MBF1223 Financial Management Prepared by Dr Khairul Anuar

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1 MBF1223 Financial Management Prepared by Dr Khairul Anuar L3 Project Financing

2 Objectives To understand what project financing is and what steps are involved in securing and managing it.

3 Part 1 Introduction For whom is it important to understand project financing? Why is it important to understand project financing? What is a project? Types of projects. What is project financing? Key characteristics of project financing. Advantages of project financing. Disadvantages of project financing.

4 Introduction For whom is it important to understand project finance? Financial managers Sponsors Lenders Consultants and practitioners Project managers Builders Suppliers Engineers. Researchers Students.

5 Introduction Why is it important to understand project finance? The people involved in a project are used to find financing deal for major construction projects such as mining, transportation and public utility industries, that may result such risks and compensation for repayment of loan, insurance and assets in process. That s why they need to learn about project finance in order to manage project cash flow for ensuring profits so it can be distributed among multiple parties, such as investors, lenders and other parties.

6 Introduction What is a Project? In our context of Project Finance, a Project is normally a long-term infrastructure, industrial or public services scheme, development or undertaking having: Large size. Capital Intensive - Intensive capital requirement. Finite Long Life. Few diversification opportunities i.e. assets specific. Stand alone entity. High operating margins. Significant free cash flows. Such projects are usually government regulated and monitored which are allowed to an entity on B.O.O or B.O.T basis.

7 Introduction Types of Project Motorway and expressway. Metro, subway and other mass transit systems. Dams. Railway network and service both passenger and cargo. Power plants and other charged utilities. Port and terminals. Airports and terminals. Mines and natural resource explorations. Large new industrial undertakings [new expansion and extensions. Large residential and commercial buildings.

8 Introduction What is Project Financing? International Project Finance Association (IPFA) defined project financing as: The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flows generated by the project. Project finance is especially attractive to the private sector because they can fund major projects off balance sheet.

9 Introduction Common features of project finance transactions 1. Capital-intensive Project financings tend to be large-scale projects that require a great deal of debt and equity capital, from hundreds of millions to billions of dollars. Infrastructure projects tend to fill this category. 2. Highly leveraged These transactions tend to be highly leveraged with debt accounting for usually 65% to 80% of capital in relatively normal cases. 3. Long term The tenor for project financings can easily reach 15 to 20 years. 4. Independent entity with a finite life Project financings frequently rely on a newly established legal entity, known as the project company, which has the sole purpose of executing the project and which has a finite life so it cannot outlive its original purpose. In many cases the clearly defined conclusion of the project is the transfer of the project assets. For example, in a buildoperate-transfer (BOT) project, the project company ceases to exist after the project assets are transferred to the local company.

10 Introduction Common features of project finance transactions 5. Non-recourse or limited recourse financing The project company is the borrower. Since these newly formed entities do not have their own credit or operating histories, it is necessary for lenders to focus on the specific project s cash flows. That is, the financing is not primarily dependent on the credit support of the sponsors or the value of the physical assets involved. Thus, it takes an entirely different credit evaluation or investment decision process to determine the potential risks and rewards of a project financing as opposed to a corporate financing. As a result, they will concern themselves closely with the feasibility of the project and its sensitivity to the impact of potentially adverse factors. 6. Controlled dividend policy To support a borrower without a credit history in a highly-leveraged project with significant debt service obligations, lenders demand receiving cash flows from the project as they are generated. In project financing, the project has a strictly controlled dividend policy, though there are exceptions because the dividends are subordinated to the loan payments. The project s income goes to servicing the debt, covering operating expenses and generating a return on the investors equity. This arrangement is usually contractually binding. Thus, the reinvestment decision is removed from management s hands.

11 Introduction Common features of project finance transactions 7. Many participants These transactions frequently demand the participation of numerous international participants. It is not rare to find over ten parties playing major roles in implementing the project. 8. Allocated risk Because many risks are present in such transactions, often the crucial element required to make the project go forward is the proper allocation of risk. This allocation is achieved and codified in the contractual arrangements between the project company and the other participants. The goal of this process is to match risks and corresponding returns to the parties most capable of successfully managing them. For example, fixed-price, turnkey contracts for construction which typically include severe penalties for delays put the construction risk on the contractor instead on the project

12 Introduction Common features of project finance transactions 9. Costly Raising capital through project finance is generally more costly than through typical corporate finance avenues. The greater need for information, monitoring and contractual agreements increases the transaction costs. Furthermore, the highly-specific nature of the financial structures also entails higher costs and can reduce the liquidity of the project s debt. Margins for project financings also often include premiums for country and political risks since so many of the projects are in relatively high risk countries.

13 Introduction Corporate Finance-Project Finance Continuum

14 Introduction Corporate Finance-Project Finance Continuum

15 Introduction Key characteristics of Project Financing The key characteristics of project financing are: Financing of long term infrastructure and/or industrial projects using debt and equity. Debt is typically repaid using cash flows generated from the operations of the project. Limited recourse to project sponsors. Debt is typically secured by project s assets, including revenue producing contracts. First priority on project cash flows is given to the Lender. Consent of the Lender is required to disburse any surplus cash flows to project sponsors Higher risk projects may require the surety/guarantees of the project sponsors.

