Principles of project finance

5 $2.1 Development of Project Finance 5 $2.2 FeaturesofProjectFinance 7 $2.3 Project Finance and Privatization 9 $2.4 ProjectFinance and Structured Finance 11 $2.5 Why Use Project Financ

Principles of

Project Finance

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02 03 04 05 06 07 MM 9 8 7 6 5 4 3 2 1

Chapter 1

Introduction 1

Chapter 2

What Is Project Finance? 5

$2.1 Development of Project Finance 5

$2.2 FeaturesofProjectFinance 7

$2.3 Project Finance and Privatization 9

$2.4 ProjectFinance and Structured Finance 11

$2.5 Why Use Project Finance? 13

$2.5.1 Why Investors Use Project Finance 14

$2.5.2 The Benefits of Project Finance to Third Parties I7

Project Development and Management 33

$5.1.6 Term Sheet, Underwriting, and Documentation 55

$5.1.7 Information Memorandum and Syndication 57

Contents vll

$5.3 Loans versus Bonds 63

$5.4 The Roles of the Lenders'Advisers 63

$6 1.3 Completion of the Plant 73

$6.1.4 Operation of the Plant '74

56.3 Term of Project Agreernent 86

$6.4 Control of Project Design and Construction, Contracts,

and Financing 87

$6.5 Compensation for Additional Costs 88

$6.5.1 Breach by the Offtaker or Contracting Authority

$6.5.2 Change in Specifications 88

$6.5.3 Changes in Law 89

$6.5.4 Latent Defects 89

56.6 Force Majeure 89

$6.7 Step-in by the Offtaker or Contracting Authority 9l

$6.8 Termination of the Project Agreement 9l

$6.8.1 Early Termination: Default by the Project Company

$6.8.2 Early Termination: Default by the Offtaker

$6.8.6 Final Maturity of a BOOT/BOT/BTO Conrract 99

$6.9 Effect of Debt Refinancing or Equity Resale

on the Project Agreement 100

$7.1.9 Suspension and Termination by the

EPC Contractor Il3

97.2.4 Incentives and Penalties 116

57.2.5 Major Maintenance Contract ll7

$7.3 Fuel or Other Input Suppty Contract ll7

$7.3.1 Supply Basis

tll-97.3.2 Physical Delivery Risks t2O

$7.3.3 Pricing Basis 120

57.3.4 Security tz}

$7.3.5 Force Majeure and Change of Law l2l

$7.3.6 Default and Termination l2l

$7.4 Permits and Other Rights 122

$7.4.1 Project Permits 122

57.4.2 Investment and Financing permits 124

91.4.3 Rights of Way and Easements 124

\7.4.4 Shared Facilities 124

Commercial Risks I37

$8.1 Categories of Project Finance Risk 137

$8.2 Risk Evaluation and Allocation 137

$8.3 Analysis of Commercial Risks 139

$8.4 Commercial ViabilitY l4O

$8.5 Completion Risks l4l

$8.5.1 Site Acquisition and Access l4I

$8.5.2 Permits I42

$8.5.3 The EPC Contractor I43

$8.5.4 Construction Cost Ovemrns 146

$8.5.5 Revenue during Construction 150

$8.7.2 General Project Operation 157

$8.7.3 General Operating Cost Overruns 158

$8.8.4 Contracts for Differences 163

$8.8.5 Long-Term Sales Contracts 164

$8.8.6 Price and Volume Risk 164

$8.8.7 Usage Risk 16l

$8.8.8 Risks for the Offtaker or Contracting Authority 169

$8.9 Input Supply Risks 170

$8.9.1 Input Supply Contracts I':.0

$8.9.2 When is an Input Supply Contract not Needed? I73

$8.9.3 Water and Wind tj3

$8.9.4 Mineral Reserves lj3

$8.9.5 Other Utilities tj4

$8.9.6 Waste Disposal lj4

$8.10 Farce Majeure 174

S8.10.1 Force Majeure and Insurance Ij5

$8.10.2 Temporary Force Majeure 176

$8.10.3 Permanent Force Majeure 178

$9.2 Interest Rate Risks 185

$9.2 I Interest Rate Swaps 186

99.2.2 Interest Rate Caps and Other Instruments lg2

$9.2.3 Scale and Timing of Interest Rate Hedging lg3

59.2.4 Additional Costs 193

$9.2.5 Redeposir Risk 194

59.2.6 Interest Rate Hedging before Financial Close lg4

$9.3 Exchange Rate Risks 195

$9.3.1 Hedging of Currency Risks 196

S9.3.2 Finance in More than One Currency lg,l

$9.3.3 Conversion ofLocal Currency Revenues l9g

$9.3.4 Fixing of Security in Local Curency lg9

59.3.5 Catastrophic Devaluation I99

Chapter 10

Political Risks 203

$10.1 Projects and Politics 203

$10.2 Ctassification of Political Risk 204

S10.7.2 "Sub-sovereign" (or "Sub-state") Risks 2I5

Chapter L1

Political Risk Guarantees, Insurance, and Finance 2I7

$ 11.6.4 Multilateral Investment Guarantee Agency 242

$l1.6.5 Asian Development Bank 243

$11.6.6 African Development Bank 244

$11.6.7 Inter-American Development Bank 244

$11.6.8 European Bank for Reconstruction and

$ I 1.6.9 European Investment Bank 245

$11.6.10 Nordic Investment Bank 249

$ I 1.6.1 1 Islamic Development Bank 24g

$12.7.1 Capitalization and Depreciation of

$12.8.3 Using NPV and IRR Calculations for Investment

$12.3.4 Noncash Investment 272

$12.9 Debt Cover Ratios ' 272

$12.9.1 Annual Debt Service Cover Ratio 273

*12.9.2 Loan Life Cover Ratio 274

$12.9.3 Average ADSCR and LLCR 274

912.9.4 Project Life Cover Ratio 275

$12.9.5 Reserve Cover Ratio 215

512.9.6 Calculating Cover Ratios 276

$12.10 The Base Case and Changes in Assumptions 277

$12.11 Sensitivity Analysis 277

Sl2.l2 Investors'Analysis 278

Sl2.I2.l Investors'Returns 218

812.12.2 Timing of Equity Commitment 279

512.12.3 Effect of Equity Resale 280

$ 1 3 1 2 Effect of Cover Ratio Requirements

$13.1.3 Projects without Equity 286

$13.1.4 Calculation of Debt:Equity Ratio

$13.4 Interest Rate and Fees 297

$13.5 Control of Cash Flow 298

$13.5.1 The Cash Flow Cascade 299

$13.5.2 Reserve Accounts 300

