RETURNS ON PROJECT-FINANCED INVESTMENTS: EVOLUTION AND MANAGERIAL IMPLICATIONS

Journal of Applied Corporate Finance S P R I N G 2 0 0 2 V O L U M E 1 5 . 1

Returns on Project-Financed Investments: Evolution and Managerial Implications by Benjamin Esty, Harvard Business School

71STERN STEWART JOURNAL OF APPLIED CORPORATE FINANCE

RETURNS ON PROJECT-FINANCED INVESTMENTS:EVOLUTION ANDMANAGERIAL IMPLICATIONS

by Benjamin Esty,Harvard Business School

roject finance has evolved considerablysince the 1970s, when it became the mainsource of funding for several large, natu-ral resource projects, and the 1980s,

needed to generate a satisfactory return on a portfo-lio of similar investments goes down. Venture capitalportfolios work according to the following principle:very high returns on a few successful investments makeup for losses or low returns on the majority of theinvestments. What is notable about project-financedinvestments, however, is that the best returns are notvery high. In fact, the nature of most projects limits theupside potential. This limitation implies that a muchhigher fraction of project-financed investments must besuccessful if the capital providers are going to earnacceptable returns on their investments. Rather thansucceeding with one or two out of every ten investments,project sponsors must achieve successful outcomes onthe majority of their investments. Despite the fact thatproject sponsors and venture capitalists both investequity in start-up companies, project sponsors mustachieve dramatically higher success rates because ofdifferences in the underlying return distributions.

The limited empirical evidence that exists onproject performance, however, shows that projects,particularly the larger ones and the ones with greaterpublic sector participation, do not exhibit mediumto high success rates. Instead, they often exhibitbudget and schedule overruns, and low equity re-turns. This comparison between extreme financingstructures—venture capital (equity finance) at oneend of the leverage spectrum and project finance(debt finance) at the other end—provides an espe-cially effective way to analyze and understand thedeterminants of capital structure. Although this paperfocuses on capital structure exclusively, similar analy-sis on other structural features of project companies(e.g., debt ownership structures, contractual struc-tures, and board composition) has the potential toshed new light on core issues in corporate finance.

when it was used extensively to finance power plantsin the U.S. Today, project finance is used for a muchwider range of assets, such as satellite telecommuni-cations systems, amusement parks, and microproces-sor factories in both developed and developingcountries.1 In this article, I explore how this evolutioninto riskier assets has changed the hypotheticaldistribution of expected asset returns on project-financed investments. Greater exposure to new kindsof risks has increased the variability of returns, createda more “bimodal” distribution (with significant num-bers of both successful and failed outcomes), andincreased the possibility of high positive returns.

The first two changes—increased variability ofreturns and greater probability of failure—have impor-tant implications for project capital structure. Theyhave caused project debt capacity to go down. Empiri-cal evidence shows that projects exposed to greatersovereign or market risk have lower leverage ratios.The move into riskier assets has also created newmotivations for using project finance. Rather than a toolto mitigate free cash flow problems or expand a firm’sdebt capacity, project finance has become a tool for riskmanagement. By investing through a project companyinstead of using its own balance sheet, a company canreduce the collateral damage caused by a failinginvestment and, through careful structuring and de-sign, can manage sovereign risks more effectively.

The third change, the greater probability of highpositive returns, affects project management and in-vestment strategy. As the probability of higher returnsincreases, the success rate on individual investments

*I would like to thank Hal Davis, Barry Gold, Bill Megginson, Bill Sahlman,and Lou Wells for comments on an earlier draft.

1. For additional information on the use of project finance, see “An Overviewof Project Finance—2001 Update,” Harvard Business School case #202-105, or theProject Finance Portal at www.hbs.edu/projfinportal/.

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72JOURNAL OF APPLIED CORPORATE FINANCE

THE EVOLUTION OF PROJECT FINANCE:1970 TO THE PRESENT

Although one can argue that the history ofproject finance goes back hundreds if not thousandsof years, the earliest applications in the U.S. were innatural resources and commercial real estate. In the1930s, “wildcat” explorers in Texas used productionpayment loans to finance oilfield exploration. Realestate developers built and financed commercialproperties using what can be considered projectfinance. In both cases, creditors had recourse only tothe project cash flows and assets.

During the early 1970s, project finance becamean established vehicle for companies seeking newways to finance large natural resource discoveries.Using project finance, British Petroleum raised $945million in the early 1970s to develop the “FortiesField” in the North Sea, while Freeport Mineralsraised $120 million for the Ertsberg copper mine inIndonesia. Despite these infrequent uses during the1970s, most people mark the beginning of modernproject finance with the passage of the Public UtilityRegulatory Policy Act (PURPA) in 1978. In the midstof soaring energy prices, the U.S. Congress passedPURPA to encourage investment in alternative (non-fossil fuel) energy generators. The act requiredutilities to purchase all of the output of qualifiedpower producers (technically, they had to purchasethe power at the “avoided cost” of production).Project finance became the structure of choice forfinancing new generating plants with long-term powerpurchase agreements. Companies known as indepen-dent power producers (IPPs) built new generatingplants and financed them on a project basis (theacronym IPP refers interchangeably to both theproducers and the plants themselves). In fact, powerprojects accounted for more than two-thirds of totalproject finance capital raised during the 1980s.2

To develop a new generating plant, a sponsor-ing firm arranged four primary contracts that unitedthe members of a “vertical chain” from input supplier

to output buyer (see Figure 1): (1) a construction andequipment contract, usually on a fixed-price, turn-key basis with an experienced contractor (oftencalled engineering, procurement, and constructioncontracts—EPC contracts); (2) a long-term fuel supplycontract; (3) a long-term power purchase agreement(PPA) with a creditworthy electric utility; and (4) anoperating and maintenance contract. Once these andother “minor” contracts were in place—a typical dealcould have as many as 100 contracts though some ofthe bigger deals have more than 1000 contracts—theIPP could finance the “contractual bundle.”

Long-term contracts work reasonably well as agovernance mechanism for tangible assets like powerplants, especially in countries with established con-tract law and reliable enforcement. It is easier andcheaper to write contracts for “hard” assets than forintangible assets because the former involve lessuncertainty and their output is more predictable.(Think of describing the quality and details of a tollroad versus a painting before either has been started.)Once the contracts have been signed, tangibilityreduces the cost of monitoring and enforcementbecause it is easier to detect if a given state of the worldhas occurred (e.g., is the road done?) and to prove itin a court of law. And, finally, when things go wrong,tangible assets can be redeployed or shifted to newownership without a significant loss in value.3

In fact, long-term contracts work better thanother governance mechanisms such as spot markettransactions or direct ownership (vertical integra-tion).4 Spot transactions are subject to opportunisticbehavior when the assets lose much of their valueoutside of a specific transaction or relationship. Forexample, you would not want to build a coal-firedpower plant next to a remote mine before signing asupply agreement stipulating prices and quantities.5

At the other end of the governance spectrum, verticalintegration does not provide sufficient risk sharingbenefits, particularly for large, risky investments.Long-term contracts lie in the middle of the gover-nance spectrum and work well with certain types of

2. A. Chen, J. Kensinger, and J. Martin, “Project Financing as a Means ofPreserving Financial Flexibility,” Working Paper, University of Texas, (1989).

3. O. Williamson (in “Corporate Finance and Corporate Governance,” TheJournal of Finance, Vol. 43 (1988), pp. 567-591 claims that leverage is positivelyrelated to the ease with which assets can be redeployed to alternative uses. Manystudies show that leverage is positively related to asset tangibility; see S. Titmanand R. Wessels, “The Determinants of Capital Structure Choice,” The Journal ofFinance, Vol. 43 (1988), pp. 1-19, and R. Rajan and L. Zingales, “What Do We KnowAbout Capital Structure? Some Evidence From International Data,” Journal ofFinance, Vol. 50 (1995), pp. 1421-1460.

