Project finance in construction a structured guide to assessment

List of illustrationsFigure 1.1 Brief history of project finance Chu, 2007 2Figure 2.1 A typical BOOT corporate structure Merna and Figure 3.1 Typical cumulative cash flow stages of a pr

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Project Finance in Construction

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Project Finance in Construction

A Structured Guide to Assessment

UK

Faisal Fahad Al-Thani

Senior Director and Head of Business Development

Maersk Oil Doha, Qatar

A John Wiley & Sons, Ltd., Publication

iii

This edition first published 2010

C

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Library of Congress Cataloging-in-Publication Data

Merna, Anthony.

Project finance in construction : a structured guide to assessment/Anthony Merna, Yang Chu, Faisal Al-Thani – 1st ed.

p cm.

Includes bibliographical references and index.

ISBN 978-1-4443-3477-7 (pbk : alk paper) 1 Infrastructure (Economics)–Finance.

2 Industrial development projects 3 Risk management 4 Public-private sector cooperation I Zhu, Yang II Al-Thani, Faisal F III Title.

HC79.C3M47 2010

2010007731

A catalogue record for this book is available from the British Library.

Printed in Malaysia

1 2010

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Who is involved in the risk assessment process? 7Where should a financial assessment be performed? 7When should a financial assessment be performed? 8

How should assessment outputs be presented? 8

2.3 The key characteristics of project finance 13

Robust income stream of the project as the basis

3.6 Cash flow modelling and project financing 34

Applications of supply and offtake contracts 64

7.3 Identify the estimated activities, time, costs and

7.6 Assessment of base case model incorporating risks 74

9.6 Other financial engineering techniques 96

10 Final assessment to determine project

Model audit and sensitivity analysis 116

Ijara Mawsufah Fi Al Dhimmah (forward lease) 133

12.6 Other Islamic finance techniques for projects 137

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List of illustrations

Figure 1.1 Brief history of project finance (Chu, 2007) 2Figure 2.1 A typical BOOT corporate structure (Merna and

Figure 3.1 Typical cumulative cash flow stages of a project

Figure 3.2 Seniority of financial instruments (Merna and

Figure 4.1 Risk management cycle (Merna and Al-Thani 2008) 42Figure 4.2 Risk assessment for an organisation (Merna and

Figure 6.1 Assessments by SPV and lenders to determine the

Figure 6.2 Supply contract and offtake contract arrangements

in the power station (adapted from Merna and

Figure 6.3 Project programme: major activities (generated by

Figure 8.1 Finance package of 80:20 debt/equity 82

Figure 10.3 Cumulative probability diagram (after mitigation) 104Figure 11.1 Due diligence process (Merna and Smith 1994) 112Figure 11.2 Typical financial close process (Merna and Smith

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List of tables

Table 4.1 Global and elemental risks (Chu 2007) 49Table 4.2 Financial and non-financial risks (Chu 2007) 49Table 4.3 Risks affecting different phases of a project’s life

Table 5.1 Typical costs and revenues over project life cycle 54Table 5.2 Typical financial instruments, repayments and cash

Table 5.3 Typical cover ratios used by lenders 55

Table 6.2 Projects with supply contracts (Chu 2007) 62Table 6.3 Projects with offtake contracts (Chu 2007) 64Table 7.1 Activities, costs and revenue estimates and their

Table 7.2 Base case model cash flow and cumulative cash flow 72

Table 7.4 Economic parameters of base, best and worst case

Table 8.1 Project economics and cover ratios under 100% debt

Table 8.2 Project economics and cover ratio table under 80:20

Table 8.3 Project cash flow allocation table under 10:80:10

debt/bond/equity for the bond with a 10-year

Table 9.1 Techniques applied in the reappraisal of PPP

concession agreements (Merna and Smith 1994) 97Table 10.1 Risks and their upside and downside ranges 102Table 10.2 Summary of the project economics and cash

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About the Authors

Dr Anthony Mernais a senior partner of Oriel Group Practice, a tidisciplinary research and consultancy practice based in Manchester,and a visiting lecturer to Manchester Business School at the University

mul-of Manchester

Dr Yang Chuis a graduate of the School of Mechanical, Aerospace andCivil Engineering at the University of Manchester and a research con-sultant with Oriel Group Practice, specialising in the areas of projectfinance and risk modelling He is currently carrying out risk manage-ment research at Manchester Business School

