Project Finance EXAM

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MORE INFORMATION IN LECTURE SLIDS
1. In order to ensure a project is completed, banks require loans to be ‘recourse’ to the sponsors during construction phase. Only once the project has reached a ‘certain point’ does it become ‘non-recourse’ to the sponsors.
a) What is the ‘certain point’ at which the financing of a project becomes non-recourse? Provide and explain two examples in relation to reaching this point. (100+ words)
ans:
2. a) Who are the parties to a Concession Deed? What rights and obligations does it provide? (120+ words)
ans:
b) Explain the purpose of both: (i) O&M agreements, and (ii) Offtake agreements. What are the key ‘bankability’ issues associated with each? (120+ words)
ans:
3. a) If you were preparing the feasibility study for the Dabhol project, what would have been the two most important risks (excluding social and environmental) that you would have identified up-front (i.e. before the project’s bankable feasibility study was produced)? Explain your choice. (150+ words)
ans:
b) In the Eurotunnel project, describe the main risk associated with the construction phase. What mechanism was used to mitigate this risk? What were the deficiencies of this mitigation? (150 +words)
ans:
4. a) In what circumstances would a project company consider obtaining a credit rating? What are the advantages and disadvantages of obtaining a credit rating? (120 + words)
ans:
b) Identify and explain different feasibility study phases. What is the rationale underlying a phased approach to feasibility studies? How can value be added to the project during these phases? (120 + words)
ans:
c) What does empirical evidence indicate in relation to the accuracy of final feasibility studies in project finance? (120 +words)
Lecture 1 – Introduction
• What is a project?
• What is project finance?
• Project finance v. other forms of finance
• Parties to projects
• Why use project finance? (the rationale)
• The project finance process
• Types of projects:
– Privatised/Public Private Partnerships (PPP’s)
– BOT, BOO, etc.
3
What is project finance?
• it is: a project where there is limited or no recourse to project
‘sponsors’ (owners), meaning that they are not the party
obliged to repay the loan(s) and interest thereon
• sponsors set up a special entity (SPV) to implement and
operate the project
• usually there will be a period for which there is recourse to the
sponsors, until a ‘Completion Test’ is met
• debt is repaid using cash flows generated from the operations
of the project and is typically secured by the project’s assets,
including revenue producing contracts
• there is limited or no recourse to cash flow from sponsors’
other assets after construction phase
– in practice, lenders may have recourse to their return of their loan
funds through various types of security arrangements
4
Project financing components
Five key components:
1. cash flow predictions derived from technical, financial,
and market studies
2. risk allocation agreements through the project contracts
and financing agreements
3. funding and repayment mechanisms
4. legal security and provision to handle defaults/workouts
5. project reporting / compliance
Source: C.R.Tinsley, Project Financing
5
6
Corporate finance vs project finance
Corporate Finance
• Lend to existing entity
• Full Recourse: access to
global corporate assets
as security for loans
• Lend against the balance
sheet of the company
Project Finance
• Lend to new entity
• Limited recourse: access
only to assets and
proceeds of the project
• Lend against forecast
income stream rather
than balance sheet
7
Parties to a Project Financing
Primary participants:
• Sponsors
• Lenders
• Contractors
• Governments
• Arranger / procurers
• Feedstock provider(s) and/or suppliers
• Offtaker(s) / purchasers
• other Participants include banks, lawyers and consultants
Refer diagram slides – numerous parties
Sponsors
Corporate Financing
Lenders
Financing Agreement
Shareholders
Agreement
Corporate
Lenders
Financing
Agreement Feedstock Supply SPV Suppliers
EPC
Agreements
Sales
Contract
O&M
Agreement
EPC
Contractors
Electricity
Company Operator
Commercial and Contractual structures tend to be unique to each Project
An example: Power Project
8
Project finance participants
9
Stages in project financing
• Project identification
• Risk identification and minimising
• Technical and financial feasibility
• Equity arrangement
• Negotiation and syndication
• Commitments and documentation
• Disbursement
• Monitoring and review
• Financial Closure / Project Closure
• Repayments
• Subsequent monitoring
10
Pre Financing Stage
Financing Stage
Post Financing Stage
Sources of project finance
Commercial
Banks MLAs ECAs Project
Bonds
Islamic
Finance DEBT
PROJECT
Shareholder
Loans Cash Mezzanine EQUITY
11
Past exam question 1 (part)
In order to ensure a project is completed, banks require
loans to be ‘recourse’ to the sponsors during construction
phase. Only once the project has reached a ‘certain point’
does it become ‘non-recourse’ to the sponsors.
a) What is meant by ‘recourse’ and ‘non-recourse’ loans?
b) Why do banks initially require ‘recourse’ loans? Why do
sponsors prefer ‘non-recourse’ loans?
c) What is the ‘certain point’ at which the financing of a
project becomes non-recourse? Provide and explain two
examples in relation to reaching this point.
d) …
12
Lecture 2 – Project Risks
• What is risk?
