Project Finance in Construction: A Structured Guide to Assessment

Project Finance in Construction Project Finance in Construction A Structured Guide to Assessment Anthony Merna Oriel ...

Author: Tony Merna | Yang Chu | Faisal F. Al-Thani

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Project Finance in Construction

Project Finance in Construction A Structured Guide to Assessment Anthony Merna Oriel Group Practice Manchester, UK

Yang Chu Postdoctoral Research Associate Manchester Business School The University of Manchester UK

Faisal Fahad Al-Thani Senior Director and Head of Business Development Maersk Oil Doha, Qatar

A John Wiley & Sons, Ltd., Publication

This edition first published 2010 C Anthony Merna Blackwell Publishing was acquired by John Wiley & Sons in February 2007. Blackwell’s publishing programme has been merged with Wiley’s global Scientific, Technical, and Medical business to form Wiley-Blackwell. Registered office John Wiley & Sons Ltd., The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom Editorial offices 9600 Garsington Road, Oxford, OX4 2DQ, United Kingdom 2121 State Avenue, Ames, Iowa 50014-8300, USA For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book, please see our website at www.wiley.com/wiley-blackwell. The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Library of Congress Cataloging-in-Publication Data Merna, Anthony. Project finance in construction : a structured guide to assessment/Anthony Merna, Yang Chu, Faisal Al-Thani. – 1st ed. p. cm. Includes bibliographical references and index. ISBN 978-1-4443-3477-7 (pbk. : alk. paper) 1. Infrastructure (Economics)–Finance. 2. Industrial development projects. 3. Risk management. 4. Public-private sector cooperation. I. Zhu, Yang. II. Al-Thani, Faisal F. III. Title. HC79.C3M47 2010 624.068 1–dc22 2010007731 A catalogue record for this book is available from the British Library. R Inc., New Delhi, India Set in 10/13pt Palatino by Aptara Printed in Malaysia

1

2010

Contents

List of illustrations List of tables About the Authors Preface

xi xiii xv xvii

1 Introduction

1

1.1 1.2

1.3 1.4

The development of project finance Financial assessment What is financial assessment? Why perform a financial assessment? Who is involved in the risk assessment process? Where should a financial assessment be performed? When should a financial assessment be performed? What data are to be used? How should assessment outputs be presented? Purpose of this guide Scope of the guide

2 Project finance 2.1 2.2 2.3

2.4

Introduction Definition of project finance The key characteristics of project finance Special project/purpose vehicle Contractual arrangement Non-/limited recourse Off-balance sheet transaction Robust income stream of the project as the basis for financing Legal and financial considerations in project finance Legal Financial

1 6 6 6 7 7 8 8 8 9 9

11 11 11 13 14 14 17 18 19 20 20 22

v

vi

Contents

3 Financial instruments and cash flow modelling 3.1 3.2 3.3

3.4 3.5 3.6

Introduction Debt finance Senior debt Mezzanine finance Subordinate debt Bond finance Equity finance Sources of debt and equity Cash flow modelling and project financing

4 Risk management 4.1 4.2 4.3

4.4

Introduction Risk Risk management process Risk identification Risk analysis Risk response Typical risks in project financing

5 The financial assessment process 5.1 5.2

Introduction The financial assessment structure SPV assessment Lenders’ assessment SPV and lender final assessment

6 Case study 6.1 6.2 6.3

6.4

Introduction Independent power project Supply and offtake contracts Supply contracts Offtake contracts Applications of supply and offtake contracts Assumptions for initial assessment

7 Developing the base case model 7.1 7.2

Introduction SPV’s initial assessment

25 25 25 27 28 28 29 31 34 34

39 39 39 41 42 44 47 49

51 51 51 51 54 55

57 57 57 58 60 61 64 65

69 69 69

vii

Contents

7.3 7.4 7.5 7.6

Identify the estimated activities, time, costs and revenues of the project Development of the base case model Identify major project risks Assessment of base case model incorporating risks

8 Initial economic assessment by lenders 8.1 8.2

8.3

Introduction Financial package assessment Finance package (1) Finance package (2) Finance package (3) Conclusions

9 Financial engineering 9.1 9.2

9.3 9.4 9.5 9.6

Introduction Financial instruments used in financial engineering Forward rates Financial futures Swaps Options Caps, floors, collars, swaptions and compound options Asset-backed securities Refinancing Reappraising public–private partnerships Techniques applied in the reappraisal of PPP concession agreement Other financial engineering techniques

10 Final assessment to determine project commercial viability 10.1 10.2 10.3

Introduction Detailed risk assessment Financial engineering Tax holiday Financial collar Extending the concession Increasing debt

70 71 73 74

77 77 77 78 82 83 87

89 89 90 90 90 91 92 92 93 94 94 95 96

101 101 101 105 105 107 107 107

viii

Contents

10.4

Grace period Phasing construction and operation Upfront payments Existing concession revenues Summary

11 Financial close 11.1 11.2

11.3

Introduction Due diligence Technical Legal due diligence Trigger step in rights Model audit and sensitivity analysis Risk valuation Term sheet Inter-creditor agreement Hedge strategy Letters of credit Reserve account Escrow and ring-fenced facilities Economic indicators Taxation Insurance Financial close Credit committee approval process Due diligence report Technical closure Financial close Technical commencement Execute interest rate swaps

12 Islamic finance and project finance 12.1 12.2 12.3 12.4

Introduction Islamic finance Shariah Qiyas and Litihad Core principles of Islamic finance Sharing (profit/loss and risk)

108 108 108 108 109

111 111 111 113 114 116 116 117 117 117 118 118 119 119 120 120 121 122 123 124 124 124 124 125

127 127 127 129 129 130 130

ix

Contents

No unfair gain No speculation No uncertainty No investments that are not in the public interest No hoarding of money Deception Islamic financial institutions Shariah supervisory boards 12.5 Project finance The Ijara principle Ijara Mawsufah Fi Al Dhimmah (forward lease) Istisna’a Sukuk Sukuk al Istisna’a A typical SAI deal Hedging Swaps 12.6 Other Islamic finance techniques for projects Musharaka (equity financing) Bai salam (forward financing) 12.7 Risks and liabilities 12.8 Summary

13 Conclusions and recommendations 13.1 13.2 13.3

Review Conclusions Recommendations

Appendix Glossary References Index

130 130 130 131 131 131 131 132 132 133 133 133 134 135 135 136 137 137 137 138 138 139

141 141 142 144

147 159 161 167

List of illustrations

Figure 1.1 Figure 2.1 Figure 3.1 Figure 3.2 Figure 4.1 Figure 4.2 Figure 5.1 Figure 6.1 Figure 6.2

Figure 6.3 Figure 7.1 Figure 7.2 Figure 8.1 Figure 8.2 Figure 10.1 Figure 10.2 Figure 10.3 Figure 11.1 Figure 11.2 Figure 12.1 Figure 12.2

Brief history of project finance (Chu, 2007) A typical BOOT corporate structure (Merna and Smith 1994). Typical cumulative cash flow stages of a project (Merna and Smith 1994). Seniority of financial instruments (Merna and Al-Thani 2008). Risk management cycle (Merna and Al-Thani 2008). Risk assessment for an organisation (Merna and Al-Thani 2008). Financial assessment structure. Assessments by SPV and lenders to determine the commercial viability. Supply contract and offtake contract arrangements in the power station (adapted from Merna and Smith 1994). Project programme: major activities (generated by Microsoft Project). Base case CCF. Base, best and worst case CCF. Finance package of 80:20 debt/equity. 80:10:10 debt/bond/equity. Sensitivity analysis. Cumulative probability diagram. Cumulative probability diagram (after mitigation). Due diligence process (Merna and Smith 1994). Typical financial close process (Merna and Smith 1994). Project financing structure. Typical Arbun arrangement.

2 15 36 38 42 43 52 59

65 67 72 75 82 85 103 104 104 112 123 135 136

xi

List of tables

Table 3.1 Table 4.1 Table 4.2 Table 4.3 Table 5.1 Table 5.2 Table 5.3 Table 6.1 Table 6.2 Table 6.3 Table 7.1 Table 7.2 Table 7.3 Table 7.4 Table 8.1 Table 8.2 Table 8.3

Table 9.1 Table 10.1 Table 10.2

Bond ratings Global and elemental risks (Chu 2007) Financial and non-financial risks (Chu 2007) Risks affecting different phases of a project’s life cycle Typical costs and revenues over project life cycle Typical financial instruments, repayments and cash flows Typical cover ratios used by lenders Basic details of the project Projects with supply contracts (Chu 2007) Projects with offtake contracts (Chu 2007) Activities, costs and revenue estimates and their timings Base case model cash flow and cumulative cash flow Base case economic parameters Economic parameters of base, best and worst case scenarios Project economics and cover ratios under 100% debt (US$ million) Project economics and cover ratio table under 80:20 debt/equity (US$ million) Project cash flow allocation table under 10:80:10 debt/bond/equity for the bond with a 10-year maturity (US$ million) Techniques applied in the reappraisal of PPP concession agreements (Merna and Smith 1994) Risks and their upside and downside ranges Summary of the project economics and cash availability (US$ million)

32 49 49 50 54 54 55 58 62 64 70 72 73 75 79 84

86 97 102 106

xiii

About the Authors

Dr. Anthony Merna is a senior partner of Oriel Group Practice, a multidisciplinary research and consultancy practice based in Manchester, and a visiting lecturer to Manchester Business School at the University of Manchester. Dr. Yang Chu is a graduate of the School of Mechanical, Aerospace and Civil Engineering at the University of Manchester and a research consultant with Oriel Group Practice, specialising in the areas of project finance and risk modelling. He is currently carrying out risk management research at Manchester Business School. Dr. Faisal Fahad Al-Thani is Senior Director and Head of Business Development, Middle East for Maersk Oil, based in Doha, and a board member of the Marsh International Risk Council.

xv

Preface

At the time of writing this guide, financial markets remain uncertain. This has led many sponsors of project financings to further consider bank liquidity, the higher cost of finance and general uncertainty for demand. This has resulted in the postponement of a number of projects in certain industry sectors. Governments have seen tax receipts drastically reduced, which has affected their ability to finance infrastructure projects, often irrespective of the perceived demand. Equity providers still seek to invest; however, there are less opportunities due to market dislocation. Due to the demand for global infrastructure, it is believed that project financings will return to their pre-crunch levels, or more so; however, lenders’ liquidity costs will be passed on to the borrowers. Lenders will also be under stricter regulation both internally and externally. The steps outlined in the guide are designed to provide a basic understanding for all those involved or interested in both structuring and assessing project financings. Secondary contracts involving constructors, operators, finance providers, suppliers and offtakers can be developed and assessed to determine their commercial viability over a project’s life cycle.

xvii

Chapter 1 Introduction

1.1

The development of project finance

Project financing is not a new financing method. It has been used to finance industrial projects such as mines, pipelines, power stations and oil fields. An early recorded application of project finance dates back to 1299, when the English Crown negotiated a loan from Frescobaldi, a leading Italian merchant bank, for which payment was to be made in the form of output from the Devon silver mines. The bank received a 1-year lease for the total output of the mines in exchange for paying all operating costs without recourse to the Crown if the value or amount of the extracted ore was less than predicted (Finnerty 1996; Esty 2004). Today, such a loan arrangement is known as a production payment loan. The brief history of the development of project finance is illustrated in Figure 1.1. Tinsley (2000) suggests that the modern history of project finance began with production payment financing in a Texas oilfield project in 1930. A driller funded the well-drilling costs in exchange for a share in future oil revenue. This technique was imported into Europe to finance large projects such as the North Sea oilfields in the late 1970s. However, the advent of modern project finance is often regarded as beginning in the 1970s, with the successful development of the North Sea oilfields by British Petroleum, which raised US$945 million on a project basis from a syndicate of 66 banks (Esty 2004). At that time, it was the largest industrial loan in history. Following the success of North Sea developments, project finance has been associated with many financial and operating success stories. These include the Ras Laffan LNG project in Qatar (Finance 2005), the Shajiao power station in China (Merna and Njiru 2002) and the Petrozuata heavy oil project in Venezuela, as well as numerous independent power projects (IPPs) in the United States (Esty et al. 1999). 1

2


PFI, PPP Devon silver Texas mine oilfield

1299

Figure 1.1

1930

North Sea oilfield

1970

Power plant in America, minerals in the UK Pipeline project, water Infrastructures Oil and gas, petrochemical Leisure and property Agriculture 1980

1990

2000

2007

Brief history of project finance (Chu 2007).

Project finance has been evolving, with the potential for significant innovation, especially in the area of collaborative public–private financing (Feming et al. 2004). The private finance initiative (PFI) was introduced to involve the private sector in financing and managing infrastructure projects and service provision in the UK in 1992 (Mustafa 1999). Project finance has spread worldwide and includes numerous industrial projects such as power stations, gas pipelines, waste-disposal plants, waste-to-energy plants, telecommunication facilities, bridges, tunnels, toll roads, railway networks, city centre tram links and now the building of hospitals, education facilities, government accommodation and tourist facilities. The technique has also been applied to aircraft and ship financing. The demand for project financing remains high throughout the world. According to Thomson Financial (2006), global project finance loan volumes grew 50.3% to reach US$88.8 billion from 182 issues in the first 6 months of 2006 and at total proceeds of US$59.1 billion from 246 issues in the same period of 2005. The power sector remains the industry leader for project finance loans. The transportation sector increased to US$24.1 billion borrowings, while the petrochemical sector also produced positive growth from US$2.8 billion in the first 6 months of 2005 to US$15.7 billion in the first 6 months of 2006. According to Platt (2006), high oil prices have contributed to an increase in the number of projects being procured in the Middle East. Project finance deals are booming in the Middle East, some incorporating Islamic finance laws. The Eastern Europe, Middle East

Introduction

3

and Africa (EMEA) region led the Americas and Asia-Pacific in midyear 2006 project finance loan volumes with total proceeds of US$56.6 billion from 97 issues. In EMEA region, US$29.1 billion project finance was loaned in the Middle East in 2006 (Thomson Financial 2006). Saudi Arabia has surpassed Qatar as the leading country for project finance in the Middle East. Saudi Petrol-Rabigh project is one of the biggest oil refining and integrated petrochemical projects in the world; meanwhile, it is the largest project financing to date in Saudi Arabia as well as the largest in the region to incorporate long-term Islamic financing. According to Thompson Reuters (2009), the first quarter of 2008 saw the highest-ever volume of project finance transactions worldwide, with more than 125 transactions totalling US$56.4 billion. In the first quarter of 2009, global project finance activity sank to its lowest level since 2003. Deals totalled just US$19.4 billion in proceeds from 69 transactions. Tullow Oil’s US$2 billion deal was the largest transaction during this period. Following record high volumes in 2008, AsiaPacific project finance totalled US$5.1 billion during the first quarter of 2009, a 76.3% decrease from the US$21.5 billion in proceeds raised during the same period in 2008. Power projects accounted for 43.1% of market activity, which was largely driven by Adani Power Maharashtra. The INR55.5 billion project loan was the largest deal in the region and the second largest transaction globally. The variety of project finance applications and locations and its growth can be summarised as follows:

Supply side factors ❒ Privatisation of state-controlled assets across the world. ❒ Increasing appeal for governments to subcontract infrastructure management and the associated risks. ❒ Budget constraints limit the ability for public sector investment in capital-intensive developments. ❒ Backlog of infrastructure investment as governments attempt to raise productivity to meet growing needs.

4


Demand-side factors ❒ Demand for infrastructure assets has risen faster than supply side for a long period, resulting in more highly leveraged transactions and ever-higher valuations. ❒ Investors have been attracted to the stable, often inflation-linked returns based on predictable underlying cash flows of monopolistic assets. ❒ Infrastructure is also seen as an alternative asset class (together with private equity, commodities and real estate) for large pension funds and well suited to match their long-term liabilities. ❒ Global economic growth such as energy consumption. Merna and Owen (1998) describe three categories of project procurement, which utilise project finance under the UK PFI: 1. Services sold to the public sector. The private sector is responsible for capital investment and the public sector only pays on the delivery of specified services to quality standards. These projects are generally procured by the design, build, finance and operate (DBFO) route. 2. Financially free-standing projects. The private sector recovers its DBFO contract costs through direct charges to users, for example, a toll bridge, rather than from public sector payments. Public sector involvement is limited to enabling the project to go ahead through assistance with planning, licensing and other statutory procedures. 3. Joint ventures. Joint ventures involve projects where the entire costs cannot be recovered through charges on end-users. The government offers a part subsidy in order for the project to go ahead. Potential advantages of PFI projects compared to the traditional methods of procuring public services include: ❒ Value for money: PFI projects, carried out by the private sector, deliver greater value for money and increased efficiency compared to similar projects financed with traditional methods.

Introduction

5

❒ Transfer of risk: The private sector accepts a wider range of risks in the project. Many risks are transferred from the public to the private sector, including design, construction, financing, completion and operational risks. ❒ Increased provision of infrastructure and services: PFI can provide additional facilities and infrastructures, which may not be in the public sector’s planning. ❒ Long-term view: PFI projects involve long-term relationships (15–30 years); hence, the public sector has to consider long-term view and interest rather than short-term capital funding. ❒ Projects delivered on time and budget: PFI is believed to be more reliable in terms of delivery of projects and services on time and budget than the traditional procurement strategies. ❒ Private sector innovations and expertise: With private sector involvement, projects gain benefits from private sector management skills and innovation, which lead to reduced project costs and increased efficiency. ❒ Maintenance of assets: Under PFI, the private sector is responsible for maintenance and repairs of the asset over the asset life cycle, ensuring good maintenance. ❒ Competition among service and asset private providers is achieved. ❒ The public sector retains control.

Potential constraints and problems include the following: ❒ The formation of the borrower/special project vehicle (SPV) can sometimes be complex as the different stakeholders seek at differing objectives. ❒ The cost of finance is higher since the public sector can fund capital with lower financial costs. ❒ Agreements are brought about through complex negotiations.

6


Merna and Owen (1998) add that ‘due to the complexity of concession contracts, the parties have to spend large amounts of money in advisory fees for lawyers and financiers’.

1.2

Financial assessment

Financial assessment is generally seen as a systematic approach to determining the commercial viability of a project to all those stakeholders involved in the project. In most cases the assessment will initially be carried out by the sponsors and if deemed commercially viable then assessed by a potential lender. What is not always apparent is how the use of finance is perceived by individual stakeholders, why a financial assessment is performed, who should be involved, where and when it should be performed, what data should be used and how financial assessments should be presented. The following briefly outlines the reasons.

