Lecture on Project Finance

Project Finance

Professor Pierre Hillion

Project Finance

“A project company is like a leveraged buyout (LBO), except that an LBO is a financing decision involving existing assets, whereas project finance is an investment and a financing decision involving new assets”

B. Esty

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Outline

• Introduction

• Part 1: Overview of Project Finance

• Part 2: Statistics

• Part 3: Project Finance versus Corporate Finance

• Part 4: Leverage and Financing Issues

• Conclusion

• Appendices

INTRODUCTION

Definition: Project Finance

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Definition of Project Finance

Project Finance (PF) involves:

• the creation of a legally independent project company

• financed with:

-non-recourse debt

-equity from one or more sponsoring firms

• for the purpose of financing an investment in a single-purpose capital asset

• usually with a limited life.

PART 1

Overview of Project Finance

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• Sponsors and investors: they are generally involved in the construction and the management of the project. Other equity-holders may be companies with commercial ties to the project, i.e., customers, suppliers…

• Lenders: The needed finance is generally raised in the form of debt from a syndicate of lenders such as banks and less frequently from the bond market.

• Government: project company need to obtain a concession from the host government.– Role of type of contract: Build-own-operate (BOO) or Build-transfer-operate (BOT).– Control on revenues such as for example: Eurostar, British Jail,

• Suppliers and Contractors: Role of turnkey contracts to make sure that construction is completed within costs and on schedule. Turnkey contracts specify a fixed price and penalties for delays.

• Customers: Depending on the contract, multiple or a single customer.

Overview of Project Finance: Parties Involved

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Overview of Project Finance: Main Characteristics

• Organizational Structure- Project companies involve separate legal incorporation.

• Capital Structure

- Project companies employ very high leverage compared to public firms.

• Ownership Structure- Project companies have highly concentrated debt and equity ownership structures.

• Board Structure- Project boards are comprised primarily of affiliated directors from the sponsoring firms.

• Contractual Structure- Project finance is referred to as “contract finance” because a typical transaction involves numerous contractual agreements from input suppliers to output buyers.

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• Independent, single purpose company formed to build and operate the project.

• Extensive contracting– As many as 15 parties and up to 1000 contracts.– Contracts govern inputs, construction, operation, outputs.– Government contracts/concessions: one off or operate-transfer.– Ancillary contracts include financial hedges, insurance for Force Majeure, etc.

• Highly concentrated equity and debt ownership– One to three equity sponsors.– Syndicate of banks and/or financial institutions provide credit.– Governing Board comprised of mainly affiliated directors from sponsoring firms.

• Extremely high debt levels– Mean debt of 70% and as high as nearly 100%.– Balance of capital provided by sponsors in the form of equity or quasi equity (subordinated debt).– Debt is non-recourse to the sponsors.– Debt service depends exclusively on project revenues.– Has higher spreads than corporate debt.

Overview of Project Finance: Main Characteristics

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Overview of Project Finance: Contractual Agreements

Contractual and financing arrangements between the various parties are essential in project finance:

• Concession agreement with a government• Engineering, Procurement and Construction (EPC) Contract

– between the Project Company & the Engineering Firm • Operations and Maintenance (O & M) Agreement

– between the Operations Contractor and the Project Company, obligates the Operator to operate and maintain the project

• Shareholders Agreement– governs the business relationship of the equity partners

• Inter-creditor Agreement– an agreement between lenders or class of lenders that describes the rights and obligations

in the event of default. • Supply Agreement

– agreement between the supplier of a critical key input and the Project Company (e.g. agreement between a coal supplier and a power station)

• Purchase Agreement– agreement between the major user of the project output and the Project Company– agreement between a metropolitan council and a power station

Overview of Project Finance: Return Distribution

• Capital providers earn an appropriate risk-adjusted rate of return on a portfolio of investments by earning, either high rates of return on just a few investments, or low rates of return on many projects. The former corresponds to the venture capital (VC) industry, and the latter to PF.