• Risk analysis, assessment and allocation
• Project risks
13
Why risk analysis?
In project finance, we perform risk analysis to:
• identify and allocate a particular risk to that party in the
project who is most appropriately placed to bear that risk
• provide efficient returns based on risk-reward relationship
• mitigate the residual risk in the project
• provide limited recourse in a non-recourse (SPV)
structure
• provide for better project monitoring mechanisms
14
Project finance risk analysis
• due diligence and risk assessment are not procedures peculiar
to project finance, as all financing involves risk in some way
• however, the process of contractual risk allocation, and then
raising finance based on this, are particular characteristics of
project finance
• it should be noted that risk assessment by lenders is based as
much on the financial impact that a particular risk may have on
the project’s viability as on the likelihood of it actually
happening – a useful tool for this is a ‘risk matrix’
• as a result of this process, sponsors sometimes feel that
lenders are concentrating on risks that are unlikely to arise and
therefore of little commercial importance
15
Example: risk assessment matrix
16
Risk analysis: cash flow waterfalls
• in risk analysis, a project’s cash flow can be summarised
using a cash flow waterfall, which shows the priority of
each cash inflow and outflow
• the cash flow waterfall depicts the seniority/ranking
between each cash flow item
• this can be especially useful when illustrating debt
repayments of many debt tranches with reducing seniority
• a cash flow waterfall is simple in its approach, as all cash
flow items are placed in the order in which they occur, i.e.
– revenues, expenses (operating and capital expenses),
taxes, debt service (principal and interest payments),
distributions and net movement in cash balance
17
Cash flow waterfalls
• key elements of a cash flow waterfall include:
– cash flow available for debt service (CFADS): this is the
most significant line which drives all debt repayment
calculations and ratios, including debt service coverage
ratio (DSCR), project life coverage ratio (PLCR) and loan
life coverage ratio (LLCR)
– cash flow before funding: this line is useful as a quick
check against funding, to ensure that initial construction
costs are being met by debt or equity
– cash flow available for debt service reserve (or other
reserve) account (DSRA)
– cash flow available to equity to calculate distributions
– net cash flow
18
Cash flow waterfall example
19
see http://www.corality.com/training/campus/post/cash-flow-waterfall-in-project-finance
Tinsley’s 16 risks
Operating Risk (3 types):
1. Technical
2. Cost
3. Management
4. Sponsor/Participant
5. Engineering
6. Completion
7. Supply/Traffic/Reserve
8. Market
9. Infrastructure
10. Environmental
11. Country / Political
12. Force Majeure
13. Foreign Exchange
14. Syndication
15. Interest/Funding
16. Legal
20
Completion risk
• also called Construction, Development, or Cost-Overrun risk,
Completion Risk is essentially the risk that the project structure
is not completed
• broadly speaking, a lender expects the loan proceeds to be
spent on building a project that is delivered on time and
budget, and is capable of producing sufficient cashflow after
completion of construction and commissioning to repay the
loan comfortably
• Completion Risk is usually not taken by financiers in project
lending; so, other financial support is necessary prior to
completion, e.g. sponsors’ own funds, other borrowings
• financiers will therefore insist (contractually) on being taken out
of their investment if completion fails to occur
21
Operating risk
• Operating Risk relates to the risks associated with
running the business following construction of the asset
• following Tinsley, Operating Risk can be thought of as
comprising three interrelated components: Technical,
Management and Costs
– some others treat these as three different risks; whilst
others just recognise a single Operating Risk category
• it makes sense to split them, as the ability to achieve the
desired production rate depends on the:
(1) engineering (technical) process used in production
(2) experience and quality of staff applied to the project, and
(3) the costs thereof
22
Supply risk
• also known as reservoir, or reserve, risk in resources
financings and traffic, or throughput, risk for infrastructure
projects
• the inputs to the project need to be capable of being
forecast and incorporated into the cashflow projections