What is financial assessment? For the purpose of this guide, financial assessment is defined as a structured, systematic approach, in a manner that clearly considers and presents a quantitative financial evaluation of the commercial viability of a project in terms of economic metrics that can be used in the decision-making process.

Why perform a financial assessment? The future income stream of a project is the most critical element in any project financing. The entire financing of a project is dependent on an assured income stream from that project since lenders and investors have recourse to no funds other than the income streams generated by the project, once it is completed, and assets of the project that may or may not have any residual value. The project sponsors, typically the SPV, therefore, need to demonstrate evidence of future income through various means such as a power sales contract for an IPP, a concession agreement for a toll road project allowing the collection of tolls, or tenant leases for a commercial real estate project (Tinsley 2000).

Introduction

7

All stakeholders to a project utilising project finance seek to meet specified, often minimum returns in the form of a minimum acceptable rate of return for a given investment or a specified margin of profit. Typically, lenders, shareholders and bondholders must consider the opportunity cost of finance for a number of projects to determine the acceptable return based on the risks perceived in a project. The size of risk perceived in a project determines the financial instruments to be used. By engaging in a financial assessment process, all parties/ stakeholders are made aware of the potential economic outcomes of the project for different scenarios of both financing instruments and the risks perceived. With a comprehensive picture of different financial scenarios, shareholders have a platform for decision-making. A financial assessment system can help to ensure that both the financial instruments considered for each scenario and their timing and the perceived risks are identified early and can be fully assessed in terms of viability, reducing the likelihood of costly mistakes.

Who is involved in the risk assessment process? Financial assessment is typically performed by sponsors to determine such metrics as internal rate of return (IRR), net present value (NPV), payback period and cash lock-up for a particular project. In some cases the SPV will determine cover ratios and debt sculpting, dependent on the expertise available. Many projects will be rejected if such metrics are well below acceptable returns, and there is no scope for increasing the commercial viability through guarantees from third parties. Lenders will seek to determine cash flows for the worst case scenario based on estimates provided by the SPV for different finance packages. Coverage ratios will be computed to determine which finance package provides the most suitable solution to a specific project. A final detailed assessment will involve the SPV, lenders and financial, legal and technical experts.

Where should a financial assessment be performed? Financial assessment should be performed by all stakeholders to a project before any finance is committed. Initially by the SPV and then

8


by lenders, shareholders and bondholders, the financial instruments of debt, equity and bonds should be considered. In PFI-type projects, it is also expected that financial assessments will be carried out by the public sector to determine budgets and acceptable unitary charges. As more information becomes available in terms of costs, revenues and their timings, more detailed assessment models can be developed and used in the decision-making process.

When should a financial assessment be performed? Due to the relationship between finance and time, financial assessments should be performed on a continuous basis, considering not only the variations in costs of materials and resources but also the costs associated with raising and servicing different financial instruments. Typically, financial assessments are performed before finance or resources are sanctioned, thus providing the opportunity to change, shelve or abandon the project without incurring financial loss. It should be emphasised that financial assessment is not a one-time occurrence. It must be done continuously to take into account market conditions and to monitor the project’s performance over the project’s life cycle.

What data are to be used? Data can be sourced from many locations, both formal and informal. Typically, project finance is associated with four packages: (a) construction, (b) operation and maintenance, (c) cost of finance and (d) revenue generation. It is important that the data are used; typically, costs, revenues and their timings are accurately reflected in the relevant package. In the initial stages, many of the costs and timings will be estimates from previous similar projects. As an assessment progresses, data often become more accurate as costs can be fixed against detailed designs and required resources.

How should assessment outputs be presented? The outputs of financial assessments should provide simple presentations on which decision-makers can base their decisions. In many

Introduction

9

organisations, presentations to decision-makers are too detailed and require too much time to interpret. The outputs suggested in this guide should be those that can be quickly interpreted by each stakeholder group such as cumulative cash flow diagrams, pie charts depicting different financing packages, tables indicating the economic parameters, such as IRR, NPV, cash lock-up, break-even points and coverage ratios associated with modelled scenarios. Risk assessments should be presented in terms of sensitivity and probability diagrams.

1.3

Purpose of this guide

The purpose of this guide is to provide a structured assessment process for determining the commercial viability of a project procured utilising project finance. The guide is best used as an aide memoir to those involved or seeking involvement in the procurement of projects utilising project finance. The financial assessment structure is applied to a case study to determine the project’s commercial viability. Readers can develop their own assessment structures as required using the assessment mechanism as a guide and the tables as templates for presenting the metrics used during the decision-making process.

1.4

Scope of the guide

The guide does not provide detailed descriptions of financial instruments or provide all those risks associated with different types of projects. References for further reading are provided to cover the main elements of finance and risk associated with project financings. Chapter 2 describes the characteristics of project finance and the parties and contracts typically involved in projects procured utilising project finance. Chapter 3 identifies typical financial instruments used in the procurement of projects utilising project finance and describes how projects’ cash flows are modelled to determine a project’s economics. Chapter 4 briefly outlines the risk assessment process through identification, analysis in terms of qualitative, semi-quantitative (deterministic) and quantitative (stochastic) and response to risks to determine the commercial viability of a project.

10


Chapter 5 provides a structured financial assessment process in the form of a flow chart, illustrating the type of assessment to be carried out at each stage of the process and the parties responsible for the assessment. Chapter 6 provides the basic details of the case study. The estimated costs and revenues and their timings are illustrated for an IPP to be procured utilising project finance in China. A number of sale and offtake strategies are also described. Chapter 7 provides the base case model assessment of the case study. Modelling projects through computer software can be an effective way of initially determining the cash flows of a project. Estimated costs and revenues can be input into a simulation model to determine the project’s economic parameters. Typically, spreadsheet software is used at this stage of the assessment. Chapter 8 provides a typical assessment performed by lenders seeking to determine the financial implications such as cash flow and coverage ratios associated with different financial packages in terms of debt, equity and bonds. Chapter 9 describes a number of financial engineering techniques that can be used in project financings. A method for reappraising public–private partnership in terms of refinancing, restructuring and termination is described. Chapter 10 describes how the final assessment of the case study is developed on the basis of the chosen financial package and the risks to be considered. This assessment uses stochastic analysis to determine the probability of the project meeting specified returns and a number of financial engineering techniques are considered to improve the project’s economics. Chapter 11 outlines the documentation and the legal considerations used in project financing and the major elements of the due diligence process, essential prior to the financial close of a project procured utilising project finance. Chapter 12 provides a brief outline of Islamic finance and describes the principles, products and techniques associated with Islamic finance and its role in project financings. Chapter 13 provides conclusions and recommendations on the financial assessment process and its application to different types of projects utilising project finance.

Chapter 2 Project finance

2.1

Introduction

The concept of project finance is widely used in business in both developed and developing countries. The term ‘project financing’ is used to refer to a wide range of financing structures; however, these structures have one feature in common – financing is not primarily dependent on the credit support of the sponsors, special project vehicle (SPV), or the value of the physical assets involved. In project financing those providing the senior debt place a substantial degree of reliance on the performance of the project itself. This chapter introduces the concept of project finance and explores briefly the features of project financing and the key characteristics with relation to the parties and contracts involved and the financial and legal considerations affecting such projects.

2.2

Definition of project finance

In the field of project finance, various definitions of project finance are cited. According to a definition provided by Nevitt and Fabozzi (2000), project finance refers to: A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.

The economic unit in the definition typically refers to a legally and economically independent project company. The definition 11

12


emphasises that repayment of loan is primarily dependent on cash flow generated by the economic unit. Esty (2004) defines ‘project finance’ as follows: Project finance involves the creation of a legally and economically independent project company financed with non-recourse debt (and equity from one or more corporate sponsors) for the purpose of financing a single purpose, capital asset usually with a limited life. The definition highlights two important features of project finance. First, a project is a set of legally and economically independent assets. Second, non-recourse debt means that the lenders only have recourse to cash flows and assets of the project. Esty et al. (1999) point out that although there may be periods when lenders have recourse to the sponsors’ cash flows and assets, often during construction, project debt must become non-recourse to the sponsors at some point during the project’s life. Merna and Owen (1998) define ‘project finance’ as follows: Financing of a stand-alone project in which the lender looks primarily to the revenue stream created by the project for repayment, at least once operations have commenced, and to the assets of the project as collateral for the loan. The lender has no or limited recourse to the project sponsors.

There is no single agreed definition for project finance as yet. It is no surprise that the market has not standardised these definitions because the field of finance is extremely dynamic and constantly changing. For the purpose of this guide, the concept of project finance is defined as follows:

Financing of a stand-alone project (or bundle of projects) is structured by using a group of agreements and contracts between lenders, project sponsors and other interested parties that create a form of economic

Project finance

13

unit; lenders and investors will look primarily to the economic unit to generate cash flow as the sole source of repayment of principal and interest and collateral. The lender has no or limited recourse to the project sponsors. (Chu 2007)

The ultimate goal in project financing is to arrange borrowing for a project, which will benefit the sponsor (SPV), whilst not affecting its credit standing or balance sheet. All the above definitions emphasise that, in project finance, lenders to the project initially look at the cash flows of a project as the source for repayment of the loan and economic unit or SPV as one of the key features of project financing. Requirements for successful projects are summarised as follows: ❒ Enforceable contractual arrangements ❒ Robust financial structures ❒ Detailed cash flow modelling ❒ Effective risk management ❒ Sensible risk apportionment ❒ Effective monitoring ❒ Stakeholder coordination

2.3

The key characteristics of project finance

Although project finance is used to refer to a wide range of possible financing structures that have been used in different industries for many years, the authors suggest that they all have five common features, which distinguish project finance from other financing methods: 1. SPV 2. contractual agreements of various third parties 3. non-/limited recourse

14


4. off-balance sheet financing 5. robust income stream

Special project/purpose vehicle An SPV is an independent legal entity, which will be committed and responsible to a contractual agreement with the parties involved in the project finance transaction (Ellafi 2005). SPVs are used in a variety of transactions, including securitisations, project finance and leasing. All those transactions are grouped as structured finance by Davis (2005). In this guide, the definition of an SPV is limited to:

A legally and economically independent project company financed with non-/limited recourse debt for the purpose of financing a single purpose, capital asset usually with a limited life.

Contractual arrangement Projects procured using project finance have to be structured through a series of contracts. Those contracts represent substantial components of credit support for a project (Orgeldinger 2006). The authors also suggest that the contractual arrangement in project finance transactions determines how the risks are structured among the parties, which provides a security to the project’s cash flow. Project finance is often regarded as ‘contract finance’ because a typical transaction can involve as many as 15 parties united in a vertical chain from input suppliers to output buyers through 40 or more contractual agreements (Esty and Christoy 2002). To arrange project finance, there must be a genuine ‘community of interest’ among the stakeholders involved in the project. Finnerty (1996) suggests that project financing arrangements invariably involve strong contractual relationships among multiple parties. Lenders will require that such contractual security arrangements must be put in place to protect them from various risks. The major contracts in typical project finance transactions are the construction contract, the product offtake contracts, the raw material

15

Project finance

Principal

Concession agreement Constructor

Construction contract

Suppliers

Supply contacts

Investors

Shareholders agreement

Operation contract

Borrower (SPV)

Bond agreement

Off-take contracts

Loan agreement

Operator

Users

Lenders

Bond holder

Figure 2.1

A typical BOOT corporate structure (Merna and Smith 1994).

supply contracts, the operations and maintenance contracts, and a large number of financial agreements, including loan agreement, bond agreement, shareholders agreement and agreements which address support from the host country (Merna and Njiru 2002). These contracts transfer many of the individual risk elements to appropriate parties. A typical structure of build-own-operate-transfer (BOOT) indicating the number of organisations and contractual arrangements that may be required to realise a particular project is shown in Figure 2.1. Project finance can work only for those projects that can establish such relationships and maintain them at a tolerable cost. The project’s cash flow is guaranteed by these contractual arrangements. These contracts form an interwoven web that determines the project’s value and risk. The key organisations and contracts involved in a BOOT project strategy have been identified and defined by Merna and Smith (1994) as follows: Principal: The organisation responsible for granting a concession and often the ultimate owner of the project when the concession period is completed. Principals are often governments, government agencies or regulated monopolies.

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Borrowers/SPV: It is the organisation, sometimes referred to as sponsor, which is granted the concession to build and operate a project for a specified period. Organisations involved are usually construction companies, operators or joint venture organisations incorporating constructors, operators, suppliers, vendors, lenders and shareholders/equity providers who set up an SPV to undertake the project. During the operating period of a project, the SPV is often referred to as the concessionaire. Concession agreement: This is the contract between the principal and the borrower/SPV in which the concession is defined and granted and essential risks associated with it are addressed, described and allocated. The agreement will describe any facility vehicle which the parties have agreed should be put in place to give effect to the concession, setting out its technical and financial requirements and specifying the parties’ relative obligations in relation to its design, construction, implementation, operation and maintenance over the lifetime of the concession. The concession agreement identifies and allocates the rights, responsibilities and risks associated with the project. It identifies and allocates the risks associated with the construction, operation, maintenance, finance and revenue packages and the terms of the concession relating to a facility. The preparation and evaluation of a project tender are based on the structure of the terms and project conditions contained within the concession agreement. Merna and Smith (1994) suggest that the concession contract is the primary contract in project financings with all other contracts, as described below, being considered as secondary contracts. Supply contract: This is the contract between the supplier and the SPV. The supplier may be a state-owned agency, a private company or a regulated monopoly which supplies raw materials to the facility during the operation period. Offtake contract: This is the contract agreed between the SPV and the user. It is applicable in contract-led projects such as power generation plants or water treatment plants. Users are the organisations or individuals purchasing the offtake or using the facility itself. In market-led projects such as toll roads where revenues

Project finance

17

are generated on the basis of directly payable tolls or tariffs for the use of the facility, an offtake contract is not applicable since the users deal with the SPV directly. Loan agreement: It is the basis of the contract between the lender and the SPV. Lenders are often commercial banks, niche banks, pension funds or export credit agencies. In some cases, several lenders will underwrite the debt and syndicate a percentage to other market participants. Operations contract: This is the contract between the operator and the SPV. Operators are often specialist operating companies or companies created specifically for the operation and maintenance of the particular facility. Shareholder agreement: This is the contract between the SPV and investors. Investors purchase equity or provide goods in kind and form part of the corporate structure. Investors may include suppliers, vendors, constructors, operators and major financial institutions as well as private individual shareholders. Investors provide equity to finance the facility, the amount of which is often determined by the debt/equity ratio required by the lenders or by a provision of the concession agreement. Construction contract: This is the contract between the constructor and the SPV. Constructors may be individual construction companies or a joint venture of specialist construction companies. Bond agreement: This is the agreement between the bondholders and the SPV. Bonds are issued for projects to suit a project’s revenue streams and because of the costs associated with raising a bond issue of projects of a high capital value.

Non-/limited recourse Non-/limited recourse is one of the key distinguishing factors used in project financing. In corporate finance, the primary source of repayment for investors and lenders is backed by the entire balance sheet of the sponsors’ companies, and usually there is a diversity of sources of

18


cash within the corporate structure (IFC 1999). Even if an individual project fails, lenders still retain a significant level of comfort in being repaid depending on the overall strength of the sponsor’s balance sheet. By contrast, for projects procured by project finance there is no operating history. Lenders and investors do not have direct recourse to the sponsors (Merna and Njiru 2002). If the project fails, the project sponsors’ organisations have no direct legal obligation to repay the project debt and will lose only the equity invested in the project. Payment of principal, interest, dividends and operating expenses should be derived only from the project’s future cash flow throughout the life of the project. However, there are very few pure project financings. Maiward (2003) claims that it is very rare for projects to be purely non-recourse. In other words, instead of being truly non-recourse, project financing often involves limited recourse to the sponsor companies. Willingham (2000) describes a banker as ‘a person who will lend you an umbrella when the sun is shining and will want it back the moment it starts to rain’. Limited-recourse debt has a repayment guarantee for a defined period for a fraction of the total principal until a certain milestone is achieved (Esty 2004). A typical example of a limited-recourse model is North Sea oil projects which were split into construction and operation stages in terms of project financing. The transactions were structured on the basis that full-recourse loans would be converted into limitedrecourse loans, typically when the lenders were satisfied with mechanical completion of the platform and other facilities (Cuthbert 2004). How much recourse is necessary to support a financing is determined by the unique characteristics of a project. Tinsley (2000) claims that the recourse is constrained in three main ways or any combination of these: 1. Time: Recourse stops after an agreed date. 2. Amount: Recourse has a ceiling or cap in money terms. 3. Event: Where satisfaction of some event or trigger is required.

Off-balance sheet transaction One of main reasons for choosing project finance is to isolate the risks and take them off the balance sheet so that a project failure does not

Project finance

19

damage the owner’s financial condition. An off-balance sheet transaction simply means that all financial matters relating to a project cannot affect the balance sheet of the sponsor’s organisation: the project stands on its own. Debt payment comes only from SPV rather than from any other entity, which becomes the essential feature of project finance. By comparison, on-balance sheet financing is any form of direct debt or equity funding of a company. If the funding is equity, it appears on the company’s balance sheet as owners’ equity. If it is debt, it appears on the balance sheet as a liability. Any asset the company acquires with the funding also appears on the balance sheet. The authors suggest that there are two significant advantages associated with the basic features of project finance. First of all, project finance structures the risk among the parties, which make it possible to undertake the projects that would have too large capital investment with too high a risk to be taken by one party on its own. Since petroleum refinery projects are capital-intensive with high risks involved, project finance is a method to allocate risks and obtain funds. Second, through non-/limited-recourse lending, the risks are separated from a sponsor’s existing business. In other words, project finance enables a project sponsor to finance the project on someone else’s credit. Nevitt and Fabozzi (2000) state that by using project finance, some credit sources that would not be available on a corporate basis may be available to the project.

