Description
PPP involves a contract between a public sector authority and a private party, in which the private party provides a public service or project and assumes substantial financial, technical and operational risk in the project.
Rev 1 5 Aug 2010
Project Finance and PPP Models
By John Macgillivray CEng, MIChemE, BA (Hons) Managing Director - Project Planning and Management Ltd.
Developing models for project finance (PF) and Public Private Partnerships (PPPs) presents some critical challenges. In this article we review some of the issues faced and make comment on how they should be handled. Why use a financial model? The basis for a project financing or a PPP is that the ring-fenced projected cash flows are strong enough to interest an investor and warrant a bank loan, and the repayments and returns will be based on the project cash flows alone. A model is therefore needed by the investors and the lenders to assess the cash flows under different scenarios throughout the life of the project. Differences between PF and PPP models PPPs use a private sector funding mechanism approach for public utilities and services. They cover many types of transactions some of which, such as pure management contracts, may not need a separate financial model. If a model is required, such as in concession-style contracts, the models differ little from private sector PF models except in the basis for calculating the revenue. PPP models will often have a reimbursement formula which is based on the capital and operating costs and may be affected by service availability and other external environmental factors. Differences between PF/PPP and corporate models PF/PPP models are similar to corporate planning models but are usually limited to a single plant or project and will include the following items not normally found in a corporate model: Cash sweeps Cash traps Waterfall of accounts Sinking funds Loans, often in more than one currency Two bank accounts (operating and escrow) Financing parties may also insist upon the minimum ratios to protect the project financial strength. These items are discussed further in this article.
Copyright © 2010 Project Planning and Management Ltd
The Model in Different Phases of the Project A simple model can be used in the pre-planning phases to compare the viability of different project designs. This financial model does not need the accounting, funding or fiscal calculations to determine the optimum project design though these are vital for fuding decisions. Models are most extensively used during the planning phases and before the “financial close”. Such models have extensive “what-if” analyses and will calculate the draw-down for the construction contract and the injection of equity and loan finance during the construction phase. The user can change, say, the construction schedule and the model will recalculate the draw-downs. A somewhat different model is needed once the design has been agreed. During the bidding and evaluation phase, the model should include the proposed contractor’s payment schedule and the corresponding loan and equity draw-down schedules as part of its inputs. During the construction and subsequent phases the model should also accept the actual accounting statements for previous periods as inputs. These are needed in order to use up-to-date figures in calculating cash flows and ratios linked to loan covenants. Design of the model The model should be as flexible as possible. If it is a planning phase model, it should allow for a change in the start date, the construction schedule, the design, the capital and operating costs, etc. There should be no hard coded figures. In the operating phase there will be less flexibility to change design inputs since these will be finalised at the end of the construction phase. The model should be laid out clearly with separate sheets for input and output. Colour coding will help the user understand which figures are inputs and which are calculated. Correct technical conversion factors are a crucial part of the model. This can be a crucial part of the model and it is very important to get them right. For instance, on a power project, the difference between a lower and a
Page - 1 -
Rev 1 5 Aug 2010
higher heating value (LHV and HHV) and when to use each variable is essential Revenues The revenues will be based on the market price and the market demand or a combination of capacity and operating cost payments as in a concession. This may come from an external expert. Operating Costs The operating costs are typically divided into fixed and variable. The fixed costs are incurred irrespective of output whilst the variable costs depend on the output. Again these may be provided by experts. Maintenance Most projects are shut down once a year for annual maintenance. Some industries require additional maintenance at longer intervals. For instance, ships are dry-docked at two or three year intervals. Under these circumstances the model should take into account the additional costs and the loss of earnings and include a sinking fund for these costs for these items. Working Capital Inclusion of the working capital is an essential (and often forgotten) item in any model. It should consist of both current assets and current liabilities. The initial working capital needs to be calculated and included in the funding. Multiple Currencies Almost all PF and most PPP models have to address multiple currencies. Whilst there will be a fixed exchange rate specified at some date, the model should calculate future exchange rates based on relative price indices assuming some form of purchasing power parity. The balances on loans, bank accounts, sinking funds and the accounting balance sheet will require an exchange adjustment entry in each period. Funding Funding typically consists of a blend of loans and equity. On some projects there may also be mezzanine loans. Funding may be supplemented by government grants, either during the construction phase, the operating phase or both. Existing project revenues may also be used. For instance, in a toll road, the net operating revenues from
early operation of part of the project may fund later phases. Where there is a significant element of foreign equipment and materials it may be possible to obtain export credits. The model may need to include some short term loans during the operating phase, such as a stand-by loan, working capital loan or “feedstock supplier” credit for periods when there is a shortfall in available cash. Cash Traps and Cash Sweeps It is quite common for lenders to request “cash traps” and “cash sweeps” from the project accounts and the model must include these constraints on cash disbursements and availability. The Waterfall of Accounts The loan documentation will contain a description of the sequence of disbursements from the escrow account. This sequence should be included in the model. Similarly, the documentation should describe how shortfalls in the net operating cash flows are made good by a combination of additional equity and/or loans.
