Corporate Finance by chenshu


									Project Finance
  Professor Pierre Hillion
             Project Finance

“A project company is like a leveraged buyout (LBO),
except that an LBO is a financing decision involving
existing assets, whereas project finance is an
investment and a financing decision involving new
                                             B. Esty


•   Introduction

•   Part 1: Overview of Project Finance

•   Part 2: Statistics

•   Part 3: Project Finance versus Corporate Finance

•   Part 4: Leverage and Financing Issues

•   Conclusion

•   Appendices
 Definition: Project Finance
                Definition of Project Finance

Project Finance (PF) involves:

•   the creation of a legally independent project company

•   financed with:
       -non-recourse debt
       -equity from one or more sponsoring firms

•   for the purpose of financing an investment in a single-
    purpose capital asset

•   usually with a limited life.
        PART 1

Overview of Project Finance
         Overview of Project Finance: Parties Involved

•   Sponsors and investors: they are generally involved in the construction and the management
    of the project. Other equity-holders may be companies with commercial ties to the project, i.e.,
    customers, suppliers…

•   Lenders: The needed finance is generally raised in the form of debt from a syndicate of lenders
    such as banks and less frequently from the bond market.

•   Government: project company need to obtain a concession from the host government.
     – Role of type of contract: Build-own-operate (BOO) or Build-transfer-operate (BOT).
     – Control on revenues such as for example: Eurostar, British Jail,

•   Suppliers and Contractors: Role of turnkey contracts to make sure that construction is
    completed within costs and on schedule. Turnkey contracts specify a fixed price and penalties
    for delays.

•   Customers: Depending on the contract, multiple or a single customer.

       Overview of Project Finance: Main Characteristics

• Organizational Structure
  - Project companies involve separate legal incorporation.

• Capital Structure
  - Project companies employ very high leverage compared to public firms.

• Ownership Structure
  - Project companies have highly concentrated debt and equity ownership structures.

• Board Structure
  - Project boards are comprised primarily of affiliated directors from the sponsoring

• Contractual Structure
  - Project finance is referred to as “contract finance” because a typical transaction
  involves numerous contractual agreements from input suppliers to output buyers.
          Overview of Project Finance: Main Characteristics

• Independent, single purpose company formed to build and operate the project.

• Extensive contracting
   –   As many as 15 parties and up to 1000 contracts.
   –   Contracts govern inputs, construction, operation, outputs.
   –   Government contracts/concessions: one off or operate-transfer.
   –   Ancillary contracts include financial hedges, insurance for Force Majeure, etc.

• 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.                                                         9
    Overview of Project Finance: Contractual Agreements

Contractual and financing arrangements between the various parties are essential in project

• Concession agreement with a government
• Engineering, Procurement and Construction (EPC) Contract
    – between the Project Company & the Engineering Firm
• Operations and Maintenance (O & M) Agreement
    – between the Operations Contractor and the Project Company, obligates the Operator to
      operate and maintain the project
• Shareholders Agreement
    – governs the business relationship of the equity partners
• Inter-creditor Agreement
    – an agreement between lenders or class of lenders that describes the rights and obligations
      in the event of default.
• Supply Agreement
    – agreement between the supplier of a critical key input and the Project Company (e.g.
      agreement between a coal supplier and a power station)
• Purchase Agreement
    – agreement between the major user of the project output and the Project Company
    – agreement between a metropolitan council and a power station                            10
        Overview of Project Finance: Return Distribution

• Capital providers earn an appropriate risk-adjusted rate of return on a
  portfolio of investments by earning, either high rates of return on just a few
  investments, or low rates of return on many projects. The former
  corresponds to the venture capital (VC) industry, and the latter to PF.

• VC is used for intangible assets with significant return uncertainty and little
  residual value in the event of failure. Equity has an effective payoff structure
  because it allows investors to capture unlimited upside. In contrast, debt
  does not work for these high risk investments with positively skewed returns.
  In VC, managers are responsible for managing growth options and
  transforming a small amount of capital into large companies.

