Project Finance in Construction

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1 Project Finance in Construction A Structured Guide to Assessment Anthony Merna Oriel Group Practice Manchester, UK Yang Chu Postdoctoral Research Associate Manchester Business School The University of Manchester UK Faisal Fahad Al-Thani Senior Director and Head of Business Development Maersk Oil Doha, Qatar A John Wiley & Sons, Ltd., Publication

3 Project Finance in Construction

5 Project Finance in Construction A Structured Guide to Assessment Anthony Merna Oriel Group Practice Manchester, UK Yang Chu Postdoctoral Research Associate Manchester Business School The University of Manchester UK Faisal Fahad Al-Thani Senior Director and Head of Business Development Maersk Oil Doha, Qatar A John Wiley & Sons, Ltd., Publication

6 This edition first published 2010 C Anthony Merna Blackwell Publishing was acquired by John Wiley & Sons in February Blackwell s publishing programme has been merged with Wiley s global Scientific, Technical, and Medical business to form Wiley-Blackwell. Registered office John Wiley & Sons Ltd., The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom Editorial offices 9600 Garsington Road, Oxford, OX4 2DQ, United Kingdom 2121 State Avenue, Ames, Iowa , USA For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book, please see our website at The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. 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 (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.C3M dc A catalogue record for this book is available from the British Library. Set in 10/13pt Palatino by Aptara R Inc., New Delhi, India Printed in Malaysia

7 Contents List of illustrations xi List of tables xiii About the Authors xv Preface xvii 1 Introduction The development of project finance Financial assessment 6 What is financial assessment? 6 Why perform a financial assessment? 6 Who is involved in the risk assessment process? 7 Where should a financial assessment be performed? 7 When should a financial assessment be performed? 8 What data are to be used? 8 How should assessment outputs be presented? Purpose of this guide Scope of the guide 9 2 Project finance Introduction Definition of project finance The key characteristics of project finance 13 Special project/purpose vehicle 14 Contractual arrangement 14 Non-/limited recourse 17 Off-balance sheet transaction 18 Robust income stream of the project as the basis for financing Legal and financial considerations in project finance 20 Legal 20 Financial 22 v

8 vi Contents 3 Financial instruments and cash flow modelling Introduction Debt finance 25 Senior debt Mezzanine finance 28 Subordinate debt 28 Bond finance Equity finance Sources of debt and equity Cash flow modelling and project financing 34 4 Risk management Introduction Risk Risk management process 41 Risk identification 42 Risk analysis 44 Risk response Typical risks in project financing 49 5 The financial assessment process Introduction The financial assessment structure 51 SPV assessment 51 Lenders assessment 54 SPV and lender final assessment 55 6 Case study Introduction Independent power project Supply and offtake contracts 58 Supply contracts 60 Offtake contracts 61 Applications of supply and offtake contracts Assumptions for initial assessment 65 7 Developing the base case model Introduction SPV s initial assessment 69

9 Contents vii 7.3 Identify the estimated activities, time, costs and revenues of the project Development of the base case model Identify major project risks Assessment of base case model incorporating risks 74 8 Initial economic assessment by lenders Introduction Financial package assessment 77 Finance package (1) 78 Finance package (2) 82 Finance package (3) Conclusions 87 9 Financial engineering Introduction Financial instruments used in financial engineering 90 Forward rates 90 Financial futures 90 Swaps 91 Options 92 Caps, floors, collars, swaptions and compound options 92 Asset-backed securities Refinancing Reappraising public private partnerships Techniques applied in the reappraisal of PPP concession agreement Other financial engineering techniques Final assessment to determine project commercial viability Introduction Detailed risk assessment Financial engineering 105 Tax holiday 105 Financial collar 107 Extending the concession 107 Increasing debt 107

10 viii Contents Grace period 108 Phasing construction and operation 108 Upfront payments 108 Existing concession revenues Summary Financial close Introduction Due diligence 111 Technical 113 Legal due diligence 114 Trigger step in rights 116 Model audit and sensitivity analysis 116 Risk valuation 117 Term sheet 117 Inter-creditor agreement 117 Hedge strategy 118 Letters of credit 118 Reserve account 119 Escrow and ring-fenced facilities 119 Economic indicators 120 Taxation 120 Insurance Financial close 122 Credit committee approval process 123 Due diligence report 124 Technical closure 124 Financial close 124 Technical commencement 124 Execute interest rate swaps Islamic finance and project finance Introduction Islamic finance Shariah 129 Qiyas and Litihad Core principles of Islamic finance 130 Sharing (profit/loss and risk) 130

