THE MECHANICS OF PROJECT FINANCE – A DISTANCE LEARNING COURSE IN PROJECT FINANCING CORE MODULE 1 An Introduction to Project Finance Steve Mills BA (Hons), MEI CEO, Abbotwood Limited

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TABLE OF CONTENTS

Page 1. STUDYING THE COURSE 3 2. MODULE 1 CONTENT 4 3. INTRODUCTION 5 4. STRUCTURE OF THIS COURSE 5 5. PROJECT FINANCE BASICS 7

5.1 What is “Project Finance”? 7 5.2 Corporate Structures in Project Financing 7 5.3 Project vs. Corporate Lending 10 5.4 Structuring to the Cashflow “Envelope” 10 5.5 The Sponsor’s and Lender’s Risk–Reward Relationship

with the Project 12

5.6 An Important Digression – Internal Rate of Return (“IRR”)

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5.7 The Disadvantages of Project Financing for Borrowers and Sponsors

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5.8 Reasons to Project Finance 17 5.9 Enter the Dragon! – The Impact of the Credit Crunch on

Project Financing 18

6. SUMMARY & CONCLUSIONS 21

© Copyright IIR Limited 2010. All rights reserved. These materials are protected by international copyright laws. This manual is only for the use of course participants undertaking this course. Unauthorised use, distribution, reproduction or copying of these materials either in whole or in part, in any shape or form or by any means electronically, mechanically, by photocopying, recording or otherwise, including, without limitation, using the manual for any commercial purpose whatsoever is strictly forbidden without prior written consent of IIR Limited. This manual shall not affect the legal relationship or liability of IIR Limited with, or to, any third party and neither shall such third party be entitled to rely upon it. All information and content in this manual is provided on an "as is" basis and you assume total responsibility and risk for your use of such information and content. IIR Limited shall have no liability for technical errors, editorial errors or omissions in this manual; nor any damage including but not limited to direct, punitive, incidental or consequential damages resulting from or arising out of its use.

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1. STUDYING THE COURSE We all have our preferred learning styles and tackle reading and learning activities in our own unique way. As the author and tutor for this course, it is my responsibility to keep you “interested” in the content and to try and help you remain motivated to learn. We will give you all the materials you need to gain a thorough understanding of the project finance sector. You will be able to take these away with you so you will need to set aside sufficient time and find a place where you can study the modules, be it at home, travelling or at work. For optimal personal development, you will need to fully engage in the learning process – studying the materials thoroughly, thinking about what you have read, reflecting on it, and no doubt challenging it. We aim to cover the subjects addressed in the course thoroughly, but you may at time wish to consult other sources on the internet, or maybe in a library, in order to delve deeper into particular issues that interest you. All these additional activities will enrich the value you get from this course. To gain a more complete understanding of project finance, you must go beyond just reading the content of each module, learning it “parrot fashion” and then moving on, without further thought or discussion with others. A large degree of thought has gone into the chronology of the modules and their sections – the ‘running order’ of this course. The sections in the modules are akin to the chapters in a book or a story, in that they build upon one another. We would respectfully encourage you to read them, in order to put you in the strongest position to address and absorb the key messages. Naturally, you will have your preferred pace and you may choose to dip in and out of the text, which is your prerogative. As a final note, a great idea that suits many people when studying by distance learning, is to consider writing their own brief summary of the key learning points being taken away at the end of each major section – which is sometimes called an “Elevator Pitch”. Where does the term “Elevator Pitch” come from? Imagine you are travelling a few floors in an elevator with your boss and he/she asks you “what did you learn from that last chapter of your course I saw you reading…?” You’ve got the time the elevator travels those few floors to succinctly tell them the main points you drew from the text. Have a go at drafting one. Remember that whatever you produce will probably vary from someone else – this is not a problem as you will probably have a different priority or focus on what is important to you in the section. Additionally, the disciplines of summarising and prioritising are very important for people to practice. Enough of the preparation and guidance for this course, let’s turn our focus to the first module.

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2. MODULE 1 CONTENT - AN INTRODUCTION TO PROJECT FINANCE What is “Project Finance” – How Does it Differ From Other Forms of Lending Who Uses Project Finance & Why?

• “Off-Balance-Sheet” lending • Project finance “Carve-Outs” • Joint ventures/unequal partnerships • Risk sharing • Capital rationing/return maximisation • “No Choice”

Key Characteristics of Project Finance – Corporate Structures & Contractual Relationships • Usually (not always) limited-liability “SPV” • Multiple contractual relationships:

o Construction contractor(s) o Suppliers o Offtakers o Operators o Insurance providers o Public sector – government bodies and agencies

Disadvantages for Borrowers/Sponsors

• Increased complexity (risk identification/mitigation/allocation) • Need for third-party due diligence reports • Longer time-lines • Higher debt costs – interest margins & fees • Supervision by & reporting to lender group • Tighter debt covenants and undertakings

Risk/Reward Relationships of the Players – Lenders & Borrowers/Sponsors

• Borrower/sponsor seeks to optimise return through NPV/IRR/WACC analysis and wide sensitivity analysis on both upside and downside

• Lender is not exposed to upside – in business of analysing and managing/mitigating/transferring risk

The Impact of the “Credit Crunch” on the Project Finance Markets

Learning Outcomes

• Explain the meaning of the term “Project Finance” and compare and contrast it with other forms of debt capital – especially corporate borrowing

• Set out the reasons why companies choose (or do not choose) to use project finance and

explain the contractual structures typically employed

• Contrast the risk/reward relationship with the project enjoyed by the sponsor with that of the banker and how this affects the lender’s attitude to acceptance of risk

• Explore the impact of the credit crisis on project financing – in particular how lenders’

attitudes have changed

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3. INTRODUCTION The good news is that project finance is not rocket science. It is often complicated, in the sense that it is necessary to master a large amount of detail and interpret the meaning of complex, interlocking contracts. The principles underlying project finance are quite simple, however, and can be easily understood. It is perhaps helpful to make a comparison with learning a new language. We can learn phrases and words and these can be quite useful, but only in a limited range of circumstances. As soon as we learn the grammar of the language, however, we can generate our own sentences and deal with a much larger range of situations. Our confidence is boosted and learning becomes easier and more enjoyable. Similarly, in learning about project finance we can look at a wide range of historical project structures and learn from them. We will not necessarily understand the logic which underlies how they have been put together, however, and what features are common to all or most of the structures. Or at least we will need to look at a very wide range of transactions over a long period of time before this becomes clear. The aim of this course is to provide its users with an accelerated and structured method of learning about this fascinating area of finance. To become a real expert does require experience, but the general principles of project finance are straightforward and can be learnt quickly, avoiding the need to learn by drawing one’s own conclusions from a large range of transactions. 4. STRUCTURE OF THIS COURSE In this distance learning course we will move from general principles to the specific methodologies applied in particular areas of project financing. First of all (in this module) we will consider: • what is meant by the term “project financing”; • what makes project financing different from other forms of lending; • the difference in the risk-reward relationships with the project enjoyed by the lender and the

sponsor1 (or sponsors) and how this difference affects their approach to the structure of the financing;

• the reasons why some companies use project financing and others do not; • the disadvantages of project financing when compared with other types of funding.