• In PF, managers are responsible for transforming a large amount of capital
  into something worth a little more. Project returns have a limited upside.
  This means that a large fraction of projects must be successful and
  generate positive returns for capital providers to earn proper returns.
       Overview of Project Finance: Return Distribution
• Projects are exposed to three types of risk:

 - Symmetric risks including: market risk (quantity), market risk (price), input
 or supply risk, exchange, interest and inflation rate risks, reserve risk,
 throughput risk. Exposures to symmetric risks causes larger positive and
 negative deviations from the expected outcome.

 - Asymmetric risks including: environmental risk, expropriation risk. These
 risks cause only negative deviations in the expected outcome.

 - Binary risks including: technology failure, full expropriation, counterparty
 failure, regulatory risk, force majeure…These risks increase the probability
 that an asset ends up worthless.

• In practice, projects have relatively low asset risk allowing a high debt
  capacity. The use of leverage introduces financial risk which allow equity-
  holders to capture unlimited upside once debt claims have been satisfied. 12
  Overview of Project Finance: Risk Management Matrix
Stage and Type of Risk     Who Bears the Risk
Pre Completion Risk

- Resource risk            Sponsors (suppliers)
- Force majeure            3rd party insurers
- Technological risk       Sponsors (contractors)
- Timing or delay risk     Sponsors (contractors)
- Completion risk          Sponsors (contractors)

Operating Risks

- Supply or input risk     Sponsors (suppliers)
- Throughput risk          Sponsors
- Force majeure            3rd party insurers
- Environmental risks      Sponsors
- Market risk: quantity    Sponsors (off-taker)
- Market risk: price       Sponsors (off-taker)

Overview of Project Finance: Risk Management Matrix

 Stage and Type of Risk       Who Bears the Risk
 Sovereign Risk

  Macroeconomic Risks
  - Exchange rates            Sponsors
  - Currency convertibility   Sponsors
  - Inflation                 Sponsors

 Political and Legal Risks
 - Expropriation              Sponsors
 - Diversion                  Sponsors
 - Changing legal rules       Sponsors
 Financial Risks

  - Funding risk              Sponsors
  - Interest-rate risk        Sponsors
  - debt service risk         Sponsors

         Overview of Project Finance:
    Comparison with Other Forms of Financing

Financing vehicle   Similarity            Dis-similarity

Secured debt        Collaterized with a   Recourse to
                    specific asset        corporate assets and
Subsidiary debt                           Possible recourse to
                                          corporate balance

Asset backed        Collateralized and    Hold financial, not
securities          non-recourse          single purpose
                                          industrial asset

LBO / MBO           High debt levels      No corporate sponsor

Venture backed      Concentrated equity   Lower debt levels;
companies           ownership             managers are equity
Lease                                     Recourse to the
                                          lessor                 15
                    Project Finance Statistics
• Historically project finance was used by private sector for industrial projects, such as
  mines, pipes, oil fields. In the early 70s, BP raised $945 million to develop the
  “Forties Field” in the North Sea.

• The beginning of modern project finance starts with the passage of the Public Utility
  Regulator Act in 1978 in the US to encourage investment in alternative non-fossil
  fuel energy generators.

• From early 1990s, private firms start financing a wide range of assets such as toll
  roads, power plants, telecommunications systems located in a wider range of

• Project sponsors have been pushing the boundaries of project finance for most of
  the last 15 years by increasing sovereign, market and technology risks.

• World Bank study: global investment in new infrastructure assets $369 billion per
  year from 2005-2010 with 63% in developing nations, e.g. Asia, Africa.
                     Project Finance Statistics
• Outstanding Statistics:

   – Over $408bn of capital expenditure using project finance in 2008.
   – US$67bn in US capital expenditures which is:
      • smaller than the US $645 billion investment grade corporate bonds market,
        $187 billion mortgage-backed security market, $160 billion asset-backed
        security market, and $387 billion tax-free municipal bond market (NB: these
        markets shrank significantly in 2008 from 2006 levels due to subprime crisis).
      • but larger than the $26bn IPO market and the $45bn venture capital market.