Dr Faisal Fahad Al-Thaniis Senior Director and Head of BusinessDevelopment, Middle East for Maersk Oil, based in Doha, and a boardmember of the Marsh International Risk Council

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At the time of writing this guide, financial markets remain uncertain.This has led many sponsors of project financings to further considerbank liquidity, the higher cost of finance and general uncertainty fordemand This has resulted in the postponement of a number of projects

in certain industry sectors Governments have seen tax receipts cally reduced, which has affected their ability to finance infrastructureprojects, often irrespective of the perceived demand Equity providersstill seek to invest; however, there are less opportunities due to marketdislocation Due to the demand for global infrastructure, it is believedthat project financings will return to their pre-crunch levels, or moreso; however, lenders’ liquidity costs will be passed on to the borrow-ers Lenders will also be under stricter regulation both internally andexternally

drasti-The steps outlined in the guide are designed to provide a basicunderstanding for all those involved or interested in both structuringand assessing project financings Secondary contracts involving con-structors, operators, finance providers, suppliers and offtakers can bedeveloped and assessed to determine their commercial viability over

a project’s life cycle

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Chapter 1 Introduction

Project financing is not a new financing method It has been used to nance industrial projects such as mines, pipelines, power stations andoil fields An early recorded application of project finance dates back

fi-to 1299, when the English Crown negotiated a loan from Frescobaldi,

a leading Italian merchant bank, for which payment was to be made inthe form of output from the Devon silver mines The bank received a1-year lease for the total output of the mines in exchange for paying alloperating costs without recourse to the Crown if the value or amount ofthe extracted ore was less than predicted (Finnerty 1996; Esty 2004) To-day, such a loan arrangement is known as a production payment loan.The brief history of the development of project finance is illustrated

in Figure 1.1

Tinsley (2000) suggests that the modern history of project financebegan with production payment financing in a Texas oilfield project in

1930 A driller funded the well-drilling costs in exchange for a share

in future oil revenue This technique was imported into Europe tofinance large projects such as the North Sea oilfields in the late 1970s.However, the advent of modern project finance is often regarded asbeginning in the 1970s, with the successful development of the NorthSea oilfields by British Petroleum, which raised US$945 million on aproject basis from a syndicate of 66 banks (Esty 2004)

At that time, it was the largest industrial loan in history Followingthe success of North Sea developments, project finance has been associ-ated with many financial and operating success stories These includethe Ras Laffan LNG project in Qatar (Finance 2005), the Shajiao powerstation in China (Merna and Njiru 2002) and the Petrozuata heavy oilproject in Venezuela, as well as numerous independent power projects(IPPs) in the United States (Esty et al 1999)

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2 Project Finance in Construction

PFI, PPP Devon silver

mine

Texas oilfield

North Sea oilfield

Power plant in America, minerals in the UK Pipeline project, water

Infrastructures Oil and gas, petrochemical Leisure and property Agriculture

Figure 1.1 Brief history of project finance (Chu 2007).

Project finance has been evolving, with the potential for cant innovation, especially in the area of collaborative public–privatefinancing (Feming et al 2004) The private finance initiative (PFI)was introduced to involve the private sector in financing and man-aging infrastructure projects and service provision in the UK in 1992(Mustafa 1999)

signifi-Project finance has spread worldwide and includes numerous dustrial projects such as power stations, gas pipelines, waste-disposalplants, waste-to-energy plants, telecommunication facilities, bridges,tunnels, toll roads, railway networks, city centre tram links and nowthe building of hospitals, education facilities, government accommo-dation and tourist facilities The technique has also been applied toaircraft and ship financing

in-The demand for project financing remains high throughout theworld According to Thomson Financial (2006), global project financeloan volumes grew 50.3% to reach US$88.8 billion from 182 issues inthe first 6 months of 2006 and at total proceeds of US$59.1 billion from

246 issues in the same period of 2005 The power sector remains theindustry leader for project finance loans

The transportation sector increased to US$24.1 billion borrowings,while the petrochemical sector also produced positive growth fromUS$2.8 billion in the first 6 months of 2005 to US$15.7 billion in thefirst 6 months of 2006