$13.5.3 Controls on Distributions to Investors

283

285 287

302

$13.5.4 Cash Sweep 303

$13.5.5 Cash Clawback 304

$13.6 Debt Prepayments and Refinancing 305

$13.6.1 Loan Commitment Reduction 305

$13.6.2 Partial Prepayment 306

$ 13.6.3 Refinancing 306

$13.7 Security 308

$13.7.1 Mortgages and Contract Assignments 309

913.7.2 Security Over project Company Shares 31"^

construc-In 2001, some $190 billion of investments in projects around the world werefinanced using project finance techniques (cf $2.1).

"Project finance" is not the same thing as "financing projects," because ects may be financed in many different ways Traditionally, large scale public-sector projects in developed countries were financed by public-sector debt; pri-vate-sector projects were financed by large companies raising corporate loans Indeveloping countries, projects were financed by the government borrowing fromthe international banking market, multilateral institutions such as the World Bank,

proj-or through expproj-ort credits These approaches have begun to change, howeveq asprivatization and deregulation have changed the approach to financing investment

in major projects, transferring a significant share of the financing burden to theprivate sector

Unlike other methods of financing projects, project finance is a seamless webthat affects all aspects of a project's development and contractual arrangements,and thus the finance cannot be dealt with in isolation If a project uses projectfinance, not only the finance director and the lenders but also all those involved

in the project (e.g., project developers, governments and other public authorities,engineers, contractors, equipment suppliers, fuel suppliers, product offtakers,and other parties to Project Contracts) need to have a basic understanding ofhow

project finance works, and how their part ofthe project is linked to and affected bythe project finance structure.

This book is therefore intended to provide a guide to the principles ofprojectfinance and to the practical issues that can cause the most diffi;ulty in commercialand financial negotiations, based on the author's own experience both as a bankerand as an independent adviser in project finance The book serves both as a struc-tured introduction for those who are new to the subject, and as an aide m1moirefor those developing and negotiating project finance transactions No knowledge

of the financial markets or financial terms is assumed or required

"The devil is in the detail" is a favorite saying among project financiers, and alot of detailed explanation is required for a book on project finance to be a practi-cal guide rather than a generalized study or a vague summary of the subject Butwith a systematic approach and an understanding of the principles that lie behindthis detail, finding a way through the thickets becomes a less formidable task.The subject of project finance is presented in this book in much the same waythat a particular project is presented to the financing market (cf 95.l.g), i.e.:' A general background on the projectfinance market and the roles of the mainparticipants:

' chapter 2 explains the recent development of project finance, its key acteristics and how these differ from other types of finance, and why proj-ect finance is used

char-' chapter 3 provides information on the markets for raising project nance debt

fi-' chapter 4 explains how Sponsors (lead investors) and the project pany develop projects as well as the competitive-bidding procedures forproject development by public authorities

com-' chapter 5 sets out the procedures for raising finance from private-sectorlenders

' A review of the commercial contracts that can form a framework for raisingproject finance:

' Chapter 6 reviews the main Project Agreement, usually an offtake tract or concession Agreement, which plays the central role in many proj-ect finance structures

con-' chapter 7 looks at the other important Project Contracts-including thosefor construction and operation of the project, provision of raw materialsand other input supplies, and insurance

An explanation of project finance risk analysis:

' Chapter 8 explains how lenders analyze and mitigate the commercial risksinherent in a project

' chapter 9 similarly examines the effect of macroeconomic risks

A description ofhow thefinancing structurefor a project is created: Chapter 12 summarizes the inputs used for a financial model of a projectand how the model's results are used by investors and lenders.

Chapter 13 demonstrates how the process ofreview and risk analysis cludes in a negotiation of the project's finance structure and terms.Technical terms used in this book that are mainly peculiar to project finance arecapitalized, and briefly explained in the Glossary, with cross-references to the sec-tions in the main text where fuller explanations can be found; other specializedfinancial terms are also explained and cross-referenced in the Glossary, as are thevarious abbreviations

con-Spreadsheets with the detailed calculations on which the tables in Chapters9,I2, and 13 are based can be downloaded from www.yescombe.com

Unless stated otherwise "$" in this book refers to U.S dollars

Chapter 2

What Is Project Finance?

