Project Finance and Credit Risk Management

1. Project Finance and Credit Risk Management???????????

2. Project Finance Overview?????? Credit Risks in Project Finance?????????? Credit Risk Management (Financial Risks)?????? (????) Cash Flow Analysis????? I (NPV and IRR?????????) Cash Flow Analysis????? II (Individual Cash Flows?????) Stress Testing/Simulation????/???? Credit Risk Management (Political Risks)?????? (????) Table of Contents??

3. Project Finance Overview??????

4. Basel’s Definition of PF (in short)?????Basel?? A simple cash-flow stream??????? The value of PF relies on a simple cash-flow stream generated by a single project and the collateral value of the project assets: the source of the cash-flow may be a single buyer or consumers.????????????????????????,???????????:?????????????????? Non- or limited-recourse????????? An independent SPE is created to hold the project assets and to integrate all legal contracts in an effective and efficient manner for funding, building and operating a single purpose project. SPE is owned by one or a few sponsors and it is highly leveraged.????????????????????????,???????????????????,?????????????????????????????????,?????????????? Risk allocation???? PF is used for large, complex, and expensive industrial facilities such as natural resources and infrastructure sectors, which involve a series of legal contracts in a vertical chain from input supplier to output purchaser.?????????,???????????,?????????????,?????????????????????????????

5. Why PF Structure? Sponsors’ Motivation?????????????????? Risk mitigation/Debt capacity????/???? By isolating the asset in a standalone project company, project finance reduces the possibility of risk contamination, the phenomenon whereby a failing asset drags an otherwise healthy sponsoring firm into distress.????????????????????,?????????????,??????????????????????? The sponsor can preserve corporate debt capacity.?????????????? To create asset specific governance structure????????????? Separate legal incorporation, which assumes a specific project and few growth options, reduces both the cost of monitoring managerial actions and assessing performance, and wasteful expenditures and sub-optimal reinvestment.????????,????????,????????,????,????????,??????? Deterrent against strategic behavior by the third parties???????????? Sponsor can involve the critical parties for the project, including the public sector, as shareholders to prevent future conflict.????????????,???????????,?????????,??????????? By involving international banks and multilateral agencies whose interest is solely in cash-flow maximization by the project, the sponsor may prevent harmful action by the host government.??????????,??????????,???????????????,????????????????????

6. PF vs. Corporate Finance???? vs. ???? Project Finance???? Limited or non-recourse?????????? Simple cash-flow structure produced from one independent waste asset??????????????? High-leverage at beginning, but getting lower toward the end of the debt repayment?????????, ??????????? Relatively a few layers of debt and equity structure (simple ownership)????????????(?????) Applied to projects attaining a scale of economy???????????? Corporate Finance???? Full recourse???? Complicated cash-flow structure produced from a set of various, replaceable profit making projects??????????????????????? Leverage depends on a company’s target capital structure???????????????? Various layers of debt and equity structure (complicated ownership)????????????(??????) Applied to all profit making business types???????????

7. Typical Structure of Conventional PF???????????

8. 2. Credit Risks in Project Finance??????????

9. Project Finance Credit Risks Overview

10. ?????????-??

11. 3. Credit Risk Management??????(Financial Risks????)

12. 3.1 Cash Flow Analysis I?????I(NPV and IRR)(??????????)

13. Net Present Value??? (NPV) I

14. Net Present Value??? (NPV) II

15. Net Present Value ???(NPV) III Implication ?? Positive NPV??????: the project will generate more cash than the necessary amount to repay debt to banks and deliver dividend to shareholders, the excess cash solely to the project’s shareholders. ??????????????????????????????,?????????????????? Zero NPV?????: the project will generate exactly the necessarily amount of cash to repay debt to the banks and deliver dividend to shareholders. ????????????????????????????? Negative NPV??????: the project cannot generate cash to repay debt to banks and deliver dividend to shareholders. ??????????????????????????? Weak point of NPV is that it produces only absolute values. ??????????,???????? $1 million investment and $1 thousand investment could, theoretically, produce the same NPV values. ?????????????,??????????????

16. Internal Rate of Return????? (IRR) Method?? IRR is defined as the discount rate that assumes NPV is equal to zero. ??????????????????????? Implication?? IRR is useful when investors assess the project against their hurdle rate, which is a cost of capital. IRR??????????????????????????? IRR > Hurdle Rate: the project will produce more cash than the necessary amount to repay debt and deliver dividend to shareholders.????????????????????????? IRR = Hurdle Rate: the project will produce the exact amount of cash to compromise investors’ cost of capital.??????????????????????????? Weak points of IRR?????????? It applies the project’s IRR to the reinvestment of cash in flows??????????????????????? When there are more than one change from cash out-flow to cash-in flow, or from cash-in flow to cash out-flow in the projection, the value of IRR are more than one: calculator would simply indicate “error”???????????????????,IRR???????:????????:??