• for an infrastructure project, this may be the traffic willing
to pay the toll
• note: traffic studies have been shown to be inefficient
tools from which to build cashflows
• in resources project financing, the estimation of reserves
has become a key element in banks’ evaluation of the
viability of the project
23
Market risk
• sometimes called sales or price risk
• this is best defined as the gross revenue line in the
cashflow; it is ‘quantity times price’
• market risk occurs, for example, when:
– the sales price falls;
– market share drops (perhaps due to shift in freight rates or due to
a new entry by a lower-cost competitor);
– demand for a product ceases; or
– sales are lost due to deteriorating quality of the project’s output
• in certain circumstances, market risk arises when sales
are cancellable after a period of below-par deliveries
• this is one of the most critical areas of risk absorption by
financiers
24
Environmental risk
• this risk must be addressed for projects in all locations
• a project financing cannot proceed without favourable
assurance of environmental compliance from the local
regulatory bodies with which the sponsors must deal
• environmental risk can also arise due to location of the
project, e.g. near towns or highway or in proximity to
wilderness, heritage, native reserve, or scenic areas
• this is not simply a sub-set of political risk but a distinct
risk aspect of project financing today
• some Multilateral Agencies (“MLAs”) will not even let a
project finance application in the door until it gets an
environmental tick first
25
2014 project Finance
26
Level of Risk
High
Medium
Low
project Phase
Construction and Engineering
Phase (2 yrs)
Start-up Phase Operation Phase
Completion Risk
Environmental
Risk
Legal Risk
Social Risk
Technology Risk
Operation Risk
Revenue Risk
Management
Risk
Infrastructure
Risk
Product Pricing
Risk
Sponsor/Counter
Party Risk
Political/Country and MacroEconomic/Financial
Risk
Diagram – key risks in different project phases
Lecture 3 – Risk Mitigation Strategies
• Who bears risks?
• Risk mitigation process
• Risk structuring
• Risk mitigation techniques
• Environmental considerations / issues
• Risk documentation matrix
27
Who bears risk in project financing?
• sponsors make key investment decisions, and earn the residual
gains and losses; in simple terms:
Return to equity = Revenues – Material / service costs – Labor costs –
Depreciation – Interest expenses – Taxes
– clearly, variability in RHS variables leads to changes in return to
equity and therein lies the risk
• financiers / lenders also bear risk and their objective is to ensure
they extract a commensurate return (interest rate)
• contractors, output purchasers and input suppliers will also bear
risks as they experience variability in their markets
• profit sharing mechanisms or tax incentives may change how
variability in income is shared among sponsors, lenders,
government, and contractors
28
The risk mitigation process
• Identification and assessment
– objective is to identify, categorise and document risks
that could affect the project
• Risk measurement
“If you can’t measure it – you can’t manage it”
• Risk allocation
– parties to the project allocate the risks by negotiation
– a general rule is to allocate commercial risks to private
sector and political risks to public sector
• Risk management
29
Risk structuring
1. Contracts:
• transferring risks to others via a contract:
– term contracts to buy output
– turnkey construction contracts
– guarantees
– fuel supply agreements, etc.
2. Trigger:
• e.g. financial ratios; failure to meet these means:
– funds are locked up
– acceleration of loan repayments
– no distribution to sponsors, etc.
30
Risk structuring
3. Financed:
• specifically relating to:
– standby debt/equity arrangement (firm commitment to buy)
– cash deficiency arrangements, to assure lenders that the
project will always have adequate cash available to service
its debt
4. Study:
• where market risk cannot be contracted readily (e.g. Toll
Roads), must rely on studies and market projections
• also assess where the project is on the industry cost curve
• sensitivity analysis is critical for these types of projects
– e.g. traffic studies
31
Risk structuring
5. Avoided:
• action to complete is taken in advance of a particular risk
aspect; e.g. transfer of a project risk (recourse to nonrecourse)
to bankers
• passing a completion test allows this
• rely on project design itself for risk mitigation (elements of
production process, technology used, etc.)
