Description
This is a presentation about how project finance works. It explains project finance and its application to infrastructure development. Infrastructure projects - asset characteristics, Project finance vs corporate finance.
INTRODUCTION TO PROJECT FINANCE
PROJECT FINANCE-WHAT IS IT?
• Finnerty: “The raising of funds on a limited or non recourse basis to finance an economically separable capital investment in which the providers of the funds look primarily to cash flows from the project as source of funds to service their loans and provide the return of and a return on their equity invested in the project”
• PROJECT - a set of legally and economically independent assets with a single industrial use
• Limited or non recourse finance of a newly to be developed project through the establishment of a vehicle company [Kleimeier and Megginson [2000]] • Financing of a particular economic unit in which the lender is satisfied to look at the cash flows of earnings of that economic unit a s a source of funds from which the loan will be repaid and at the assets as collateral for the loan. [Nevitt and Fabozzi [2000]]
PROJECT FINANCE - MORE DEFINITIONS
HOW PROJECT FINANCE WORKS
Sponsor Lender
Minimum recourse
PROJECT
Sufficient credit support Credit/ contract support
Third party participants
PROJECT FINANCE AND ITS APPLICATION TO INFRASTRUCTURE DEVELOPMENT
WHAT IS INFRASTRUCTURE?
INFRASTRUCTURE INCLUDES….
• ENERGY –ELECTRICITY, OIL, GAS • MINING • INFORMATION AND COMMUNICATIONS TECH [ICT] • TRANSPORTATION- ROADS, PORTS, AIRPORTS • WATER SUPPLY • SANITATION AND OTHER URBAN SERVICES
INFRASTRUCTURE INVESTMENT AND ECONOMIC GROWTH • Research over last 15 years
– proved high economic returns to infrastructure investment – Where infrastructure investment inadequate, proved retarded growth – crippled productivity and opportunities
• At least 5.5% of GDP of developing countries required as infrastructure investment for projected growth • Present investment ranges from 2% -3% GDP
THE UNMET NEED FOR INFRASTRUCTURE –developing countries
100%
% of Developing Country Population
Number of people who…
80%
60%
4.0 bn
40%
2.0 bn
20%
2.3 bn
1.2 bn 1.0 bn
0% …Lack AllSeason Road Access …Lack Clean Water …Lack Sanitation …Lack Modern …Have Never Energy Made a Phone Call
TOMORROW’S INFRASTRUCTURE CHALLENGE….. • Will stem from population growth in developing countries • Over next 25 years, another 2 billion people added globally • Of these, 97% will be in developing countries • Urban population would double • Energy sector alone would require annual investment of USD 320 billion [currently less than half being spent]
India’s Infra Requirement
• Infrastructure growth- the need of the hour for India • India requires at least 10% of GDP invested in infrastructure • At present, only 6% of GDP invested • 11th plan estimates - India requires USD 320 billion in infra investment over the next 5 years [about USD 525bn at current prices- about Rs 19,00,000 crore] • China – 20% of GDP into infra investment
THE INFRA CHALLENGE
WHO WILL FUND THIS MASSIVE INVESTMENT THE
WORLD NEEDS??
WHO WILL FUND INFRASTRUCTURE INVESTMENT?
• • • • THE GOVERNMENT? THE BANKING SYSTEM? THE CAPITAL MARKETS? WHAT ARE THE INCENTIVES FOR CAPITAL PROVIDERS TO PARTICIPATE IN INFRASTRUCTURE DEVELOPMENT? • WHO WILL BEAR THE RISKS?
HOW ARE INFRASTRUCTURE PROJECTS DIFFERENT?