The Accounting Currency The project documentation will state the currency in which the accounts will be prepared, usually the local currency. The formula for the calculation of the undepreciated assets needs to be carefully considered. If the calculations are done and displayed in another currency, say US Dollars, it needs to recognize the currency exchange differences. Otherwise if the local currency depreciates against the US Dollar the
Copyright © 2010 Project Planning and Management Ltd
Page - 2 -
Rev 1 5 Aug 2010
undepreciated assets will be overstated and the corresponding corporate taxes will be understated. Legal Structures Most projects are set up as corporate entities in the form of special purpose vehicles. Some project financings can adopt different forms, such as a joint ventures or partnerships. These may impose additional expectations in the design of the model. Other types of projects, such as a privatised railway or a lease or a service agreement for an oil field, will inevitably gain from a model which looks at the cash flows for both parties. More complex projects, such as LNG trains with the shipping and re-gasification terminals may involve multiple corporations in different countries and need a more complex model to accommodate all stakeholders. Accounting Statements It is normal to include an Income Statement (Profit and Loss statement), a Cash Flow Statement and a Balance Sheet for the project entity. It is also normal to include a reconciliation of the dividends paid and earnings retained, sometimes included at the bottom of the Income Statement. The layout of these statements normally conforms to one of the acceptable layouts specified by the IFRS. Bank Accounts and Sinking Funds A typical model will include an Operating Account for day to day operating costs and an Escrow Account from which all other disbursements are made. It will also include one or more sinking funds. One of them is usually a Debt Service Reserve Accounts but there may be others such as a Maintenance Reserve Account. Fiscal Calculations Depending on the fiscal regime, the model may need to include calculations for any one or more of the following taxes: import duties, sales tax, loan interest withholdings, corporate tax, dividend withholdings and grants. If the project involves mineral recovery such as oil and gas, the model may also include bonuses, royalties and the financial consequences of production sharing agreements. Key Results The model should calculate the following results based on the project cash flows:
The Internal Rate of Return (IRR) in real and nominal terms, the Net Present Value (NPV), the Payback period in real and nominal terms (specify whether it is calculated from the start of construction or start of operation) and a Profitability Index (state how it is calculated). It is useful to record the same results but based on the equity cash flows (the draw down of the equity and the payment of dividends). Finally financial stakeholders expect the model to calculate the loan cover and any other ratios (periodic interest and debt service, loan life and project life). Expansions or Changes to the Project Models for some specific industries normally include calculations to determine when additional investments need to be made to ensure a minimum level of service when demand increases. Toll roads and railways are two such examples. In the case of railways, models include calculations for the number of trains needed to handle the expected traffic in each of the periods. In the case of toll roads, calculations to determine the number of lanes to handle the expected demand are important. The additional investments, such as more trains or lanes, require consideration as well as any sinking fund to meet the additional investments. Sensitivity analyses Tests on the robustness of the project include sensitivity analyses on key input variables. A “spider diagram” offers a good visual display of the results for, say, the construction schedule, capital costs, product price, utilization and operating costs. Another diagram can display the results for the project life.