4. See B. Klein, R.G. Crawford, and A.A. Alchian, 1978, “Vertical Integration,Appropriable Rents, and the Competitive Contracting Process,” Journal of Law andEconomics, Vol. 21 (1978), pp. 297-326; and O. Williamson, The Mechanism ofGovernance, (New York: Oxford University Press, 1996).

5. P. Joskow analyzes this situation in his article, “Vertical integration and long-term contracts: The case of coal-burning electric generating plants,” in the Journalof Law, Economics, and Organizations, (Fall 1985), Vol. 33, pp. 32-80.

73VOLUME 15 NUMBER 1 SPRING 2002

assets (i.e. tangible, large, no growth). Even in thebest of circumstances, however, the contracts end upbeing “incomplete” in that they do not specify actionsfor all parties in all possible states of the world. As aresult, capital providers must design compensationschemes that encourage value-maximizing behavior,monitor compliance with contractual terms, anddiscipline parties who violate contractual terms.

Project finance is particularly attractive for IPPsbecause it offers high leverage with limited or norecourse to the sponsor’s balance sheet. Sponsorsfinance IPPs with debt-to-total capitalization ratiosranging from 70-95%. Because the ideal assets forproject finance require mainly upfront (but little on-going) investment, the plants generate large amountsof free cash flow. For example, a gas-fired power plantmight generate operating margins of 20-50% whileother projects can generate operating margins of 70-95%. By employing high leverage, sponsors ensurethat project managers generate and then disgorge freecash flow rather than making negative net presentvalue investments or wasteful expenditures.6

Lenders became comfortable with terms andexposures that appeared aggressive by conventionalstandards because the contractual structure lockedin long-term cash flow streams. Under the IPPstructure, lending decisions depend more on thecreditworthiness of the counterparties than on theproject sponsors themselves. As a result, projectfinance allows small, sub-investment grade firms toraise funds and build power plants. Sponsors thususe project finance to avoid the opportunity cost ofleverage-induced underinvestment. By allocatingproject returns to new capital providers rather thansubsidizing existing holders of risky debt, projectfinance solves the so-called “debt overhang” prob-lem.7 Calpine is a good example of a firm that usedproject structures to finance numerous IPPs eventhough it had a consolidated corporate debt-to-totalcapitalization ratio in excess of 90%. Through the1980s, these two motivations—reducing costly agencyconflicts over free cash flow and expanding debtcapacity in low-rated firms—drove the majority ofproject-financed transactions.

6. M.C. Jensen, “Agency costs of free cash flow, corporate finance, andtakeovers,” American Economic Review 76 (1986), pp. 323-329. In fact, projectcompanies provide some of the strongest empirical support for agency-basedtheories of capital structure. Even projects not subject to taxes use high leverage.See Financing the Mozal Project (HBS case #200-005) or The International Investor:Islamic Finance and the Equate Project (HBS case #200-012).

7. In brief, the debt overhang problem stems from the reluctance of investorsto commit new funds to a highly leveraged firm because much of the new capitalgoes to shoring up the value of the existing debt. See S. Myers, “Determinants ofCorporate Borrowing,” Journal of Financial Economics, Vol. 5 (1977), pp. 147-175.

FIGURE 1 TYPICAL STRUCTURE FOR AN INDEPENDENT POWER PLANT (IPP)

Today, project finance is used for a much wider range of assets, such as satellitetelecommunications systems, amusement parks, and microprocessor factories in

both developed and developing countries.

Multi-lateral, Bi-lateral,and Export Credit Agencies

BankSyndicate

Non-Recourse DebtInter-CreditorAgreement

SponsorA

SponsorB

SponsorC

EquityShareholderAgreement

Labor

Gas InputUnder a Supply

Contract

TechnologyLicense

Power OutputUnder a Purchase

Contract

EquipmentContract(Turbines)

ConstructionContract

(EPC Contract)

Operating &Maintenance

Contract

Project Company(Power Plant)

80% 20%

Board of Directors


Mozal

Chad-CameroonPipeline

Petrozuata

SuttonBridge

EquatePetrochenical

EuroTunnel

EmergingMarket IPP

Calpine pre-1996 orEdison Mission Energy

U.K. MPPU.S. IPP

Bulong Mine

IridiumA2 Motorway

Hong KongDisneyland

Australia-Japan Cable

DANGERZONE

Dabhol

Beginning in the early 1990s, however, spon-sors began to finance a wider range of assets locatedin a wider range of countries (see Figure 2). One ofthe earliest forays into new territory was the con-struction of IPPs in countries with high sovereign risk(the upper left quadrant). For example, Enron,through a project company, negotiated and signeda power purchase agreement with the MaharashtraState Electricity Board in 1993 as Phase 1 of the $900million Dabhol Power Project. At the time, India hadan Institutional Investor credit rating of 38.4 on a scaleof zero (high risk) to 100 (low risk), putting it in the“high risk” category.8 (By way of comparison, the U.S.had a rating of 89.2, while Turkey and Venezuela hadratings of 45.1 and 37.6, respectively, at the time.)

Sponsors also began financing projects withgreater market and technology risks in safe countries(the lower right quadrant in Figure 2). Good ex-amples of projects facing greater market risk are themerchant power plants (MPPs) built in the U.S. andthe U.K. Unlike IPPs, which have long-term fuelinput and power purchase agreements with fixedprices and quantities, MPPs are exposed to price andquantity changes on both inputs and outputs. Calpinefinanced one of the first merchant plants in the U.S.

in 1996 (the Pasadena Power Plant); Enron financedone of the first “hybrid” plants in the U.K. in 1997 (theSutton Bridge Plant). This hybrid MPP/IPP plant hasa power purchase agreement covering the first 15years of projection (the IPP phase), but operates ona merchant basis thereafter (the MPP phase), whichleave the debt exposed to market forces. These twoprojects represent turning points in field of powerfinance as lenders began to accept much greaterexposure to market risks.

A second form of market risk that became morecommon during the 1990s is exposure to retaildemand. Whereas the IPPs and most of the naturalresource projects involved wholesale customers, themore recent projects involved retail customers buyingtransportation and telecommunication services. Asproject sponsors moved away from a small number ofhigh-rated wholesale customers, often a single cus-tomer, to a large number of retail customers, theybecame exposed to greater demand uncertainty.Poland’s A2 Motorway (a toll road) and the HongKong Disneyland (a theme park and resort complex)are good examples of projects exposed to retaildemand and greater sovereign risks (the center ofFigure 2).

8. The Institutional Investor country credit rating is based on a semi-annualsurvey of 75-100 international bankers who grade each country on a scale of 0 (veryhigh chance of default) to 100 (least chance of default).