It will be important also to discuss in general terms the impact of the “Credit Crunch” on the project financing market, as this has been very significant. This will set the scene for us to study in the remaining core modules the project financing methodologies which provide the internal “engine” of most project financing structures. These can be seen as the project financier’s toolkit and they consist of three main elements: 1. Qualitative Risk Assessment, Risk Mitigation and Allocation (Core Modules 2 and 3); 2. Quantitative Risk Assessment, Economic Debt Modelling and Debt Structuring (Core Module 4); 3. Project Finance Documentation (Core Module 5). First we will be looking at the risk factors which a banker typically analyses when trying to decide whether or not to support a particular project with debt. The banker will essentially be trying to decide which risks are “bankable” and which require to be allocated to third parties or controlled by other means (risk mitigation). We shall study the risk areas of most concern to bankers and learn to apply a qualitative risk matrix which has been designed to prompt the key questions which must be answered to determine whether a project is bankable. Having decided to support a particular project, the lender will have to consider how much can be safely lent and how the financing (especially repayment of the debt) should be structured. This involves the use of the “debt-to-equity ratio” and forward-looking “cover ratios”. The former is used to ensure that a minimum amount of capital is injected by the sponsor. The latter have a number of uses: • To build in to the structure appropriate “cushions” or safety margins to ensure that the lender’s debt

service is adequately protected if the economics of the project deteriorate; 1 “Sponsor” means here (and throughout this course) the investor who is providing part of the project

construction cost and who wishes to raise funding from banks or other lenders to finance the rest of the project costs. The Sponsor will generally create and invest in a separate company (a Single-Purpose Vehicle Company or “SPV”) to own, construct and operate the project. This SPV will be the borrower of the project financing (see also below).

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• To allow the stress-testing of the project’s economics under adverse conditions by means of

“sensitivity analysis”; • To incorporate into the loan agreement certain “command-and-control” mechanisms which provide

early warnings of potential problems with the servicing of debt and which will bring the parties to the table for discussions well before the project company actually fails to meet its obligations or “defaults”.

There is an close relationship, which we shall explore, between the debt-to-equity ratio and the other cover ratios. Just as important is the relationship between the cover ratios and the investors’ return from the project, which is usually measured by the “Internal Rate of Return” on capital invested. It is very important for lenders to understand this relationship and to take it into account when structuring a potential loan. In my experience project lenders who have mainly participated in transactions structured by other banks, rather than acting as “Lead Arrangers” themselves, often do not understand this relationship well. They therefore frequently fail to appreciate the impact of their actions on an investor’s return, with obvious consequences for their chances of winning the opportunity to lead a financing. The final stage of the banker’s work is to document the transaction by means of detailed loan and security agreements, which will incorporate command and control structures designed to provide early warning signals as well as triggers to allow the lender to protect their position if the project begins to deteriorate and their debt service2 appears to be threatened. In Core Module 5 we will examine how these mechanisms operate and how they are embedded in the loan agreement. For those who are not especially familiar with wholesale lending agreements for financing to be provided by syndicates of banks it will be necessary to provide some explanation of the terminology used in such agreements. The emphasis however will be on the practical and commercial aspects of project loan documentation. In particular we shall focus on what borrowers and lenders disagree about most and the options which are available for resolving such differences. In Core Module 6 we will study the security instruments which are usually required by lenders to protect their interests when they are lending to a project SPV. Often a project lender will be providing a very large part (perhaps as much as 90%) of the costs of constructing the project. The lender will therefore require formal security documents to provide him with a first-ranking security interest in the assets and revenue streams of the project. This security is mainly defensive. It is taken to prevent other creditors acquiring a better position and a prior claim to assets and revenues. In this way the lender ensures that only a very small pool of preferential creditors (e.g. tax liabilities or employees’ salaries for a limited period) can enjoy a higher-ranking claim. If the project SPV becomes insolvent however, the banker will wish to have the right to enforce the security rights and, if necessary, to sell the project SPV or its assets to recover the project loans. Core Module 6 also traces the process of structuring, arranging and syndicating a project loan from start to finish. The roles of the different players (sponsor, lead arrangers, financial advisers and syndicate participant banks) are discussed in some detail and the impact of recent developments in the financing markets on lenders and borrowers are reviewed. The toolkit discussed in the core modules is widely applicable to all types of project financing, regardless of the nature of the project being financed (oil and gas, power, infrastructure or PPP). The differences between the sectors are really differences of emphasis. It is logical therefore for the newcomer to project finance to master these techniques before looking at how project finance in used in different sectors of the market. In the elective modules we will move on to examine how these tools are used in different business sectors. Each elective also includes a certain amount of sector background information – on the oil and gas value chain and the workings of liberalised power markets for example – so that newcomers to these sectors can appreciate how and why project financing methodology has been adapted by lenders to meet the needs of sector projects. The structure of the electives has been standardised as far as possible to make the learning process easier. Each elective is built up in the same way, with the following major areas: • Industry Background Information

2 Debt service means the sum of interest payments and loan principal repayments required to be paid by

the borrower.

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• Key Lender Risk Issues and Structuring/Pricing Drivers • Sector Structuring Methodologies • Case Study Building on the industry background information, the electives outline the key risks evaluated by lenders working in the sector and the major issues which determine the interest return and other fees which lenders will require to accept project risk. This leads naturally to an analysis of the standard structures – and their variants – which are used in the relevant sector. Each elective also includes a summary sheet which is intended to act as a quick reference (for example in the back of the taxi on the way to the meeting!). The electives all close with a detailed case study designed to allow trainees to test their understanding on a realistic transaction. 5. PROJECT FINANCE BASICS 5.1 What is “Project Finance”?

Projects can be financed in many ways, not all of which may be regarded as “project financing” in the sense in which bankers understand that term. The definition of project financing in the box (left) is one which most bankers would accept. The key issue in a project financing is that the lenders to the project have very limited access (“recourse”) to the balance sheet and revenues of the sponsor(s). Unless

other rights are negotiated, the lenders will typically have recourse only to the amount of equity which is being injected. If problems arise, such as construction cost increases or time delays, the lenders will not have a contractual right to call for more equity. This is why project financing is often also referred to as “limited-recourse” or “non-recourse” finance. The difference between the two terms is mainly one of point of view. Investors will tend to speak of “non-recourse” finance. They wish to emphasise the fact that once they have injected their equity into the SPV they cannot be called upon to provide further funding. Lenders tend to talk in terms of “limited-recourse” financing because they wish to stress the fact that few financings are truly non-recourse. Well-structured project financings, the lender will say, usually result from a careful risk analysis and an agreed sharing of risk with all parties understanding well which risks they accept. It is not always the case, as we shall see, that the best structure for a sponsor is one which limits recourse to the maximum. A sponsor may be able to negotiate a lower interest cost or increase the amount of funds lent to a project, for example, if he is prepared to accept certain defined risks. 5.2 Corporate Structures in Project Financing

The diagram (left) illustrates a typical project financing structure. Two sponsors working in joint venture have created a single-purpose project company into which they will inject equity. Project lenders are to provide loans to finance the remainder of the project cost. There could of course be a single sponsor, or more than two. The lender(s) could be a single bank, a small group or “club”, or a very large syndicate of financial institutions working under the leadership of a smaller number of “lead arrangers”.