• VC is used for intangible assets with significant return uncertainty and little residual value in the event of failure. Equity has an effective payoff structure because it allows investors to capture unlimited upside. In contrast, debt does not work for these high risk investments with positively skewed returns. In VC, managers are responsible for managing growth options and transforming a small amount of capital into large companies.

• In PF, managers are responsible for transforming a large amount of capital into something worth a little more. Project returns have a limited upside. This means that a large fraction of projects must be successful and generate positive returns for capital providers to earn proper returns.

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Overview of Project Finance: Return Distribution

• Projects are exposed to three types of risk:

- Symmetric risks including: market risk (quantity), market risk (price), input or supply risk, exchange, interest and inflation rate risks, reserve risk, throughput risk. Exposures to symmetric risks causes larger positive and negative deviations from the expected outcome.

- Asymmetric risks including: environmental risk, expropriation risk. These risks cause only negative deviations in the expected outcome.

- Binary risks including: technology failure, full expropriation, counterparty failure, regulatory risk, force majeure…These risks increase the probability that an asset ends up worthless.

• In practice, projects have relatively low asset risk allowing a high debt

capacity. The use of leverage introduces financial risk which allow equity-holders to capture unlimited upside once debt claims have been satisfied. 12

Overview of Project Finance: Risk Management Matrix

Stage and Type of Risk Who Bears the Risk

Pre Completion Risk

- Resource risk - Force majeure - Technological risk - Timing or delay risk - Completion risk

Sponsors (suppliers)3rd party insurersSponsors (contractors)Sponsors (contractors)Sponsors (contractors)

Operating Risks

- Supply or input risk - Throughput risk - Force majeure - Environmental risks - Market risk: quantity - Market risk: price

Sponsors (suppliers)Sponsors3rd party insurersSponsorsSponsors (off-taker)Sponsors (off-taker)

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Overview of Project Finance: Risk Management Matrix

Stage and Type of Risk Who Bears the Risk

Sovereign Risk

Macroeconomic Risks - Exchange rates - Currency convertibility - Inflation

Political and Legal Risks - Expropriation - Diversion - Changing legal rules

SponsorsSponsorsSponsors


Financial Risks

- Funding risk - Interest-rate risk - debt service risk


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Financing vehicle

Similarity Dis-similarity

Secured debt Collaterized with a specific asset

Recourse to corporate assets and CFs

Subsidiary debt Possible recourse to corporate balance sheet

Asset backed securities

Collateralized and non-recourse

Hold financial, not single purpose industrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backed companies Lease

Concentrated equity ownership

Lower debt levels; managers are equity holders Recourse to the lessor

Overview of Project Finance: Comparison with Other Forms of Financing

PART 2

Statistics

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Project Finance Statistics

• Historically project finance was used by private sector for industrial projects, such as mines, pipes, oil fields. In the early 70s, BP raised $945 million to develop the “Forties Field” in the North Sea.

• The beginning of modern project finance starts with the passage of the Public Utility Regulator Act in 1978 in the US to encourage investment in alternative non-fossil fuel energy generators.

• From early 1990s, private firms start financing a wide range of assets such as toll roads, power plants, telecommunications systems located in a wider range of countries.

• Project sponsors have been pushing the boundaries of project finance for most of the last 15 years by increasing sovereign, market and technology risks.

• World Bank study: global investment in new infrastructure assets $369 billion per year from 2005-2010 with 63% in developing nations, e.g. Asia, Africa.

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• Outstanding Statistics:

– Over $408bn of capital expenditure using project finance in 2008.

– US$67bn in US capital expenditures which is:

• smaller than the US $645 billion investment grade corporate bonds market, $187 billion mortgage-backed security market, $160 billion asset-backed security market, and $387 billion tax-free municipal bond market (NB: these markets shrank significantly in 2008 from 2006 levels due to subprime crisis).

