possible
managerial
mismanagement
through wasteful
expenditures and suboptimal investments.
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Structural Solutions:
 Given the nature of projects,
investment opportunities are few and
thus investment distortions/conflicts
are negligible.
 Separate ownership: single cash flow
stream, easier monitoring.
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Motivations: Other
 Opportunistic behavior by host governments: expropriation. Either
direct through asset seizure or creeping through increased
tax/royalty. Solution: since company is stand alone, acts of
expropriation against it are highly visible to the world which detracts
future investors. Multilateral lenders’ involvement detracts
governments from expropriating since these agencies are
development lenders and lenders of last resort. However these
agencies only lend to stand alone projects.
 A high risk project can potentially drag a healthy corporation into
distress. Short of actual failure, the risky project can increase cash
flow volatility and reduce firm value. Conversely, a failing
corporation can drag a healthy project along with it. Solution: project
financed investment exposes the corporation to losses only to the
extent of its equity commitment, thereby reducing its distress costs.
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Disadvantages of Project Financing
 Often takes longer to structure than equivalent size
corporate finance.
 Higher transaction costs due to creation of an
independent entity.
 Project debt is substantially more expensive due to
its non-recourse nature.
 Extensive contracting restricts managerial decision
making.
 Project finance requires greater disclosure of
proprietary information and strategic deals.
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Comparison with Other Vehicles
Financing vehicle
Similarity
Dis-similarity
Secured debt
Collaterized with a
specific asset
Recourse to
corporate assets
Subsidiary debt
Possible recourse to
corporate balance
sheet
Asset backed
securities
Collaterized and non- Hold financial, not
recourse
single purpose
industrial asset
LBO / MBO
High debt levels
No corporate sponsor
Venture backed
companies
Concentrated equity
ownership
Lower debt levels;
managers are equity
holders
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Real World Cases
Australia Japan cable
Poland’s A2 Motorway
Petrolera Zuata
Chad Cameroon
Calpine Corporation
Iridium LLC
Bulong Nickel Mine
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Case : Australia Japan Cable
Background: 12,500km cable from Sydney, Australia to Japan via Guam
at a cost of $520m. Key sponsors: Japan Telecom, Telstra and Teleglobe.
Asset life of 15 years.
Key Issues:
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High risk from fast changing telecom market
Risk from project delay
Specialized assets
Significant Free Cash Flow
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Another example
 British Petroleum: North Sea and Trans-Atlantic
Pipeline
Constructed to move oil from the North Slope of Alaska
to the northern most ice- free port- Valdez, Alaska
 Joint venture between BP, Standard Oil of Ohio, Atlantic
Richfield, Exxon, Mobil Oil, Philips Petroleum, Union Oil
and Amerada Hess
 Cost: $1 billion—too much for any one firm to handle
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Case : The Chad Cameroon Project
Background: An oil exploration project sponsored by Exxon-Mobil in
Central Africa with two components:
 Field system: Oil wells in Chad, cost: $1.5bn.
 Export System: Pipeline through Chad and Cameroon to the Atlantic,
cost: $2.2bn.
Key Issues:
 Chad is a very poor country ruled by President De’by, a “warlord”.
Expropriation risk.
 Possibility of hold up by Cameroon.
 Allocation of proceeds – World Bank’s role and Revenue Management
Plan.
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Asset Securitization
 Asset Securitization: separating assets producing
a steady stream of income from other assets of a
company, then selling securities that have a claim
on the cashflows of these assets exclusively
 Non-recourse finance: when the lenders to a
corporation have claims to the profits of the
corporation and not to the assets themselves
 Asset securitization is an example of using nonrecourse finance
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Securitizable Assets
 Some examples of what companies have
securitized:
Receivables (i.e. A/R, credit card balances, etc)
 Commercial and residential mortgages
 Equipment Leases
 Intellectual Property
 Rights to future cashflows from mining/exploration
(Royalty Trusts)
 Strategic Business Units (Corporate Divisions)
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• Recent example: Bell Canada Enterprises (BCE) recently
securitized the profits from their Ontario and Quebec phone
line services creating Bell Aliant, an income trust
• Commonly take the form of an income trust
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Fixed vs. Revolving
 Mortgage Backed Securities: a pool of
mortgages (commercial or residential)
where the security holder owns the right to
receive principal + interest on the
mortgages
A fixed MBS has an initial amount of
mortgages, the total value of mortgages
declines as the principals are paid down
 A revolving MBS will replenish the paid off
principals by adding new mortgages to the pool
 These securities discussed later
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Synthetic IPO
 Asset securitization, when done for business units, is
also known as a synthetic IPO
 The main difference is that securitization can be used
more broadly to include assets that are not business
units/divisions of companies (e.g. mortgages)
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Formula One’s Synthetic IPO
 6 different companies were involved:
SLEC: The originating company which owns Formula One
Management
 Formula One Management: owns Formula One business,
sells broadcasting rights to TV and other mediums
 2 SPVs were created
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• Formula One Administration: holds the securitized assets
• Formula One Finance: issues the bonds to investors
Formula One Licensing: owns the Formula One trademarks
 Formula One Holdings: owns Formula One Administration
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 By observing the structure of this you can see why
good financial lawyers are needed in the underwriting
process
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Improving Moral Hazard
 To reduce agency costs two conditions must hold:
 Securitized cashflows are insensitive to managerial
effort (no effort needed to produce cashflows)
 Securitized assets are risky (but not as much as the
assets of the firm)
 Recall agency costs are those incurred when the
manager’s incentives do not equal shareholder
incentives
 Securitization segregates the assets that manager’s do
not impact as directly into the SPV, while retaining the
assets they can directly impact
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Asymmetric Information and
Securitization
Between Managers and Investors
 Segregating the assets makes the quality of the assets
and cashflow clearer, making it easier to quanitfy risk
 This helps avoid the “lemon’s premium” on issuing
equity (recall the MM argument)
 Lemon’s premium: increased cost of capital to firm
as a result of issuing equity (a signal that the firm is a
low-type firm)
 Securitizing signals to potential investors the firm is
high-type
 Signalling benefit: the benefit of avoiding lemon’s
market premium on newly issued equity for firms with
securitized assets
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ABS Example: Bowie Bonds
 Bowie Bonds: David Bowie issued $55 million in
bonds in 1997 to finance the purchase of the rights to
his 287 songs from his manager
 This was the first instance of intellectual property
securitization
 The bonds gave investors the right to receive
royalties to Bowie’s music from 1997-2007, and
turned out being a poor investment for those who
bought them because of the movement away from
buying CDs and into downloading music
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Subsequently other artists such as James Brown have done
this as well
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ABS Example: Bowie Bonds
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