A financial structure where lenders have recourse primarily to the

revenue-stream of the project or asset they are financing, rather than to the

balance sheet of the sponsors.

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The lender(s) and sponsors will agree the percentage of equity (owners’ funds) to be injected into the project company, with the balance of funds required to finance construction being provided by the banks. The sponsors will provide their equity in proportion to their ownership of the project company and will typically regulate their relationship by means of a formal joint venture agreement. The project vehicle is almost always a limited liability company. The sponsors will generally desire this, as they will want to have the protection which this provides against the banks “looking through” the project vehicle and being able to have recourse against the balance sheet and revenue streams of the sponsors. Project financings have been successfully structured however in cases where the project vehicle has been a limited liability partnership. Oil industry joint ventures can often be structured on an unincorporated basis and this does not prevent the use of project financing by one or more partners. Limited-liability project SPVs are much more usual however. The sponsors will usually inject their equity as a mix of ordinary share capital and inter-company loans. The ordinary share capital element will usually be kept to a minimum. Many countries insist on minimum levels of capital being provided as ordinary share capital and these levels will set an effective floor when the share to loan ratio is being considered. There are two main reasons for the sponsor to prefer debt over shares: 1. Ease of distribution

Accounting rules usually prevent the distribution of dividends on ordinary share capital until a company has generated accounting profits. It is quite possible for a company to be cash-positive before it has accounting profits. Injecting a large proportion of the equity funds as inter-company loans therefore allows a quicker return of capital – through interest on the loans and repayment of principal – than would be possible if all of the equity were injected as ordinary shares.

2. Tax efficiency

Interest on inter-company loans can usually be applied as a deduction against profits tax payable by the borrower and/or its group.

Lenders are generally quite comfortable to have equity funds injected in this way, provided that their own rights are protected by means of agreements which ensure sponsors’ payments have a lower priority than (i.e. are “subordinated to”) the debt service payments to the lenders. This may be a subject requiring considerable negotiation, with lenders for example being willing to permit interest payments on the subordinated loans but reluctant to allow the repayment of any of the loans until a certain amount of the bank loans have been repaid.3 We need, however, to add more “boxes and arrows” to create a picture of a typical project financing structure. The diagram on the next page builds on the one above, and is fairly typical of a project financing structure in the infrastructure or Public–Private Partnership (PPP) sector. The reader will note that in this case the SPV benefits from a concession granted by the government – which might provide an exclusive right for example to construct, own, operate and maintain a road, tunnel, hospital or other major asset to be used by the public. In the upstream oil and gas sector (exploration, development and operation of oil and gas fields) project companies are usually granted a licence, concession or production sharing agreement by a state body such as the Ministry of Energy. The diagram also shows oversight by a regulator, who is also frequently a very important counter-party for project companies. The regulator exists to ensure that business which operate as natural monopolies or near-monopolies (such as water, gas or power transmission utilities) do not abuse their position and that the security of supply for the end-user of the relevant services is not endangered. In addition to these contractual and oversight relationships, however, project SPVs generally also have contractual links to a significant number of other third parties. The most common ones are shown in the diagram below. There will usually be formal contracts with one or more construction companies governing the building or development of the asset in question. These contracts are, in project-financed transactions, frequently “fixed-price turnkey” (FPTK) in nature. FPTK contracts have the benefit (for the SPV) of transferring to the contractor a significant portion of the risk that the project may suffer time delays or cost overruns. We will examine this type of contract much more closely in Core Module 2. 3 There are some indications that banks are taking a stronger line on this issue since the “Credit Crunch”.

Before the crisis banks were often quite happy to allow repayment of sponsor loans even if this resulted in effect in an increase in the debt-to-equity ratio. It would seem that some banks are now only permitting such repayments if they do not result in an increase in this ratio.

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Where they are for example generating power, manufacturing products for sale or processing inputs into saleable outputs such as renewable fuels, project SPVs frequently need reliable supplies of feedstocks, raw materials or energy. For this reason they may contract on a long-term basis with suppliers, for specified volumes at a fixed, formula-driven (e.g. inflation-linked) or market price. As we shall see in Core Module 2, project lenders are generally much more comfortable accepting the price risk on the supply side than the so-called “volume risk” – the risk that sufficient volume of what is required will be available at appropriate quality. Where the project company is developing a mine, quarry or oil/gas field the supply risk is really one of the availability of sufficient reserves of ore or petroleum. This reserve or reservoir risk is a rather specialised form of supply risk and we shall spend much more time considering it in the oil and gas elective module. Banks look at “offtake” or sales risk in a very similar way, splitting it into “volume” and “price risk”. Some projects do not have long-term sale contracts for their output. This often reflects the fact that banks do not believe that there is a substantial risk that a project’s production will not be sold. This might be the case for example in the crude oil sector. Black oil (as opposed to natural gas) is traded in very large volumes on a “spot” basis. Where lenders see a substantial volume risk, perhaps because the project’s output has a limited number of potential buyers, they will generally seek the comfort of a committed long-term contract with a reliable “offtaker”, even if this is at current market prices. Banks feel much better able to assess and accept the risk of price fluctuation, which they will do through financial

modelling, than to accept the danger that the SPV might not find buyers for its output at all. Project SPVs may well benefit from a range of insurances. During the construction phase there will usually be cover such as contractor’s all-risk and third-party liability policies and perhaps also marine cargo to protect equipment packages on the high seas. When the project begins to operate it will be

necessary to put in place also policies to deal with issues like physical damage risk and environmental pollution hazards. In addition to these insurance covers, which are normal for any major construction project, project-financed transactions may also include additional insurance-based risk mitigation features such as:

• delay-in-startup insurance;

• business interruption insurance;

• political risk insurance;

• inherent defects cover. Because of the tailored nature of project financings, limited-recourse lenders generally prefer the insurance arrangements of a project to be structured by and for the project SPV. It is not usually acceptable for the project insurances to be handled within a comprehensive insurance package arranged by the sponsor on a group basis for its wider business. If the project financing is to be syndicated, prospective lenders will normally require a report from an experienced insurance due diligence consultant as part of the project information package submitted to them for review, so that they can satisfy themselves that the insurances arranged are appropriate and comprehensive. As we shall see, the predictability of a project’s forecast cashflow is one of the most important factors in determining the cost of a limited-recourse financing and the level of debt which lenders will make available. The arrangements for operating and maintaining the project are therefore of great importance and lenders will review them carefully. In some cases the SPV’s own staff will be responsible for the operation and maintenance (“O&M”) and this may well be the cheapest option. As we shall see in more