This chapter reviews the factors behind the recent rapid growth of project finance(cf $2.1), its distinguishing features (ct.82.2), and relationship with privatization(cf $2.3), and also with other forms of structured finance (cf $2.4) Finally, thebenefits of using project finance are considered from the point of view of the vari-ous project participants (cf $2.5)

52.L DEVELOPMENT OF PROIECT FINANCE

The growth of project finance over the last 20 years has been driven mainly

by the worldwide process of deregulation of utilities and privatization of sector capital investment This has taken place both in the developed world as well

public-as developing countries It hpublic-as also been promoted by the internationalization ofinvestment in major projects: leading project developers now run worldwide port-folios and are able to apply the lessons learned from one country to projects in an-other, as are their banks and financial advisers Governments and the public sec-tor generally also benefit from these exchanges of experience

Private finance for public infrastructure projects is not a new concept: the glish road system was renewed in the 18th and early 19th centuries using private-sector funding based on toll revenues; the railway, water, gas, electricity, and tele-phone industries were developed around the world in the 19th century mainly withprivate-sector investment During the first half of the 20th century, however, thestate took over such activities in many countries, and only over the last 20 yearshas this process been reversing Project finance, as an appropriate method oflong-term financing for capital-intensive industries where the investment financed has

En-Table 2.1Private-Sector Project Finance Loan Commitments, 1996-2001

($ millions) 1996 1997 1998 L999 2000 zML

Power

Telecommunications

Infrastructure

OiI and gas

Real estate and leisure

64,528)5 44\14,47312,6386,5303,8983,646

z , J z J

133,481

Adapted from: Project Finance Intemational, issues I 13 (January 13, lgg'l),137 (January 2g, 199s),

161 (January 27,1999),185 (January 26,2000),209 (January 24,2OOl),233 (Jarnary 23,2002).

a relatively predictable cash flow, has played an important pafi in providing thefunding required for this change,

Some successive waves ofproject finance can be identified:

Finance for natural reso'rces projects (mining, oil, and gas), from whichmodern project finance techniques are derived, developed first in the Texasoil fields in the 1930s; this was given a considerable boost by the oil price in-creases, and the development of the North Sea oil fields in the 1970s, as well

as gas and other natural resources projects in Australia and variousdeveloping countries

' Finance for independent power projects ("IPPs") in the electricity sector marily for power generation) developed first after the private utility Regula-tory Policies Act ("PURPA') h the united states in 1978, which encouragedthe development of cogeneration plants, electricity privatization in theUnited Kingdom in the early 1990s, and the subsequent worldwide process

(pri-of electricity privatization and deregulation

Finance for public infrastructure (roads, transport, public buildings, etc.) wasespecially developed though the united Kingdom's private Finance Initia-tive ("PFI") from the early 1990s; such projects are now usually known aspublic-private partnerships ("PPPs")

' Finance for the explosive worldwide growth in mobile telephone networksdeveloped in the late 1990s

An analysis by industry sectors of the project finance loan commitments vided by private-sector lenders in recent years illustrates these trends (Table 2.1).The effects ofrecent electricity deregulation in parts ofthe United States and theupsurge in worldwide investment in mobile phone networks are especially evident

pro-in these figures The steady growth pro-in PPP-related project fpro-inance (pro-infrastructure

$2.2 Features ofProject Finance /and real estate) is also notable (For a fuller analysis on a geographical basis, cf.Chapter 3.)

Assuming that debt averages TOVo oftotalproject costs, in 2001 on the basis ofthese figures some $190 billion of new investments worldwide were financed withproject finance from private-sector lenders

It should be noted that these statistics do not include direct lending for projects

by export credit agencies and multilateral development banks (cf Chapter 11)

or other public-sector agencies In addition, because (a) it is debatable whethercertain structured finance loans should be classified as project finance or not(cf $2.a), and (b) the borderline between project finance and financing projects(cf Chapter 1) is not always clear, market statistics compiled by different sourcescan vary considerably;t however, the overall trends in and scale ofproject financeare reasonably clear

s2.2 FEATURES OF PROIECT FINANCE

Project financd structures differ between these various industry sectors andfrom deal to deal: there is no such thing as "standard" project finance, since eachdeal has its own unique characteristics But there are common principles under-lying the project finance approach

Some typical characteristics ofproject finance are

It is provided for a "ring-fenced" project (i.e., one which is legally and nomically self-contained) through a special purpose legal entity (usually acompany) whose only business is the project (the "Project Company") It is usually raised for a new project rather than an established business (al-though project finance loans may be refinanced)

eco- There is a high ratio of debt to equity ("leverage" or "gearing")-roughlyspeaking, project finance debt may cover 70 -907o of the cost of a project There are no guarantees from the investors in the Project Company ("non-recourse" finance), or only limited guarantees ("limited-recourse" finance),for the project finance debt

Lenders rely on the future cash flow projected to be generated by the projectfor interest and debt repayment (debt service), rather than the value of its as-sets or analysis of historical financial results

The main security for lenders is the project company's contracts, licenses, orownership of rights to natural resources; the project company's physicalassets are likely to be worth much less than the debt if they are sold off after

a default on the financing

rFor example, Euromoney's Loanware database estimated the total project finance market in 2001

Figure 2.1 Simplified project finance structure.

The project has a finite life, based on such factors as the length of the tracts or licenses or the reserves ofnatural resources, and therefore the proj-ect finance debt must be fully repaid by the end of this life

con-Hence project finance differs from a corporate loan, which is primarily lentagainst a company's balance sheet and projections extrapolating from its past cashflow and profit record, and assumes that the company will remain in business for

an indefinite period and so can keep renewing ("rolling over") its loans

Project finance is made up of a number of building blocks, although all of theseare not found in every project finance transaction (cf g2.a), and there are likely to

be ancillary contracts or agreements not shown in Figure 2.1

The project finance itself has two elements:

Equity, provided by investors in the project

Project finance-based debt, provided by one or more groups of lendersThe project finance debt has first call on the project's net operating cash flow; theequity investors' return is thus more dependent on the success ofthe project.The contracts entered into by the Project company provide support for theproject finance, particularly by transferring risks from the Project company to the

