Project Finance An Overview

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1 Project Finance An Overview KAMAL TAK ICAI, Navi Mumbai Chapter December 16,

2 Project Finance An Overview What is Project Financing? How is it different? How are Projects developed? Various Project structures Project Appraisal Summary About me 2

3 Project Finance What is it Project financing refers to financing in which lenders to a project look primarily at the cash flow and assets of that project as the source of repayment of their loans. It relies on future cash flows from a specific development as the primary source of repayment with that development s assets, rights and interests legally held as security. 3

4 Project Finance Key Feature Presence of strong contractual relationships among multiple parties. An extensive network of contractual agreements is developed to suit specific project structures and various project risks are allocated to parties best suited to bear them (e.g. construction risks, market/demand risks). Project Financing can, therefore, only work for those projects that can establish such relationships and maintain them at an acceptable cost. 4

5 Project Finance Other Characteristics It enables the sponsor to shift the operating risk and debt servicing burden to the project entity while retaining some benfits from the project. P.F. Is usually restricted to large scale, capital intensive infrastructure projects which often involve a high proportion of debt finance provided by a group of lenders.(toll roads, power, ports projects) Revenue generated from the project should be adequate to cover all operating expenses, debt-servicing burden and adequate return to the equity investors. 5

6 Project Finance Other Characteristics It enables the sponsor to shift the operating risk and debt servicing burden to the project entity while retaining some benfits from the project. P.F. Is usually restricted to large scale, capital intensive infrastructure projects which often involve a high proportion of debt finance provided by a group of lenders.(toll roads, power, ports projects) Revenue generated from the project should be adequate to cover all operating expenses, debt-servicing burden and adequate return to the equity investors. 6

7 Project Finance What is different Organization Corporate Financing Project Financing Organized in Corporate form Cash flows from different assets co-mingled Project can be any form dependent on Tax issues Assets and Cash flows of project segregated from Sponsor s other activities 7

8 Project Finance What is different Allocation of risks Corporate Financing Creditors have full recourse to project sponsors Risks are diversified across Sponsor s portfolio of assets Risks partially transferred by purchasing insurance, hedging etc Project Financing Creditors have limited recourse and in some cases no recourse to project Sponsors Contractual agreements redistribute project related risks Project risks allocated to parties who are best able to t bear them 8

9 Project Finance What is different Control & Monitoring Corporate Financing Control vested primarily in Management Board of Directors monitors corporate performance Limited direct monitoring by the Shareholders Project Financing Management remains in control but subjected to closer monitoring Segregation of assets and cash flows facilitates greater accountability to investors Debt and equity investment arrangements contain covenants that facilitate monitoring 9

10 Project Finance What is different Financial Flexibility Corporate Financing Financing can be typically arranged quickly Internally generated funds can be used to finance other projects Project Financing Higher information, contracting and transaction costs are involved Financial arrangements are highly structured and very time consuming Internally generated cash flow can be reserved for proprietary projects 10

11 Project Finance What is different Free Cash Flow Corporate Financing Managers have broad discretion regarding allocation of free cash flows between dividends and reinvestments Cash flows are co-mingled and then allocated in accordance with corporate policy Project Financing Managers have limited discretions By contract, free cash flow must be distributed to equity investors 11

12 Project Finance What is different Structure of debt finance Corporate Financing Creditors look to sponsors entire asset portfolio for their debt service Debt may be secured or unsecured Project Financing Creditors look to specific assets or a pool of assets for their debt service Typically debt is secured Debt contracts are tailored to the specific characteristics of the project 12

13 Project Finance What is different Bankruptcy Corporate Financing Costly and time consuming financial distress can be avoided Lenders can have the benefit of the sponsor s entire asset portfolio Difficulties in one key line of business could drain cash from good projects Project Financing The cost of resolving financial distress is lower The project can be insulated from the sponsor s possible bankruptcy Lenders chances of recovering principal are more limited; the debt is generally not repayable from the proceeds of other unrelated projects 13

14 Project Finance Why do it Project financing makes it possible for undertaking projects that are too large or pose a great risk to one party on its own. It leads to structuring of the project in manner that it makes the project attractive to various classes of investors, each of which have a different perspective of risk/return profile and a different horizon for return of & on investment. 14