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detail in Core Module 2 however, lenders often feel much more comfortable if there is a long-term O&M contract between the SPV and a recognised and financially-creditworthy contractor. This offers a deeper reservoir of human and technical resources which can be drawn upon if the project experiences difficulties. It is likely to be a more expensive option and may not be preferred by the sponsor and/or borrower. The lender will usually be more interested in protecting the security of cashflow, however, rather than maximising the sponsor’s return. 5.3 Project vs. Corporate Lending With due respect to my former colleagues in corporate banking, I often think of corporate lending as the “work-horse” of bank lending to companies. It is not especially complex. Most critically, when a lender provides finance on a corporate basis by means of revolving credit lines or medium-term loans it is usually on a basis of full recourse to all the assets and revenue streams represented by the borrower’s consolidated group balance sheet. There is thus a spread of risk, or portfolio effect. The lender generally also has access to historical accounts which may go back over a long period of time and which provide a good insight into a borrower’s key strengths and weaknesses and potential areas of vulnerability. Peer group analysis may also be possible to compare the borrower’s income statement, cashflow and balance sheet ratios with those of other companies in the same sector. Especially if they have a maturity of several years, corporately-based facilities may well incorporate ratios and covenants to protect the lender’s position. Some forward-looking cashflow projection work may also form part of the prospective lender’s due diligence. The lender derives most comfort, however from the breadth of his recourse and the historical performance analysis he has carried out.

Project finance is all about predicting and projecting rather than the application of historical credit analysis. The project SPV is generally a new company with no performance history. A limited-recourse lender is typically asked to lend a high proportion of a project’s construction cost based on predicted performance, with recourse being limited (once equity has been injected) to the revenue streams and assets of a single venture. If there is no cashflow, or insufficient cash generation to meet operating costs and debt service, the value of the project’s assets will probably be low. Project lenders are thus primarily cashflow-based lenders.

5.4 Structuring to the Cashflow “Envelope” Project bankers must structure a financing around a predicted cashflow “envelope”. From the envelope, the size of which is necessarily an estimate, certain costs will need to be paid in a strict order in a given operating period. Operating costs must come first, since if they are not paid the project will come to a halt. Taxation must effectively be treated in much the same way as direct operating costs, since a failure to pay the project’s tax liabilities is likely to result in the project being closed down. Only once these two prior claims on cashflow have been met can the lender lay claim to project cashflow to meet interest liabilities and to begin to repay his loan. Once the lender’s claims in a given period have been met, any remaining cashflow is available to be distributed to the sponsor(s) of the project, as dividends on ordinary share capital and/or interest payments/capital repayments in respect of intercompany loans from the sponsor to the SPV as part of the project’s equity. The need to regulate the use of project revenues carefully is the main driver behind the concept of the cashflow “waterfall” or “cascade”. In any given period during the operating life of the project, lenders will wish to control the expenditure of cash generated by the project, primarily to ensure that there is no over-spend on operating costs (including taxes) during that period which might endanger the making of debt service payments.

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Surplus cashflow after the payment of operating costs including taxes is normally referred to as “Cashflow Available for Debt Service” or “CFADS”. This is a very important measure in project financing, for a number of reasons. Pre-CFADS cashflow is not available to the lender as it must be spent for the project to function. Projected CFADS is therefore the starting point for the lender’s structuring of the limited-recourse financing. The lender will develop a “base case” cashflow projection against which he will “sculpt” a loan repayment schedule to ensure that sufficient margins of safety are available between total anticipated CFADS and the amount which is to be used to pay interest and repay loan principal. The margins of safety will then be stress-tested under adverse conditions, with the lender constructing “sensitivity cases” where in particular:

• the loan amount structured in the base case analysis has been fully utilised, but CFADS is weaker than expected – e.g. sales revenues are reduced or operating costs are increased;

• CFADS is as expected but the loan amount is increased – e.g. as a result of construction cost increases or time delays.

Because limited-recourse financings are tailored to a predicted cashflow envelope, project finance cannot possibly be a “fire and

forget” type of instrument. It is indeed much more “fly by wire”, requiring detailed and project-specific command-and-control mechanisms which must be forward rather than backward looking. These mechanisms frequently require regular revisions of predicted projected cashflows so that underperformance against base case expectations is picked up early and remedial action can be taken. Project financings therefore generally include significantly greater reporting obligations, more forward-looking ratio tests and tighter controls on cash distributions than corporately-based loan instruments.

Project financings are “Term Loans” With few exceptions, limited-recourse project financings are generally structured as “term loans”. One important exception is in the area of upstream oil and gas project lending, where certain facilities are structured as revolving credits although they share many other features with conventional project term loans. The project SPV will utilise or “draw down” the loan facility during an “availability period” which broadly matches the construction period of the project. During the construction period the borrower will normally be cashflow-negative, meaning that interest due to the banks will have to be added to the loan or “capitalised”. On completion of the project’s construction the loan facility will cease to be available for drawing and any unutilised debt capacity will be cancelled. An agreed repayment schedule mechanism will then begin to apply and interest will be required to be paid rather than capitalised. Two features of term loans are worth emphasising further. They are:

• drawn once and repaid once – amounts repaid are not capable of being redrawn as in a revolving loan facility;

• not repayable on demand – they are repaid in accordance with a pre-agreed schedule or mechanism and can generally only be declared due for repayment at an earlier stage by the lenders on occurrence of an event of default.