• • • • VERY LARGE INVESTMENTS VERY RISKY – HIGH DISTRESS COSTS LONG DURATION CAN GENERATE SIGNIFICANT FINANCIAL, DEVELOPMENTAL AND SOCIAL RETURNS WHEN SUCCESSFUL
INFRASTRUCTURE PROJECTSASSET CHARACTERISTICS
• • • • • • • • Very large Takes time to construct Tangible Specific use – no alternative uses Cannot be moved or divided Most cash outflows before one rupee of revenue Project valuable only after completion Only after completion – asset economically independent, capable of generating recession free cash flows
WE RETURN TO THE QUESTION…
WHO WILL FUND THESE RISKY PROJECTS?
ENTER ---THE PRIVATE SECTOR
• TRADITIONALLY, PUBLIC INFRASTRUCTURE WAS FINANCED BY THE GOVERNMENT OR GOVERNMENT OWNED BODIES • IN THE 1980s, FISCAL PRESSURES FORCED GOVERNMENTS TO INVOLVE THE PRIVATE SECTOR IN PUBLIC INFRASTRUCTURE PROJECTS – PUBLIC PRIVATE PARTNERSHIPS
TYPICAL ROLES IN PPP
The Public Sector (i.e. Government): - identifies the demand for a public service - defines the service outputs • agrees long-term concession (franchise) for the service - payment made against performance measures - imposes regulatory regime The Private Sector: - provides service; - design, builds, finances, operates and maintains the service and the assets
• operates within regulated environment [i.e. “public interest” requirements]
The Regulatory Challenge - Balancing Different Interests
Service Provider State
maximize profits Maintain priveleges
maximize sale/concession value; protect influential users; reduce state subsidies
Current Consumers (non-poor)
Excluded Households (Poor)
-
-
reduce tariffs
expand coverage
CONVENTIONAL FUNDING STRUCTURE – WORKS CONTRACTS
Contractor or Supplier
EPC Contract
PURCHASER Govt. Agency
BUDGET FUNDS
Govt.
WHO BEARS THE RISK IN THESE STRUCTURES?
PPPSPECTRUM OF OPTIONS
BUT….AS WE MOVE ALONG THE SPECTRUM…..
• THE PRIVATE INVESTORS HAVE TO BEAR MORE AND MORE RISKS • WHAT ARE THE INCENTIVES FOR PRIVATE INVESTORS TO TAKE ON RISKS FOR A PUBLIC GOOD? • HOW SHOULD PROJECTS BE STRUCTURED SO THAT MAJOR RISKS ARE MITIGATED?
A SATISFACTORY ANSWER..
…..LIES IN
“PROJECT FINANCE”
NON RECOURSE PROJECT FINANCE STRUCTURE
equity equity
VEHICLE COMPANY
Loan repayment contracts Construction, revenues loan guarantees ownership, operation 3rd parties Project assets lenders collateral
BUILD-OPERATE-TRANSFER MODEL
Concession SPONSOR SPONSOR agreementHOST GOVERNMENT EQUITY
VEHICLE COMPANY
Take over after concession period
3RD PARTIES
PROJECT ASSETS
LENDERS
HOW THE STRUCTURE WORKS
WARRANTIES OFFTAKE AGREEMENTS
TURNKEY
LONG TERM AGREEMENTS
OPERATIONS & MAINTENANCE
In a world with perfect capital markets • no transaction costs /single interest rate for all market participants • no bankruptcy cost • no taxes • no agency cost • no asymmetric information when a company has already decided on its investment decision the value of the firm (value of debt and equity combined) is independent of its financial structure.
Modigliani & Miller Proposition I
Modigliani & Miller Proposition
M&M premise Of Real World situations Structure irrelevance • Very high transaction costs that can • No transaction Costs affect the investment decision. • No taxes • Taxes are mostly positive and high and results in valuable tax shields. • No cost of Capital and governance structure decreases risk thereby decreasing cost Financial Distress of distress. • No agency conflict • Behavior of various parties can be controlled through structure. • No asymmetric • Type and sequence of financing can Information improve information.
