Project Organizing in the construction industry Project financing: guidelines & best practices Padova, March 28th 2014 Palazzo del Bo Put simply: a PPP Project is considered bankable if lenders are willing to finance it, Head of Corporate Finance 1
Project financing 2
Some basic concepts In project finance, banks provide finance for a single project and take a large part of the risk of the success or failure of that project. The project may be or offices or shops, or any other venture involving construction or engineering a jails, schools and a hospital; a toll tunnel, bridge or highway; a sport infrastructure (stadium, pool, sporting arena, etc..); a cable network; a power station or pipeline; An asset serving an entity belonging to the pubilc sector 3
and a simplified structure A typical basic structure is as follows: A single purpose project company is formed to build and operate the project. The shares in the project company are owned by the project sponsors who enter into a shareholders or joint venture agreement governing their duties as shareholders. The host government grants the project company a concession or licence to operate the project. A construction company agrees to construct the project. A purchaser agrees to buy the project company s product and this produces the cash to repay the bank loan. 4
Project finance and PPP 5
Infrastructure financing PRIVATISATION PPP PUBLIC SECTOR PROPERTY Passage from public to private sector Long term concession to private sector Public property COST, RISK E RETURN Private ownership The majority of the costs, risks and returns are met by the private owner. The granting Authority pays for the use of the services Public company ownership QUALITY Standards established by private owners Granting Authority establishes standards Standards established by public company 6
Infrastructure financing MACROECONOMIC RELEVANCE Converting up-front fixed expenditures into a stream of future obligations MICROECONOMIC RELEVANCE Value for money Alleviating pressure on public company balances Improving efficiency in the public sector 7
PPP: what they are? Throughout the European Union and New Europe the decrease of available public resources and the restrictions imposed on the rate of increase of public deficits, have stimulated the search for alternative ways of financing infrastructural projects. Some examples: Public interest projects developed by public-private special purpose vehicles whose investments are made through the contribution of private expertise and private funds with part of equity funds provided by public shareholders ( Institutional PPPs ). Projects with an intrinsic capacity to generate profit through income. Public interest projects developed by private owned special purpose vehicles, through the awarding of DBFO concessions. The public sector is the grantor of the concession and sometime will provide subsidies in order to contribute to the funding of the project. The private sponsors will raise debt financing and will provide equity capital. Projects in which the private concessionary provides a service directly to the Public sector (eg. jails, schools, hospitals) in consideration of a revenue stream (availability fee) owed from the Public sector ( Contractual PPPs ). 8
PPP: main characteristics (1) MAIN CHARACTERISTICS OF PPPs Risk sharing between public and private sector Long term relationship between the parties Public service and ultimate regulatory responsibility remain in public sector USING PRIVATE SECTOR SKILLS FOR PUBLIC SECTOR SERVICES Contracts for services, not procurement of assets Output, not input, specifications Payments related to service delivery Whole life approach to design, build and operation CRITERIA FOR PPPs Economically viable for public sector Financially viable for the Private sector Appropriate risk and reward balance for public and private sector Public Sector: value for money FUNDAMENTAL MARKET CONDITIONS Public Sector political commitment/government partnership Reasonable project pipeline Focused, dedicated and experienced public sector team/ppp task force Clear legal and institutional environment Robust, transparent and competitive procurement Realistic risk sharing/sensible risk allocation 9
PPP: main characteristics (2) REASONABLE PROJECT PIPELINE Reasonable flow of affordable, viable and bankable projects Committed, structured and coordinated approach from public sector Pilots and pathfinders Prioritisation Political will at national level Ability to manage mix of grants vs. private sector grants Communication RISK ALLOCATION Standardised approach Bankable approach Value for Money Approach PROCUREMENT PROCESS Structured, transparent, non-discriminatory and consistent process Adequate planning and consent process Improved public sector understanding Public sector audit Adequate concession/public works/service legislation INSTITUTIONAL CAPABILITY Dedicated and resourced centre of excellence Sufficiently empowered decision-making bodies Use of experienced advisers Development of domestic private sector capacity (legal, financial, technical) Understanding the meaning of partnership 10
PPP: main characteristics (3) Distinguishing factors Active participation of the private sector in all phases of the infrastructure project through to the actual provision of the service (daily running); The involvement of the public sector is limited to its role as the principal buyer of this service and regulator of the quality of the services to be provided; Essentially private nature of the finance source (private bonds, equity, bank loans, etc ); Optimization of public sector costs (value for money) is considered throughout all project phases; Part of the risks are transferred to the private sector. 11
