Description
Finance is the study of funds management, or the allocation of assets and liabilities over time under conditions of certainty and uncertainty.
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A REPORT ON PROJECT FINANCING
PROJECT GUIDE : Prof. Mrs. Vrinda Kamat
SUBMITTED BY : Deven Nadkarni MFM III B Roll No. 106
Narsee Monjee Institute of Management Studies
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TABLE OF CONTENTS
1. 2. 3. 4. 5. 6. 7. 8. 9.
Introduction System of Project Financing Project Viability Project Financing Risks and their Allocation Security Arrangements Legal Structure Sources of Funds Conclusion and Future Prospects Case Study
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CHAPTER 1: INTRODUCTION
1.1 Role of Infrastructure in Development It is now well recognized that a country’s development is strongly linked to its infrastructure strength. Infrastructure helps determine a country’s ability to expand trade, cope with population growth, reduce poverty and a host of other factors that define economic and human development. Good infrastructure raises productivity and lowers production cost, but must also expand fast enough to accommodate growth. The precise links between infrastructure and development have been subject to extensive debate. The link between infrastructure and economic growth has been studied extensively in literature, the World Bank report (1994) of the World Bank for instance. The results show that infrastructure development can have a significant impact on the economic growth. For low-income countries basic infrastructure such as water, irrigation and to a lesser extent transportation are more important. As the economies mature into a middle-income category, their share of power and telecommunications in the infrastructure and investment increases. An estimate however shows that a 1% increase in infrastructure stock* is positively associated with a corresponding growth in GDP across countries. Infrastructure is a necessary but not a sufficient condition for growth. Adequate complements of other resources must be present as well. In developing countries like India, infrastructure development and financing has largely been the prerogative of the government. Since infrastructure is typically a natural monopoly, the government considered it necessary to keep control of the same, in public interest. The success and failure of infrastructure to meet the needs of the people is largely a story of the government’s performance.
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In the case of India, the government has taken great strides in improving the infrastructure stock of the nation since independence. However, when compared to developed countries we still have a long way to go. For instance, per capita power consumption in India is a meagre 282 KWH compared to 18,117 KWH for Canada. The situation has worsened in the 90’s with frequent revisions being made to the eighth plan document owing to the government’s inability to bear the cost of infrastructure anymore. The simple truth is that public money is no longer sufficient to meet the burgeoning needs of the nation in line with its economic aspirations. Reluctantly, therefore the government has to throw open the doors to private participation in infrastructure.
1.2 Impact of Infrastructure on External Trade and Production Reliable and adequate quantity of infrastructure is a key factor in the ability of countries to compete globally. In particular, the competition for new export markets is specially dependant on high quality infrastructure. According to studies, increased globalisation of the world trade has been not only due to the liberalization of trade policy but also due to the major advances in the communication, transport and technologies. There is an increasing trend not only in terms of greater globalisation of trade but also in terms of globalization of production. It is possible for companies located in different parts of the globe to produce components. In the recent years India has been used as a base for sourcing by a host of companies such as Sony, Toyota, ABB and the like for their raw materials as well as for components. To be able to fulfil the requirements of sourcing MNCs worldclass infrastructure facilities including appropriate logistical support and multi-modal transport facilities are essential. *1infrastructure is taken to include road, rails, power, irrigation and telephones *2world Development Report 1994,p2.
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Infrastructure faculties are critical for the modernization and diversification of production. A good system of EDI involving telecommunications and In addition to computer networking is essential for efficient operations.
sourcing, off shore software design, engineering and development is possible, thanks to the advances made in the global market. Thus developing countries can leap frog into hi-tech areas with the help of good infrastructure facilities. 1.3 Public Sector in Infrastructure Development Infrastructure represents a strong public interest and so mer5its the attention of the government. The dominant role, that the public sector has assumed in the infrastructure • • • Recognition of the economic importance of infrastructure Belief that the problems with supply and technology require highly active intervention by the government. Faith that the government could succeed where markets appear to fail
There is enough evidence to show that, despite significant growth in a number of developing countries infrastructure facilities have fallen far short of the requirements, Though each sector has special problems, there are common patterns in the provision of infrastructure services and shortcomings such as: • • • • • Operational deficiencies Inadequate maintenance Extensive dependence on fiscal resources Lack of responsiveness to the needs Limited benefits to the poor
1.4 Need for Increasing the Role of the Private Sector In the mid 1980s evidence emerged in several countries that infrastructure services were not meeting the demand. Many governments have realized that the traditional state owned utility approach is no longer adequate. Although
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circumstances have varied across countries and sectors, the shift towards greater private involvement has been driven by the need to provide better services to more people at a lower cost. The main reason for a shift towar4ds private infrastructure is the growing dissatisfaction with the public ownership monopoly and provision of infrastructure facilities. Under-investment by many state utilities has resulted in a back-log of unmet demand for infrastructure services: in many countries this is the principal constraint to growth. Power shortages have led to a shortfall in production, higher costs and a decline in investment. Similarly limited availability and the poor quality of telecommunications have made it difficult for business in many developing countries to participate in the new international information based economy, Fiscal constraints faced by the governments and technological developments are other factors which have favoured increased private participation Technology developments have reduced the natural monopoly characteristics that have allowed unbinding private entry and competition into many infrast5ructure services. • • • • Technology developments in many cases have helped to create more competitive pressures. For example: Containerization has facilitated competition in port services. Falling costs of wireless telecommunications have enabled small operators to compete with wire-based networks. Independent power producers can construct and operate relatively small plants at unit costs comparable to the large generators Contract based relationships (eg. Build-Operate-transfer, Build-ownOperate, Concessions) have allowed private entry even within the existing regulatory network but with minor modifications. Also, the private sector entry often sets up a pressure for further regulatory changes and sometimes competition may mitigate the need for close regulation.
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1.5 Financing Infrastructure. Private financing is expected to ease the burden of infrastructure borne b the government. More importantly it will encourage better risk sharing, accountability and management in infrastructure provision. The task for the future is to channel private savings directly to private risk bearers who make long term investments in institutions and financing instruments adapted to the needs of different investors in different projects. Unless these financing needs can be met the country will gain precious little from privatising infrastructure.
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CHAPTER 2: SYSTEM OF PROJECT FINANCING
There is a growing realisation in many developing countries of the limitations of governmentsin a manging and financing economic activiteies, particularly large infrastructure projects. Provision of infrastructure facilities, traditionally in the government domain, is now being offered for private sectore investments and management. This trend has been reinforced by the resource crunch faced by many governments. specific domestic markets. In project financing the project, its assets, contracts, inherent economic and cash flows are separated from their promoters or sponsors in order to permit credit appraisal and loan to the project, independent of the sponsors. The assets of the specific project serve as a collateral for the loan, and all loan repayments are made out of the cash of the project. In this sense, the loan is said to be of non-resource to the sponsor. Thus, project financing may be defined as the scheme of ‘financing of a particular economic unit in which l lender is satisfied in looking at the cash flows and the earnings of that economic unit as a source of funds, from which a loan can be repaid, and to the assets of the economic unit as a collateral forte the loan’*2. In the past, project financing was mostly used in oil exploration and other mineral extraction through joint ventures with foreign firms. The most recent use of project financing can be found in infrastructure projects, particularly in power a telecommunication projects. *2Nevitt, P.K., Project Financing, Euro money Publications, 1983. Project financing is made possible by combining undertakings and various kinds of guarantees by parties who are interested in a project. It is built in such a way that no one party alone has to assume the full credit responsibility Infrastructure projects are usually characterised by large investments long gestation periods, and very
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of the project.
When all the undertakings are combined and reviewed
together, it results in an equivalent of the satisfactory credit risk for the lenders. It is often suggested that the project financing enables a parent company to obtain inexpensive loans without having to bear all the risks of the project. This is not true, in practice, the parent company is affected by the actual plight of the project, and the interests on the project loan depends on the parents stake in the project.1* 1*Breaket, R.A. and Myers, S.C. Principles of Corporate Finance, fourth Ed. McGraw Hill,pp.608-612. The traditional form of financing is the corporate financing or the balance sheet financing. In this case, although financing is apparently for a project, the lender looks at the cast flows and assets of the whole company in order to service the debt and provide security. Figure 30.3 shows the basic differences between balance sheet financing and project financing.
