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INTRODUCTION TO PROJECT FINANCE

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  1. INTRODUCTION TO PROJECT FINANCE

  2. OUTLINE • What is Project Finance? • How does project finance create value? • Project valuation • Case analyses • Recap

  3. What Is Project Finance? • Definition • Major characteristics • Schematic example of a project structure • Major project contracts

  4. Definition: “Project Finance involves one or more corporate sponsors investing in and owning a single purpose, industrial asset through a legally independent project company financed with limited or non-recourse debt.” A relevant question to investigate: Finance separately with non-recourse debt? (Project Finance) SPONSOR + PROJECT? Finance jointly with corporate funds? (Corporate Finance)

  5. Major characteristics: • Economically and legally independent project company • Founded extensively on a series of legal contracts that unite parties from input suppliers to output purchaser • Project assets/liabilities, cash flows, and contracts are separated from those of the sponsors, conditional on what accounting rules permit • Investors and creditors have a clear claim on project assets and cash flows, independent from sponsors’ financial condition • Debt is either limited (via completion guarantees) or non-recourse to the sponsors

  6. Major characteristics: • Highly leveraged project company with concentrated equity ownership • Partly due to firms’ need for flexibility and excess debt capacity to invest in attractive opportunities whenever they arise • Syndicate of banks and/or financial institutions provide debt • Typical D/V ratio as high as 70% and above • Debt has higher spreads than corporate debt • One to three equity sponsors • Sponsors provide capital in the form of equity or quasi-equity (subordinated debt) • Governing Board comprises of mainly affiliated directors from sponsors

  7. Major characteristics: • Historically formed to finance large-scale projects • Industrial projects: mines, pipelines, oil fields • Infrastructure projects: toll roads, power plants, telecommunications systems • Significant financial, developmental, and social returns • Examples of project-financed investments • $4bn Chad-Cameroon pipeline project • $6bn Iridium global satellite project • $1.4bn aluminum smelter in Mozambique • €900m A2 Road project in Poland

  8. Major characteristics: • Statistics as of year 2002 • $135bn of capital expenditure globally using project finance • $19bn of capital expenditure in the US • Smaller than the $612bn corporate bonds market, $397bn asset backed securities market and $205bn leasing market; approximately same size with the $27bn IPO and $26bn venture capital market

  9. A simplified project structure example: A “nexus of contracts” that aids the sharing of risks, returns, and control Source: Esty, B., “An Overview of Project Finance – 2002 Update: Typical project structure for an independent power producer”

  10. The Offtake Contract: A framework under which Project Company obtains revenues Provides the “offtaker” (purchaser) with a secure supply of project output, and the Project Company with the ability to sell the output on a pre-agreed basis Can take various forms, such as “Take or Pay” Contract: “Power Purchase Agreement” (PPA) Input Supply Contract: The Offtake Contract for the input supplier Provides the Project Company the security of input supplies on a pre-agreed pricing basis The terms of the Input Supply Contract are usually crafted to match those of the Offtake Contract (such as input volume, length of contract, force majeure, etc.) Major project contracts:

  11. Construction Contract: A contract defining the “turnkey” responsibility to deliver a complete project ready for operation (a.k.a. Engineering, Procurement, Construction (EPC) Contract) Operation and Maintenance Contracts: Ensures that the operating and maintenance costs stay within budget, and project operates as planned. Permits: Contracts that ensure permits and other rights for construction and operation of the project, as well as for investing in and financing of the Project Company May be provided by central governments and/or local authorities Government Support Agreements: Provisions may include guarantees on usage of public utilities, compensation for expropriation, tax exemptions, and litigation of disputes in an agreed jurisdiction Major project contracts:

  12. OUTLINE • What is Project Finance? • How does project finance create value? • Project valuation • Case analyses • Recap

  13. How Does It Create Value? • Drawbacks of using Project Finance • Value creation by Project Finance • Organizational structure • Agency costs, debt overhang, risk contamination, risk mitigation • Contractual structure • Structuring the project contracts to allocate risk, return, and control • Governance structure • Benefits of debt-based governance • Case examples to value creation

  14. Takes longer to structure and execute than equivalent size corporate finance Higher transaction costs due to creation of an independent entity and complex contractual structure Non-recourse project debt is more expensive due to greater risk and high leverage High leverage and extensive contracting restricts managerial flexibility Project finance requires greater disclosure of proprietary information to lenders Drawbacks of Using Project Finance Structure: Still, the combination of organizational, financial, and contractual features may offer an opportunity to reduce net costof financing and improve performance Structure matters, contrary to MM Proposition!