A2 Motorway: $900 mil-lion toll road in Poland(HBS case # 202-030).Australia-Japan Cable:$520 million underseacommunications cable(HBS case # 203-029).Bulong Mine: $350 mil-lion nickel/cobalt mine inAustralia (HBS case # 203-027).Calpine Corporation:$1 billion financing facil-ity to build IPP’s in the US(HBS case # 201-098).Chad-Cameroon Pipe-line: $4 billion oil fielddevelopment and pipe-line project in Africa (HBScase # 202-010)Dabhol: first phase was$900 million, total expenditure was $3 billion for this Indian IPP(HBS case # 596-009)

FIGURE 2 DISTRIBUTION (AND EVOLUTION) OF PROJECTS BY TYPE OF RISK

Euro Tunnel: $15 billionundersea tunnel betweenFrance and the UK.Equate Petrochemical:$2 billion petrochemicalplant in Kuwait (HBS case#200-012).Hong Kong Disneyland:$14 billion theme park (HBScase # 201-072)Iridium: $5.5 billion glo-bal satellite telecommu-nications system (HBScase # 200-039).Mozal: $1.4 billion alumi-num smelter in Mozambique(HBS case # 200-005).Petrozuata: $2.4 billion oilfield development projectin Venezuela (HBS case #299-021)

Sutton Bridge: $570 million hybrid IPP/MPP power project inthe UK (HBS case # 200-051)


Finally, sponsors began to use project financefor projects with new, and sometimes unproven,technologies. These projects were more likely to fail(e.g. the Bulong nickel mine in Australia, whichdefaulted on its senior secured notes when its newpressure acid leach technology did not work asexpected)9 and to experience major cost overruns(e.g. the EuroTunnel, which had to be restructuredshortly after completion or the Central Artery Tunnel,the “Big Dig,” in Boston). According to one study onthe performance of large projects, “The incorpora-tion of a new technology in a megaproject almostensures that the project will make more mistakesthan money…megaprojects are simply inappropriatevehicles for experimentation.”10 In response, lendersbegan to require “limited recourse” rather than non-recourse loans for projects facing significant technol-ogy risks. Limited recourse loans have a period oftime during which creditors have full recourse to thesponsor’s assets and cash flows. The transition fromfull to non-recourse status often occurs on the“completion date.” Defining this milestone in termsof operating and financial metrics is an extremelycomplicated matter. The use of limited recourseloans shows that creditors are willing to acceptmarket risks, but are much more reluctant to accepttechnology risks.

In sum, project sponsors have been pushing theboundaries of project finance for most of the last 15years by increasing sovereign, market, and technol-ogy risks. What they have not done, however, isattempt projects with both high sovereign risk andhigh market or technology risk. Such projects,portrayed graphically as the “Danger Zone” in theupper right quadrant of Figure 2, are not goodcandidates for project finance, at least using existingstructures. For projects facing significant uncer-tainty, the standard project structure with rigidcontractual agreements and high leverage is notappropriate because it prevents managers fromresponding quickly and easily to changing circum-stances.11 In these settings, managerial discretion isnot only preferred over rules; it is required if theproject is going to succeed. Besides changing thecontractual structure, sponsors responded to tech-

nology and market risks by reducing leverage andotherwise adjusting changing capital structure.

THE RELATIONSHIP BETWEEN ASSET RISKAND PROJECT LEVERAGE

As a general rule, project leverage ratios shouldbe negatively related to asset risk. Thus, it is notsurprising that the evolution of project finance overthe last 15 years into progressively riskier assets hasresulted in lower leverage ratios on project-financedinvestments. As the nature of projects has changed,so too has the motivations for using project finance.By creating a separate legal entity and financing itwith non-recourse debt, project sponsors can cap-ture the benefits of investing without incurring all ofthe deadweight costs associated with financial dis-tress. Today, sponsoring firms use project finance asa risk management tool as well as a way to solve freecash flow problems associated with certain assets.

Asset Risk as a Determinant of ProjectCompany Leverage

According to the trade-off theory of capitalstructure, a firm should increase leverage to the pointwhere the marginal gain from incremental tax shieldsequals the marginal loss from incremental distresscosts. The expected cost of distress is equal to theprobability of distress times the cost of distress,where the cost includes both direct costs such aslegal, financial advisory, and accounting fees andindirect costs such as lost reputation, distractedmanagement, and missed investment opportunities.The probability that a company will incur significantdistress costs depends on, among other things, itsleverage ratio and asset risk. For a given level of assetrisk, the probability of distress increases with lever-age. Alternatively, for a given leverage ratio, theprobability of distress increases with asset risk. Inessence, the equityholders sell the safest cash flows todebt providers who agree to forgo the upside potentialin return for taking a senior claim on the cash flows. Withlow-risk assets (i.e. low-variance asset returns),equityholders can sell virtually all of the expected cash

9. See B. Esty, Restructuring Bulong’s Project Debt (HBS case #203-027).10. E. Merrow, L. McDonnell, and R. Arguden, “Understanding the Outcomes

of MegaProjects: A Quantitative Analysis of Very Large Civilian Projects,” The RandCorporation Publication Series #R-3560-PSSP (Santa Monica, CA: March 1988), pp.62-63.

11. R. Miller and D. R. Lessard (in The Strategic Management of LargeEngineering Projects, Cambridge, MA: MIT Press, 2000) refer to the unforeseenchanges as “turbulence.” They note that turbulence is negatively related to projectperformance. The key challenge for sponsors is to build in what they call“governability” to ensure that projects can respond to inevitable turbulence.

By employing high leverage, sponsors ensure that project managers generate andthen disgorge free cash flow rather than making negative net present value

investments or wasteful expenditures. High leverage can also deter acts of creepingexpropriation by removing cash from project companies


flows to debtholders and pick up valuable interesttax shields in the process. This is, in fact, one of thearguments used to justify hedging activities. Byreducing cash flow volatility, firms can add leverageand increase value from interest tax shields.12

In practice, projects have relatively low assetrisk and correspondingly high debt capacity. Usinga sample of projects drawn from Thompson Finan-cial Securities Data Corporation’s Project Financedatabase that were financed from 1990 to 2000, Figure3 shows the average (median) debt-to-total capitaliza-tion ratio was 70% (70%).13 A project company is likea leveraged buyout (LBOs), except that an LBO is afinancing decision involving existing assets whereasproject finance is an investment and financing deci-sion involving new assets.14 The capital structures ofproject companies are very different from those ofpublic companies: the mean (median) book valuedebt-to-total capitalization ratio for similar sizedCompuStat firms in 2001 ($100 million to $2 billion intotal assets) was 33.1% (30.5%), approximately halfthe leverage ratio for project companies.

Industry Evolution Affects Asset Risk andReturns

One way to evaluate asset risk is to analyze thevariance of possible returns—the greater the vari-ance, the higher the risk. The first modern applica-tions of project finance, IPPs in the U.S., hadrelatively little asset risk. Figure 4 shows the hypo-thetical distribution of asset returns for U.S. IPPs.15 Asnoted above, low-risk assets have very high debtcapacity. Although sponsors still use project financefor IPPs in high-rated countries, they have appliedproject structures to an increasingly diverse set ofassets. These assets, to varying degrees, are exposedto three types of risks. The first type, symmetric risks,includes such things as:

Market risk—quantity: is demand higher or lowerthan expected?

Market risk—price: are output prices higher orlower than expected?

Input or supply risk: are input prices higher orlower than expected?

12. R. Stulz, “Rethinking Risk Management,” Journal of Applied CorporateFinance, Vol. 9 No. 3, (Fall 1996), pp. 8-24.

13. This sample includes only projects with information on project size,leverage, and equity ownership.

14. S. Kaplan, “The Staying Power of Leveraged Buyouts,” Journal of FinancialEconomics, Vol. 29 (1991), pp. 287-313, which analyzes 183 large leveragedbuyouts (LBOs) and finds that they, like project-finance deals, are private firms with

very high leverage: the average D/TC ratio is 87%. In contrast to projects, however,LBOs pay down debt quickly and often return to public ownership.

15. Where the return is defined as the present value of the asset minus theinvestment cost divided by the investment cost. This definition of returns assumesthat assets cannot be worth less than zero (i.e. there are no product orenvironmental liabilities, managers do not operate assets that generate negativeoperating cash flows, etc.)