• Some major deals:

   –   US$10.65bn 2005 Qatargas 2 project (LNG production) – involved 57 lenders
   –   US$3.8bn 2006 Peru LNG plant
   –   US$3.7bn 2007 Madagascar Nickel-Cobalt Mining and Processing Project
   –   In Singapore, US$1.4bn Singapore Sports Hub
              Project Finance Statistics
       Total Project Finance Investm ent (US$m )


$400                                                    Overall 5-Year
$350                                                    CAGR of 19% for
                                                        private sector
$300                                                    investment.
$250                                                    Project Lending 5-
$200                                                    Year CAGR of


       2003    2004    2005   2006    2007   2008

Bank loans            Bonds          MLA/ BLA       Equity Finance    19
                   Project Finance Statistics
          Amount of Project Lending by Sector (US$m)

250                                                            Water & Sewage
150                                                            Telecom
100                                                            Leisure & Property
                                                               Oil & Gas
   0                                                           Transportation











• 34% of overall lending in Power Projects, 21% in Transportation.              22
                  Project Finance Statistics

  5-year CAGR in Project Lending by Sector
































• 5-Year CAGR for Power Projects: 30%, Oil & Gas:30%, Mining: 59% and
  Leisure & Property: 36%.                                              23
                        Project Finance Statistics

• Size distribution of projects:
  - 41% < $ 100 million, (7% of the total value of the PF market)
  - 19% > $500 million, (70% of the total value)
  - 8% > $1.0 billion, (55% of the total value)
  - mean size: $435 million, median size: $139 million

• Project duration:
  - Mean (median) construction years: 2.1 (2.0) years
  - Mean (median) concession contract: 28 (25) years
  - Mean (median) length of off-take agreements: 19 (20) years

• Project leverage: Mean (median) debt-to-capitalization ratios: 71% (76%)

• Maturity of debt instruments:
 -Median maturity of bank loans: 9.8 years
 - Median maturity of bonds: 11.6 years                                      24
Project Finance (PF) versus Corporate Finance (CF)
             PF versus CF: Rationale for Project Finance

Project finance allows firms:

• to minimize the net costs associated with market imperfections such as:

 - incentive conflicts,
 - asymmetric information,
 - financial distress,
 - transaction costs,
 - taxes.

• to manage risks more effectively and more efficiently.

          PF versus CF: Rationale for Project Finance
             Project Finance                              Corporate Finance

• Purpose: a single purpose capital            • A company invests in many projects
  asset, usually a long-term illiquid asset.     simultaneously.
  The project company is dissolved once
  the project is completed. No growth
                                               • The investment is financed as part of
• A legally independent project: The             the company’s existing balance sheet.
  project company does not have access           The lenders can rely on the cash flows
  to the internally-generated cash flows         and assets of the sponsor company
  of the sponsoring firm and vice versa.         apart from the project itself. Lenders
                                                 have a larger pool of cash flows from
• The investment is financed with non-           which to get paid. Cash flows and
  recourse debt. All the interest and            assets are cross-collateralized.
  loan repayments come from the cash
  flows generated from the project.

• Project companies have very high             • Publicly traded firms have typical
  leverage ratios, with the majority of          leverage ratios of 20% to 30%.
  debt coming from bank loans.
        PF versus CF: Rationale for Project Finance
• Modigliani and Miller show that corporate financing decisions do not affect firm value
  under perfect and efficient markets. The rise of project finance provides strong
  evidence that financing structures do matter.

• it is not clear why firms use project finance given that:

  - It takes longer and it costs more to structure a legally independent project
  company than to finance a similar asset as part of a corporate balance sheet.

  - Project debt is often more expensive (50 to 400 bps) than corporate debt due to its
  non-recourse nature (no benefit of co-insurance).

  - The combination of high leverage and extensive contracting restricts managerial
  discretion and managerial flexibility.

  - Project finance requires greater disclosure of proprietary information which can
  be costly from a competitive perspective.

  - It is harder to obtain operating synergies as the project is independent.

  - The likelihood of using interest tax shields and net operating losses is lower.
        PF versus CF: Rationale for Project Finance

• Financing decisions matter under imperfect/inefficient markets. Firms bear
  “deadweight costs” (DWC) when they invest in and finance new assets.

• DWCs result from market imperfections. They include:

 - agency costs and incentive conflicts
 - asymmetric information costs
 - financial distress costs
 - transaction costs
 - taxes

• DWCs change under alternative financing structures, i.e., corporate finance
  versus project finance.