• but larger than the $26bn IPO market and the $45bn venture capital market.

• Some major deals:

– US$10.65bn 2005 Qatargas 2 project (LNG production) – involved 57 lenders

– US$3.8bn 2006 Peru LNG plant

– US$3.7bn 2007 Madagascar Nickel-Cobalt Mining and Processing Project

– In Singapore, US$1.4bn Singapore Sports Hub


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$-

$50

$100

$150

$200

$250

$300

$350

$400

$450

2003 2004 2005 2006 2007 2008

Total Project Finance Investment (US$m)

Bank loans Bonds MLA/ BLA Equity Finance

Overall 5-Year CAGR of 19% for private sector investment.

Project Lending 5-Year CAGR of 21%.


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0

50

100

150

200

250

300

2003

2004

2005

2006

2007

2008

Amount of Project Lending by Sector (US$m)

Other

Water & Sewage

Mining

Industrial

Telecom

Leisure & Property

Petrochemicals

Oil & Gas

Transportation

Power


• 34% of overall lending in Power Projects, 21% in Transportation.

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0%

10%

20%

30%

40%

50%

60%

5-year CAGR in Project Lending by Sector

• 5-Year CAGR for Power Projects: 30%, Oil & Gas:30%, Mining: 59% and Leisure & Property: 36%.


• Size distribution of projects:

- 41% < $ 100 million, (7% of the total value of the PF market)

- 19% > $500 million, (70% of the total value)

- 8% > $1.0 billion, (55% of the total value)

- mean size: $435 million, median size: $139 million

• Project duration:

- Mean (median) construction years: 2.1 (2.0) years

- Mean (median) concession contract: 28 (25) years

- Mean (median) length of off-take agreements: 19 (20) years

• Project leverage: Mean (median) debt-to-capitalization ratios: 71% (76%)

• Maturity of debt instruments:

-Median maturity of bank loans: 9.8 years

- Median maturity of bonds: 11.6 years

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Project Finance (PF) versus Corporate Finance (CF)

PART 3

PF versus CF: Rationale for Project Finance

Project finance allows firms:

• to minimize the net costs associated with market imperfections such as:

- incentive conflicts,

- asymmetric information,

- financial distress,

- transaction costs,

- taxes.

• to manage risks more effectively and more efficiently.

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Project Finance

• Purpose: a single purpose capital asset, usually a long-term illiquid asset. The project company is dissolved once the project is completed. No growth opportunities.

• A legally independent project: The project company does not have access to the internally-generated cash flows of the sponsoring firm and vice versa.

• The investment is financed with non-recourse debt. All the interest and loan repayments come from the cash flows generated from the project.

• Project companies have very high

leverage ratios, with the majority of debt coming from bank loans.

Corporate Finance

• A company invests in many projects simultaneously.

• The investment is financed as part of the company’s existing balance sheet. The lenders can rely on the cash flows and assets of the sponsor company apart from the project itself. Lenders have a larger pool of cash flows from which to get paid. Cash flows and assets are cross-collateralized.

• Publicly traded firms have typical leverage ratios of 20% to 30%.


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PF versus CF: Rationale for Project Finance• Modigliani and Miller show that corporate financing decisions do not affect firm value

under perfect and efficient markets. The rise of project finance provides strong evidence that financing structures do matter.

• it is not clear why firms use project finance given that:

- It takes longer and it costs more to structure a legally independent project company than to finance a similar asset as part of a corporate balance sheet.

- Project debt is often more expensive (50 to 400 bps) than corporate debt due to its non-recourse nature (no benefit of co-insurance).

- The combination of high leverage and extensive contracting restricts managerial discretion and managerial flexibility.

- Project finance requires greater disclosure of proprietary information which can be costly from a competitive perspective.

- It is harder to obtain operating synergies as the project is independent.

- The likelihood of using interest tax shields and net operating losses is lower.