$2.3 Project Finance anil Priaatization

other parties to the Project Contracts, and form part of the lenders' security age The Project Contracts may include the following:

pack- A Project Agreement, which may be

either an Off-take Contract (e.g., a power purchase agreement), under whichthe product produced by the project will be sold on a long-term pric-ing formula

or a Concession Agreement with the government or another public thority, which gives the Project Company the right to construct theproject and earn revenues from it by providing a service either to thepublic sector (e.9., a public building) or directly to the general public(e.9., a toll road)

au-Alternatively, the project company may have a license to operate under theterms of general legislation for the industry sector (e.g a mobile phonenetwork)

Other project contracts, e.g.:

A turnkey Engineering, Procurement and Construction (EPC) Contract,under which the project will be designed and built for a fixed price, andcompleted by a fixed date

An Input Supply Contract, under which fuel or other raw material forthe project will be provided on a long-term pricing formula in agreedquantities

An Operating and Maintenance (O&M) Contract, under which a third partywill be responsible for the running of the project after it has been built A Government Support Agreement (usually in a developing country),which may provide various kinds of support, such as guarantees for theOfftaker or tax incentives for the investment in the project

Project Agreements are discussed in detail in Chapter 6 and other Project tracts in Chapter 7 Of course none of these structures or contractual relationshipsare unique to project finance: any company may have investors, sign contracts, getlicenses from the government, and so on; however, the relative importance of thesematters, and the way in which they are linked together, is a key factor in projectfinance

Con-s2.3 PROIECT FTNANCE AND PRTVATTZAIION

Project finance should be distinguished from privatization, which:

either conveys the ownership of public-sector assets to the private this does not necessarily involve project finance: a privatized formerstate-owned company may raise any finance required through a corpo-rate loan

sector-or provides for services to be supplied by a private company that had viously been supplied by the public sector (e.g., street cleaning)-again, this does not necessarily involve project finance: the private com-pany may not have to incur major new capital expenditure and so notrequire any finance at all, or may use a corporate loan to raise the finance

pre-to make the investment required pre-to provide the service

Project finance may come into the picture if a company needs finance for the struction of public infrastructure on the basis of a contract or licence, e.g.: An Off-take Contract, based on which a project will be constructed to sell itsoutput to a public-sector body (e.g., construction of a power station to sellelectricity to a state-owned power company)

con- A Concession Agreement under which a project will be constructed to vide a service to a public-sector body (e.g., provision of a public-sector hos-pital building and facilities)

A Concession Agreement under which a project will be constructed to vide a service to the general public normally provided by the public sector(e.g., a toll road)

pro- A Concession Agreement or licence under which a project will be structed to provide new services to the public (e.9., a mobile phonenetwork)

con-Such Project Agreements with the public sector, which provide a basis for ect finance can take several different forms:

proj-Build-own-operate-transfer ("BOOT") projects: The Project Companyconstructs the project and owns and operates it for a set period of time, earn-ing the revenues from the project in this period, at the end of which owner-ship is transferred back to the public sector For example, the project com-pany may build a power station, own it for 20 years during which time thepower generated is sold to an Offtaker (e.g., a state-owned electricity distri-bution company), and at the end of that time ownership is transferred back

to the public sector

Build-operate-transfer ("BOT") projects (also known as finance-operate ["DBFO"] projects) In this type of project, the ProjectCompany never owns the assets used to provide the project services How-ever the Project Company constructs the project and has the right to earn rev-enues from its operation ofthe project (It may also be granted a lease oftheproject site and the associated buildings and equipment during the term ofthe project-this is known as build-lease-transfer C'BLT") or build-lease-operate-transfer ("BLOT") This structure is used where the public nature

design-build-of the project makes it inappropriate for it to be owned by a private-sector

$2.4 Project Finance and Structured Finance 11company-for example, a road, bridge, or tunnel-and therefore ownershipremains with the public sector.

Build-transfer-operate ("BTO") projects These are similar to a BOT ect, except that the public sector does not take over the ownership of the proj-ect until construction is completed

proj-Build-own-operate ("BOO") projects These are projects whose ship remains with the Project Company throughout its life-for example,

owner-a power stowner-ation in owner-a privowner-atized electricity industry or owner-a mobile phone work The Project Company therefore gets the benefit of any residual value

net-in the project (Project agreements with the private sector also normally fallinto this category.)

There are other variations on these acronyms for different project structures,and the project finance market does not always use them consistently-forexample, "BOT" is often used to mean "Build-Own-Transfer," i.e., the same

as "BOOT."

Clearly a Project Company would always prefer to own the project assets, butwhether or not the ownership of the project is transferred to the public sector inthe short or the long term, or remains indefinitely with a private-sector company,

or is never held by the private-sector company, makes little difference from theproject finance point of view This is because the real value in a project financed

in this way is not in the ownership of its assets, but in the right to receive cash flowsfrom the project But although these different ownership structures are of limitedimportance to lenders, any long-term residual value in the project (as there may be

in a BOO but not a BOOT/BOT/BTO project) may be of relevance to the vestors in assessing their likely return

in-S2.4 PROIECT FINANCE AND STRUCTURED FINANCE

Although there are general characteristics or features to be found in what themarket calls "project finance" transactions, as already mentioned, all of the

"building blocks" shown in Figure 2.1 are not found in every project financing, forexample:

If the product of the project is a commodity for which there is a wide market(e.g., oil), there is not necessarily a need for an Offtake Contract

A toll-road project has a Concession Agreement but no Offtake Contract A project for a mobile phone network is usually built without a fixed price,date-certain EPC Contract, and has no Offtake Contract

A mining or oil and gas extraction project is based on a concession or license

to extract the raw materials, but the Project Company may sell its products intothe market without an Offtake Contract