17. Modified Internal Rate of Return ???????(MIRR) I

18. Method?? MIRR is defined as the discount rate that forces the present value of cash in flows (CIF) to equal the present value of cash out flows (COF).???????????????????????????????? Implication?? MIRR is better than IRR because it reinvest the cash-in flow by using the cost of capital which is more realistic. Thus, MIRR tells more accurate profitability of the project.??????????????????,????????????????????????? MIRR > Hurdle Rate: the project will produce more cash than the necessary amount to repay debt and deliver dividend to shareholders.???????????????????? MIRR is better than IRR because it allows more than one changes in plus and minus signs in cash flow projection. MIRR?????????????????? Modified Internal Rate of Return???????(MIRR) II

19. Profitability Index ??????(PI) Method?? PI is another way of using NPV by dividing PV of future cash flow by initial investment.?????????????????????????? Implication PI tells the relative profitability of the project by indicating the value of the future cash flows par dollar of initial investment. When PI > 1, the project should be accepted. When PI = 1, this basically means NPV = 0 and MIRR = Hurdle Rate.???????????????????????????????????PI>1?,??????????PI=0?,??????=0?????????=????????

20. Comparing two projects with NPV and IRR????????????????????

21. Other Important Indicators?????? Debt service coverage ratio?????? Loan life coverage ratio??????????? Project life coverage ratio??????????? Debt-to-equity ratio?????

22. Decreasing Debt/Equity Ratio???????? For calculating NPV for a project within a company or for a company’s valuation, generally WACC (weighted average cost of capital) is used. ????????????????????????????,???????????? In case of project finance the outstanding debt constantly declines and debt/equity ratio keeps changing throughout the project life. ????????,?????????,???????,????????????? Issues on Cost of Capital ????I

23. Issues on Cost of Capital???? II Reliability of CAPM in Project Finance Situation?????????????????? Both NPVP1 and NPVP2 in the previous slide involve the concept of CAPM (capital asset pricing model) to get debt, equity and asset beta, which would not work appropriately in case of project finance for several reasons:???????????????????????????????????,???? A country where project is located may not have integrated/efficient market ???????????????/?????? Data would be not available for market risk premium ??????????????? An ideal instrument represents the risk free rate would not be available ??????????? CAPM may not able to incorporate all risks associated with the project ????????????????????????? CAPM does not consider asymmetric down side risks?????????????? Required return on debt may different between construction and operating periods ?????????????????????? What if there is single purchaser located in other country??????????????? What to do????

24. 3.2 Cash Flow Analysis????? II(Individual Cash Flows?????)

25. Analysis of Individual Cash Flows???????

26. Construction?? I Construction contracts???? Fixed price contract?????? (high premium/low risk, payment based on progress???/???,?????) Turn-key contract?????? The contractor accepts full responsibility for delivering a fully operational facility on a date-certain, fixed price basis.?????????,????????? EPC contract ??????(engineering, procurement, and construction contract??,??,????) Cost plus fee contract????????? (low premium/high risk, frequent payments???/???,????) Cost plus fee contract with maximum price and incentive fee??????????????????

27. Construction?? II Major risks???? I Increase in construction cost?????? (cost over-run????) Unavailability of sufficient funds to complete construction?????????? Inability to the project company to pay increased debt service during operation, even if funded by debt???????,????????????????????? Risk mitigation???? Turn-key contract?????? Contractual undertakings—infusion of additional equity, standby equity participants, contingency tranche in construction loan, standby cost over-run funding agreements?????????,????????,????????,?????????? Escrow funds, contingency account????,??????? Delay in completion???? Increase in construction costs and in debt service costs??????????? Delay in the scheduled flow of revenue to cover debt service and expenses???????,?????????? Breach of project contracts, such as fuel supply or off-take???????,?????????????? Risk mitigation???? Turn-key contract?????? Stated milestones tied to construction loan contract????????????????

28. Construction?? III Major risks???? II Project performance at less guaranteed levels???????? Breach of off-take contract/decrease in project revenue?????????/??????? Increase in maintenance costs and input/utility costs??????????/???? Inability to the project company to repay debt?????????? Risk mitigation???? Performance liquidated damage to cover the loss??????????? Third party guarantees such as letter of credit or performance bond (payment bond), when financially weak contractors??????????,??????????????????(????) Bid bond/warranty bond/retention bond????/????/????? Other risks???? Site acquisition and construction related facilities????????? Equipment, building material, and utility supply??,????,???? Labor/environmental issues ??/???? Force majeure risks?????? Risk mitigation???? All risk contractor’s riks insurance????????