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• Financing decisions matter under imperfect/inefficient markets. Firms bear “deadweight costs” (DWC) when they invest in and finance new assets.

• DWCs result from market imperfections. They include:

- agency costs and incentive conflicts- asymmetric information costs

- financial distress costs- transaction costs

- taxes

• DWCs change under alternative financing structures, i.e., corporate finance versus project finance.

• Sponsors should use project finance whenever the DWC are lower than their corporate finance counterparts.

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• Project finance reduces costly agency conflicts:

- Conflicts between ownership and control

- Conflicts between ownership and related parties

- Conflicts between ownership and debtholders

• Project finance reduces information costs (asymmetric information).

• Project finance reduces costly underinvestment, in particular leverage-Induced underinvestment.

• Project finance, as a organizational risk management tool, reduces the

potential collateral damage that a high risk project can impose on a sponsoring firm, i.e., risk contamination. It also reduces the costs of financial distress and solves a potential underinvestment problem.

Resolution of Agency Conflicts between Ownership and Control

Project Finance versus Corporate Finance

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Agency Conflicts between Ownership and Control

• Costly agency conflicts arise when managers who control investment decisions and cash flows have different incentives from capital providers.

• Certain asset characteristics make assets prone to costly agency conflicts: Tangible assets that generate high operating margins and significant amounts of cash flow can lead to:

- inefficient investment

- excessive perquisite consumption

- value destruction

Ex: The agency costs of free cash flows are higher in cement than in drugs.

• Solving the problem of ownership and control is important in project companies where few of the traditional sources of discipline are present or effective.


Corporate Finance

• Company invests in many projects and possesses many growth opportunities.

• Cash flow separation is difficult to accomplish in corporate finance. Project cash flows are co-mingled with the cash flows from other assets making monitoring of cash flows difficult.

• The verifiability of cash flows is difficult.

Project Finance

• Project company is dissolved once the project gets completed. No future growth opportunities.

• Cash flows of the project are separated from cash flows of sponsors. The single discrete project enable lenders to easily monitor project cash flows.

• The verifiability of CFs is enhanced by the waterfall contract that specifies how project CFs are used.

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Corporate Finance

Traditional monitoring mechanisms include:

• Takeover market

• Product market

• Reputation

• Staged investment

• Staged financing

• Leverage: high debt service forces managers to disgorge free cash flows.

• Creditors rights: lenders threat to seize collateral and threat of liquidation to deter borrowers’ opportunism.

Project finance

Monitoring mechanisms include:

• Managerial discretion is constrained by extensive contracting. Claims on cash flows are prioritized through the CF waterfall.

• Concentrated equity ownership provides critical monitoring, The unique board of directors and separate legal incorporation makes monitoring more simple and efficient.

• High leverage both the amount and type (maturity…); Bank loans provide credit monitoring.

• Senior bank debt disgorges cash in early years.

From a sample of 6045 project loans (provided to project companies and corporations) from 40 countries originated between 1993 and 2003:

• PF is much less likely in the US (19%) than in the rest of the world (53%) and in English and Scandinavian legal origin countries than in French or German legal origins. Why?

• PF is more likely in countries with weak protection against managerial self-dealing.

• In countries that provide weak protection to minority investors against expropriation by insiders, PF is relatively more likely than CF in industries where free cash flows to assets is higher.

• In countries that provide stronger protection to creditors, the effects of weaker protection against managerial self-dealing in encouraging PF is lower.

• Large deadweight costs incurred in bankruptcy increase the likelihood of PF as bankruptcy costs are lower in PF than in CF. PF is less likely when the bankruptcy process is more efficient.

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Resolution of Agency Conflicts between Ownership and Related Parties

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Standard Approach

• Vertical integration (not always possible or desirable).

• Long term contracts, with contract duration increasing with asset specificity.Project Finance Approach

• Joint ownership that allocate the residual cash flow rights and asset control rights among the deal participants.

• High debt level. With high leverage, small attempts to appropriate value will result • In costly default and possibly a change in control.