11 Contents ix No unfair gain 130 No speculation 130 No uncertainty 130 No investments that are not in the public interest 131 No hoarding of money 131 Deception 131 Islamic financial institutions 131 Shariah supervisory boards Project finance 132 The Ijara principle 133 Ijara Mawsufah Fi Al Dhimmah (forward lease) 133 Istisna a 133 Sukuk 134 Sukuk al Istisna a 135 A typical SAI deal 135 Hedging 136 Swaps Other Islamic finance techniques for projects 137 Musharaka (equity financing) 137 Bai salam (forward financing) Risks and liabilities Summary Conclusions and recommendations Review Conclusions Recommendations 144 Appendix 147 Glossary 159 References 161 Index 167

13 List of illustrations Figure 1.1 Brief history of project finance (Chu, 2007) 2 Figure 2.1 A typical BOOT corporate structure (Merna and Smith 1994). 15 Figure 3.1 Typical cumulative cash flow stages of a project (Merna and Smith 1994). 36 Figure 3.2 Seniority of financial instruments (Merna and Al-Thani 2008). 38 Figure 4.1 Risk management cycle (Merna and Al-Thani 2008). 42 Figure 4.2 Risk assessment for an organisation (Merna and Al-Thani 2008). 43 Figure 5.1 Financial assessment structure. 52 Figure 6.1 Assessments by SPV and lenders to determine the commercial viability. 59 Figure 6.2 Supply contract and offtake contract arrangements in the power station (adapted from Merna and Smith 1994). 65 Figure 6.3 Project programme: major activities (generated by Microsoft Project). 67 Figure 7.1 Base case CCF. 72 Figure 7.2 Base, best and worst case CCF. 75 Figure 8.1 Finance package of 80:20 debt/equity. 82 Figure :10:10 debt/bond/equity. 85 Figure 10.1 Sensitivity analysis. 103 Figure 10.2 Cumulative probability diagram. 104 Figure 10.3 Cumulative probability diagram (after mitigation). 104 Figure 11.1 Due diligence process (Merna and Smith 1994). 112 Figure 11.2 Typical financial close process (Merna and Smith 1994). 123 Figure 12.1 Project financing structure. 135 Figure 12.2 Typical Arbun arrangement. 136 xi

15 List of tables Table 3.1 Bond ratings 32 Table 4.1 Global and elemental risks (Chu 2007) 49 Table 4.2 Financial and non-financial risks (Chu 2007) 49 Table 4.3 Risks affecting different phases of a project s life cycle 50 Table 5.1 Typical costs and revenues over project life cycle 54 Table 5.2 Typical financial instruments, repayments and cash flows 54 Table 5.3 Typical cover ratios used by lenders 55 Table 6.1 Basic details of the project 58 Table 6.2 Projects with supply contracts (Chu 2007) 62 Table 6.3 Projects with offtake contracts (Chu 2007) 64 Table 7.1 Activities, costs and revenue estimates and their timings 70 Table 7.2 Base case model cash flow and cumulative cash flow 72 Table 7.3 Base case economic parameters 73 Table 7.4 Economic parameters of base, best and worst case scenarios 75 Table 8.1 Project economics and cover ratios under 100% debt (US$ million) 79 Table 8.2 Project economics and cover ratio table under 80:20 debt/equity (US$ million) 84 Table 8.3 Project cash flow allocation table under 10:80:10 debt/bond/equity for the bond with a 10-year maturity (US$ million) 86 Table 9.1 Techniques applied in the reappraisal of PPP concession agreements (Merna and Smith 1994) 97 Table 10.1 Risks and their upside and downside ranges 102 Table 10.2 Summary of the project economics and cash availability (US$ million) 106 xiii

17 About the Authors Dr. Anthony Merna is a senior partner of Oriel Group Practice, a multidisciplinary research and consultancy practice based in Manchester, and a visiting lecturer to Manchester Business School at the University of Manchester. Dr. Yang Chu is a graduate of the School of Mechanical, Aerospace and Civil Engineering at the University of Manchester and a research consultant with Oriel Group Practice, specialising in the areas of project finance and risk modelling. He is currently carrying out risk management research at Manchester Business School. Dr. Faisal Fahad Al-Thani is Senior Director and Head of Business Development, Middle East for Maersk Oil, based in Doha, and a board member of the Marsh International Risk Council. xv

19 Preface At the time of writing this guide, financial markets remain uncertain. This has led many sponsors of project financings to further consider bank liquidity, the higher cost of finance and general uncertainty for demand. This has resulted in the postponement of a number of projects in certain industry sectors. Governments have seen tax receipts drastically reduced, which has affected their ability to finance infrastructure projects, often irrespective of the perceived demand. Equity providers still seek to invest; however, there are less opportunities due to market dislocation. Due to the demand for global infrastructure, it is believed that project financings will return to their pre-crunch levels, or more so; however, lenders liquidity costs will be passed on to the borrowers. Lenders will also be under stricter regulation both internally and externally. The steps outlined in the guide are designed to provide a basic understanding for all those involved or interested in both structuring and assessing project financings. Secondary contracts involving constructors, operators, finance providers, suppliers and offtakers can be developed and assessed to determine their commercial viability over a project s life cycle. xvii

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