Copyright © 2010 Project Planning and Management Ltd
Page - 3 -
Rev 1 5 Aug 2010
Other analyses can include price and capacity break evens and foreign exchange savings. Goal Seeking Models often include a facility to allow the user to set a goal and a variable which it will change in order to achieve that goal. For instance “What product price will yield a project IRR in real terms of 10%?” Cases and Scenarios Different cases (“scenarios”) are often used to illustrate the result of combinations of variations to key input variables (“what-ifs”). As a minimum, one low and one high case are essential, but usually others are run. During the construction and operating phase, tracking of budget versus actual expenditures in the financial model is desirable Risk Analyses Monte Carlo risk analyses undertaken by specialists are fast becoming the norm in financial modelling, as well as in project management models. PF,PPP projects often have a risk analysis carried out before any commitments are made, conventionally performed with a project management package such as Primavera, Artemis or Open Plan. They generate histograms illustrating the risk of building the project on time and within budge but do not cover: ? the risk weighted periodic revenues and operating costs over the life of the project. ? the chances of obtaining the budgeted Equity Net Present Value and IRR. ? the likelihood of a draw down on a standby loan or injection of additional equity into the project. ? the likelihood that the loan life cover ratios always remain above the limit imposed by the banks
A suitable financial model with Monte Carlo features answers such questions. Visual Presentation Pictures are worth a thousand words, so suitable charts bring the data to life in an attractive and informative way. In particular, charts for the cash flows and for the results of the sensitivity and risk analyses are helpful for stakeholders and lead the developer to potential errors. Documenting and Auditing the Model Finally, the model should always contain an area set aside for the developer to record explanatory comments and notes to help others understand the basis upon which it has been developed. Models may be initiated by the developer, then used and amended by various advisors and interested parties, in particular the banks. Responsibility for compliance with the amended agreed financial model during construction and operation of the project returns to the project developer after financial close. During the run up to this point, it can be difficult to keep track of changes to the model, so who did what? and when?. PRINCE 2 addresses this using Version Control and it would thus unite good project management with good project finance practices to have a clear auditable trail using a versioning system. Summary In this article we have reviewed some critical challenges in developing models for Project Financing and PPPs. Additionally we have explored the desirability of using a separate project financing model as a complement to a project management model.
.
John Macgillivray is a co-founder of Project Planning and Management Ltd and Promoter Software Ltd. He holds a BA Hons degree from Cambridge University and is a Chemical Engineer and a Chartered Engineer. He worked in the chemical contracting business for some 20 years and was a project manager for M W Kellogg Ltd. Amongst other projects, he worked on the Kuwait Oil Company Gas Project, at that time the largest LPG recovery project in the world. He changed direction and started to develop financial models beginning with Excel. Recognizing the limitations of using spreadsheets in this field, he has led the development of a software package for project finance and PPP models and has consulted in this area for over twenty years.
Copyright © 2010 Project Planning and Management Ltd
Page - 4 -
doc_637632192.pdf
PPP involves a contract between a public sector authority and a private party, in which the private party provides a public service or project and assumes substantial financial, technical and operational risk in the project.
Rev 1 5 Aug 2010
Project Finance and PPP Models
By John Macgillivray CEng, MIChemE, BA (Hons) Managing Director - Project Planning and Management Ltd.
Developing models for project finance (PF) and Public Private Partnerships (PPPs) presents some critical challenges. In this article we review some of the issues faced and make comment on how they should be handled. Why use a financial model? The basis for a project financing or a PPP is that the ring-fenced projected cash flows are strong enough to interest an investor and warrant a bank loan, and the repayments and returns will be based on the project cash flows alone. A model is therefore needed by the investors and the lenders to assess the cash flows under different scenarios throughout the life of the project. Differences between PF and PPP models PPPs use a private sector funding mechanism approach for public utilities and services. They cover many types of transactions some of which, such as pure management contracts, may not need a separate financial model. If a model is required, such as in concession-style contracts, the models differ little from private sector PF models except in the basis for calculating the revenue. PPP models will often have a reimbursement formula which is based on the capital and operating costs and may be affected by service availability and other external environmental factors. Differences between PF/PPP and corporate models PF/PPP models are similar to corporate planning models but are usually limited to a single plant or project and will include the following items not normally found in a corporate model: Cash sweeps Cash traps Waterfall of accounts Sinking funds Loans, often in more than one currency Two bank accounts (operating and escrow) Financing parties may also insist upon the minimum ratios to protect the project financial strength. These items are discussed further in this article.