Balance sheet financing
Project Financing
Lender
Lender
Project Sponsor
Project Sponsor
Equity Equity Loan Owns Project Assets Owns Project Assets Special Project Entry
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The following are the characteristics of project financing: • • • • • • A separate project entity is created that receives loans from lenders and equity from sponsors. The component of debt is very high in project financing. project financing is a highly leveraged financing. The project funding and all its other cash flows are separated from the parent company’s balance sheet. Debt services and repayments entirely depend on the project’s cash flows. Project assets are used as collateral for loan repayments. Project financers’ risks are not entirely covered by the sponsor’s guarantees. Third parties like suppliers, customers, government and sponsors commit to share the risk of the project. Project financing is most appropriate for those projects, which require large amount of capital expenditure and involve high risk. It is used by companies to reduce their own risk by allocating the risk to a number of parties. It allows sponsors to: • • • Finance large projects than the company’s credit and financial capability would permit. Insulate the company’s balance sheet from the impact of the project. Use high degree of leverage to benefit the equity owners. Thus,
Project Financing Arrangements The project financing arrangements may range from simple conventional type of loans to more complex arrangements like the build-own-operate-transfer (BOOT). The typical arrangements, particularly in the power sector, include: 1. ‘The build-own-operate-transfer (BOOT) structure 2. The build-own-operate (BOO) structure 3. The build-lease-transfer (BLT) structure
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The Build-Own-Operate-Transfer (BOOT) Arrangement The build-own-operate-transfer (BOOT) is essentially an extension of the project-financing concept. It is a special financing scheme, which is designed to attract private participation in financing constructing and operating infrastructure projects. In BOOT scheme, a private project company builds a project, operates it for a sufficient period of time to earn an adequate return on investment, and then transfers it to the host government or its agency. Quite often, the value of efficiency gain from private participation can outweigh the extra cost of borrowing through a BOOT project, relative to direct government borrowing*1. *1World Bank, World Development Report 1994 BOOT projects can be either solicited or unsolicited. When proposals are solicited, the project is identified and formulated by the government and the private sector is invited to submit unsolicited proposals on their own accord. The private group usually consists of international construction contractors, heavy equipment suppliers, and plant and system operators along with local partners. BOOT projects have been implemented or a rein the process of being implemented in many developing countries. Power and roads are the two sectors with the largest number of projects. BOOT projects have also been implemented for ports and mass transit and rail. There have been only a few BOOT projects in the telecommunication se tore in Thailand Indonesia. According to a recent World Bank study, the reason why BOOT schemes have not been p0opulare in the telecommunication sector its he potential complexity associated with co-ordinating the BOOOT operator’s distribution networks with those of the state-owned incumbent, Issues involving interconnections, sharing of ducts, maintenance and new investments, all must be resolved. These factors tend to increase risks for investors, make management co-ordination harder, and raise the questions for investors as to whether the will have adequate control over the facilities in which they have invested to achieve appropriate levels of productivity.
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*1Smith, P.L. and Staple. G. Telecommunication Sector Reform in Asia: Towards a New Pragmatism, World Bank, Discussion Paper No. 232, the World Bank, 1994. The Build-Own-Operate (BOO) Arrangement The issue of “transfer”(the T in BOOT projects) is ambiguus because most of the BOOT projects under operation or consideration have the transfer dates quite far away and, therefore, they are not a real concern as yet. One problem with the transfer provision is the likelihood of the capital stock of the project being run down as the date of transfer draws bearer.
Lenders Contractor Loan Debt Service Fuel Equity Investors Return on Equity Ownership Payment
Electricity Supply Company
Owner
Transport Operation & Maintenance Payment Land Lease
Power Plant KW Hrs
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BOOT/BOO structure of power plant This may take place in spite of legal agreements, which includes inspection plans and other such measures. In any case, there does not seem to be any rationale for such a transfer if the very basis of the projects was to run it outside the public sector. One alternative to transfer that has been suggested is for the foreign shareholders to divest themselves of their equity either entirely or up to some negotiated percentage at the end of the stipulated time period. Such an arrangement is generally referred to as the build-operate-own (BOO) arrangement. In BOO arrangement, projects are funded without any direct sovereign guarantee. Thus, it implies limited recourse financing. Unlike in BOOT arrangements, in BOO structure, the project is not transferred to the host government, rather the owner will divest his stake and seek investment =s from investors in the capital markets. This facilitates the availability of finances. BOOT and BOO arrangements are essentially similar except thT IN boo arrangement the sponsor preserves the ownership.
Build-Lease-Transfer arrangement In the build lease transfer arrangement, the control of the project is transferred from the project owners to a lease. The shareholders retain the full ownership of the project, but, for operation purposes, they lease it to a lessee. The host government agrees with the lessee to buy the output or service of the project. The lessor receives the lease rental guaranteed by the host government.
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CHAPTER 3: PROJECT VIABILITY Investors are concerned about all the risks a project involves, who will bear each of them, and whether their returns will be adequate to compensate them for the risks they are being asked to bear. Both the sponsors and their adviser must be thoroughly familiar with the technical aspects of the project and the risks involved, and they must independently evaluate a projects economics and its ability to service project related borrowings. Technical Feasibility: Prior to the start of construction, the project sponsors must undertake extensive engineering work to verify the technological processes and design of the proposed facility. If the project requires new or unproven technology, test facilities or a pilot plant will normally have to be constructed to test the feasibility of the process involved and to optimise the design of full scale facilities. A well-executed design will accommodate future expansion of the project; often, expansion beyond the initial operating capacity is planned at the outset. Rhe related capital cost and the impact of project expansion on operating efficiency are then reflected in the original design specifications and financial projections. Project Construction Cost The detailed engineering and design work provides the basis for estimating the construction costs for the project. Construction costs should in clued the cost of all facilities necessary for the project’s operation as a freestanding entity. Construction costs should include contingency factor adequate to cover possible design errors or unforeseen costs. Project sponsors or their advisers generally prepare a time schedule detailing the activities that must be accomplished before and during the construction period. A quarterly breakdown of capital expenditures normally accompanies the time schedule. The time schedule specifies (1) time expected to be required to obtain regulatory or environmental approvals and permits for construction. (2) The
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procurement lead time anticipated for major pieces of equipment and (3) the time expected to be required fro pre-construction activities- performing detailed design work, ordering the equipment and building materials, preparing the site and hiring the necessary manpower. The project sponsor examines the critical path of the construction schedule to determine where the risk of delay is greatest and then assesses the potential financial impact of any projected delay. Economic Viability The critical issue concerning economic viability is whether the project’s expected net present value is positive. It will be positive only if the expected present value of the future free cash flows exceeds the expected present value of the project’s construction costs. All the factors that can affect project cash flows are important in making this determination. Assuming that the project is completed on schedule and within budget, its economic viability will depend primarily on the marketability of the projects output (price and volume). To evaluate marketability, the sponsors arrange for a study of projected supply and demand conditions over the expected life of the project. The marketing study is designed to confirm that, under a reasonable set of economic assumptions, demand will be sufficient to absorb the planned output of the project at a price that will cover the full cost of production, enable the project to service its debt, and provide an acceptable rate of return to equity investors. The marketing study generally includes 1) a review of competitive products and their relative cost of production; 2) an analysis of the expected life cycle for project output, expected sales volume, and projected prices; and 3) an analysis of the potential impact of technological obsolescence. The study is usually performed by an independent firm of experts. If the project will operate within a regulated industry, the potential impact of regulatory decisions on production levels and prices—and, ultimately, on the profitability of the project –must also be considered.
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The cost of production will affect the pricing of the project output. Projections of operating costs are prepared after project design work has been completed. Each cost element, such as raw materials, labor, overhead, taxes, royalties, and maintenance expense, must be identified and quantified. Typically, this estimation is accomplished by dividing the cost element into fixed and variable cost components and estimating each category separately. Each operating cost element should be escalated over the term of the projections at a rate that reflects the anticipated rate of inflation. From a financing standpoint, it is important to assess the reasonableness of the cost estimates and the extent to which the pricing, and hence the marketability, of the project output is likely to be affected by estimated cost inflation rates. In addition to operating costs, the project’s cost of capital must be determined. The financial adviser typically is responsible for this task. He develops and tests various financing plans for the project in order to arrive at an optimal financing plan that is consistent with the business objectives of the project sponsor. Adequacy of raw material supplies: The project should have sufficient supplies of raw materials to enable it to operate at design capacity over the term of the debt. Independent consultants mat be summoned to evaluate the quantity, grade, and rate of extraction that the mineral reserves available to the project are capable of supporting. The project should have the ability to access the nerves of raw materials through contractual agreements like direct ownership, lease, purchase agreement etc. Creditworthiness: A project has no operating history at the time of its initial debt financing. Consequently, the amount of debt the project can raise is a function of the project’s expected capacity to service debt from project cash flow- or more simply, its credit strength. A project’s credit strength derives from (1) the inherent value of the assets included in the project, (2) the expected profitability of the project, (3) the amount of equity project sponsors have at
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risk and indirectly, (4) the pledges of creditworthy third parties or sponsors involved in the project. Expected profitability of the project: The expected profitability of a project represents the principal source of funds to service project debt and provide an adequate rate of return to the project’s equity investors. Lenders generally look for two sources of repayment for their loans: (1) the credit strength of the entity to which they are loaning funds and (2) the collateral value of any assets the borrower pledges to secure the loans. Also, there is a third source, the credit support derived indirectly from pledges of third parties. Amount of equity project sponsors have at risk: Debt ranks senior to equity. In the event a business fails, debt holders have a prior claim on the assets of the business. Given the value of project assets, the greater the amount of equity, the lower the ratio of debt to equity. Therefore, the lower the degree of risk lenders face. Credit support derived indirectly from pledges by third paries. Although lenders look principally to the revenues generated from the operations of a project to determine its viability and credit worthiness, supplemental credit support for a project may have to be provided by the sponsors or other creditworthy parties benefiting from the project. The contractual agreements among the operator / borrower, the sponsors, other third parties, and the lenders, which are designed to ensure debt repayment and servicing, as well as the credit standing of these guarantors, are necessary to provide adequate security to support the project’s financing arrangements.