This chart compares the distribution of book value debt-to-total capitalization ratios for a sample of 1,799 CompuStat firms rangingin size from $100 million to $2 billion in total assets as of 2001, and 1,050 project companies financed between 1990 and 2000(70% of the projects are in the same size range in terms of total cost). The CompuStat sample excludes firms with negative bookequity; the project company sample excludes projects with 100% leverage (additions to existing projects financed with all debt).

FIGURE 3DISTRIBUTION OFLEVERAGE RATIOS

Per

cen

t o

f T

ota

l O

bse

rvat

ion

s

5%

0%

25%

20%

15%

10%

0%

Debt-to-Total Capitalization (Book Value)

CompuStat FirmsProject Companies

10% 20%

CompuStatFirms

ProjectCompanies

MeanMedian 30.5% 70.0%# obs. 1,799 1,050

30% 40% 50% 60% 70% 80% 90% 100%

33.1% 70.0%


Exchange, interest, and inflation rate risks: arerates higher or lower than expected?

Completion risk: will the project be finished ontime and on budget?

Reserve risk: are resources in the ground or not(such as oil or minerals)

Throughput risk: does the process produce out-put in the expected quantity and quality, at theexpected cost?Exposure to symmetric risks causes larger positiveand negative deviations from the expected return(see Figure 4). Merchant power plants (MPPs), whichare exposed to changes in prices and quantities onboth inputs and outputs, are good examples ofprojects that face symmetric risks. Depending on theoutcome of a particular risk factor, the observedreturns can be higher or lower than expected—thegreater the risk, the further the observed return willbe from the average return.

At the same time, certain risks cause onlynegative deviations in expected returns. Two no-table examples are:

1. Environmental risk: expenditures needed tomitigate environmental damage can reduce returns(though most social and environmental risks are notpriced); and

2. Expropriation risk: creeping expropriationcan reduce returns (e.g. an increase in corporate taxor royalty rates)

Finally, some of the newer applications ex-posed projects to risks with more binary outcomes(did the event occur or not?). Examples of binaryrisks include:

Technology failureDirect (full) expropriationCounterparty failureRegulatory risk or failure to obtain necessary

permitsForce majeure (Acts of God—floods, fires, earth-

quakes, etc.)Force majeure (political risks—currency incon-

vertibility, war, strikes, etc.)These risks increase the probability that an asset

will end up worthless. With zero asset value, thereturn is negative 100% (using my definition).

Figure 4 shows the hypothetical distribution ofasset returns for a project exposed to all three typesof risk: symmetric, asymmetric downside, and binaryrisks. This distribution of returns for more recentprojects differs from the historical distribution inthree important ways: it has a higher variance, it ismore bimodal (with both positive and negativeoutcomes), and there is a greater probability ofachieving high positive returns (i.e. there is greaterpositive skewness).

Before discussing the implications of thesechanges, it is important to keep in mind that Figure4 describes asset returns and how various project

FIGURE 4 HYPOTHETICAL DISTRIBUTION OF ASSETRETURNS FOR PROJECT-FINANCEDINVESTMENTS

FIGURE 5 HYPOTHETICAL DISTRIBUTION OF EQUITYRETURNS FOR PROJECT-FINANCEDINVESTMENTS

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

have not done, however, is attempt projects with both high sovereign risk andhigh market or technology risk.

PV[(Asset Value – Investment Cost)/Investment Cost]PV[(Asset Value – Investment Cost)/Investment Cost]

Pro

bab

ilit

y

-100% 0 100% 200% 300%

Low variance return distributionfor projects with few risks suchas U.S. IPPs

High variance return distribution forprojects facing multiple risks such asU.S. MPPs (market risk) or emergingmarket projects (sovereign risk)

Pro

bab

ilit

y

-100% 0 100% 200% 300% 1000%


risks affect them. The use of high leverage in projectcompanies introduces another type of risk, namelyfinancial risk. By their very nature, levered equityreturns are more bimodal than asset returns given thepriority debt claims have on asset cash flows. At thesame time, the residual nature of equity claimsmeans that equityholders capture unlimited upsideonce the fixed debt claims have been satisfied. Thus,the returns on levered equity will be an exaggeratedversion of high-variance return distribution in Figure4. Figure 5 shows the hypothetical distribution ofequity returns.

Evidence on the Relationship Between AssetRisk and Project Leverage

Using data from the Thomson Financial Securi-ties Project Finance database, I tested for a relation-ship between project risk and leverage ratios. Be-cause there are more projects in the power sectorthan in any other sector, and I wanted to control forknown relations between leverage and asset type, Icollected data on the 1,144 power projects announcedbetween 1980 and 2002 (all but 12 are from 1990 to2002); only 643 projects have reported leverage ratios,where leverage is defined as the project’s book valuedebt-to-total capitalization ratio. Table 1 shows thedistribution of leverage ratios by the S&P sovereignrating for the country in which they are located.Consistent with the statistics in Figure 3, powerprojects have high leverage ratios: the mean is 76%and the median is 75%. There is also a very clearnegative relation between leverage ratios and sover-eign risk: leverage falls as sovereign risk increases(i.e. the Standard & Poor’s sovereign rating falls fromAAA to CCC/Unrated). Although the relationship isnot monotonic because other structural details affectdebt capacity, the differences between high- and low-rated countries are very dramatic: the leverage ratio ofthe median project in a AAA-rated country is almost20 percentage points higher than that of the medianproject in a low-rated (CCC) or unrated country (88%vs. 70%)—and the difference is statistically as well aseconomically significant. The data show that sponsorsuse less leverage when projects are exposed tosovereign risks like macroeconomic instability, cur-rency inconvertibility, and civil unrest.

Because this sample includes all kinds of powerprojects, from hydroelectric and coal-fired generat-ing plants to transmission lines, the leverage differ-ences could be due to differences in project types

rather than country risk. When I re-ran the analysisusing only the 188 combined-cycle gas turbine(CCGT) generating plants—the largest class of powerprojects—the results were the same: leverage issignificantly higher in safer countries (median of 90%vs. 69%). I did not control for the presence ofmultilateral agencies such as the International Fi-nance Corporation, bilateral agencies such as theExport-Import Bank of the U.S., or project guarantorssuch as the Overseas Private Investment Corpora-tion. If anything, however, the multilateral andbilateral agencies would be lending to projects inriskier countries and adding safety to them, whichwould cause the observed capital structures in thelow-rated countries to be higher than they wouldotherwise be without agency involvement.

Leverage ratios should also decline as projectstake on additional market risk. To test this hypothesis,I compared the leverage ratios for 121 CCGT projectswith power purchase agreements (PPAs) against theleverage ratios for 14 merchant power plants exposedto market risks. I could not determine the credit-worthiness of the counterparty to the power purchaseagreement or the length of the agreement; I was ableto find only if a contractual agreement was present.

At first glance, the data do not appear to beconsistent with the hypothesis that projects withPPAs should have higher leverage ratios than mer-chant projects. In fact, the mean leverage ratio forMPPs is slightly higher than the mean for projectswith purchase agreements in investment grade coun-tries: 85% vs. 83% (results not shown). But thisfinding is biased by the fact that all but one of theMPPs are in AAA-rated countries, compared to onlyhalf of the projects with PPAs, and we know from thefindings in Table 1 that sovereign risk affects lever-age ratios. When I restricted the sample to just theprojects in AAA-rated countries, the results corrobo-rated the original hypothesis: the projects with PPAshad an average leverage ratio of 95% as comparedto only 85% for the MPPs (results not shown).Perhaps more interesting, yet consistent with theidea that the upper right box in Figure 2 is “thedanger zone,” I find only one MPP project in a non-investment grade country, and it has a leverage ratioof only 48%. It appears that sponsors are reluctant toundertake, and bankers are unwilling to finance,projects with both sovereign and market risks. Nev-ertheless, a debt-to-total capitalization ratio of 48% isstill very high compared to leverage ratios in publiclytraded companies.