Problem (Hold Up)

A second type of agency conflict is the opportunistic behavior by related parties, causing ex-ante reduction in expected returns and ex-ante incentives to invest. The most common culprits are related parties that supply critical inputs, buy primary outputs, and host nations that supply the legal system and contractual enforcement.

Agency Conflicts between Ownership and Related Parties

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Standard Approach

• Visibility/reputation

• High leverage.

Project Finance Approach

• High leverage to discourage expropriation (excess cash is disgorged, lower profits and less visibility).

• Multilateral lenders’ involvement as a deterrent against expropriation.• Joint ownership.

Problem (Expropriation)

Opportunistic behavior by host governments. They provide a critical input, the legal system and the protection of property rights. Either direct through asset seizure or creeping through increased tax/royalty. This causes an ex-ante increase in risk and required return.

Agency Conflicts between Ownership and Related Parties


Resolution of Agency Conflicts between Ownership and Debtholders

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Standard Approach

• Strong debt covenants allow both equity/debt holders to better monitor management.

Agency Conflicts between Ownership and Debtholders


• Cash flow waterfall reduces managerial discretion and thus potential conflicts • Concentrated ownership ensures close monitoring and adherence to the prescribed rules.• To facilitate restructuring, concentrated debt ownership, less classes of debtors, and bank

debt, are preferred. Bank debt is much easier to restructure than bonds.• With few growth options, the opportunity cost of underinvestment due to leverage is

negligible in project companies.• Opportunities for risk shifting do not exist because the cash flow waterfall restrict

investment decisions.

Problem• Debt/Equity holder conflict in distribution of cash flows, re-investment and restructuring

during distress. High leverage can lead to risk shifting and underinvestment.


Decrease in Asymmetric Information Costs

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Standard Approach

• Disclosure.

• Analyst-relationship.

• Institutional shareholder, activist game.

• Signaling

Decrease in Asymmetric Information Costs


• Segregated cash flows enhance transparency, which decreases monitoring costs.

• Segregation eliminates the need to analyze other corporate assets or cash flows. Creditors can analyze the project on a stand-alone basis.

• Project structure reserves the sponsors’ debt capacity/ flexibility to fund higher risk projects internally

Problem

• .Insiders know more about the value of assets in place and growth opportunities than outsiders. Asymmetric information increases monitoring costs and increases cost of capital (equity is more costly than debt).


Resolution of Under-Investment problem

Resolution of Under-Investment Problem

• Debt Overhang: Firms with high leverage, risk averse managers and asymmetric information have trouble financing attractive investment opportunities. This leads to under investment in positive NPV projects due to limited corporate debt capacity as new debt is limited by covenants.

• Standard Approach: Use of secured debt, senior bank debt, new equity (raised at a discount).

• Project Finance Approach

- Non recourse debt in an independent entity allocates returns to new capital providers without any claims on the sponsor’s balance sheet. This preserves scarce corporate debt capacity and allows the firm to borrow more cheaply than it otherwise would.

- Project finance is more effective than secured debt because it eliminates recourse back to the sponsoring firm.

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Project Finance as an Organizational Risk Management Tool

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Standard Approach• Hedging, or foregoing the project (under-investment)



• Project financed investment exposes the corporation to losses only to the extent of its equity commitment, thereby reducing its distress costs.

• Through project financing, sponsors can share project risk with other sponsors. Pooling of capital reduces each provider’s distress cost due to the relatively smaller size of the investment and therefore the overall distress costs are reduced.

• PF adds value by reducing the probability of distress at the sponsor level and by reducing the costs of distress at the project level. This facilitates the use of high leverage.

Problem• A high risk project can potentially drag a healthy corporation into distress. Short of actual

failure, the risky project can increase cash flow volatility, the expected costs of financial distress, and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it.

