What is project
finance?
Introduction
Risk minimization process
STEP 1 - Risk
identification and analysis
STEP 2
- Risk allocation
STEP 3
- Risk management
Types of risks
1. Construction
phase risk - Completion risk
2. Operation
phase risk - Resource / reserve risk
Operating risk
Market /
off take risk
3. Risks common to both construction and operational phases
Participant / credit risk
Technical risk
Currency risk
Regulatory / approvals risk
Political risk Force
Conclusion
Introduction
Project financing is an innovative and timely financing technique that
has been used on many high-profile corporate projects, including Euro
Disneyland and the Eurotunnel. Employing a carefully engineered
financing mix, it has long been used to fund large-scale natural
resource projects, from pipelines and refineries to electric-generating
facilities and hydro-electric projects. Increasingly, project financing
is emerging as the preferred alternative to conventional methods of
financing infrastructure and other large-scale projects worldwide.
Project Financing discipline includes
understanding the rationale for project financing, how to prepare the
financial plan, assess the risks, design the financing mix, and raise
the funds. In addition, one must understand the cogent analyses of why
some project financing plans have succeeded while others have failed. A
knowledge-base is required regarding the design of contractual
arrangements to support project financing; issues for the host
government legislative provisions, public/private infrastructure
partnerships, public/private financing structures; credit requirements
of lenders, and how to determine the project's borrowing capacity; how
to prepare cash flow projections and use them to measure expected rates
of return; tax and accounting considerations; and analytical techniques
to validate the project's feasibility
Project finance is finance for a
particular project, such as a mine, toll road, railway, pipeline, power
station, ship, hospital or prison, which is repaid from the cash-flow of
that project. Project finance is different from traditional forms of
finance because the financier principally looks to the assets and
revenue of the project in order to secure and service the loan. In
contrast to an ordinary borrowing situation, in a project financing the
financier usually has little or no recourse to the non-project assets of
the borrower or the sponsors of the project. In this situation, the
credit risk associated with the borrower is not as important as in an
ordinary loan transaction; what is most important is the identification,
analysis, allocation and management of every risk associated with the
project.
The purpose of this paper is to explain,
in a brief and general way, the manner in which risks are approached by
financiers in a project finance transaction. Such risk minimization lies
at the heart of project finance.
In a no recourse or limited recourse
project financing, the risks for a financier are great. Since the loan
can only be repaid when the project is operational, if a major part of
the project fails, the financiers are likely to lose a substantial
amount of money. The assets that remain are usually highly specialized
and possibly in a remote location. If saleable, they may have little
value outside the project. Therefore, it is not surprising that
financiers, and their advisers, go to substantial efforts to ensure that
the risks associated with the project are reduced or eliminated as far
as possible. It is also not surprising that because of the risks
involved, the cost of such finance is generally higher and it is more
time consuming for such finance to be provided.
Risk minimization process
Financiers are concerned with minimizing the dangers of any events which
could have a negative impact on the financial performance of the
project, in particular, events which could result in: (1) the project
not being completed on time, on budget, or at all; (2) the project not
operating at its full capacity; (3) the project failing to generate
sufficient revenue to service the debt; or (4) the project prematurely
coming to an end.
The minimization of such risks involves
a three step process. The first step requires the identification and
analysis of all the risks that may bear upon the project. The second
step is the allocation of those risks among the parties. The last step
involves the creation of mechanisms to manage the risks.
If a risk to the financiers cannot be
minimized, the financiers will need to build it into the interest rate
margin for the loan.
STEP 1 - Risk
identification and analysis
The project sponsors will usually prepare a feasibility study, e.g.
as to the construction and operation of a mine or pipeline. The
financiers will carefully review the study and may engage independent
expert consultants to supplement it. The matters of particular focus
will be whether the costs of the project have been properly assessed and
whether the cash-flow streams from the project are properly calculated.
Some risks are analyzed using financial models to determine the
project's cash-flow and hence the ability of the project to meet
repayment schedules. Different scenarios will be examined by adjusting
economic variables such as inflation, interest rates, exchange rates and
prices for the inputs and output of the project. Various classes of risk
that may be identified in a project financing will be discussed below.