Robust income stream of the project as the basis for financing The future income stream of a project is the most important element in project finance. Repayment of the financing relies on the cash flow and assets of a project itself as the lenders have no recourse to other funds or assets owned by the SPV. Therefore, the SPV has to demonstrate strong evidence of future income through various means such as power sales contracts for a power plant or through tolls for a market-led bridge project. In general, there are two types of revenues streams: contract led and market led (Merna and Njiru 2002). In a contract-led revenue stream project, the SPV enters into contracts with users of the facility before the project is sanctioned. This guarantees revenues to the

20


SPV provided the service or product is provided to specification. For example, in a power plant project, the SPV will enter into a contract with the offtaker, usually a transmission company, who guarantees to purchase a specified amount of electricity over a period. In effect, this mitigates the market risk. In many public–private partnerships, the SPV provides the availability of the facility and is paid irrespective of the demand for the facility. In a market-led revenue stream project, there is no contract with the users, hence no revenue guarantee. An example of a market-led project is a toll road where revenues are expected to be generated from motorists using the toll road. If motorists find an alternative route or use other forms of transport not dependent on the toll road, no revenue will be generated; hence, the project is subjected to the market risk. A contract-led revenue stream provides more security to the lenders as they look to the revenues to repay both principal and interest on loans. Lenders often provide more favourable terms of loans to projects having contract-led revenues since the risk of default is less than in market-led projects. This is often in the form of a lower interest rate.

2.4 Legal and financial considerations in project finance Legal The main reasons for the complexity of project finance structures can be summarised as follows: ❒ Reliance on contracts to define the responsibilities and liabilities; ❒ Several related parties; ❒ Long-term nature of projects; ❒ Dependency on cash flow with no recourse to the project lenders; ❒ Due diligence requirements of lenders providing the bulk of the capital; ❒ Involvement of the public sector.

Project finance

21

The commercial influences on the choice of both legal and financial structures are dependent on: ❒ The extent of recourse to the borrower group or the public sector; ❒ Credit appraisal of the borrower group or the public sector; ❒ Nature of the project such as static or dynamic; ❒ Technical complexity of the project and its product or service; ❒ Exposure to precompletion, operating and market risk; ❒ Volatility of cash flows; ❒ Political risk; ❒ One-off financing or a series of financings; ❒ Supply-side factors such as competition for service. The legal considerations in the choice of structure typically depend on the following: ❒ Types of concession agreements • Availability-based payments: The concessionaire is paid for making the facility available for public use. • Production sharing agreements: The concessionaire is paid a share of the revenue generated from the facility. • Forward purchase agreements: The concessionaire is paid a fixed price for its product or service over a specified period. • Demand-based payments: The concessionaire is paid on the basis of demand for the facility such as tolls for a bridge project. ❒ Security for lenders includes: • step in rights • guarantees • liquidity facilities

22


• equity • cover ratios • bonding

Financial The key financial parameters considered in project finance are typically: Operating parameters ❒ Cost forecasts (capital expenditures and operational expenditures); ❒ Revenue forecasts based on throughput and price; ❒ Cost to the public sector in terms of unitary payments and/or subsidies; ❒ Tax; ❒ Global concerns such as interest rate, inflation, price of product or service; ❒ Length of concession/operation. Funding parameters ❒ Equity returns such as nominal (time-related) and real (non-timerelated internal rate of returns); ❒ Debt coverage ratios such as debt service coverage ratio, loan life coverage ratio, project life cover ratio and interest rate cover ratio; ❒ Valuation multiples; ❒ Gearing in terms of debt/equity ratio; ❒ Security on fixed and floating loans; ❒ Parent company guarantees. Many of the above coverage ratios are determined by lenders to ensure that a project can repay both principal and interest based on the forecasted cash flows over the life cycle of the project.

Project finance

23

Financial considerations in terms of sources of finance include: ❒ Senior ranking bank loans which can be split into multiple tranches for different maturities or purposes such as working capital and also used as bridging finance; ❒ Mezzanine bank loans which fill the void between debt and equity; ❒ Junior ranking bank loans often in the form of loan stock or subordinated debt; ❒ Equity in the form of ordinary shares or preference shares which attract voting rights; ❒ Capital markets utilising fixed coupon bonds, index-linked bonds or asset-backed commercial paper; ❒ Monoline insurers who take on credit risk by selling protection on the default of loans or bonds; ❒ Development finance through institutions such as EBRD, World Bank; ❒ Export credit agencies and political risk insurance such as OPIC and ECGD; ❒ Grant funding direct from government subsidies.

Chapter 3 Financial instruments and cash flow modelling

3.1

Introduction

Projects have to raise cash to finance their investment activities. This is usually done through issuing or selling securities. These securities, known as ‘financial instruments’, are in the form of a claim on the future cash flow of a project. Traditionally, financial instruments were in the form of either debt or equity. As market-based structures with different risk profiles have been used in an increasing number of industries, capital market project investors have grown in both number and type. Presently, projects procured by utilising project finance are often financed by a combination of debt, mezzanine finance (bonds) and equity capital. In this chapter, a number of financial instruments are discussed and their sources and how cash flows are developed for projects utilising project finance. Typical sources of project finance and the development of cash flows and their application to project financings are also described.

3.2

Debt finance

Most projects are financed utilising debt as part of the financing package. In project finance, mobilising commercial debt can be quite difficult due to several reasons: ❒ High demand, cautious lenders. Lenders face the same risks as equity investors when arranging loans to finance a project. They also fear the risk of not getting any money back in the event of default. In addition, there is a limit to how far loan pricing can be pushed. So, the lenders often have the major say in how financing is 25

26


to be structured and seek to reduce the project risks by negotiating the conditions with the borrower under which they will participate. ❒ Foreign lenders. In developing countries, most domestic markets cannot mobilise high volumes of long-term debt, so they turn to foreign lenders. Foreign lending involves foreign currency, thus exposing the borrower to currency risks. ❒ The number of banks involved in project finance has increased greatly in the last 5 years. Each bank has exposure limits to the project finance environment, and thus organising a syndicate of lenders is complex and time-consuming. ❒ In developing countries, there are many potential non-bank lenders such as pension funds and insurance companies. However, this potential is not being met as many of these companies are publicly owned monopolies and most developing countries also require pension funds and insurers to invest mostly in government securities. Merna and Njiru (2002) define debt instruments as the raising of term loans from banks, other financial institutions (including commercial banks, merchant banks, investment banks, development agencies, pension funds and insurance companies), debentures and export credits. There are many conditions attached to obtaining funds from these sources, but it all depends on the criteria of the lender and the borrower as well as the type of project being considered. Debt is senior to all other claims on the project’s cash flow and assets. However, the lender will never receive more than the interest and principal repayments if a project goes well. The downside risk is that the senior lender faces losing 100% of the loan to the project if the project does not perform well (Grimsey and Lewis 2002). Thus, lenders concentrate closely on all aspects of risk and want to take the least risk of all parties involved. Large-scale, capital-intensive projects such as petroleum refineries usually require considerable investments upfront and only start to generate revenues after a relatively long construction period. Therefore, to match the repayment of loan obligations, the maturity of loans in project financing is much longer than other forms of financing. A project raises long-term debt financing primarily for long-term investment purposes. Long-term financing is usually needed because

Financial instruments and cash flow modelling

27

the asset created by the project has a gestation lag before it starts to generate revenues. Long-term financing helps the project by deferring, partly or fully, the servicing of securities sold until the project starts to generate revenues (Merna and Dubey 1998). Long-term debt is typically used for a term of 5 years or more (Merna and Njiru 2002). Short-term debt is usually with a term of less than 1 year. Typically, there are two kinds of short-term debt financing used in project financings. First, working capital is used once the project has been commissioned where payment is required for the purchase of raw materials and to cover operation and maintenance costs. Second, short-term debt is required as bridging finance to meet temporary deficits. Medium-term debt is between 1 and 5 years and has some characteristics of both long- and short-term debts. From a project finance perspective, it is more reasonable to discuss financial instruments according to their maturity (Merna and Dubey 1998). Lamb and Merna (2004a) suggest that the financial instrument used in a project financing can be restricted by the financial market that supplies the finance, purpose or element of the project being financed and variations in the terms and covenants associated with specific lending parties. The instruments available to different projects are often dictated by the financial markets, often dictating which projects are suited to particular forms of financing. They, however, suggest that such structures can be generalised accordingly. In developing or illiquid markets, the instruments select the project. In developed or liquid markets, the projects select the instruments.

Senior debt The senior debt of project financing usually constitutes the largest portion of the financing and is usually the first debt to be in place. Senior debt is debt which is not subordinated to any other liability. It is first in the priority of payment from general revenues of the borrower in the event of project default. Generally, senior debt will be more than 80% of the total financing. Senior debt falls into two categories: unsecured and secured loans. Unsecured loans basically rely on the borrower’s general creditworthiness, such as reputation of their sponsors, as opposed to a perfected security arrangement. It is not secured by specific assets but senior to

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equity and pseudo-equity in receiving dividends and repayment of principal. Secured loans are loans where the assets securing the loan have value as collateral, which means that such assets are marketable and can readily be converted into cash (Flight 2006). In financial difficulties, the secured creditor is in control of key assets of a project and in a position to demand its debt be serviced.

3.3

Mezzanine finance

Development in the financial markets and financial innovations has led to the development of various other kinds of financial instruments. Mezzanine finance or quasi-equity groups together form a variety of structures positioned in the financing package somewhere between the high-risk/high-upside equity position and lower-risk/fixed returns debt position. There is no one definition for mezzanine finance. Mezzanine finance typically takes the form of subordinated debt, junior subordinated debt, bonds and preferred stock or some combination of each. The authors believe that mezzanine finance is a variation of private equity and falls between debt and equity; therefore, it shares some characteristics of both debt and equity in a project’s capital structure. Private mezzanine transactions are thoroughly negotiated to meet the specific requirements of projects while providing investors with fundamental investment protection.

Subordinate debt Subordinated debt, a type of mezzanine, is the debt that ranks below senior debt in terms of its priority of payment (cash waterfall) or in liquidation (Nevitt and Fabozzi 2000). The senior debt is usually bank debt, and there may be several layers of subordinated debt between the bank debt and equity. Subordinated debt is paid only after the principal and interest of the senior debt are paid. As it is second only to senior debt in terms of claims on the project’s assets, the interest rate on subordinated debt is usually higher than that on senior debt. Subordinated debt may or may not be secured. It is flexible and may almost take on the characteristics of equity. Subordinated debt usually has the advantage of being fixed-rate and long-term, and may be considered as equity by senior lenders and sponsors for the purpose of calculating the debt/equity ratio (Grimsey and Lewis 2002).


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Parra et al. (2001) studied subordinate loans with different perspectives and objectives. They found that some institutional investors, such as insurance companies and pension funds, which are not affiliated with a special project vehicle (SPV) but desire to make an investment in the project, may choose to become a subordinated lender to characterise its investment as debt rather than equity. Typically, these investors seek profits from the conversion of their debt to equity if the project is successful. Other subordinated debt may be provided by the parties such as a government who are unaffiliated to the project but desire to promote investment in a country to motivate commercial lenders to participate as senior lenders in a given project’s funding.

Bond finance The use of the bond market as a vehicle for obtaining debt funds has increased greatly. In 1996, the Ras Lafan LNG project (Ras Gas) was financed using a bond of US$1.2 billion, which was the largest bond investment for any international project to date. It represented a milestone in using bond investment. Oil and gas sectors accounted for 15% of the total bond financing from 1998 to 2002. The main bond markets are in Germany, Japan, the United Kingdom and the United States. Oil and gas companies sell bonds in the markets to raise funds for long-term investments. A bond is typically a long-term contract between the borrower and the bondholders in which the borrower agrees to make a series of payments of interest (coupons). Zero coupon bonds may also be used, where the bondholder receives no coupons during the term of the bond, relying on one final payment at the end of the term. Merna and Njiru (2002) define bonds as follows:

a bond like any other form of indebtedness is a fixed income security. The holder receives a specified annual interest income and a specified amount at maturity.

Bond financings are similar to commercial loan structures, except that the lenders are investors purchasing the borrower’s bonds in a private placement or through the public debt market (Flight 2006).

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Bond issues have advantages over bank debt. First of all, they can provide a source of longer term money sometimes with better commercial terms. Bonds can provide sufficient time (maturity up to 30 years) to develop projects, especially for the oil and gas projects which may have financial difficulties in repayment of their borrowings at the beginning of operation. Second, using bonds can attract longterm fixed-income investors because they are backed by the long-term identifiable cash flows of a project. However, bonds are less flexible than bank financing. An organisation’s ability to honour interest and principal payments on schedule is important to bondholders. Some organisations are financially stronger than others, and this affects their ability to honour the debt. An organisation’s ability to pay off their debt is rated. Bond ratings are a reflection of the creditworthiness of an organisation. Bond ratings are based on: ❒ The likelihood an organisation will default on its interest repayment; ❒ The likelihood an organisation will default on its principal repayment; ❒ The creditor’s protection in the event of a default. Bond issues are normally assigned quality ratings that indicate the strength of the bond. This takes into account different financial factors such as market conditions and the political situation of the country where the company operates and many other factors, which may encourage or deter the company in financing its project (Merna and Dubey 1998). Two of the major independent credit rating services are Moody’s and Standard and Poor’s. They research the financial health of each bond issuer and assign ratings to the bonds being offered. Rating affects a bond’s percentage return that investors can expect to receive. A highly rated bond typically has a lower yield with strong capacity to pay interest and repay principal, whilst a lower-rated bond typically has a higher yield with lower capacity to pay interest and repay the principal. For example, the high-grade bonds such as AAA Standard and Poor’s and Aaa Moody’s have strong capacity to repay


31

the debt. Rating is important because bonds with lower ratings tend to have higher interest cost and vice versa. The two leading bond-rating organisations are Standard and Poor’s and Moody’s. Table 3.1 explains the ratings and the definitions of the type of bonds available.

3.4

Equity finance

Equity usually comes from individuals, companies involved in a project such as project sponsors and equipment manufactures, or sometimes from institutional investors such as insurance companies or energy investment funds. Equity represents the investment injected by the owners of the project. Both ordinary equity and preferred equity represent ownership of the project. However, sponsors have a priority over the ordinary equity holders in receiving dividends and funds in the event of liquidation. A project financing starts with the setting up of a particular project legal entity, known as SPV. The sponsors of the project provide the initial equity capital known as the seed equity capital. Merna and Owen (1998) define equity capital as follows:

Pure equity is the provision of risk capital by investors to an investment opportunity and usually results in the issuance of shares to those investors. A share may be described as an intangible bundle of rights in a company, which both indicates proprietorship and defines the contract between the shareholders.

The terms of the contract, that is the particular rights attaching to a class of shares, are contained in the article of association of the company. Equity as the residual value of a company’s assets after all outside liabilities (other than to shareholders) has been allowed for. Equity is also known as risk capital, because these funds are usually not secured and have no registered claim on any assets of the business, thus freeing these assets to be used as collateral for the loans (debt financing). Equity, however, shares in the profits of the project and any appreciation in the value of the enterprise, without limitation.

Aaa Aa A B

Ba B Caa Ca C D

High-grade bonds AAA AA

Medium-grade bonds A BBB

Low-grade bonds BB B CCC CC

Very low-grade bonds C D

Adapted from Mera and Khu (2003).

Moody’s

Standard and Poor’s

Bond ratings

Table 3.1 Bond ratings

This rating is reserved for income bonds on which no interest is being paid This rating is in default, and payment of interest and/or repayment of principal is in arrears

Adequate capacity to pay interest and principal, although adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and principal. These are regarded mainly as speculative bonds, with CC and Ca being the bonds with the highest degree of speculation

Strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions. Both high-grade and medium-grade bonds are investment-quality bonds

Capacity to pay interest and principal is very strong

Comments


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The compensation for equity is dividends (dividends are the amount of profits paid to shareholders). No dividends are paid if the project does not make profits. Dividends to the shareholders can be paid only after debt claims have been met. The return on the equity, therefore, is the first to be affected in case of financial difficulties being faced by the project entity. This means that equity investors, in the worst case scenario, may be left with nothing if the project fails, and hence they demand greater return on their capital in order to bear a greater risk. This explains the general rule that high-risk projects use more equity while low-risk projects use higher debt. A high proportion of equity means a lower financial leverage and a higher proportion of debt equals a high leverage. Leverage is measured by the ratio of long-term debt to long-term debt plus equity. Leverage is also called gearing or ‘debt/equity ratio’. High financial leverage means that more debt capital has been used in the project, signifying more debt service and less funds being available for distribution to the equity holders as dividend payments. However, once the project breaks even and profit starts to grow fast, shareholders receive a higher dividend. The seed capital/pinpoint equity provided by the sponsors of the project, which is normally a very small amount as compared to the total finances raised for the project, is also known as founders or deferred shares. These are lower in status than ordinary and preference shares in the event of winding up. In non-recourse financing, the debt/equity ratio may be higher if the margin on the debt is high, provided lenders are satisfied with the risk structure of the project. If, however, a project is considered innovative then more equity will be demanded by lenders and the equity will be drawn down before debt becomes available to the project. Ordinary share capital for project procured using project finance is typically raised from institutional investors. Holding of these shares entitles dividends, and provides the right of one vote per share held and the right to a pro rata proportion of the project’s assets in the event of winding up of the project. The right to participate in the assets of the project provides the opportunity for the highest return on the capital invested. Lenders normally require that the sponsors or outside equity investors to invest a certain amount of equity in the project prior to

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the initial drawdown of any debt funds. This assures lenders that the project’s equity investors have substantial financial commitment to the project from its earliest stages. Nevitt and Fabozzi (2000) claim that lenders expect sponsors or investors to invest enough equity to ensure their continued interest and attention to complete and operate the project. Lenders sometimes put equity alongside their debt as a way to obtain an enhanced return if the project is successful.

3.5

Sources of debt and equity

There are various funding sources which are available for project financing. These sources are from both internal and external sources. The parties participating in project investment include those with a commercial interest in the project, for instance, project sponsors, raw material suppliers and purchasers of a product or service. These providers usually purchase shares through a private placement. In larger projects such as the Channel Tunnel project, the public were given the opportunity to buy shares through a public share offering. External parties also provide a wide range of funding sources to a project, such as export credit agencies, multilateral agencies and development banks, bilateral development banks and agencies, and commercial banks. These sources provide equity, debt or a mixture thereof for project financing (Merna and Njiru 2002).