Risky projects impose deadweight costs on sponsors. Costs of financial distress represent a low of 3% up to 10-20% of firm value. They include both direct costs, such as legal expenses, bankers’ fees and indirect costs such as:

- Underinvestment by the sponsor.

- Underinvestment by related parties as distress may deter business partners, from making long-term investments.

- Lost sales as distress may discourage customers.

-Lost interest tax shield as volatility increases the probability of generating losses.

- Human capital

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• If a firm uses corporate finance, it becomes vulnerable to risk contamination, the possibility that a poor outcome for the project causes financial distress for the parent. This cost is offset by the benefit of co-insurance whereby project cash flows prevent the parent from defaulting.

• From the parent corporation perspective, corporate finance is preferred when the benefits of co-insurance exceed the risk of contamination and vice versa.

• Project finance is more likely when projects are large compared to the sponsor, have greater total risk and have high positively correlated cash flows.

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Risk (variance) is a proxy fro distress costs and the probability of risk contamination. Combined cash flow variance (of project and sponsor) with joint financing increase with:

–Relative size of the project.–Project risk.–Positive Cash flow correlation between sponsor and project.

Firm value decreases due to cost of financial distress which increases with combined variance

Project finance is preferred when joint financing (corporate finance) results in increased combined variance.

Corporate finance is preferred when it results in lower combined variance due to diversification (co-insurance).

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Corporate-financed investment involves the combination of 2 risky assets:

Sponsor (S) + Project (P)

Total Risk = Variance of Combined returns

Compare Risk with and without investment: Var(RP+RS) vs. Var(RS)

Portfolio Theory tells us:

Var(RP+RS) = wP2Var(RP)+ wS

2Var(RS)+ 2wPwSCorr(RP+RS)σPσS

where:

wP ,wS = proportion of value in the project/sponsor

Var(RP), Var(RS) = variance of project/sponsor returns

σP ,σS = standard deviation of project/sponsor returns

Corr(RP ,RS) = correlation of returns


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Financial Distress is costly :

Expected costs of financial distress = Prob(distress)*Cost of Distress

Probability(distress) is related to Total Risk, leverage and asset/,liability matching

Total Risk is a function of Risk Contamination.

So what factors matter the most for Risk Contamination?

Relative Size = Project/(Project + Sponsor)

Project Risk = Var(RP)

Return Correlation = Corr(RP,RS)


Project Finance as an Organizational Risk Management Tool Impact of Project Size on Total Risk (Project Risk = 50%)

Correlation of Sponsor and Project Returns

Big Project (wP = 50%)

Return Variance

Sponsor Stand-Alone Return Variance = 20%20%

1.0 -1.0

Medium Project (wP = 33%)

Small Project (wP = 5%)

Project Finance as a n Organizational Risk Management Tool

Impact of Project Size on Total Risk (Project Risk = 33%)

Correlation of Sponsor and Project Returns

High Risk (VarP = 50%)

Return Variance

Sponsor Stand-Alone Return Variance = 20%20%

1.0 -1.0

Medium Risk (VarP = 20%)

Low Risk (VarP = 10%)


• Usually diversification is beneficial. Here, diversification (corporate finance) can be worth less than specialization (project finance).

• If corporate-financed investment causes total risk, and hence costs of financial distress to increase enough, PF may reduces the incremental costs of financial distress by isolating and containing project risk.

- For project finance to make sense, the reduction in the costs of financial distress must exceed the incremental transaction costs .

- Project finance lowers the net costs of financing certain assets. Large, tangible, risky assets make the best candidates for project finance, particularly when they have returns that are positively correlated with the sponsors existing assets.

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Example

Consider a riskless sponsor. Its assets are worth 100 in all states of the world and it is financed with 30 of riskless debt. It has the opportunity to invest in a 0 NPV, risky project worth 200 in the good state and 0 in the bad state and is financed with 85 of (junior) debt. Assume that with the possibility of default, the costs of financial distressed imposed on the sponsors existing assets are equal to 5. The manager’s job is to decide whether to invest using corporate finance, invest using project finance, or not at all.