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 1] TRANSACTION COSTS
• PF
• Higher structuring costs to set up project co.[lawyers/consultants/fin ancial advisors etc] • Harder to obtain operating synergies [project economically independent]
• CF • Lower structuring costs
• Easier to obtain operating synergies
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 2] Distress costs
• PF • Less threat of risk contamination [isolate losses at project level] • Little benefit from coinsurance • CF • Greater threat of risk contamination
• Greater potential for coinsurance
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 3] Taxes
• PF • Less ability to use interest tax shields and net operating losses • CF • Greater ability to use interest tax shields and Net Operating Losses
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 4] Information costs
• PF • Better information about project assets and cash flows [more credible] • CF • Less information on multiple, co-mingled assets and cash flows
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 5] Agency / incentive costs
• PF • Little managerial discretion [more discipline] • Restrictions on use of cash flow • Little risk of under-investment [projects have limited investment needs] • Better defense against sovereign interference [expropriation and hold up]
• CF • Greater managerial discretion
• Greater risk of leverage-induced under-investment
COMPARISON OF PF AND CF ORGANISATION
• CF • PF • Large businesses usually organized in • Project can be organized as partnership / limited liability corporate form company to utilize tax shields • Cash flows from more efficiently different assets and • Project related assets and cash businesses are coflows segregated from mingled sponsor’s other activities
COMPARISON OF PF AND CF – control and monitoring
• CF • • Control vested primarily in • management • Board of directors monitors corporate performance on behalf of shareholders • • Limited direct monitoring by investors • PF Management in control but project subject to closer monitoring Segregation of assets and cash flows enables greater accountability to investors Contractual arrangements governing debt and equity contain covenants / provisions for monitoring
COMPARISON OF PF AND CF – allocation of risk
• CF • Creditors have full recourse to project sponsor • Risks diversified across sponsor’s asset portfolio • Certain risks mitigated by insurance, hedging etc • PF • Creditors have limited or no recourse to sponsors • Contractual arrangements redistribute project related risks • Project risks allocated to parties who are best suited to bear them
COMPARISON OF PF AND CF – financial flexibility
• CF • Financing can be arranged relatively quickly /easily • Internally generated funds can be used to finance other projects, bypassing the discipline of the capital market • PF • Higher information, contracting and transaction costs • Financing arrangements structured and time consuming • Internally generated cash flows best reserved for proprietary projects
COMPARISON OF PF AND CF – free cash flow
• CF • Managers have broad discretion regarding allocation of free cash flow between dividends and reinvestment • Cash flows co-mingled and allocated according to corporate policy
• PF • Managers have limited discretion • By contract, free cash flows to be distributed to equity investors
COMPARISON OF PF AND CF – agency costs
• CF • Equity investors exposed to agency costs of free cash flow • Project specific management incentives more difficult • Agency costs greater than for project financing • PF • Agency costs of free cash flows reduced • Management incentive tied to project performance • Closer monitoring by investors possible • Under investment problem mitigated
COMPARISON OF PF AND CF – structure of debt contracts
• CF • Creditors look to sponsor’s entire asset portfolio for debt service • Debt could be unsecured [especially when borrower is a large corporation]
• PF
• Creditors look to specific project assets for debt service • Debt is secured • Debt contracts tailored to specific project characteristics
COMPARISON OF PF AND CF – debt capacity
• CF • Debt financing based on sponsor’s debt capacity
• PF • Credit support from other sources, e.g., purchasers of project output • Sponsor’s debt capacity can be expanded • Higher leverage [providing valuable tax shields] can be achieved
COMPARISON OF PF AND CF – bankruptcy