• Tinsley further suggests that the categories of risk sharing
in a project financing can be specified in terms of which
party ‘controls’ each specific risk, as demonstrated on the
following slide
32
Risk sharing
PROJECT COMPANY
SPONSORS BANKS
SHAREHOLDERS’
AGREEMENT
CREDIT
ENHANCEMENT
LOCAL LAWS
GOVERNMENT
SUPPLIERS
EPC CONTRACTOR
OPERATOR
GUARANTEES
SUPPLY
AGREEMENTS
EPC CONTRACT
O&M AGREEMENT
AGREEMENTS
GUARANTEES
Cost curve – iron ore
34
Guarantees
• one important method of mitigating commercial, political, legal
and construction risks is for the SPV to acquire guarantees by
the parties best able to provide them
• may be defined as “a formal assurance (typically in writing) that
certain conditions will be fulfilled, especially that a product will
be repaired or replaced if not of a specified quality”
– for example, during the early stages of construction, the sponsor
company may guarantee completion of the project
• contractors usually guarantee project completion either by
performance bonds or payment bonds (guarantees that
subcontractors will be paid)
• so, guarantees are credit enhancement devices
• often, multilateral and bilateral organisations mitigate financial
and political risks by issuing guarantees
35
Guarantees: example 1
36
Risk before and after mitigation
37
Lecture 4 – Case Studies I
• Successful project financing case studies
1. Petrozuata
2. Australia-Japan Cable
• Causes of project finance failures
• Unsuccessful project financing case studies
1. RiverCity Motorway
2. Enron / Dabhol power plant
38
Petrozuata project
• on 17 November 1991, Conoco and PdVSA executed letters of
intent indicating their interest in examining the feasibility of
developing an extra-heavy oil project in the Orinoco Oil Belt
• the Petrozuata project was designed to extract about 120,000
barrels per day (“bbl/d”) of extra-heavy crude and to upgrade it
into 104,000 bbl/d of a lighter, sweeter synthetic crude oil
(syncrude)
• the project’s term was 35 years
• the syncrude was to be sold to Conoco under an offtake
agreement for further refining at its Lake Charles (US) refinery,
which Conoco reconfigured for the purpose
• DuPont, Conoco’s parent company at the time, and PdVSA
provided guarantees in relation to the debt for the precompletion
period
39
Petrozuata risk identification and mitigation
• reserve risk
– relatively low – the project forecast extraction of only about
7% of identified reserves in the region (Zuata field)
• construction risk
– no general contractor
– cost overruns remained the responsibility of the sponsors
• revenue risk
– volume sold under contract to refineries in the US
– price was not fixed, but break-even price was well below
the actual prices
– the debt service reserve account provided protection
against financial default
40
Petrozuata financing
• PdVSA had strong cash flow, but raising debt had initial
problems because of the country risk problem
• both sponsors took a significant equity stake, totalling
USD950m (of USD2.4b total project budget)
• this provided the ability to eventually obtain investment grade
rating, which lowered the cost of funds significantly
• in addition, the project maintained Conoco’s ability to raise
debt for other projects (off balance sheet)
• the sponsors obtained project financing consisting of a public
bond issuance ($1b) and a commercial bank facility ($450m)
• financing for the project closed on 27 June 1997
• the cumulative project debt, which was incurred by the joint
venture company, Petrozuata C.A., totalled US$1.45 billion
41
42
Petrozuata completion
• on 15 March 2002, Petrozuata announced that all performance
requirements associated with the project financing have
successfully been met
• as a result, the institutional debt became non-recourse to
Petrozuata’s shareholders
• the last of six completion certificates had been delivered to the
lenders as required, verifying compliance of stipulated
conditions in the areas of reserves, operations, physical
facilities, insurance, legal and finance
• accordingly, both Conoco and PdVSA were released from
maintaining the $1.4 billion debt guarantees that they had
provided at the time of financing
• successful project financing (some later operating problems)
43
Australia Japan Cable (AJC)
Background:
• 12,500 km cable from Australia (Sydney) to Japan, via Guam
• capital cost of $520m before contingency
• key sponsors: Telstra, Japan Telecom and Teleglobe
• asset life of 15 years
Key Issues:
• growth potential
• high capacity, high volume, low unit cost project
• potential market risk from fast changing telecom market
• potential risk from project delay
• specialised use asset: Collapsed Ring Network technology
• significant free cash flow
44
AJC summary
Structural highlights:
• avoided hold up problem through governance structure:
– joint equity ownership of asset with Telstra and landing station
owners both as sponsors; gave long term landing station contracts
• single asset company
– limited, well defined expansion opportunities
– execution on the core asset important
– debt and equity ownership concentrated
– highly leveraged capital structure to leave minimum free cash
flows with managers
Conclusion:
– facts and qualitative data suggest AJC was a good bet
– risks mitigated effectively and strong cash flow led to success
45
RiverCity Motorway project
Brisbane City
Council
RiverCity
Motorway *
O&M Contractor
Brisbane Motorway Services
D&C Contractor
LBB JV
Debt Financiers
Equity Investors
Finance
Agreements
Equity Agreements D&C Advisers &
Consultants
Principal Subcontractors
Debt Finance
Sole Deed
Project Deed &
Licences(s) /
Lease(s)
Independent Reviewer
Independent
engineering and other
advisers to RiverCity
Motorway
Consultancy
Agreements
Other Subcontract
Arrangements / Agreements
O&M Sole
Deed
Interface
Agreement
D&C Sole
Deed
Consultancy
Agreements
Customers
Customer
Contacts
O&M
Contract
D&C
Contract
IR Deed of
Appointment
* RiverCity Motorway is comprised of a series of trusts and operating companies for tax
purposes. For the purpose of the this diagram, RiverCity Motorway is shown as one entity.
