project finance model

project finance model

Developing a Comprehensive Project Finance Model: A Practical Guide

1. Introduction to Project Finance

In recent years, the technique of project finance has gained increasing market penetration with the privatization or joint ventures of many structurally larger and more advanced projects. The financial markets are developing a comprehensive and consistent range of techniques, tools, and products for the project process, such that the controlling financial engineering discipline can be strengthened, with the result that many projects are completed more quickly and cheaply. By its nature of enabling the funding of an undertaking through non-recourse or limited recourse finance, project financing is often the only funding solution where a development might have fragmented or problematic resources, such as political or economic risks. Major projects typify these criteria, particularly newer projects that stretch ‘the art of the possible’ such as power plants for a large-scale project in emerging market countries, pipeline development, infrastructure projects such as transport or telecoms that act as a catalytic enabler for a country’s development needs, and sports, stadia, and entertainment sponsored projects.

2. Key Components of a Project Finance Model

– Rating Agency and Market “Over the Wall” Reports

– Project Finance Documentation Support – Project finance model reports used for support of charter parties, credit agreements, management agreements, off-take agreements, O&M agreements, and roll-up of various entity distributions and tax equity benefits.

– Industry and Security-Specific Ratios and Metrics – EBITDARM, DSCR, LLCR, Loan Life Cover Ratio, establishment of reserves, audits, effectiveness percentages, hedge ratios, IR Trigger Ratios, interest rate spread and locked box percentage, performance ratios, and project size and feasibility.

– Sensitivity Analysis Use of a project finance model can highlight areas of risk involved in a project, the likely outcomes if these are realized, and how much a financial structure will need to adjust to accommodate these scenarios. For example, a value-at-risk study of the model can highlight potential problem areas for certain project entities and entities owning large blocks of debt or equity.

The most detailed (and commonly used) feature of a project finance model is the development of a monthly cash flow “waterfall” order of distribution schedule. The waterfall enables the model to calculate fundable reserves within a transaction, implement the flip model in private equity transactions, overlay additional model structures such as the Parri Pass model, and model a variety of other features. The waterfall is the single most critical element of a model. It will be discussed in thorough detail during this model primer and will be referenced and built upon in all the subsequent articles. Non-cash flow-based, but nonetheless critical, features of a project finance model include:

Features of a Cash Flow Waterfall Model

3. Building Financial Projections and Sensitivity Analysis

In essence, when the combined debt service coverage ratio (DSCR) is being tested for the base case and during sensitivity analysis, the sponsor has to calculate the ratio of projected cash flows during the same time period to the expected debt service. The ideal way to perform this analysis with a project finance model is to incorporate both DSCR and LTV tests into the model. This way, both debt and equity holders can check debt service capacity relative to existing liabilities and assets at each point in time, and thus gain an understanding that both ratios must be satisfied in order to ensure financial viability. However, it is important to understand that the LTV line is fundamentally different from the DSCR line drawn in the model, which can lead to a potential alignment issue.

Detailed financial projections provide a means of understanding project performance over time. A structured financial model allows managers and financiers to examine different aspects of risk and make a judgment on the likely performance of the project under various economic environments. Most importantly, the sponsor will have to develop a budgeted income statement, calculate estimated sales, taxable income and income taxes, and examine how the project’s financial statements are expected to evolve over time. But before discussing and constructing the basic income statement, I will develop a base-case cash flow projection, which lays the foundation for the debt coverage ratio calculation when the time periods are different.

4. Risk Assessment and Mitigation Strategies

For each risky aspect of a project, the modeler should try to identify legal, commercial or physical circumstances, covenants or guarantees or other forms of offsetting or protection that should mitigate that risk and, most importantly, develop a theory that relates the risk with the financial structure of a project. This is a requirement for the inclusion of the risk in the quantification in the model that will permit cost-efficient assessment of the proper risk allocation among the different participants of the project. Such diagnoses cannot be done in a vacuum. To allow for the highest quality solution, the project modeler must consult legal, commercial, and structural experts in a multidisciplinary approach. Remember that managing risk consequently involves the exchange of detailed requirements and the formulation of accepted and transparent quantifiable liabilities while issuing proper and complete financial guarantee papers.

Risk identification, assessment, and mitigation strategies development are among the most challenging aspects of a project finance model and typically involve specialized knowledge of the commercial, political, and legal environment and experience in the identification and proper allocation of risk in project finance agreements. In Chapter 10, we will provide a general understanding and background information to assist the project finance modeler in the identification of risks characteristic of most infrastructure projects. These general guidelines will not be specific to any industry or transaction and are not to be used as a substitute for a specialized legal opinion or experience for a particular project or industry. It is planned as future work of the IPFS to develop specialized guidelines for a project modeler that, if carefully followed, will provide a safeguard to reduce by a minimum threshold the potential risk damage to go otherwise without not quantified, to at least remind the modeler about the risk that was not included in the analysis.

5. Case Studies and Real-World Applications

The scope of possible project financings is vast. However, in terms of the kinds of projects, the circumstances of the financings, and the nature of the parties with which the author is most familiar, project financings can be described with reasonable generality: they are typically large, represent mergings or acquisitions (including greenfield projects or turnkey installations), are structured on a nonrecourse basis, and are documented with many sophisticated contractual features. Furthermore, many model parameters are drawn from costs and revenues, which are not explicitly modeled. In developing a project model, it is necessary to specify the names and identities of those to be associated with the project, and the nature and extent of their legal financial relationships.

Project finance is a field in which the sophisticated techniques developed by the financial innovation of the past thirty years have been put to work, often under somewhat complex and specialized circumstances. To develop a comprehensive project survey, it is not sufficient to place all of the financial variables in a cash-flow model. It is also necessary to include the conditions and provisions of the contracts under which the project is to be financed and constructed. The purpose of this book is to develop within the confines of project finance an integrated model of the basic equity and debt contracts often employed in this field. Whereas many books have analyzed the details of specific contractual forms, this is the first to present them in an integrated form. The contents of the book are somewhat specialized; some of the material is novel. These case studies illustrate the use of the book in practical and real-world applications.