These results are consistent with the way ratingsanalysts view merchant risk. According to S&P’sratings criteria for merchant power plants:

Standard & Poor’s considers the minimum DSCR(debt service coverage ratio) threshold tests typicallyseen in traditional IPP project financings (for equitydistributions), such as 1.30, to be too low for MPPs.Instead, minimum DSCR levels for MPP equity distri-butions should exceed 1.70 for investment gradetransactions…Standard & Poor’s concludes that thecapitalization (of MPPs) should reflect a highersponsor-equity position than the typical 20-30% rangethat characterizes IPP project financings.16

Project Evolution Affects the Motivations forUsing Project Finance

In addition to lowering leverage in projectcompanies, the application of project structures toriskier assets changed the motivations for usingproject finance. In the early days, the IPP structure,with extensive contracting, bank monitoring, andhigh leverage, provided a way to mitigate agencyproblems over free cash flow and to expand debtcapacity for financially-constrained firms. Over time,however, project finance has also increasingly be-come a risk management tool.

Investment in a risky asset exposes a firm to thepossibility of risk contamination, the phenomenon

whereby a failed investment drags an otherwisehealthy firm into default. Even short of default, afailing investment can impose serious collateraldamage. For example, an increased possibility ofdefault may discourage suppliers and customersfrom dealing with the firm. Alternatively, the in-creased volatility of corporate cash flows can makeexternal finance more costly and interfere with thefirm’s ongoing investment program. Because ofthese distress costs, a manager may be unwilling toundertake a high-risk investment even if it has apositive net present value. Perhaps more impor-tantly, managers tend to be risk averse because theyhave limited ability to diversify their personal expo-sure to large corporate risks. Yet by financing aninvestment through a project company, the managercan capture incremental value without incurring allof the incremental distress costs.17 The non-recoursenature of project debt reduces the potential forcollateral damage from a failing investment.

Take the case of BP Amoco. The idea thatproject finance is a form of risk management is theguiding principle in BP Amoco’s policy statement onits use of project finance.18 In general, BP Amocouses standard corporate finance unless the invest-ment is very large (greater than approximately 5% oftotal assets) and risky. By isolating asset risk in aproject company, managers not only reduce ex-pected distress costs, they also protect their humanand financial capital against major losses.

16. Rigby, P., “Merchant Power: Project Finance Criteria,” Standard & Poor’sCorporation 1999 Infrastructure Finance: Criteria and Commentary, pp. 30, 31.

17. R. Brealy, I.A. Cooper, and M.A. Habib, “Using Project Finance to FundInfrastructure Investments, Journal of Applied Corporate Finance, Vol. 9 (1996), pp.

Debt-to-Total Capitalization Ratios a

All Power Projects CCGT Power Projectsb

No. of No.S&P Sovereign Rating Obs. Mean Median of Obs. Mean Median

AAA 220 85% 88% 88 87% 90%

AA 88 80 79 19 81 80

A 39 79 80 4 75 73

BBB 84 71 72 30 77 75

BB 124 74 70 28 73 70

B 42 75 75 11 83 75

CCC and Unrated 46 71 70 8 63 69

TOTAL 643 76% 75% 188 77% 75%

TABLE 1RELATION BETWEENS&P SOVEREIGN RATINGSAND LEVERAGE FORPOWER PROJECTS

Source: Thompson Financial SDC Project Finance Database.a Includes some projects with D/TC = 100%. These transactions (projects) are expansions of existing projects.b CCGT means Combined-Cycle Gas Turbine power plant. The full sample includes all kinds of projects includinghydroelectric, gas-fired, and coal-fired generating plants as well as transmission lines.

25-38. These authors note that project finance re-arranges the states of the worldin which the project and/or sponsor fails.

18. B.C. Esty, BP Amoco (A): Policy Statement on the Use of Project Finance,Harvard Business School case #201-054.

Sponsoring firms use project finance as a risk management tool as well as a way tosolve free cash flow problems associated with certain assets. The non-recourse

nature of project debt reduces the potential for collateral damage froma failing investment.


Of the newly encountered risks, sovereign riskin particular is better managed through project ratherthan corporate structures. The use of project financeallows sponsoring firms to create new, and possiblyvery different, governance structures for the assetcompared to the firm’s existing corporate gover-nance structure.19 For example, high leverage candeter acts of creeping expropriation by removingcash from project companies and, in so doing,decreasing the temptation for host governments toexpropriate it.20 High leverage also ensures that evensmall acts of expropriation result in default and,presumably, corrective action. In contrast, undercorporate finance, creeping expropriation on asingle asset would rarely cause the corporation todefault on its debt obligations.

Besides changing the capital structure, spon-sors can change the debt and equity ownershipstructures to deter sovereign interference. Withregard to debt ownership, sponsors intentionallyborrow from bilateral and multilateral agencies suchas the U.S. Export-Import Bank and the InternationalFinance Corporation (IFC, a member of the WorldBank Group). Agencies like the IFC (a member of theWorld Bank Group) lend only to projects, notcompanies, and deter sovereign interference bymaking it more costly to do. Because these develop-ment agencies are among the few lenders that willextend credit to high-risk countries, defaulting ontheir loans can jeopardize future access to badlyneeded funds.

In summary, sponsors now use project financeto isolate project risk and to mitigate sovereign risksas well as agency costs (free cash flow problems andleverage-induced underinvestment). Whereas therisk management motivation drove some of the largenatural resource projects completed during the1970s, this motivation for using project finance hasbecome far more prevalent in the past ten years.

THE IMPORTANCE OF HIGHER POSITIVERETURNS

The changing distribution of asset returns alsohas implications for project management and invest-ment strategy. To ensure that capital providers earnan appropriate, risk-adjusted rate of return on aportfolio of investments, they can either earn highrates of return on just a few investments, or low ratesof return on many projects. The former correspondsto the venture capital industry while the lattercorresponds to project finance. Whether project-financed investments have high success rates re-mains an open question.

Venture Capital Returns

Returns in the venture capital industry arenotoriously skewed. In some of the earliest researchon venture capital returns, the annualized grossreturns showed an average of 19% and a median of4%.21 Only a quarter of the investments earned morethan the mean return and 17% were a total loss.22 Amore recent study of a sample of 1,004 investmentsfound that the average “return” (defined as value/cost) was 3.2 times cost, and that 8% of the projectsgenerated 41% of the total value.23 These “bigwinners” had returns that were 18.0 times their cost.Figure 6 shows a rough approximation of the returnson venture-backed firms. When compared to thedistribution of equity returns on project-financedinvestments shown in Figure 5, the extreme positiveskewness is readily apparent—some investmentscan generate returns of 1,000% or more! In mostventure capital portfolios, a small number of invest-ments generate the majority of the profits.

Typically, venture capital is used for intangibleassets with significant return uncertainty and littleresidual value in the event of failure.24 What makes

19. For examples of how sponsors use project structure to mitigate sovereignrisk, see Financing the Mozal Project (Harvard Business School case #200-005) andPetrolera Zuata, Petrozuata (Harvard Business School case #299-021). The formeranalyzes a project with multi-lateral and bi-lateral agency participation; the latteranalyzes a project without it.

20. Similar motivations drive unionized firms to use greater leverage. S.G.Bronars, and D.R. Deere, 1991, The Threat of Unionization, the Use of Debt, andthe Preservation of Shareholder Wealth, Quarterly Journal of Economics, 232-254.