3.6 Cash flow modelling and project financing In project finance, it is the future cash flow that becomes the basis for raising resources for investing in the project (Merna and Njiru 2002). Mills (1996) claims that, compared to other financing methods, predictability of cash flows is even more important because the lenders have limited or no recourse to the sponsor for repayment obligations of the SPV. The lender principally looks to the project’s cash flow as the source of repayment. Therefore, the focus should be mainly on the elements that influence cash flow. Typically, the SPV does not concern itself with discounting, inflation and deflation at the initial assessment. Economic parameters


35

calculated at this stage are in money terms only. The effects of discounting will be assessed by the lenders to adjust cash flows to present-day values. Different inflation rates will also be applied by lenders at different cost and revenue centres, allowing the model to simulate the effect of inflation over different phases of the project. Under project financing, a project is legally independent and thus lenders only have recourse to a project’s future cash flow and assets. It is this future cash flow that becomes the basis for raising resources for investing in the project. Lenders and investors will look at this cash flow before making any investment decision. Therefore, this cash flow needs to be tailored in a way that meets the needs of the project and at the same time is attractive to the potential lenders and investors. A successful project financing significantly depends on the strength of the contractual commitments among various project participants. These contracts are taken together and ensure lenders that there will be a reliable source of cash flow for repayment of the debt. Lenders estimating a project’s economics begin with estimates of construction costs and timings followed by operation and maintenance costs and the revenues generated by the project. Broadly speaking, a project may be said to pass through three major phases: 1. project appraisal 2. project implementation 3. project operation Cash flow is defined by the sum of cash inflows and cash outflows through the project stages in a particular period. The cash flow of a project is the only source of income for the borrower. After servicing the debt, paying the dividends on equity, paying the coupon rate on bonds, spending for general operation and maintenance, and tax to the government, the borrower is left with either a surplus or a deficit. The amount of surplus or deficit depends on the terms of repayment, the revenue generation capacity of the SPV and the risks involved in the project. A project can still be considered a risk until it crosses the break-even point. During the appraisal phase, the projected cash flows of a project would be the basis on which various contractual agreements with the parties involved are shaped and a decision whether to sanction the project is made.

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+

Project Project appraisal implementation

Project operation

£ Time

– Figure 3.1

Typical cumulative cash flow stages of a project (Merna and Smith 1994).

Cumulative cash flows, also known as net cash flows, are defined as the sum of cash flows in each fiscal year of the project. The cumulative flow for a particular year in the life cycle of the project is calculated by adding the net cash inflows with the net cash outflows. Cumulative cash flows can be used to determine surpluses or deficits within each period. A typical cumulative cash flow curve for a project is illustrated in Figure 3.1. The precise shape of the cumulative cash flow curve for a particular project depends on variables such as: ❒ The time taken in setting up the project’s objective; ❒ Obtaining statutory approvals; ❒ Design finalisation; ❒ Finalisation of the contracts; ❒ Finalisation of the financing arrangement; ❒ The rate and amount of construction; ❒ Operational speed. Negative cash flow, until a project breaks even, clearly indicates that a typical project needs financing from outside until it breaks even. The shape of the curve also reveals that in the initial phase of the project


37

less financing is required. As the project moves on to the implementation phase, there is a steady increase in the finance requirement, which peaks at the completion stage. This point is defined as the cash lock-up in the project. The rate of spending is also depicted by the steepness of the curve. The rate of spending is often termed the ‘cash burn’, which is the rate at which cash is spent over a specified period; the steeper the curve, the greater the need for finance to be made available to the project. Once the project is commissioned and starts to yield revenues, the requirement of financing from outside the project becomes less. Finally, the project starts to generate sufficient resources for the operation and maintenance and also a surplus of cash. However, even after the break-even point, the project may require financing for short periods to meet the mismatch between receipts and payments (Merna and Njiru 2002). In project financing, it is this future cash flow forecast that becomes the basis for raising resources for investing in the project. It is the job of the finance manager of the project to package this cash flow in such a way that it meets the needs of the project and at the same time is attractive to potential agencies and individuals willing to provide resources to the project for investment. In order to achieve this objective effectively, a thorough knowledge of the financial instruments and the financial markets in which they are traded is essential. Project finance is dependent on the revenues of a project (the project’s cash flow) to repay loans without affecting the balance sheet of the organisation. In the case of default in project finance, lenders have only recourse to the project facilities and to the main organisation. Project finance is a key factor in the successful development of infrastructure projects. Project finance provides an alternative source of finance to cash-starved governments to provide infrastructure to sustain economic growth. Within project finance, raising the finance is an important issue. Without finance the project cannot go ahead. Therefore, the borrower needs to determine the sources of finance available. Each of the instruments discussed has a claim on future revenue generation. The seniority of these instruments, in terms of their claim on project assets, in the event of default is illustrated in Figure 3.2. Debt is the most used instrument to fund projects. With debt there is an interest charge on the loan. Bond issues are becoming popular

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Debt (senior)

Mezzanine/bonds

Equity (junior) Figure 3.2

Seniority of financial instruments (Merna and Faisal Fahad Al-Thani 2008).

amongst borrowers to raise project finance. Projects have been funded worldwide partly by bonds. Equity is considered risk capital because investors bear a higher degree of risk than other lenders. Equity ranks the lowest in terms of its claim on the assets of the project. Debt is structured to meet forecasted cash flows to allow debt service. Typically, this is achieved by sculpting the debt repayments against forecasted cash inflows.

Chapter 4 Risk management

4.1

Introduction

Many projects are considered high risk because of the uncertainty involved in them and the method of financing them. The risks associated with project financing are numerous, and an integral part of project assessment is the risk management process. This chapter defines the concept of risk and introduces the principles of risk management and then explores the typical risks of projects procured utilising project finance and how these risks can be managed. Risk modelling is discussed at the end of this chapter with respect to the economic parameters used to determine the commercial viability of a project.

4.2 Risk Risk influences the amount, timing and availability of funds for project financing (Feming et al. 2004). Arunkumar and Kotreshwar (2006) state that risk is the fundamental element that drives financial decisions. Without risk, financing a project would be significantly simplified. Risk is generally seen as an abstract concept whose measurement is very difficult (Baloi and Price 2003). However, in order to manage risk, it must be understood. According to Ejinimma (2004), risk can be defined as follows:

A situation where the future outcome is not known with certainty, but where the various possible outcomes can be predicted from knowledge of past or existing events.

39

40


From the above definition of risk, it can be seen that risk is different from uncertainty. Risk and uncertainty are distinguished by Merrett and Sykes (1983) as follows: Uncertainty exists when there is more than one possible outcome to a course of action but the probability of each outcome is not known.

For the purpose of this guide, risk is defined in terms of project finance as follows: the possibility that unexpected event occurs which have impacts on economic return; as resulting of risk, project finance has to be structured within a risk confident envelope to secure and increase the financial viability of a project. (Chu 2007)

Thus, management of all risks is crucial in the project financing. Project finance loans are perceived as riskier than other corporate loans due to the lower degree of recourse (Esty and Christov 2002). Thus, the lenders and other investors will be particularly interested in how project risks are structured and mitigated. The authors believe that it is an essential part of the risk structuring in project financing to identify and quantify the various risks and then allocate these risks acceptably among various parties, primarily through the complex matrix of contractual agreements. Projects are financed in this way because they involve risks which cannot be diversified within the portfolio of any primary sponsors. By efficiently structuring the risks, risks can be managed by the parties who should be best equipped to handle them at the lowest cost. The success of the project finance structure depends on the satisfactory and economical allocation of project risks among the various interested parties (Beenhakker 1997). The extent to which any party will be willing to accept project risk depends on the return it expects to receive. There is no general body of law in the world that indicates how projects must be structured or how the risk should be shared amongst the project parties (Cuthbert 2004).

Risk management

4.3

41

Risk management process

Risk is regarded as the existence of uncertainty concerning future outcomes (Salvary 2004). Risks are multidimensional and thus need to be categorised for a clear understanding of causes, outcomes and drivers. Risk can never be completely removed from the project; however, they can be effectively managed to mitigate the impacts on to the achievement of a project’s goals (Cohen and Palmer 2004). The objectives of risk management are to increase the probability and impact of positive events and decrease the probability and impact of events adverse to the project’s objectives (PMBOK 2004). Essinger and Rosen (1991) defined risk management as follows: An effective method for minimising the adverse effects of risk and maximising the benefits of incurring the risk.

Merna and Njiru (2002) summarise risk management as: Any set of actions taken by individuals or corporations in an effort to alter the risk arising from their business.

There are many variations of the project risk management process which have been suggested. However, no general agreement has been reached regarding what should be included in the process. Risk management processes involve identifying, assessing and judging risks, assigning ownership, taking actions to mitigate or anticipate them, and monitoring and reviewing progress (HM Treasury 2004). Project risk management includes planning, identification, analysis, responses, and monitoring and control of a project (PMBOK 2004). From the literature review, the authors have found that risk management is widely accepted as an approach that involves formal orderly process (Chapman and Ward 2000; PMI 2000; HM Treasury 2004; Schatteman et al. 2006; Merna and Faisal Fahad Al-Thani 2008) for systematically identifying, analysing and responding to risk throughout

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Risk identification Risk management cycle Risk analysis

Risk response Figure 4.1

Risk management cycle (Merna and Faisal Fahad Al-Thani 2008).

the life of a project, as illustrated in Figure 4.1. The risk management process is summarised in Figure 4.2.

Risk identification Risk identification is the first step of risk management. Risk identification and definition are at the core of risk structuring (Tinsley 2000). Several authors (Marsh 2004; PMBOK 2004; Merna and Faisal Fahad Al-Thani 2008) define risk identification as determining which risks are likely to affect the project and documenting their characteristics. The risk identification process involves the identification of the major potential sources of risk associated with the project objectives (Schatteman et al. 2006). According to RAMP (2007), the aim of project risk identification is to: ❒ Identify types and sources of major risks and uncertainty associated with each of the investment objectives and the key parameters regarding these objectives; ❒ Identify the causes of each risk; ❒ Assess how risks are interrelated to each other and how risks should be classified and grouped for analysis and evaluation. Risk identification is assisted by many methods. Merna and Njiru (2002) have identified five key risk identification methods, namely

43

Risk management

Start Information: Processed history data; output from others; planning services; organisational-specific knowledge Participants: Relevant stakeholder representatives

Assign risk management process responsibility

Define

Risk identification

Techniques: Brainstorming, Delphi technique, interviews, checklists and risk registers

Information

Screening

Qualitative analysis techniques

Stakeholders

Risk analysis

Quantitative analysis techniques

Information

Risk response options

Risk response techniques Risk response process Risk response methods

Participants

Figure 4.2 2008).

Risk register (corporate, strategic business and project)

Risk assessment for an organisation (Merna and Faisal Fahad Al-Thani

brainstorming, the Delphi technique, interviews, checklists and risk registers. The outputs of risk identification are (Merna and Faisal Fahad Al-Thani 2008): ❒ sources of risk ❒ potential risk events ❒ risk symptoms ❒ inputs to other process

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Having identified as many risks as practicable, it is necessary to classify risks to aid risk modelling and evaluation.

Risk analysis Risk analysis provides systematic insight into the risks that a project is exposed to. The aim of risk analysis is to evaluate the potential impact of identified risks on cost and return and to estimate the probability of their occurrence. Risk analysis is performed by categorising all the identified risks according to the likelihood of their occurrence and the impact that they will have on the project (Marsh 2004). With the aid of risk analysis, the method of risk mitigation can be applied to each risk. There are two methods used in the risk analysis process: qualitative and quantitative risk analyses. The qualitative approach is used for defining the actual problem and verifying the outcomes, while the quantitative approach is used in numerical calculations (Huseby and Skogen 1992). The qualitative and quantitative risk analysis processes can be used separately or together. Most modern risk analysts combine the two approaches. The output from risk analysis process is summarised by Merna and Faisal Fahad Al-Thani (2008) as: ❒ Clear understanding of which threats require response and which opportunities should be pursued; ❒ Appreciation of risk exposure distribution within the project; ❒ Most significant risks; ❒ Variation of project outcome values with risk occurrences; ❒ Probability distributions of project outcome values. Qualitative risk analysis Following risk identification, qualitative risk analysis enables an organisation to estimate the probability of a risk occurrence and estimate the potential impact of the risk on the project (Altug 2002). However, the authors suggest that qualitative analysis allows risks that require further attention to be prioritised. Qualitative risk analysis techniques are used to determine which risks are important enough to

Risk management

45

manage, but the evaluations do not reflect the strictness of a detailed, numerical analysis. Instead, this analysis describes the nature of the risk and helps to improve the understanding of the risk. Typically, probability impact grids are developed with each identified risk being allocated a high, low or medium classification. Since the risks involved in a project are very complex, it is difficult for one party to identify and analyse all the risks. Cuthbert (2004) suggests that the task of identifying and analysing risks is likely to involve the project parties, accountants, lawyers, engineers and other experts who all need to provide inputs and advice on the risks involved and how they might be managed. The qualitative risk group is significantly enhanced when the participants who are from varied organisational backgrounds enable their wide experience and knowledge to be captured within the process. Qualitative risk analysis provides a foundation for a focused quantitative analysis and risk response plan. Merna and Faisal Fahad Al-Thani (2008) state that the qualitative risk analysis is the most important analysis, since one or a number of major risks could provide the basis for a ‘no-go’ decision and this negates the requirement for a quantitative analysis. Quantitative risk analysis Quantitative risk analysis is defined as numerically analysing the effect on overall project objectives of identified risks (PMBOK 2004). Quantitative risk analysis generally follows qualitative risk analysis. Quantitative risk methods aggregate interdependent, identified risk variables and objectively evaluate and compare the combined effect of risks on the project activities using tools such as sensitivity analysis, probability analysis, decision trees, algorithmic methods and Monte Carlo analysis. Monte Carlo simulation is probably the best known and possibly the most widely used quantitative technique. The significant development of computer technology from the start of the twenty-first century allows fully developed detailed analyses to be produced. Computer simulation through computer models allows analysts to imitate real life and make predictions. Khedr (2006) defined quantitative risk analysis as the process of quantifying the total impact of risks imposed on the project using computer simulation to various scenarios.

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The authors summarise quantitative risk analysis results in terms of project finance transaction deals as follows: ❒ Reveals aggregate effect of risk on key economic parameters: net present value (NPV), internal rate of return (IRR), cash-lock up, payback period, capacity to service debt service coverage ratio; ❒ Identifies the major risks through sensitivity analysis; ❒ Supports structuring of risks and helps establish basis for risk mitigation plan; ❒ Reveals impact of individual risks on whole project economics; ❒ Supports decision-making under conditions of uncertainty; ❒ Helps to set contingency levels, milestones and budget; ❒ Permits ‘what-if analysis’ to test effectiveness of proposed actions. Bessis (1998) suggests that quantitative techniques address only those risks that are measurable. According to Gill and Hillson (1998), the weaknesses of using quantitative risk analysis techniques are: ❒ Inputs are often subjective; ❒ Requires analysts to be trained; ❒ Expensive and time-consuming to implement; ❒ Viewed as a specialist function; ❒ Output needs interpretation; ❒ May focus on numbers too early without taking a broader view. Before the commitment of the project’s major capital expenditure, the major risks of the project should be identified and quantified, which determine how the project is to be structured in terms of risks allocated in order to maximise the chances of success. Monte Carlo simulation Monte Carlo simulation, a form of stochastic simulation, adds the dimension of dynamic analysis to project evaluation by building up

Risk management

47

random scenarios which are consistent with the analyst’s key assumptions about risk (Savvides 1994). It is a method for iteratively evaluating a deterministic model using sets of random numbers as inputs. By using random inputs, deterministic models are essentially turned into stochastic models (Wittwer 2004). Using this method the probability of project outcome is calculated by carrying out a number of iterations, depending on the degree of confidence required (Akintoye and Macleod 1997). Sensitivity analysis Sensitivity analysis can help to determine which risks have the most potential impact on the project. It models the impact of change in variables on the project’s economic parameters such as IRR and NPV to identify factors that are particularly risk-sensitive in a project finance transaction. It examines the extent to which the uncertainty of a variable affects the objective being examined when all other uncertain elements retain their baseline values (Altug 2002). As a result, sensitivity of a variable to a project’s objectives can be ranked. Lenders and sponsors need to identify which risk variables the project is highly sensitive to in terms of their impact on the project’s economic parameters. In the assessment shown in Chapter 10, a spider diagram is used to illustrate the sensitivity of the project’s IRR against identified risk ranges. Probability analysis Probability analysis is a more sophisticated technique which uses Monte Carlo simulation to model the combined effects of numerous risk elements according to relative frequencies. The main limitation of the sensitivity analysis is that it gives no indication of the likely probability of risk becoming real. This limitation is overcome by probability analysis, which can specify probability distributions for each variable and its impact on economic parameters.

Risk response Risk responses are usually grouped according to their intended effect on the risk they treated. It is common to use four risk strategies

48


(Smallman and Elkington 2000; Dey 2002; Merna and Njiru 2002; PMBOK 2004): 1. Avoid: Risk avoidance involves the removal of a particular threat. This may be either by eliminating the source of risk within a project or by avoiding projects (Merna 2004). 2. Transfer: Shifting the risk to a third party to better able to manage them. 3. Mitigate: Reducing risks to a more acceptable level by reducing the probability of a risk’s occurrence or its impact on the project. 4. Accept: Recognising that residual risks exist, and responding either actively by allocating an appropriate contingency or passively doing nothing except monitoring the status of the risk. It is impossible to predict all potential risks. Some risks that occur very rarely but may have great impact on the project can be classified as unpredictable special events. However, predictable risks must be identified, fully analysed and efficiently responded to. Risk management has the following benefits (Chapman and Ward 1997): ❒ The risks associated with the project or business are defined clearly and in advance of commencement of the project. ❒ Management decisions are supported by a thorough analysis of the data available. Estimates can be made with greater confidence. ❒ Improvement of project or business planning by answering ‘whatif’ questions with imaginative scenarios. ❒ The definition and structure of the project are continually and objectively monitored. ❒ Provision of alternative plans and appropriate contingencies and consideration concerning their management as part of a risk response. ❒ The generation of imaginative responses to risks. ❒ The building up of a statistical profile of historical risk, which allows improved modelling for the future projects.