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Sponsors and borrowers are sometimes surprised by the range of circumstances in which a project lender can call an “Event of Default”. It should be remembered however that calling an event of default is something of a “nuclear button” which lenders will certainly not use without a great deal of careful deliberation. If an event of default is called, the SPV will almost certainly not be able to repay, since the debt facility will have been structured so as to require the use of cashflow throughout much of the life of the project in payment of debt service obligations. The failure to repay will admittedly give the lender the ability to enforce security, including potentially the right to sell the project SPV as a going concern or on a break-up basis.4 Whether this will enable him to recover his debts however is another matter. It is better therefore to see events of default – or the threat of their use – as a method of bringing all interested parties to the table to discuss the restructuring of an ailing project. They will certainly be invoked with caution and reluctance by lenders.5 5.5 The Sponsor’s and Lender’s Risk-Reward Relationship with the Project It would be simplistic to think only in terms of “sponsor versus lender” when considering their relationship with a given project. While their interests and drivers are different, it is critical to achieve a balance between their needs if a well-structured project financing is to be achieved. What must not be forgotten, however, is that their risk and reward profiles are quite different. The sponsor is exposed both to downside risk and to upside potential. He or she ranks behind the project’s lenders as regards their claims on the project’s cashflow. In an insolvency the return of their capital will only happen if the banks have been fully repaid. If the project outperforms expectations, however, the sponsor can expect to receive a return which reflects this outperformance. Indeed, because of the effect of gearing (see below), the sponsor’s return on investment may in such cases be very attractive indeed. The sponsor may be expected therefore to focus on the return on their investment. A project lender is exposed to potential downside risk, but rarely has any upside potential. If the project under-performs expectations, the lender could lose a significant part of their loan capital. At the limit – if for example the project is never built – they could lose it all. The lender’s interest return is typically fixed at the outset, or if it varies it does so within a known and relatively narrow band. If the project performs well the lender will usually not share in the excess returns. Indeed, if the over-performance is substantial there is a good chance that the lender will be repaid early. Thus a loan which a lender expected to have on their books for a significant period generating an attractive return may well disappear much more quickly than expected. With little or no upside potential and substantial downside risk, and with little opportunity to increase their return, the lender may be expected to focus principally on the return of their funds. The above comparison is not intended to make the reader feel sorry for bankers. As an ex-banker myself I know that it is almost impossible to generate sympathy for our profession. I have never understood why this should be! The reason for emphasising the contrasting positions of sponsor and lender is to make clearer why lenders approach project analysis and debt structuring as they do. With little scope to share in upside and the potential for losing all of their investment (which might represent as much as 90% of project construction costs), the lender will be intensely focused on analysing and controlling risk, not maximising returns. Although project finance returns are higher than those which can be earned in corporate lending, they cannot possibly compensate for substantial losses of project principal. If a bank project finance team incurs a substantial loss on more than a very small number of project loan transactions, its very survival will potentially be at risk. 5.6 An Important Digression – Internal Rate of Return (“IRR”) 4 There is significant evidence that project lenders who do not use their security rights to dispose of the SPV or its assets in (part) settlement of their debt, but rather try to manage their way through the issues, do ultimately achieve better outcomes in terms of their debt recovery percentage. Some project lenders have indeed made substantial profits, after a period of “care and maintenance” from the disposal of project assets which they were forced to acquire when changes in market conditions wiped out the equity of the project sponsors. 5 In fact it is often the case that the collapse of a project SPV is precipitated by the directors of the company rather than its lenders. Many legal systems impose harsh penalties on directors who allow their company to continue trading when they are aware that the company is not solvent. It is frequently the recognition of this situation, and the (often) personal liabilities which it could involve for the directors, which triggers an approach by them to the banks.

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IRR is a very important concept in project financing. It also one of which, I have certainly found, some project lenders have only a hazy understanding. Readers who are fully familiar with the time value of money, discounted cashflow and IRR may wish to skip over this section. Many actions of the lender in structuring a financing have a major impact on IRR, which is a (perhaps the) key measure of an investment’s attractiveness for the sponsor. We shall see in particular in Core Module 4 how close the relationship is between the lender’s “cover ratios” and the sponsor’s IRR. Without wanting to enter deeply into investment appraisal techniques, it is perhaps useful to approach this topic by examining the different ways in which an investor can measure the attractiveness of competing investment opportunities. The simplest way in which the return from investments can be compared is by using the “cashback” technique. The investor calculates how long is required for his capital investment to be repaid. A project which has a shorter cashback period looks more attractive than one which takes longer to return the invested capital. The major drawback of cashback is that it takes no account of the time value of money. Two projects with the same capital investment and the same time period to full cashback will be rated equally, even if one has a slower rate of investment than the other or a different distribution of cash received during the payback period. This is illustrated in the table below. Despite the different timing of the capital injection in these two cases, the cashback method treats both projects as effectively being of equal value.

These examples illustrate how cashback ignores the time value of money. Although in Project B the investor does not need to inject capital until the final year of the construction period, the cashback method gives no value for this, whereas in fact the investor would have the benefit of this cash for at least two years and could for example earn deposit interest on it. This important failing of cashback is addressed by the use of discounted cashflow (“DCF”) techniques. If the investor discounts future inflows and outflows by a string of discount factors which increase over time and which are set by reference to a chosen discount rate, the sum of all these discounted values will provide a “net present value” for each potential investment. These net present values (“NPVs”) can then be compared and an assessment can be made of their attractiveness which does take account of the time value of money. The impact of this can be seen in the tables below, which apply NPV techniques to the same two projects.

In Project A the sum of the discounted future values of inflows and outflows is 51.20, based on a discount rate of 10.0%. Using the same discount rate we derive an NPV of 57.03 for Project B, with the difference between the two values being due to the slower rate of equity injection in Project B. Assuming that the investor is acting in a rational economic manner, he should prefer Project B. NPV is clearly a major step forward from cashback, but when using it there is always a need to ensure that the same discount rate is being used to evaluate competing investments. IRR removes the need for this. The internal rate of return is that rate of discount which returns an NPV of zero. In the tables below

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a spreadsheet-based model has been programmed to calculate that discount rate (it does this by a process of iteration) which reduces the NPV of the cash inflows and outflows to zero. It might help the reader to see IRR as measuring how hard the cashflows can be discounted before they are effectively eliminated. In the case of Project A this occurs at 18.38%, while Project B can be discounted by up to 21.37% before a zero NPV is reached.

An investor who knows an investment’s IRR does not need to ask what discount rate is being used as is the case with NPV. Also, the investor can compare the IRR with his own “Weighted Average Cost of Capital”. “WACC” measures the weighted average cost of the investor’s capital which will typically come from a number of sources – investors, creditors, bank lenders etc. If the IRR of a project exceeds the investor’s WACC then logically it is worth considering, although a premium to reflect the risk of the project will be required. It may be felt that too much emphasis has been given to this topic but just as it is important for a sponsor to understand the lender’s drivers and “hot buttons”, so the lender must have an appreciation of the tools which the sponsor will use to measure the attractiveness of a particular financing proposal.6 We shall refer to investor IRR repeatedly in the following modules. Bankers who have structured project financings as lead arrangers typically appreciate much better the potential impact of their actions on investor rates of return and how this might affect their prospects of winning a particular transaction. Those who have not structured such financings, but who aspire to do so, need to develop an understanding for those structural features which impact sponsor IRR most heavily. 5.7 The Disadvantages of Project Financing for Borrowers and Sponsors It may seem rather odd to deal with the disadvantages of project financing for borrowers and sponsors before addressing the reasons which lead some companies to use this technique. By looking first at the disadvantages, however, we will perhaps see more clearly why limited-recourse financing is very much a specialist form of finance which will be avoided by borrowers who have an alternative method of raising debt. First of all, project financing is expensive when compared with debt raised against a creditworthy company’s balance sheet. Because project lenders are asked to share in the risks of a project, to contribute a very substantial portion of the project’s costs and to limit their recourse to the project’s owners, it is logical that they will require a higher return. This requirement will be reflected in both higher interest margins (see box overleaf) and higher arrangement fees. The higher interest margins recognise the greater risks which are being assumed by the lenders and the higher arrangement fees compensate them for the much greater burden of analytical and structuring work which they will need to undertake, possibly over a period of many months. The higher costs incurred by project borrowers do not arise solely as a result of increased lender returns however. Banks providing debt against a project will frequently also require detailed reports from third-party “due diligence” consultants to assist in the work of risk analysis and finance structuring. The costs involved in due diligence reporting can be substantial and they are required to be borne by the project SPV, whether or not the financing ultimately goes ahead. In most cases these costs are financeable, and will be effectively be paid for out of equity and debt in the agreed ratio. The debt thus incurred will however ultimately have to be serviced from project cashflow. 6 It may also be felt by those more familiar with this area that the treatment of investment appraisal given here is simplified to the point of being simplistic. The intention is not, however, to provide the more detailed analysis which would be appropriate in a corporate finance textbook. The aim is simply to lay the foundations necessary for the quantitative analysis work to be undertaken in Core Module 4.

