the economics of large scale infrastructure project finance an empirical examination of the propensity to project finance

Lenders achieve a high degree of transparency for project financed transactions due to the non-recourse nature of the debt which also entails higher setting up costs and cost of debt com

The Economics of Large Scale Infrastructure Project

Finance: An Empirical Examination of the Propensity to

Project Finance

A Thesis Presented to the Faculty

Of The Fletcher School of Law and Diplomacy

By

RAJEEV JANARDAN SAWANT

In partial fulfillment of the requirements for the

Degree of Doctor of Philosophy

DECEMBER 2007

Dissertation Committee Prof Laurent Jacque, Chair Prof Patrick Schena

Prof Bruce Everett

3320163

3320163 2008

Abstract

This dissertation empirically examines a financing and governance structure called

Project Finance that typically funds large scale, capital intensive, infrastructure

investments in risky countries Separate incorporation by investing firms (sponsors), long term detailed contracts between suppliers and buyers, vertical integration, high debt levels and non-recourse lending characterizes project finance Project finance finances tangible, decaying assets with low growth options that do not require strong managerial skills UK’s North Sea oil fields, Ras Laffan gas company in Qatar, and Chad Cameroon pipeline are examples of project financed transactions Lenders achieve a high degree of transparency for project financed transactions due to the non-recourse nature of the debt which also entails higher setting up costs and cost of debt compared to corporate finance Theoretical research hypothesizes that project finance solves the problem of potentially opportunistic concentrated suppliers/buyers facing large sunk investments in risky

countries Theory also hypothesizes that project finance mitigates underinvestment

resulting from conflict between debt and equity holders within a firm The dissertation compares project financed and corporate financed transactions in the oil, gas and

petrochemical industry to test these hypotheses I compile a dataset of over 400

investments by 340 firms in 74 countries over 17 years to test these two theories I find that the propensity of firms to use project finance is high and statistically significant when large sunk investments have concentrated buyers/suppliers in risky countries The propensity for project finance is high when debt coverage ratios are low after controlling for leverage and the volatility of the debt coverage ratios but weakly so Project finance therefore fulfills the role of a self regulating contract that reduces transaction costs

DEDICATION

To

my parents, Janardan and Charulata Sawant

whose passion, encouragement, dedication and personal example made all this possible,

Manisha for patience and understanding,

Mehr and Manav, my personal investments in the future,

and Rahul for constant and loyal support

ACKNOWLEDGEMENTS

I thank my committee members for their advise, rigor and generosity I especially thank Prof Laurent Jacque for his insightful, penetrating, incisive and rigorous feedback, for his patience, compassion and faith in me I thank Prof Schena for his attention and enormous help with the econometric details and Prof Bruce Everett for his tremendous knowledge of the oil and gas industry, for enabling the data collection effort and for his sense of humor I thank Prof Paul Vaaler for starting me off and supporting me as his Teaching Assistant and Prof Robert Nakosteen who selflessly gave of his time with statistical advice I also thank the Hitachi Center for financial support and for selecting

me as a Hitachi Scholar None of this would have been possible without the dedication, passion, and superb teaching skills of my teachers particularly Prof Richard Shultz, Prof Carsten Kowalczyk, Prof Steve Block, Prof Joel Trachtman, Prof Ravi Sarathy, Prof Sanjiv Das, Prof Julie Schaffner Finally I thank Carol Murphy the International Student Advisor for her enormous patience, Nora Moser and the Registrars Office for their

understanding and support, Miriam Seltzer, Paula Cammarata and the staff of the Ginn library, Shelley Adams, Dorothy Orszulak and Jenifer Burckett-Picker for making the Fletcher experience an incredible one All errors and mistakes are entirely mine