Identifying and structuring a successfull PPP GOVERNMENT SIDE ❶ Select suitable projects ❷ Manage for best value Define objectives structure project begin procurement PRIVATE SECTOR ❶ Optimise return on investments ❷ Manage project risk Establish feasibility; define bidding group; allocate resources Negotiate optimal risk transfer Define a value for money pricing mechanism and performance measurement Successful PFI/PPP Project Manage risks: construction, supply, operation, finance Define competitive bid; financing strategy; equity investment requirements Competitive and profitable bid 12
The role of the banks in infrastructure financing 13
Role of the banks (adviser, arranger, underwriter) Risks Allocation Project funding Adviser Lender COMMERCIAL CONTRACTS (construction, o&m, etc.) TERM SHEETS (Main Terms and Conditions) Underwriting FINANCING CONTRACTS (financial & security) Conditions precedent assessment Arranger Underwriter 14
Syndication and the credit process (for large transaction) Risk Management Internal RATING Syndication package Analysis of: (i) Information Memorandum (ii) Due Diligence reports (iii) Financial Plan (iv) Term sheets Risk Adjusted Return Over Capital Credit Committee Report Credit Committee approval Project Documentation Final commitment Analysis of: (i) Commercial Contracts (ii) Financial Documents Preliminary commitment 15
Major criteria for credit assessment: Risk apportionment and sustainable financial planning from a lender perspective 16
Sustainable financial planning DEFINING A BALANCED FINANCIAL STRUCTURE The financial structure of PFI/PPP is characterised by high ratios of debt to equity in the borrowing entity (special purpose vehicle or SPV) The willingness of investors to provide loans is a function of market conditions and the risk attached to the projects, as well as the level of government involvement Where the income stream to meet interest payment and repayment schedules comes from an availability/capacity charge which is paid by the Public Sector Client, long term investors and financiers wish to be assured that the availability/capacity charge provides a sufficient safety margin to ensure that the SPV can meet its financial obligations. For this reason the negotiation of cover ratios is important in providing a measure of security to loan providers Increasing competition, growing experience of PFI/PPP projects and the comfort provided by the Public Sector client have reduced the margins attached to the interest rates for such kind of initiatives..as well as (sometimes ) the level of financial ratios...but market trends suddenly changed upon the recent financial turmoil!!! 17
Risk analysis and allocation (the rating agencies 5 steps) ❶ ❷ Key risks Risk Allocation Identification Contracts & laws Insurance Guarantees ❸ Quantify the risks Experience rules Benchmarks Advisers Report No simple matrix A rather complicated balance of quantitative (leverage, base case, sensitivities) and qualitative (law, contracts, type of asset) ingredients ❹ ❺ Review the financing structure Long term cash flow projections Leverage / tenor Documentation covenants Base case Sensitivities Satisfactory financial ratio? NO YES 18
Risk analysis: how do we achieve an effective risk allocation? Due Diligence Risks Analysis Financing structure Legal Technical Risk Matrix Financial optimisation Insurance Bankability is, as it sounds, the acceptability or otherwise of a project s structure as the basis of a project financing.bankability is an art, not a science. (Graham D. Vinter) Risks Allocation 19 YES
Principles of risk allocation and risk management (1) RISK ALLOCATION AND VALUE FOR MONEY Risk should be borne by the party, which is best able to control them Complexity transaction costs Financing costs Optimal risk allocation Cost/time discipline Sharing risks is not a goal in itself but a way to achieve efficiency and quality as well as to create correct disciplines and incentives to achieve optimal outcome There are certain risks that are best managed by the Public Sector and to seek to transfer these risks would either not be viable or not offer value for money to the public sector (i.e. force majeure) (i.e. change in law/requirements change) (i.e risk of long term need for the service) RISK TRANSFER: REALITY & MITH Risk trasfer works up to a certain point! Innovation Completion Optimal lifecycle costs Risk has a price (value for money cheapest) Only certainty: outcome will differ from assumptions Scenario analysis should include multiple components (use multicriteria analysis ) Weight to common interest to see the asset built and operated 20
Principles of risk allocation and risk management (2) KEY FINANCIERS RISKS Construction Delay Price Performance Operation & Maintanance Cost Technical issues Legal and political Market (where applicable) Demand volume (traffic/users ) Toll, fare, evasion, delinquency Competition/diversion risk Other Insurance, Inflation, Interest rate, tax ISSUE OF CONCERN TO LENDERS IN CONCESSION FINANCING Award concessions fairly Clarify power of granting authorities Clarify tax and licencing regimes Provide lenders effective security Provide government undertakings to lenders Risk management devices Pass through and back to back agreements with contractors and subcontractors ring fencing (project company, segregated assets) insurance, hedging instruments indexation and provision for contingencies and contingency funding 21