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Conclusion: To arrange financing for a stand-alone project, prospective lenders must be convinced that the project is technically feasible and economically viable and that the project will be sufficiently creditworthy if financed. Establishing technical feasibility requires demonstrating that the construction can be completed on schedule and within budget and that the project will be able to operate at its design capacity following completion. Establishing economic viability requires demonstrating hat the project will be able to generate sufficient cash flow so as to cover its overall cost of capital. Creditworthiness will be established by demonstrating that even under reasonably pessimistic circumstances, the project will be able to generate sufficient revenue to cover all operating costs and to service project debt in a timely manner. The loan terms have an impact on how much debt the project can incur and still remain creditworthy.
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CHAPTER 4: Project Financing Risks and their Allocation From the perspective of potential investors, the main risks relate to project completion, market, foreign currency, and supply of inputs. The objective is to allocate these risks to those parties who are in the best position to control particular risk factors. This reduces the ‘moral hazard’ problem and minimises the costs of bearing risks.
Project completion risk: This is the major risk factor in most infrastructure projects. It is usually covered by a fixed price, firm date, and turnkey construction contract with liquidated damages for delay supported by performance bonds. The contract specifies performance parameters and warranty periods for effects. Lenders require sponsors of the project company to provide a guarantee to fund costs overruns. In addition, a standby credit facility may also be employed. Market risk: Having long-term quantity and price agreements covers this risk. In the case of power projects where the electricity is likely to be sold to government controlled distribution company, this is achieved through a ‘take or pay’ power purchase agreement (PPA). Under this contract, certain payments have to be made irrespective of the actual off-take as long as the company makes available the capacity. The tariff is determined on a cost plus basis using standard costs. For power projects in India, the government has evolved a system of two part tariffs. The first part ensures recovery of fixed costs based on performance at normative parameters. Fixed costs include depreciation, operating and maintenance expenses, tax on income, interest on loans, and working capital and a return on equity. This part of the tariff is paid irrespective of the amount of power actually taken. The second part covers variable expenses based on the units of electricity actually supplied. Variable costs are the costs of primary and secondary fuel based on set norms for fuel
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consumption. Apart from the PPA, payments may be made to a trustee, usually an international bank, as additional security, in an escrow account, which then directly makes payments to creditors and suppliers. In the case o transport projects, tolls have to be collected from the public and not from the government agency. This can give rise to problems while enforcing toll agreements. Competition from alternative roads or transit systems can also affect the traffic flow. Therefore, unlike power projects, which have power purchase agreements, in transport projects, lenders cannot rely on fixed revenue over the life of the project. Hence the project continues to carry market risk. This is sought to be mitigated by other arrangements. Foreign Exchange risk: Foreign exchange risks are perhaps the single largest concern of foreign financiers investing in developing countries. In the case of infrastructure projects, the risk is greater since most of these projects, with the exception of some telecommunication and port projects, generate local currency revenues. The risk is at two levels • Macro-economic convertibility i.e. whether the project will have access to foreign exchange to cover debt service and equity payments and • Tariff adjustment for currency depreciation i.e., whether foreign exchange equivalent of the project’s local revenues will be adequate to service foreign debts and equity. The risk of macro-economic convertibility will generally require a few government guarantees. In many BOOT projects, there is a provision for tariff escalation to account for currency depreciation and protect returns to investors in foreign currency terms. For Indian power projects, the return on foreign equity included in the tariff can be provided in the respective foreign currency.
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Supply of inputs: This is important for power projects, which require a reliable supply of quality fuel. The risk is covered through a contract with a fuel supply agency. The price risk is usually covered through a provision to pass on increases in fuel prices through higher tariffs. Such an arrangement i.e. transferring the ris of increases in fuel prices from the project to the power purchaser, may have an adverse impact on the incentives of the project sponsor to control price increases. A corollary, it increases the responsibility of the power purchaser to monitor the increase in input prices. Hedging with forwards and futures: A forward contract obligates the contract seller to deliver to the contract buyer (1) a specified quantity (2) of a particular commodity, currency, or some other item (3) on a specified future date to a stated price that is agreed to at the tie the two parties enter into the contract. A futures contract is similar to a forward contract except that a futures contract is traded on an organized exchange whereas forwards are traded over the counter and a futures contract is standardized whereas forwards is customized. Interest rate Cap Contract: An interest rate cap contract obligates the writer of the contract to pay the purchaser of the contract the difference between the market interest rate and the specified cap rate whenever the market interest rate exceeds the cap rate. Interest rate swap agreement: An interest rate swap agreement involves an agreement to exchange interest rate payment obligations based on some specified notional principal amount. A project that borrows funds from a commercial bank on a floating-rate basis an enter into an agreement with a financial
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institution under which it agrees to pay a fixed rate of interest and receive a floating rate of interest. The floating rate receivable under the swap agreement is designed to cancel out the floating –rate payable under the bank loan agreement. Eg.:- The project borrows funds from a bank at an interest rate of LIBOR + 1 percent. It agrees to pay 8 percent and receive LIBOR under the swap agreement. Its net interest cost is 9 percent (fixed rate).
Government guarantees and risk mitigation Most BOOT projects have guarantees by the government or government agencies in various forms. Government guarantees relate to Country Risk: Country risk includes risks of currency transfer, expropriation, war and civil disturbances, and breach of contract by the host government. The multilateral Investment guarantee Agency (MIGA) of the World Bank provides guarantee against country risk for an appropriate premium. Export credit agencies also provide such guarantees but they usually seek counter-guarantees from the host government.
Sector Risk: Sector risk refers to the risk in certain sectors because of the role of government agencies in those sectors. For example, in the power sector, the buyer is usually a government utility agency that transmits and distributes power. The solvency of the utility is critical for the ‘take or pay’ power purchase agreement to have any value. For selected power projects, the Indian government has agreed in principle to give counter guarantees to back up state guarantees for the State Electricity Boards (SEBs), payment obligations to private generating companies, on a specific request to the state government
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concerned and subject to the state government agreeing to certain terms and conditions. For toll roads, government support may be necessary to enforce toll collections. Similarly, in the case of municipal services such as water supply and solid-state disposal, the support of municipal authorities is important. In each case, the government may guarantee contract compliance of the respective agencies.
Commercial risk: Commercial risk refers to the risk to profitability arising from market demand and price; availability of inputs and prices; and variations in operating efficiency. These risks, except to the extent they are induced by country risk and sector policy risk, should ideally be borne by the investors. However, as noted in the World Developmental Report, 1994, in such projects, the market risk or the risk arising from fluctuation in demand is effectively transferred to the government through the ‘ take or pay’ formula. This becomes necessary because the market risk is intermingled with the danger that financially troubled power purchasers or water users may not honour their commitments. Overall sector reform is required to eliminate policy-induced risk and thus reveal the market risk.
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CHAPTER 5: SECURITY ARRANGEMENTS Arranging sufficient credit support for project debt securities is a necessary precondition to arranging debt financing for any project. Lenders to a project will require that security arrangements be put in place to protect them from various risks. The contractual security arrangements apportion the risks among the project sponsors, the purchasers of the project output, and the other parties involved in the project. They represent a means of conveying the credit strength of going-concern entities to support project debt. Security arrangements covering completion of project: The security arrangements covering completion typically involves an obligation to bring the project to completion one else repay all project debt. Lenders normally require that the sponsors or creditworthy parties provide an unconditional undertaking to furnish any funds needed to complete the project in accordance with the design specifications and place it into service by a specified date. The specified completion date normally allows for reasonable delays. If the project is not completed by the specified date, or if the project is abandoned prior to completion, the completion agreement typically requires the sponsors or other designated parties to repay all project debt. The obligations of the parties providing the completion undertaking terminates when completion of the project is achieved. Direct security interest in project facilities: Lenders require a direct security interest in project facilities, usually in the form of a first mortgage lien on all project facilities. This security interest is often of limited value prior to project completion. Following completion of the project, the first lien provides added security for project loans. The lien gives lenders the anility to seize the assets and sell them if the project defaults on its debt obligations. It thus affords a second possible source of debt repayment apart from cash flows of the project.
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Security covering debt service: After the project commences operations, contracts for the purchase and sale of the project’s output or utilization of the project’s services normally constitute the principal security arrangements for project debt. Such contracts are intended ensure that the project will receive revenues that are sufficient to cover operating costs fully and meet debt service obligations in a timely manner.