• Sponsors should use project finance whenever the DWC are lower
  than their corporate finance counterparts.
       PF versus CF: Rationale for Project Finance

• Project finance reduces costly agency conflicts:

 - Conflicts between ownership and control
 - Conflicts between ownership and related parties
 - Conflicts between ownership and debtholders

• Project finance reduces information costs (asymmetric information).

• Project finance reduces costly underinvestment, in particular leverage-
  Induced underinvestment.

• Project finance, as a organizational risk management tool, reduces the
  potential collateral damage that a high risk project can impose on a
  sponsoring firm, i.e., risk contamination. It also reduces the costs of
  financial distress and solves a potential underinvestment problem.
Project Finance versus Corporate Finance
       Resolution of Agency Conflicts between Ownership and Control
 Agency Conflicts between Ownership and Control
• Costly agency conflicts arise when managers who control investment
  decisions and cash flows have different incentives from capital providers.

• Certain asset characteristics make assets prone to costly agency conflicts:
  Tangible assets that generate high operating margins and significant
  amounts of cash flow can lead to:

        - inefficient investment
        - excessive perquisite consumption
         - value destruction

Ex: The agency costs of free cash flows are higher in cement than in drugs.

• Solving the problem of ownership and control is important in project
  companies where few of the traditional sources of discipline are present or
Agency Conflicts between Ownership and Control

Corporate Finance                        Project Finance

• Company invests in many projects       • Project company is dissolved once
  and possesses many growth                the project gets completed. No
  opportunities.                           future growth opportunities.

• Cash flow separation is difficult to   • Cash flows of the project are
  accomplish in corporate finance.         separated from     cash flows of
  Project cash flows are co-mingled        sponsors. The single discrete
  with the cash flows from other           project enable lenders to easily
  assets making monitoring of cash         monitor project cash flows.
  flows difficult.
                                         • The verifiability of CFs is
• The verifiability of cash flows is       enhanced by the waterfall contract
  difficult.                               that specifies how project CFs are
                                           used.                           33
Agency Conflicts between Ownership and Control
Corporate Finance                                 Project finance

 Traditional monitoring mechanisms include:        Monitoring mechanisms include:

• Takeover market                                 • Managerial discretion is constrained by
                                                    extensive contracting. Claims on cash flows
                                                    are prioritized through the CF waterfall.
• Product market

                                                  • Concentrated equity ownership provides
• Reputation                                        critical monitoring, The unique board of
                                                    directors and separate legal incorporation
• Staged investment                                 makes monitoring more simple and efficient.

• Staged financing                                • High leverage both the amount and type
                                                    (maturity…);  Bank loans provide credit
• Leverage: high debt service forces
  managers to disgorge free cash flows.
                                                  • Senior bank debt disgorges cash in early
• Creditors rights: lenders threat to seize
  collateral and threat of liquidation to deter                                                34
  borrowers’ opportunism.
 Agency Conflicts between Ownership and Control
From a sample of 6045 project loans (provided to project companies and
 corporations) from 40 countries originated between 1993 and 2003:

• PF is much less likely in the US (19%) than in the rest of the world (53%)
  and in English and Scandinavian legal origin countries than in French or
  German legal origins. Why?
• PF is more likely in countries with weak protection against managerial self-
• In countries that provide weak protection to minority investors against
  expropriation by insiders, PF is relatively more likely than CF in industries
  where free cash flows to assets is higher.
• In countries that provide stronger protection to creditors, the effects of
  weaker protection against managerial self-dealing in encouraging PF is
• Large deadweight costs incurred in bankruptcy increase the likelihood of
  PF as bankruptcy costs are lower in PF than in CF. PF is less likely when
  the bankruptcy process is more efficient.                                  35
Project Finance versus Corporate Finance
   Resolution of Agency Conflicts between Ownership and Related Parties
  Agency Conflicts between Ownership and Related Parties

Problem (Hold Up)

A second type of agency conflict is the opportunistic behavior by related parties, causing ex-
 ante reduction in expected returns and ex-ante incentives to invest. The most common
 culprits are related parties that supply critical inputs, buy primary outputs, and host nations
 that supply the legal system and contractual enforcement.

Standard Approach

• Vertical integration (not always possible or desirable).

• Long term contracts, with contract duration increasing with asset specificity.
Project Finance Approach

• Joint ownership that allocate the residual cash flow rights and asset control rights
  among the deal participants.