TABLE OF CONTENTS

Introduction 1

Chapter 1: Literature Review of Project Finance 4

1.1 Introduction Project Finance 7

1.2 Project Finance Applications 8

1.3 Project Finance loan characteristics 10

Chapter 2 : Theories of Project Finance 15

2.1 Project Finance as an asset specific investment by an initial user and a ‘redeployer’ of an asset 16

2.2 Theory of Incumbent management’s control benefits 19

2.3 Signaling Theory of Project Finance 21

2.4 Agency costs of free cash flow 23

2.5 Agency Costs of Risky Debt (Underinvestment) 25

3 Solutions to the Underinvestment Problem 29

3.1 Design of ex-ante contracts 33

3.1.1 The case of New Debt’s Strict Subordination to Existing Debt 34

3.1.2 The Case of New Debt’s Complete Seniority to Existing Debt 36

3.1.3 The Case of Project Finance 37

3.1.4 The Case of Secured Financing and Leasing 39

3.1.5 Analysis of corporate structure (Separate project finance structure or combined corporate structure) 41

4 Project Finance Asset Characteristic – High value under default 43

4.1 The case of high project value under default and low cash flow variance 44

4.2 The Case of high asset value under default and high cash flow variance 45

4.3 The case of low asset value under default and high variance in cash flows 46

4.4 The case of low asset value in default and low variance in cash flows 47

5 Agency Costs of Opportunism or Asset Specificity (Hold-up problem) 48

5.1 Introduction 48

5.2 Solutions for the hold up problem 50

5.2.1 Vertical Integration 52

5.2.2 Long term contracts 54

5.2.3 Use of debt 58

5.3 Empirical Research on the hold up problem 62

6 Conclusion 64

Chapter 3: Development of Hypotheses 66

1 Introduction 66

2 Testable Propositions from theory of Underinvestment 67

3 Testable Hypotheses – Transaction Costs of Opportunism or Hold-up 71

4 Table of Explanatory Variables 78

5 Conclusion 79

Chapter 4: Description of Data 81

1 Introduction 81

2 Data Collection Methodology 81

2.1 Corporate Financed Investments 81

2.2 Project Financed Investments 84

3 Data description 89

4 Conclusion 92

Chapter 5: Econometric Model Specification 93

1 Introduction 93

2 Model Specification 93

3 Logit and Probit models 95

4 Omitted variables bias 98

5 Treatment of JV partners 100

6 Conclusion 101

Chapter 6: Results of Econometric Analysis 102

1 Introduction 102

2 Bivariate Analysis 102

3 Panel 1 – Lead Firm In a project 104

4 Probit Model Results – Panel 1 109

5 Probit Model Results – Panel 2 114

6 Robustness Testing of the Results 116

7 Conclusion 121

Conclusion 123

Reference List……… ………131

List of Sources 130

List of Tables

Table I: Summary of Theoretical & Empirical Literature……… 9

Table II: Analysis of Asset Risk………46

Table III: List of Explanatory Variables……… 82

Table IV: Summary of Data……… 93

Table V: Statistical Properties of Corporate Vs Project Financed Investments… 93

Table VI: Summary of Statistics – Explanatory Variables………94

Table VII: Pairwise Correlations……….……… 106

Table VIII: LPM, Logit and Probit Model coefficients… ……… 109

Table IX: Probit Model Marginal Effects, Panel 1……… 113

Table X: Probit Model Marginal Effects, Panel 2……… 117

List of Figures Figure I: LOWESS of PF Propensity and Size of Investment………120

Figure I: LOWESS of PF Propensity and Country Risk…….………121

Figure I: LOWESS of PF Propensity and Fuel Exports…… ………122

Figure I: LOWESS of PF Propensity and Debt Coverage Ratio….………123

Introduction

The financing and governance structure known as Project Finance has been used

since Roman times1 In modern times Project Finance has grown as the form of financing

structure for building pipelines, refineries, drilling oil wells, gasification plants2 and other

large capital-intensive infrastructure projects Infrastructure Journal reports that project

finance reached $212 B in 2006, an increase of 35% over 20053 Project Finance has

traditionally been a significant tool for cash strapped governments seeking to develop

vital infrastructure In fact according to a 2005 report by the Asian Development Bank,

Japan Bank of International Cooperation and World Bank, Asia alone needs to spend $1

trillion over the next five years in road, water, communication and other infrastructure

projects to meet the rapid rise of urbanization, population growth and growing demands

of the private sector4 The European Union plans to spend €300B up to 2013 on

infrastructure assets5 An understanding of project finance and its determinants is

therefore likely to be helpful to governments, lenders, infrastructure funds and firms

investing in these assets

Stulz and Johnson (1985), Berkovitch and Kim (1990), John and John (1991) and

Esty (2003) all contend that firms use project finance to lower “deadweight” costs

induced by stockholder-debtholder conflict (underinvestment), and by the threat of

opportunism between project sponsors and suppliers, customers and host governments

ADB, JBIC, and the World Bank, "Connecting East Asia: A New Framework for Infrastructure"

Accessed Jan 2008 Available from

http://www.adb.org/Projects/Infrastructure-Development/infrastructure-study.pdf

5

Financial Times, Oct 22, 2007

arising from high asset specificity Although the theoretical literature is well developed, supporting empirical evidence has largely been restricted to case studies (Esty 1999, 2001) I fill this empirical research gap with a large sample statistical study to formally test the transaction costs problem and the underinvestment problem

Since investments are a result of firm-level factors as well as project characteristics

I focus on why and how firm-level factors as well as project characteristics induce

managers to decide on the financing and governance structures of new investments Theory posits that the deadweight costs of underinvestment require an investigation of individual firm level characteristics while deadweight costs from asset specificity and opportunism between project sponsors, customers, suppliers and host governments

requires investigation of individual project characteristics To this end I use firm-level stock market and balance sheet data comprising both project finance and corporate

financed investments to test underinvestment variables I use project-level supplier, customer, and host government data comprising both project finance and corporate

financed investments to test the transaction costs from the threat of opportunistic

behavior I construct a database of project finance and non project finance investments restricting the sample to the oil and gas industry

Consistent with the core contention of the underinvestment and transaction costs theory, I test whether firms with high underinvestment and transaction costs are more likely to undertake project finance than corporate financed modes of investments I

conduct this test by regressing the propensity of a firm to undertake project finance against a set of control variables and key explanatory variables suggested in previous conceptual research as leading to high agency costs

To make these points in greater detail, the remainder of my dissertation is

structured in five additional chapters Chapter 1 reviews the theoretical and empirical literature on project finance Chapter 2 reviews the theoretical and empirical literature on capital structure, underinvestment and transaction costs Chapter 3 follows on with

statements of the key propositions of this research, that project finance reduces costs from underinvestment and transaction costs and derives empirically testable hypotheses

Hypotheses most important to this dissertation include, “Firms with risky debt

outstanding have a high propensity to undertake project finance ” and “Supplier and

Buyer concentration increases the propensity for project finance.”

Chapter 4 describes the data and the methodology of data collection Chapter 5 explains how these and related hypotheses are to be tested It lays out the econometric models and the econometric issues arising from the possibility of omitted variables and the independence of individual observations Chapter 6 lays out and discusses the results

of this empirical investigation

Chapter 1: Literature Review of Project Finance

Theoretical research (Nevitt (1979) and others) and empirical research (Megginson and Kleimeier (2000), Esty (2003)) shows that project finance is indeed a distinct form of financing with unique characteristics Sections 1.1, 1.2 and 1.3 of the review lays out these characteristics of project finance The use of project finance and its persistence through history and into modern times indicates that project finance indeed serves an economic purpose Theoretical research into the economic determinants of project

finance reveals at least six distinct theories about the economic problems that project finance solves