Purchase and Sale Contracts: Take-if-offered contract Such a contract obligates the purchaser of the project’s output or services to accept delivery and pay for the output and services that the project is able to deliver. It does not require the purchaser to pay if the project is unable to deliver the product. That is the contract protects the lenders only if the project is operating at a level that enables it to service its debt. Lenders would therefore require additional credit support or security arrangements in order to provide against unforseen events. Take-or-pay contract: A Take-or-pay contract is similar to a Take-if-offered contract; it gives the buyer the option to make cash payment in lieu of taking delivery, whereas the take-if-offered contract requires the buyer to accept deliveries. Cash payments are usually credited against charges for future deliveries. Like the take-if-offered contract, a take-or-pay contract does not require the purchaser to pay if the project is unable to deliver the output or services. Hell-or-high water contract: This is similar to a take-or-pay contract except that there are no ‘outs’ even when adverse circumstances are beyond the control of the purchaser. The purchaser must pay in all events, regardless of whether any output is
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delivered. It therefore provides lenders with tighter security than other contracts. Step-up provisions: The strength of these various agreements can be enhanced in situations where there are multiple purchasers of the output. A step-up provision is often included in the purchase and sale contracts. It obligates all the other purchasers to increase their respective participation in case one of the purchasers goes into default. Raw material supply agreements: A raw material supply agreement represents a contract to fulfil the project’s raw material requirements. The contract specifies certain remedies when deliveries are not made. Often both purchase and supply contracts are made to prove=ide credit support for a project. A supply-or-pay contract obligates the raw material supplier to furnish the requisite amounts of the raw material specified in the contract or else make payments to the project entity that are sufficient to civer the project’s debt service. Supplemental credit support: Depending on the structure of a project’s completion agreement and the purchase and sale contracts, it may be necessary to provide supplemental credit support through additional security arrangements. These arrangements will operate in the event the completion undertaking or the purchase and sale contracts fail to provide the cash to enable the project entity to meet its debt service obligations. Financial support agreement: A financial support agreement can take the form of a letter of credit or similar guarantee provided by the project sponsors. Payments made under the letter of credit or similar guarantee are treated as subordinated loans to the project company. In some cases it is advantageous to purchase the guarantee of a
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financially able party to provide credit support for the obligations of a project company/ Cash deficiency agreement: It is designed to cover any cash shortfalls that would impair the project company’s ability to meet its debt service requirements. The obligor makes a cash payment sufficient t cover the cash deficiency. Payments made under a cash deficiency agreement are usually credited as cash advances toward payment for future services or product from the project. Escrow Fund In certain instances lenders may require the project to establish an escrow fund that typically contains between 12 and 18 mnth’s debt service. A trustee can draw money from the escrow fund if the project’s cash flow from operations proves insufficient to cover the project’s debt service obligations. Insurance: Lenders typically require that insurance betaken out to protect against certain risks of force majeure. The insurance will provide funds to restore the project in the event of force majeure, thereby ensuring that the project remains a viable entity. The project sponsors normally purchase commercial insurance to cover the cost of damage caused by natural disasters. They may also secure business interruption insurance to cover certain other risks. In addition lenders may require the sponsors to agree contractually to provide additional funds to the project to the extent insurance proceeds are insufficient to restore the operations.
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CHAPTER 6: LEGAL STRUCTURE One of the most critical questions project sponsors need to address is whether a legally distinct “ project financing entity” should be employed and how it should be organized. The appropriate legal structure for a project depends on a variety of business, legal, accounting, tax, regulatory factors. Undivided Joint interest: Projects are often owned directly by the participants as tenants in common. Under the undivided joint interest ownership, each participant owns an undivided interest in the real and personal property constituting the project and shares in the benefits and risks of the project in direct proportion to the ownership percentage. The ownership interests relate to the entire assets of the project; no participant is entitled to any particular portion of the property. When the project is organized, the participants choose someone in their ranks to serve as the project operator. This arrangement is particularly suitable when one of the owners already has operations in the same industry that are of a similar nature, or otherwise has qualified employees available. The duties of the operator and obligations of all other parties are specified in an operating statement. The joint venture will require each participant to assume responsibility for raising its share of the project’s external financing requirements. Each sponsor will be free to do so by whatever means are most appropriate to its circumstances. Thus for example, if a sponsor owns 25 percent of the project, it will be required to provide, from its resources, 25 percent of the funds necessary to construct the project. The undivided joint interest has particular appeal when firms of widely differing credit strength are sponsoring the project. By financing independently, the higher-rated credits can borrow at a cost that is lower than the cost at which the project entity can borrow based on its composite credit. Depending on the sponsor’s ability to take immediate advantage of the tax benefits of ownership arising out of the project, direct co-ownership may also
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provide the project sponsors with immediate cash flow to fund their equity investments. Corporation: The form of organization most frequently chosen for a project is the corporation. A new corporation is formed to construct, own, and operate the project. This corporation, which is typically owned by the project sponsors, raises funds through the sponsors’ equity contributions and through the sale of senior debt securities issued by the corporation. The senior debt securities typically take the form of either first mortgage bonds or debentures containing a negative pledge covenant that protects their senior status. The negative pledge prohibits the project corporation from granting a lien on project assets in favour of other lenders unless the debentures are secured rateable. The corporate form permits creation of other types of securities, such as junior debt (second mortgage, unsecured, or subordinated debt), preferred stock, or convertible securities. The corporate form of organization offers the advantages of limited liability and an issuing vehicle. Nevertheless, the corporate form has disadvantages that must be considered. The sponsors usually do not receive immediate tax benefits from any investment tax credit (ITC) the project entity can claim or from construction period losses of the project (see “Tax Considerations” below). Also, the ability of a sponsor to invest in the project corporation may be limited by provisions contained in the sponsor’s bond indentures or loan agreements. In particular, the provisions restricting “investments” either by amount or by type may impose such limitations. Partnership: The partnership of organization is frequently used in structuring joint venture projects. project. Each project sponsor, either directly or through a subsidiary, The partnership issues securities (either directly or through a becomes a partner in a partnership that is formed to own and operate the corporate borrowing vehicle) to finance construction. Under the terms of a
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partnership agreement, the partnership hires its own operating personnel and provides for a management structure and decision-making process. A partnership is particularly attractive for so-called “cost companies”; a profit is not realized at the project level but instead is earned further downstream in the sale of the project’s output. The Uniform Partnership Act imposes joint and several liabilities on all the general partners for all obligations of the partnership. They are also jointly and severally liable fro certain other project-related obligations any of the general partners incurs in the ordinary course of business or within the scope of a general partner’s apparent authority. A partnership can also have any number of limited partners. They are not exposed to unlimited liability. However, there must be at least one general partner who does have such exposure.
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CHAPTER 7: SOURCES OF FUNDS
Financing options (a) Equity finance Government policy allow a debt equity ratio of 8:2, however lending institutions advocate a gearing ratio up to 7:3 as a prudent measure of lending. Specialised infrastructure and mutual funds have come up to bridge the equity gap in mega projects such as Global Power investment of GE Caps, the AIG Asian Infrastructure Fund, and the Asian Infrastructure Fund of Peregrine Capital Ltd. And ICICI. (b) Debt Financing In raising debt or financing the power sector projects he list of funds should be the lowest so that the ultimate cost of electricity will be the lowest for the end consume. The decision of the promoter to go in for equity or debt financing depends on various factors like go guidelines for power projects, incentives available and return on equity as also the cost of debt vis-a Vis equity. © Domestic Capital market Bonds are issued by the Central / State Government and Publish/private Ltd. Companies t augment the resources of the power sector in the capital market. Presently, internal rates are regulated and credit rating is mandatory if the maturity of the instruments exceeds 18 months. NCDs with an option of buy back, debentures with equity warrants, floating rate bonds and deep discount bonds are some of the innovative instruments offered in the market.
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(c) Indian Financial Institutions The area of project financing in the Indian context is mainly limited to the Indian Term Lending Institutions. In addition a large number of state level institutions, finance projects of smaller size commercial banks also participate in the term loans to a limited extent, besides meeting the working capital requirements. As no individual FI can feed to the power sector because of the huge funds requirements and the long gestation period of the projects. The concept of loan syndication amongst the FIs is gaining momentum. This also helps in sharing the risk among the Fis apart from saving o the efforts and the cost because of the appraisal done by the leading institution.
(d) Sources of international finance Due to the domestic finance viable for the power projects, the need to tap international markets has become inevitable which is characterised by the long tenure of maturities and availability of various modes of finance. (e) Multilateral Institutions Institutions like the World Bank, IFC, ADB etc. have traditionally been financing infrastructure in developing countries. The financing comer with restrictive covenants affordable costs, long tenure and in an assured manner. The co-financing facility extended by some of the multilateral institutions is gaining popularity. In many of these loans, sovereign guarantee is required. (f) Export Credit Agencies ECAs are a common source of bilateral funding. Credit is provided by ECAs such as the US Exim Bank, Exim Japan, etc. ECAs have a long history of providing fiancé for all types of power generation equipment. There are certain limitations in ECA financing like
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exposure limits, exchange risk, transfer to IPP guarantee requirements and cost of insurance etc. (g) External commercial borrowings These include Yankee bonds, Dragon bonds, Euro Currency syndicated loans, US 144A private placements, Global Registered Notes (GNRs) Global Bonds etc. (J) Syndicated loans The special features of syndicated loans are that they are for medium to longer period; specific to the requirements of the borrowers to suite their projects and availability of floating rate of interest. Most of the investors are Asian/European Banks, Fis, Insurance Companies and pension funds. (h) US rule 144A Private placement Rule 144A allows for private placement of debt to financial institutions known as QIB, without the kind of stringent disclosure requirements needed for equity issues. Long tenure of bonds and less restrictive covenants makes this proposition conducive to the financing of power projects. (I) Global Depository receipts(GDRs) GDRs present an attractive avenue of funds for the Indian companies. Indian Companies can collect a lage volume of funds in foreign currency in Euro issues. GDRs are usually listed in Luxembourg and are traded in London in the OTC market or among a restricted group such as Qualified Institutional Buyers (QIBs) in the USA. The GDRs do not have a voting right; there is no fear of loss of management control.
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CHAPTER 8: CONCLUSION AND FUTURE PROSPECTS For the trend towards privatisation in infrastructure projects to continue, financial markets need to respond by providing the necessary long-term resources. Considering the inadequate level of development in the domestic capital markets that results in low levels of tradability and liquidity of stocks traded in the stock market, there is a need to look towards the international financial markets for rising.