STEP 2 - Risk allocation
Once the risks are identified and analyzed, they are allocated by
the parties through negotiation of the contractual framework. Ideally a
risk should be allocated to the party who is the most appropriate to
bear it (i.e. who is in the best position to manage, control and insure
against it) and who has the financial capacity to bear it. It has been
observed that financiers attempt to allocate uncontrollable risks widely
and to ensure that each party has an interest in fixing such risks.
Generally, commercial risks are sought to be allocated to the private
sector and political risks to the state sector.
STEP 3 - Risk management
Risks must be also managed in order to minimize the possibility of
the risk event occurring and to minimize its consequences if it does
occur. Financiers need to ensure that the greater the risks that they
bear, the more informed they are and the greater their control over the
project. Since they take security over the entire project and must be
prepared to step in and take it over if the borrower defaults. This
requires the financiers to be involved in and monitor the project
closely. Such risk management is facilitated by imposing reporting
obligations on the borrower and controls over project accounts. Such
measures may lead to tension between the flexibility desired by borrower
and risk management mechanisms required by the financier.
Types of
risks
Of course, every project is different and it is not possible to
compile an exhaustive list of risks or to rank them in order of priority.
What is a major risk for one project may be quite minor for another. In
a vacuum, one can just discuss the risks that are common to most
projects and possible avenues for minimizing them. However, it is
helpful to categorize the risks according to the phases of the project
within which they may arise: (1) the design and construction phase; (2)
the operation phase; or (3) either phase. It is useful to divide the
project in this way when looking at risks because the nature and the
allocation of risks usually change between the construction phase and
the operation phase.
1. Construction
phase risk - Completion risk
Completion risk allocation is a vital part of the risk allocation of
any project. This phase carries the greatest risk for the financier.
Construction carries the danger that the project will not be completed
on time, on budget or at all because of technical, labor, and other
construction difficulties. Such delays or cost increases may delay loan
repayments and cause interest and debt to accumulate. They may also
jeopardize contracts for the sale of the project's output and supply
contacts for raw materials.
Commonly employed mechanisms for minimizing completion risk before lending takes place include: (a)
obtaining completion guarantees requiring the sponsors to pay all debts
and liquidated damages if completion does not occur by the required
date; (b) ensuring that sponsors have a significant financial interest
in the success of the project so that they remain committed to it by
insisting that sponsors inject equity into the project; (c) requiring
the project to be developed under fixed-price, fixed-time turnkey
contracts by reputable and financially sound contractors whose
performance is secured by performance bonds or guaranteed by third
parties; and (d) obtaining independent experts' reports on the design
and construction of the project. Completion risk is managed during the
loan period by methods such as making pre-completion phase drawdown's of
further funds conditional on certificates being issued by independent
experts to confirm that the construction is progressing as planned.
2. Operation
phase risk - Resource / reserve risk
This is the risk that for a mining project, rail project, power
station or toll road there are inadequate inputs that can be processed
or serviced to produce an adequate return. For example, this is the risk
that there are insufficient reserves for a mine, passengers for a
railway, fuel for a power station or vehicles for a toll road.
Such resource risks are usually
minimized by: (a) experts' reports as to the existence of the inputs
(e.g. detailed reservoir and engineering reports which classify and
quantify the reserves for a mining project) or estimates of public users
of the project based on surveys and other empirical evidence (e.g. the
number of passengers who will use a railway); (b) requiring long term
supply contracts for inputs to be entered into as protection against
shortages or price fluctuations (e.g. fuel supply agreements for a power
station); (c) obtaining guarantees that there will be a minimum level of
inputs (e.g. from a government that a certain number of vehicles will
use a toll road); and (d) "take or pay" off-take contacts which require
the purchaser to make minimum payments even if the product cannot be
delivered.
Operating
risk
These are general risks that may affect the cash-flow of the project by
increasing the operating costs or affecting the project's capacity to
continue to generate the quantity and quality of the planned output over
the life of the project. Operating risks include, for example, the level
of experience and resources of the operator, inefficiencies in
operations or shortages in the supply of skilled labor. The usual way
for minimizing operating risks before lending takes place is to require
the project to be operated by a reputable and financially sound operator
whose performance is secured by performance bonds. Operating risks are
managed during the loan period by requiring the provision of detailed
reports on the operations of the project and by controlling cash-flows
by requiring the proceeds of the sale of product to be paid into a
tightly regulated proceeds account to ensure that funds are used for
approved operating costs only.