According to Platt (2006), high oil prices have contributed to anincrease in the number of projects being procured in the MiddleEast Project finance deals are booming in the Middle East, someincorporating Islamic finance laws The Eastern Europe, Middle East

and Africa (EMEA) region led the Americas and Asia-Pacific in year 2006 project finance loan volumes with total proceeds of US$56.6billion from 97 issues In EMEA region, US$29.1 billion project financewas loaned in the Middle East in 2006 (Thomson Financial 2006).Saudi Arabia has surpassed Qatar as the leading country for projectfinance in the Middle East Saudi Petrol-Rabigh project is one of thebiggest oil refining and integrated petrochemical projects in the world;meanwhile, it is the largest project financing to date in Saudi Arabia

mid-as well mid-as the largest in the region to incorporate long-term Islamicfinancing

According to Thompson Reuters (2009), the first quarter of 2008saw the highest-ever volume of project finance transactions world-wide, with more than 125 transactions totalling US$56.4 billion In thefirst quarter of 2009, global project finance activity sank to its lowestlevel since 2003 Deals totalled just US$19.4 billion in proceeds from

69 transactions Tullow Oil’s US$2 billion deal was the largest tion during this period Following record high volumes in 2008, Asia-Pacific project finance totalled US$5.1 billion during the first quarter

transac-of 2009, a 76.3% decrease from the US$21.5 billion in proceeds raisedduring the same period in 2008 Power projects accounted for 43.1% ofmarket activity, which was largely driven by Adani Power Maharash-tra The INR55.5 billion project loan was the largest deal in the regionand the second largest transaction globally

The variety of project finance applications and locations and itsgrowth can be summarised as follows:

Supply side factors

❒ Privatisation of state-controlled assets across the world

❒ Increasing appeal for governments to subcontract infrastructuremanagement and the associated risks

❒ Budget constraints limit the ability for public sector investment incapital-intensive developments

❒ Backlog of infrastructure investment as governments attempt toraise productivity to meet growing needs

4 Project Finance in Construction

Demand-side factors

❒ Demand for infrastructure assets has risen faster than supply sidefor a long period, resulting in more highly leveraged transactionsand ever-higher valuations

❒ Investors have been attracted to the stable, often inflation-linkedreturns based on predictable underlying cash flows of monopolisticassets

❒ Infrastructure is also seen as an alternative asset class (together withprivate equity, commodities and real estate) for large pension fundsand well suited to match their long-term liabilities

❒ Global economic growth such as energy consumption

Merna and Owen (1998) describe three categories of project curement, which utilise project finance under the UK PFI:

pro-1 Services sold to the public sector The private sector is

responsi-ble for capital investment and the public sector only pays on thedelivery of specified services to quality standards These projectsare generally procured by the design, build, finance and operate(DBFO) route

2 Financially free-standing projects The private sector recovers its

DBFO contract costs through direct charges to users, for example, atoll bridge, rather than from public sector payments Public sectorinvolvement is limited to enabling the project to go ahead throughassistance with planning, licensing and other statutory procedures

3 Joint ventures Joint ventures involve projects where the entire costs

cannot be recovered through charges on end-users The governmentoffers a part subsidy in order for the project to go ahead

Potential advantages of PFI projects compared to the traditional ods of procuring public services include:

meth-❒ Value for money: PFI projects, carried out by the private sector,deliver greater value for money and increased efficiency compared

to similar projects financed with traditional methods

❒ Transfer of risk: The private sector accepts a wider range of risks inthe project Many risks are transferred from the public to the privatesector, including design, construction, financing, completion andoperational risks.