Project finance has been posited as a means of allocating optimal ownership over specific assets by Habib and Johnsen (1996) This theory is explored in Section 2.1 Analysis of managerial decisions leads Chemmanur and John (1996) to posit that the project finance structure confers benefits on incumbent managers that is advantageous in the competition for corporate control with rival managements Section 2.2 delves further into this theory Research into informational asymmetry between lenders and borrowers

of capital has lead Shah and Thakor (1987) to posit that the project financing structure is

a means of signaling the riskiness of assets Section 2.3 explores this theory The theory

of agency costs delineates the perverse incentives arising from conflict between owners and managers of firms Esty (2003) theorizes that the project finance structure lowers these costs This theory is explored in Sections 2.4

I then focus on the final two distinct strands of literature that have been identified

by research6 as the economic determinants of project finance The first strand of literature deals with conflict between equity holders and debt holders that causes firms to bypass investment in positive NPV projects Existing risky debt creates incentives for equity holders to bypass positive NPV projects or underinvest which destroys firm value

Project finance has been proposed as a solution, among others, to this underinvestment problem I review this strand of theoretical and empirical literature in Sections 2.5 to Section 4.4

The second strand of literature deals with the possibility of opportunistic behavior arising from investment in specific assets This strand of literature considers the problem

of incomplete contracts that can be renegotiated after sunk investment in specific assets is complete A party making these sunk investments is liable to be ex-post held up by its counterparty Since this behavior can be anticipated ex-ante, rational investors do not commit to sunk assets and the result is socially harmful underinvestment A number of solutions like vertical integration, long term contracts and the use of debt have been proposed as a solution to the hold-up problem The project finance structure incorporates these features and has also been proposed as a way of ameliorating the agency cost of opportunistic behavior I review this strand of theoretical and empirical literature in Section 5 Section 6 concludes the literature review

The following table summarizes the main theoretical and empirical research in project finance I have organized the table to reveal the research in underinvestment and

6

Myers (1977), E Berkovitch and Kim, E H., (1990), Klein, Crawford and Alchian (1978), Bronars and Deere (1991), Esty (2002)

the hold-up problem The table also highlights the gap in empirical research in project

finance as a solution to the underinvestment problem or the hold-up problem

Table I: Summary of Theoretical & Empirical Literature

Underinvestment – Debt Overhang

Transaction Cost Economics Project Finance

1988

− E Berkovitch and Kim, E H.,

− Williamson O.E (1975)

(1978)

− Baldwin C., (1983)

− Titman Sheridan, (1984)

− Grossman S., and Hart O., (1986)

− Riordan Michael (1989)

− Stulz R., (1990)

− Wiggins Steven (1990)

− Bronars S., and Deere D., (1991)

− Perotti E and Spier K., (1993)

− Hermalin and Katz (1993) Subramaniam V., (1996)

− Edlin and Reichelstein (1996)

− J W Kensinger and J D Martin,

1988

− T A John and K John, 1991

− S Shah and A V Thakor, 1987

− Chemmanur, T J., and K John,

1996

− Esty B.C 2002

− Esty B.C 2003

− Brealey R A., and Cooper I A., and Habib M A.,

− Esteban C

Buljevich, and Yoon S Park,

1999

Empirical Research

(Note: Case studies

− Bradley M., Jarrell G A.,

− Titman S., and Opler T., 1993

− Megginson W L., and Kleimeier S.,

are not included in

− Morgado A and Pindado J., 2002

− Lehn K., and Poulsen A., 1989

− Lieberman M., (1991)

2000

− Richard Klompjan and Marc J.F Wouters, 2002

1.1 Introduction Project Finance

Nevitt (1979) defines project finance as “the financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which the loan will be repaid and to the assets

of the economic unit as collateral for the loan.” Esty (2003) believes that non-recourse lending is the sine qua non of project financing, i.e his view alters the above definition

from “… a lender is satisfied to look initially to the cash flows…” to “…a lender is

satisfied to look only to the cash flows…”

Brealey, Cooper and Habib (1996) define the characteristics of project finance as

a distinct financing structure These characteristics are;

a) The project manager or sponsor establishes a separate company specifically limited to execution and management of the project

b) The sponsor/sponsors provide the major proportion of the equity of the project

c) The project company’s relationships with its lenders, building contractors, suppliers, customers, host government and international lending agencies are defined and

regulated through formal, legally binding, detailed contracts

d) The project company exhibits high leverage

e) Lenders to the project have only limited or no recourse to the equity-holders sheets Therefore, they can only look to the performance of the project company’s assets to satisfy their outstanding loans

balance-1.2 Project Finance Applications

Project finance applications were mostly related to the investments in natural resources or extractive industries and to finance oilfield exploration, for e.g British Petroleum raised $945 million to develop the North Sea oilfields, Freeport Minerals raised $120 million for the Ertsberg copper mines in Indonesia7 The Public Utility

Regulatory Policies Act of 1978 heralded the large scale use of project finance in the electricity generation industry Independent power producers financed electricity plants with project finance The generated power was contractually sold through long term power purchase agreements A host of contracts also linked fuel suppliers, contractors and regulatory authorities The 1990’s witnessed project finance being used for a wide

7

Esty (2002) p 72

Project Finance is the financing of a particular economic unit in which a lender is

satisfied to look only to the cash flows and earnings of that economic unit as the

source of funds from which the loan will be repaid and to the assets of the

economic unit as collateral for the loan

range of assets and industries Project finance has been used to finance theme parks like the Hong Kong Disneyland theme park, undersea telecommunication cable companies like the Australia-Japan Cable project, the Euro-tunnel project, the A2 Motorway in Poland, and Chad-Cameroon Pipeline Project finance loans have been very successfully used in the development of the North Sea oil fields, the Ras Laffan LNG project in Qatar, the Hopewell Partners Guangzhou Highway in China and the Petrozuata heavy oil project

in Venezuela Certainly some projects have not been financial successes such as the Channel Tunnel (Eurotunnel) and the Eurodisney theme park in Paris The box below shows the structure of a fairly typical project, the $2.55 Billion Ras Laffan LNG project

in the state of Qatar

The Ras Laffan project exploits the massive 265 terra cubic feet of gas reserves in Qatar’s North Field and clearly demonstrates project finance characteristics The size of the investment can be gauged from the fact that all of Australia consumes less than 1 TCF