29. Off-take Purchase ??????I Off-take agreements?????? Take-or-pay contract ??????(a form of unconditional guarantee???????) the purchaser is required to pay for a certain amount (fixed cost), even the product is not delivered. The rest of the amount (variable cost) will be paid if the purchaser wants to buy. ?????????,?????????????(????)??????????,??????????(????) Take-and-pay ???????(a form of conditional guarantee?????) the purchaser required to pay for a certain amount (fixed cost) for the product delivered, when the product meets the contract quality requirements.???????????????,???????????(????) Long-term sales agreements ??????(obligation to purchase) typically one- to five-year agreement for the purchase and sale of specified quantities of the project’s output. The purchaser has the obligation to purchase the contract quantity only if it is produced and delivered, and meet the contract quality requirements. Off-take purchaser’s financial strength???????????? Market for product or service (in the long run)????????(??)

30. Off-take Purchase??????II Merchant project ????(Merchant facility) Merchant facility is a project finance without off-take contracts?????????????????????? Cash flow fully relies on the market for project output and forecasts of future market conditions (revealed to market risks).????????????????????????? The analysis of market risk is similar to that used in any business model ????????????????(price, supply and demand??,?????). Risk mitigation???? Linking inputs and outputs???????? Reserve funds???? Cash calls???? Subordination of project costs to debt services??????????? Hedging strategies???????? The commodity supplier as project partner?????????????

31. Input?? Major risks???? Increase in input costs?????? Risk mitigation???? Supply-or-pay contract??????? Fixed amount contract?????? Requirements contract (cap/floor)????????(??/??) Output contract???? Subordination of project costs to debt services????????????? Other issues???? Delay in completion of transportation facilities????????? Availability of supply????? Disruption of transportation????? Title and risk of loss????????? Force majeure???? Financial strength of supplier????????

32. Operation?? Major risks???? Increase in operating costs??????? Excessive equipment replacement and unscheduled maintenance?????????????? Poor productivity of labors, incorrect assumptions of required labor????????,???????????? Increase in utility costs??????? Risk mitigation???? Performance guarantee???? (liquidated damage???) Fixed price operation and maintenance contract??????????? (very rare????) Cost plus fee operation and maintenance contract???????????? Cost plus fee contract with maximum price and incentive fee?????????????????? Other risks???? Force majeure risks?????? Risk mitigation???? All risk operator’s risk insurance????????? Financial strength of the operator????????

33. Exchange/Interest/Inflation Rate??/??/????? Currency and exchange risks?? Loan agreement???? Loan disbursements???? (construction loan and term loan?????????) Principal repayment and interest repayment???????? Availability of swap markets???????? All other agreement???? Export and import of equipment, input, out-put, operating costs???????,??,??,???? Cash flow will be affected depends who takes the risks and covers??????????????? Interest rate?? Incorrect interest rate projections can severely affect the ability of the project revenue to service debt by ???????????????,??????????????????????? Inflation rate????? Risk allocation???? Cash flow projection?????

34. Collateral?? I The “blanket” lien????? The blanket lien covers all the assets of the project company, including real (unmovable) and personal (movable), tangible and intangible.????????????????,?????,??(???)??,???????? Project cash flow????? A security interest in the cash flows generated by the project under long-term off-take agreements.??????????????????? Accomplished through a cash collateral account in which off-take purchaser pays all payments into the account established by the lenders.?????????????????????????????? Offshore accounts/escrow accounts????/???? Ownership interests????? Pledge of ownership interests??????? Voting trust????? Negative pledges???? An agreement under which the project company will not create, directly or indirectly, any security interest, lien or encumbrance in its assets for the benefit of any other entity.??????,??????????????????????,???,????????????

35. Collateral?? II Personal (movable) property??(???)?? Intangible assets???? Permits, licenses and concessions???,???,??? Contracts?? Insurance proceeds???? Surety bonds???? Guarantees?? Liquidated damages??? Political risk insurance?????? Accounts?? Disbursement agreement????

36. Collateral?? III Review the contracts to verify that they are each assignable under the country’s law. ??????????????? In the event of a foreclosure, the contracts will only have value to the lender if they can be assumed by the lender and later assigned to a purchaser of the project.?????????????,????????????? Other issues???? Types of liens allowed???????? Local formalities???? Denomination of lien in local currency???????? Priority of lien (perfection)?????? Enforcement?? Foreclosure????

37. Equity and Dividends???????? Timing and certainty of equity contribution??????????? A part of equity contributions to the project company may be planned after the financial closing. Some funds may be injected with construction draw-downs, or await investment until project completion. ????????????????????????,?????????????????????????? Risk mitigation???? Condition precedents in loan agreement?????????? Covenants in loan agreement???????????? Some conditions for dividend payments????????? Requirement to replenish before dividend payments????? Reserve (contingent) account??(??)?? Off-shore account???? Financial covenants: a financial covenant limiting the dividend payments to a certain level??????:???????????????