16 Introduction - Advantages of Project Financing Eliminate or reduce the lender s recourse to the sponsors. Permit an off-balance sheet treatment of the debt financing. Maximize the leverage of a project. Avoid any restrictions or covenants binding the sponsors under their respective financial obligations. Avoid any negative impact of a project on the credit standing of the sponsors. Obtain better financial conditions when the credit risk of the project is better than the credit standing of the sponsors. Allow the lenders to appraise the project on a segregated and standalone basis. Obtain a better tax treatment for the benefit of the project, the sponsors or both.

17 Introduction Disadvantages of Project Financing. Often takes longer to structure than equivalent size corporate finance. Higher transaction costs due to creation of an independent entity. Can be up to 60 basis points (bp) Project debt is substantially more expensive ( bp) due to its non-recourse nature. Extensive contracting restricts managerial decision making. Project finance requires greater disclosure of proprietary information and strategic deals. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001)

18 Part 2 Stages in Project Financing Project identification Risk identification & controls Pre Financing Stage Technical and financial feasibility Equity arrangement Negotiation and syndication Financing Stage Commitments and documentation Disbursement. Monitoring and review Post Financing Financial Closure / Project Closure Stage Repayments & Subsequent monitoring.

19 Stages in Project Financing Project Identification Pre Financing Stage. Identification of the Project Government announced Self conceived / initiated Identification of market Product of the project Users of the product Marketability of the product Marketing Plan

20 Stages in Project Financing Risk Identification and Minimizing Pre Financing Stage Risk Completion Risk Price Risk Resource Risk Operating Risk Environmental Risk Technology Risk Interest Rate Risk Insolvency Risk Solution Contractual guarantees from contractors, manufacturer, selecting vendors of repute. hedging Keeping adequate cushion in assessment. Making provisions, insurance. Insurance Expert evaluation and retention accounts. Swaps and Hedging Credit Strength of Sponsor, Competence of management, good corporate governance

21 Stages in Project Financing Risk Identification and Minimizing Post Financing Stage Currency Risk Political and Sovereign Risk Hedging Externalizing the project company by forming it abroad or using external law or jurisdiction External accounts for proceeds Political risk insurance (Expensive) Export Credit Guarantees Contractual sharing of political risk between lenders and external project sponsors Government or regulatory undertaking to cover policies on taxes, royalties, prices, monopolies, etc External guarantees or quasi guarantees

22 Stages in Project Financing Technical and Financial Feasibility Pre Financing Stage. Technical feasibility Location Design Equipment Operations / Processes. Financial feasibility Business plan / model Projected financial statements with assumptions Financing structure Pay-back, IRR, NPV etc.

23 Stages in Project Financing Equity arrangement Financing Stage Sponsors Lead sponsors Co sponsors Private equity participation Angel investors Private equity funding Financial institutions Non-financial institutions.

24 Stages in Project Financing Negotiation and syndication Financing Stage Lenders Banks. Non- banking financial institutions. International lending institutions. Syndication Lead arranger. Co-arrangers. Negotiation Pricing. Documentation. Disbursement.

25 Stages in Project Financing Negotiation and syndication Financing Stage Commitment letters / MOUs Commitment letters from sponsors and investors MOU signing with financiers. Documents Offer Letters Lending agreements Security documents Disbursement plan Contracts Management/shareholder agency relationship Inter corporate agency relationship Government/corporate agency relationship Bondholder stockholder relationship

26 Stages in Project Financing Disbursement Financing Stage Equity Disbursement Shares application. Shares proceeds. Share certificates. Loan Disbursement Sponsor loans Advance payments Progress Payment

27 Stages in Project Financing Monitoring and Review Post Financing Stage Why? Project is running on schedule Project is running within planned costs. Project is receiving adequate costs. How? First hand information. Project completion status reports. Project schedule chart. Project financial status report. Project summary report. Informal reports.

28 Stages in Project Financing Financial Closure / Project Closure Post Financing Stage Financial closure is the process of completing all project-related financial transactions, finalizing and closing the project financial accounts, disposing of project assets and releasing the work site. Financial closure is a prerequisite to project closure and the Post Implementation Review (PIR). A project cannot be closed until all financial transactions are complete, otherwise there may not be funds or authority to pay outstanding invoices and charges. Financial closure establishes final project costs for comparison against budgeted costs as part of the PIR. Financial closure also ensures that there is a proper disposition of all project assets including the work site. Project closure and commencement take place after financial closure.

29 Stages in Project Financing Repayment & Subsequent Monitoring Post Financing Stage Repayments Grace period. Monthly installment. Quarterly installments. Dividends Monitoring? Appointment of directors and managers. Management meetings. Board meetings.