Traffic & Economic
Forecast Advisers
Tolling System &
Customer Services
Interface Agreement
46
RiverCity Motorway
• the equity in RiverCity Motorway was provided by outside
investors via an ASX listing
• it opened to traffic in late March 2010, ahead of schedule
• within weeks its share price dropped after vehicle numbers were
far below forecast
• the situation continued throughout 2010:
– June: Bankers to Brisbane’s RiverCity Motorway, which owns the Clem
Jones Tunnel, are facing a $700 million haircut as the road operator
falls well short of meeting its traffic projections
– June: Tolls for Brisbane’s unpopular Clem7 tunnel have been slashed
further in a bid to boost its use
– Sept: Just five months after opening, the demise of Brisbane’s
RiverCity Motorway is almost certain, after the company said yesterday
it only had enough cash to see it through the next 10 months
– Nov: RiverCity Motorway Group has told shareholders that it is
desperately seeking a ‘standstill’ agreement with its banks so that it
can sign off on half year financial accounts next month
47
RiverCity Motorway
• Dec 2010: Bankers for RiverCity Motorway Group are cashing in while
they can with three of the big four having now exited at less than 50¢ in
the dollar as the toll road battles for survival
• Feb 2011: Voluntary administrators PPB Advisory and receivers
KordaMentha have been appointed to decide the future of tunnel
operator RiverCity Motorway Group, after the company’s directors
conceded it is likely to become insolvent
• April 2011: NYSE-listed technical consultant firm Aecom, the company
that prepared failed toll road operator RiverCity Motorway’s traffic
forecasts when it floated in 2006, is facing class action threats from
litigation funder IMF Australia and law firm Maurice Blackburn
• July 2013: Queensland Motorways, Access Capital and UBS
Infrastructure Fund are believed to head the shortlist of bidders for
RiverCity’s Clem Jones Tunnel, with formal due diligence to start in
coming weeks and binding offers due in September
• Sept 2013: Queensland Motorways acquires RiverCity for $600m
48
Dabhol Power Company
• the Dabhol project was the largest foreign investment in India,
for a power station with port facilities for Liquified Natural Gas
(LNG) and an LNG regasification facility
• located in the Ratnagiri district, Maharashtra state, around
300km from Mumbai, India
• begun in 1992, the Dabhol power plant was to have gone
online by 1997
• it was intended to supply energy-hungry India with more than
2,000mw of electricity, about one-fifth the new energy needed
by India each year
– first phase was the power plant with 695mw capacity
• USD 920m project financing closed in June 1995
Government
of Maharashtra
Lending Banks
Dabhol
Power
Corp
Maharashtra
State
Electricity
Board
Full
Guarantee
PPA
Loan
Agreement
FX Availability
Reserve
Bank of
India
Ministry
of Power
Comfort
Letter
Government
of India
Limited
guarantee
Domestic
(Indian)
Financial
Institutions
(Banks)
US Exim
Political Risk
Guarantee
State
Support
Agreement
Dabhol structure
Dabhol risk analysis
51
Risk Mitigation
Strategy
Borne By Ability to
bear
Magnitude
Economic/
Demand
Through
Contract -PPA
MSEB Questionable High
Currency Through
Contract
MSEB/GoM/
GoI Questionable Medium
Financial Leverage Good
Credit Rating DPC Good Low
Technical Partner with
GE and Bechtel DPC Good Low
Political PRI, Govt
Guarantees
OPIC/GoM/
GoI Good Low
Social – DPC/MSEB/
GoM Questionable Medium-High
Environmental Lobby GoI, WB DPC Questionable Medium
Dabhol project problems
• not cost effective
• insufficient understanding of the political environment
• lack of transparency in the deal
• failure of the Indian government
• failure of Maharashtra local government
• dispute over the cost of power
• World Bank turned down financing, as it:
i. felt that the project was “not economically viable”
ii. also advised the project did not satisfy the test of least cost
power; and
iii. believed it was too large for the power demands of Maharashtra
52
Past exam question 3 (part)
c) If you were preparing the feasibility study for the Dabhol
project, what would have been the two most important
risks (excluding social and environmental) that you
would have identified up-front (i.e. before the project’s
bankable feasibility study was produced)? Explain your
choice.