38. Permit/License/Concession???/??/??? Status?? Permits already obtained and in full force and effect?????????????? Permits routinely and mandatorially granted on application and fulfillment of applicable criteria and that would not normally be obtained before construction (before loan agreement)???????????,??????????????,?????????????(????????) Other than above?? Risks?? Unable to operate/termination of project??????/???? Damage payments???? Different policies between central and local governments???????????? Permit vocation, additional permit requirements????,?????? Risk mitigation???? Integrated management of all necessary permits: apply, obtain, maintenance, renew processes?????????????:??,??,??,????

39. 3.3. Stress Testing/Simulation????/????

40. Basics of Risk Analysis Techniques???????? I Three stages of risk analysis techniques?????????? Sensitivity Analysis?????: a linear relation between a cash flow factor and NPV?????????????? Scenario Analysis????: estimate probabilities of each individual cash flow on the basis of base-case, best-case, and worst-case scenario, which in turn provides mean and standard diviation of NPV ??????,????,?????????,???????????,?????????????????? Monte-Carlo Simulation??????: obtain expected NPV and standard deviation from randomly selected scenarios based on the probability distribution of each cash flow factors?????????????????????,????????????

41. Sensitivity Analysis????? I Method?? Sensitivity analysis is a risk analysis technique that tells how much NPV will change in response to given changes in one cash flow factor with other factors held constant. ??????????????,???????????,?????????????,?????????

42. Sensitivity Analysis?????II The slopes of the lines indicate how sensitive NPV is to changes in each individual cash flow.????????????????????????? Relatively small error in estimating individual cash flow with steeper slope leads to a large error in estimating project’s NPV.?????????????????????????,?????????????????????

43. Sensitivity Analysis????? III Implication?? Sensitivity analysis is a powerful technique to understand which factors need to be more accurately examined to reduce the entire credit risk.???????????????,??????????????????????,????????? Weak Points?? Sensitivity analysis does not incorporate a concept of probability??????????????? It can deal with only one cash flow for each analysis??????????????? NPV Breakeven Analysis?????????? NPV breakeven analysis examines a value of each factor which makes NPV exactly zero. ??????????????????????????????

44. Scenario Analysis???? I Method?? Scenario analysis examines a set of scenarios under the assumption that each scenario occurs with a certain probability ???????????,???????????????? Example 1: sales price would drop by 6% with 25% probability for worst case scenario.?1:??????????25%,??????6%? Example 2: operating cost would be reduced by 2% with 25% probability for best case scenario.?2:??????????25%,???????2%? Then obtain base-case, best-case, and worst-case NPV and calculate mean NPV and standard deviation to (roughly) estimate the magnitude of the risk inherent to the project. ????????,????,?????????,?????????????,(???)???????????????? Implication?? Scenario analysis is very useful technique to grasp the worst case situation of the project (by assuming 1.0 correlation).????????????????????????(???????1.0)

45. Scenario Analysis???? II Simplified illustration of scenario analysis process ?????????

46. Monte Carlo Simulation?????? Simplified illustration of monte-carlo simulation process ???????????

47. 4. Credit Risk Management(Political Risks)??????(????)

49. Useful Documents????? Project Finance: Introductory Manual on Project Finance for Managers of PPP Projects, National Treasury, South Africa????:PPP????????? Although this document is prepared for public-private partnership (PPP) managers, it provides a good overview of project finance credit analysis, by addressing the general structure of a project, funding alternatives, investor profiles, and the criteria investors will consider. Also, it contains good illustrations for cash flow analyses. (46 pages) ??????PPP????,????????????????,??????????,????,???????????,??????????????? Available at: http://www.finint.ase.ro/Masterate/Masterat_Alexandra/Bibliografie/Project_Finance_Manual.pdf Tools for Project Evaluation,?????? Nathaniel Osgood, 2004 Detailed and clear explanation on time value of money, the concept of discounting, and NPV and IRR methods, with cases. (41 slides)???????????????,??????,?????????????? Available at: http://ocw.mit.edu/NR/rdonlyres/Civil-and-Environmental-Engineering/1-040Spring-2004/ABF26C4A-8572-498D-ACE3-98D2E8AD0685/0/l3prj_eval_fina2.pdf Thought process during the project initiation pahse, ???????????H. Griesel, 2004 An excellent summary of project finance risks in the mining sector. ?????????????(6 pages) Available at: http://www.platinum.org.za/Pt2004/Papers/237_Griesel.pdf Glossary of Project Finance Terms???????, Foster Wyatt Training, 2003 Useful glossary for project finance. ???????????(12 pages) Available at: http://www.fosterwyatt.com/filesdownload/HNDOUT39.pdf