• CF • Lenders have the benefit of• sponsor’s entire asset • portfolio • • Difficulties in one key business could drain cash from ‘good’ projects and • vice versa • Financial distress costly and time consuming
PF Cost of financial distress lower Project can be isolated from sponsor’s possible bankruptcy and vice versa Lender’s chances of recovering principal more limited; debt not repayable from cash flows of other unrelated projects of sponsor
RISK MANAGEMENT IN PF
Underlying Fundamental: Risk borne by participant who is most efficient in managing this risk / who can best control this risk. Risks can be Exogenous or Endogenous to the project
RISK MANAGEMENT IN PF -contd
• Risk Sources [during chronological progress of project] • Performance • Technological • Economic • Financial • Force Majeure • Political
RISK CLASSIFICATION AND MANAGEMENT
• Performance Risk
• Exogenous - not significant • Endogenous • Project completion [delay, cost overrun]
• Project performance • • • • • • • • Technological risk Exogenous new untried tech unanticipated problems obsolescence Raw material availability Endogenous Initial development and analysis • Tech expertise
• Hedging Tools Completion
Guarantee Fixed Price Contracts
RISK CLASSIFICATION AND MANAGMENT-contd
• Economic risks • Exogenous • Input price, commodity, labor, output price, product demand, offtake competitor • Endogenous • product demand forecast, competitor anticipation. Agency costs Hedging Tools • Long Term Supply and Purchase Contracts Incentive compensation
• • • • • • •
Financial risks Exogenous FX, interest rate Endogenous Financial distress costs credit risk of purchasers Hedging Tools 1.Financial Instruments 2.Loan Denomination
RISK CLASSIFICATION AND MANAGEMENT-contd
• Force majeure risks • Exogenous • Acts of God, catastrophies Hedging tool • Insurance
• Political risks • Exogenous • Regulatory and tax risks, expropriation • Endogenous • Govt stake in project Hedging Tools 1.Insurance 2. Local Project Participants 3.Government Involvement
How can ‘risky’ PF have high leverage and average price?
• PF is not ‘risky’
Effective risk management • Large set of risk mgt contracts, guarantees, etc Reduction of agency cost of equity • Create incentive-structure for management • Reduce free-cash-flow problem • Reduce agency problems between sponsors Reduction of asymmetric information • Monitoring by lenders • Provision of information by government to bidders (BOT)
OTHER MOTIVATIONS FOR PROJECT FINANCE
• Tax: An independent company can avail of tax holidays. • Location: Large projects in emerging markets cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive. Debt is the only option and project finance is the optimal structure. • Heterogeneous partners:
– – – – Financially weak partner needs project finance to participate. It bears the cost of providing the project with the benefits of project finance. The bigger partner if using corporate finance can be seen as free-riding. The bigger partner is better equipped to negotiate terms with banks than the smaller partner and hence has to participate in project finance.
PROJECT FINANCE: THE FLIP SIDE
• Takes longer to structure than equivalent size corporate finance. • Higher transaction costs due to creation of an independent entity. • Project debt could be more expensive (50-400 basis points) due to its non-recourse nature. • Extensive contracting restricts managerial decision making. • Project finance requires greater disclosure of proprietary information and strategic deals.
PPP IN INDIA
• NATIONAL HIGHWAY PROJECTS [USD 38 BN SO FAR] • AIRPORTS • MEGA POWER PROJECTS • TELECOM • PORTS • WATER SUPPLY [ IN A SMALL WAY – TIRUPPUR WATER SUPPLY PROJECT]
IS THE INVESTMENT ENOUGH FOR INDIA’S GROWTH?
• INDIA REQUIRES AT LEAST 10% OF GDP INVESTED IN INFRASTRUCTURE • AT PRESENT, ONLY 6% OF GDP INVESTED • COMPARE THIS TO CHINA – 20% OF GDP INTO INFRA INVESTMENT
Active bond markets a must for infrastructure growth
• Bond markets provide long term funds for infrastructure • Infrastructure assets have the ability to generate stable, recession-proof cash flows, once the project is on stream • Institutional investors view infrastructure investment as a preferred way to hedge their long term liabilities • Active secondary markets would help in transferring credit risk
THANX
doc_204258150.pptx
This is a presentation about how project finance works. It explains project finance and its application to infrastructure development. Infrastructure projects - asset characteristics, Project finance vs corporate finance.