• High debt level. With high leverage, small attempts to appropriate value will result
• In costly default and possibly a change in control.
  Agency Conflicts between Ownership and Related Parties

Problem (Expropriation)

Opportunistic behavior by host governments. They provide a critical input, the legal system
 and the protection of property rights. Either direct through asset seizure or creeping
 through increased tax/royalty. This causes an ex-ante increase in risk and required return.

Standard Approach

• Visibility/reputation
• High leverage.

Project Finance Approach

• High leverage to discourage expropriation (excess cash is disgorged, lower profits
  and less visibility).
• Multilateral lenders’ involvement as a deterrent against expropriation.
• Joint ownership.
Project Finance versus Corporate Finance
    Resolution of Agency Conflicts between Ownership and Debtholders
   Agency Conflicts between Ownership and Debtholders
• Debt/Equity holder conflict in distribution of cash flows, re-investment and restructuring
  during distress. High leverage can lead to risk shifting and underinvestment.

Standard Approach
• Strong debt covenants allow both equity/debt holders to better monitor management.

 Project Finance Approach

 • Cash flow waterfall reduces managerial discretion and thus potential conflicts
 • Concentrated ownership ensures close monitoring and adherence to the prescribed rules.
 • To facilitate restructuring, concentrated debt ownership, less classes of debtors, and bank
   debt, are preferred. Bank debt is much easier to restructure than bonds.
 • With few growth options, the opportunity cost of underinvestment due to leverage is
   negligible in project companies.
 • Opportunities for risk shifting do not exist because the cash flow waterfall restrict
   investment decisions.                                                                  41
Project Finance versus Corporate Finance

          Decrease in Asymmetric Information Costs
              Decrease in Asymmetric Information Costs
• .Insiders know more about the value of assets in place and growth opportunities than
  outsiders. Asymmetric information increases monitoring costs and increases cost of
  capital (equity is more costly than debt).
Standard Approach
• Disclosure.
• Analyst-relationship.
• Institutional shareholder, activist game.
• Signaling
Project Finance Approach
• Segregated cash flows enhance transparency, which decreases monitoring costs.

• Segregation eliminates the need to analyze other corporate assets or cash flows.
  Creditors can analyze the project on a stand-alone basis.

• Project structure reserves the sponsors’ debt capacity/ flexibility to fund higher risk
  projects internally
Project Finance versus Corporate Finance
           Resolution of Under-Investment problem
            Resolution of Under-Investment Problem
• Debt Overhang: Firms with high leverage, risk averse managers and
  asymmetric information have trouble financing attractive investment
  opportunities. This leads to under investment in positive NPV projects due
  to limited corporate debt capacity as new debt is limited by covenants.

• Standard Approach: Use of secured debt, senior bank debt, new equity
  (raised at a discount).

• Project Finance Approach

 - Non recourse debt in an independent entity allocates returns to new capital
 providers without any claims on the sponsor’s balance sheet. This
 preserves scarce corporate debt capacity and allows the firm to borrow
 more cheaply than it otherwise would.

 - Project finance is more effective than secured debt because it eliminates
 recourse back to the sponsoring firm.
Project Finance versus Corporate Finance

        Project Finance as an Organizational Risk Management Tool
Project Finance as an Organizational Risk Management Tool
• A high risk project can potentially drag a healthy corporation into distress. Short of actual
  failure, the risky project can increase cash flow volatility, the expected costs of financial
  distress, and reduce firm value. Conversely, a failing corporation can drag a healthy
  project along with it.
Standard Approach
• Hedging, or foregoing the project (under-investment)

 Project Finance Approach
 • Project financed investment exposes the corporation to losses only to the extent of its
   equity commitment, thereby reducing its distress costs.

 • Through project financing, sponsors can share project risk with other sponsors. Pooling of
   capital reduces each provider’s distress cost due to the relatively smaller size of the
   investment and therefore the overall distress costs are reduced.
 • PF adds value by reducing the probability of distress at the sponsor level and by reducing
   the costs of distress at the project level. This facilitates the use of high leverage.  47
Project Finance as an Organizational Risk Management Tool

  Risky projects impose deadweight costs on sponsors. Costs of financial
   distress represent a low of 3% up to 10-20% of firm value. They include
   both direct costs, such as legal expenses, bankers’ fees and indirect
   costs such as:

   - Underinvestment by the sponsor.