Assume:

- a one period model

- the good and the bad states are equally probable

- the risk-free rate is 0

- the manager is risk-neutral

- the organizational form does not affect operating synergies

- no structuring costs

- no relation between project structure and project cash flows 56


Example

• No investment: The sponsor is worth 100, the debt is worth its face value of 30 and the equity is worth 70. There is no possibility of default.

• Corporate financed investment: Assets are reduced by 5 in both states of the world. The new debt-holders invest only 75 for the project and equity-holders the remaining 25. Equity is worth 65 (=90-25). The equity-holders bear the distress costs. Managers acting on behalf on existing shareholders would not make the investment.

• Project-financed investment: The sponsor raises 42.5 of new project debt and invests 57.5 into the project. Default is contained at the project level and there is no collateral damage inflicted at the sponsor level. The sponsor does not incur incremental distress costs.

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Project Finance Versus Corporate Finance

Project Finance as Insurance

Project Finance as Insurance

Compare the choice faced by sponsors between corporate finance and project finance:

• When sponsors use corporate finance, they expose themselves to the full range of outcomes (NPVs).

• When sponsors use project finance, they truncate the downside. The

decision to use project finance can be thought of as the decision to buy a “walkaway” put option on the project. The combination of holding an underlying asset (project) and buying a put option on that asset gives the payoff function of a call option.

The downside protection may be valuable but the choice between corporate finance and project finance depends on the put premium and the willingness of sponsors to exercise the put option.

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Project Finance as InsurancePayoffs to Project-Financed vs.Corporate Financed Investment

Project Finance Payoff

Corporate Finance Payoff

Sponsor Equity Value

Project Value$0

Walkaway Put Option

$D


Tax and Other Benefits of project Finance

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• Location: Large projects in emerging markets cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive. Debt is the only option and project finance is the optimal structure.

• Heterogeneous partners:

– Financially weak partner needs project finance to participate.

– Financially weak partner if using corporate finance can be seen as free-riding.

– The bigger partner is better equipped to negotiate terms with banks than the smaller partner and hence has to participate in project finance.

• Tax: An independent economic entity allows projects to obtain tax benefits that are not available to the sponsors. When a project is located in a high-tax country and the project company in a lower tax country, it may be beneficial for the sponsor to locate the debt in the high tax country.

Taxes, Location, Heterogenous Partners

Part 4

Leverage and Financing Issues

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Debt offers multiple benefits:

• Tax Advantages.

• Helps to solve Free Cash Flow Problem.

• Helps to solve Political Problem (Hold Up)

There are lower bankruptcy costs than in corporate finance (large tangible assets).

Leverage and Financing Issues

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• Bank Loans:

– Advantages

• Cheaper to issue.• Concentrated ownership makes it easier for lending.• Tighter covenants and better monitoring.• Easier to restructure during distress.• Lower duration forces managers to disgorge cash early.• Bond market may be fickle.• Draw on credit line as needed.

– Disadvantages

• Short maturity.• Restrictive Covenants.• Variable interest rates.• Limited size.

Leverage and Financing Issues: How to Finance the Project:

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Project Bonds (144A Market):

– Advantages

• Private placement: does not through SEC registration procedure.• Lower interest rates (given good credit rating).• Less and flexible covenants.• Long Maturity.• Fixed rates.• Size, ($US 100-200 million).• Secondary trading.

– Disadvantages

• Disperse ownership:– less monitoring– less efficient negotiations

• New market• Lump sum nature

– Negative carry• Markets can change at any time making issuance difficult• Bond need investment grade rating

Leverage and Financing Issues: How to Finance the Project

Leverage and Financing Issues: How to Finance the Project

Project Bonds

• Project bonds have “negotiated” ratings: sponsors adjust leverage, covenants and deal structure until the projects achieve an investment-grade rating.