15 Project Finance Why do it Project finance holds out the hope that a well structured and economically viable project will attract long-term financing, even if the project dwarfs its Sponsors own resources or entails the risk that they are unable to bear alone. 15

16 Project Finance Project Development Identification and Screening Project Economics Business Concept Political Viability Technical Feasibility Environmental Considerations 16

17 Project Finance Project Development Concept Formulation Select Partners Negotiate Risk Allocation Obtain Key Franchise Elements Offtake/ User Agreements Site Lease Government Support Prepare Preliminary Feasibility Study Technical/ Economic/ Financial 17

18 Project Finance Project Development Commercial Structuring Finalize Major Contracts EPC O & M Fuel/ Feedstock Partnership Agreements Perform Preliminary Engineering And Obtain Permits Prepare Financing Information Memorandum 18

19 Project Finance Project Development Financing Issue Offering Memo Obtain Credit Exchange Rate Agreements Finalize Term Sheet Financial Institutions Perform Due Diligence Finalize Documents 19

20 Project Finance Project Structures Brown field Expansion of capacity of product lines by existing ventures. Expansion by adding new product lines. Investment by existing ventures for new technologies. Green field Entirely new industrial venture being established. 20

21 Project Finance Project Structures Financing Structures With Recourse To sponsors Non Recourse Recourse only to Project Cash Flows & Project Assets Limited Recourse Recourse to sponsors under certain defined circumstances 21

22 Project Finance Project Structures PPP Structures Licensor Concession Agreement Transfer T Lease Concessionaire Own L Build B Operate O O

23 Project Finance Key Participants Sponsor Government Contractor Equipment Suppliers Operator Input Supplier Output Buyer Independent Engineer Insurance Consultant Legal Counsel Marketing Consultant Financial Advisor Lenders- Residual Risk Takers Borrower 23

24 Project Finance Contractual Structure Power Project Framework EPC Contractors/ Technology Licenser EPC Contract Sponsors & Other Shareholders Shareholders Agreement Lenders / Security Package Facility Agreement Fuel Supplier FSA PPA Offtakers Fuel Take or Pay Project Company Power Take or Pay Fuel Transporter Transportation Agreement O&M Contract O&M Contractor Insurance Package Insurers 24

25 Project Finance Project Appraisal Adoption of a process to enable an independent & objective assessment of the inter-relationship between Technical, Financial, Commercial, Economic, Managerial, Ecological and Social aspects of an investment proposition for arriving at a financing decision Determination of the viability of a project Help re-shape project to enhance viability 25

26 Project Finance Project Appraisal Management Manpower Market Materials Machinery Methods Margins & Risks Operation Factors Land & Building Technical Installation Operating Costs Capital Costs Contractual Framework Risk Mitigation Mechanism Sensitivity Analysis Revenues Financial & Commercial Analysis Viability 26

27 Project Finance Project Appraisal It is not rocket science Just common sense 27

28 Project Finance Project Appraisal Major Areas of Evaluation Management Analysis Technical Evaluation Market Assessment Contractual Framework Financial Assessment Risks & Mitigation 28

29 Project Finance Project Appraisal Managerial Evaluation Past track record & group performance Managerial Competence Financial Strength Project team Subjective criteria 29

30 Project Finance Project Appraisal Technical Evaluation Technology (availability, appropriateness) Equipment Suppliers (reputation, basis of selection) Terms of supply (scope, LDs) Raw material (adequacy) Implementation schedule (feasibility, single point responsibility) 30

31 Project Finance Project Appraisal Market Assessment Marketing arrangements Demand supply projections Price trends Competition Contractual obligations 31

32 Project Finance Project Appraisal Contractual Aspects Statutory Clearances Environmental Clearances Project Contracts EPC, O&M Off-take (e.g. PPA) Raw material supply & transport Credit worthiness of off-taking party 32

33 Project Finance Project Appraisal Financial Assessment Accuracy of cost estimates, soundness of the capital structure Profitability, debt servicing ability and servicing of sponsor interests Aspects to be analyzed for impact Itemized cost of the project Means of finance Working capital requirements 33

34 Project Finance Project Appraisal Commercial Assessment Profitability projections Break-even analysis Sensitivity analysis Debt service coverage ratio Pay-back period Net present value Internal rate of return Scenario Analysis 34

35 Project Finance Project Appraisal Debt service coverage ratio - DSCR The cash flow generated by the project to cover its debt servicing requirements. PAT + Non Cash Exp. + Int. on TL Int. on TL + Principal repayment Average DSCR is an incomplete picture. 35