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Given the above, the gestation period of project financings is generally much longer than that for corporate loans of comparable size. The need for exhaustive bank analysis, due diligence reporting, preparation of comprehensive information memoranda where syndication is planned and the obtaining of credit approvals (potentially from a large number of banks) means that the time from first discussion to financial close is rarely less than three or four months. It can extend to a period of a year or two for very large projects with complex, multi-sourced financing arrangements. Because of their greater risk acceptance and financial exposure, project lenders will also seek much greater rights of supervision and will expect much more extensive reporting than would be the case for corporate facilities where the lenders are protected by their access to a large and relatively liquid balance sheet. Lenders will require that they and/or their technical consultants shall have the right to visit the project to check on the progress of construction and on project operations, frequently at short notice. It is common for the borrower to be required to submit technical information and to provide construction milestone reporting in support of drawdown requests during the construction period, so that the lenders can track progress and anticipate the emergence of any time or cost overrun. Even once the project is operating, lenders will insist on regular financial and/or operational performance reporting, including (usually) the running of regular revised cashflow projections to check that debt-servicing cover remains acceptable.

“Bips” and “Spreads” – Project Loan Interest Pricing Project financing loan agreements are most often arranged by banks based in major money centres (especially London), even if the borrower or project is located in emerging market. As such the way in which such banks typically fund their operations has a major impact on the way in which these borrowing instruments are “priced”. Unlike emerging-market banks, which often fund themselves very heavily from customer deposits, money-centre banks may well have quite a small deposit base, particularly if they do not have a developed branch network. Equity/retained earnings will be a (small) source of funding for operations and many banks also issue long-term fixed rate bonds to investors. This latter source of finance is a very welcome source of long-term funding at stable cost, but its share of the overall financing mix is generally small. Many money-centre banks are therefore heavily reliant on the inter-bank money markets for the funding of a large part of their loan portfolio. In this market banks lend to and borrow from each other, with surplus banks funding deficit banks with short-term advances of up to 12 months’ duration, which are frequently “rolled over”. The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money (interbank) markets. LIBOR is calculated by and published by the British Bankers’ Association (BBA) after 11:00 am (and generally around 11:45 am) each day (London time). It is an average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. LIBOR is calculated for 10 currencies. Euribor (Euro Interbank Offered Rate) is the rate at which euro interbank term deposits are being offered by one prime bank to another within the EMU zone. Because inter-bank deposits are the dominant (and the marginal) source of finance for money funding for money-centre banks, these financial institutions tend to price their loans to wholesale borrowers such as major companies (and project borrowers) by reference to the cost of this source of funding. Thus, in common with other types of large-scale corporate borrowing, the interest payable by project borrowers is usually charged at a margin over LIBOR or Euribor. Although finance is committed over a period of as long as 20 years or more, the day-to-day cost of the SPV’s borrowings is fixed periodically (usually for periods of 1, 3, 6 or possibly 12 months) with the underlying LIBOR/Euribor rate changing to reflect movements in the markets and the margin remaining the same (or at least not changing as Euribor/LIBOR changes). The size of the margin is a reflection of the perceived risk of the borrower. Major corporate borrowers with a strong balance sheet might borrow at a margin significantly below 1%. Project borrowers in today’s market might have to pay a risk margin or “spread” of 4% or more. Margins are often quoted in hundredths of 1% or “basis points” (“bips”).

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Project finance documentation is more detailed, prescriptive and onerous for the borrower than corporate loan agreements. Indeed borrowers who are new to this type of financing are frequently surprised by the extent to which the lenders could be seen as interfering in the day-to-day running of their business. Lenders usually reject any suggestion that they are interfering unduly, and they will certainly wish to avoid any suggestion that they might be regarded as “shadow directors” of the borrowing company. They will point out that they:

• are providing a substantial amount of the cost of project construction;

• lend against a projected cashflow “envelope”, the predictability of which is by no means an exact science;

• commit funding to a project over periods of up to 20 years or even more, when their sources of funding are overwhelmingly of much shorter duration;

• generally will be expected by the sponsors/borrower to increase the debt level (as compared to equity) to the highest level which the project SPV can sustain;

• are not exposed to project upside potential, but do share downside risk;

• receive returns which, although high by banking standards, cannot possibly compensate them for losses of principal.

Against this background lenders’ requirements for further-reaching control features than would be required in shorter-term corporate loan facilities may not seem so unusual. The restrictive features included in project finance loan agreements typically include:

• prohibitions/severe limits on the raising of new debt by the project SPV;

• a requirement that the SPV shall not create new subsidiaries and/or engage in new projects without the lenders’ approval;

• limitations on contracts with other companies within the sponsor group;

• controls on distributions to shareholders by the SPV when actual or predicted cashflow falls below certain levels.

As we shall see in Core Module 5, these restrictions will be built into a detailed list of “covenants” or “undertakings” within the project financing agreement, which will also include a set of events of default designed to trigger lenders’ rights to accelerate repayment of the debt and if necessary to enforce their security. Especially where they receive significant levels of negotiated support from sponsors, lenders may also seek to bind sponsors by means of selected covenants and events of default. If, for example, sponsors are providing debt guarantees up until the point of project completion, lenders may seek to incorporate an event of default which would become effective if the sponsors’ credit rating(s) suffered a downgrade. They will often also try to constrain sponsors’ ability to dispose of their interest in the SPV, especially during the all-important construction period. Given the limited-recourse nature of project finance, sponsors will naturally seek to limit any extension of covenants and events of default beyond the project SPV and, as we shall see, this is frequently a heavily-negotiated part of the financing agreements. In addition to the financing agreement provisions, lenders will also “ring-fence” the project SPV by means of far-reaching security agreements designed to give the lenders a first-ranking, fully-perfected security interest in the assets and revenue-generating agreements of the company. We shall look in more detail at the nature of the instruments used to create these security interests in Core Module 6. They tend to be project-specific and will also be heavily influenced by where the project assets are located. Suffice it to say here that wherever possible the lenders will wish to create security interests over most or all of the following: 1. The share capital of the project SPV owned by the sponsor(s); 2. Any licence or concession agreements which regulate the activities of the SPV; 3. Contracts for the construction and operation/maintenance of the project; 4. Fuel and raw material supply agreements; 5. The fixed physical assets of the project; 6. Current assets such as stock, debtors and cash; 7. Key revenue-generating contracts such as sales agreements; 8. Policies of insurance (usually with the lenders named as loss-payee in the event of a claim being

made).