Procurement Contracts

EXIM Bank loan guarantee

a year and that Qatar’s North Field is so large that ExxonMobil engineers actually had to take into account the curvature of the earth’s surface when designing the project’s

infrastructure Ras Laffan also shows that a large portion of the $2.55 B investment comprises debt; $1.2 B Project finance leverage is typically higher at about 70% Ras Laffan also shows that equity investors incorporate a separate project company – Ras Laffan LNG Company and their composition reflects aspects of vertical integration A very large proportion of the project’s output (4.9 Million metric tons of gas out of total of 6.6 Million metric tons or 74.44%) is purchased by a single customer, Korea Gas which also has a 5% stake in the project equity The state of Qatar through Qatar Petroleum and Japanese customers for the project, also have equity stakes in the project The project’s output is guaranteed for purchase through long term (25 year) contract and a host of contracts for engineering and procurement lower risks The presence of multilateral funding institutions completes the picture with EXIM bank guaranteeing the debt

Therefore, Project finance exhibits separate incorporation, high debt levels, long term contracts, buyers/suppliers purchasing/selling large levels of output/inputs and vertical integration The next section explores some project finance loan characteristics

1.3 Project Finance loan characteristics

Megginson and Kleimeier’s (2000) empirical study of project finance from a data set comprising other types of syndicated credit lending (corporate control loans, capital structure loans, fixed asset based loans, and general corporate purpose loans) shows that project finance is a different form of financing They measure the impact of loan size, maturity, guarantee, currency risk, country risk and the presence of collateralizable assets

on the cost of project finance loans measured as a spread over LIBOR They find that

project finance differs from corporate finance in the following manner:

a) PF loans have longer average maturities than corporate finance loans

b) PF loans are more likely to have third party guarantees

c) PF loans are more likely to be extended to non US borrowers and to borrowers in

riskier countries

d) PF loans are more likely to be extended to tangible-asset-rich industries

e) PF loans are not larger than non-PF loans but are significantly smaller than

corporate control or capital structure loans

f) The spread over LIBOR for PF loans is about 130 basis points A comparable

type of syndicated lending used to fund purchases of aircraft, property or shipping

and called “fixed asset based loans” by the authors have a spread of about 86

basis points over LIBOR PF loans are also more expensive than general

corporate purpose loans which have a spread of 113 basis points over LIBOR

Capital Structure Loans

Fixed Asset

Based Loans

Corporate Control Loans

General corporate loans

Not to Scale

g) Interestingly PF loans have a lower spread than corporate control loans used to fund acquisitions, leveraged buyouts, and employee stock option plans which have a spread of 195 basis points

h) PF loans are priced at about the same spread as that of capital structure loans (those booked in order to repay maturing lines of credit or for recapitalizations, share repurchases, debtor in possession financing, standby commercial paper support, or other refinancing) at about 135 basis points over LIBOR

i) Loan size does not seem to impact the spread over LIBOR for project finance while it impacts corporate finance loans An increase of $100 million in a project finance loan decreases the spread by 5 basis points

j) A project finance loan exhibits a reduction in spread if the maturity is increased

by a year while a one year increase in the maturity of corporate debt exhibits an increase in spreads Thus the impact of a maturity increase on a project finance loan is opposite to that of a corporate finance loan Megginson and Kleimeier hypothesize that this result is explained because PF loans have a maturity that is

on average twice that of corporate loans Without such a negative spread to

maturity relationship long tenor loans would be extremely expensive However, they reflect that additional research is required in this direction

k) The presence of a guarantee reduces the spread for a PF loan by almost 43 basis points while it only reduces the spread for a corporate loan by 3.7 basis points l) Finally, their model shows that the relationship between collateralizable asset rich

industries and the spread over LIBOR for PF loans is negative, i.e a borrower

from a tangible asset-rich industry will be charged a higher rate For corporate

loans however, a borrower from a collateralizable asset-rich industry will be charged a lower rate Megginson and Kleimeier hypothesize that this intriguing result is because PF lending is concentrated in asset-rich industries, the specific industries chosen as asset-rich industries may be riskier than these, or that only risky projects are funded by PF loans This study might shed additional light on this result because of its treatment of project risk

Klompjan and Wouters (2002) study of default risk in project finance examined 210 projects of which 37 were in default Klompjan and Wouters use the following factors to predict the probability of default

a) Experience of the sponsor

b) Proven technology

c) Presence of commercial risk cover

d) Presence of political risk cover

e) Presence of host government

f) Presence of multilateral institutions

g) Industry

h) Country

i) Debt service coverage ratio

j) Presence of off-take agreement

k) Term to maturity

l) Debt/Equity ratio

m) Whether loan was extended in the same currency as that of income generated by the project