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doc_715080659.doc
Finance is the study of funds management, or the allocation of assets and liabilities over time under conditions of certainty and uncertainty.
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A REPORT ON PROJECT FINANCING
PROJECT GUIDE : Prof. Mrs. Vrinda Kamat
SUBMITTED BY : Deven Nadkarni MFM III B Roll No. 106
Narsee Monjee Institute of Management Studies
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TABLE OF CONTENTS
1. 2. 3. 4. 5. 6. 7. 8. 9.
Introduction System of Project Financing Project Viability Project Financing Risks and their Allocation Security Arrangements Legal Structure Sources of Funds Conclusion and Future Prospects Case Study
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CHAPTER 1: INTRODUCTION
1.1 Role of Infrastructure in Development It is now well recognized that a country’s development is strongly linked to its infrastructure strength. Infrastructure helps determine a country’s ability to expand trade, cope with population growth, reduce poverty and a host of other factors that define economic and human development. Good infrastructure raises productivity and lowers production cost, but must also expand fast enough to accommodate growth. The precise links between infrastructure and development have been subject to extensive debate. The link between infrastructure and economic growth has been studied extensively in literature, the World Bank report (1994) of the World Bank for instance. The results show that infrastructure development can have a significant impact on the economic growth. For low-income countries basic infrastructure such as water, irrigation and to a lesser extent transportation are more important. As the economies mature into a middle-income category, their share of power and telecommunications in the infrastructure and investment increases. An estimate however shows that a 1% increase in infrastructure stock* is positively associated with a corresponding growth in GDP across countries. Infrastructure is a necessary but not a sufficient condition for growth. Adequate complements of other resources must be present as well. In developing countries like India, infrastructure development and financing has largely been the prerogative of the government. Since infrastructure is typically a natural monopoly, the government considered it necessary to keep control of the same, in public interest. The success and failure of infrastructure to meet the needs of the people is largely a story of the government’s performance.
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In the case of India, the government has taken great strides in improving the infrastructure stock of the nation since independence. However, when compared to developed countries we still have a long way to go. For instance, per capita power consumption in India is a meagre 282 KWH compared to 18,117 KWH for Canada. The situation has worsened in the 90’s with frequent revisions being made to the eighth plan document owing to the government’s inability to bear the cost of infrastructure anymore. The simple truth is that public money is no longer sufficient to meet the burgeoning needs of the nation in line with its economic aspirations. Reluctantly, therefore the government has to throw open the doors to private participation in infrastructure.
1.2 Impact of Infrastructure on External Trade and Production Reliable and adequate quantity of infrastructure is a key factor in the ability of countries to compete globally. In particular, the competition for new export markets is specially dependant on high quality infrastructure. According to studies, increased globalisation of the world trade has been not only due to the liberalization of trade policy but also due to the major advances in the communication, transport and technologies. There is an increasing trend not only in terms of greater globalisation of trade but also in terms of globalization of production. It is possible for companies located in different parts of the globe to produce components. In the recent years India has been used as a base for sourcing by a host of companies such as Sony, Toyota, ABB and the like for their raw materials as well as for components. To be able to fulfil the requirements of sourcing MNCs worldclass infrastructure facilities including appropriate logistical support and multi-modal transport facilities are essential. *1infrastructure is taken to include road, rails, power, irrigation and telephones *2world Development Report 1994,p2.
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Infrastructure faculties are critical for the modernization and diversification of production. A good system of EDI involving telecommunications and In addition to computer networking is essential for efficient operations.
sourcing, off shore software design, engineering and development is possible, thanks to the advances made in the global market. Thus developing countries can leap frog into hi-tech areas with the help of good infrastructure facilities. 1.3 Public Sector in Infrastructure Development Infrastructure represents a strong public interest and so mer5its the attention of the government. The dominant role, that the public sector has assumed in the infrastructure • • • Recognition of the economic importance of infrastructure Belief that the problems with supply and technology require highly active intervention by the government. Faith that the government could succeed where markets appear to fail
There is enough evidence to show that, despite significant growth in a number of developing countries infrastructure facilities have fallen far short of the requirements, Though each sector has special problems, there are common patterns in the provision of infrastructure services and shortcomings such as: • • • • • Operational deficiencies Inadequate maintenance Extensive dependence on fiscal resources Lack of responsiveness to the needs Limited benefits to the poor
1.4 Need for Increasing the Role of the Private Sector In the mid 1980s evidence emerged in several countries that infrastructure services were not meeting the demand. Many governments have realized that the traditional state owned utility approach is no longer adequate. Although
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circumstances have varied across countries and sectors, the shift towards greater private involvement has been driven by the need to provide better services to more people at a lower cost. The main reason for a shift towar4ds private infrastructure is the growing dissatisfaction with the public ownership monopoly and provision of infrastructure facilities. Under-investment by many state utilities has resulted in a back-log of unmet demand for infrastructure services: in many countries this is the principal constraint to growth. Power shortages have led to a shortfall in production, higher costs and a decline in investment. Similarly limited availability and the poor quality of telecommunications have made it difficult for business in many developing countries to participate in the new international information based economy, Fiscal constraints faced by the governments and technological developments are other factors which have favoured increased private participation Technology developments have reduced the natural monopoly characteristics that have allowed unbinding private entry and competition into many infrast5ructure services. • • • • Technology developments in many cases have helped to create more competitive pressures. For example: Containerization has facilitated competition in port services. Falling costs of wireless telecommunications have enabled small operators to compete with wire-based networks. Independent power producers can construct and operate relatively small plants at unit costs comparable to the large generators Contract based relationships (eg. Build-Operate-transfer, Build-ownOperate, Concessions) have allowed private entry even within the existing regulatory network but with minor modifications. Also, the private sector entry often sets up a pressure for further regulatory changes and sometimes competition may mitigate the need for close regulation.
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1.5 Financing Infrastructure. Private financing is expected to ease the burden of infrastructure borne b the government. More importantly it will encourage better risk sharing, accountability and management in infrastructure provision. The task for the future is to channel private savings directly to private risk bearers who make long term investments in institutions and financing instruments adapted to the needs of different investors in different projects. Unless these financing needs can be met the country will gain precious little from privatising infrastructure.
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CHAPTER 2: SYSTEM OF PROJECT FINANCING
There is a growing realisation in many developing countries of the limitations of governmentsin a manging and financing economic activiteies, particularly large infrastructure projects. Provision of infrastructure facilities, traditionally in the government domain, is now being offered for private sectore investments and management. This trend has been reinforced by the resource crunch faced by many governments. specific domestic markets. In project financing the project, its assets, contracts, inherent economic and cash flows are separated from their promoters or sponsors in order to permit credit appraisal and loan to the project, independent of the sponsors. The assets of the specific project serve as a collateral for the loan, and all loan repayments are made out of the cash of the project. In this sense, the loan is said to be of non-resource to the sponsor. Thus, project financing may be defined as the scheme of ‘financing of a particular economic unit in which l lender is satisfied in looking at the cash flows and the earnings of that economic unit as a source of funds, from which a loan can be repaid, and to the assets of the economic unit as a collateral forte the loan’*2. In the past, project financing was mostly used in oil exploration and other mineral extraction through joint ventures with foreign firms. The most recent use of project financing can be found in infrastructure projects, particularly in power a telecommunication projects. *2Nevitt, P.K., Project Financing, Euro money Publications, 1983. Project financing is made possible by combining undertakings and various kinds of guarantees by parties who are interested in a project. It is built in such a way that no one party alone has to assume the full credit responsibility Infrastructure projects are usually characterised by large investments long gestation periods, and very
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of the project.
When all the undertakings are combined and reviewed
together, it results in an equivalent of the satisfactory credit risk for the lenders. It is often suggested that the project financing enables a parent company to obtain inexpensive loans without having to bear all the risks of the project. This is not true, in practice, the parent company is affected by the actual plight of the project, and the interests on the project loan depends on the parents stake in the project.1* 1*Breaket, R.A. and Myers, S.C. Principles of Corporate Finance, fourth Ed. McGraw Hill,pp.608-612. The traditional form of financing is the corporate financing or the balance sheet financing. In this case, although financing is apparently for a project, the lender looks at the cast flows and assets of the whole company in order to service the debt and provide security. Figure 30.3 shows the basic differences between balance sheet financing and project financing.