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The objectives of the lenders in putting such security agreements in place are mainly defensive. They will wish to ensure that:

• their claims against the project SPV rank higher than almost all other creditors,7 defeating the “pari passu” principle whereby all creditors will generally be treated equally in the event of insolvency;

• they have rights of inspection and supervision, so that they can monitor and protect the value of the project’s assets;

• disposal or mortgaging of project assets will be difficult without their agreement;

• they have rights of seizure and (especially importantly) sale with regard to the SPV or its assets if this necessary to recover their debt.

The reader will not be surprised to learn that project financing documentary packages can run into many hundreds of pages. The project finance loan agreement itself may well be 200 pages long. Indeed, project financing documentation is almost certainly becoming longer. Fortunately however it also becoming clearer and easier for non-lawyers to read and interpret! 5.8 Reasons to Project Finance Against the above background, it might appear strange that sponsors and borrowers should choose to use project finance at all! But they do – and for a variety of reasons. 1. The most obvious is that some companies have no

choice. They simply do not have the financial creditworthiness to be able to raise the required funding against their balance sheets. An independent oil and gas or mining company for example, which might just have been established, may be contemplating a project which dwarfs the company at its current stage of development. A developer of a renewable energy project, such as a windfarm or biomass-burning power station, may not have the financial track record and corporate net worth to convince a bank to lend on a corporate basis. Such borrowers have little option but to seek to convince a lender that he should take a project view and advance the bulk of the required capital as loans against a limited equity injection from the sponsor.

2. Slightly larger companies may have access to more

significant resources but may still wish to ration available capital across a range of projects, asking lenders once again to provide the largest part of the required finance as debt. Construction companies bidding on major infrastructure projects to be built under concessions or PPP arrangements may be required to take an equity stake in the concessionaire company, but such investors will not wish to tie up large amounts of scarce capital given the capital-hungry nature of their core business. Their prime objective is after all usually to win the construction contract. The ability to inject a small amount of equity, probably alongside other investors, and have banks fund the largest part of the project’s cost is an attractive option. The fact that the “gearing” effect brought about by the lower long-term cost of debt will enhance the return on equity invested is a happy by-product (see box).

7 As mentioned above the list of “preferential creditors” is quite small and will usually include liabilities to the tax authorities and perhaps also employee payments for a short period.

“Gearing” or “Leverage” When project lenders refer to the gearing or leverage of a project, they mean its debt-to-equity ratio. Gearing is the English term, while leverage originates from the US, but they are used interchangeably in project lending. It is important also to understand the “gearing effect” of raising the debt level of a project while reducing the amount of equity subscribed by its sponsors. The interest payable on debt is in most cases available as an offset to reduce corporate/profits taxes. The fact that the lenders do not receive a return linked to the performance of the project means that any performance upside in a highly-geared (high debt-to-equity) project feeds through to a very small equity base. The combination of these factors means that there is a very considerable accelerator effect on IRR as gearing levels are increased. Other things being equal, therefore, we might expect sponsors to push for the highest possible level of gearing to maximise investor IRR.

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3. Despite the significant disadvantages of limited-recourse finance for major corporate borrowers, large companies do use project finance. A key reason for this can be the desire to share specific risks with lenders.

We might consider the case of a major oil company considering the construction of a pipeline spanning a number of emerging-market countries with a history of some political instability. The oil company might be completely comfortable with the (possibly considerable) technical and construction challenges presented by the pipeline, but nervous that changes of regime or government policy in a transit country could result in negative consequences for the users of the pipeline and its investors. A transit country situated at a mid-point on a long and major pipeline does after all have some economic influence if it feels its interests are not being respected! If the pipeline is financed on a project finance basis, the sponsor can simultaneously:

• limit their exposure in financial terms (by investing a modest amount of equity rather than funding the whole project on a corporate basis);

• share the risk of adverse government actions with the lenders, who will suffer along with the investors if the project is damaged.

The sponsor may also feel that the risk of interference by transit country governments will be reduced if a wide range of important international financing institutions are also involved and stand to lose in the event that a transit country host government takes hostile action. While an emerging market country government may consider that it can accept the risk of upsetting a single international oil company, it may think twice about incurring the hostility of a representative slice of the international banking community. The support of such lenders may be required at a later stage.

4. Perhaps the most common reason why major companies overcome their general aversion to project

finance is in circumstances of joint venture or unequal partnership.

A major national power company, in expanding outside its own home country, might for example find itself in partnership with much smaller renewable power developers who are quite incapable of funding their share of the cost of project developments on a corporate basis. The last 20 years have seen a number of joint venture oil and gas and petrochemical projects in the Middle East between very large private-sector international companies and national oil or petrochemical companies in the region. It would certainly not be the first instinct of the international sponsors in such cases to employ project financing. Indeed they might resist it quite fiercely on the basis that the higher cost of limited-recourse finance when compared with balance-sheet-based debt constitutes a major drain of economic rent away from the project owners to the banks. If however the national partner is capital-constrained, wishes to ration resources carefully to allow for upcoming projects or (as is sometimes the case) believes that the involvement of international banks brings valuable discipline and structure to the process, the international partner may have little choice to agree to the use of project-based finance.

5.9 Enter the Dragon! – The Impact of the Credit Crunch on Project Financing The general impact of the “Credit Crunch” in 2007–08 is well understood and its effects are still with us. The reduction of banks’ lending capacity as a result of losses arising in connection with the collapse of the US housing market, coupled with an acute dislocation of the interbank markets, caused a sea-change in the relative positions of lenders and borrowers in the wholesale debt markets. Up until the advent of the credit crisis the financing markets had consistently been remarkably liquid for the longest period of time that many market participants could remember. Banks and other financial intermediaries were the beneficiaries of a regular flow of liquidity (if beneficiary is the right word to use of a process which steadily eroded bank returns). Banks’ ability – in fact their need – to lend during this period created conditions of acute lender competition, with banks actively pursuing borrowers and offering pricing and structural conditions which would certainly not have been available in conditions of lower market liquidity. What was true in general terms was equally true for project finance. In these conditions of fierce lender competition it was possible for the strongest and most sophisticated sponsors to achieve extremely fine pricing by the standards of limited-recourse financing. Through the astute use of skilled financial