  15. Why does structure matter? • Structural decisions may affect the existence and magnitude of costs due to market perfections: • * Agency conflicts • * Financial distress • * Structuring and executing transactions • * Asymmetric information between parties involved • * Taxes Value Creation Governance Structure Organizational Structure Contractual Structure

  16. How Does It Create Value? • Drawbacks of using Project Finance • Value creation by Project Finance • Organizational structure • Agency costs, debt overhang, risk contamination, risk mitigation • Contractual structure • Structuring the project contracts to allocate risk, return, and control • Governance structure • Benefits of debt-based governance • Case examples to value creation

  17. Agency conflicts between sponsors (owners) and management (control) High levels of free cash flow leading to overinvestment in negative NPV projects Risk shifting/debt shifting by managers to invest in high risk, negative NPV projects to recoup past losses Refusal to make additional investment Concentrated equity ownership and single cash flow stream provides critical monitoring Strong debt covenants allow both sponsors and creditors to better monitor management High debt service reduces the free cash flow exposed to discretion Extensive contracting reduces managerial discretion “Cash Flow Waterfall” mechanism facilitates the management and allocation of cash flows, reducing managerial discretion. Covers capex, debt service, reserve accounts, and distribution of residual income to shareholders Given the projects are defined within narrow boundaries with limited investment opportunities, moral hazard (risk shifting, debt shifting, reluctance to invest) is minimized Value creation by organizational structure: Agency Costs Problems Structural Solutions:

  18. Agency conflicts between sponsors and creditors: Distribution of cash flows, re-investment, and restructuring during distress Moral hazard (such as risk shifting and debt shifting) encouraged by full recourse nature of debt to sponsor “Cash Flow Waterfall” mechanism reduces potential conflicts in distribution and re-investment of project revenues Legally/economically separate project company eliminates potential for risk shifting and debt shifting Concentrated debt ownership is preferred (i.e. bank loans vs. bonds) to facilitate the restructuring and speedy resolutions Usually subordinated debt (quasi equity) is provided by sponsors Strong debt covenants allow better monitoring Single cash flow stream and separate ownership provides easier monitoring Value creation by organizational structure: Agency Costs Problems Structural Solutions:

  19. Conflicts between sponsors and other parties (purchasers, suppliers, etc.) Vertical integration is effective in precluding opportunistic behavior but not at sharing risk. Also, opportunities for vertical integration may be absent. Long term contracts such as supply and off take contracts: these are more effective mechanisms than spot market transactions and long term relationships. Joint ownership with related parties to share asset control and cash flow rights. This way counterparty incentives are aligned. Value creation by organizational structure: Agency Costs Problems Structural Solutions:

  20. Conflicts between sponsors and government: Expropriation through either asset seizure, diversion, or creeping Since project is large scale and the company is stand alone, acts of expropriation are highly visible in the international arena which detracts future investors High leverage leaves less on the table to be expropriated Multilateral lenders’ involvement detracts governments from expropriation since these agencies are development lenders and lenders of last resort. However these agencies only lend to stand alone projects. High leverage also reduces accounting profits thereby reducing the potential of local opposition to the company. Value creation by organizational structure: Agency Costs Problems Structural Solutions:

  21. Sponsor’s under-investment in positive NPV projects when sponsor has: limited corporate debt capacity agency or tax reasons that exclude equity as a valid option pre-existing debt covenants that limit possibility of new debt Non-recourse debt in an independent entity allocates returns to capital providers without any claim on the sponsor’s balance sheet. Preserves corporate debt capacity. The fact that non-recourse debt is backed by project assets/cash flows and not by the sponsor’s balance sheet increases the chances of an already highly leveraged sponsor to separately finance a viable project Value creation by organizational structure: Debt Overhang Problems Structural Solutions:

  22. A high risk project may potentially drag a healthy sponsor into distress, by increasing cash flow volatility and reducing firm value. Conversely, a failing sponsor can drag a healthy project along with itself. Very large projects can potentially destroy the sponsor’s balance sheet and lead to managerial risk aversion Benefit from portfolio diversification is negative (risk is higher) when sponsor and project cash flows are strongly positively correlated. Project financed investment exposes the sponsor to losses only to the extent of its equity commitment, thereby reducing its distress costs Through project financing, sponsors can share project risk with other sponsors: Pooling of capital reduces each provider’s distress cost due to the relatively smaller size of the investment and therefore the overall distress costs are reduced. Separate incorporation eliminates potential increase in risk when financing a project strongly correlated to sponsor’s existing asset portfolio. Value creation by organizational structure: Risk Contamination Problems Structural Solutions:

  23. Joint venture projects with heterogeneous partners: Financially weaker partner cannot finance its share of investment through corporate borrowings, and needs project finance to participate Location: Large projects in emerging markets usually cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive. The stronger partner is better equipped to negotiate terms with banks than the weaker partner and hence participates in project finance even if it can finance its share via corporate financing Debt may be the only option and project finance the optimal structure. Besides, host government may grant the project “tax holiday”, which provides sponsors exemptions from taxation Value creation by organizational structure: Other motivations Problems Structural Solutions:

  24. How Does It Create Value? • Drawbacks of using Project Finance • Value creation by Project Finance • Organizational structure • Agency costs, debt overhang, risk contamination, risk mitigation • Contractual structure • Structuring the project contracts to allocate risk, return, and control • Governance structure • Benefits of debt-based governance • Case examples to value creation

  25. Value creation by contractual structure: • An introduction to risk management • Risk management defined • Sources of risks • Who bears risk? • Mechanisms for reducing cost of risk • Contractual structure in Project Finance to reduce cost of risk and create value

  26. Value creation by contractual structure:An Introduction to Risk Management Risk Management: The process of identification, assessment, mitigation, and allocation of risks to reduce cost of risk and improve incentives Sources of risk: • External: • Markets: Availability and quality of products, inputs, and services used • Financial markets • Government policy • Natural resource availability and quality • Natural disasters, politics • Internal: • Incentive problems during construction and operation stages • Relationships between management, sponsors, lenders, workers, suppliers, government (some addressed in the previous slides under “value creation by organizational structure”)

  27. Value creation by contractual structure:An Introduction to Risk Management Who bears risk? • Sponsors bear the residual gains and losses, and make key investment decisions. In simple terms, Return to equity = Revenues – Material / service costs – Labor costs - Depreciation – Interest expenses – Taxes Variability in RHS variables lead to changes in return to equity • Other earners of net income (or net value added) from investment can also share risk: Net Value added = Return to equity + Interest expenses + Taxes + Labor costs = Revenues – Material / service costs – Depreciation Profit sharing mechanisms or tax incentives may change how variability in income is shared among sponsors, lenders, government, and labor • Output purchasers and input suppliers can also share the risks as they experience variability in their markets

  28. Value creation by contractual structure:An Introduction to Risk Management How are costs of risk reduced? • Some risks can be reduced by spreading the burden across many participants; some other risks cannot be spread, but can be shifted or reallocated • Different stakeholders in a project may have different preferences, and hence different willingness and capacity to bear risks • Cost of risk is lower to those with greater capacity and willingness to bear risk • Risk-return trade-offs may enable integrative (not necessarily competitive) negotiations among different stakeholders and may create value in a project setting • Gains in economic efficiency can be achieved if overall cost of risk declines through risk shifting and reallocating: • The same risk will have a lower cost if born by parties better capable and willing to do so

  29. Value creation by contractual structure:An Introduction to Risk Management Mechanisms to reduce cost of risk: • Capital, financial, and futures markets: • Mix of debt and equity (capital structure) and probability of default • Risk spreading / pooling • Risk diversification • Insurance markets (for residual risks) • Derivative financial instruments (not available for asymmetric risks) • Futures markets • Real options: Design flexibility into project to allow for responses of new information or market changes • Project design itself for risk mitigation (elements of production process, technology used, etc.) • Project Finance mechanism: complex contractual arrangements involving all mechanisms of contractual risk allocation and reduction to deal with risk in large scale investments

  30. Value creation by contractual structure:Contracting and Project Finance to reduce cost of risk • Generally well developed capital, financial, and futures markets may not always be available • Special contractual arrangements are often required to manage risk to make projects viable • The aim of extensive contracting is to reduce cash flow volatility, increase firm value and debt capacity in a cost-effective way • Guarantees and insurance for those risks that cannot be handled through contracting Elements of contracting: • General form: • Exchange risk (x) for return (y) • Additional considerations: • Participation or partial transfer of ownership • Timing of x and y • Contingency of x and y (under what circumstances) • Penalties on non-performance • Bonus on performance

  31. Value creation by contractual structure:Contracting and Project Finance to reduce cost of risk Contracting criteria: • Contract with lowest cost not necessarily best contract • Effective contracts may provide: • Better risk shifting: better distributions of cost • Better incentives: higher project returns or lower total project risk as a result of incentives • Change the incentive structure to change the probabilities of different outcomes  stakeholders have incentives to increase probability of success and reduce probability of failure in project • “Zero Sum” (Competitive) versus “Positive Sum” (Integrative) perspectives • Cost focus is implicitly a zero sum perspective: one stakeholder gains and the other stakeholder loses • Integrative focus is explicitly a positive sum perspective: By crafting the right contract, one stakeholder can gain without necessarily costing to the other one (due to differences between perceived values, preferences, and risk bearing capacity)  contracts that create increased value through risk sharing and /or improved incentives

