structured project finance

structured project finance

Exploring the Fundamentals of Structured Project Finance

1. Introduction to Project Finance

These are several underlying principles that creditors utilize in evaluating the credit risk of project financings and that equity investors utilize to maximize shareholder value. These principles shape the financing process of a project finance transaction. Including the evaluation of these principles and the long-term relationship these project financings have with their creditors are essential to properly structuring the project finance transaction. Projects other than natural resource and infrastructure projects do contain many of the same fundamental principles of project finance. These principles are their developments in stages, their limited or non-recourse debt structures, their contracted cash flows, their asset-based financing, their project sponsor’s special purpose company, and, to some extent, the regulatory privileges they enjoy. The purpose of this primer is to introduce these fundamental principles to authors and to provide references for the reader to research in more detail the application of these principles to project financings other than natural resource and infrastructure projects. In subsequent primers, we will review how these principles are applied to regulated private equilibrium market projects, to merchant market projects, including the various available merchant market financings such as production tandems and hedges, and to the financing of existing project refinancing, recapitalizations, and restructuring.

Project finance has emerged as the preferred method sponsors use to finance their large capital natural resource and infrastructure development projects. From its early beginnings as a method of joint venturing large projects through “project financing,” today non-recourse or limited recourse debt in the public and private capital markets provides the bulk of project financing. In 2008, the global capital markets even provided over $7 quadrillion in tax-equity financing to newly-constructed projects to take advantage of the U.S.’s thirty percent investment tax credit for solar energy. With its emphasis on use of cash flow from the project’s assets solely eroding in bankruptcy to repay the debt and the minimization of corporate and sovereign obligations supporting the project, project finance allows project sponsors to efficiently structure their projects to obtain the lowest cost of debt and the highest possible debt to equity ratio to support their high-risk development efforts. And, with an emphasis on economically justifying the project’s rationale—its ability to “stand-alone” either in an electricity bidding market or a global petrochemical pricing market—project finance helps assure the project sponsor’s secured creditors that the project’s assets have been developed prudently and have been operationally approved to ensure steady cash flow and timely repayment of debt.

2. Key Components of Structured Project Finance

For most new, greenfield capital projects, committed bank financing is essential to ensure that funds are available at key stages in the construction period. There are a number of limitations and restrictions on the investment of both equity and debt capital, and these will be discussed in more detail in subsequent chapters. Some funds, such as the existing cash reserves of the investing company, or international capital market debt issues, can be freely used to finance capital projects. A larger proportion of project finance equity comes from retained earnings, which are generated from company profits. Unlike company equity, debt capital can be more freely raised than equity, typically from commercial banks and other financial institutions, with the security offered normally consisting of the cash flows associated with the underlying project, rather than the financial strength of the borrowing sponsor. A key objective of the financial structuring process is to assign, as efficiently as possible, the risks of the investment project to the party who is most able to control and manage the total risk. Shifting the project risks to the project’s suppliers, who are typically well-positioned to manage the technical or physical risk, will result in a lower cost of project finance once the construction of the project is completed and the project is in the operational phase.

3. Risk Management and Mitigation Strategies in Project Finance

Alongside the setting up of potential liability businesses, the evaluation stage must come to grips with risk analysis and mitigation. From industry variability through performance or execution problems or lender adverse situations, many project restructurings are now being undertaken. It is important that the “what if” situations contain as much detail ultimately develop their own dedicated community of expertise. Significant expertise in credit matters has developed over many years in specialist departments of most major project lending banks. Escalates will play the next role in the success of future projects. These have been the areas of greatest conflict and schism between sponsors and lenders. Some might say the least risk element lenders seek comfort that the sponsor has staked enough skin into the project. Concurrently, they want to be sure that the project’s substantial completion is not compromised by the need to deploy other parts of the sponsor’s corporate monolith. Actually, risk profiling at financial close has shown that an expertly completed project is significantly of lesser importance than the need for adequate assessed authorized limits in the probability of completion risk.

Risk management is a fundamental aspect of project finance. The principal aim of this aspect of finance is to implement mechanisms to reduce potential damage to the project or to determine, at the very onset, the likelihood of associated risks and whether the project is financially worthwhile undertaking given these risks. Among the main risks are completion risk, operational or process risk, market risk, credit risk, and government risk. Each of these risks is analyzed in detail to understand what is at stake. Should such risks be material between them or if the total risk exceeds the bank’s maximum acceptable levels, the bank’s willingness to provide financing terms will decrease or their final decision will be unfavorable to the project. Such risks, part of which come under the “front-end costs” heading, have to be rigorously addressed to produce the most favorable and objective assessment that can be made before financial close.

4. Case Studies and Real-World Applications

Start at the beginning. Infrastructure is about operating 100-year-old enterprises. The skill set to maintain and improve nursing homes and bridges are quite different. In the case of power, we need to bring together good engineering skills, supply chain management, construction expertise (partial success in the construction of new capacity even within a well-established framework), commercial and financial management, utility cycle planning, and effective communication with stakeholders. The attributes of infrastructure proved so tempting that many utilities and some well-established non-utility players tried to participate. Is there a free lunch? The success seen by a handful of successful pioneers attracted newcomers from the telecom, network, and transportation industries. Good regulation also attracted other “tour char” investors. The failure rate was initially high around 2001 during the “bubble burst” years. Terms, skill set inadequacies, inadequate financial capabilities, lack of relevant expertise, adding value are reasons often cited for these failures. Case studies would provide an empirical test of these “fatal flaws.” We have reliable data and other good data will appear.

Summary: Infrastructure provides infrastructure players with stable, predictable outcomes. That is the illusion. This chapter shows how two big power players – GE and AES – were caught by adverse changes in the business model. Host economies are reconsidering policy objectives and the financing models takes advantage. We illustrate with examples from Ghana, Brazil, China, and Finland.

By Macky Tall

A Guide to a Successful Infrastructure Play

5. Emerging Trends and Future Directions in Structured Project Finance

Equally, the recognition of the significance of infrastructure in the potential development of economies and the privatization of state-owned assets that have been encouraged, to a large extent, by supranational institutions has drawn a range of private investors concerned with both turning a profit and securing a balanced risk/reward profile given the particular construction/facility/country risk combination. Different geographic regions are producing different results. The toll roads of Newfoundland are often held out as a model for the world, while Latin America struggles to improve on the model of privatization carried out in the early 1990s. These developments are fostering more flexibility in the traditional project structures. The single rule book on how these risks can be managed and internalized within the financing that has often been applied in the unregulated sector has now to accommodate either the complexity of the particular development in question or the innovations in the approaches taken due to significant variations in stages of development of particular national or groups of economic development.

Project-financed transactions are evolving and showing a range of innovations, some of which may be driven by the perceived maturity or lack of inherent innovation in the model of project finance usually utilized. It is important to consider that a number of factors can be managed via project financing, and several mechanisms may be called upon through structuring to manage these risks. They are also increasingly relying on both the development of new technologies and the advance of public policy. For example, global warming issues and the responses that this may require have been highlighted. Issues related to the sustainable development of economies in an era of unrelenting global pressure to exploit natural and physical comparative advantage profitably are being put to national authorities.