21. B. Huntsman and J.P. Hoban, “Investment in New Enterprise: SomeObservations about Risk, Return, and Market Structure,” Financial Management,Vol. 9 (1980), pp. 44-51.

22. The average returns on venture-backed investments have been decliningin recent years as the frequency of negative outcomes increases. During the mid-1990s, approximately 20% of investments resulted in a total loss. More recently,according to Harvard Business School Professor Bill Sahlman, as many as two-thirds of the investments in funds started between 1997 and 2001 are resulting inlosses.

23. P. Horsley, “Trends in Private Equity,” Horsley Bridge Partners, SanFrancisco, CA., 4/21/97. Subsequent research using slightly different methodologyon a sample of 110 venture-backed firms that went public between 1983 to 1986revealed that the top 10% of the IPO’s generated 62% of the total returns from allthe firms in the sample; see F.M. Scherer, D. Harhoff, and J. Kukies, “Uncertaintyand the Size Distribution of Rewards From Technological Innovation, Journal ofEvolutionary Economics, Vol. 10 (2000), pp. 175-200.

24. P. Gompers and J. Lerner, The Money of Invention: How Venture CapitalCreates New Wealth (Boston: Harvard Business School Press, 2001).


equity finance in general—and equity from venturecapital organizations in particular—appropriate forthese kinds of investments is that equity can be usedto align incentives between managers and capitalproviders. When value is highly dependent on whoowns the assets and how they are used, yet there isvery limited information about asset value, thepotential for destructive incentive conflicts is aserious concern. Venture capitalists use many strat-egies to deal with these conflicts: screening projects,staging of financial commitments, syndicating in-vestments to other venture capitalists, monitoringmanagerial behavior, restricting managerial actionsthrough covenants, and so on. These strategiesappear to work. For, as shown in a fairly recent study,companies with venture backing Figure better post-IPO performance than non-venture backed firms.25

Equity has a payoff structure that is effective inthis setting because it allows investors to captureunlimited upside potential. In contrast, debt is a fixedclaim with limited upside potential. For high-riskinvestments with positively skewed returns, debt

simply does not work. Lenders cannot charge highenough rates of return without encouraging onlyhigh-risk borrowers to apply for loans.26 Equity, orequity-related securities such as convertible debt,can be used effectively without creating such “ad-verse selection” problems.

Project Returns

Compared to venture-backed firms where man-agers are responsible for managing growth optionsand for transforming a small amount of capital intolarge companies worth 10 to 1000 times the originalinvestment amount, project company managers areresponsible for transforming a large amount of capitalinto something worth just a little more. The “best case”scenarios in project-financed investments are oftenonly two to 10 times the “base case” scenarios becauseof underlying limitations in upside potential.

There are many reasons why the upside islimited. First, there are often physical constraints oncapacity or output quantities. “Flow type” projectsthat depend on use to generate value (such astunnels, power plants, toll roads, and pipelines)often have limited throughput capacity. For ex-ample, only so much oil can pass through a pipelineor so many cars through a tunnel. “Stock type”projects, which involve the depletion of a resource(such as mines, oil fields, or forests), also havelimited quantities; when the resource runs out, theproject is over. A limited life is, after all, one of thehallmarks of project assets. The opportunity toincrease output usually comes in the form of repli-cation, not increased output through existing assets.For example, the sponsors in the Mozal project (analuminum smelter in Mozambique) built virtually allof the necessary infrastructure to double the plant’scapacity by adding a second potline to the smelterat some point in the future. It is worth noting thatcontraction is also very difficult, because either therelative costs of running at less than full capacity areprohibitive or the costs of shutting down and re-starting are very significant (for example, minesoften fill with water, smelters are costly to start upand shut down, and so on).

25. A. Brav and P. Gompers, “Myth or Reality? The Long-Run Underperformanceof Initial Public Offerings: Evidence from Venture and Non Venture Capital-BackedCompanies,” Journal of Finance, Vol. 52 (1997), pp. 1797-1821.

26. On adverse selection in lending, see J. Stiglitz and A. Weiss, “CreditRationing in Markets with Imperfect Information,” American Economic Review,Vol. 73 (1983), pp. 919-927. On banks’ inability to earn acceptable returns on high-risk projects in competitive lending markets, see M. Petersen and R. Rajan, “TheEffect of Credit Market Competition on Lending Relationships,” Quarterly Journalof Economics, Vol. 110 (1995), pp. 407-444.

FIGURE 6 DISTRIBUTION OF RETURNS ON VENTURECAPITAL-BACKED INVESTMENTS

To ensure that capital providers earn an appropriate, risk-adjusted rate of return ona portfolio of investments, they can either earn high rates of return on just a fewinvestments, or low rates of return on many projects. The former corresponds to

the venture capital industry while the latter corresponds to project finance.

PV[(Asset Value – Investment Cost)/Investment Cost]

Pro

bab

ilit

y

-100% 0% 100% 200% 1000-10000%


Prices, too, are often limited. Projects thatinvolve natural resources do not have market power;all but the very largest producers are price takers. Theyoperate in settings where prices tend to stay within acertain range due to fundamental supply and demanddynamics. Oil prices, for example, have varied be-tween $5 and $40 per barrel for almost 50 years. Asecond reason why prices are limited is that manyinfrastructure projects (water, power, sewer, and soon) provide vital public services. To prevent sponsorsfrom “gouging” citizens, government officials eitherrestrict prices in concession documents (such as tollrates on Poland’s A2 Motorway), prevent the projectfrom opening (such as the Bangkok Second StageExpressway), or renegotiate agreements as time goesby (such as Enron’s Dabhol power project in India).27

Large projects and retail projects are especially proneto regulatory conflicts with host nations.28

Finally, the bulk of the costs are constructioncosts, which are spent upfront and determined bythe technology employed. In fact, most projectsoccur in “heavy” industries in which the technologyhas not changed much in decades.29 With stabletechnologies, and little accumulated experience inproject construction—Calpine is clearly an anomalyhere—there is little opportunity to drive downconstruction costs through learning. As a result,

projects typically have relatively low operating costsand operating margins in the range of 50-90%. To theextent that there is an input to the project—forexample, gas for a power plant—project managersoften have limited control over input prices, so thereis little opportunity to reduce costs.

To illustrate the limited upside for projectreturns, I ran an experiment with the discounted cashflow (DCF) model that a project sponsor used toevaluate its equity investment in a recent project.Although I changed the data and the units topreserve confidentiality, the detailed model remainsroughly intact. Rather than using sensitivity analysisas the sponsor and its financial advisor did, I useMonte Carlo simulation (Crystal Ball®) to generate adistribution of project returns. Using a plausiblerange of input values for prices, quantities, and costs,and reasonable assumptions about the probability ofexpropriation, delays, and technological failure, Iran 10,000 iterations of the model, and report theresults in Figure 7. As described above, I measuredthe project’s equity returns as the project’s netpresent value normalized by the present value of theinvestment. This approach further disguised the sizeof the NPV of the specific project while producing anormalized return that gives a clear sense of theupside potential in project returns.

27. R. Vernon (in Sovereignty at Bay: The Multinational Spread of U.S.Enterprise, Chapter 2, New York: Basic Books, 1971) called this phenomenon the“obsolescing bargain.” He observed that expropriation is more likely when thebenefits of foreign participation decline over time or when the costs increase overtime. One such cost is the public perception of being gouged by an infrastructureprovider.

28. Merrow et al. (1988), p. 61, cited earlier.29. The exception would be the introduction of new combined-cycle gas

turbine (CCGT) technology in the power industry. CCGT generating plants havemuch higher heat rates than older generating plants, which has allowed them todisplace existing capacity.