d) In the Eurotunnel project, describe the main risk
associated with the construction phase. What
mechanism was used to mitigate this risk? What were
the deficiencies of this mitigation?
e) …
53
Lecture 5 topics
• Ownership structures
• Credit ratings in project finance
54
Ownership structures
• appropriate structure depends on a variety of business,
legal, accounting, tax, and regulatory factors, including:
1. the number of participants (sponsors) and the
business objectives of each;
2. the project’s capital cost and the anticipated earnings
pattern of the project;
3. the requirements of regulatory bodies;
4. the existing debt instruments and the tax positions of
the participants; and
5. the political jurisdiction(s) in which the project will
operate
55
Ownership structures
• there are four main business structures:
– incorporated structure (company)
– partnership
– trust
– other joint ventures / other unincorporated entities
• the choice of legal structure can have important tax
implications and can also affect the availability of funds to
a project and the cost of raising project financing
• also, as we know, project financing requires that the
economic rewards be allocated in a manner
commensurate with the project risks – the choice of a
project’s legal structure affects both allocations
56
Credit ratings in project finance
• the credit rating system is the traditional and prevalent
approach to credit risk assessment
• most rating systems are based on both quantitative and
qualitative evaluations – the final decision is based on
many different attributes, but usually it is not calculated
using a formal model that would show how to weight all
these attributes in a normative way
• in essence, the systems are based on general
considerations and on experience, and not on
mathematical modelling
• they cannot therefore be regarded as precise, and they
clearly rely on the judgement of the ratings evaluators
57
Credit rating – why and when?
• why should a project obtain a credit rating?
• it is required for refinancing the bank syndicated loan, or
for funding via direct bond issues (e.g. Petrozuata)
– as noted, a refinancing can result in lower interest costs
– it also allows the ‘negative’ financial ratios to be relaxed or even
removed
• when should a project obtain a credit rating?
• normally when a project reaches:
– end of stage 1 (construction stage) and is entering phase 2 (startup
phase)
– meets the completion test and is non-recourse to sponsors
– project then has the ability to seek a stand-alone credit rating as
the construction risk has been diminished/removed
58
Attraction of ‘investment grade’ ratings
• investment grade ratings (BBB/BAA3 and up) provide:
– access to a large and liquid market (banks, pension funds,
insurance companies, some investment funds)
– longer maturities (up to 20/25 years) to match average
useful life of the project
– competitive fixed rate pricing
– less onerous financial covenants negotiated with fewer
lenders
– efficient new issuance
• rating by at least two agencies eliminates negotiation with
multiple lenders
59
Lecture 6
• Project finance costs
• Sources of project funds
– Equity investment
– Debt funding
– Export Credit Agencies / Multilateral Agencies
60
Project costs – direct and indirect
• Direct project costs are associated with design, implementation
and monitoring and evaluation of the project, including:
– investment outlays
– construction costs
– operating costs
• Indirect project costs include:
– financing-related charges (including interest and fees)
– the cost of financial guarantees / other credit support mechanisms
– economic costs (e.g. loss of productivity due to more stringent safety
procedures)
– social costs (e.g. adverse health impacts)
– environmental costs (e.g. deforestation, land-use changes,
greenhouse gas emissions, loss of biodiversity, etc.)
61
Estimation of direct project costs
• a cost estimate is obtained through the following steps:
• Identify Cost Categories: the risk management scenario is
broken down into cost categories
• Gather cost data: unit costs must be assessed for each of the
cost category identified. This unit cost list can be drawn from
various data sources (market survey, statistical collection, etc.)
or from direct consultation with providers. Cost studies
conducted for similar projects can also be used; and
• Adjust costs to local conditions: where applicable, cost data
must be adjusted to take into account local conditions,
including timing (costs estimated in past years must be
escalated to account for inflation), local market conditions, etc.