   - Underinvestment by related parties as distress may deter business
   partners, from making long-term investments.

   - Lost sales as distress may discourage customers.

   -Lost interest tax shield as volatility increases the probability of generating

   - Human capital
Project Finance as an Organizational Risk Management Tool

  • If a firm uses corporate finance, it becomes vulnerable to risk
    contamination, the possibility that a poor outcome for the project causes
    financial distress for the parent. This cost is offset by the benefit of co-
    insurance whereby project cash flows prevent the parent from defaulting.

  • From the parent corporation perspective, corporate finance is preferred
    when the benefits of co-insurance exceed the risk of contamination and
    vice versa.

  • Project finance is more likely when projects are large compared to the
    sponsor, have greater total risk and have high positively correlated cash

Project Finance as an Organizational Risk Management Tool

   Risk (variance) is a proxy fro distress costs and the probability of risk
   contamination. Combined cash flow variance (of project and sponsor) with
   joint financing increase with:
        –Relative size of the project.
        –Project risk.
        –Positive Cash flow correlation between sponsor and project.

    Firm value decreases due to cost of financial distress which increases with combined

Project finance is preferred when joint financing (corporate finance) results in increased
combined variance.

Corporate finance is preferred when it results in lower combined variance due to             50
diversification (co-insurance).
Project Finance as an Organizational Risk Management Tool

 Corporate-financed investment involves the combination of 2 risky assets:
 Sponsor (S) + Project (P)
 Total Risk = Variance of Combined returns
 Compare Risk with and without investment: Var(RP+RS) vs. Var(RS)

 Portfolio Theory tells us:
          Var(RP+RS) = wP2Var(RP)+ wS2Var(RS)+ 2wPwSCorr(RP+RS)σPσS

 wP ,wS = proportion of value in the project/sponsor
 Var(RP), Var(RS) = variance of project/sponsor returns
 σP ,σS = standard deviation of project/sponsor returns
 Corr(RP ,RS) = correlation of returns
Project Finance as an Organizational Risk Management Tool

 Financial Distress is costly :

 Expected costs of financial distress = Prob(distress)*Cost of Distress

 Probability(distress) is related to Total Risk, leverage and asset/,liability matching

 Total Risk is a function of Risk Contamination.

 So what factors matter the most for Risk Contamination?

  Relative Size = Project/(Project + Sponsor)

  Project Risk = Var(RP)

  Return Correlation = Corr(RP,RS)

   Project Finance as an Organizational Risk Management Tool
     Impact of Project Size on Total Risk (Project Risk = 50%)

Return        Big Project
Variance      (wP = 50%)

                   Medium Project
                    (wP = 33%)

                                                               Sponsor Stand-Alone
    20%                                                        Return Variance = 20%

                                                                          Small Project
                                                                           (wP = 5%)

     1.0                                                                      -1.0
                  Correlation of Sponsor and Project Returns
   Project Finance as a n Organizational Risk Management Tool
     Impact of Project Size on Total Risk (Project Risk = 33%)

Variance       High Risk
              (VarP = 50%)

                                                                Sponsor Stand-Alone
    20%                         Medium Risk                     Return Variance = 20%
                                (VarP = 20%)

                                                                                 Low Risk
                                                                                (VarP = 10%)
     1.0                                                                       -1.0
                   Correlation of Sponsor and Project Returns
Project Finance as an Organizational Risk Management Tool

• Usually diversification is beneficial. Here, diversification (corporate finance)
  can be worth less than specialization (project finance).

• If corporate-financed investment causes total risk, and hence costs of
  financial distress to increase enough, PF may reduces the incremental costs
  of financial distress by isolating and containing project risk.

  - For project finance to make sense, the reduction in the costs of financial
  distress must exceed the incremental transaction costs .