INTRODUCTION TO PROJECT FINANCE
PROJECT FINANCE-WHAT IS IT?
• Finnerty: “The raising of funds on a limited or non recourse basis to finance an economically separable capital investment in which the providers of the funds look primarily to cash flows from the project as source of funds to service their loans and provide the return of and a return on their equity invested in the project”
• PROJECT - a set of legally and economically independent assets with a single industrial use
• Limited or non recourse finance of a newly to be developed project through the establishment of a vehicle company [Kleimeier and Megginson [2000]] • Financing of a particular economic unit in which the lender is satisfied to look at the cash flows of earnings of that economic unit a s a source of funds from which the loan will be repaid and at the assets as collateral for the loan. [Nevitt and Fabozzi [2000]]
PROJECT FINANCE - MORE DEFINITIONS
HOW PROJECT FINANCE WORKS
Sponsor Lender
Minimum recourse
PROJECT
Sufficient credit support Credit/ contract support
Third party participants
PROJECT FINANCE AND ITS APPLICATION TO INFRASTRUCTURE DEVELOPMENT
WHAT IS INFRASTRUCTURE?
INFRASTRUCTURE INCLUDES….
• ENERGY –ELECTRICITY, OIL, GAS • MINING • INFORMATION AND COMMUNICATIONS TECH [ICT] • TRANSPORTATION- ROADS, PORTS, AIRPORTS • WATER SUPPLY • SANITATION AND OTHER URBAN SERVICES
INFRASTRUCTURE INVESTMENT AND ECONOMIC GROWTH • Research over last 15 years
– proved high economic returns to infrastructure investment – Where infrastructure investment inadequate, proved retarded growth – crippled productivity and opportunities
• At least 5.5% of GDP of developing countries required as infrastructure investment for projected growth • Present investment ranges from 2% -3% GDP
THE UNMET NEED FOR INFRASTRUCTURE –developing countries
100%
% of Developing Country Population
Number of people who…
80%
60%
4.0 bn
40%
2.0 bn
20%
2.3 bn
1.2 bn 1.0 bn
0% …Lack AllSeason Road Access …Lack Clean Water …Lack Sanitation …Lack Modern …Have Never Energy Made a Phone Call
TOMORROW’S INFRASTRUCTURE CHALLENGE….. • Will stem from population growth in developing countries • Over next 25 years, another 2 billion people added globally • Of these, 97% will be in developing countries • Urban population would double • Energy sector alone would require annual investment of USD 320 billion [currently less than half being spent]
India’s Infra Requirement
• Infrastructure growth- the need of the hour for India • India requires at least 10% of GDP invested in infrastructure • At present, only 6% of GDP invested • 11th plan estimates - India requires USD 320 billion in infra investment over the next 5 years [about USD 525bn at current prices- about Rs 19,00,000 crore] • China – 20% of GDP into infra investment
THE INFRA CHALLENGE
WHO WILL FUND THIS MASSIVE INVESTMENT THE
WORLD NEEDS??
WHO WILL FUND INFRASTRUCTURE INVESTMENT?
• • • • THE GOVERNMENT? THE BANKING SYSTEM? THE CAPITAL MARKETS? WHAT ARE THE INCENTIVES FOR CAPITAL PROVIDERS TO PARTICIPATE IN INFRASTRUCTURE DEVELOPMENT? • WHO WILL BEAR THE RISKS?
HOW ARE INFRASTRUCTURE PROJECTS DIFFERENT?