A project that does not use fuel or a similar raw material does not require anInput Supply Contract

Government Support Agreements are normally only found in projects in veloping countries

de-There is, therefore, no precise boundary between project finance and othertypes of financing in which a relatively high level of debt is raised to fund a busi-ness The boundaries are also blurred as transactions that begin as new projectsbecome established and then are refinanced, with such refinancing taking on more

of the characteristics of a corporate loan

Lenders themselves draw the boundaries between project finance and othertypes of lending based on convenience rather than theory, taking into account thatskills used by loan officers in project finance may also be used in similar types offinancing Many lenders deal with project finance as part of their "structuredfinance" operations, covering any kind of finance where a special-purpose vehicle(SPV) like a Project Company has to be put in place as the borrower to raise thefunding, with an equity and debt structure to fit the cash flow, unlike corporateloans, which are made to a borrower already in existence (cf 95.1) As a result,project finance market statistics have to be treated with some caution, as they may

be affected by inclusion or exclusion oflarge deals on the borderline between ect finance and other types of structured finance

Examples of other types of structured finance and their differences from ect finance include the following:

proj-Receivables financing This is based on lending against the established cashflow of a business and involves raising funds through an SPV similar to

a Project Company (but normally off the balance sheet of the true ciary of the cash flow) The cash flow may be derived from the general busi-ness (e.g., a hotel chain) or specific contracts that give rise to this cash flow(e.g., consumer loans, sales contracts, etc.) The key difference with projectfinance is that the latter is based on a projection of cash flow from a projectyet to be established

benefi-Although telecommunication financing is often included under the ing of project finance, it has few of the general characteristics shared byother types of project finance It could be said to come halfway between suchreceivables financing and "true" project finance, in that the financing may

head-be used towards construction of a project (a new telephone network), butloans are normally not drawn until the initial revenues have been established(cf $8.8.7)

Securitization If receivables financing is procured in the bond market (cf

$5.2), it is known as securitization of receivables (There have also been afew securitizations of receivables due from banks' project finance loanbooks, but so far this has not been a sisnificant feature in the market.)

$2.5 Why Use Project Finance?

Leveraged buyout ("LBO") or management buyout ("MBO") financing.This highly leveraged financing provides for the acquisition of an existingbusiness by portfolio investors (LBO) or its own management (MBO) It

is usually based on a mixture of the cash flow of the business and the value

of its assets It does not normally involve finance for construction of a newproject, nor does this type of financing use contracts as security as does proj-ect finance

Acquisition finance Probably the largest sector in structured finance tion finance enables company A to acquire company B using highly leverageddebt In that sense it is similar to LBO and MBO financing, but based on thecombined business of the two companies

acquisi-Asset finance acquisi-Asset finance is based on lending against the value of assetseasily saleable in the open market, e.g., aircraft or real estate (property) fi-nancing, whereas project finance lending is against the cash flow produced

by the asset, which may have little open-market value

Leasing Leasing is a form of asset finance, in which ownership of the assetfinanced remains with the lessor (i.e., lender) (cf $3.4)

s2.s wHY usE PROIECT FTNANCE?

A project may be financed by a company as an addition to its existing businessrather than on a stand-alone project finance basis In this case, the company usesits available cash and credit lines to pay for the project, and if necessary raise newcredit lines or even new equity capital to do so (i.e., it makes use of corporatefinance) Provided it can be supported by the company's balance sheet and earn-ings record, a corporate loan to finance a project is normally fairly simple, quick,and cheap to arrange

A Project Company, unlike a corporate borrower, has no business record toserve as the basis for a lending decision Nonetheless, lenders have to be confidentthat they will be repaid, especially taking account of the additional risk from thehigh level of debt inherent in a project finance transaction This means that theyneed to have a high degree of confidence that the project (a) can be completed ontime and on budget, (b) is technically capable of operating as designed, and(c) that there will be enough net cash flow from the project's operation to covertheir debt service adequately Project economics also need to be robust enough tocover any temporary problems that may arise

Thus the lenders need to evaluate the terms of the project's contracts insofar asthese provide a basis for its construction costs and operating cash flow and quan-tify the risks inherent in the project with particular care They need to ensure thatproject risks are allocated to appropriate parties other than the Project Company,

or, where this is not possible, mitigated in other ways This process is known as

1 3

Table2.2Benefit of Leverage on Investors' Return

Lowleverage Highleverage Project cost

(a) Debt

(b) Equity

(c) Revenue from project

(d) Interestrate on debt (p.a.)

(e) Interest payable t(a) x (d)l

(f) Profit t(c) - (e)l

Return on equity t(f) : (b)l

1,0003007001005Va

1 585l2Va

1,0008002001007Vo5644227o

"due diligence." The due-diligence process may often cause slow and frustratingprogress for a project developer, as lenders inevitably tend to get involved-di-rectly or indirectly-in the negotiation of the Project Contracts, but it is an un-avoidable aspect of raising project finance debt (The issues covered during duediligence are discussed in Chapters 8 to 10.)

Lenders also need to continue to monitor and control the activities of the ect Company to ensure that the basis on which they assessed these risks is not un-dermined This may also leave the investor with much less independent manage-ment of the project than would be the case with a corporate financing (Thecontrols imposed by lenders are discussed in Chapter 13.)