Balance sheet financing
Project Financing
Lender
Lender
Project Sponsor
Project Sponsor
Equity Equity Loan Owns Project Assets Owns Project Assets Special Project Entry
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The following are the characteristics of project financing: • • • • • • A separate project entity is created that receives loans from lenders and equity from sponsors. The component of debt is very high in project financing. project financing is a highly leveraged financing. The project funding and all its other cash flows are separated from the parent company’s balance sheet. Debt services and repayments entirely depend on the project’s cash flows. Project assets are used as collateral for loan repayments. Project financers’ risks are not entirely covered by the sponsor’s guarantees. Third parties like suppliers, customers, government and sponsors commit to share the risk of the project. Project financing is most appropriate for those projects, which require large amount of capital expenditure and involve high risk. It is used by companies to reduce their own risk by allocating the risk to a number of parties. It allows sponsors to: • • • Finance large projects than the company’s credit and financial capability would permit. Insulate the company’s balance sheet from the impact of the project. Use high degree of leverage to benefit the equity owners. Thus,
Project Financing Arrangements The project financing arrangements may range from simple conventional type of loans to more complex arrangements like the build-own-operate-transfer (BOOT). The typical arrangements, particularly in the power sector, include: 1. ‘The build-own-operate-transfer (BOOT) structure 2. The build-own-operate (BOO) structure 3. The build-lease-transfer (BLT) structure
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The Build-Own-Operate-Transfer (BOOT) Arrangement The build-own-operate-transfer (BOOT) is essentially an extension of the project-financing concept. It is a special financing scheme, which is designed to attract private participation in financing constructing and operating infrastructure projects. In BOOT scheme, a private project company builds a project, operates it for a sufficient period of time to earn an adequate return on investment, and then transfers it to the host government or its agency. Quite often, the value of efficiency gain from private participation can outweigh the extra cost of borrowing through a BOOT project, relative to direct government borrowing*1. *1World Bank, World Development Report 1994 BOOT projects can be either solicited or unsolicited. When proposals are solicited, the project is identified and formulated by the government and the private sector is invited to submit unsolicited proposals on their own accord. The private group usually consists of international construction contractors, heavy equipment suppliers, and plant and system operators along with local partners. BOOT projects have been implemented or a rein the process of being implemented in many developing countries. Power and roads are the two sectors with the largest number of projects. BOOT projects have also been implemented for ports and mass transit and rail. There have been only a few BOOT projects in the telecommunication se tore in Thailand Indonesia. According to a recent World Bank study, the reason why BOOT schemes have not been p0opulare in the telecommunication sector its he potential complexity associated with co-ordinating the BOOOT operator’s distribution networks with those of the state-owned incumbent, Issues involving interconnections, sharing of ducts, maintenance and new investments, all must be resolved. These factors tend to increase risks for investors, make management co-ordination harder, and raise the questions for investors as to whether the will have adequate control over the facilities in which they have invested to achieve appropriate levels of productivity.
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*1Smith, P.L. and Staple. G. Telecommunication Sector Reform in Asia: Towards a New Pragmatism, World Bank, Discussion Paper No. 232, the World Bank, 1994. The Build-Own-Operate (BOO) Arrangement The issue of “transfer”(the T in BOOT projects) is ambiguus because most of the BOOT projects under operation or consideration have the transfer dates quite far away and, therefore, they are not a real concern as yet. One problem with the transfer provision is the likelihood of the capital stock of the project being run down as the date of transfer draws bearer.
Lenders Contractor Loan Debt Service Fuel Equity Investors Return on Equity Ownership Payment
Electricity Supply Company
Owner
Transport Operation & Maintenance Payment Land Lease
Power Plant KW Hrs
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BOOT/BOO structure of power plant This may take place in spite of legal agreements, which includes inspection plans and other such measures. In any case, there does not seem to be any rationale for such a transfer if the very basis of the projects was to run it outside the public sector. One alternative to transfer that has been suggested is for the foreign shareholders to divest themselves of their equity either entirely or up to some negotiated percentage at the end of the stipulated time period. Such an arrangement is generally referred to as the build-operate-own (BOO) arrangement. In BOO arrangement, projects are funded without any direct sovereign guarantee. Thus, it implies limited recourse financing. Unlike in BOOT arrangements, in BOO structure, the project is not transferred to the host government, rather the owner will divest his stake and seek investment =s from investors in the capital markets. This facilitates the availability of finances. BOOT and BOO arrangements are essentially similar except thT IN boo arrangement the sponsor preserves the ownership.
Build-Lease-Transfer arrangement In the build lease transfer arrangement, the control of the project is transferred from the project owners to a lease. The shareholders retain the full ownership of the project, but, for operation purposes, they lease it to a lessee. The host government agrees with the lessee to buy the output or service of the project. The lessor receives the lease rental guaranteed by the host government.
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CHAPTER 3: PROJECT VIABILITY Investors are concerned about all the risks a project involves, who will bear each of them, and whether their returns will be adequate to compensate them for the risks they are being asked to bear. Both the sponsors and their adviser must be thoroughly familiar with the technical aspects of the project and the risks involved, and they must independently evaluate a projects economics and its ability to service project related borrowings. Technical Feasibility: Prior to the start of construction, the project sponsors must undertake extensive engineering work to verify the technological processes and design of the proposed facility. If the project requires new or unproven technology, test facilities or a pilot plant will normally have to be constructed to test the feasibility of the process involved and to optimise the design of full scale facilities. A well-executed design will accommodate future expansion of the project; often, expansion beyond the initial operating capacity is planned at the outset. Rhe related capital cost and the impact of project expansion on operating efficiency are then reflected in the original design specifications and financial projections. Project Construction Cost The detailed engineering and design work provides the basis for estimating the construction costs for the project. Construction costs should in clued the cost of all facilities necessary for the project’s operation as a freestanding entity. Construction costs should include contingency factor adequate to cover possible design errors or unforeseen costs. Project sponsors or their advisers generally prepare a time schedule detailing the activities that must be accomplished before and during the construction period. A quarterly breakdown of capital expenditures normally accompanies the time schedule. The time schedule specifies (1) time expected to be required to obtain regulatory or environmental approvals and permits for construction. (2) The
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procurement lead time anticipated for major pieces of equipment and (3) the time expected to be required fro pre-construction activities- performing detailed design work, ordering the equipment and building materials, preparing the site and hiring the necessary manpower. The project sponsor examines the critical path of the construction schedule to determine where the risk of delay is greatest and then assesses the potential financial impact of any projected delay. Economic Viability The critical issue concerning economic viability is whether the project’s expected net present value is positive. It will be positive only if the expected present value of the future free cash flows exceeds the expected present value of the project’s construction costs. All the factors that can affect project cash flows are important in making this determination. Assuming that the project is completed on schedule and within budget, its economic viability will depend primarily on the marketability of the projects output (price and volume). To evaluate marketability, the sponsors arrange for a study of projected supply and demand conditions over the expected life of the project. The marketing study is designed to confirm that, under a reasonable set of economic assumptions, demand will be sufficient to absorb the planned output of the project at a price that will cover the full cost of production, enable the project to service its debt, and provide an acceptable rate of return to equity investors. The marketing study generally includes 1) a review of competitive products and their relative cost of production; 2) an analysis of the expected life cycle for project output, expected sales volume, and projected prices; and 3) an analysis of the potential impact of technological obsolescence. The study is usually performed by an independent firm of experts. If the project will operate within a regulated industry, the potential impact of regulatory decisions on production levels and prices—and, ultimately, on the profitability of the project –must also be considered.
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The cost of production will affect the pricing of the project output. Projections of operating costs are prepared after project design work has been completed. Each cost element, such as raw materials, labor, overhead, taxes, royalties, and maintenance expense, must be identified and quantified. Typically, this estimation is accomplished by dividing the cost element into fixed and variable cost components and estimating each category separately. Each operating cost element should be escalated over the term of the projections at a rate that reflects the anticipated rate of inflation. From a financing standpoint, it is important to assess the reasonableness of the cost estimates and the extent to which the pricing, and hence the marketability, of the project output is likely to be affected by estimated cost inflation rates. In addition to operating costs, the project’s cost of capital must be determined. The financial adviser typically is responsible for this task. He develops and tests various financing plans for the project in order to arrive at an optimal financing plan that is consistent with the business objectives of the project sponsor. Adequacy of raw material supplies: The project should have sufficient supplies of raw materials to enable it to operate at design capacity over the term of the debt. Independent consultants mat be summoned to evaluate the quantity, grade, and rate of extraction that the mineral reserves available to the project are capable of supporting. The project should have the ability to access the nerves of raw materials through contractual agreements like direct ownership, lease, purchase agreement etc. Creditworthiness: A project has no operating history at the time of its initial debt financing. Consequently, the amount of debt the project can raise is a function of the project’s expected capacity to service debt from project cash flow- or more simply, its credit strength. A project’s credit strength derives from (1) the inherent value of the assets included in the project, (2) the expected profitability of the project, (3) the amount of equity project sponsors have at
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risk and indirectly, (4) the pledges of creditworthy third parties or sponsors involved in the project. Expected profitability of the project: The expected profitability of a project represents the principal source of funds to service project debt and provide an adequate rate of return to the project’s equity investors. Lenders generally look for two sources of repayment for their loans: (1) the credit strength of the entity to which they are loaning funds and (2) the collateral value of any assets the borrower pledges to secure the loans. Also, there is a third source, the credit support derived indirectly from pledges of third parties. Amount of equity project sponsors have at risk: Debt ranks senior to equity. In the event a business fails, debt holders have a prior claim on the assets of the business. Given the value of project assets, the greater the amount of equity, the lower the ratio of debt to equity. Therefore, the lower the degree of risk lenders face. Credit support derived indirectly from pledges by third paries. Although lenders look principally to the revenues generated from the operations of a project to determine its viability and credit worthiness, supplemental credit support for a project may have to be provided by the sponsors or other creditworthy parties benefiting from the project. The contractual agreements among the operator / borrower, the sponsors, other third parties, and the lenders, which are designed to ensure debt repayment and servicing, as well as the credit standing of these guarantors, are necessary to provide adequate security to support the project’s financing arrangements.