Klompjan and Wouters use a correlation matrix to investigate the relationship

between the event of default and the explanatory factors They show that four factors, presence of commercial risk cover, experience of sponsor, proven technology and debt service coverage ratio, are significantly correlated with an event of default Klompjan and Wouters find that a project is less likely to default if the sponsor has prior experience and the debt service coverage ratio is high Proven technology also causes the probability of default to fall However, the presence of commercial risk cover increases the probability

of default Klompjan and Wouters believe that the presence of commercial risk cover indicates a higher commercial risk and therefore increases the probability of default Klompjan and Wouters however point out that their data belongs to the portfolio of only one bank, that the transactions are still running and therefore future defaults could change the results The next section lays out the theoretical literature explaining the determinants

of project finance

Chapter 2 : Theories of Project Finance

Project Finance as a unique financing structure has received considerable attention in the theoretical literature The main theories are as follows;

a Habib and Johnsen (1999) have posited that project finance is a means of

allocating optimal ownership over specific assets The particular financing

structure of project finance enables investors to hand control over of project financed assets to ‘redeployers’ in a state of the world where the primary use of the asset has lost value The redeployer is skilled in the alternate use of the asset

b Chemmanur and John (1996) analyze project finance through the lens of control benefits to management

c Shah and Thakor (1987) posit that project finance may be used as a signaling mechanism by firms

d Jensen and Meckling (1976) analyze agency costs arising from conflict between managers of firms and shareholders who own the firm Managers control the assets of a firm and may misuse them particularly if the assets throw off large amounts of free cash flow Esty (2003) has theorized that project finance lowers agency costs arising from conflict between incumbent management and

shareholders due to the unique structure of project financed firms

e Berkovitch and Kim (1990) argue that project financing structures mitigate the problem of underinvestment pointed out by Myers (1977)

f Williamson (1975) and Klein, Crawford and Alchian (1978) developed the theory

of the role of economic organization as a means of avoiding the threat of post

contractual opportunism Esty (2003) theorizes that the project financing structure minimizes the costs from the threat of hold up by parties to a transaction that have invested in specific assets

The following sub-sections elucidate these theories in greater detail

2.1 Project Finance as an asset specific investment by an

initial user and a ‘redeployer’ of an asset

Habib and Johnsen (1999) posit that non-recourse project finance is a means of allocating optimal ownership over specific assets Habib and Johnsen argue that firms invest in specific assets, defined as “assets with a specified use before investment” Firms however do anticipate that there are states of the world wherein the assets in their

intended use may not be of any value In the instance that this bad state of the world occurs, the assets are redeployed to alternative uses Habib and Johnsen assume that the investing firm does not have the skills to redeploy the assets The investing entrepreneur

is a specialized entrepreneur with the skills to use the asset in the good state of the world, but lacks the skills to use the asset in a bad state of the world Knowing this, the

entrepreneur firm contracts with a specialist redeployer to hand over control of the asset

in the bad state of the world

Habib and Johnsen argue that lenders and lessors are asset redeployers In the event of the bad state of the world occurring, these asset redeployers change the use of the asset and generate cash thereby creating value Debt therefore acts as a means of transferring

control over assets in some states of the world

Habib and Johnsen (1999) define specific assets as assets with a specified use before investment

Habib and Johnsen argue that once the bad state of the world occurs, rents from the redeployment of the asset should go to the redeployer The entrepreneur should not be

in a position to extract rents from the redeployer Since the entrepreneur is in control of the asset when the investment is made and before the state of the world is known, he is in

a position to bargain with the redeployer The redeployer has committed funds upfront by contracting with the entrepreneur in anticipation of getting rents by redeploying the asset once the bad state of the world occurs The possibility of the entrepreneur resorting to opportunistic bargaining and extracting rents that should go to the redeployer will cause distortions in the investments made by both, the redeployer and the entrepreneur Habib and Johnsen argue that if the parties rely on negotiated spot exchange to transfer

ownership of the asset in the bad state the rents from redeployment are split between them in some way The redeployer has an incentive to reduce his investment in

identifying the asset’s next best use because he recognizes that the entrepreneur can resort to opportunistic behavior

If there is no possibility of post contractual opportunism by the entrepreneur, the amount of investment by the redeployer should equal the value of the asset in the critical state that separates the good and bad states Habib and Johnsen argue that non-recourse project finance loans solve the problem of investment distortion caused by post

contractual opportunism If the good state prevails, the entrepreneur owns the asset which

is used as intended to generate the cash used for repaying the loan If the bad state

prevails, the lenders repossess the asset, redeploy it and keep the rents arising from the redeployment Since there is no ex-post bargaining involved the entrepreneur captures the surplus in the good state while the redeployers capture the surplus in the bad state Thus,

their respective ex-ante investments are optimal Habib and Johnsen argue that the

redeployer’s control of the asset only on default combined with his ability to keep all the surplus arising out of the redeployment causes the redeployer to perform zealously The redeployer has an incentive to find a higher-order use for the asset and not just use it as scrap Therefore, Habib and Johnsen argue that a net social gain results because both parties gain from the redeployer’s special skill at identifying the next best use of the asset

Habib and Johnsen present the case of the airline industry as an example of the use of debt as an asset-transfer mechanism and as a motivation for the use of project finance They claim that aircraft industry finance firms invested substantial resources towards acquiring general knowledge of secondary market redeployment opportunities for used aircraft Aircraft industry finance firms also invested in acquiring specific

knowledge of secondary uses for specific aircraft For example, when passenger traffic declined in the 1980’s Boeing 747 aircraft were taken over from defaulting airlines and reconfigured for freight use Most airlines lease their aircraft from leasing companies that are specialists at redeployment of aircraft Airline loans are also secured against their aircraft fleets Lenders are therefore able to obtain possession of aircraft for redeployment without ex-post bargaining with the airlines Habib and Johnsen also cite the case of lending by finance companies secured by receivables and inventories of the firms they finance They hypothesize that finance companies possess special skills at redeploying these assets and thus can loan to riskier borrowers Carey, Post and Sharpe (1998) find that lenders are specialized, with banks financing low-order alternative uses of general assets since they do not possess skills at redeploying assets Bank skills lie in pure asset

valuation and monitoring Finance companies, on the other hand, specialize in asset valuation, monitoring and redeployment or repossession and sale

However, it is not clear that the redeployment hypothesis can be extended to include the more typical industries that use non-recourse project finance like power plants, toll roads and bridges because these assets can be used only for the purpose they were intended for Additionally these are assets which do not require extensive

managerial skills for performance (Esty (2003)) I therefore do not test this theory in this study