Proj-Besides being sloq complex, and leading to some loss of control of the ect, project finance is also an expensive method of financing The lenders' marginover cost of funds may be 2-3 times that of corporate finance; the lenders' duediligence and control processes, and the advisors employed for this purpose (cf

proj-$5.4), also add significantly to costs

It should also be emphasized that project finance cannot be used to finance aproject that would not otherwise be financeable

52.5.1 Wny INvEsrnns UsE Pnoyncr FrNnNcn

Why, despite these factors, do investors make use of project finance? There areavariety of reasons:

High leverage One major reason for using project finance is that investments

in ventures such as power generation or road building have to be long termbut do not offer an inherently high return: high leverage improves the returnfor an investor

Table 2.2 sets out a (very simplified) example of the benefit of leverage on

52.5 Wlly Use Project Finance?

an investor's return Both the low-leverage and high-leverage columns relate

to the same investment of 1,000, which produces revenue of 100 p.a If it isfinanced with 30Vo debt, as in the low-leverage column (a typical level ofdebt for a good corporate credit), the return on equity is ll%o On the otherhand, if it is financed with807o (project finance-style) leverage, the return onthe (reduced level) of equity is 22Vo, despite an increase in the cost of thedebt (reflecting the higher risk for lenders):

Project finance thus takes advantage of the fact that debt is cheaper thanequity, because lenders are willing to accept a lower return (for their lowerrisk) than an equity investor Naturally the investor needs to be sure that theinvestment in the project is not jeopardized by loading it with debt, andtherefore has to go through a sound due diligence process to ensure that thefinancial structure is prudent Of course the argument could be turned theother way around to say that if a project has high leverage it has an inherentlyhigher risk, and so it should produce a higher return for investors But inproject finance higher leverage can only be achieved where the level of risk

in the project is limited

Tax benefits A further factor that may make high leverage more attractive

is that interest is tax deductible, whereas dividends to shareholders are not,which makes debt even cheaper than equity, and hence encourages highleverage Thus, in the example above, if the tax rate is 30Vo, the after-taxprofit in the low leverage case is 60 (85 X 7O7o), or an after-tax return on eq-uity of 8.5Vo, whereas in the highJeverage case it is 3l (44 X TOVo), or anafter-tax return on equity of 15.47o

In major projects there is, howeva, likely to be a high level of tax tions anyway during the early stages of the project because the capital cost

deduc-is depreciated against tax (cf gl2.7.I), so the ability to make a further duction of interest against tax at the same time may not be significant.Off-balance-sheet financing If the investor has to raise the debt and then in-ject it into the project, this will clearly appear on the investor's balance sheet

de-A project finance structure may allow the investor to keep the debt off theconsolidated balance sheet, but usually only if the investor is a minorityshareholder in the project-which may be achieved if the project is ownedthrough a joint venture Keeping debt offthe balance sheet is sometimes seen

as beneficial to a company's position in the financial markets, but a pany's shareholders and lenders should normally take account of risks in-volved in any off-balance-sheet activities, which are generally revealed innotes to the published accounts even ifthey are not included in the balancesheet figures; so althoughjoint ventures often raise project finance for otherreasons (discussed below), project finance should not usually be undertakenpurely to keep debt offthe investors' balance sheets

com-Borrowing capacity Project finance increases the level of debt that can be

1 5

borrowed against a project: nomecourse finance raised by the project pany is not normally counted against corporate credit lines (therefore in thissense it may be off-balance sheet) It may thus increase an investor's overallborrowing capacity, and hence the ability to undertake several major projectssimultaneously.

Com-Risk limitation An investor in a project raising funds through project financedoes not normally guarantee the repayment of the debt-the risk is thereforelimited to the amount of the equity investment A company's credit rating isalso less likely to be downgraded if its risks on project investments are lim-ited through a project finance structure

Risk spreading /joint ventures A project may be too large for one investor toundertake, so others may be broughtin to share the risk in a joint-venture proj-ect Company This both enables the risk to be spread between investors andlimits the amount of each investor's risk because of the nonrecourse nature ofthe Project Company's debt financing

As project development can involve major expenditure, with a significantrisk ofhaving to wrire it all offifthe projecr does not go ahead (cf 94.2), aproject developer may also bring in a partner in the development phase of theproject to share this risk

This approach can also be used to bring in "limited partners" to the ect (e.g., by giving a share in the equity of a Project Company to an Offtakerwho is thus induced to sign a long-term Offtake Contract, without being re-quired to make any cash investment, or with the investment limited to a smallproportion of the equity.)

proj-Creating ajoint venture also enables project risks to be reduced by bining expertise (e.g., local expertise plus technical expertise; construc-tion expertise plus operating expertise; operating expertise plus marketingexpertise) In such cases the relevant Project Contracts (e.g., the EPC Con-tract or the O&M Contract) are usually allocated to the partner with the rel-evant expertise (but cf g4.l)

com-Long-term finance Project finance loans typically have a longer term thancorporate finance Long-term financing is necessary if the assets financednormally have a high capital cost that cannot be recovered over a short termwithout pushing up the cost that must be charged for the project's end prod-uct So loans for power projects often run for nearly 20 years, and for infra-structure projects even longer (Oil, gas, and minerals projects usually have

a shorter term because the reserves extracted deplete more quickly, andtelecommunication projects also have a shorter term because the technologyinvolved has a relatively short life.)

Enhanced credit If the Offtaker has a better credit standing than the equityinvestor, this may enable debt to be raised for the project on better terms thanthe investor would be able to obtain from a corporate loan

Unequal partnerships Projects are often put together by a developer with an

$2.5 Why Use Project Finance? 1 7

Table 2.3Effect of Leverage on Offtaker's Cost

Low leverage High leverage

Return on equity(b) x l57ol

Interest rate on debt (p.a.)