49

Risk management

Table 4.1 Global and elemental risks (Chu 2007) Global risks

Elemental risks

❒ ❒ ❒ ❒ ❒

❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒

4.4

Political Legal Commercial Environmental Force majeure

Construction Operation Financial Revenue Completion Raw material supply Product offtake Technology Credit Market Design

Typical risks in project financing

Typical risks involved in project financing vary from project to project, industry to industry. Different parties perceive risks from different perspectives according to their attitudes and experience. For instance, engineers are concerned about the risks which may affect the engineering success of a project, whereas the lenders and sponsors concentrate Table 4.2 Financial and non-financial risks (Chu 2007) Financial risks

Non-financial risks

❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒ ❒

❒ ❒ ❒ ❒ ❒ ❒ ❒

Construction delay Currency Interest rate Equity Corporate bond Liquidity Counterparty Maintenance Reinvestment Country

Dynamic Inherent Contingent Regulatory Reputation Organisational Interpretational

50


Table 4.3 Risks affecting different phases of a project’s life cycle Construction-phase risks

Operation-phase risks

Generic risks in all phases

Construction Completion

Operation Revenue Supply Offtake Market

Financial Credit Legal Environmental Political Force majeure Counterparty

on how risk could affect the cash flow profile of a project. This is probably one of the main reasons why risks are broadly categorised in different ways by different authors. Global and elemental risks are categorised as shown in Table 4.1. Global risks are those outside the project packages and which the parties do not generally control, whereas elemental risks are the risks that are within the control of one or other project participants, and appropriate risk mitigation methods can be applied. The financial risk and non-financial risk: financial risk is the risk associated with the financial viability of the project (Logan 2003; Merna and Faisal Fahad Al-Thani 2008). Financial and non-financial risks are categorised by Merna and Faisal Fahad Al-Thani (2008), as shown in Table 4.2. Risk can also be categorised in different phases of a project’s life cycle, as shown in Table 4.3.

Chapter 5 The financial assessment process

5.1

Introduction

Many organisations have developed and continue to use financial assessment structures in isolation, particularly for projects procured using project finance. Although each assessment will have its merits, it is often difficult to gain an overall understanding of the processes and the economic parameters each stakeholder evaluates in their own assessment process. In this chapter, a financial assessment process that can be used by all stakeholders, specifically the special project vehicle (SPV) and lenders who in turn are involved in assessing all the secondary contracts and their associated financial and risk issues, is presented.

5.2

The financial assessment structure

Figure 5.1 illustrates the major processes involved in the assessment of a project procured using project finance from inception to financial close. The financial assessment structure is developed in three stages with the initial assessment by the SPV, typically the shareholders to the SPV, followed by the lender’s assessment and finally a joint assessment by both SPV and lenders.

SPV assessment The SPV is initially concerned with the commercial viability of a project. In most cases the SPV will be involved in a competitive bid, usually awarded on the basis of the lowest price offered to the principal for providing a product or service. It should be noted that the principal is accountable to the public and must ensure they achieve 51

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Development of base case to determine CCF and economic parameters (IRR, NPV, CLU, PB)

SPV assessment

Reassessment

Estimate of activities, times, costs and revenues of a project

Identification of risks and deterministic assumptions (best and worst case) Assessment of base case model incorporating risks Decision regarding further assessment

No go

Development a financial package based on assessment provided by SPV

Lender assessment

Reassess

Assessment of financial package for worst case scenario Determination of project economics and cover ratios (CAPEX, OPEX, revenue, cash flows and cover ratios for worst case scenario) Financial assessment typically using different ratios of financial instruments Building financial model Decision regarding further assessment of preferred financial package

No go

Risk assessment: identification, analysis and response Financial engineering Determine preferred financial and technical structure Due diligence Financial close

Figure 5.1

Financial assessment structure.

SPV and lender final assessment

Financial and risk assessment on project

The financial assessment process

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value for money from a project using project finance. The SPV initially identifies the project’s major activities, costs and revenues based on estimated values either from past experience or from other sources such as consultant organisations. The SPV is therefore initially concerned with estimates of the project’s capital (CAPEX) and operational expenditures (OPEX) and revenue generation over its life cycle. Using the timing of activities and costs and revenues, the SPV can quickly develop a cumulative cash flow (CCF) model to determine the project’s base case economic parameters. These are typically the amounts of cash required at different intervals referred to as cash lockup, the rate at which cash can be required and spent (cash burn), the time required to break-even, interest cover and the project’s internal rate of return (IRR) and net present value (NPV). From these economic parameters, a decision can be made on whether the project is commercially viable based on the estimated values. In many cases the project’s IRR is the metric used to determine whether further assessment is required. This is often based on its relationship to the minimum acceptable rate of return (MARR) set by the SPV. The MARR is often determined on the characteristics of the project, its location and the perceived risks. At this stage the cost of finance is not included in the assessment. An example of this assessment and its generated outputs are provided in Chapter 7. Risks associated with the project are identified to determine whether the project should undergo further assessment. In most cases these risks will not be assessed individually, with the SPV relying only on a deterministic analysis to determine the worst and best case scenarios. This is often performed by assuming a range of 5% gain in the best case and 10% loss for the worst case. The 10% worst case is sometimes referred to as the red line case (Merna and Faisal Fahad Al-Thani 2008). If the CCFs are found to be lower than the red line in the worst case scenario, the assessment may be abandoned or the cost estimates associated with construction and operation are revisited to identify possible savings. Similarly, if an identified risk cannot be managed then a decision to cancel further assessment may be taken. The economic parameters for the worst case scenario are then computed. If the project is deemed commercially viable, typically based on the worst case scenario IRR, then further assessment by a lender to determine whether the project is bankable is performed. If the worst

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Table 5.1 Typical costs and revenues over project life cycle CAPEX Capitalised interest Total revenue OPEX Cost of supplied materials

case scenario does not meet the SPV’s required return, the project can be reassessed or no further assessment can be recommended.

Lenders’ assessment The initial model developed by the SPV, based on estimates of time, CAPEX and OPEX and revenue generation, forms the basis of the lender’s assessment. From the estimated costs, revenues and their timings, a CCF can be developed on the basis of the worst case scenario and a financial package developed by the lender to reflect the cash flows. An assessment of this financial package will typically determine the project’s economics and specified coverage ratios and be presented in tabular form as shown in Chapter 8. These may include some or all the following depending on the type of project, financial instruments used and the ratio of financial instruments required in the decision-making process as illustrated in Tables 5.1–5.3. A project economics and cover ratio table incorporating the above is shown in Chapter 8, with values assigned relating to the case study described in Chapter 6. Table 5.2 Typical financial instruments, repayments and cash flows Project finance loan (debt) Equity Bonds Loan interest payment Capital repayment Cash available for dividends and coupons Actual cash flow available for debt service Cumulative (actual) cash flow Cumulative (predicted) cash flow

The financial assessment process

55

Table 5.3 Typical cover ratios used by lenders Actual debt service cover ratio Interest cover ratio Loan life cover ratio Project life cover ratio

Further assessment can then be undertaken using different financial packages often incorporating different ratios of debt in combination with equity or equity and bonds to determine the associated economic parameters and cover ratios. It should be noted that as alternative financial instruments are selected variations in the terms and conditions of borrowing occur, usually in the debt service coverage ratio, loan life coverage ratio and project life cover ratio. Having assessed a number of financial packages, the lender would determine the preferred package and build a financial model, often after discussions with equity and bond providers. If the preferred finance package is acceptable to the SPV and other finance providers then a more detailed final assessment is carried out jointly between the SPV and the lender incorporating a detailed stochastic analysis, often assisted by technical advisers. If no suitable package can be developed then further reassessment may be required, which will often involve decisions regarding the scope of the project or whether other sources of finance such as aid or grants can be made available. In most cases, financial engineering techniques may also be considered where beneficial to the project’s cash flows. If no satisfactory financial package can be found then no further assessment would be recommended.

SPV and lender final assessment The final assessment provides both the SPV and the lender with the opportunity to assess the project based on the lenders’ financial package and to incorporate risks identified by both parties and, if necessary, explore suitable financial engineering techniques to improve the project’s economics. In most cases the risks associated with the project’s activities and financings will be identified and a qualitative analysis will be

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performed. Many of these risks may be mitigated, leaving only a small number of risks to be addressed in a quantitative analysis, as described in Chapter 4. The effects of quantified risks can be evaluated against the project’s cash flows and the economic parameters. A stochastic analysis will provide probability distributions against any of the economic parameters used in the decision-making progress. In some cases, financial engineering techniques involving interest rate collars, demand guarantees, refinancing, additional revenue generation and extending concession periods as described in Chapter 9 can be incorporated to improve the project’s economics. A full financial assessment is described in Chapter 10 and provides outputs expected from this type of assessment to be used in the decision-making process. Once the final assessment is agreed, the preferred technical and financial structure can be developed and due diligence can be performed prior to financial close as described in Chapter 11.

Chapter 6 Case study

6.1

Introduction

In this chapter, the basic details of the parties and contracts to an independent power project (IPP) to be procured under a BOOT strategy utilising project finance in China are described. The types of supply and offtake contracts associated with such projects are provided along with the basic costs, revenues and times relevant to the case study project. The major activities over the project life cycle are outlined, and assumptions regarding the potential structure and participants to the project are also considered.

6.2

Independent power project

The proposed project is to be located in China. China has large reserves of coal suitable for the power-generating process to feed its booming economy. This project requires a major investment to burn coal to generate power. The IPP is located in the centre of North West China close to coal reserves, currently being mined and in easy reach of power transmission facilities. The IPP is to be procured on a competitive tender basis so that a major criterion for award of the project is the sale price of electricity based on a US$/kWh rate. The offtaker guarantees to purchase 90% of the power produced. Initially, the IPP is proposed to be totally completed and commissioned before operation. The principal is keen to see the project generates power earlier than 3 years from granting the concession to meet shortfalls in power generation. The special project vehicle (SPV) would also prefer to reduce the construction period or bring on 50% of output earlier to generate revenues earlier than projected and reduce borrowing. 57

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Table 6.1 Basic details of the project Project location: China Capacity: 2 × 350 MW generators The type of plant: coal fired (continuous fuel supply) Procurement method: BOOT Estimated capital expenditures: US$900 million Annual O&M estimate: US$15 million Annual cost of coal: US$30 million Estimated annual revenue: US$250 million Project life cycle period: 18 years (3 years construction and 15 years operation) Possible financing instruments: debt, bonds and equity

Basic technical and financial details of the proposed IPP are shown in Table 6.1.

6.3

Supply and offtake contracts

Project finance is often regarded as ‘contract finance’ because a typical transaction can involve as many as 15 parties united in a vertical chain from input suppliers to output buyers through 40 or more contractual agreements (Esty 2004). To arrange project finance, there must be a genuine ‘community of interest’ among the stakeholders involved in the project. Finnerty (1996) suggests that project financing arrangements invariably involve strong contractual relationships among multiple parties. Lenders will require that such contractual security arrangements must be put in place to protect them from various risks. The major contracts in typical project finance transactions are the construction contract, the product offtake contracts, the raw material supply contracts, the operations and maintenance contracts, and a large number of financial agreements, including loan agreement, bond agreement, shareholders’ agreement and agreements which address support from the host country (Merna and Njiru 2002). These contracts transfer many of the individual risk elements to appropriate parties. A typical structure of build-own-operate-transfer (BOOT) projects indicating the number of organisations and contractual arrangements that may be required to realise a particular project is shown in Figure 2.1.

59

Case study

Principal

Concession agreement

Promoter

SPV SPV assessment as discussed in Chapter 7

Assessment

Lenders Lender assessment as discussed in Chapter 8

Final assessment by SPV and lenders as discussed in Chapter 10

Figure 6.1

Assessments by SPV and lenders to determine the commercial viability.

Figure 6.1 illustrates the assessments required by the SPV and lenders for this project. It should be noted that each assessment allows the SPV and lenders to determine whether the project assessment should continue and thus support the decision-making process as illustrated in Figure 5.1. Project finance can work only for those projects that can establish such relationships and maintain them at a tolerable cost. The project’s cash flow is guaranteed by these contractual arrangements. These contracts should form an interwoven web that determines the project’s value and risk. Although the granting of a concession is legally crucial to a project, from a financial perspective, the arrangement of supply and offtake contracts is the basis on which revenue is generated (Elsey et al. 1996). Both lenders and sponsors, in this case the SPV, strive to ensure a reliable, consistent supply of raw materials to achieve certainty of revenues generated by the sales of products. All the major contracts involved in BOOT are structured to serve the commercial objective of a project: cash flow being secured. Eventually, it is through the selling of products or providing services that a project can achieve revenue generation. Therefore, it is important to explore the interrelationship between supply and offtake contracts and the interrelationship between these

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contracts and the concession agreement. The issues such as how the durations of supply and offtake contract match the period of the concession agreement, and how an individual supply or offtake contract default can affect the contracts which are bundled with that contract should be assessed before making investment decisions.

Supply contracts Merna and Njiru (2002) defined a supply contract as a signed agreement between suppliers and promoters in which the supplier is obliged to provide the raw materials needed by a project to produce a required output during the operation stage. This gives the fundamental definition of a supply contract. Finnerty (1996) argues that raw material supply contracts oblige the suppliers of the project’s inputs to also lend credit support to the project. Successful project operation requires that raw material must be available in quantities and of the quality needed to operate at its design capacity over its entire life. Supply contracts represent agreements to fulfil the project’s input requirements such as quality, quantity and price of raw materials. Long-term supply contracts for feedstocks, coal or energy are necessary for the financial feasibility of many projects (Nevitt and Fabozzi 2000). The project’s raw material supply requires just as much structuring as the offtake of the project’s product (Tinsley 2000). A typical traditional supply contract is a supply-or-pay contract, which obligates the suppliers to supply the requisite amounts of the raw material specified in the contract or otherwise suppliers would indemnify the project company for excess costs incurred in securing the inputs from third parties or make payment to cover debt service (Vega 1997). There are also other supply contracts such as sole supply contracts under which the SPV agrees with a single supplier from which the SPV will purchase the project’s required raw material. However, the actual amount and price of the raw material will not necessarily be specified (Cuthbert 2004). Thus, the form of supply contract may vary from project to project. The contract conditions and content entirely depend on the characteristics of an individual project. Packard (1996) claims major stakeholders require the following conditions to be elaborated in great detail in the fuel supply agreement in a power plant:

Case study

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❒ The quality of fuel; ❒ The length of the supply contract; ❒ The reserve and production levels for each supply; ❒ The pricing formula; ❒ The interpretability (and which party bears risks); ❒ The transportation arrangements; ❒ The backup arrangements; ❒ Minimum and maximum purchase. Supply contracts have been used in many industrial projects, such as the Jawa power project in Indonesia (Johnson et al. 1996), the Dhahol project in India (Ullman and Dayal 1996), the Hubco power project in Pakistan (Schell 1996), the Paiton power plant development in eastern Java in Indonesia and the Hopewell energy project in the Philippines (Tinsley 2000). Table 6.2 illustrates the details of those contracts. Suppliers, or perhaps sponsors, commit to deliver the key inputs to a given standard for commissioning and during the operating phase of those projects. It was found that most of these supply contracts were traditionally signed between promoters and local government, sponsors or some other major parties which have good credit. The inputs of these projects were contracted from reliable sources, which created a great certainty of project raw material supply in terms of price, quality, quantity and availability. The authors believe that the supply contracts used in those projects can be defined as traditional supply contracts. The traditional supply contracts vary from project to project and industry to industry. However, those contracts are usually long-term contracts.

Offtake contracts As limited-recourse projects are funded on the security of the future cash flow, there must be some form of offtake. Both supply and offtake contracts are fundamentally important to the project economics. The purpose of supply contracts is to minimise supply risk in order to

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Table 6.2 Projects with supply contracts (Chu 2007) Project name

Supply contract arrangement

Jawa project

Long-term supply contracts signed with two suppliers: PT Berau Coal and PT Kideco Jaya

Dhahol power plant

Long-term fuel contracts signed with Coal India Limited

Hubco power project

30-year oil agreement

Paiton power plant

The coal supplier dedicated some of its reserves in priority to Paiton sufficient to cover 83% power plant availability for 28 years

Hopewell power plant

The Filipino state electricity utility, National Power Corporation, contracted to supply the diesel oil fuel at no cost. It also contracted to take the electrical output on a peak-load capacity change basis

provide secured raw material supply, whereas the aim of offtake contracts is to minimise the market risk and to provide the revenue stream to finance not only the supply of the raw material but also the construction of the required processing plant, its operation and maintenance and the cost of financing. Elsey et al. (1996) claim that offtake contracts provide the revenue stream, which is the foundation of project finance. Traditionally, there are two basic types of offtake contracts: the contract-led and market-led contracts (Merna and Njiru 2002). In a contract-led project, a contract is entered into between the promoter and the user. The user may be an individual or an organisation who has agreed to purchase an agreed amount of output. An example of a contract-led project is a power station which normally has power purchase agreements (PPAs) with reliable offtakers. Traditional contract-led offtake contracts can also be defined as the following types: Take-if-offered contract: The contract obliges the purchasers to take delivery of, and pay for, the output or service only if the project is able to deliver to them. No payment is required unless the project is able to make deliveries (Finnerty 1996).

Case study

63

Take-or-pay contract: Take-or-pay contracts require purchasers to pay for a contractually specified minimum quantity of output; even if the good or service is not taken, payment must still be made (Masten and Crocker 1985). It gives the buyer the option to make cash payments in lieu of taking delivery, whereas the take-ifoffered contract requires the buyer to accept deliveries (Finnerty 1996). The price which the user pays under a take-or-pay contract is sometimes directly related to an independent market price for the relevant product. In other take-or-pay contracts, the price is established through the application of a formula and may bear little resemblance to the market price (Terry 2000). Like take-ifoffered contracts, a take-or-pay contract usually does not require the purchaser to pay if the project is unable to deliver the product or perform the services. Throughput agreement: A throughput agreement is typically employed in connection with oil or petroleum product pipeline finance. During a specified period, the oil or gas producers are required to provide a certain throughput to the pipeline so that the pipeline operator can cover all its operating expenses and meet its debt service (Finnerty 1996). Tolling Contract: A tolling contract means the project offtaker also agrees to supply the key project raw materials, usually for free to the project entity (Tinsley 2000). Tolling contracts are usually used in power and refinery projects (Beenhakker 1997). In a power station, these are sometimes called energy conversion agreements. For example, the government power utility of the Philippines, Napocor, has been a proponent of liquid fuel-based power generation, whereby it supplies the fuel for free, yet it is the offtaker of the electricity. The tolling commitment is the main support for mitigating market risk as well as avoiding the operating cost risk and supply risks of the fuel. In projects where the use of contract-led contracts is considered unfeasible, a market-led contract is used. In a market-led project, revenues are generated only when users are using the facility. An example of a market-led project is a toll road. Revenues are generated only when motorists pay to use the toll road.