2.2 Theory of Incumbent management’s control benefits

Chemmanur and John (1996) present a theory viewed through the lens of

managerial control benefits for the optimal corporate organization structure, capital structure and the ownership structure of a firm with multiple projects Their model

analyzes the choices that a firm’s management makes with regard to debt versus equity financing (ownership structure choice), combining both projects in the same firm versus separate firms (incorporation choice) and use of non-recourse project finance versus corporate finance (capital structure choice) when faced with the threat of a rival

management taking over the firm Incumbent management derives benefits from being in control of the firm called control benefits and if a rival takes over the firm they lose their control benefits, not to mention their jobs Examples of such control benefits or non-cash benefits to management are management perquisites, synergy with other projects run by the same management, enhanced skills (from on the job training that is paid for by

shareholders) leading to better job prospects, enhanced reputation from successfully managing the project that could lead to better pay and future job prospects Chemmanur

and John assume that these benefits cannot be contracted away and assert that the benefits are a function of the project’s characteristics

For e.g a complex project will generate high reputation and increased skills for

management Chemmanur and John assume that an entrepreneur with access to two projects faces the choice of selling securities with voting power i.e equity or nonvoting power i.e debt Selling equity carries with it the threat of a rival wresting control by gathering enough equity while selling debt reduces control benefits because it increases the threat of bankruptcy Bankruptcy eliminates all control benefits Debt may also

include restrictive covenants and monitoring by debtholders that reduces control benefits Therefore, the higher the debt ratio the lower will be the control benefits However, Chemmanur and John argue that the level of control benefits and their rate of decline with debt may differ across projects, so that the flexibility to allocate debt optimally across different corporations or different projects in the same corporation is significant

Chemmanur and John argue that incumbent management’s abilities relative to the rival and the structure of the control benefits from each project are the determining

variables for the equilibrium solution to management’s problem Initially, the

entrepreneur uses debt along with equity if selling equity alone does not guarantee

control Also, Chemmanur and John show that if management’s relative abilities across

Control Benefits for management – These are benefits derived by managers

from being in control of projects which cannot be contracted away These benefits among other things include reputation, managerial experience and improved

managerial skills

both projects are similar and their control benefits from both projects are similar, the projects will be incorporated in a single firm and corporate finance i.e equity and straight debt on the joint firm, will be used to finance them If management’s relative abilities across both projects are not similar then the projects will be incorporated as separate firms with debt levels that maximize their control benefits If management’s relative abilities across both projects are similar but the structure of the control benefits from both projects are different then project finance is used Debt is used flexibly to maximize control benefits from each project Chemmanur and John also show that the project with smaller control benefits per dollar of value will be allocated a higher debt ratio The explanatory variables used in this study do not proxy for the structure of control benefits

to the equityholders The construction of a variable that proxies for the structure of

control benefits from a project that can be compared across different projects requires further research and is beyond the scope of this study

2.3 Signaling Theory of Project Finance

Shah and Thakor (1987) develop a theory of capital structure based on risk and information asymmetry They use risk in the sense of variance of cash flows and view the capital structure choice of a firm as a signaling device under conditions of information asymmetry However, in their model the capital structure choice is an endogenous result

of an equilibrium condition Their main result is that riskier firms have higher leverage than less risky firms, risky firms have higher values in equilibrium and pay higher

interest rates The intuition behind their result is that high risk firms have an incentive to understate their risk to get lower interest rates on their debt Also, high risk firms are more likely to have high incomes in some states of the world and therefore prefer the

high tax shields that high debt levels afford In order to induce high risk firms to report their correct risk measure, creditors offer them higher debt level as a reward for reporting higher risk8 Low risk firms however should not misrepresent their risk measure and are offered low interest rates in equilibrium The low risk firm foregoes high debt level because it does not anticipate a very high income in most states of the world and

therefore does not need the tax shields from debt

In the above analysis, Shah and Thakor assume that production of information to overcome the information asymmetry is prohibitively costly for creditors In the case of project finance however they relax this assumption Shah and Thakor then show that project finance is beneficial when the net gains from information production versus revelation are sufficiently high because creditors incur lower screening costs in

evaluating a separately incorporated project They also show that if revelation is preferred

to information production then project financing should attract high debt level and is value creating when the risk parameter for the project is higher than the risk parameter for the firm9 Shah and Thakor suggest that the economic motivation for project financing stems from a rational attempt to minimize the allocational distortions of asymmetric information The empirical implications of this theory outlined by Shah and Thakor are that project financing ventures with high leverage should see creditors deeply involved in various phases of the project since they are engaging in information production Another empirical implication is that if information production is prohibitively costly, any project that is riskier if separately incorporated than it is if adopted within the firm, will be

organized as a project financing In other words the capital structure choice of project

financing is an equilibrium condition obtained by firms to signal creditors that their project has high cash flow variance and is risky Creditors will accordingly be induced to demand high interest rates and provide the project with high debt levels since they do not need to incur the prohibitive costs of information production before providing the funds Anecdotal evidence however suggests that information asymmetry is not high for projects financed as project finance Lenders spend considerable time and effort at uncovering the economic realities of a project before committing to non-recourse or limited recourse financing Also, the signaling hypothesis predicts that an ex-post comparison of project financed ventures and conventionally financed ventures should show that project

financed ventures are riskier Casual empiricism however, suggests that intangible assets which are the most risky (have the highest cash flow variance), for e.g biotechnology firms and high technology start-ups do not use project finance A substantive test of the signaling hypothesis must therefore await further study