• • • • VERY LARGE INVESTMENTS VERY RISKY – HIGH DISTRESS COSTS LONG DURATION CAN GENERATE SIGNIFICANT FINANCIAL, DEVELOPMENTAL AND SOCIAL RETURNS WHEN SUCCESSFUL
INFRASTRUCTURE PROJECTSASSET CHARACTERISTICS
• • • • • • • • Very large Takes time to construct Tangible Specific use – no alternative uses Cannot be moved or divided Most cash outflows before one rupee of revenue Project valuable only after completion Only after completion – asset economically independent, capable of generating recession free cash flows
WE RETURN TO THE QUESTION…
WHO WILL FUND THESE RISKY PROJECTS?
ENTER ---THE PRIVATE SECTOR
• TRADITIONALLY, PUBLIC INFRASTRUCTURE WAS FINANCED BY THE GOVERNMENT OR GOVERNMENT OWNED BODIES • IN THE 1980s, FISCAL PRESSURES FORCED GOVERNMENTS TO INVOLVE THE PRIVATE SECTOR IN PUBLIC INFRASTRUCTURE PROJECTS – PUBLIC PRIVATE PARTNERSHIPS
TYPICAL ROLES IN PPP
The Public Sector (i.e. Government): - identifies the demand for a public service - defines the service outputs • agrees long-term concession (franchise) for the service - payment made against performance measures - imposes regulatory regime The Private Sector: - provides service; - design, builds, finances, operates and maintains the service and the assets
• operates within regulated environment [i.e. “public interest” requirements]
The Regulatory Challenge - Balancing Different Interests
Service Provider State
maximize profits Maintain priveleges
maximize sale/concession value; protect influential users; reduce state subsidies
Current Consumers (non-poor)
Excluded Households (Poor)
-
-
reduce tariffs
expand coverage
CONVENTIONAL FUNDING STRUCTURE – WORKS CONTRACTS
Contractor or Supplier
EPC Contract
PURCHASER Govt. Agency
BUDGET FUNDS
Govt.
WHO BEARS THE RISK IN THESE STRUCTURES?
PPPSPECTRUM OF OPTIONS
BUT….AS WE MOVE ALONG THE SPECTRUM…..
• THE PRIVATE INVESTORS HAVE TO BEAR MORE AND MORE RISKS • WHAT ARE THE INCENTIVES FOR PRIVATE INVESTORS TO TAKE ON RISKS FOR A PUBLIC GOOD? • HOW SHOULD PROJECTS BE STRUCTURED SO THAT MAJOR RISKS ARE MITIGATED?
A SATISFACTORY ANSWER..
…..LIES IN
“PROJECT FINANCE”
NON RECOURSE PROJECT FINANCE STRUCTURE
equity equity
VEHICLE COMPANY
Loan repayment contracts Construction, revenues loan guarantees ownership, operation 3rd parties Project assets lenders collateral
BUILD-OPERATE-TRANSFER MODEL
Concession SPONSOR SPONSOR agreementHOST GOVERNMENT EQUITY
VEHICLE COMPANY
Take over after concession period
3RD PARTIES
PROJECT ASSETS
LENDERS
HOW THE STRUCTURE WORKS
WARRANTIES OFFTAKE AGREEMENTS
TURNKEY
LONG TERM AGREEMENTS
OPERATIONS & MAINTENANCE
In a world with perfect capital markets • no transaction costs /single interest rate for all market participants • no bankruptcy cost • no taxes • no agency cost • no asymmetric information when a company has already decided on its investment decision the value of the firm (value of debt and equity combined) is independent of its financial structure.
Modigliani & Miller Proposition I
Modigliani & Miller Proposition
M&M premise Of Real World situations Structure irrelevance • Very high transaction costs that can • No transaction Costs affect the investment decision. • No taxes • Taxes are mostly positive and high and results in valuable tax shields. • No cost of Capital and governance structure decreases risk thereby decreasing cost Financial Distress of distress. • No agency conflict • Behavior of various parties can be controlled through structure. • No asymmetric • Type and sequence of financing can Information improve information.