Financing requirements and credit enhancement techniques: a lender perspective 22
Key issues for financiers in PFI/PPP projects MICRO Well defined projects; clarity on output specification Strong, experienced contractors Reliable completion undertakings Appropriate allocation of risk reflected in payment regime High quality predictable cash flows / low volatility Alternative service providers in the event of financiers step-in Protection from other adverse events, change in law, force majeure, insurance etc. MACRO Legal regime permitting taking of security and enforcement of contractual rights Political commitment to PFI/PPP and to specific projects Competition amongst constructions companies Availability of sercive providers Availability/capacity of long term debt market Availability of project equity Established exit route of equity Transparent procurement process 23
Requirements for financial viability: an outline External Internal Institutional Sound project foundamentals (economic rationale) Formalities / security effective at law / enforceability Possibility to create effective security Key Elements for a successful infrastructure financing Coherent legislative framework Rule of Law & role of the courts Coherence / consistency / coesion / stability Permits and consents One partnership, many interest! Reliability of the contractual framework Creditworthiness of the major project parties Political commitment (and grants ) 24
Risk allocation and sustainable financial planning CASH FLOWS STABILITY AND FINANCIERS REQUIREMENT Annual Debt Service Cover Ratio (ADSCR) Loan Life Cover Ratio (LLCR) Project Life Cover Ratio (PLCR) Debt/Equity Ratios Concession tail Sensitivities and stress tests Shape of repayment profile (sculpted, miniperm, balloon, bullet, cash sweep adjustment) Role of the Reserve Accounts (Debt Service Reserve Account; Maintanance Reserve Account ) 25
The contractual structure 26
Requirements for financing: an outline The importance of the contractual framework a) Consents, permits, authorisations b) Shareholders agreement and the sponsors contributions c) Concession agreement d) Construction contract e) Operation and maintenance agreement f) Supply contract/offtake agreement 27
Risk allocation and sustainable financial planning MITIGATION OF CONSTRUCTION RISK THROUGH DEDICATED DEVICES Turn key, lump sum, fixed price contract Experienced contractors Buffer in construction schedule Completion buffer Joint and several liability (single point of responsibility) Completion Guarantee Liability caps Liquidated damages for delay in completion Advance payment bonds; Retention Bonds; Performance Bonds Warranty periods Direct Agreement 28
The concession agreement: bankability and other selected issues 29
Requirements from a financier perspective: an outline THE CONCESSION AGREEMENT (1) The terms of the concession should be fixed for the life of the project; there should not be any unduly onerous terms imposed on the project company, e.g. a high level of liquidated damages if completion is not achieved by a fixed date if the project company is unable to pass-through all of those liquidated damages to its own contractor; the grantor of the concession should accept the change in law risk. So, for example, at the very least the concession period will be extended if the construction of the project is delayed because new regulations come into force requiring a re-working of the design or the retrofitting of new environmental protection equipment; the concession period should be extended by any period of force majeure; the concession should not terminate simply because the banks enforce their security; the arrangements for termination of the concession (when permitted) should not be expropriator and any compensation and compensation to which the project company is entitled should always be sufficient to repay the banks (even if the concession is being terminated for default by the project company) 30
Requirements from a financier perspective: an outline (2) THE CONCESSION AGREEMENT (2) on an enforcement, the banks should be able to freely transfer the concession to a third party; step-in rights provisions properly drafted and enforceable; financial balance clause; payment/indemnity provisions in case of contractual default by the public authority and revocation of the concession due to reasons of public interest ; payment/indemnity provisions in case of termination for breach of contract attributable to the concessionaire as an additional tool of credit enhancement, the terms of the concession must provide that any amount to be paid to the concessionaire in case of termination/revocation/withdrawal of the concession will have to be applied with priority to satisfy the claim of the lenders of the project. As an additional security for financial institutions, concession agreement must provide that revocation of the concession shall be ineffective until full payment of the indemnification 31
Lessons learnt: an international comparison 32
Need for clarity of requirements Costs of Procurement Dealing with the public Clear understanding Of service required Of the budgetary requirements Of the risk transferred Extended bid timetable Costs to public sector and private bidders Examples of failure of bids Political perception privatisation and managing borrowing Union opposition Profit in contract and refinancing Move towards Long Term Parterships Recent Policy Emphasis 33