  - Project finance lowers the net costs of financing certain assets. Large,
  tangible, risky assets make the best candidates for project finance,
  particularly when they have returns that are positively correlated with the
  sponsors existing assets.
Project Finance as an Organizational Risk Management Tool
  Consider a riskless sponsor. Its assets are worth 100 in all states of the world
   and it is financed with 30 of riskless debt. It has the opportunity to invest in a
   0 NPV, risky project worth 200 in the good state and 0 in the bad state and
   is financed with 85 of (junior) debt. Assume that with the possibility of
   default, the costs of financial distressed imposed on the sponsors existing
   assets are equal to 5. The manager’s job is to decide whether to invest
   using corporate finance, invest using project finance, or not at all.
   - a one period model
   - the good and the bad states are equally probable
   - the risk-free rate is 0
   - the manager is risk-neutral
   - the organizational form does not affect operating synergies
   - no structuring costs
   - no relation between project structure and project cash flows                  56
Project Finance as an Organizational Risk Management Tool


  • No investment: The sponsor is worth 100, the debt is worth its face value
    of 30 and the equity is worth 70. There is no possibility of default.

  • Corporate financed investment: Assets are reduced by 5 in both states of
    the world. The new debt-holders invest only 75 for the project and equity-
    holders the remaining 25. Equity is worth 65 (=90-25). The equity-holders
    bear the distress costs. Managers acting on behalf on existing shareholders
    would not make the investment.

  • Project-financed investment: The sponsor raises 42.5 of new project debt
    and invests 57.5 into the project. Default is contained at the project level and
    there is no collateral damage inflicted at the sponsor level. The sponsor
    does not incur incremental distress costs.
Project Finance Versus Corporate Finance
             Project Finance as Insurance
                  Project Finance as Insurance

Compare the choice faced by sponsors between corporate finance and
 project finance:

• When sponsors use corporate finance, they expose themselves to the full
  range of outcomes (NPVs).

• When sponsors use project finance, they truncate the downside. The
  decision to use project finance can be thought of as the decision to buy a
  “walkaway” put option on the project. The combination of holding an
  underlying asset (project) and buying a put option on that asset gives the
  payoff function of a call option.

The downside protection may be valuable but the choice between corporate
 finance and project finance depends on the put premium and the willingness
 of sponsors to exercise the put option.
                 Project Finance as Insurance
Payoffs to Project-Financed vs.Corporate Financed Investment

        Sponsor          Corporate
       Equity Value       Finance

  $0                                              Project Value

                                     Walkaway Put Option
Project Finance versus Corporate Finance
       Tax and Other Benefits of project Finance
               Taxes, Location, Heterogenous Partners
• Tax: An independent economic entity allows projects to obtain tax benefits that are not
  available to the sponsors. When a project is located in a high-tax country and the project
  company in a lower tax country, it may be beneficial for the sponsor to locate the debt in
  the high tax country.

• Location: Large projects in emerging markets cannot be financed by local equity due to
  supply constraints. Investment specific equity from foreign investors is either hard to get
  or expensive. Debt is the only option and project finance is the optimal structure.

 • Heterogeneous partners:

     – Financially weak partner needs project finance to participate.

     – Financially weak partner if using corporate finance can be seen as free-riding.

     – The bigger partner is better equipped to negotiate terms with banks than the smaller
       partner and hence has to participate in project finance.
Part 4
Leverage and Financing Issues
                    Leverage and Financing Issues

Debt offers multiple benefits:

• Tax Advantages.

• Helps to solve Free Cash Flow Problem.

• Helps to solve Political Problem (Hold Up)

There are lower bankruptcy costs than in corporate finance (large tangible assets).

Leverage and Financing Issues: How to Finance the Project:
 • Bank Loans:
   – Advantages
     •   Cheaper to issue.
     •   Concentrated ownership makes it easier for lending.
     •   Tighter covenants and better monitoring.
     •   Easier to restructure during distress.
     •   Lower duration forces managers to disgorge cash early.
     •   Bond market may be fickle.
     •   Draw on credit line as needed.

   – Disadvantages
     •   Short maturity.
     •   Restrictive Covenants.
     •   Variable interest rates.
     •   Limited size.
Leverage and Financing Issues: How to Finance the Project
Project Bonds (144A Market):
   – Advantages
      •   Private placement: does not through SEC registration procedure.
      •   Lower interest rates (given good credit rating).
      •   Less and flexible covenants.
      •   Long Maturity.
      •   Fixed rates.
      •   Size, ($US 100-200 million).
      •   Secondary trading.