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 1] TRANSACTION COSTS
• PF
• Higher structuring costs to set up project co.[lawyers/consultants/fin ancial advisors etc] • Harder to obtain operating synergies [project economically independent]
• CF • Lower structuring costs
• Easier to obtain operating synergies
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 2] Distress costs
• PF • Less threat of risk contamination [isolate losses at project level] • Little benefit from coinsurance • CF • Greater threat of risk contamination
• Greater potential for coinsurance
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 3] Taxes
• PF • Less ability to use interest tax shields and net operating losses • CF • Greater ability to use interest tax shields and Net Operating Losses
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 4] Information costs
• PF • Better information about project assets and cash flows [more credible] • CF • Less information on multiple, co-mingled assets and cash flows
PF VS CORPORATE FINANCE: MARKET IMPERFECTIONS 5] Agency / incentive costs
• PF • Little managerial discretion [more discipline] • Restrictions on use of cash flow • Little risk of under-investment [projects have limited investment needs] • Better defense against sovereign interference [expropriation and hold up]
• CF • Greater managerial discretion
• Greater risk of leverage-induced under-investment
COMPARISON OF PF AND CF ORGANISATION
• CF • PF • Large businesses usually organized in • Project can be organized as partnership / limited liability corporate form company to utilize tax shields • Cash flows from more efficiently different assets and • Project related assets and cash businesses are coflows segregated from mingled sponsor’s other activities
COMPARISON OF PF AND CF – control and monitoring
• CF • • Control vested primarily in • management • Board of directors monitors corporate performance on behalf of shareholders • • Limited direct monitoring by investors • PF Management in control but project subject to closer monitoring Segregation of assets and cash flows enables greater accountability to investors Contractual arrangements governing debt and equity contain covenants / provisions for monitoring
COMPARISON OF PF AND CF – allocation of risk
• CF • Creditors have full recourse to project sponsor • Risks diversified across sponsor’s asset portfolio • Certain risks mitigated by insurance, hedging etc • PF • Creditors have limited or no recourse to sponsors • Contractual arrangements redistribute project related risks • Project risks allocated to parties who are best suited to bear them
COMPARISON OF PF AND CF – financial flexibility
• CF • Financing can be arranged relatively quickly /easily • Internally generated funds can be used to finance other projects, bypassing the discipline of the capital market • PF • Higher information, contracting and transaction costs • Financing arrangements structured and time consuming • Internally generated cash flows best reserved for proprietary projects
COMPARISON OF PF AND CF – free cash flow
• CF • Managers have broad discretion regarding allocation of free cash flow between dividends and reinvestment • Cash flows co-mingled and allocated according to corporate policy
• PF • Managers have limited discretion • By contract, free cash flows to be distributed to equity investors
COMPARISON OF PF AND CF – agency costs
• CF • Equity investors exposed to agency costs of free cash flow • Project specific management incentives more difficult • Agency costs greater than for project financing • PF • Agency costs of free cash flows reduced • Management incentive tied to project performance • Closer monitoring by investors possible • Under investment problem mitigated
COMPARISON OF PF AND CF – structure of debt contracts
• CF • Creditors look to sponsor’s entire asset portfolio for debt service • Debt could be unsecured [especially when borrower is a large corporation]
• PF
• Creditors look to specific project assets for debt service • Debt is secured • Debt contracts tailored to specific project characteristics
COMPARISON OF PF AND CF – debt capacity
• CF • Debt financing based on sponsor’s debt capacity
• PF • Credit support from other sources, e.g., purchasers of project output • Sponsor’s debt capacity can be expanded • Higher leverage [providing valuable tax shields] can be achieved