Copyright © 2010 Project Planning and Management Ltd
The Model in Different Phases of the Project A simple model can be used in the pre-planning phases to compare the viability of different project designs. This financial model does not need the accounting, funding or fiscal calculations to determine the optimum project design though these are vital for fuding decisions. Models are most extensively used during the planning phases and before the “financial close”. Such models have extensive “what-if” analyses and will calculate the draw-down for the construction contract and the injection of equity and loan finance during the construction phase. The user can change, say, the construction schedule and the model will recalculate the draw-downs. A somewhat different model is needed once the design has been agreed. During the bidding and evaluation phase, the model should include the proposed contractor’s payment schedule and the corresponding loan and equity draw-down schedules as part of its inputs. During the construction and subsequent phases the model should also accept the actual accounting statements for previous periods as inputs. These are needed in order to use up-to-date figures in calculating cash flows and ratios linked to loan covenants. Design of the model The model should be as flexible as possible. If it is a planning phase model, it should allow for a change in the start date, the construction schedule, the design, the capital and operating costs, etc. There should be no hard coded figures. In the operating phase there will be less flexibility to change design inputs since these will be finalised at the end of the construction phase. The model should be laid out clearly with separate sheets for input and output. Colour coding will help the user understand which figures are inputs and which are calculated. Correct technical conversion factors are a crucial part of the model. This can be a crucial part of the model and it is very important to get them right. For instance, on a power project, the difference between a lower and a
Page - 1 -
Rev 1 5 Aug 2010
higher heating value (LHV and HHV) and when to use each variable is essential Revenues The revenues will be based on the market price and the market demand or a combination of capacity and operating cost payments as in a concession. This may come from an external expert. Operating Costs The operating costs are typically divided into fixed and variable. The fixed costs are incurred irrespective of output whilst the variable costs depend on the output. Again these may be provided by experts. Maintenance Most projects are shut down once a year for annual maintenance. Some industries require additional maintenance at longer intervals. For instance, ships are dry-docked at two or three year intervals. Under these circumstances the model should take into account the additional costs and the loss of earnings and include a sinking fund for these costs for these items. Working Capital Inclusion of the working capital is an essential (and often forgotten) item in any model. It should consist of both current assets and current liabilities. The initial working capital needs to be calculated and included in the funding. Multiple Currencies Almost all PF and most PPP models have to address multiple currencies. Whilst there will be a fixed exchange rate specified at some date, the model should calculate future exchange rates based on relative price indices assuming some form of purchasing power parity. The balances on loans, bank accounts, sinking funds and the accounting balance sheet will require an exchange adjustment entry in each period. Funding Funding typically consists of a blend of loans and equity. On some projects there may also be mezzanine loans. Funding may be supplemented by government grants, either during the construction phase, the operating phase or both. Existing project revenues may also be used. For instance, in a toll road, the net operating revenues from
early operation of part of the project may fund later phases. Where there is a significant element of foreign equipment and materials it may be possible to obtain export credits. The model may need to include some short term loans during the operating phase, such as a stand-by loan, working capital loan or “feedstock supplier” credit for periods when there is a shortfall in available cash. Cash Traps and Cash Sweeps It is quite common for lenders to request “cash traps” and “cash sweeps” from the project accounts and the model must include these constraints on cash disbursements and availability. The Waterfall of Accounts The loan documentation will contain a description of the sequence of disbursements from the escrow account. This sequence should be included in the model. Similarly, the documentation should describe how shortfalls in the net operating cash flows are made good by a combination of additional equity and/or loans.
The Accounting Currency The project documentation will state the currency in which the accounts will be prepared, usually the local currency. The formula for the calculation of the undepreciated assets needs to be carefully considered. If the calculations are done and displayed in another currency, say US Dollars, it needs to recognize the currency exchange differences. Otherwise if the local currency depreciates against the US Dollar the
Copyright © 2010 Project Planning and Management Ltd
Page - 2 -
Rev 1 5 Aug 2010
undepreciated assets will be overstated and the corresponding corporate taxes will be understated. Legal Structures Most projects are set up as corporate entities in the form of special purpose vehicles. Some project financings can adopt different forms, such as a joint ventures or partnerships. These may impose additional expectations in the design of the model. Other types of projects, such as a privatised railway or a lease or a service agreement for an oil field, will inevitably gain from a model which looks at the cash flows for both parties. More complex projects, such as LNG trains with the shipping and re-gasification terminals may involve multiple corporations in different countries and need a more complex model to accommodate all stakeholders. Accounting Statements It is normal to include an Income Statement (Profit and Loss statement), a Cash Flow Statement and a Balance Sheet for the project entity. It is also normal to include a reconciliation of the dividends paid and earnings retained, sometimes