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Table 6.3 Projects with offtake contracts (Chu 2007) Offtake contract

Offtake contract arrangement

Hubco power project

30-year PPA with National Water and Power Development Authority

Indiantown cogeneration project

30-year PPA signed between Indiantown and Florida Power & Light Company

Shajiao power station

Long-term offtake with Chinese Electricity Authority (60% of electricity), 1987–1997

Petrozuata project

35-year guaranteed offtake contracts

Ras Laffan LNG project

The Ras Laffan LNG project in Qatar was project-financed on the back of a 25-year contract on a take-or-pay basis with South Korea

There are many projects which have employed offtake contracts all over the world, such as the Hubco power project in Pakistan (Schell 1996), the Indiantown cogeneration project (Finnerty 1996), the Shajiao power station (Merna and Njiru 2002), the Petrozuata project in Venezuela (Tinsley 2000) and the Ras Laffan LNG project in Qatar (Dailami and Hauswald 2000). The basic details of these contracts are illustrated in Table 6.3. It was found that most of these contracts are used in natural resource-related projects and normally over a long term. Similar to traditional supply contracts, those offtake contracts have simple forms and are normally signed between promoters and end-users that have very good credit ratings. The authors define those offtake contracts as traditional offtake contracts.

Applications of supply and offtake contracts The concepts of supply and offtake contract have been applied in many projects such as power station projects, mining projects and petroleum projects. Gatti (2005) claims that from a historical standpoint, project finance was first launched in well-defined sectors marked by two important factors: (1) long-term contracts in return for predetermined

65

Case study

Government

Concession agreement

Fuel suppliers

Long-term supply contracts

Power station

Long-term offtake contracts Electricity authority

Figure 6.2 Supply contract and offtake contract arrangements in the power station (adapted from Merna and Smith 1994).

prices involving large, financially sound buyers and (2) absence of high-level technological risks when constructing plants. In power station projects, the lender requires that projects must be capable of continuing to sell their power for at least the duration of the loan (Morcos 2001). The market demand risk is mitigated by PPA with high creditability of offtakers. Figure 6.2 shows a typical arrangement of supply and offtake contracts, which was used in the procurement of the Shajiao power station. In Shajiao, the Chinese Electricity Authority agreed to purchase a minimum of 60% of the electricity from the plant on a take-or-pay basis and also agreed to pay a fixed price per kilowatt hour over the concession period (Merna and Njiru 2002). This has provided a steady stream of revenue for the promoter. As a result, the promoter has made positive cash flows since the start of the concession period through the sale of the electricity. Shajiao is the first BOOT project in China and was successfully transferred to the Shenzhen government in September 1999. Thus, it appears that the offtake contract is one of the most important factors that contributed to the success of the project. The supply contract governs the supply of the raw material that is required to be processed in order to produce the end product, and the offtake contract governs the sale of this end product to the consumer in most raw material process projects.

6.4

Assumptions for initial assessment

Clearly, the SPV must decide which supply–purchase contract offers the best return and security on the investment. In this case the SPV considers a take-or-pay contract where:

66


The supplier is the State Power Development Company under a feedstock agreement where the price is index-linked over the first 10 years of operation. The offtaker will also be the State Power Development Company who will purchase 90% of the power produced on a take-or-pay basis with an index-linked sale price over the first 10 years of the operation period. The parties and contracts as shown in Figure 6.1 may include: Principal: The government of China who will grant a concession to the successful SPV. SPV: The consortium of four European contractors experienced in the construction and operation of coal-powered IPPs initially assessing the commercial viability of the project. The primary agreement will be the concession agreement, which will outline the risks and responsibilities of each party and the terms of reference. Secondary contracts will be those associated with the construction, operation and finance and are initially assumed to be from a pool of organisations including: Constructor: A joint venture between a local Chinese civil engineering contractor and a European civil engineering contractor, with specialist knowledge of coal-fired power generation plants. Operator: A European organisation specialising in the operation, maintenance and training requirements of coal-fired generating facilities. Lender: An experienced lender in the financing of IPPs to provide debt through a syndicated loan arrangement. Shareholder: Shares would be sold through a private placement with at least 10% of the equity taken by stakeholders to the project such as the constructor, operator, vendor and offtaker.

Case study

Figure 6.3

67

Project programme: major activities (generated by Microsoft Project).

Bondholder: If bonds are perceived to offer a more practical solution than debt then an offshore bond issue denominated in US dollars would be considered to raise the bulk of capital required in the form of plain vanilla bonds. Costs and revenues are typically estimated by the SPV along with the activity timings often on the basis of previous projects. The timings of each major activity form the basis of the project programme as shown in Figure 6.3. The costs and revenues associated with the project programme can be used to develop the project’s initial cash flows. The bar chart illustrated in Figure 6.3 provides a basic understanding of the major project activities and their timings during the initial assessment. As more data become available, bar charts can be further developed to provide a more detailed output, offering more realistic solutions. The task abbreviations used in Figure 6.3 represent the following activities: INV: Invitation to tender FEA: Design and feasibility AWA: Award of concession MOB: Mobilisation and temporary work

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SUB: Substructure works STL: Steelworks BLK: Building works ELE: Installation of electrical systems BDG: Installation of building services BLR: Installation of boilers TUR: Installation of turbines/generators COL: Installation of cooling systems CHS: Installation of coal-handling systems AHS: Installation of ash-handling systems WTS: Installation of water treatment systems COM: Testing and commissioning of the power station O&M: Operation and maintenance Revenue: Revenue generation

Chapter 7 Developing the base case model

7.1

Introduction

The independent power project (IPP) described in Chapter 6 is a contract-led project whereby the special project vehicle (SPV) enters into a contract (concession agreement) with the principal (government). Before the project is sanctioned, a power purchase agreement specifying a minimum amount electricity to be purchased by the state power development company (SPDC) to secure a certain amount of revenue and a coal supply contract to secure the supply of coal and hedge price risk, also with the SPDC, is developed. In this chapter, the authors demonstrate how an initial assessment on behalf of the SPV can be developed to determine the commercial viability of the project.

7.2

SPV’s initial assessment

Without considering the cost of finance, the SPV initially evaluates the commercial viability of the project. Typically, the SPV is concerned with assessing the best, base and worst case scenarios based on estimated costs and revenue streams in money terms so that a decision can be made on whether further assessment is required. Typically, this assessment requires several steps to prepare a cash flow model of the project as shown: ❒ Estimate the time and costs of activities in the construction and operation phase of the project; ❒ Develop a cumulative cash flow (CCF) for the base case model in money terms; ❒ Identify the major risks the project is exposed to over its life cycle; 69

70


❒ Develop deterministic models for the project’s best and worst cases; ❒ Present the results for decision-making purposes.

7.3 Identify the estimated activities, time, costs and revenues of the project The activities, costs and revenue estimates and their timings are shown in Table 7.1. The data used to develop this table are derived from basic Table 7.1 Activities, costs and revenue estimates and their timings Name INV FEA AWA MOB SUB SLT BLK ELE BDG BLR TUR COL CHS AHS WTS COM O&M Revenue

Cost (US$ million) 10.00 51.00 1.50 5.00 55.00 75.00 7.50 60.00 45.00 165.00 150.00 50.00 105.00 65.00 18.00 37.00 45.00 250.00

Start

Finish

January 2007 February 2007 December 2007 January 2008 February 2008 March 2008 May 2008 July 2008 November 2008 December 2008 January 2009 February 2009 February 2009 March 2009 May 2009 October 2009 January 2010 January 2010

February 2007 December 2007 January 2008 February 2008 October 2008 November 2008 August 2008 March 2009 May 2009 October 2009 October 2009 Sept 2009 October 2009 October 2009 October 2009 December 2009 January 2025 January 2025

INV, invitation to tender; FEA, design and feasibility; AWA, award of concession; MOB, mobilisation and temporary work; SUB, substructure works; SLT, steelworks; BLK, building works; ELE, installation of electrical systems; BDG, installation of building services; BLR, installation of boilers; TUR, installation of turbines/generators; COL, installation of cooling systems; CHS, installation of coal-handling systems; AHS, installation of ash-handling systems; WTS, installation of water treatment systems; COM, testing and commissioning of the power station; O&M, operation and maintenance; revenue, revenue generation.

Developing the base case model

71

estimates of the project, described in Chapter 6. The SPV has set a minimum acceptable rate of return (MARR) of 12% for this project.

7.4

Development of the base case model

The SPV will initially be interested in identifying economic parameters such as internal rate of return (IRR), net present value (NPV), payback/break-even points and the cash lock-up. In most cases, SPVs will set an MARR that being a return in terms of IRR, which suggests the project is commercially viable and meets predetermined criteria, in this case 12%. This can be quickly achieved by developing a base case model normally presented in terms of a CCF and a table of economic parameters. Spreadsheet software is ideal for this computation and can be performed using the costs and timings associated with the construction and operation packages and the revenues and timings associated with the revenue generation package. In this case the construction package represents a capital expenditure of US$900 and the operation package represents operational expenditure of US$675 million, with a total revenue package of US$3750 million based on selling 90% of the power produced to the state-owned offtaker. The computation is performed in money terms only at this stage of the assessment. The profit can be calculated in money terms as: Profit = 3750 − (900 + 675) = US$2175 million The costs associated with construction and operation phases are allocated to the relevant activities and their timings. If as in this example a number of construction activities run concurrently then the costs of each activity can be added together to determine the total cost of construction in one time period. This can be stated in a week, month or yearly intervals depending on the accuracy required and sufficiency of the estimated values. In this example, CCFs are based on yearly periods. Operational activities can be similarly presented. Finally, the revenues generated by the project can be allocated to the cash flow table. Table 7.2 shows the annual cash flows and cumulative cash flow for the project over its life cycle.

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3.0 2.5 2.0

(109)

1.5 1.0 0.5 2024

2023

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

0.0 –0.5 –1.0 –1.5 Figure 7.1

Base case CCF.

A simple computation provides the information for the base case model as shown in Figure 7.1 and Table 7.3. The project’s base case CCF shown in Figure 7.1 illustrates clearly the flows of cash in the project phases and shows a payback/breakTable 7.2 Base case model cash flow and cumulative cash flow Year

Cash flow

Cumulative cash flow

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

0 −62 500 000 −219 000 000 −637 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000 205 000 000

0 −62 500 000 −281 500 000 −918 500 000 −713 500 000 −508 500 000 −303 500 000 −98 500 000 106 500 000 311 500 000 516 500 000 721 500 000 926 500 000 1 131 500 000 1 336 500 000 1 541 500 000 1 746 500 000 1 951 500 000 2 156 500 000


73

Table 7.3 Base case economic parameters Economic parameters IRR (%) NPV (US$ million) Construction cost cash lock-up (US$ million) Operation cost (US$ million) Revenue (US$ million) Payback period (years)

Base case 19.15 2156.50 −900.00 −675.00 3750.00 7.48

even point approximately 7.5 years after the start of construction, with an NPV approximately 2.4 times greater than the capital expenditures. Table 7.3 indicates the economic parameters developed from the base case cash flow computation. The base case IRR is over 19%, which is 7% over the MARR with a payback/break-even point of 7.48 years. Cash lock-up is US$900 million. Based on these initial economic parameters, a decision to assess the effect of risk on the project is sanctioned. It should be noted that no effects of inflation are taken into account and no discount factors are used at this stage of the assessment. This exercise is simply performed to determine the commercial viability of the project to the SPV. In some cases, SPVs may consider other technical means of realising the project, such as staged construction resulting in early revenue generation and to compare results.

7.5

Identify major project risks

Project financing is all about identifying risks, allocating them to appropriate parties and ensuring that the responsible parties manage their risks efficiently. The following risks are initially identified by the SPV as being typical to IPP procurement: ❒ Cash flow problems at start-up; ❒ Technical failure causing delay; ❒ Lower production than projected;

74


❒ Poor management of the facility; ❒ Technical obsolescence; ❒ Increased prices or shortages of raw materials and consumables; ❒ Foreign currency exchange, availability of currency and inflation; ❒ Government interference; ❒ Force majeure during the operation period. Many of the above risks are considered manageable by the SPV at this point, and a deterministic risk analysis is performed. This risk analysis simply looks at a 5% upside effect and a 10% downside effect of the estimated costs, revenues and their timings on the project. The 5% upside risk would be assumed on the basis that the remaining 10% of production not sold to the state-owned operator could be sold on a market-led basis to other, possibly privately owned purchasers, and thus increase revenues over the life of the concession. The 10% downside risk would take into account possible construction and commission delays as well as poor operation and inability to meet demand over the concession period. A detailed financial assessment assessing identified risks is performed in Chapter 10 after the lenders have determined the financial package and terms of lending.

7.6 Assessment of base case model incorporating risks After computer simulation, a CCF diagram is presented, as shown in Figure 7.2, and the economic parameters for the base, best and worst case scenarios are presented, as shown in Table 7.4. In Table 7.4, the IRRs for the base and best cases are 19.15 and 21.86%, respectively; the IRR for the worst case is a low 14.14%. The NPVs for the base and best cases are US$2156 million and US$2423 million, respectively. For the cash lock-up, the cost of construction for the base is US$900 million. This figure drops to US$855 million for the best case and dramatically increases to US$990 million.

75


3.0 2.5 2.0

(109)

1.5 1.0 0.5 2024

2023

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

0.0 –0.5 –1.0 –1.5

Figure 7.2

Base, best and worst case CCF.

Figure 7.2 provides a diagrammatic presentation of the cash flows over the life cycle of the project. The area between the best and worst case lines is relatively small and implies that risk mitigation could bring the worst case cash flow nearer the base case cash flow line and thus suggest further assessment by a lender, as shown in Chapter 8. This initial assessment, albeit a simplified assessment, provides the SPV with the necessary economic parameters and projected cash flows to determine if further assessment is required. Presentation of the assessment is often through CCF diagrams and tables indicating the major economic parameters. Table 7.4 Economic parameters of base, best and worst case scenarios Economic parameters

Base case

Worst case

Best case

IRR (%) NPV (US$ million) Construction cost cash lock-up (US$ million) Operation cost (US$ million) Revenue (US$ million) Payback period (years)

19.15 2156.50 −900.00

14.14 1622.15 −990.00

21.86 2423.68 −855.00

−675.00 3750.00 7.48

−742.50 3375.00 8.76

−641.25 3937.50 6.97

Chapter 8 Initial economic assessment by lenders

8.1

Introduction

Lenders seek to initially assess a project based on estimates of time, costs and revenues provided by a special project vehicle (SPV) for the worst case scenario. The lender is primarily concerned with the risk of default on the debt provided and thus seeks to determine through the simulation of models, the probability of default and loss given default, associated with different financial packages and businesses. In this chapter, the authors demonstrate how the project is assessed from a lender’s perspective on the basis of the following three different financial packages: Finance package (1): 100% debt Finance package (2): 80% debt and 20% equity Finance package (3): 10% debt, 80% bond and 10% equity, respectively

8.2

Financial package assessment

The development of a financial package that is the number and ratio of financial instruments considered to provide a project financing is the starting point of the lender’s assessment. In most cases, lenders will be experienced in providing finance to different types of facilities and quickly assess the risk associated with the facility and its ability to service debt. The three financial packages described below are developed specifically to demonstrate how each package would be assessed by 77

78


the lenders to determine the most suitable package for detailed final assessment.

Finance package (1) The first assessment is based on 100% debt. It is highly unlikely that a project open to the effects of risk would be financed this way, but for the purpose of this guide, this finance package is assessed purely to illustrate its ability to service the debt in terms of interest and principal repayments. The lenders’ simulation is different from the SPV’s initial assessment, where no financial cost was considered. In this case an interest rate of 8% is assumed with a payback of approximately 10 years after the start of operation and revenue generation. In most cases the interest rate used in a project financing takes into account not only a margin above the base rate but also the costs of lender’s fees associated with management, commitment, agency, underwriting, success and guarantees (Merna and Njiru 2002). In some cases the interest rate margin used takes into account the interest accrued during the construction period before any revenues are generated. From Table 8.1 the following can be easily computed: Capital expenditures (CAPEX): US$990 million Operational expenditures (OPEX): US$742.5 million Total interest: US$422.43 million Revenue: US$3375 million In money terms, the profit or net present value (NPV) with a discount rate of 0 would be: Profit = 3375.00 − (990.00 + 742.50 + 422.43) = US$ 1220.07 million Principal and interest would be repaid over a period of 10 years from the start of operation.