Market / off-take risk
Obviously, the loan can only be repaid if the product that is
generated can be turned into cash. Market risk is the risk that a buyer
cannot be found for the product at a price sufficient to provide
adequate cash-flow to service the debt. The best mechanism for
minimizing market risk before lending takes place is an acceptable
forward sales contact entered into with a financially sound purchaser.
3. Risks common to both construction and operational phases
Participant / credit risk
These are the risks associated with the sponsors or the borrowers
themselves. The question is whether they have sufficient resources to
manage the construction and operation of the project and to efficiently
resolve any problems which may arise. Of course, credit risk is also
important for the sponsors' completion guarantees. To minimize these
risks, the financiers need to satisfy themselves that the participants
in the project have the necessary human resources, experience in past
projects of this nature and are financially strong (e.g. so that they
can inject funds into an ailing project to save it).
Technical
risk
This is the risk of technical difficulties in the construction and
operation of the project's plant and equipment, including latent defects.
Financiers usually minimize this risk by preferring tried and tested
technologies to new unproven technologies. Technical risk is also
minimized before lending takes place by obtaining experts reports as to
the proposed technology. Technical risks are managed during the loan
period by requiring a maintenance retention account to be maintained to
receive a proportion of cash-flows to cover future maintenance
expenditure.
Currency risk
Currency risks include the risks that: (a) a depreciation in loan
currencies may increase the costs of construction where significant
construction items are sourced offshore; or (b) a depreciation in the
revenue currencies may cause a cash-flow problem in the operating phase.
Mechanisms for minimizing resource include: (a) matching the currencies
of the sales contracts with the currencies of supply contracts as far as
possible; (b) denominating the loan in the most relevant foreign
currency; and (c) requiring suitable foreign currency hedging contracts
to be entered into.
Regulatory / approvals risk
These are risks that government licenses and approvals required to
construct or operate the project will not be issued (or will only be
issued subject to onerous conditions), or that the project will be
subject to excessive taxation, royalty payments, or rigid requirements
as to local supply or distribution. Such risks may be reduced by
obtaining legal opinions confirming compliance with applicable laws and
ensuring that any necessary approvals are a condition precedent to the
drawdown of funds.
Political
risk
This is the danger of political or financial instability in the host
country caused by events such as insurrections, strikes, suspension of
foreign exchange, creeping expropriation and outright nationalization.
It also includes the risk that a government may be able to avoid its
contractual obligations through sovereign immunity doctrines. Common
mechanisms for minimizing political risk include: (a) requiring host
country agreements and assurances that project will not be interfered
with; (b) obtaining legal opinions as to the applicable laws and the
enforceability of contracts with government entities; (c) requiring
political risk insurance to be obtained from bodies which provide such
insurance (traditionally government agencies); (d) involving financiers
from a number of different countries, national export credit agencies
and multilateral lending institutions such as a development bank; and
(e) establishing accounts in stable countries for the receipt of sale
proceeds from purchasers.
Force majeure risk
This is the risk of events which render the construction or
operation of the project impossible, either temporarily (e.g. minor
floods) or permanently (e.g. complete destruction by fire). Mechanisms
for minimizing such risks include: (a) conducting due diligence as to
the possibility of the relevant risks; (b) allocating such risks to
other parties as far as possible (e.g. to the builder under the
construction contract); and (c) requiring adequate insurances which note
the financiers' interests to be put in place.
Conclusion
This paper only gives a brief overview of the common risks and methods
of risk minimization employed by financiers in project finance
transactions. As stated previously, each project financing is different.
Each project gives rise to its own unique risks and hence poses its own
unique challenges. In every case, the parties - and those advising them
- need to act creatively to meet those challenges and to effectively and
efficiently minimize the risks embodied in the project in order to
ensure that the project financing will be a success.
Recommended further reading:
Books on Project financing
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