• the quality of the estimate depends on the availability and
accuracy of quantitative data at each of these steps
62
Financing structure
• in practice, we find that most sponsor groups choose a
company as the SPV, but some choose partnerships
• once an ownership structure is agreed, the next choice
relates to implementing a financing arrangement that
meets the sponsors’ financing objectives, providing:
– appropriate debt:equity ratio
• sometimes driven by DSCR in project model
• many different varieties of debt financing available
• sometimes equity raised by IPO
– risk sharing amongst project participants; returns
commensurate with risk
– limited recourse to sponsors
– access to sufficient funds in a timely manner
63
Example – Quezon project financing
• the sponsors’ equity contribution was US$204.2m
• debt package was $662.5m, as follows
1. $405m as a 60-month construction loan priced at 137.5
basis points (bps) over Libor
– principal and interest was insured against political risk by
US Eximbank, 25 bps front-end fee and 35 bps commitment
fee on undrawn amounts
2. $100m as a trustee loan facility underwritten by BA,
supported by the US OPIC
3. $115m as an uninsured construction loan
4. $30m as an uninsured cost overrun loan
5. $12.5m as a coal supply and PPA IC facility
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Refinancing
• it is common that once a project is running, the initial
commitments will be refinanced in the bond or single
bank markets
• refinancing the construction loan allows:
– reduced borrowing (interest) cost
– removal of negative covenants / debt ratios
– removal of cash flow restrictions (cash flow waterfall)
– better debt maturity profile to match asset life
– removes necessity for debt and interest reserves
– funding diversification
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Pros and cons of financing with bonds
• Pros
– tapping new debt capacity
– better pricing (cheaper)
– major public relations exercise
for host country sponsors
• can open markets for other
financings, improve corporate
credit rating
– the ratings process brings
some measure of political
protection and risk mitigation
• bad behavior reflects back on
sovereign and state company
credit ratings
• Cons
– lump sum drawdown often
creates ‘negative carry’ on
cash
– costs fees to get/maintain
ratings
– extensive public disclosure
of proprietary information
– not easy to prepay and
refinance bonds
– bond markets can shut with
little / no notice
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Lecture 7 – Establishing project viability
• Economic viability
• Feasibility studies
– Process
– Technical feasibility
– Financial feasibility
• Due diligence process
– Project finance due diligence
– Environmental due diligence
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Economic viability
• to arrange financing for a stand-alone project, prospective
lenders (and prospective outside equity investors, if any) must
be convinced that the project is both technically feasible and
economically viable and that it will be sufficiently creditworthy if
financed on the basis that the project sponsors propose
• establishing technical feasibility requires demonstrating, to
lenders’ satisfaction, that construction can be completed on
schedule and within budget and that the project will be able to
operate at its design capacity following completion
• equally, establishing economic (financial) viability requires
demonstrating that the project will be able to generate sufficient
cash flow so as to cover its overall cost of capital
• leads to the concept of technical and financial feasibility studies
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Feasibility studies
• it is common for the process to involve three phases: (i) the
conceptual or scoping phase, (ii) the preliminary or prefeasibility
phase, and the (iii) final or definitive phase
• each phase will be analysed in terms of:
– an independent engineer’s objectives
– expected benefits for banks
– basic documentation necessary for the phase concerned
– supplementary and accessory activities and services (as
appropriate)
– scope of activities for each phase and reports produced by
the independent engineer
• the entire feasibility study process can require considerable time,
effort and funding (e.g. BHP spent $85m on Ravensthorpe)
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Feasibility study phases
1. Scoping study
– what could the project be?
– does it make sense to pursue this opportunity?
2. Prefeasibility study
– what should the project be?
– have we analysed enough alternatives?
– have we identified the optimum project configuration?
3. Feasibility study
– what will the project be?
– what risks will this project involve?
– what rewards will this project provide?
– have we presented an investment case that is unlikely to vary
significantly, i.e. we are confident of the parameters?