Interest payable[(a) x (d)]

Revenue requiredl(c) + (e)]

1,000300700105

59a

l 5t20

1,0008002N307Vo5686

idea but little money, who then has to find investors A project finance ture, which requires less equity, makes it easier for the weaker developer tomaintain an equal partnership, because if the absolute level of the equity in theproject is low, the required investment from the weaker partner is also low

struc-52.5.2 Tnn BrNnFrrs oF Pnolncr FrNaNcE To THIRD Penrrns

Equally, there are benefits for the Offtaker or end user of the product or serviceprovided by the Project Company, and also for the government of the countrywhere the project is located:

Lower product or service cost In order to pay the lowest price for the ect's product or service, the Offtaker or end user will want the project to raise

proj-as high a level of debt proj-as possible, and so a project finance structure

is beneficial This can be illustrated by doing the calculation inTable 2.2

in reverse: suppose the investor in the project requires a return of at leastl5%o,then, as Table 2.3 shows, to produce this, revenue of 120 is required us-ing low-leverage finance, but only 86 using highJeverage project finance,and hence the cost to the Offtaker or end user reduces accordingly (Infinance theory, an equity investor in a company with high leverage would ex-pect a higher return than one in a company with low leverage, on the groundthat high leverage equals high risk However, as discussed above, this effectcannot be seen in project finance investment, since its high leverage does notimply high risk.) (Also cf $13.1 for other issues affecting leverage.) So if the Offtaker or end user wishes to fix the lowest long-term purchasecost for the product ofthe project and is able to influence how the project isfinanced, the use ofproject finance should be encouraged, e.9., by agreeing

to sign a Project Agreement that fits project finance requirements

Additional investment in public infrastructure Project finance can provide

funding for additional investment in infrastructure that the publicsector might otherwise not be able to undertake because of economic orfinancial constraints on the public-sector investment budget.

Ofcourse, ifthe public sectorpays for the project through a long-term ject Agreement, it could be said that a project financed in this way is merelyoff-balance sheet financing for the public-sector, and should therefore be in-cluded in the public-sector budget anyway Whether this argument is a validone depends on the extent to which the public sector has transformed real proj-ect risk to the private sector

Pro-Risk transfer A project finance contract structure transfers risks of, for ample, project cost overruns from the public to the private sector It alsousually provides for payments only when specific performance objectivesare met, hence also transferring to the private sector the risk that these arenot met

ex-Lower project cost Private finance is now widely used for projects thatwould previously have been built and operated by the public sector (cf 92.3).Apart from relieving public sector budget pressures, such PPP projects alsohave merit because the private sector can often build and run such invest-ments more cost-effectively than the public sector, even after allowing for thehigher cost of project finance compared to public-sector finance

This lower cost is a function of:

The general tendency of the public sector to "overengineer" or plate" projects

"gold- Greater private-sector expertise in control and management of project struction and operation (based on the private sector being better able to of-fer incentives to good managers)

con- The private sector taking the primary risk of construction and operationcost overruns, for which public-sector projects are notorious

"Whole life" management of long-term maintenance of the project, ratherthan ad hoc arrangements for maintenance dependent on the availability

of further public-sector funding

However, this cost benefit can be eroded by "deal creep" (i.e., increases incosts during detailed negotiations on terms or when the specifications for theproject are changed during this period-cf $4.6.3)

Third-party due diligence The public sector may benefit from the dent due diligence and control of the project exercised by the lenders, who willwant to ensure that all obligations under the Project Agreement are clearlyfulfilled and that other Project Contracts adequately deal with risk issues.Transparency As a project financing is self-contained (i.e., it deals only withthe assets and liabilities, costs, and revenues of the particular project), thetrue costs of the product or service can more easily be measured and moni-tored Also, if the Sponsor is in a regulated business (e.g., power distribu-

indepen-$2.5 Why Use Project Finance?

tion), the unregulated business can be shown to be financed separately and

on an arm's-length basis via a project finance structure

Additional inward investment For a developing country, project financeopens up new opportunities for infrastructure investment, as it can be used

to create inward investment that would not otherwise occur Furthermore,successful project finance for a major project, such as a power station, canact as a showcase to promote further investment in the wider economy.Technolog5r transfer For developing countries, project finance provides away of producing market-based investment in infrastructure for which thelocal economy may have neither the resources nor the skills

19

Chapter 3

The Project Finance Markets

This chapter reviews the private-sector debt markets for project finance in ticular commercial banks (cf $3.1) and bond investors (cf $3.2) The uses of mez-zanine or subordinated debt (cf $3.3), leasing (cf $3.a), and vendor finance(cf $3.5) are also considered Loans and guarantees provided by export creditagencies and multilateral and bilateral development banks, mainly for projects indeveloping countries where the private sector is not willing to assume the creditrisk in the country concerned, are discussed in Chapter 11 (but cf $3.6)

par-Private-sector project finance debt is provided from two main mercial banks and bond investors Commercial banks provide long-term loans toproject companies; bond holders (typically long-term investors such as insurancecompanies and pension funds) purchase long-term bonds (tradable debt instru-ments) issued by project companies Although the legal structures, procedures,and markets are different, the criteria under which debt is raised in each of thesemarkets are much the same ("Lender" is used in this book to mean either a banklender or a bond investor.)

sources-com-In 2001 (according to market statistics collected by the journal Project FinanceInternational), the total amount ofproject finance debt raised from private-sectorlenders was approximately $133 billion, of which $108 billion was raised throughbank loans and $25 billion through bonds Around a third of the total, $47 billion,was raised for projects in the United States, and $38 billion went to projects inWestern Europe

The World Bank estimates that total bank debt provided to developing tries in 2000 was $125 billion and bond debt $77 billion.t Based on the Project Fi-nance International statistics (which are not entirely comparable), developing

coun-rWorld Bank: Global Development Finance 2000 (World Bank, Washington D.C., 2001).

countries (notably in Latin America) raised approximately $35 billion of projectfinance debt in 2000, of which some $31 billion was raised from banks and $4 bil-lion in the bond market The world Bank also estimates that total private-sectorinfrastructure investment in developing countries in 1999 (i.e., excluding naturalresources projects) was $68 billion,2 which compares with some $20 billion ofproject finance debt to developing countries in the same year The importance ofproject finance for developing countries is therefore evident.