❒ Increased provision of infrastructure and services: PFI can provideadditional facilities and infrastructures, which may not be in thepublic sector’s planning

❒ Long-term view: PFI projects involve long-term relationships(15–30 years); hence, the public sector has to consider long-termview and interest rather than short-term capital funding

❒ Projects delivered on time and budget: PFI is believed to be morereliable in terms of delivery of projects and services on time andbudget than the traditional procurement strategies

❒ Private sector innovations and expertise: With private sector volvement, projects gain benefits from private sector managementskills and innovation, which lead to reduced project costs and in-creased efficiency

in-❒ Maintenance of assets: Under PFI, the private sector is responsiblefor maintenance and repairs of the asset over the asset life cycle,ensuring good maintenance

❒ Competition among service and asset private providers is achieved

❒ The public sector retains control

Potential constraints and problems include the following:

❒ The formation of the borrower/special project vehicle (SPV) cansometimes be complex as the different stakeholders seek at differingobjectives

❒ The cost of finance is higher since the public sector can fund capitalwith lower financial costs

❒ Agreements are brought about through complex negotiations

6 Project Finance in Construction

Merna and Owen (1998) add that ‘due to the complexity of sion contracts, the parties have to spend large amounts of money inadvisory fees for lawyers and financiers’

Financial assessment is generally seen as a systematic approach to termining the commercial viability of a project to all those stakeholdersinvolved in the project In most cases the assessment will initially becarried out by the sponsors and if deemed commercially viable thenassessed by a potential lender What is not always apparent is how theuse of finance is perceived by individual stakeholders, why a financialassessment is performed, who should be involved, where and when

de-it should be performed, what data should be used and how financialassessments should be presented The following briefly outlines thereasons

What is financial assessment?

For the purpose of this guide, financial assessment is defined as astructured, systematic approach, in a manner that clearly considersand presents a quantitative financial evaluation of the commercialviability of a project in terms of economic metrics that can be used inthe decision-making process

Why perform a financial assessment?

The future income stream of a project is the most critical element in anyproject financing The entire financing of a project is dependent on anassured income stream from that project since lenders and investorshave recourse to no funds other than the income streams generated bythe project, once it is completed, and assets of the project that may ormay not have any residual value The project sponsors, typically theSPV, therefore, need to demonstrate evidence of future income throughvarious means such as a power sales contract for an IPP, a concessionagreement for a toll road project allowing the collection of tolls, ortenant leases for a commercial real estate project (Tinsley 2000)

All stakeholders to a project utilising project finance seek to meetspecified, often minimum returns in the form of a minimum acceptablerate of return for a given investment or a specified margin of profit.Typically, lenders, shareholders and bondholders must considerthe opportunity cost of finance for a number of projects to determinethe acceptable return based on the risks perceived in a project Thesize of risk perceived in a project determines the financial instruments

to be used

By engaging in a financial assessment process, all parties/stakeholders are made aware of the potential economic outcomes ofthe project for different scenarios of both financing instruments andthe risks perceived With a comprehensive picture of different finan-cial scenarios, shareholders have a platform for decision-making Afinancial assessment system can help to ensure that both the financialinstruments considered for each scenario and their timing and the per-ceived risks are identified early and can be fully assessed in terms ofviability, reducing the likelihood of costly mistakes

Who is involved in the risk assessment process?

Financial assessment is typically performed by sponsors to determinesuch metrics as internal rate of return (IRR), net present value (NPV),payback period and cash lock-up for a particular project In some casesthe SPV will determine cover ratios and debt sculpting, dependent onthe expertise available Many projects will be rejected if such metricsare well below acceptable returns, and there is no scope for increas-ing the commercial viability through guarantees from third parties.Lenders will seek to determine cash flows for the worst case scenariobased on estimates provided by the SPV for different finance pack-ages Coverage ratios will be computed to determine which financepackage provides the most suitable solution to a specific project Afinal detailed assessment will involve the SPV, lenders and financial,legal and technical experts

Where should a financial assessment be performed?

Financial assessment should be performed by all stakeholders to aproject before any finance is committed Initially by the SPV and then

8 Project Finance in Construction

by lenders, shareholders and bondholders, the financial instruments

of debt, equity and bonds should be considered In PFI-type projects,

it is also expected that financial assessments will be carried out by thepublic sector to determine budgets and acceptable unitary charges Asmore information becomes available in terms of costs, revenues andtheir timings, more detailed assessment models can be developed andused in the decision-making process

When should a financial assessment be performed?

Due to the relationship between finance and time, financial ments should be performed on a continuous basis, considering notonly the variations in costs of materials and resources but also thecosts associated with raising and servicing different financial instru-ments Typically, financial assessments are performed before finance

assess-or resources are sanctioned, thus providing the oppassess-ortunity to change,shelve or abandon the project without incurring financial loss

It should be emphasised that financial assessment is not a one-timeoccurrence It must be done continuously to take into account marketconditions and to monitor the project’s performance over the project’slife cycle

What data are to be used?