70
Feasibility studies and value creation
71
Feasibility studies and value creation
• regardless of where the study phases begin and end or how
many phases are recognised, and even regardless of whether
a study recommends proceeding to the next stage of the
development cycle or not, each study phase can create value
for the project owners
• this value can arise either:
– directly, by ensuring that viable opportunities are identified
and developed, and by aiding in the identification of the
optimal configuration if a project is developed; or
– indirectly, by halting or redirecting further effort on a project
that is either technically infeasible or economically unviable
in its proposed configuration
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Past exam question 4 (part)
a) In what circumstances would a project company
consider obtaining a credit rating? What are the
advantages and disadvantages of obtaining a credit
rating?
b) Identify and explain different feasibility study phases.
What is the rationale underlying a phased approach to
feasibility studies? How can value be added to the
project during these phases?
c) What does empirical evidence indicate in relation to the
accuracy of final feasibility studies in project finance?
d) …
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Lecture 8 – The project finance model
• the critical (yet basic) issue concerning economic viability
of a project is whether its expected NPV is positive
• this will be the case if the expected present value of the
estimated cash inflows exceeds the expected present
value of the project’s construction costs
• a financial model that effectively performs this analysis,
given the quantum of required data, is therefore an
essential tool for financial evaluation of the project
• this model serves several purposes, including use by
investors to evaluate their returns and by lenders to
calculate the level of cover for their loans and to create a
Base Case bankable study
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The project finance model
• the input assumptions for the project company’s financial
model can be classified into five broad areas:
1. Macroeconomic assumptions
2. Project costs and funding structure
3. Operating revenues and costs
4. Loan drawings and debt service
5. Taxation and accounting
• clearly, estimation of variables is paramount
• model needs to include sensitivity analyses
• see Bodmer web site for fully worked examples
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Project finance model outputs
• the model outputs are a series of financial data including:
– construction phase costs
– drawdown of equity
– drawdown and repayment of debt
– interest calculations
– operating revenues and costs
– tax
– profit and loss account (income statement)
– balance sheet
– cash flow (source and use of funds)
– lenders’ cover ratios and investors’ returns
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Lecture 9 – Documentation
• from Seminar 1: “…risk allocation through Project
Contracts and Financing Agreements…” refers to:
– finance documents
– security documents
– hedging agreements
– equity documents
– tax documents
– concession deeds
– project documents
– real property documents
– tripartite agreements
77
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Facilities agreements – structure
• project finance facilities agreements are typically long and
complex documents, but the underlying structure is
closely correlated with the APLMA standard form
• common points of negotiation:
* Reserves, lock-up, sweeps, prepayment, distributions to equity
79
Debt
Sizing
Control of
Free Cash*
Cost to
Complete
Covenant
Package
Transfers of
Debt & Equity
Facilities agreements – common types
• “Mini perm”
– construction tranche Ö capitalising
– term tranche Ö amortising
– syndicated
• Senior and mezzanine tranches
– second-ranking vs structurally subordinated
– complex intercreditor arrangements
• Senior and ECA tranches
• Senior and monoline “wrapped” tranches
• Commitments and underwriting
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Facilities Agreement
• Pricing
– Base rate
– Margin
• Debt ‘sizing’ methodology
– quality of reserves / feedstock / wind / sun
– contracted vs uncontracted revenue
– market risk?
• Base case financial model
• Refinancing
– do lenders assume an exit or rollover?
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Project documents
• in this category, project documents refer to the contracts under which
the project is executed
• they are as diverse and bespoke as the underlying project itself
• e.g. renewable energy project
82
EPC
Agreement
WTG Supply
Agreement
Power Line
Construction
Deed
Network &
Connection
Deed
O&M
Agreement
Offtake
Agreement
Project documents – EPC Agreement
Key bankability issues of the EPC Agreement
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• creditworthiness of builder
• fixed price + fixed time +
fixed scope
• EOTs Ö time, cost or both
• liquidated damages
• performance security
• practical completion
• defects
• site conditions and
environmental liability
• variations
• insurance and force majeure
• termination and replacement
• caps on liability
Project documents – Supply Agreement
• creditworthiness of supplier
• reliability of technology
• fixed price
• lead time for delivery
• intellectual property
• title to, and certification of, equipment
• performance warranties and LDs
• defects
• insurance (including maritime insurance)
• termination and replacement
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Past exam question 2 (part)
c) Who are the parties to a Concession Deed? What
rights and obligations does it provide?
d) Explain the purpose of both: (i) O&M agreements, and
(ii) Offtake agreements. What are the key ‘bankability’
issues associated with each?
e) …
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