included at the bottom of the Income Statement. The layout of these statements normally conforms to one of the acceptable layouts specified by the IFRS. Bank Accounts and Sinking Funds A typical model will include an Operating Account for day to day operating costs and an Escrow Account from which all other disbursements are made. It will also include one or more sinking funds. One of them is usually a Debt Service Reserve Accounts but there may be others such as a Maintenance Reserve Account. Fiscal Calculations Depending on the fiscal regime, the model may need to include calculations for any one or more of the following taxes: import duties, sales tax, loan interest withholdings, corporate tax, dividend withholdings and grants. If the project involves mineral recovery such as oil and gas, the model may also include bonuses, royalties and the financial consequences of production sharing agreements. Key Results The model should calculate the following results based on the project cash flows:
The Internal Rate of Return (IRR) in real and nominal terms, the Net Present Value (NPV), the Payback period in real and nominal terms (specify whether it is calculated from the start of construction or start of operation) and a Profitability Index (state how it is calculated). It is useful to record the same results but based on the equity cash flows (the draw down of the equity and the payment of dividends). Finally financial stakeholders expect the model to calculate the loan cover and any other ratios (periodic interest and debt service, loan life and project life). Expansions or Changes to the Project Models for some specific industries normally include calculations to determine when additional investments need to be made to ensure a minimum level of service when demand increases. Toll roads and railways are two such examples. In the case of railways, models include calculations for the number of trains needed to handle the expected traffic in each of the periods. In the case of toll roads, calculations to determine the number of lanes to handle the expected demand are important. The additional investments, such as more trains or lanes, require consideration as well as any sinking fund to meet the additional investments. Sensitivity analyses Tests on the robustness of the project include sensitivity analyses on key input variables. A “spider diagram” offers a good visual display of the results for, say, the construction schedule, capital costs, product price, utilization and operating costs. Another diagram can display the results for the project life.
Copyright © 2010 Project Planning and Management Ltd
Page - 3 -
Rev 1 5 Aug 2010
Other analyses can include price and capacity break evens and foreign exchange savings. Goal Seeking Models often include a facility to allow the user to set a goal and a variable which it will change in order to achieve that goal. For instance “What product price will yield a project IRR in real terms of 10%?” Cases and Scenarios Different cases (“scenarios”) are often used to illustrate the result of combinations of variations to key input variables (“what-ifs”). As a minimum, one low and one high case are essential, but usually others are run. During the construction and operating phase, tracking of budget versus actual expenditures in the financial model is desirable Risk Analyses Monte Carlo risk analyses undertaken by specialists are fast becoming the norm in financial modelling, as well as in project management models. PF,PPP projects often have a risk analysis carried out before any commitments are made, conventionally performed with a project management package such as Primavera, Artemis or Open Plan. They generate histograms illustrating the risk of building the project on time and within budge but do not cover: ? the risk weighted periodic revenues and operating costs over the life of the project. ? the chances of obtaining the budgeted Equity Net Present Value and IRR. ? the likelihood of a draw down on a standby loan or injection of additional equity into the project. ? the likelihood that the loan life cover ratios always remain above the limit imposed by the banks
A suitable financial model with Monte Carlo features answers such questions. Visual Presentation Pictures are worth a thousand words, so suitable charts bring the data to life in an attractive and informative way. In particular, charts for the cash flows and for the results of the sensitivity and risk analyses are helpful for stakeholders and lead the developer to potential errors. Documenting and Auditing the Model Finally, the model should always contain an area set aside for the developer to record explanatory comments and notes to help others understand the basis upon which it has been developed. Models may be initiated by the developer, then used and amended by various advisors and interested parties, in particular the banks. Responsibility for compliance with the amended agreed financial model during construction and operation of the project returns to the project developer after financial close. During the run up to this point, it can be difficult to keep track of changes to the model, so who did what? and when?. PRINCE 2 addresses this using Version Control and it would thus unite good project management with good project finance practices to have a clear auditable trail using a versioning system. Summary In this article we have reviewed some critical challenges in developing models for Project Financing and PPPs. Additionally we have explored the desirability of using a separate project financing model as a complement to a project management model.
.
John Macgillivray is a co-founder of Project Planning and Management Ltd and Promoter Software Ltd. He holds a BA Hons degree from Cambridge University and is a Chemical Engineer and a Chartered Engineer. He worked in the chemical contracting business for some 20 years and was a project manager for M W Kellogg Ltd. Amongst other projects, he worked on the Kuwait Oil Company Gas Project, at that time the largest LPG recovery project in the world. He changed direction and started to develop financial models beginning with Excel. Recognizing the limitations of using spreadsheets in this field, he has led the development of a software package for project finance and PPP models and has consulted in this area for over twenty years.
Copyright © 2010 Project Planning and Management Ltd
Page - 4 -
doc_637632192.pdf