Data can be sourced from many locations, both formal and formal Typically, project finance is associated with four packages:(a) construction, (b) operation and maintenance, (c) cost of finance and(d) revenue generation It is important that the data are used; typically,costs, revenues and their timings are accurately reflected in the rele-vant package In the initial stages, many of the costs and timings will

in-be estimates from previous similar projects As an assessment gresses, data often become more accurate as costs can be fixed againstdetailed designs and required resources

pro-How should assessment outputs be presented?

The outputs of financial assessments should provide simple tations on which decision-makers can base their decisions In many

presen-organisations, presentations to decision-makers are too detailed andrequire too much time to interpret The outputs suggested in this guideshould be those that can be quickly interpreted by each stakeholdergroup such as cumulative cash flow diagrams, pie charts depictingdifferent financing packages, tables indicating the economic parame-ters, such as IRR, NPV, cash lock-up, break-even points and coverageratios associated with modelled scenarios Risk assessments should bepresented in terms of sensitivity and probability diagrams.

The purpose of this guide is to provide a structured assessment cess for determining the commercial viability of a project procuredutilising project finance The guide is best used as an aide memoir tothose involved or seeking involvement in the procurement of projectsutilising project finance The financial assessment structure is applied

pro-to a case study pro-to determine the project’s commercial viability ers can develop their own assessment structures as required usingthe assessment mechanism as a guide and the tables as templates forpresenting the metrics used during the decision-making process

The guide does not provide detailed descriptions of financial ments or provide all those risks associated with different types ofprojects References for further reading are provided to cover the mainelements of finance and risk associated with project financings.Chapter 2 describes the characteristics of project finance and theparties and contracts typically involved in projects procured utilisingproject finance

instru-Chapter 3 identifies typical financial instruments used in the curement of projects utilising project finance and describes howprojects’ cash flows are modelled to determine a project’s economics.Chapter 4 briefly outlines the risk assessment process through iden-tification, analysis in terms of qualitative, semi-quantitative (determin-istic) and quantitative (stochastic) and response to risks to determinethe commercial viability of a project

pro-10 Project Finance in Construction

Chapter 5 provides a structured financial assessment process in theform of a flow chart, illustrating the type of assessment to be carriedout at each stage of the process and the parties responsible for theassessment

Chapter 6 provides the basic details of the case study The estimatedcosts and revenues and their timings are illustrated for an IPP to beprocured utilising project finance in China A number of sale andofftake strategies are also described

Chapter 7 provides the base case model assessment of the case study.Modelling projects through computer software can be an effective way

of initially determining the cash flows of a project Estimated costsand revenues can be input into a simulation model to determine theproject’s economic parameters Typically, spreadsheet software is used

at this stage of the assessment

Chapter 8 provides a typical assessment performed by lenders ing to determine the financial implications such as cash flow and cov-erage ratios associated with different financial packages in terms ofdebt, equity and bonds

seek-Chapter 9 describes a number of financial engineering techniquesthat can be used in project financings A method for reappraisingpublic–private partnership in terms of refinancing, restructuring andtermination is described

Chapter 10 describes how the final assessment of the case study

is developed on the basis of the chosen financial package and therisks to be considered This assessment uses stochastic analysis todetermine the probability of the project meeting specified returns and anumber of financial engineering techniques are considered to improvethe project’s economics

Chapter 11 outlines the documentation and the legal considerationsused in project financing and the major elements of the due diligenceprocess, essential prior to the financial close of a project procuredutilising project finance

Chapter 12 provides a brief outline of Islamic finance and describesthe principles, products and techniques associated with Islamic financeand its role in project financings

Chapter 13 provides conclusions and recommendations on the nancial assessment process and its application to different types ofprojects utilising project finance

fi-Chapter 2 Project finance

struc-on the performance of the project itself This chapter introduces theconcept of project finance and explores briefly the features of projectfinancing and the key characteristics with relation to the parties andcontracts involved and the financial and legal considerations affectingsuch projects

In the field of project finance, various definitions of project finance arecited

According to a definition provided by Nevitt and Fabozzi (2000),project finance refers to:

A 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 a loan will be repaid and to the assets of the economic unit as collateral for the loan.