36 Project Finance Project Appraisal Risk Mitigation Risks are allocated, priced or mitigated between parties. Allocated to agency best placed to manage it. Risk allocation through extensive, detailed and enforceable contracts. Residual risks minimized through insurance, financial hedging instruments 36

37 Project Finance Project Appraisal Development Phase risk From project conceptualization till start of construction Mitigating Development Phase Risks Sponsors / Joint Venture Agreement Project Development Agreement Equity Contribution Agreement Detailed Feasibility Reports by independent experts Permits, Approvals Risks mainly borne by Sponsors 37

38 Project Finance Project Appraisal Construction Phase risk Till commencement of successful commercial operations Mitigating Construction Phase Risks Fixed Price, Date Certain Turnkey EPC Contract Liquidated Damages for delay Performance Guarantees Experienced Contractors Proven Technologies Completion guarantees by Sponsors Risks mainly borne by Contractors 38

39 Project Finance Project Appraisal Funding Risks Non-availability of sufficient funds to complete the Project Mitigating Funding Risks Shareholders Agreements Financing Agreements with Lenders Sponsors Cost Over-run Support Upfront Equity Contributions from Sponsors Visibility of balance equity tie-up Risks Spread between Sponsors/ Lenders 39

40 Project Finance Project Appraisal Operation Phase risk During useful life of the project Mitigating Operations Phase Risks Experienced O&M contractor Fuel Supply/Transportation Agreements Supply or Pay Provisions Completion guarantees for facilities required Risks spread mainly between Contractor/ Supplier 40

41 Project Finance Project Appraisal Market Risks Related to off-take/ sale ability of the product Mitigating Market Risks Long Term Off-take Agreement Take or Pay Provisions Monopoly / Exclusivity (Road, telecom) Ability for third party sales in case of default Scientific Demand Estimation Risks spread mainly between Off-taker/ Project Company 41

42 Project Finance Project Appraisal Revenue Risks Related to adequacy & timeliness of cash flows and creditworthiness of off-takers Mitigating Revenue Risks Escrow Accounts to trap cash inflows of Offtakers at source Letters of Credit from acceptable Banks to tide over temporary liquidity mismatches Risks spread mainly between Off-taker/ Project Company 42

43 Project Finance Project Appraisal Economic Environment Risks Impact of external factors like Inflation, Exchange rates, Interest rates Mitigating Economic Environment Risks Interest Rate Swaps Pass through of interest charges to Off-takers Foreign Currency Hedging Pass through of exchange rate variations to Offtakers at actuals Risks spread mainly between Banks/ Off-takers 43

44 Project Finance Project Appraisal Political, Legal & Regulatory Risks Government actions/regulations affecting project, policy environment, extent of government control War, insurrection Lack of adequate reserves of foreign currency or government regulations restricting repatriations affecting returns to foreign stakeholders Well developed legal system a must Necessity of Independent Regulatory Bodies 44

45 Project Finance Project Appraisal Mitigating Political, Legal & Regulatory Risks Provisions for restoring status quo in case of Change in Law Buy Out of facilities by Government Agencies Back to Back Force Majeure Clauses Political Risk Insurance Risks spread between Lenders/ Project Company/ Sponsors 45

46 Project Finance Project Appraisal Non-Political Force Majeure Risks - OMG Events not under the control of project participants (acts of God, epidemics, strikes) Mitigating Non-Political Force Majeure Risks Comprehensive Insurance Coverage for Project Advance Loss of Profit / Business Interruption Insurances to cover fixed costs Back to Back Force Majeure Clauses Risks Spread between Insurers/ Project Company/ Lenders 46

47 Project Finance Summary Non-recourse financing necessitates exhaustive due-diligence process on the part of the funding agencies Risk analysis & Risk Mitigation Process to address all aspects Success of project financing depends in large measure on good risk management Importance of project cash flows in loan repayment 47

48 About Me Project Finance executive, engaged in financing projects in the Energy, Hydrocarbons and Infrastructure verticals. Specialized in due diligence, financial modeling, term sheets, documentation and negotiations. Evaluated more than 50 project, closed more than 30 transactions (combined cost more than USD 30 Billion) Made debt investment in excess of USD 4 Billion. 48

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