2.4 Agency costs of free cash flow

Agency costs are related to the agency problem that occurs when cooperating parties have different goals and require a division of labor The agency relationship between two parties is a relationship where one party (the principal) delegates work to another (the agent) who performs the work The agency problem arises when a) the goals

or aim of the principal and the agent conflict and b) when it is difficult or expensive for the principal to verify what the agent is actually doing In the context of a firm, the

shareholders are principals who delegate work to the managers who are agents When a firm throws off free cash flow, managers may undertake unwise investments or resort to profligacy and wasteful expenditure Jensen and Meckling (1976) refer to these costs as

the agency costs arising from conflicts between owners and managers of a firm

Managers may misuse their control over the assets of a firm particularly when the assets create large amounts of free cash flow Esty (2003) contends that project finance

companies are particularly well suited to reduce the agency costs of free cash flow since the structure of a project company reduces managerial discretion over free cash flow He cites concentrated debt and equity ownership of a project, high project leverage, separate legal incorporation and the detailed contracts that characterize project finance, as a means

of monitoring and mitigating managerial discretion within project companies

Concentrated debt and equity ownership makes it easy to monitor management Separate incorporation increases transparency and reduces monitoring costs Detailed contracts particularly the cash flow water-fall contract, divvy up cash flows and eliminate

managerial discretion High leverage ensures that the scope for management performance

is strictly limited and even slightly poor performance will result in default and managerial replacement Esty (2003) focuses on conflict within the separately incorporated project company as opposed to managerial conflict within the sponsoring firm It is feasible that shareholders of sponsoring firms would not be comfortable with managerial discretion over free cash flow from assets if these were financed on a corporate basis within the firm and would therefore require project finance or separate incorporation for more

transparency and oversight However, the free cash flow resulting from project financed assets flows through to the sponsoring firms and does not resolve agency costs at the

Agency Costs of Free Cash Flow – Costs arising when shareholders are either

unable to monitor or verify management’s use of free cash flow Also costs arising when management’s incentives are not aligned with shareholders interests

sponsoring firm level It does increase transparency and shareholders can observe these cash flows but this study focuses on the motivations of sponsoring firms in undertaking project finance and more research would be needed to understand this motivation for project finance

2.5 Agency Costs of Risky Debt (Underinvestment)

Merton H Miller and Franco Modigliani (1958) showed that the financing policy of a firm is irrelevant to the value of the firm The perfect functioning of capital markets was one assumption among others that they used to derive the result Joseph Stiglitz (1969, 1974) argued that in addition to perfect capital markets, a necessary assumption for the Miller Modigliani theorem to hold was that the debt held by firms and individuals was default-free However, Miller and Fama (1972) argued that the theorem held even when

the debt held by individuals and firms was not default-free, in other words, was risky, if

the stockholders and debtholders protected themselves from each other by seniority rules These rules called “me-first rules” which they assumed to be costlessly enforced are designed to protect existing debtholders by ensuring that the value of outstanding debt does not change if the firm alters its capital structure For example, bondholders may insist on covenants that new debt is junior to existing debt This would protect them in case of bankruptcy These rules basically ensure that new financing does not improve the position of existing bondholders Fama (1978) argued that the assumptions for riskless debt or me-first rules were not necessary for the Miller Modigliani theorem to hold Fama argued that if some firms or investors want to issue unprotected debt (debt without me-first rules) then investors will be willing to hold them at the right price, i.e investors

acting rationally would price these securities assuming that stockholders would act

opportunistically

However, all the above results about the irrelevance of the financing choices to the value of a firm rest on the assumption that the investment strategies of the firm are given The rules that firms use to make current and future investment decisions are

assumed to be independent of how the investments are financed (See Fama (1978),

pp.273) The theory of agency costs led Myers (1977) to argue that risky debt induces a sub-optimal investment policy In other words, he dropped the assumption that

investments are independent of their mode of financing Myers argued that costs of negotiation, monitoring and enforcement of contracts were not negligible and agency costs influenced the rules that firms used to make

investments

Myers (1977) theorized that firms behaving rationally have a strong incentive to follow a sub-optimal investment policy when they finance a project with debt

Specifically the sub-optimal policy followed by firms is that they choose to forego

positive NPV projects to which they have monopolistic access This policy of rejecting

Underinvestment – Underinvestment is a result of agency conflict between equity holders and debt holders of a firm Equity holders choose to forego positive NPV projects when the firm has outstanding risky debt because debt holders have first right on the cash flow from the project Therefore although equity holders take the risk the benefit accrues to debt holders

positive NPV projects reduces the value of the firm Myers argues that this suboptimal investment policy is an agency cost of risky debt Myers defines rejection of positive NPV projects as underinvestment Myers shows that risky debt causes underinvestment when capital markets are perfect and complete He begins the argument by assuming that the value of a firm comprises the sum of the value of its assets in place and the present value of future growth

opportunities

The firm is required to invest capital in order to exercise its growth options Myers

restricts his analysis to equity and debt as the forms of capital10 Although the decision to exercise these options rests with management, Myers assumed that management acts in the best interests of shareholders, and thereby transformed the problem into an agency conflict between debt holders and equity holders Future growth options in the form of positive NPV projects are ‘in the money’ growth options at maturity (Stulz & Johnson 1985) Myers showed that shareholders choose to allow some ‘in the money’ options to expire, if the payoff from exercising the option (the value of the project) is less than the

10

Later papers showed that hybrid forms of capital like preferred equity, convertible debt, and warrants are

a solution for the underinvestment problem See Bodie & Taggert (1978) who suggest the use of callable bonds that can be called before undertaking a project Jensen and Meckling (1976) and Green (1984) suggest convertible debt as a solution to the underinvestment problem because it converts existing debt holders into equity holders and neutralizes debtholder and stockholder conflict