   – Disadvantages
      • Disperse ownership:
          – less monitoring
          – less efficient negotiations
      • New market
      • Lump sum nature
          – Negative carry
      • Markets can change at any time making issuance difficult            67
      • Bond need investment grade rating
Leverage and Financing Issues: How to Finance the Project

  Project Bonds

  • Project bonds have “negotiated” ratings: sponsors adjust leverage,
    covenants and deal structure until the projects achieve an investment-grade

  • The largest advantage in pricing and liquidity occurs above the BBB- cutoff
    due to institutional restrictions against investment in sub-investment grade
    securities. Bonds must have an investment grade to sell in the market.

  • Since 1998, the percentage of project bonds with an investment grade
    (BBB- or higher) has ranged from 63% to 67%.

Leverage and Financing Issues: How to finance the project
• Agency Loans:
  – Advantages
     • Reduce expropriation risk.
     • Validate social aspects of the project.
     • Reduce political risk
        – countries less likely to want to injure multilateral agency.
     • Provide political risk insurance
        – Overseas Private Investment Corporation (OPIC) in U.S.
        – Multilateral Investment Guarantee Agency (MIGA) of World Bank
            » provide insurance against political risks for up to 20 years.
  – Disadvantages
     • Cost (300 bp)
     • Time (12-18 months to arrange)

• Insider debt:
  – Reduce information asymmetry for future capital providers.                69
              Conclusion: Future of Project Finance

The future of PF will be shaped by many factors:

• Financing structure: There are four specific financing trends:
  - hybrid project-corporate financings (corporate debt structure with project-
  finance-like covenants, with recourse to the sponsors in the event of default
  unless default is due to political risk); portfolio financing, i.e., the bundling of
  multiple projects into a single transaction.

 - use of Term B loans, a bond with back-end amortization with bank-type
 covenants, heavily collateralized and carrying high interest rates.

 - use of monoline bonds, bonds that wrap the credit rating of the insurer
 around the debt issue to raise the credit rating to AAA.

 - participation of private equity, purchasing both non-distressed and
 distressed assets.                                                 71
             Conclusion: Future of Project Finance

• Regulatory and environmental policy:

 - new international capital standards (Basel II), risk-weighting of project
  - management of environmental and social risks (Equator Principles)
 whose focus is to assess and minimize the social risks of large projects.

• Expropriation risk has risen especially in developing countries; sponsors
  are increasingly challenged to design and implement sustainable long-term
  contracts and agreements with governments or face the risk of

• Valuation of infrastructure assets with the infrastructure sector in danger of
  suffering from the dual curse of over-valuation and excessive leverage, the
  classic symptoms of an asset bubble.
Project Finance versus Corporate Finance: An example
                        Example: BP AMOCO
                    The Corporate Finance Model
                                                                      Long-term Financing:
                            BP Amoco                                  • Bonds
                                                                      • Equity

                                                                      Short-term Financing:
                                                                      • Commercial paper
                                                                      • Bank loans
            Business                           Treasury
             Units                              Group                  Cash Management
                            Cash Flow                                  and Money Market

                                    40% of
                                   Cash Flow

               $250m                                         $350m
Partner A                          Project                            Partner B
25% share        25% of
                               Cost = $1 billion           35% of
                                                                      35% share
                Cash Flow                                 Cash Flow
                                 Example:BP AMOCO
                               The Project Finance Model
                                                                                  BP Amoco

Partner A                  Partner B
25% share                  35% share                            Treasury Group
                                                                                                Business Units
                                                                  (40% share)

                      $140 million
                        equity                   $160 million
                                                                           40% of operating
            $100 million                                                      cash flow

                                                                                 $300 million
               $300 million                                                      secured loan
               secured loan                      Project                                           144A Bond
Banks                                        Cost = $1 billion                                       Market
                                           Equity = $400 million
                                           Debt = $600 million              payback+ Interest

        Contractors                  Suppliers           Government                 International Org.
                     Alternative Sources of Risk Mitigation

                  Risk                                   Solution

Completion Risk                    Contractual guarantees from manufacturer, selecting
                                   vendors of repute.

Price Risk                         Hedging

Resource Risk                      Keeping adequate cushion in assessment.

Operating Risk                     Making provisions, insurance.

Environmental Risk                 Insurance

Technology Risk                    Expert evaluation and retention accounts.

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