30 Part 3 Project financing structure A typical project financing structure. Highlights of project financing structure.

31 Part 3 Project financing structure A typical project financing structure. Highlights of project financing structure.

32 Part 3 Project financing structure A Typical Project Finance Structure.

33 Part 3 Project financing structure A Typical Project Finance Structure.

34 Part 3 Project financing structure Project sponsors or owners - The sponsors are the generally the project owners with an equity stake in the project. Typical sponsors include foreign multinationals, local companies, contractors, operators, suppliers or other participants. The World Bank estimates that the equity stake of sponsors is typically about 30% of project costs. Because project financings use the project company as the financing vehicle and raise nonrecourse debt, the project sponsors do not put their corporate balance sheets directly at risk in these often high-risk projects. However, some project sponsors incur indirect risk by financing their equity or debt contributions through their corporate balance sheets. Project company - The project company is a single-purpose entity created solely for the purpose of executing the project. Controlled by project sponsors, it is the center of the project through its contractual arrangements with operators, contractors, suppliers and customers. Typically, the only source of income for the project company is the tariff or throughput charge from the project. The amount of the tariff or charge is generally extensively detailed in the off-take agreement. Thus, this agreement is the project company s sole means of servicing its debt. The creation of the project company and its role as borrower represent the limited recourse characteristic of project finance. However, this does not have to be the case. It is possible for the project sponsors to borrow funds independently based on their own balance sheets or rights to the project.

35 Part 3 Project financing structure Contractor - The contractor is responsible for constructing the project to the technical specifications outlined in the contract with the project company. These primary contractors will then sub-contract with local firms for components of the construction. Contractors also own stakes in projects. For example, Asea Brown Boveri created a fund, ABB Funding Partners, to purchase stakes in projects where ABB is a contractor. Chase Manhattan Bank - much of the infrastructure development is being driven by the contractors which may ultimately view equity investment as a cost of doing business. Operator - Operators are responsible for maintaining the quality of the project s assets and operating the power plant, pipeline, etc. at maximum efficiency. It is not uncommon for operators to also hold an equity stake in a project. Depending on the technological sophistication required to run the project, the operator might be a multinational, a local company or a joint-venture.

36 Part 3 Project financing structure Supplier. The supplier provides the critical input to the project. For a power plant, the supplier would be the fuel supplier. But the supplier does not necessarily have to supply a tangible commodity. In the case of a mine, the supplier might be the government through a mining concession. For toll roads or pipeline, the critical input is the right-of-way for construction which is granted by the local or federal government. Customer. The customer is the party who is willing to purchase the project s output, whether the output be a product (electrical power, extracted minerals, etc.) or a service (electrical power transmission or pipeline distribution). The goal for the project company is to engage customers who are willing to sign long-term, offtake agreements. Commercial banks. Commercial banks represent a primary source of funds for project financings. In arranging these large loans, the banks often form syndicates to sell-down their interests. The syndicate is important not only for raising the large amounts of capital required, but also for de facto political insurance. Even though commercial banks are not generally very comfortable with taking long term project finance risk in emerging markets, they are very comfortable with financing projects through the construction period. In addition, a project might be better served by having commercial banks finance the construction phase because banks have expertise in loan monitoring on a month-to-month basis, and because the bank group has the flexibility to renegotiate the construction loan.

37 Part 3 Project financing structure Capital markets - Capital markets has become the instrument of choice for financing emerging markets transactions. The capital market route can be cheaper and quicker than arranging a bank loan. In addition, the credit agreement under a capital market is often less restrictive than that in a bank loan. Furthermore, these financings might be for longer periods than commercial bank lending; might offer fixed interest rates; and can access wider pool of available capital and investors such as pension funds. Direct equity investment funds - Private infrastructure funds represent another source of equity capital for project financings. Examples of these funds include AIG Asian Infrastructure Fund ($1.1 billion), Peregrine s Asian Infrastructure Fund ($500 million), Global Power Investments23 ($500 million) and the Scudder Latin America Infrastructure Fund ($100 million, with target of $600 million). The funds typically take minority stakes of the infrastructure projects in which they invest. Multilateral agencies. The World Bank, International Finance Corporation and regional development banks often act as lenders or co-financers to important infrastructure projects in developing countries.

38 Part 3 Project financing structure Independent, single purpose company formed to build and operate the project. Extensive contracting As many as 15 parties in up to 1000 contracts. Contracts govern inputs, off take, construction and operation. Government contracts/concessions: one off or operate-transfer. Ancillary contracts include financial hedges, insurance for Force Majeure, etc.

39 Part 3 Project financing structure Highly concentrated equity and debt ownership One to three equity sponsors. Syndicate of banks and/or financial institutions provide credit. Governing Board comprised of mainly affiliated directors from sponsoring firms. Extremely high debt levels Mean debt of 70% and as high as nearly 100%. Balance of capital provided by sponsors in the form of equity or quasi equity (subordinated debt). Debt is non-recourse to the sponsors. Debt service depends exclusively on project revenues. Has higher spreads than corporate debt.

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