  32. Value creation by contractual structure:Contracting and Project Finance to reduce cost of risk Sources of contracting benefits: • Stakeholders’ differing risk preferences • Differing capability to diversify • Differing capability to manage risks • Differing information or predictions regarding future • Differing ability to influence project outcomes Risks manageable via contractual structure or other mechanisms in Project Finance: • Pre-completion risks: Resource, technological, timing, and completion risks • Post-completion risks: Market risk, supply risk, operating cost risk, and force majeure • Sovereign risks: Inflation risk, exchange rate volatility, convertibility risk, expropriation • Financial risks: Default risk

  33. Value creation by contractual structure:Pre-completionrisks:

  34. Value creation by contractual structure:Pre-completionrisks:

  35. Value creation by contractual structure:Pre-completionrisks:

  36. Value creation by contractual structure:Pre-completionrisks:

  37. Value creation by contractual structure:Post-completionrisks:

  38. Value creation by contractual structure:Post-completionrisks:

  39. Value creation by contractual structure:Sovereignrisks:

  40. Value creation by contractual structure:Sovereignrisks:

  41. Value creation by contractual structure:Sovereignrisks:

  42. Value creation by contractual structure:Financialrisks:

  43. How Does It Create Value? • Drawbacks of using Project Finance • Value creation by Project Finance • Organizational structure • Agency costs, debt overhang, risk contamination, risk mitigation • Contractual structure • Structuring the project contracts to allocate risk, return, and control • Governance structure • Benefits of debt-based governance • Case examples to value creation

  44. Benefits of debt-based governance Tighter covenants limit managerial discretion and enforces greater discipline via better monitoring High leverage reduces free cash flow exposed to discretion High leverage reduces expropriation risk High leverage also reduces accounting profits thereby reducing the potential of local opposition to the company Tax shields Value creation by governance structure:

  45. 2. How Does It Create Value? • Drawbacks of using Project Finance • Value creation by Project Finance • Organizational structure • Agency costs, debt overhang, risk contamination, risk mitigation • Contractual structure • Structuring the project contracts to allocate risk, return, and control • Governance structure • Costs and benefits of debt-based governance • Case examples to value creation

  46. Background: The project included a 12,500 km submarine telecommunications system between Australia and Japan via Guam at a cost of $ 520M. The project would use Telstra’s two landing stations at Australia. In Japan, it needed to either obtain permit from the government for building new stations, or contract or partner with other companies to obtain access to the existing ones. Japanese Government seemed not likely to approve building of a new landing station. Most significant risks were market and completion risks. The lead sponsor, Telstra, has to structure the project company, selecting an ownership, financial, and governance structure. • Case examples to value creation Australia-Japan Cable – Structuring a Project Company:

  47. Issues: Selection of strategic sponsors who would bring the most value to the project Mitigation of market risk: Growing demand and capacity shortfall that triggers competition, rapid improvements in cable technology and resulting price decline necessitates moving very quickly Completion risk: Potential delays due to environmental approvals and other permits Management of possible agency conflicts between: sponsors and management sponsors and other parties (capacity buyers (purchasers), suppliers, etc.) sponsors and creditors - decision of how many and which banks to invite to participate • Case examples to value creation

  48. Case examples to value creation How project structure may help: • Telstra partnered with Japan Telecom (who would bring its landing station in Japan and was interested in buying capacity) and Teleglobe (a major carrier who would bring significant volume) as sponsors (reducing cash flow variability) • Other equity investors to be selected would be high rated sponsors who were also capacity buyers. They would be made to sign presale capacity agreements ( reducing variability). • Capacity agreements with high rated sponsors would also be instrumental in raising debt with favorable conditions

  49. Case examples to value creation How project structure may help: • Contemplated on concentrated equity ownership to maintain more effective management and monitoring • As for an interim management team, sponsors would also be made equal partners in control, regardless of individual ownership shares • A permanent management team was discussed, that would work exclusively for the project: • Management compensation package was easier to craft, since it was a single purpose company with limited and well-defined growth opportunities • Single cash flow easier to monitor

  50. Case examples to value creation How project structure may help: • Decided on high leverage and project finance structure to help: • limit the amount of equity they needed to invest to an acceptable size • share the project risk with debt holders • enforce management discipline by reduced free cash flow and contractual agreements • Bank debt with a small banking group was preferred rather than project bonds to have flexibility • The initial tranche of bank debt would be secured and repaid in 5 years with presale commitments • The second tranche would also be repaid in 5 years, but from future sales, acting as “trip wires” for the management team