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advisors, sponsors were also increasingly able to achieve more borrower/sponsor-friendly structures than lenders would have preferred. For big-ticket, multi-sourced projects with the highest visibility in the markets the “financing competition” increasingly became the norm, with potential lenders being required to bid – almost exclusively on price and in conditions of tight confidentiality – on structures developed by advisers to the sponsors. So fierce was this competition that risk margins over LIBOR fell to levels which many lenders felt did not reflect the risks they were being asked to accept, the more so since because of competition the level of risk assumed by lenders was increasing. Risk margins for Middle Eastern transactions fell considerably below 1%, while spreads for very long-term infrastructure or PPP projects (25–30-year maturities) in OECD countries often struggled to rise above 70 bps. Arrangement fees for project finance transactions also came under severe pressure during this period. It has always been the case that the amount of work involved to structure and arrange a transaction is by no means proportionate to its size. Small transactions often require just as much work as much larger ones. Across the board however fees were cut sharply as banks competed for the available transactions. The “rule of thumb” arrangement fee of 1% for a transaction of reasonable size (at least as a starting point for negotiation) came under very strong pressure. The Credit Crunch triggered not so much a swing of the pendulum as a violent lurch! In all bank lending sectors the power of the borrower diminished as the issue became one of raising sufficient credit capacity to finance a transaction, rather than negotiating the last few basis points on the margin. Project finance in particular came under significant pressure because of the very long maturities of its loan facilities. Banks had just been reminded very forcibly of the fact that their business was one of “borrowing short and lending long” and the spectre of depositors queuing to require the return of their funds caused an understandable reassessment of whether it was really “banking business” to lend over 25 to 30 years. This was particularly true when banks could earn attractive margins on much shorter-term transactions in the new, tighter credit environment. Where banks did agree to offer long “headline” maturities they showed a strong tendency to include features in loan structures designed to shorten actual loan maturity, such as cash-sweeps8 and mini-perms,9 or to encourage refinancing (particularly aggressive margin ratchets10). Some banks have withdrawn completely from the project finance market. Other names have disappeared as a result of mergers with other project finance market players (RBS and ABN-Amro, BNP Paribas and Fortis). It has been noticeable that there has been a tendency by those banks which have received significant state support to concentrate more strongly on projects in their own home markets. Even the lenders who have remained most active have, for a time at least, been extremely cautious about longer-term maturities. Margins have increased sharply, with those in the infrastructure and PPP sectors doubling or even trebling. Fees have also risen sharply so that the rule of thumb number is probably now closer to 2% than 1%. Bank credit committees are noticeably more cautious than before the crisis and the time taken for the bank approval process has lengthened appreciably. Lenders have also in recent times been more selective with regard to the projects (and sponsors) they will support. Debt-to-equity ratios have eased down somewhat from their pre-Crunch levels and the safety margins required within structures have 8 We shall meet the cash-sweep again in Core Modules 4 and 5. Essentially a cash-sweep is a mechanism which requires the borrower, after normal debt service, to use part of any surplus cash in a given operating period to make additional debt repayments – before any distributions to sponsors. Originally used more for projects with highly-volatile cashflow profiles, the cash-sweep has been used more widely since the credit crisis as a means of accelerating the repayment of project debt. 9 The “mini-perm” is a variation on a methodology previously used for assets with a very long operating life (such as gas pipelines). Mini-perms have been used recently in financings with long maturities (15 years plus) to impose a refinancing obligation on the borrower, say by year 10 of a 20-year transaction. In a “hard” mini-perm failure to refinance would result in an event of default. In a “soft” mini-perm a 100% cash-sweep obligation would result. Both types of mini-perm offer bank credit committees an increased degree of comfort that the facility will not in fact ever reach its “headline” maturity. 10 Banks conventionally expect their margins on lending to increase over time, reflecting the increased risk to them of long-term loans when they raise much of their debt in shorter-term markets. The rising profile of margins over time is often referred to as the margin “ratchet” because the margin “clicks” up in known steps over defined periods (years 1–5, years 6–10 etc.). Where banks wish to incentivise early refinancing – to shorten maturity perhaps – or to give themselves an opportunity to earn additional fees on a refinancing – they will increase the size of the steps in the margin ratchet in the later years of the facility’s life.

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become more generous to lenders. Cover ratios have increased somewhat and banks tend to include reserve accounts for debt service and maintenance costs in their term-sheets. They are not inclined to negotiate too much on these issues and borrowers have found themselves agreeing to lenders’ requirement in order to put financing in place. It must be expected that sponsors/borrowers will seek refinancing when market conditions ease in order to improve their financing terms. Banks certainly expect this and we have seen the re-emergence of the “pre-payment penalty” to a degree, with banks seeking to compensate themselves for lost earnings when refinancing becomes attractive. We shall look in more detail at the impact of the Credit Crunch on loan documentation in Core Module 5. There has been some indication that banks, recognising on the one hand that they need to do business and on the other hand that margins and fees are at very attractive levels, have become somewhat less demanding in their requirements. The situation is a fragile one however, which is very susceptible to influence by developments in the currency and interest rate markets. Syndication remains difficult, and underwriting especially so, with lenders preferring in most cases to work on a “club” basis. This means that smaller deals (say up to €150 million or so of project debt) will generally be done by single banks, or small groups of banks, with no approach to the wider syndications markets. Project finance remains an active market, and there is something of a back-log of projects to be financed. Limited bank capacity, syndication difficulties and the reluctance of borrowers to commit in the long term at today’s levels of margins and fees have all played a part. In the modules that follow we shall look in greater detail at how structuring practices and pricing have changed over the last year or two and try to draw some (tentative) conclusions on whether and how the current approach of banks may change in the future.

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6. SUMMARY & CONCLUSIONS We hope that you have enjoyed Core Module one. Now that we have reviewed the basics of project financing, we shall be in a position in the next core module to move on to the first part of the project lender’s toolkit – ‘Qualitative Risk Analysis.’ Whether you as a reader approach project financing as a lender or as a borrower, it is critical to understand how a lender will analyse the risks to which a particular project is subject. It is obvious why a lender needs to know this. It is their job! But if a borrower is to maximise the amount of debt within a project SPV and to optimise the transfer/ haring of project risk, they must understand:

• how a lender typically views particular types of risk; • what risks they are likely to be prepared to accept (i.e. what risks are “bankable”);

• how the lender will seek to mitigate or transfer risks which are not deemed to be bankable

The Next Module In Core Module 2 we will study in particular:

• sponsor risk • country & political risk

• construction risk

• operation & maintenance risk

The first two parts above, can, as we shall see, be “on-off” switches. If the lender cannot accept these risks or mitigate them sufficiently there is a real chance that they will not proceed to a detailed review of the risks specific to the project. The construction period is the period of highest risk for the lender and will consequently receive a great deal of attention. Once the project is operating, a satisfactory operation & maintenance regime can be a critical element in the stability of cashflow generation. What Now? Hopefully you will have enjoyed this module and can see the quality of knowledge you could potentially gain from the course. To guarantee your place on this highly unique course, please register now: www.iff-training.com/dl/projectfinance