The economic unit in the definition typically refers to a legallyand economically independent project company The definition

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emphasises that repayment of loan is primarily dependent on cashflow generated by the economic unit

Esty (2004) defines ‘project finance’ as follows:

Project finance involves the creation of a legally and economically pendent project company financed with non-recourse debt (and equity from one or more corporate sponsors) for the purpose of financing a single purpose, capital asset usually with a limited life.

inde-The definition highlights two important features of project finance.First, a project is a set of legally and economically independent assets.Second, non-recourse debt means that the lenders only have recourse

to cash flows and assets of the project Esty et al (1999) point outthat although there may be periods when lenders have recourse tothe sponsors’ cash flows and assets, often during construction, projectdebt must become non-recourse to the sponsors at some point duringthe project’s life

Merna and Owen (1998) define ‘project finance’ as follows:

Financing of a stand-alone project in which the lender looks primarily

to the revenue stream created by the project for repayment, at least once operations have commenced, and to the assets of the project as collateral for the loan The lender has no or limited recourse to the project sponsors.

There is no single agreed definition for project finance as yet It is nosurprise that the market has not standardised these definitions becausethe field of finance is extremely dynamic and constantly changing Forthe purpose of this guide, the concept of project finance is defined asfollows:

Financing of a stand-alone project (or bundle of projects) is structured

by using a group of agreements and contracts between lenders, project sponsors and other interested parties that create a form of economic

unit; lenders and investors will look primarily to the economic unit

to generate cash flow as the sole source of repayment of principal and interest and collateral The lender has no or limited recourse to the project sponsors (Chu 2007)

The ultimate goal in project financing is to arrange borrowing for aproject, which will benefit the sponsor (SPV), whilst not affecting itscredit standing or balance sheet All the above definitions emphasisethat, in project finance, lenders to the project initially look at the cashflows of a project as the source for repayment of the loan and economicunit or SPV as one of the key features of project financing

Requirements for successful projects are summarised as follows:

❒ Enforceable contractual arrangements

❒ Robust financial structures

❒ Detailed cash flow modelling

❒ Effective risk management

❒ Sensible risk apportionment

❒ Effective monitoring

❒ Stakeholder coordination

Although project finance is used to refer to a wide range of possiblefinancing structures that have been used in different industries formany years, the authors suggest that they all have five common fea-tures, which distinguish project finance from other financing methods:

1 SPV

2 contractual agreements of various third parties

3 non-/limited recourse

14 Project Finance in Construction

4 off-balance sheet financing

5 robust income stream

Special project/purpose vehicle

An SPV is an independent legal entity, which will be committed andresponsible to a contractual agreement with the parties involved in theproject finance transaction (Ellafi 2005) SPVs are used in a variety oftransactions, including securitisations, project finance and leasing Allthose transactions are grouped as structured finance by Davis (2005)

In this guide, the definition of an SPV is limited to:

A legally and economically independent project company financed with non-/limited recourse debt for the purpose of financing a single purpose, capital asset usually with a limited life.

Contractual arrangement

Projects procured using project finance have to be structured through

a series of contracts Those contracts represent substantial components

of credit support for a project (Orgeldinger 2006) The authors also gest that the contractual arrangement in project finance transactionsdetermines how the risks are structured among the parties, whichprovides a security to the project’s cash flow

sug-Project finance is often regarded as ‘contract finance’ because atypical transaction can involve as many as 15 parties united in a ver-tical chain from input suppliers to output buyers through 40 or morecontractual agreements (Esty and Christoy 2002) To arrange projectfinance, there must be a genuine ‘community of interest’ among thestakeholders involved in the project Finnerty (1996) suggests thatproject financing arrangements invariably involve strong contractualrelationships among multiple parties Lenders will require that suchcontractual security arrangements must be put in place to protect themfrom various risks

The major contracts in typical project finance transactions are theconstruction contract, the product offtake contracts, the raw material

Concession agreement

Borrower (SPV)

Principal

Off-take contracts

Operation contract

Construction contract

Loan agreement

Shareholders agreement

Bond agreement

Bond holder

Figure 2.1 A typical BOOT corporate structure (Merna and Smith 1994).