It should be noted that the Project Finance International statistics do not clude direct lending to private-sector projects by export credit agencies and mul-tilateral development banks, although they do include loans guaranteed by them.They also do not include loans by national (bilateral) development banks andsome domestic commercial banks in developing countries The figures thereforeunderstate somewhat the level of project finance for developing countries Thefigures for bank loans also relate to amounts committed during the year, ratherthan those actually lent, and the figures include refinancings of other loans on aproject finance basis

in-53.L COMMERCTAL BANKS

Commercial banks are the largest providers of project-finance (cf 95.1), with82Vo of the private-sector project finance debt raised in 2001 The division be-tween different market sectors set out in Table 2.1 for the private-sector fundingmarket as a whole is broadly reflected pro rata in the banking market

53.L.1 Annas oF AcrrvrrY

As can be seen from the figures set out in Table 3.1, bank project finance tivity is heavily concentrated in the Americas (especially the United States) andWestern Europe

ac-The following comments can be made on recent project finance developments

in some of the more active markets:

United States: Project finance business in 2000/1 was driven primarily bylarge investment in the power sector, as well as telecommunications Brazil: The sharp increase in Brazilian loans in 2000 was based mainly onsome major oil and gas projects, continuing at a lower level in 2001 alongwith power projects

2A.K Izaguirre&G.Rao: rzre, (World Bank, Washington D.C., 2000).

PublicPolicyforthePrivateSector,NoteN"2l5-Privatelnfrastruc-63.1 Commercial Banks

Table 3.1Bank Project Finance Loan Comrnitments, 1996-2001

3 5 11,096427874,40149

1 , t 5 1

1 1 6550

1 , 1 3 58,0487,74672,392

52,795 4'7,44'733,573 31,254

' Mexico: A high level of activity in the power and telecommunications sectors Germany: A sharp increase in 2000, based mainly on mobile phone andcable projects.

Italy: The growth in 2000/1 reflects the beginning of Italy's ppp program, aswell as a number of major power project telecommunications financings.' Portugal: Figures reflect an active program of ppps in road construction United Kingdom: A major user of project finance for its pFI (ppp) program,

as well as for telecommunications and power projects

Turkey: Project finance has mainly been for power-generation projects.' spain:2001 figures reflect some major financings in the telecommunicationsand infracture sectors, as well as power projects

' Australia: Like the United Kingdom, Australia has a substantial ppp gram, and project finance is also used for natural resources and power_generation projects

pro- Japan: The development of Japan's PPP program is reflected in the 2001figures

In the Middle East, project finance has been used for petrochemical, LNG, and(more recently) power-generation projects, and it tends to fluctuate from year

to year based on relatively few large projects Project finance was used heavily

in Asia in 1996-1997 for power-generation projects, many of which sufferedbadly from the catastrophic currency devaluations of 199'7 (cf 99.3.5), and by

2001 the overall level of project finance business in Asia was still low compared

to similar markets in Latin America In particular, after promising initial growth

in the power sector, development of project finance in china and India has sofar been limited similarly, the effect of the Russian debt repudiation of 199g isevident

53.1 2 BaNrs rN THE Mnnxnr

It is usually preferable for a project in a particular country to raise its fundingfrom banks operating in that country, first because they have the best understand-ing oflocal conditions, and second because the funding can be provided in the cur-rency of the country, so avoiding foreign exchange risks (cf 99.3, but note also10.3.1) Thus in developed countries projects are normally financed by local banks

or foreign banks with branch or subsidiary operations in the country concerned.Such financing constitutes the largest proportion of the project finance market

In some developing countries, however, this approach may not be possible.There may be no market for long-term loans in the domestic banking market, orthe domestic banks may have no experience in project finance In some develop-ing countries (such as India and Brazil), there are public-sector local development

63.1 Commercial Banks 25

Table 3.2Major Lead Managers of Bank Project Finance Loans,2001"

Lead Manager

Average Amount Numberof Loan Country ($ millions) Loans ($ millions) Citigroup

Santander Central Hispano

Crddit Agricole Indosuez

U.S.A.

Germany France France Switzerland

U S A Germany Netherlands Germany

U,K

Japan Italy U.S.A.

France U.K.

Sweden Japan Australia Spain France

15,5128,2356,4295,3014,'7424,3334,0384,O19

I 6 ? 1

3,6123,t872,6272,2822,019

I , 1 9 1 I1,582

I 5 ? 1

I 5 ? ?

1,4651.366

287305222

J L '

59324r238

2 1 225920r159524t76168

1 1 97918'l128t4"l

t - ) t

542729

l 78

t 3

1 2

1 62

pro-It can be said that there is an inner circle of some 20 major banks that put gether project finance transactions as Lend Managers on a worldwide basis, withreasonably large project finance operations concentrated in key locations aroundthe world At a minimum, a leading international project finance bank will haveone project finance office in the United States (covering the Americas), one in Eu-rope (covering Europe, the Middle East, and Africa), and one in Asia/Australasia,and perhaps 50 professional staff (at least) in these offrces The top 20 banks in2OOl are set out in Table 3.2

to-In 2001 a total of 123 banks were Lead Managers of project finance loans, themajority of these working jointly in groups of banks (cf $5.1.5) By comparingthe figures for the top 20 in Table 3.2 with those in Table 3.1, it can be seen that