• The largest advantage in pricing and liquidity occurs above the BBB- cutoff due to institutional restrictions against investment in sub-investment grade securities. Bonds must have an investment grade to sell in the market.

• Since 1998, the percentage of project bonds with an investment grade (BBB- or higher) has ranged from 63% to 67%.

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• Agency Loans:

– Advantages

• Reduce expropriation risk.• Validate social aspects of the project.• Reduce political risk

– countries less likely to want to injure multilateral agency.

• Provide political risk insurance– Overseas Private Investment Corporation (OPIC) in U.S. – Multilateral Investment Guarantee Agency (MIGA) of World Bank

» provide insurance against political risks for up to 20 years.

– Disadvantages

• Cost (300 bp)

• Time (12-18 months to arrange)

• Insider debt:

– Reduce information asymmetry for future capital providers.

Leverage and Financing Issues: How to finance the project

Conclusion

Conclusion: Future of Project Finance

The future of PF will be shaped by many factors:

• Financing structure: There are four specific financing trends:

- hybrid project-corporate financings (corporate debt structure with project-finance-like covenants, with recourse to the sponsors in the event of default unless default is due to political risk); portfolio financing, i.e., the bundling of multiple projects into a single transaction.

- use of Term B loans, a bond with back-end amortization with bank-type covenants, heavily collateralized and carrying high interest rates.

- use of monoline bonds, bonds that wrap the credit rating of the insurer around the debt issue to raise the credit rating to AAA.

- participation of private equity, purchasing both non-distressed and distressed assets.

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Conclusion: Future of Project Finance

• Regulatory and environmental policy:

- new international capital standards (Basel II), risk-weighting of project loans.

- management of environmental and social risks (Equator Principles) whose focus is to assess and minimize the social risks of large projects.

• Expropriation risk has risen especially in developing countries; sponsors are increasingly challenged to design and implement sustainable long-term contracts and agreements with governments or face the risk of expropriation.

• Valuation of infrastructure assets with the infrastructure sector in danger of suffering from the dual curse of over-valuation and excessive leverage, the classic symptoms of an asset bubble.

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APPENDIX

Project Finance versus Corporate Finance: An example

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Example: BP AMOCOThe Corporate Finance Model

ProjectCost = $1 billion


Partner A25% sharePartner A25% share

Partner B35% sharePartner B35% share

BP AmocoBP Amoco

BusinessUnits

BusinessUnits Cash Management

and Money Market Instruments

Cash Management and Money Market

Instruments

Short-term Financing:• Commercial paper• Bank loans

Short-term Financing:• Commercial paper• Bank loans

TreasuryGroup

TreasuryGroup

OperatingCash Flow

$400m

40% ofCash Flow

$250m $350m

25% ofCash Flow

35% ofCash Flow

Long-term Financing:• Bonds• Equity

Long-term Financing:• Bonds• Equity

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Example:BP AMOCOThe Project Finance Model

BanksBanks

Partner B35% sharePartner B35% share

BP AmocoBP Amoco

Treasury Group(40% share)

Treasury Group(40% share)

Business UnitsBusiness Units

payback+interest

$300 millionsecured loan

40% of operatingcash flow

Partner A25% sharePartner A25% share


Equity = $400 millionDebt = $600 million


Equity = $400 millionDebt = $600 million

144A Bond Market

144A Bond Market

$300 millionsecured loan

payback+ Interest

$100 millionequity

$140 millionequity $160 million

equity

International Org.International Org.GovernmentGovernmentSuppliersSuppliersContractorsContractors

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Alternative Sources of Risk Mitigation

Risk Solution

Completion Risk Contractual guarantees from manufacturer, selecting vendors of repute.

Price Risk Hedging

Resource Risk Keeping adequate cushion in assessment.

Operating Risk Making provisions, insurance.

Environmental Risk Insurance

Technology Risk Expert evaluation and retention accounts.

Documents

Lecture on Project Finance