supply contracts, the operations and maintenance contracts, and alarge number of financial agreements, including loan agreement, bondagreement, shareholders agreement and agreements which addresssupport from the host country (Merna and Njiru 2002) These contractstransfer many of the individual risk elements to appropriate parties

A typical structure of build-own-operate-transfer (BOOT) indicatingthe number of organisations and contractual arrangements that may

be required to realise a particular project is shown in Figure 2.1.Project finance can work only for those projects that can establishsuch relationships and maintain them at a tolerable cost The project’scash flow is guaranteed by these contractual arrangements Thesecontracts form an interwoven web that determines the project’s valueand risk

The key organisations and contracts involved in a BOOT projectstrategy have been identified and defined by Merna and Smith (1994)

as follows:

Principal: The organisation responsible for granting a concession

and often the ultimate owner of the project when the concessionperiod is completed Principals are often governments, govern-ment agencies or regulated monopolies

16 Project Finance in Construction

Borrowers/SPV: It is the organisation, sometimes referred to as

spon-sor, which is granted the concession to build and operate a projectfor a specified period Organisations involved are usually con-struction companies, operators or joint venture organisations in-corporating constructors, operators, suppliers, vendors, lendersand shareholders/equity providers who set up an SPV to un-dertake the project During the operating period of a project, theSPV is often referred to as the concessionaire

Concession agreement: This is the contract between the principal

and the borrower/SPV in which the concession is defined andgranted and essential risks associated with it are addressed, de-scribed and allocated The agreement will describe any facilityvehicle which the parties have agreed should be put in place togive effect to the concession, setting out its technical and finan-cial requirements and specifying the parties’ relative obligations

in relation to its design, construction, implementation, tion and maintenance over the lifetime of the concession Theconcession agreement identifies and allocates the rights, respon-sibilities and risks associated with the project It identifies andallocates the risks associated with the construction, operation,maintenance, finance and revenue packages and the terms of theconcession relating to a facility The preparation and evaluation

opera-of a project tender are based on the structure opera-of the terms andproject conditions contained within the concession agreement.Merna and Smith (1994) suggest that the concession contract isthe primary contract in project financings with all other contracts,

as described below, being considered as secondary contracts

Supply contract: This is the contract between the supplier and the

SPV The supplier may be a state-owned agency, a private pany or a regulated monopoly which supplies raw materials tothe facility during the operation period

com-Offtake contract: This is the contract agreed between the SPV and

the user It is applicable in contract-led projects such as powergeneration plants or water treatment plants Users are the organ-isations or individuals purchasing the offtake or using the facilityitself In market-led projects such as toll roads where revenues

are generated on the basis of directly payable tolls or tariffs forthe use of the facility, an offtake contract is not applicable sincethe users deal with the SPV directly.

Loan agreement: It is the basis of the contract between the lender

and the SPV Lenders are often commercial banks, niche banks,pension funds or export credit agencies In some cases, severallenders will underwrite the debt and syndicate a percentage toother market participants

Operations contract: This is the contract between the operator and the

SPV Operators are often specialist operating companies or panies created specifically for the operation and maintenance ofthe particular facility

com-Shareholder agreement: This is the contract between the SPV and

investors Investors purchase equity or provide goods in kindand form part of the corporate structure Investors may includesuppliers, vendors, constructors, operators and major financialinstitutions as well as private individual shareholders Investorsprovide equity to finance the facility, the amount of which is oftendetermined by the debt/equity ratio required by the lenders or

by a provision of the concession agreement

Construction contract: This is the contract between the constructor

and the SPV Constructors may be individual construction panies or a joint venture of specialist construction companies

com-Bond agreement: This is the agreement between the bondholders and

the SPV Bonds are issued for projects to suit a project’s revenuestreams and because of the costs associated with raising a bondissue of projects of a high capital value

Non-/limited recourse

Non-/limited recourse is one of the key distinguishing factors used inproject financing In corporate finance, the primary source of repay-ment for investors and lenders is backed by the entire balance sheet ofthe sponsors’ companies, and usually there is a diversity of sources of