Cover ratios Discount rate DSCR Operating profit IRCR Outstanding NPV LLCR 4.5% NPV PLCR 4.5% LLCR PLCR

4.50%

Finance Project finance loan 100% Equity 0% Bond 0% Loan interest payment Capital repayment Cash available for dividend Actual cash flow available for debt service

−68.75 −240.9 −680.35 −5.50 −25.21 −81.65

2009

CAPEX Capitalised interest Total revenue Operating cost Coal cost

2008

2007

Financial year

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 225.00 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00

2011

0.95 175.50 2.20 184.26 1874.49 1969.21 1.03 1.08

1.00 1.05 1.10 1.16 1.23 1.31 1.40 1.49 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 2.46 2.78 3.20 3.78 4.61 5.91 8.22 13.50 175.91 167.55 159.20 150.84 142.49 134.14 125.78 117.43 1775.45 1672.15 1564.00 1450.98 1332.87 1209.60 1080.64 945.87 1874.43 1775.60 1672.10 1563.95 1450.93 1332.98 1209.57 1080.60 1.09 1.15 1.21 1.28 1.36 1.44 1.53 1.63 1.15 1.22 1.29 1.38 1.48 1.59 1.72 1.87

1.61 1.74 1.90 2.09 2.32 0.00 175.50 175.50 175.50 175.50 175.50 175.50 37.74 109.07 0 0 0 0 0 805.03 657.94 504.15 343.44 175.50 343.42 945.83 805.09 657.92 504.13 343.42 175.50 1.74 2.05

−79.84 −71.48 −63.13 −54.77 −46.42 −38.07 −29.71 −21.36 −13.00 −4.65 −104.42 −104.42 −104.42 −104.42 −104.42 −104.42 −104.42 −104.42 −104.42 −104.42 −8.76 −0.41 7.95 16.30 24.66 33.01 41.36 49.72 58.07 66.43 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50 175.50

225.00 −16.50 −33.00

2010

Table 8.1 Project economics and cover ratios under 100% debt (US$ million)

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Debt service coverage ratio Lenders usually determine borrowing capacity on the cash flow available for debt service (CFADS) basis of debt coverage ratios. One of the most common debt coverage ratios in project finance is the debt service cover ratio (DSCR), where: DSCR = CFADS/debt service and Debt service = interest + principal The DSCR is the metric widely used in project finance models to determine if the projects’ cash flows are able to repay debt at periodically defined intervals. A DSCR of less than 1 typically means that the cash flows from the project are not sufficiently robust to meet debt service requirement. Banks typically seek a DSCR of 1.15 times or above over the concession period to ensure sufficient cover for downside scenarios. Also, lenders may require covenants in places such as lock-up, which means that shareholders cannot draw dividends if the DSCR falls to 1.10 times or below. This gives lenders time to exercise their step-in rights and, if necessary, appoint a new contractor capable of fulfilling the obligations of construction and operation of the facility, or to restructure the existing debt. Table 8.1 illustrates the project economics and cover ratios and shows that the DSCR calculated is 0.95 in 2010 and suggests that there is only enough net operating income to cover 95% of annual debt payments, which is less than the typical DSCR requested in power industry projects. This would typically result in lenders seeking other financial instruments or other cost-efficiencies. Loan life coverage ratio (LLCR) is one of the most commonly used debt metrics in project finance, where: LLCR = NPV (cash available)/debt balance Unlike period-on-period measures such as the DSCR, the LLCR provides an analyst with a measure of the number of times the cash flow over the scheduled life of the loan can repay the outstanding debt balance. In other words, it indicates how many times the

Initial economic assessment by lenders

81

projects-discounted cash inflow can cover the debt service. LLCR is the discounted version of the DSCR. It is the project’s NPV of available cash for debt service to the maturity of the credit facilities divided by the principal outstanding. A number greater than 1.0 means the projects’ cash flows can repay the debt. This ratio is slightly higher than the DSCR. The discount rate used in this computation and for the project life cover ratio (PLCR) is 4.5%. Lock-up and default covenants may also be applied here to shareholders where the cover ratios are smaller than required. In Table 8.1, the LLCR is shown as 1.03, 1.09 and 1.15 from the beginning of the loan repayment period starting in 2010. This suggests that it would be difficult for the borrowers to meet the default LLCR during the first 3 years of operation and lenders would need to inject other financial instruments, such as equity into the finance package, as this is close to default. Project life cover ratio PLCR is basically the same as LLCR but includes cash inflows from the tail, which is the period between the maturity of the loan and the end of the concession. For example, debt is repaid by September 2025, but concession end is September 2026, resulting in 5-year tail, as shown in Table 8.1. The PLCR will be slightly higher than LLCR and becomes infinite after the loan period because there is no denominator, that is, no debt outstanding. The PLCR is basically redundant after the end of the loan life. The higher the tail is, the greater the difference is between the LLCR and PLCR. Interest rate cover ratio The interest rate cover ratio (IRCR) indicates the safety margin that the project has in terms of being able to meet its interest obligations, where: IRCR = net profit before interest/interest paid The higher the IRCR is, the higher the probability that the project is able to meet its interest obligations from its profits. A low IRCR means that the project is potentially in danger of not being able to

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meet its interest obligations. An IRCR is typically 2.00 times the cover. No principal is included in this. This is generally seen in a bullet or balloon deal that is, no amortisation, structured to refinance. It should be borne in mind that the figures used in this assessment are based on estimates and forecasts of cash flows. Any deviation, particularly the effect of downside risks at specific times in the concession, would result in default and thus not be considered as applicable to the project by the lenders.

Finance package (2) SPVs involved in the procurement of IPPs typically commit 20% of the project’s CAPEX in the form of equity, usually from stakeholders to the project. This equity commitment is normally considered as risk capital. The greater the equity commitment, the greater the risk perceived in a project. This financial input ensures that there are sufficient funds available at the early stages of development and also provides a commitment to the project on behalf of the stakeholders. From the lenders’ point of view, this financial input not only ties the stakeholders to the project during difficult times but also provides a debt cushion so that lenders’ losses would be reduced should the project company go into default and also secures an earlier repayment of debt. Figure 8.1 illustrates the financial package assessed in terms of debt and equity. Lenders are again concerned with the worst case scenario at this stage of the assessment. 20%

Equity Debt

80% Figure 8.1

Finance package of 80:20 debt/equity.


83

After modelling the project under this finance package, it can be seen that the DSCR has improved as there is a substantial reduction of debt financing. The interest repayment however is approximately US$490 million, that is, US$67.5 million higher than the 100% debt assessment. This is because the interest payments and principal repayments are now spread over a 14-year period rather than 10 years as a result of sculpting the repayments to the forecasted cash flows. The reduction in annual interest and principal repayments as shown in Table 8.2 results in money being available for dividend payments. The DSCR increases from 0.95 to 1.40 in the first year of operation. Similarly, there is a significant improvement of LLCR and PLCR. For example, LLCR under the 100% debt in 2010 is 1.03, whereas it is 1.49 under 80:20 debt/equity ratio, as shown in Table 8.2. From the lenders’ viewpoint, this 80:20 structured finance package provides a suitable project financing based on the costs, revenues and forecasted cash flows. Money for dividend payments is available from the first year of operation and steadily grows as interest repayments are reduced. Debt as previously discussed is senior to equity and lenders would therefore be confident that a financial cushion was available should the projects’ revenues fall slightly below those expected. From Table 8.2 it can be seen that the cash available for dividends in the first year of operation is US$50.52 million. This equates to a pre-tax dividend of 25.5%, should all the cash be made available for such payments. By year 2020, the cash available for dividends would be US$97.88 million, equating to a pre-tax dividend of 49.4%. It is important to note that there should be no cash left in the project after dividends have been paid.

Finance package (3) The third assessment is performed on a finance package using small amounts of debt and equity, 10% for each and a large bond issue, 80%. In a project having a CAPEX of nearly US$1 billion, the use of a bond could offer a realistic alternative to large amounts of debt but would cost more to borrow. Six years to maturity plain vanilla bond based on a fixed coupon rate of 10%, with 10% debt, at 8% interest rate and a 10% equity contribution is proposed, as shown in Figure 8.2.

−240.9 −20.10

−68.75 −4.40


Cover ratios Discount rate DSCR Operating profit IRCR Outstanding NPV LLCR 4.5% NPV PLCR 4.5% LLCR PLCR

4.50%

Actual cash flow available for debt service

Finance Project finance loan 80% Equity 20% Bond 0% Loan interest payment Capital repayment Cash available for dividend and coupon

2008

2007

Financial year

175.50

50.52

−680.35 −64.93

2009

1.40 175.50 2.67 124.98 1874.49 1969.21 1.42 1.49

175.50

−65.78 −59.20 55.26

225.00 −16.50 −33.00

2010

1.46 175.50 2.88 120.24 1775.45 1874.43 1.49 1.57

175.50

−61.04 −59.20 60.00

225.00 −16.50 −33.00

2011

1.52 175.50 3.12 115.50 1672.15 1775.60 1.56 1.65

175.50

−56.31 −59.20 64.73

225.00 −16.50 −33.00

2012

1.58 175.50 3.40 110.77 1564.00 1672.10 1.63 1.75

175.50

−51.57 −59.20 69.47

225.00 −16.50 −33.00

2013

1.66 175.50 3.75 106.03 1450.98 1563.95 1.71 1.85

175.50

−46.84 −59.20 74.20

225.00 −16.50 −33.00

2014

1.73 175.50 4.17 101.30 1332.87 1450.93 1.80 1.96

175.50

−42.10 −59.20 78.94

225.00 −16.50 −33.00

2015

1.82 175.50 4.70 96.56 1209.60 1332.98 1.89 2.08

175.50

−37.36 −59.20 83.67

225.00 −16.50 −33.00

2016

1.91 175.50 5.38 91.83 1080.64 1209.57 1.99 2.23

175.50

−32.63 −59.20 88.41

225.00 −16.50 −33.00

2017

2.02 175.50 6.29 87.09 945.87 1080.60 2.09 2.39

175.50

−27.89 −59.20 93.15

225.00 −16.50 −33.00

2018

2.13 175.50 7.58 82.35 805.03 945.83 2.21 2.60

175.50

−23.16 −59.20 97.88

225.00 −16.50 −33.00

2019

Table 8.2 Project economics and cover ratio table under 80:20 debt/equity (US$ million)

2.26 175.50 9.53 77.62 657.94 805.09 2.33 2.85

175.50

−18.42 −59.20 102.62

225.00 −16.50 −33.00

2020

2.41 175.50 12.82 72.88 504.15 657.92 2.47 3.22

175.50

−13.68 −59.20 107.35

225.00 −16.50 −33.00

2021

2.58 175.50 19.61 68.15 343.44 504.13 2.61 3.83

175.50

−8.95 −59.20 112.09

225.00 −16.50 −33.00

2022

2.77 175.50 41.65 63.41 175.50 343.42 2.77 5.42

175.50

−4.21 −59.20 175.50

225.00 −16.50 −33.00

2023

0.00 343.42 175.50

175.50

225.00 −16.50 −33.00

2024

85


10%

10%

Equity Debt Bond

80% Figure 8.2

80:10:10 debt/bond/equity.

Table 8.3 shows that the 10% debt contribution equates to a loan of approximately US$100 million over a 12-year repayment period after the start of operation, with interest repayment of US$53.52 million over the same period. Since debt is senior to bonds in terms of repayment, this 10% debt loan would not be considered to be risky. In this case the authors have not considered coverage ratios as relevant to the assessment. The bond, which is senior to the equity, is over a short period of 6 years, with payments starting at the beginning of operation, means that both the bond principal and coupon must be repaid in the first 6 years of operation. The bond principal of US$792 million and six annual payments of US$79.2 million must be available in the first 6 years of operation. This equates to a total repayment of: 792.0 + 475.2 = 1267.2 million From Table 8.3 it can be seen that the cash available for payments of bonds and equity is only US$964.07 million, a shortfall of US$303.13 million. If the same bond was issued with a maturity of 10 years, then from Table 8.3 it can be seen that the cash available over a 10-year period from the start of operation is US$1618.87 million and the repayments associated with the bond would be US$1584.00 million, leaving a negligible amount for equity dividends. Dividends on equity would be extremely be small until the year 2020.


Loan interest payment Capital repayment Actual debt service Cash available for dividend and coupon Bond interest 10% Bond principal Total bond service Cash available for dividend Dividend

Finance Project finance loan 10% Equity 80% Bond 10% Actual cash flow available for debt service

2008

−240.9 −2.48

2007

−68.75 −0.55

Financial year −680.35 −7.94

2009

175.50 −7.46 −8.34 −15.81 159.69 −79.2 −79.2 −158.4 1.29

−8.13 −8.34 −16.47 159.03 −79.2 −79.2 −158.4 0.63

225.00 −16.50 −33.00

2011

175.50

225.00 −16.50 −33.00

2010

−6.80 −8.34 −15.14 160.36 −79.2 −79.2 −158.4 1.96 −

175.50

225.00 −16.50 −33.00

2012

−6.13 −8.34 −14.47 161.03 −79.2 −79.2 −158.40 2.63

175.50

225.00 −16.50 −33.00

2013

−5.46 −8.34 −13.80 161.70 −79.2 −79.2 −158.4 3.30

175.50

225.00 −16.50 −33.00

2014

−4.79 −8.34 −13.14 162.36 −79.2 −79.2 −158.4 3.96

175.50

225.00 −16.50 −33.00

2015

−4.13 −8.34 −12.47 163.03 −79.2 −79.2 −158.4 4.63

175.50

225.00 −16.50 −33.00

2016

−3.46 −8.34 −11.80 163.70 −79.2 −79.2 −158.4 5.30

175.50

225.00 −16.50 −33.00

2017

−2.79 −8.34 −11.13 164.37 −79.2 −79.2 −158.4 5.97

175.50

225.00 −16.50 −33.00

2018

−2.12 −8.34 −10.47 165.03 −79.2 −79.2 −158.4 6.63

175.50

225.00 −16.50 −33.00

2019

−1.46 −8.34 −9.80 165.70 0.00 0.00 0.00 165.70

175.50

225.00 −16.50 −33.00

2020

−0.79 −8.34 −9.13 166.37 0.00 0.00 0.00 166.37

175.50

225.00 −16.50 −33.00

2021

−0.12 −8.34 −8.46 167.04 0.00 0.00 0.00 167.04

175.50

225.00 −16.50 −33.00

2022

−7.80 167.70 0.00 0.00 0.00 167.70

175.50

225.00 −16.50 −33.00

2023

0.00 175.50 0.00 0.00 0.00 175.50

– – – 175.50

225.00 −16.50 −33.00

2024

Table 8.3 Project cash flow allocation table under 10:80:10 debt/bond/equity for the bond with a 10-year maturity (US$ million)


87

Clearly, the fixed-rate plain vanilla bond is not suitable for this project if repayments are to be made in the first year of operation with a coupon of 10%. A fixed-rate 8-year bond starting in year 6 of operation would need to provide a better coupon rate than that initially proposed due to the time value of money.

8.3

Conclusions

The costs associated with borrowing debt and bonds and their tenure for each finance package are shown as follows: Finance package (1): US$1412.42 million over 10 years Finance package (2): US$1282 million over 14 years Finance package (3): US$1267 million over 6-year bond Finance package (3): US$1584 million over 10-year bond From the three assessments performed in this chapter, the 80:20 debt/equity finance package offers the most suitable project financing to both SPV and lenders. It provides a 20% element of risk capital from the equity contribution, flexibility in terms of a longer repayment period and a cushion for lenders. This finance package will form the basis of the detailed final assessment described in Chapter 10.

Chapter 9 Financial engineering

9.1

Introduction

Just as engineers use special tools and instruments to achieve engineering perfection, the financial engineers use specialised financial instruments and tools to improve financial performance. International Association of Financial Engineers describes the term ‘financial engineering’ as ‘the development and creative application of financial technology to solve financial problems and exploit financial opportunities’. Galitz (1995) defines the concept of financial engineering as the use of financial instruments to restructure an existing financial profile into one having more desirable properties. Financial engineering techniques are being put to wide application such as modelling and forecasting financial markets, the development of derivative instruments and securities, hedging and financial risk management, asset allocation and investment management and asset/liability management. The tools used by financial engineers comprise the new financial instruments created during the last two to three decades forwards, futures, swaps and options. Further, these basic tools are being combined in different ways by the financial engineers to build more complex systems to meet specific requirements of their clients. In this chapter, a number of financial engineering techniques are discussed and how they can be used to improve the economics of a project financings and how projects can be refinanced in terms of gain and losses once in operation.

89

90


9.2 Financial instruments used in financial engineering Over the last 20 years, there has been a massive increase in the development of new financial instruments, many of which have been associated with off-balance sheet activities. The basic instruments and some of their variants used in financial engineering are shown below. Descriptions and applications of these instruments are discussed in detail by Merna and Dubey (1998).

Forward rates Forward rate is the price the market sets for an instrument traded today, but where the resulting transaction is executed at some date in the future. The most common forward rates used in the financial world are forward exchange rates and forward interest rates.

Financial futures Before there were organised grain and commodity markets, farmers would bring their harvested crops to major population centres in search of buyers. There were no storage facilities, and many times the harvest would rot before buyers were found. Many farmers would also bring their crops to market at the same time, which resulted in the price of crops or commodities going down. If, however, there was a shortage of crops and commodities then prices would rise sharply. This was because of a mismatch between supply and demand. There was no organised or central marketplace where competitive bidding could take place. Initially, the first organised and central marketplaces were created to provide spot prices for immediate delivery. Shortly thereafter, forward contracts were established. These types of ‘forwards’ were forerunners to the present-day futures contract. Futures market in currency and interest rates gradually spreads to interest-bearing assets and to stock indices. The futures contracts can be classified in the following four categories:

Financial engineering

91

1. Short-term interest rate futures such as the Eurodollar, Euroyen, 3-month sterling and euro; 2. Bond futures such as the US T-Bond, T-Notes, French government bond and British gilt; 3. Stock index futures such as the S&P 500, Nikkei 225 and FTSE 100; 4. Currency futures such as sterling against US dollar. The four categories shown above and their application are described in detail by Merna and Dubey (1998). Galitz (1995) defines a futures contract as a legally binding agreement to take or make delivery of a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future. Dixon and Holmes (1992) define futures contract as an agreement to buy or sell a standard quantity of a particular commodity or financial instrument at a future date for a price which is agreed at the time the contract is drawn up. Just like any other contract, a future contract involves an obligation on the part of both the buyer and the seller to fulfil the conditions of the contract.

Swaps Financial engineers primarily classify swaps in two categories: interest rate swaps and cross-currency swaps. Interest rate swap Galitz (1995) defines an interest rate swap as an agreement between two parties to exchange streams of cash flows denominated in the same currency but calculated on different bases. Other forms of interest rate swaps ❒ Accreting, amortising and roller coaster swaps; ❒ Basis swaps; ❒ Forward-start swaps; ❒ Zero-coupon and back-set swaps; ❒ Cross-currency swaps.

92


Options All the instruments of financial engineering discussed so far – forwards, futures and swaps – provide immunity against future movements in market rates (Galitz 1995). Whereas forwards and futures can provide this guarantee for months or a year, a swap can provide the guarantee for several years. Certainty, however, is not always the best thing. For example, a floating interest rate borrower will like to protect himself or herself against a rise in interest rate but would welcome an interest rate fall. Similarly, a fixed-rate borrower will feel happy if interest rates move up but would like to reap the benefits of a fall in interest rate. None of the instruments discussed above provide this flexibility. They only protect against adverse movements but relative loss if change is favourable.