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Conclusion: To arrange financing for a stand-alone project, prospective lenders must be convinced that the project is technically feasible and economically viable and that the project will be sufficiently creditworthy if financed. Establishing technical feasibility requires demonstrating that the construction can be completed on schedule and within budget and that the project will be able to operate at its design capacity following completion. Establishing economic viability requires demonstrating hat the project will be able to generate sufficient cash flow so as to cover its overall cost of capital. Creditworthiness will be established by demonstrating that even under reasonably pessimistic circumstances, the project will be able to generate sufficient revenue to cover all operating costs and to service project debt in a timely manner. The loan terms have an impact on how much debt the project can incur and still remain creditworthy.
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CHAPTER 4: Project Financing Risks and their Allocation From the perspective of potential investors, the main risks relate to project completion, market, foreign currency, and supply of inputs. The objective is to allocate these risks to those parties who are in the best position to control particular risk factors. This reduces the ‘moral hazard’ problem and minimises the costs of bearing risks.
Project completion risk: This is the major risk factor in most infrastructure projects. It is usually covered by a fixed price, firm date, and turnkey construction contract with liquidated damages for delay supported by performance bonds. The contract specifies performance parameters and warranty periods for effects. Lenders require sponsors of the project company to provide a guarantee to fund costs overruns. In addition, a standby credit facility may also be employed. Market risk: Having long-term quantity and price agreements covers this risk. In the case of power projects where the electricity is likely to be sold to government controlled distribution company, this is achieved through a ‘take or pay’ power purchase agreement (PPA). Under this contract, certain payments have to be made irrespective of the actual off-take as long as the company makes available the capacity. The tariff is determined on a cost plus basis using standard costs. For power projects in India, the government has evolved a system of two part tariffs. The first part ensures recovery of fixed costs based on performance at normative parameters. Fixed costs include depreciation, operating and maintenance expenses, tax on income, interest on loans, and working capital and a return on equity. This part of the tariff is paid irrespective of the amount of power actually taken. The second part covers variable expenses based on the units of electricity actually supplied. Variable costs are the costs of primary and secondary fuel based on set norms for fuel
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consumption. Apart from the PPA, payments may be made to a trustee, usually an international bank, as additional security, in an escrow account, which then directly makes payments to creditors and suppliers. In the case o transport projects, tolls have to be collected from the public and not from the government agency. This can give rise to problems while enforcing toll agreements. Competition from alternative roads or transit systems can also affect the traffic flow. Therefore, unlike power projects, which have power purchase agreements, in transport projects, lenders cannot rely on fixed revenue over the life of the project. Hence the project continues to carry market risk. This is sought to be mitigated by other arrangements. Foreign Exchange risk: Foreign exchange risks are perhaps the single largest concern of foreign financiers investing in developing countries. In the case of infrastructure projects, the risk is greater since most of these projects, with the exception of some telecommunication and port projects, generate local currency revenues. The risk is at two levels • Macro-economic convertibility i.e. whether the project will have access to foreign exchange to cover debt service and equity payments and • Tariff adjustment for currency depreciation i.e., whether foreign exchange equivalent of the project’s local revenues will be adequate to service foreign debts and equity. The risk of macro-economic convertibility will generally require a few government guarantees. In many BOOT projects, there is a provision for tariff escalation to account for currency depreciation and protect returns to investors in foreign currency terms. For Indian power projects, the return on foreign equity included in the tariff can be provided in the respective foreign currency.
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Supply of inputs: This is important for power projects, which require a reliable supply of quality fuel. The risk is covered through a contract with a fuel supply agency. The price risk is usually covered through a provision to pass on increases in fuel prices through higher tariffs. Such an arrangement i.e. transferring the ris of increases in fuel prices from the project to the power purchaser, may have an adverse impact on the incentives of the project sponsor to control price increases. A corollary, it increases the responsibility of the power purchaser to monitor the increase in input prices. Hedging with forwards and futures: A forward contract obligates the contract seller to deliver to the contract buyer (1) a specified quantity (2) of a particular commodity, currency, or some other item (3) on a specified future date to a stated price that is agreed to at the tie the two parties enter into the contract. A futures contract is similar to a forward contract except that a futures contract is traded on an organized exchange whereas forwards are traded over the counter and a futures contract is standardized whereas forwards is customized. Interest rate Cap Contract: An interest rate cap contract obligates the writer of the contract to pay the purchaser of the contract the difference between the market interest rate and the specified cap rate whenever the market interest rate exceeds the cap rate. Interest rate swap agreement: An interest rate swap agreement involves an agreement to exchange interest rate payment obligations based on some specified notional principal amount. A project that borrows funds from a commercial bank on a floating-rate basis an enter into an agreement with a financial
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institution under which it agrees to pay a fixed rate of interest and receive a floating rate of interest. The floating rate receivable under the swap agreement is designed to cancel out the floating –rate payable under the bank loan agreement. Eg.:- The project borrows funds from a bank at an interest rate of LIBOR + 1 percent. It agrees to pay 8 percent and receive LIBOR under the swap agreement. Its net interest cost is 9 percent (fixed rate).
Government guarantees and risk mitigation Most BOOT projects have guarantees by the government or government agencies in various forms. Government guarantees relate to Country Risk: Country risk includes risks of currency transfer, expropriation, war and civil disturbances, and breach of contract by the host government. The multilateral Investment guarantee Agency (MIGA) of the World Bank provides guarantee against country risk for an appropriate premium. Export credit agencies also provide such guarantees but they usually seek counter-guarantees from the host government.
Sector Risk: Sector risk refers to the risk in certain sectors because of the role of government agencies in those sectors. For example, in the power sector, the buyer is usually a government utility agency that transmits and distributes power. The solvency of the utility is critical for the ‘take or pay’ power purchase agreement to have any value. For selected power projects, the Indian government has agreed in principle to give counter guarantees to back up state guarantees for the State Electricity Boards (SEBs), payment obligations to private generating companies, on a specific request to the state government
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concerned and subject to the state government agreeing to certain terms and conditions. For toll roads, government support may be necessary to enforce toll collections. Similarly, in the case of municipal services such as water supply and solid-state disposal, the support of municipal authorities is important. In each case, the government may guarantee contract compliance of the respective agencies.
Commercial risk: Commercial risk refers to the risk to profitability arising from market demand and price; availability of inputs and prices; and variations in operating efficiency. These risks, except to the extent they are induced by country risk and sector policy risk, should ideally be borne by the investors. However, as noted in the World Developmental Report, 1994, in such projects, the market risk or the risk arising from fluctuation in demand is effectively transferred to the government through the ‘ take or pay’ formula. This becomes necessary because the market risk is intermingled with the danger that financially troubled power purchasers or water users may not honour their commitments. Overall sector reform is required to eliminate policy-induced risk and thus reveal the market risk.
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CHAPTER 5: SECURITY ARRANGEMENTS Arranging sufficient credit support for project debt securities is a necessary precondition to arranging debt financing for any project. Lenders to a project will require that security arrangements be put in place to protect them from various risks. The contractual security arrangements apportion the risks among the project sponsors, the purchasers of the project output, and the other parties involved in the project. They represent a means of conveying the credit strength of going-concern entities to support project debt. Security arrangements covering completion of project: The security arrangements covering completion typically involves an obligation to bring the project to completion one else repay all project debt. Lenders normally require that the sponsors or creditworthy parties provide an unconditional undertaking to furnish any funds needed to complete the project in accordance with the design specifications and place it into service by a specified date. The specified completion date normally allows for reasonable delays. If the project is not completed by the specified date, or if the project is abandoned prior to completion, the completion agreement typically requires the sponsors or other designated parties to repay all project debt. The obligations of the parties providing the completion undertaking terminates when completion of the project is achieved. Direct security interest in project facilities: Lenders require a direct security interest in project facilities, usually in the form of a first mortgage lien on all project facilities. This security interest is often of limited value prior to project completion. Following completion of the project, the first lien provides added security for project loans. The lien gives lenders the anility to seize the assets and sell them if the project defaults on its debt obligations. It thus affords a second possible source of debt repayment apart from cash flows of the project.
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Security covering debt service: After the project commences operations, contracts for the purchase and sale of the project’s output or utilization of the project’s services normally constitute the principal security arrangements for project debt. Such contracts are intended ensure that the project will receive revenues that are sufficient to cover operating costs fully and meet debt service obligations in a timely manner.