FIGURE 7MONTE CARLOSIMULATION OFPROJECT RETURNS(FREQUENCYDISTRIBUTION)

Note: The “return” is defined as the net present value (NPV) of total free cash flows (investing plus operating cash flows) dividedby the net present value of the investing cash flows (capital expenditures plus investments in working capital).

Mean = 0.30P

rob

abil

ity F

requ

ency

.110

.055

.000

.082

.027

109.7

822.7

548.5

274.2

0-1.00 0.00 1.00 2.00 3.00

Certainty is 61.53% from 0.00 to +Infinity

Forecast: NPV/(PV of Investment)10,000 Trials 53 OutliersFrequency Chart


To a first approximation, Figure 7, the distribu-tion of equity returns for this project, resemblesFigure 5, the hypothetical distribution of equityreturns for project-financed investments: both distri-butions are somewhat bimodal and both haverelatively few very high returns. In the case of Figure7, there is an 11% chance of losing the total invest-ment, and the maximum returns are three to fourtimes the original investment cost (there are 53realized observations that do not show up on theright-hand side of distribution in Figure 7). Statedsomewhat differently, the best outcomes are five toten times larger than the mean return of 10% (= 3.00/0.30, mean return). This analysis shows that even thebest-case scenarios generate relatively limited re-turns. To use a baseball analogy, we see a lot of“singles” and an occasional “triple,” but we never see“grand slams” in the field of project finance.

The Negative Relation Between UpsidePotential and Portfolio Success Rates

When one invests on a portfolio basis, higherupside potential lowers the success rate needed onindividual investments to generate a portfolio returnthat is commensurate with overall risk. Although thisportfolio perspective is not necessarily representa-tive of how most project sponsors invest, it iscertainly representative of how the industry works asa whole, how certain large sponsors invest, and howbankers look at lending decisions. When there is apossibility of achieving high returns on individualinvestments, similar to that in the venture capitalindustry, one or two very successful outcomes canoffset the poor returns on the majority of the invest-ments. In other words, a venture capital fund canmake virtually all of its profits on one or two bigwinners. Even with a 10-20% success rate, the overallportfolio can earn significant returns as long as thewinners generate annualized returns of 100% or more.

Given a portfolio of 20 projects, if the bestproject has a return of 300%, then only eight otherprojects need an average return of 25% to yield aportfolio return of 25%—thus only nine out of 20projects must succeed (for a 45% success rate).However, if the best project has a return of only100%, then 16 projects must generate the 25%

average return for the portfolio to have an overallaverage return of 25%, implying that 17 out of 20projects must succeed (85% success rate). By simplydecreasing the maximum potential returns on a singleproject, the required portfolio success rate doubles.

This example shows the negative relation be-tween project success rates and positive returns onwinning outcomes, holding portfolio returns con-stant. The relevant question for project-financedinvestments is this: given the limited upside, do alarge enough fraction of projects generate positivereturns? While the exact return distribution and,therefore, the required success rate are both un-known, a reasonable estimate is that at least six orseven projects out of ten must succeed to generatean acceptable return overall.

SOME EVIDENCE ON PROJECTPERFORMANCE

There is reason to believe that projects, particu-larly larger projects, do not exhibit high success ratesmeasured using either financial or operating criteria.Industrial projects like the EuroTunnel, EuroDisney,Enron’s Dabhol power plant, Iridium, ICO Commu-nications, Global Crossing (the Atlantic Crossing andPacific Crossing Cables), Globalstar, and MurrinMurrin (an Australian nickel mine), as well as realestate projects like the Millennium Dome and CanaryWharf in London, have all encountered financial distressor been restructured in recent years. Of course, thissample of large projects is not representative of theproject finance market as a whole. Still, there aresuggestive pieces of evidence on different aspects ofproject performance that can be summarized in fivefollowing categories: construction costs, completionschedules, bank loan performance, overall financialperformance, and returns to capital providers.

Project construction costs: A 1988 study of 47large projects found that only four (9%) came in onbudget, and that the average project went overbudget by 88%.30 These overruns were not just theresult of scale or scope changes. For similar reasons,some of the earliest research on large projectsconcluded that “…substantial cost growth is the rulerather the exception.”31 Cost overruns, however, arenot just associated with large projects. According to

30. Merrow et al. (1988), p. 60, cited earlier. 31. J.R. Fox, “The Management of Large, Complex Projects: A Synthesis ofObservations from the Literature,” Working Paper #1-784-004, Harvard BusinessSchool (1984), pp. II-1.

The relevant question for project-financed investments is this: given the limitedupside, do a large enough fraction of projects generate positive returns?

A reasonable estimate is that at least six or seven projects out of ten must succeed togenerate an acceptable return overall.


an internal International Finance Corporation (IFC)study of 233 greenfield projects with an average sizeof $130 million, 45% of the projects experienced costoverruns.32 Project structures are designed, throughcontingency funds and other support commitments,to withstand a certain amount of time and costvariation. But in the extreme, large cost overrunsresult in poor equity returns and, in some cases, poordebt returns.

Project completion schedules: The IFC, in astudy of 48 infrastructure projects financed withprivate funds, also found that schedule overrunsaveraged 5.3 months on projects with constructionperiods averaging 29.2 months, for a 22% scheduleoverrun [= 5.3/(29.2 – 5.3)].33 In comparison, 1,160projects financed with public funds from the WorldBank averaged 54-68% time overruns.34 Thus, pri-vate participation seems to have a positive impact onproject performance (although one must be carefulwhen assessing causality, at least when it comes toownership effects). Nevertheless, projects regularlymiss targeted completion dates.

Bank loan performance: Chemical Bank (nowJP Morgan Chase), historically one of the leadingproject finance lenders, conducted a study of itsloans during the 1970s and found that 14 out of 17projects ran into “some form of trouble,” while nineout of 17 encountered “severe trouble.”35 Yet despiteproblems at the project level, the lenders lost moneyin only one out of the 17 projects. This finding isconsistent with what the ratings agencies say aboutproject finance loans. According to Standard &Poor’s, project credits “.…generally have superiorpost-default recovery (compared to corporateloans).”36 What seems to be the case is that projectsare frequently restructured prior to actual default,which is one reason why sponsors prefer to borrowfrom a small groups of banks rather than largenumbers of bondholders—restructuring and renego-tiation is much easier. Even when default does occur,the losses to debtholders tend to be quite small.

Returns to capital providers: The IFC has con-ducted one of the most extensive analyses of projectperformance. Before discussing the results, it isimportant to remember that the IFC participates insome of the riskiest private-sector-sponsored projects.In fact, project sponsors come to the IFC whenbankers refuse to lend without IFC participation.

The IFC’s project evaluation team found that therealized financial rate of return on its projects wasabout half the projected rate of return. (The financialrate of return is equal to the internal rate of returnbased on pre-interest, after-tax cash flows withconstant dollar price projections, or essentially freecash flow in real terms.) In one study of 347 projectscompleted from 1978 to 1995, the average projectedreturn was 19%, as compared to an actual return of12%.37 In a second study of 110 projects completedfrom 1980 to 1989, the average projected return was20% but the actual return was only 10%.38

Overall financial performance: A study of 60large engineering projects (average size $1 billion)undertaken from 1980 to 2000 found that almost 40%of the 60 projects performed very badly, and wereeither abandoned totally or restructured after expe-riencing some kind of financial crisis.39 An olderstudy found that only ten out of 36 projects with anaverage size of $2 billion achieved their profitobjectives.40 While not all the projects in these twostudies fit a strict definition of project finance, theresults are nevertheless important to consider.