Value of

Firm = Value of Assets in place + Value of Growth Options

sum of the equity investment required plus the promised payment to debt holders

Myers also shows that since the value of a firm’s debt is a function of the value of the firm as well as uncertainty about the firm’s future value i.e the debt is risky; an incremental discretionary positive NPV investment increases firm value However, its effect is to transfer wealth to existing debt holders (who contribute nothing to the new project since Myers assumes that the new project is financed with equity) from

stockholders (who make the investment) If the debt is default free, i.e its value does not depend on the uncertainty of the firm’s future value then an incremental discretionary investment will not transfer value from stockholders to debt holders Stockholders will exercise all their ‘in the money’ options and thereby maximize the value of the firm However, stockholders will not exercise their ‘in the money’ options when their payoff transfers most of the value to debt holders, a situation that obtains in the event of default

or bankruptcy Thus, risky debt induces a sub optimal investment policy for the firm Myers also points out that this result rests on no assumption about the firm’s other assets

Equity holders do not undertake positive NPV projects when the following

condition holds

increase their required rate of return Myers thus shows that, ceteris paribus, debt

supported by growth opportunities will always be less than debt supported by assets in place Empirically it has been shown that investments in firms in high technology

industries like bio-technology and computer software that have little assets in place but have high growth opportunities, are funded primarily by equity Bradley, Jarrell & Kim (1984) show that there is a significant inverse relationship between debt ratios and the level of advertising and R&D expenditure R&D investments and advertising are related

to the acquisition of options for future growth Therefore industries that invest heavily in R&D and advertising, like the drugs and cosmetic industry should have lower debt ratios than other industries This is indeed the case with the average debt ratio for the drugs and cosmetic industry being about 9.1%11 Similarly heavily regulated industries that have stable cash flows and little growth options have the highest debt equity ratios at about 53%12 Firms also use debt as a tax shield Myers shows that the analysis does not change when taxation is introduced in the model

The following sections explore the extant theoretical literature about the problem

of underinvestment and the use of project finance as a solution

3 Solutions to the Underinvestment Problem

Berkovitch and Kim (1990) argued that one financing structure that reduced these agency costs was project finance They categorize solutions to the underinvestment problem as follows;

a) Devise ways which allow a firm to eliminate existing debt or neutralize its

term debt that matures and is paid off before the real option matures or the

discretionary decision to invest needs to be taken Since there will be no more promised payments required to debt holders all positive NPV projects will be

undertaken by the firm However, following this policy is costly because of asset liability mismatches, frequent trips to the capital markets especially when market conditions are unfavorable and high transaction costs

b) Renegotiate prior contracts in order to resolve conflicts between different

call in a third party mediator if there is suspicion that the firm is following a optimal investment strategy However, this strategy will incur costly monitoring since without monitoring debt holders will not be able to call in the mediators at the right time Myers further makes the point that a bankruptcy is also a mediating and fact-finding service provided by society although its value is limited since it is reserved for only terminal cases

sub-c) Design ex-ante debt contracts to mitigate the agency costs of debt Stulz and

Johnson (1985) show that the possibility of financing new projects with secured debt reduces the underinvestment problem Ex-ante, stockholders retain the right to finance new projects with secured debt by including this provision in existing bond covenants Stulz and Johnson argue that stockholders will invest in a new project only if the project is available at below market price The assumption of a perfect market implies that a project priced correctly must have an NPV=0 The project can

be priced below market price i.e has an NPV greater than zero because stock

holders have special capabilities that allow them to execute the project better, or

have better information (the true state of nature is revealed to them) or management knows the true distribution of project returns before the market (See Myers and Majluf (1984)) Stulz and Johnson argue that stockholders can finance the

investment by using the new asset as collateral and thereby divert from the existing creditors some payoffs of the new project that would accrue to the existing

creditors, if unsecured debt was used The use of unsecured debt to finance the new asset would mean that in the event of bankruptcy or liquidation, existing creditors would have a claim on the new asset before stockholders Therefore taking on the new project even with positive NPV, in some cases, can make stockholders worse off and existing creditors better off, which is the root of the underinvestment

problem However, issuing secured debt modifies the existing debt holder claims to cash flows from the new asset In the case of senior secured debt, existing debt holders are made worse off in all cases since the secured creditors have prior claims

to not just the collateral but also all other assets of the firm In the case of junior secured debt, the value of the unsecured debt always increases but less than if only unsecured debt was used This is because unsecured debt holders can claim a

portion of the secured asset in the event of bankruptcy or liquidation only if secured claims are fully satisfied first In addition, secured claim holders have rights on the existing assets of the firm once existing debt holders are satisfied Therefore,

existing debt holders are placed lower than the new capital providers are This causes secured debt to be cheaper and induces shareholders to undertake some positive NPV projects that otherwise they would have rejected In effect, some payoffs from the new project are diverted away from the existing creditors towards

shareholders Stulz and Johnson argue that the new secured creditors do not capture value diverted from existing creditors because the market prices their debt fairly Therefore, the diversion of payoff from the existing creditors makes stockholders better off The use of secured debt therefore increases the incentives for

stockholders to undertake positive NPV projects and reduces underinvestment Stulz and Johnson point out that including the provision for financing new

investments with secured debt is costly when issuing the original unsecured debt

Unsecured debt holders will expect stockholders to behave rationally and price their debt higher than if the secured debt provision was not included This price would be borne by stockholders Stulz and Johnson therefore point out that the value of including the option

to issue secured debt in the future will be worthwhile to stockholders only if stockholders expected to undertake positive NPV projects they would otherwise reject The more likely that some positive NPV projects would be rejected in the absence of this option, the more valuable this option to finance new projects with secured debt becomes Stulz and Johnson show that the value of the security provision is an increasing function of the face value of secured debt, the face value of unsecured existing debt, rate of interest and a decreasing function of the time to maturity The intuition behind this effect is that the probability of default increases with the increase in the face value of existing debt

Therefore, existing debt becomes more risky leading to a larger underinvestment

problem Therefore the option to finance a new asset with secured debt increases in value since it reduces the deadweight costs of underinvestment Thus secured debt is likely to

be used by firms with a high leverage ratio The same logic operates in the case of the rate of interest A higher interest rate increases the probability of default thereby making