Purchase and Sale Contracts: Take-if-offered contract Such a contract obligates the purchaser of the project’s output or services to accept delivery and pay for the output and services that the project is able to deliver. It does not require the purchaser to pay if the project is unable to deliver the product. That is the contract protects the lenders only if the project is operating at a level that enables it to service its debt. Lenders would therefore require additional credit support or security arrangements in order to provide against unforseen events. Take-or-pay contract: A Take-or-pay contract is similar to a Take-if-offered contract; it gives the buyer the option to make cash payment in lieu of taking delivery, whereas the take-if-offered contract requires the buyer to accept deliveries. Cash payments are usually credited against charges for future deliveries. Like the take-if-offered contract, a take-or-pay contract does not require the purchaser to pay if the project is unable to deliver the output or services. Hell-or-high water contract: This is similar to a take-or-pay contract except that there are no ‘outs’ even when adverse circumstances are beyond the control of the purchaser. The purchaser must pay in all events, regardless of whether any output is
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delivered. It therefore provides lenders with tighter security than other contracts. Step-up provisions: The strength of these various agreements can be enhanced in situations where there are multiple purchasers of the output. A step-up provision is often included in the purchase and sale contracts. It obligates all the other purchasers to increase their respective participation in case one of the purchasers goes into default. Raw material supply agreements: A raw material supply agreement represents a contract to fulfil the project’s raw material requirements. The contract specifies certain remedies when deliveries are not made. Often both purchase and supply contracts are made to prove=ide credit support for a project. A supply-or-pay contract obligates the raw material supplier to furnish the requisite amounts of the raw material specified in the contract or else make payments to the project entity that are sufficient to civer the project’s debt service. Supplemental credit support: Depending on the structure of a project’s completion agreement and the purchase and sale contracts, it may be necessary to provide supplemental credit support through additional security arrangements. These arrangements will operate in the event the completion undertaking or the purchase and sale contracts fail to provide the cash to enable the project entity to meet its debt service obligations. Financial support agreement: A financial support agreement can take the form of a letter of credit or similar guarantee provided by the project sponsors. Payments made under the letter of credit or similar guarantee are treated as subordinated loans to the project company. In some cases it is advantageous to purchase the guarantee of a
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financially able party to provide credit support for the obligations of a project company/ Cash deficiency agreement: It is designed to cover any cash shortfalls that would impair the project company’s ability to meet its debt service requirements. The obligor makes a cash payment sufficient t cover the cash deficiency. Payments made under a cash deficiency agreement are usually credited as cash advances toward payment for future services or product from the project. Escrow Fund In certain instances lenders may require the project to establish an escrow fund that typically contains between 12 and 18 mnth’s debt service. A trustee can draw money from the escrow fund if the project’s cash flow from operations proves insufficient to cover the project’s debt service obligations. Insurance: Lenders typically require that insurance betaken out to protect against certain risks of force majeure. The insurance will provide funds to restore the project in the event of force majeure, thereby ensuring that the project remains a viable entity. The project sponsors normally purchase commercial insurance to cover the cost of damage caused by natural disasters. They may also secure business interruption insurance to cover certain other risks. In addition lenders may require the sponsors to agree contractually to provide additional funds to the project to the extent insurance proceeds are insufficient to restore the operations.
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CHAPTER 6: LEGAL STRUCTURE One of the most critical questions project sponsors need to address is whether a legally distinct “ project financing entity” should be employed and how it should be organized. The appropriate legal structure for a project depends on a variety of business, legal, accounting, tax, regulatory factors. Undivided Joint interest: Projects are often owned directly by the participants as tenants in common. Under the undivided joint interest ownership, each participant owns an undivided interest in the real and personal property constituting the project and shares in the benefits and risks of the project in direct proportion to the ownership percentage. The ownership interests relate to the entire assets of the project; no participant is entitled to any particular portion of the property. When the project is organized, the participants choose someone in their ranks to serve as the project operator. This arrangement is particularly suitable when one of the owners already has operations in the same industry that are of a similar nature, or otherwise has qualified employees available. The duties of the operator and obligations of all other parties are specified in an operating statement. The joint venture will require each participant to assume responsibility for raising its share of the project’s external financing requirements. Each sponsor will be free to do so by whatever means are most appropriate to its circumstances. Thus for example, if a sponsor owns 25 percent of the project, it will be required to provide, from its resources, 25 percent of the funds necessary to construct the project. The undivided joint interest has particular appeal when firms of widely differing credit strength are sponsoring the project. By financing independently, the higher-rated credits can borrow at a cost that is lower than the cost at which the project entity can borrow based on its composite credit. Depending on the sponsor’s ability to take immediate advantage of the tax benefits of ownership arising out of the project, direct co-ownership may also
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provide the project sponsors with immediate cash flow to fund their equity investments. Corporation: The form of organization most frequently chosen for a project is the corporation. A new corporation is formed to construct, own, and operate the project. This corporation, which is typically owned by the project sponsors, raises funds through the sponsors’ equity contributions and through the sale of senior debt securities issued by the corporation. The senior debt securities typically take the form of either first mortgage bonds or debentures containing a negative pledge covenant that protects their senior status. The negative pledge prohibits the project corporation from granting a lien on project assets in favour of other lenders unless the debentures are secured rateable. The corporate form permits creation of other types of securities, such as junior debt (second mortgage, unsecured, or subordinated debt), preferred stock, or convertible securities. The corporate form of organization offers the advantages of limited liability and an issuing vehicle. Nevertheless, the corporate form has disadvantages that must be considered. The sponsors usually do not receive immediate tax benefits from any investment tax credit (ITC) the project entity can claim or from construction period losses of the project (see “Tax Considerations” below). Also, the ability of a sponsor to invest in the project corporation may be limited by provisions contained in the sponsor’s bond indentures or loan agreements. In particular, the provisions restricting “investments” either by amount or by type may impose such limitations. Partnership: The partnership of organization is frequently used in structuring joint venture projects. project. Each project sponsor, either directly or through a subsidiary, The partnership issues securities (either directly or through a becomes a partner in a partnership that is formed to own and operate the corporate borrowing vehicle) to finance construction. Under the terms of a
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partnership agreement, the partnership hires its own operating personnel and provides for a management structure and decision-making process. A partnership is particularly attractive for so-called “cost companies”; a profit is not realized at the project level but instead is earned further downstream in the sale of the project’s output. The Uniform Partnership Act imposes joint and several liabilities on all the general partners for all obligations of the partnership. They are also jointly and severally liable fro certain other project-related obligations any of the general partners incurs in the ordinary course of business or within the scope of a general partner’s apparent authority. A partnership can also have any number of limited partners. They are not exposed to unlimited liability. However, there must be at least one general partner who does have such exposure.
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CHAPTER 7: SOURCES OF FUNDS
Financing options (a) Equity finance Government policy allow a debt equity ratio of 8:2, however lending institutions advocate a gearing ratio up to 7:3 as a prudent measure of lending. Specialised infrastructure and mutual funds have come up to bridge the equity gap in mega projects such as Global Power investment of GE Caps, the AIG Asian Infrastructure Fund, and the Asian Infrastructure Fund of Peregrine Capital Ltd. And ICICI. (b) Debt Financing In raising debt or financing the power sector projects he list of funds should be the lowest so that the ultimate cost of electricity will be the lowest for the end consume. The decision of the promoter to go in for equity or debt financing depends on various factors like go guidelines for power projects, incentives available and return on equity as also the cost of debt vis-a Vis equity. © Domestic Capital market Bonds are issued by the Central / State Government and Publish/private Ltd. Companies t augment the resources of the power sector in the capital market. Presently, internal rates are regulated and credit rating is mandatory if the maturity of the instruments exceeds 18 months. NCDs with an option of buy back, debentures with equity warrants, floating rate bonds and deep discount bonds are some of the innovative instruments offered in the market.
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(c) Indian Financial Institutions The area of project financing in the Indian context is mainly limited to the Indian Term Lending Institutions. In addition a large number of state level institutions, finance projects of smaller size commercial banks also participate in the term loans to a limited extent, besides meeting the working capital requirements. As no individual FI can feed to the power sector because of the huge funds requirements and the long gestation period of the projects. The concept of loan syndication amongst the FIs is gaining momentum. This also helps in sharing the risk among the Fis apart from saving o the efforts and the cost because of the appraisal done by the leading institution.
(d) Sources of international finance Due to the domestic finance viable for the power projects, the need to tap international markets has become inevitable which is characterised by the long tenure of maturities and availability of various modes of finance. (e) Multilateral Institutions Institutions like the World Bank, IFC, ADB etc. have traditionally been financing infrastructure in developing countries. The financing comer with restrictive covenants affordable costs, long tenure and in an assured manner. The co-financing facility extended by some of the multilateral institutions is gaining popularity. In many of these loans, sovereign guarantee is required. (f) Export Credit Agencies ECAs are a common source of bilateral funding. Credit is provided by ECAs such as the US Exim Bank, Exim Japan, etc. ECAs have a long history of providing fiancé for all types of power generation equipment. There are certain limitations in ECA financing like
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exposure limits, exchange risk, transfer to IPP guarantee requirements and cost of insurance etc. (g) External commercial borrowings These include Yankee bonds, Dragon bonds, Euro Currency syndicated loans, US 144A private placements, Global Registered Notes (GNRs) Global Bonds etc. (J) Syndicated loans The special features of syndicated loans are that they are for medium to longer period; specific to the requirements of the borrowers to suite their projects and availability of floating rate of interest. Most of the investors are Asian/European Banks, Fis, Insurance Companies and pension funds. (h) US rule 144A Private placement Rule 144A allows for private placement of debt to financial institutions known as QIB, without the kind of stringent disclosure requirements needed for equity issues. Long tenure of bonds and less restrictive covenants makes this proposition conducive to the financing of power projects. (I) Global Depository receipts(GDRs) GDRs present an attractive avenue of funds for the Indian companies. Indian Companies can collect a lage volume of funds in foreign currency in Euro issues. GDRs are usually listed in Luxembourg and are traded in London in the OTC market or among a restricted group such as Qualified Institutional Buyers (QIBs) in the USA. The GDRs do not have a voting right; there is no fear of loss of management control.
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CHAPTER 8: CONCLUSION AND FUTURE PROSPECTS For the trend towards privatisation in infrastructure projects to continue, financial markets need to respond by providing the necessary long-term resources. Considering the inadequate level of development in the domestic capital markets that results in low levels of tradability and liquidity of stocks traded in the stock market, there is a need to look towards the international financial markets for rising.
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