The conclusion—based on this admittedly un-scientific and quite limited collection of evidence—is that projects seem to experience serious cost andtime overruns. In the best cases, these problemsreduce equity returns; in the worst cases, they causedefault and, possibly, significant losses to debtholders.The evidence indicates that the worst problemsoccur in large projects and those with a greaterproportion of public ownership. Without a doubt,more rigorous analysis is needed before we can drawfirm conclusions regarding project performance or

32. International Finance Corporation, “Lessons of Experience #7: ProjectFinance in Developing Countries,” The World Bank (Washington, DC, 1999).

33. International Finance Corporation, “Lessons of Experience #4: FinancingPrivate Infrastructure,” The World Bank, Washington, DC, (1996).

34. Privatization improves financial performance, consistent with this perfor-mance difference between publicly and privately financed projects; see W.Megginson and J.M. Netter, “From State to Market: A Survey of Empirical Studieson Privatization,” Journal of Economic Literature, Vol. 39 (2001), pp. 321-389.Merrow et al. (1988, p. 65, cited earlier) find the same result for “mega projects.”

35. G. Castle, “Project Financing—Guidelines for the Commercial Banker,” TheJournal of Commercial Bank Lending, (April 1975), pp. 14-30.

36. W. Chew, “Project and Infrastructure Debt Faces Tests Along WithOpportunities In 2001,” Standard & Poor’s Corporation, Project & InfrastructureFinance Review 2001-2002: Criteria and Commentary, pp. 9-15.

37. International Finance Corporation, “The Private Sector and Development:Five Case Studies, Results on the Ground,” The World Bank, Washington, DC,(1997).

38. International Finance Corporation, “The Development Contribution of IFCOperations, Discussion Paper #5,” The World Bank, Washington, DC, (1989).

39. R. Miller and D. R. Lessard, The Strategic Management of Large EngineeringProjects, Cambridge, MA: MIT Press, (2000), pp. 13-14.

40. Merrow et al. (1988), pp. v, 60, cited earlier.


know whether this evidence is representative ofoverall performance. Nevertheless, the existing evi-dence does not appear to be consistent with a high“batting average” for project-financed transactions,which is somewhat of a puzzle and something of aconcern.

At this point, one might argue that projectsponsors must be earning a fair rate of return or theywould not be putting money into deals. But there areother, less sanguine explanations. For example, it ispossible that the sponsors are not earning appropri-ate risk adjusted rates of return. The problem is thatwe do not have sufficient data or understanding ofhistorical performance to justify changing currentpractice. Measuring financial returns is especiallydifficult when the investments are large (there arefewer projects and less statistical power), are chang-ing over time, or have long-term payoffs. In projectfinance, all three factors are present. Another expla-nation is that most sponsors do not invest on aportfolio basis. Instead, they do one deal, or at mosta few deals, every 10 years. For this group ofsponsors, a “small numbers problem” makes itdifficult to extract information about the distributionof returns. They may be willing to ascribe poorperformance to bad luck rather than poor structuraldesign or execution. Until we have a better under-standing of project finance and more data on histori-cal performance, it is going to be difficult to determinewhether there is a problem or not. To the extent thereis a problem, we then need to determine whether itis due to the project structures themselves, to poorapplication of existing structures, or to bad luck.

CONCLUSION

The changing distribution of returns on project-financed investments, combined with the prelimi-nary evidence on project performance, has implica-tions for at least three aspects of project finance. First,it sheds some light on the effectiveness of existingproject structures. As sponsoring firms attempt tofinance new and riskier assets, the traditional finan-cial and contractual structures will become less andless appropriate. The original structures were neverdesigned to handle large amounts of asset risk other

than sovereign risk (i.e. expropriation). One of twochanges, or both, is likely to occur in the years ahead.First, the boundaries of applicability will becomeclearer, which will help sponsors understand whenand in which situations the traditional structures areappropriate. At the same time, sponsors may changethe way they finance risky assets. Traditional singleasset structures with extensive contracting will bereplaced by either corporate structures or hybridstructures involving elements of both project andcorporate finance. One example of a hybrid struc-ture is Calpine’s revolving construction facilities,which it used to finance portfolios of merchant powerplants.41 Rather than financing single peaking plantswith 30% debt, the portfolio structure allows Calpineto increase leverage ratios to 70% or more. The projectportfolio also provides lower transaction costs, greatermanagerial flexibility, and quicker execution speed.Through time, we should see better matching be-tween financing structures and asset types.

Second, better performance data will affect thesupply of funds that is available to finance newprojects. The Basel Committee on Banking Supervi-sion is currently reviewing proposals for capitaladequacy standards that are due to take effect in2004. One of the major areas of disagreement is theappropriate risk weightings for project loans. In itspreliminary assessment, the Committee claimed thatproject loans “possess unique loss distribution andrisk characteristics,” including “greater risk volatility”than other types of bank loans, which could in turnlead to “both high default rates and high loss rates” indistress situations.42 In an attempt to convince theCommittee that not all project finance loans deserve thehighest risk ratings, banks, sponsors, and ratingsagencies have banded together to provide historicalperformance data to the Committee. The preliminaryfindings seem to refute the Committee’s assertions:project loans perform substantially better than corpo-rate loans, and default rates and recovery rates are notnecessarily positively correlated.43 Whether the indus-try data will convince the regulators to revise theirposition remains to be seen. If not, project financeloans, particularly those in high-risk countries, will bepenalized with the highest risk weightings, an outcomethat will discourage banks from making project loans.

41. Calpine Corporation: The Evolution From Project to Corporate Finance,Harvard Business School case #201-098.

42. Basel Committee on Banking Supervision, “Working Paper on the InternalRatings-Based Approach to Specialized Lending Exposures,” Bank for InternationalSettlements, (October 2001), p. 1.

43. “League of Bankers,” ProjectFinance, (April 2002), pp. 25-26.


Third, new performance data will affect thedevelopment and liquidity of secondary markets forproject loans and project bonds. CS First Bostoncompleted the first securitization—a collateralizedloan obligation (CLO)—of project loans in 1998.Since then, CSFB and Citibank have both closed CLOtransactions while Société Générale is in the processof closing one. Clearly, the major project financelenders have an interest in securitizing their portfo-lios of project loans as a means of increasing liquidityand lowering funding costs, yet they are hamperedby a lack of accurate data on project default rates,recovery timing, and losses.44 Until the banks and therating agencies accumulate sufficient data on losscharacteristics, securitization is going to remain

difficult and institutional investors are going to bereluctant to enter the market.

The common theme running through each ofthese implications is that we need additional researchon project finance, project companies, and projectperformance. This article shows that studying projectcompanies can improve our understanding of coreissues and theories in corporate finance such as thedeterminants of capital structure. There are also validpractical reasons for studying project companies. Theabsence of good performance data is limiting thesupply of project funds. Facing an enormous need tofinance infrastructure investments, this shortage ofcapital is extremely costly in terms of economicgrowth for both developed and developing countries.

BENJAMIN ESTY

is Associate Professor of Business Administration at the HarvardBusiness School.

44. A. Simonson, W. Chew, and H. Albulescu, “Project Collateralized Loans andBonds: Rating Considerations,” Standard & Poor’s Corporation, Project & Infra-structure Finance Review: Criteria and Commentary, (October 2001), pp. 67-77.

The preliminary evidence indicates that project loans have superior post-defaultrecovery (that is, shorter recovery timing and higher recovery rates) than forcomparable corporate loans.

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Documents

RETURNS ON PROJECT-FINANCED INVESTMENTS: EVOLUTION AND MANAGERIAL IMPLICATIONS