COMPARISON OF PF AND CF – bankruptcy
• CF • Lenders have the benefit of• sponsor’s entire asset • portfolio • • Difficulties in one key business could drain cash from ‘good’ projects and • vice versa • Financial distress costly and time consuming
PF Cost of financial distress lower Project can be isolated from sponsor’s possible bankruptcy and vice versa Lender’s chances of recovering principal more limited; debt not repayable from cash flows of other unrelated projects of sponsor
RISK MANAGEMENT IN PF
Underlying Fundamental: Risk borne by participant who is most efficient in managing this risk / who can best control this risk. Risks can be Exogenous or Endogenous to the project
RISK MANAGEMENT IN PF -contd
• Risk Sources [during chronological progress of project] • Performance • Technological • Economic • Financial • Force Majeure • Political
RISK CLASSIFICATION AND MANAGEMENT
• Performance Risk
• Exogenous - not significant • Endogenous • Project completion [delay, cost overrun]
• Project performance • • • • • • • • Technological risk Exogenous new untried tech unanticipated problems obsolescence Raw material availability Endogenous Initial development and analysis • Tech expertise
• Hedging Tools Completion
Guarantee Fixed Price Contracts
RISK CLASSIFICATION AND MANAGMENT-contd
• Economic risks • Exogenous • Input price, commodity, labor, output price, product demand, offtake competitor • Endogenous • product demand forecast, competitor anticipation. Agency costs Hedging Tools • Long Term Supply and Purchase Contracts Incentive compensation
• • • • • • •
Financial risks Exogenous FX, interest rate Endogenous Financial distress costs credit risk of purchasers Hedging Tools 1.Financial Instruments 2.Loan Denomination
RISK CLASSIFICATION AND MANAGEMENT-contd
• Force majeure risks • Exogenous • Acts of God, catastrophies Hedging tool • Insurance
• Political risks • Exogenous • Regulatory and tax risks, expropriation • Endogenous • Govt stake in project Hedging Tools 1.Insurance 2. Local Project Participants 3.Government Involvement
How can ‘risky’ PF have high leverage and average price?
• PF is not ‘risky’
Effective risk management • Large set of risk mgt contracts, guarantees, etc Reduction of agency cost of equity • Create incentive-structure for management • Reduce free-cash-flow problem • Reduce agency problems between sponsors Reduction of asymmetric information • Monitoring by lenders • Provision of information by government to bidders (BOT)
OTHER MOTIVATIONS FOR PROJECT FINANCE
• Tax: An independent company can avail of tax holidays. • Location: Large projects in emerging markets cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive. Debt is the only option and project finance is the optimal structure. • Heterogeneous partners:
– – – – Financially weak partner needs project finance to participate. It bears the cost of providing the project with the benefits of project finance. The bigger partner if using corporate finance can be seen as free-riding. The bigger partner is better equipped to negotiate terms with banks than the smaller partner and hence has to participate in project finance.
PROJECT FINANCE: THE FLIP SIDE
• Takes longer to structure than equivalent size corporate finance. • Higher transaction costs due to creation of an independent entity. • Project debt could be more expensive (50-400 basis points) due to its non-recourse nature. • Extensive contracting restricts managerial decision making. • Project finance requires greater disclosure of proprietary information and strategic deals.
PPP IN INDIA
• NATIONAL HIGHWAY PROJECTS [USD 38 BN SO FAR] • AIRPORTS • MEGA POWER PROJECTS • TELECOM • PORTS • WATER SUPPLY [ IN A SMALL WAY – TIRUPPUR WATER SUPPLY PROJECT]
IS THE INVESTMENT ENOUGH FOR INDIA’S GROWTH?
• INDIA REQUIRES AT LEAST 10% OF GDP INVESTED IN INFRASTRUCTURE • AT PRESENT, ONLY 6% OF GDP INVESTED • COMPARE THIS TO CHINA – 20% OF GDP INTO INFRA INVESTMENT
Active bond markets a must for infrastructure growth
• Bond markets provide long term funds for infrastructure • Infrastructure assets have the ability to generate stable, recession-proof cash flows, once the project is on stream • Institutional investors view infrastructure investment as a preferred way to hedge their long term liabilities • Active secondary markets would help in transferring credit risk
THANX
doc_204258150.pptx