18 Project Finance in Construction

cash within the corporate structure (IFC 1999) Even if an individualproject fails, lenders still retain a significant level of comfort in be-ing repaid depending on the overall strength of the sponsor’s balancesheet By contrast, for projects procured by project finance there is nooperating history Lenders and investors do not have direct recourse

to the sponsors (Merna and Njiru 2002) If the project fails, the projectsponsors’ organisations have no direct legal obligation to repay theproject debt and will lose only the equity invested in the project Pay-ment of principal, interest, dividends and operating expenses should

be derived only from the project’s future cash flow throughout the life

on the basis that full-recourse loans would be converted into recourse loans, typically when the lenders were satisfied with mechan-ical completion of the platform and other facilities (Cuthbert 2004).How much recourse is necessary to support a financing is determined

limited-by the unique characteristics of a project Tinsley (2000) claims that therecourse is constrained in three main ways or any combination of these:

1 Time: Recourse stops after an agreed date.

2 Amount: Recourse has a ceiling or cap in money terms.

3 Event: Where satisfaction of some event or trigger is required.

Off-balance sheet transaction

One of main reasons for choosing project finance is to isolate the risksand take them off the balance sheet so that a project failure does not

damage the owner’s financial condition An off-balance sheet tion simply means that all financial matters relating to a project cannotaffect the balance sheet of the sponsor’s organisation: the project stands

transac-on its own Debt payment comes transac-only from SPV rather than from anyother entity, which becomes the essential feature of project finance Bycomparison, on-balance sheet financing is any form of direct debt orequity funding of a company If the funding is equity, it appears on thecompany’s balance sheet as owners’ equity If it is debt, it appears onthe balance sheet as a liability Any asset the company acquires withthe funding also appears on the balance sheet

The authors suggest that there are two significant advantages sociated with the basic features of project finance First of all, projectfinance structures the risk among the parties, which make it possible

as-to undertake the projects that would have as-too large capital ment with too high a risk to be taken by one party on its own Sincepetroleum refinery projects are capital-intensive with high risks in-volved, project finance is a method to allocate risks and obtain funds.Second, through non-/limited-recourse lending, the risks are sepa-rated from a sponsor’s existing business In other words, project fi-nance enables a project sponsor to finance the project on someoneelse’s credit Nevitt and Fabozzi (2000) state that by using project fi-nance, some credit sources that would not be available on a corporatebasis may be available to the project

invest-Robust income stream of the project as the basis for financing

The future income stream of a project is the most important element

in project finance Repayment of the financing relies on the cashflow and assets of a project itself as the lenders have no recourse toother funds or assets owned by the SPV Therefore, the SPV has todemonstrate strong evidence of future income through various meanssuch as power sales contracts for a power plant or through tolls for amarket-led bridge project

In general, there are two types of revenues streams: contract ledand market led (Merna and Njiru 2002) In a contract-led revenuestream project, the SPV enters into contracts with users of the facil-ity before the project is sanctioned This guarantees revenues to the

20 Project Finance in Construction

SPV provided the service or product is provided to specification Forexample, in a power plant project, the SPV will enter into a contractwith the offtaker, usually a transmission company, who guarantees topurchase a specified amount of electricity over a period In effect, thismitigates the market risk In many public–private partnerships, theSPV provides the availability of the facility and is paid irrespective ofthe demand for the facility

In a market-led revenue stream project, there is no contract withthe users, hence no revenue guarantee An example of a market-ledproject is a toll road where revenues are expected to be generated frommotorists using the toll road If motorists find an alternative route oruse other forms of transport not dependent on the toll road, no revenuewill be generated; hence, the project is subjected to the market risk

A contract-led revenue stream provides more security to the lenders

as they look to the revenues to repay both principal and interest onloans Lenders often provide more favourable terms of loans to projectshaving contract-led revenues since the risk of default is less than inmarket-led projects This is often in the form of a lower interest rate

project finance

Legal

The main reasons for the complexity of project finance structures can

be summarised as follows:

❒ Reliance on contracts to define the responsibilities and liabilities;

❒ Several related parties;

❒ Long-term nature of projects;

❒ Dependency on cash flow with no recourse to the project lenders;

❒ Due diligence requirements of lenders providing the bulk of thecapital;

❒ Involvement of the public sector