Caps, floors, collars, swaptions and compound options These are an important group of option instruments primarily to hedge interest rate risk. Caps, floors and collars among these are quite extensively used in project financing. An interest rate cap provides protection against an increase in interest rate, but at the same time allows the benefits of interest rate fall to be enjoyed. For example, a borrower has taken a 5-year loan at London Interbank Offered Rate (LIBOR) +5% and has also bought an 8% 5-year interest rate cap. At each interest rate reset date, if LIBOR comes below 8%, the borrower simply pays the prevailing market rate and takes advantage of the lower rates. On the other hand, if the interest rates on any reset date are higher than the cap rate, the cap will provide a payoff to offset the consequences of the higher rate, effectively limiting the borrowing rate to the cap level. An interest rate floor is used to limit the benefits from a fall in the interest rate once the floor level is reached. In practice, many users of interest rate caps seek to lower the cost of protection by selling a floor at a lower strike price. If interest rate falls through the floor level on any reset date, the floor is exercised against the seller, who must pay the difference between the prevailing rate and floor rate. A collar is a combination of selling a floor at a lower strike rate and buying a cap at a higher strike rate. It provides protection against


93

a rise in rates and some benefits from a falling rate. A collar can be tailored to meet a compromise between interest rate protection and cost. By adjusting with the cap and floor rates, it is possible to create a zero-cost collar for which no premium is to be paid. A swaption is an option to enter into an interest rate swap on some future date. A payer’s swaption is the right to pay the fixed rate on the swap, while a receiver’s swaption is the right to receive the fixed rate. Compound options are options on options. Just as we have option on swap (swaption), we can have option on caps (captions), on floors (floortions) and on collars (collartions). Compound options come in four possible categories: a call on a call, a call on a put, a put on a call and a put on a put. The first two give the holder the right to buy the underlying option, and the other two give the right to sell option. The underlying assets can be a call or a put. Galitz (1995) suggests that compound options are bought primarily for two reasons. First, to provide protection in a contingency situation when protection may or may not be needed, and second, as a form of risk insurance cheaper than buying the option itself.

Asset-backed securities The financial innovation of asset-backed securities (ABS) or asset securitisation, during 1980s, dramatically changed the way of financing the acquisition of assets. In the traditional financing system, a bank or an insurance company provides the loan and retains it on its portfolio thereby accepting the credit risk and seeks additional funds from the public to finance its assets. In ABS a group of lendings are packaged together and then issued as a new security whose purchaser has a claim against the cash flows generated by the original lending. In ABS more than one bank or financial institution may be involved in the lending capital. Returns to the investors in ABS may be guaranteed by an insurance company. The asset securitisation has several benefits. It helps in obtaining a lower cost of funding. The capital is used more efficiently. It also diversifies the funding sources. The original lenders of the loan do not retain the credit risk. Their locked assets are released, which can be used for more funding. This method is widely being used for mortgage loans, home equity loans, loan by manufacturing companies and lease

94


receivable. A major disadvantage, prevailing at the time of writing this guide, is when assets lose their values, in this case as a result of subprime lending.

9.3

Refinancing

Loan refinancing, bond refinancing, leasing and debt-to-equity swaps are identified by Merna and Njiru (2002) as the ways of finance restructuring. Refinancing is defined as repaying existing debt and entering into a new loan, typically to meet some corporate objective such as the lengthening of maturity or lowering the interest rate (Flight 2006). In other words, refinancing involves paying off an existing loan with proceeds from a new loan, using the same property as collateral. Similarly, in some cases, corporate bonds with a long maturity and identifiable coupon payments can be issued to refinance short-term loans. There are two situations where the project needs to be refinanced or restructured. First of all, if the current interest rate is lower than the rate on the debt, refinancing may be considered so that short loans can be rolled over into longer term maturity loans. Second, if a project is having difficulties in generating sufficient revenues, promoter has to restructure its financing techniques to maintain its project financial viability. When the project is facing the difficulties but has great potential for growth, the debt-to-equity swap technique can be employed. The benefit of debt-to-equity swap is reducing the level of debt payment so the project can be given sufficient time to overcome the difficulties. The authors believe, in the capital-intensive industry such as refinery industry, when the final financial package has been determined, the borrower can look at the prospects of refinancing a particular facility after the completion of the project; similarly, the borrower also needs to perceive the refinancing risk if the project risks such as delay and cost overrun occur.

9.4

Reappraising public–private partnerships

Lamb and Merna (2004b) state that public–private partnerships (PPPs) typically have long concession periods. During a project’s life cycle, the risk may occur altering the risk profile, challenging the original


95

terms of the lending or concession agreement. In circumstances where the original terms may be either inefficient or breached, PPPs are reappraised. They suggest that the following three appraisal strategies can be considered: 1. Refinancing is the alteration of financial instruments used for the financing of a project, asset or economic unit with a view to fulfilling specific financial objectives whilst maintaining the debt/equity ratio post-refinancing. It is also completed whilst maintaining the original lending and concession agreements. Refinancing has limited scope in its ability to improve the commercial and financial robustness of a project. 2. Restructuring is the alteration of a project’s original debt/equity ratio, degrees of financial seniority and/or the redistribution of risks in a concession agreement. Restructuring of a project involves the re-evaluation and allocation of the risk in either/or lending and concession agreement. 3. Termination is the defaulting of a party on a contractual obligation held in the lending and/or concession agreement of a PPP, resulting in the closure of the contract. There is no limit to the number of times a PPP can be refinanced or restructured, but the commercial sensibility of such actions in relation to the incurred additional transaction costs upon the project’s cash flow forms limitations. Termination of the agreement theoretically can occur only once, unless the same concession agreement is used to control the parties that may be contracted to take over the project or service.

9.5 Techniques applied in the reappraisal of PPP concession agreement Based on the definitions of the reappraisal strategies, a series of techniques applicable to each strategy have been identified after a thorough review of current literature in the field of project finance. The nature of control a party holds over an investment has been proposed by Rode et al. (2003), using a debt and equity model. However,

96


as PPP incorporates a public participation, by way of either equity or some form of risk capital, extensions upon such former models are required as can be seen by the contractual control heading in Table 9.1. This has been combined with a scale for project risk, where the positive impact of events typically results in either refinancing or restructuring gains or early termination whereas the negative impacting risk results in refinancing and restructuring losses or early termination. The base case represents the initial structure used to finance the PPP. From the base case several reappraisal strategies can be applied to improve a project’s technical or financial performance. Being aware of which techniques and thus the strategy required is useful when determining the skills, resources and period necessary for concession reappraisal (Table 9.1).

9.6

Other financial engineering techniques

Finnerty (1996) states that financial engineering involves the design, development and implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems with respect to project financing. Many projects can be engineered to meet specified economic parameters to make them commercially viable by applying such processes. The following processes and techniques are widely used in the procurement of projects as described by Merna and Njiru (2002): ❒ Extending the concession period; ❒ Bullet payments on the assets sale at the end of the concession; ❒ Grace periods on repayment of loans; ❒ Incremental repayments of loans; ❒ Moratorium on interest or principal; ❒ Tax holidays; ❒ Phasing construction to generate revenues early in the project and reducing borrowing; ❒ Upfront payments from offtakers;

Senior lender/ public Negative Points of termination

Availability issues Performance standards Failure to meet specification Rectification infringement Corruption

Contractual control Project risk

Public

Promoter/ equity investor Refinancing losses Dividend policy alteration Reserve account dispersion

Senior lender/ public Restructuring losses Loan covenant restructuring Asset redistribution Soft loans Concession period extension Haircutting specifications Tariffs and pricing policy adjustment Tax holidays Guarantees/ revenue support

Concession agreement Performance standards Input/output specification Lending agreements Escrow arrangements Sureties/rights/ leases Payment mechanism

Base vase

Promoter/ equity investor Restructuring gains Hypothecation Super-taxation Equity injection Reducing the concession periods Tariffs and pricing adjustment Lengthening of output/input specifications Profit share

Dividend policy alteration Reserve account dispersion

Promoter/ equity investor/public

Refinancing gains

Promoter/ equity investor

Table 9.1 Techniques applied in the reappraisal of PPP concession agreements (Merna and Smith 1994)

(Continued)

Trigger for early termination Maximum internal rate of return Maximum net present value

Public Positive Points of termination

Senior lender/ public Negative Points of termination

Borrowers default Debt services coverage ratios Loan life coverage ratios Operational default Contractor default

Contractual control Project risk

Private

Table 9.1 (Continued)

Amortisation Principal sculpting Maturity extensions Fixed or floating finance Fees and margins adjustment

Refinancing losses

Restructuring losses Monetarisation Grace period Waivers Haircuts to the principal Extension of lines of credit Tariff variation formulas adjustment Standstill periods Equity for debt Leniency on loan covenant Leniency on operation agreement Debundling Cash traps/ lock-ins


Senior lender/ public

Loan agreement Supply agreements Construction agreement Operator agreement Credit Enhancements/ guarantees Hedging strategies

Base vase

Promoter/ equity investor Restructuring gains Debt for equity Bonds for debt Debt for debt Bundling

Amortisation Principal sculpting Maturity extensions Fixed or floating finance Fees and margins adjustment

Promoter/ equity investor/public

Refinancing gains


Minimum acceptable rates of returns Minimum net present value Minimum return of equity

Public Positive Points of termination


❒ Revenues from associated existing concessions; ❒ Aid and grants; ❒ Interest-free long-term loans or deferred loans; ❒ Equity in the form of land or existing services; ❒ Bundle; ❒ Securitise; ❒ Guarantees from government or third parties relating to: • Minimum demands; • Exchange rates and foreign currency transfer; • Interest rate guarantees; • Interest-free stand by loans.

99

Chapter 10 Final assessment to determine project commercial viability

10.1

Introduction

The assessments described in Chapters 7 and 8 provide the basis for developing the final assessment performed in this chapter. Those are the estimates of time, costs and revenues related to the projects’ activities provided by the special project vehicle (SPV) and the preferred lending package developed and accepted by the lender. A detailed risk assessment is initially performed, and then a number of the financial engineering techniques, described in Chapter 9, are considered for inclusion and further assessment.

10.2

Detailed risk assessment

The detailed risk assessment follows the three stages of identification, analysis and response, discussed in Chapter 4. In the initial assessment discussed in Chapter 7, the best case and worst case scenarios were assumed simply by applying risk levels of 5–10% in terms of upside and downside risks, respectively. In Chapter 8, the worst case scenario considered only a 10% downside risk as assessed by the lender. The lenders’ assessment suggested that the project’s cash flows could meet both the lenders’ and SPV’s requirements based on a finance package of 80% debt and 20% equity for the worst case scenario. The base model to be used in risk assessment is now developed on the basis of the costs, revenues and timings related to the model assessed by the SPV in Chapter 7. This model, which does not incorporate the cost of finance, shows a base case internal rate of return (IRR) of 19.15%, which is much higher than the SPV’s minimum acceptable rate of return (MARR) of 12%. 101

102


Table 10.1 Risks and their upside and downside ranges Range (%) Risk identified

Upside

Downside

Change in construction Commissioning risk Changes in production Operational management Demand over the last 5 years of operation

−5 −10 +10 −5 +10

+10 +15 −20 +25 −25

A number of the risks identified in Chapter 7, those being risks associated with the procurement of independent power projects (IPPs), are included in this risk assessment. In the detailed risk assessment, the risks are identified individually and their effects are simulated against this base case model to determine the worst case and best case scenarios for the project’s IRR. This detailed risk analysis is far more accurate than simply assuming the best and worst case scenarios as shown in Chapter 7. Table 10.1 shows the risks identified and their upside and downside ranges of risk variables. The effect of the identified risks is initially analysed in terms of sensitivity through computer software. The result of the sensitivity analysis is illustrated in the spider diagram, shown in Figure 10.1. The sensitivity analysis shown in Figure 10.1 illustrates the effect of each of the risks on the project’s IRR. Clearly, it can be seen that the project’s IRR is most sensitive to changes in production and least sensitive to commissioning risk based on the percentages used. A stochastic probability analysis is then performed based on the ranges used in the sensitivity analysis. A cumulative probability analysis is prepared as shown in Figure 10.2. From the cumulative probability diagram, it can be seen that the project’s worst case IRR at the 15% percentile is 15.83% and best case scenario at 85% percentile is 19.55%. The project has 50% chance of attaining an IRR of 18%. Clearly, the best and worst cases of IRR are seen to be above the SPV’s MARR. However, by mitigating the two major risks affecting the project’s IRR, those being changes in production and changes in construction, the results can be improved. These risks can be mitigated and their ranges can be reduced by increasing resources in the

103

Final assessment to determine project commercial viability

24.00%

22.00%

20.00%

18.00%

16.00%

14.00% –30.0%

–15.0%

0.0%

15.0%

30.0%

Changes in production

Change in construction

Operational management

Demand over last 5 years of operation

Commissioning risk Figure 10.1 Sensitivity analysis.

production phase and entering into a fixed-price lump-sum turnkey contract. The new ranges reflected by these mitigation methods, those being (+5 and −5) and (+2 and −2), can now be simulated in the probability analysis and a new worst and best IRR can be computed, as shown in Figure 10.3. From Figure 10.3 it can be seen that the IRR for the worst case scenario has increased to 17.76% and the best case has increased to 19.67%. The project has also an improved 50% chance of IRR attainment over the non-mitigated analysis. Similarly, the project can be seen to have a 15% chance of being less than IRR of 17.76% and an 85% chance of being greater than 17.76%. These results in terms of IRR clearly show that the project is commercially viable and the cash flows associated with this model can now be developed to determine whether they


1.00

200

0.90

180

0.80

160

0.70

140

0.60

120

0.50

100

0.40

80

Cumulative frequency

Cumulative probability

104

60

0.30 85% = 19.55% 0.20

40

15% = 15.83%

20

0.10 0.00 14.00%

16.00%

18.00%

20.00%

0 22.00%

1.00

200

0.90

180

0.80

160

0.70

140

0.60

120

0.50

100

0.40

80

0.30

60 85% = 19.67%

0.20

40

15% = 17.76%

20

0.10 0.00 17.00%

18.00%

19.00%

20.00%

Figure 10.3 Cumulative probability diagram (after mitigation).

0 21.00%

Cumulative frequency

Cumulative probability

Figure 10.2 Cumulative probability diagram.


105

can service the finance package proposed by the lender and provide sufficient returns in dividends. The pre-tax profits generated by the project, that sufficient cash is available for dividend payments, as shown in Table 10.2, show that after the stochastic risk assessment more money is available than initially determined in the deterministic assessment. For example, the cash available in 2010 from the stochastic assessment is US$61.86 million compared with US$50.52 million in the deterministic assessment. This trend continues over the life of the concession. The project is therefore considered commercially viable by the SPV based on the finance package proposed by the lender. Money is available from the first year of operation to pay dividends, and the lender has a financial cushion for principal and interest payments over the term of the loan based on the worst case scenario. The SPV can also look to better returns since it is highly unlikely that all the risks will occur as identified in the stochastic analysis.

10.3


Having performed a detailed risk assessment and determined both worst case and best case scenarios for the projects’ IRR and a summary of the project economics and cash available, the effects of financial engineering can now be investigated and assessed. The authors illustrate how the following financial engineering techniques can be applied to the case study project.

Tax holiday The cash available for dividends in each year of operation, as shown in Table 10.2, does not incorporate deductions for tax payments. If tax was to be paid at a rate of 20% then this sum would need to be reduced by 20% each year. Both the SPV and lender would seek the benefits of a tax holiday for the first 5 years of operation. The early stages of operation are always considered the most risky and thus any help from the principal would be welcome. Tax payments from year 6 of operation would not be a burden since it can be seen that interest payments have been greatly reduced.

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

175.50 186.84

Actual cash flow available for debt service (stochastic model)

61.86

186.84

175.50

66.6

186.84

175.50

71.34

186.84

175.50

76.07

186.84

175.50

80.81

186.84

175.50

85.54

186.84

175.50

90.28

186.84

175.50

95.01

186.84

175.50

99.75

186.84

175.50

104.49

186.84

175.50

109.22

186.84

175.50

113.96

186.84

175.50

118.69

186.84

175.50

123.43

−59.20 −54.94 −50.68 −46.41 −42.16 −37.89 −33.62 −29.37 −25.10 −20.84 −16.58 −12.31 −8.06 −3.79 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 −59.20 50.52 55.26 60.00 64.73 69.47 74.20 78.94 83.67 88.41 93.15 97.88 102.62 107.35 112.09

186.84

175.50

186.84

175.50

250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 250.00 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −16.50 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00 −33.00

2010

Actual cash flow available for debt service (deterministic model)

Cash available for dividend (stochastic model)

Finance Project finance loan 80% Equity 20% Bond 0% Loan interest payment Capital repayment Cash available for dividend (deterministic model)

−62.50 −219.00 −618.50 −4.40 −20.10 −64.93

2009

Capital expenditures Capitalised interest Total revenue Operating cost Coal cost

2008

2007

Financial year

Table 10.2 Summary of the project economics and cash availability (US$ million)


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Financial collar The interest rate used in the assessment is 8%. The SPV would seek to ensure that interest payments do not increase and thus reduce money available for dividend payments. In this case the SPV would seek a financial collar with a cap of 10% and floor of 6% for the first 3 years of operation. This would ensure that the SPV could service interest payments without defaulting on the terms of the loan. After 3 years, interest payments are seen to be lower and a higher interest rate would not have a major effect on the project economics. However, the SPV would consider a financial collar over the next 3 years should the base rate have increased over the initial 8%. The use of fixed or floating swaps to mitigate interest rate changes may be considered as an alternative to financial collars.

Extending the concession The cash available for dividends in the last year of operation is very high. If the concession was extended for an additional year, the money accrued could be used a guarantee, in terms of a bullet payment, to service debt should the project be refinanced. Since this project offers great opportunity for refinancing in terms of gains, different refinancing packages such as refinancing debt at 8% for debt at 7% would be considered so that the project’s IRRs increase even though the net present value would be less.

Increasing debt The project economics and cash availability, shown in Table 10.2, are extremely robust, and should the SPV seek to increase the debt to 90% and provide only 10% in equity, sufficient cash is available to provide a financial cushion for the lender and provide a high dividend to shareholders. By increasing the gearing from 80:20 to 90:10, the SPV would need to ensure that debt payments could be met. In some cases too much debt may result in default, often forcing the SPV to swap debt for equity. Debt is cheaper than equity, and in most cases SPVs will seek to maximise debt and, should the project perform as expected, refinance the debt during the early years of operation.

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Grace period If the SPV considers a higher debt contribution as discussed above then a grace period may be negotiated with the lender. This could be done by delaying the first interest payment in year 2010 and then spreading the interest payments over the remaining years of the loan. This would make cash available to the SPV in the first year of operation, which could be used to buy shares originally purchased by stakeholders such as vendors, contractors or operators and thus earn more money from dividends since more shares are owned by the SPV.

Phasing construction and operation In some cases, revenues are generated earlier by phasing the construction and operation. If the first set of generators is brought on stream after 2 years whilst construction proceeds on the second set, then power generated by the first set can be sold, providing revenue earlier than forecasted. This revenue can be used to repay some of the debt incurred and thus reduce the overall lending.

Upfront payments Similarly, upfront payments from offtakers such as transmission companies can reduce the borrowing and thus improve cash flows. This can often be done instead of taking an equity contribution in the project, particularly by state-owned offtakers who are often not permitted to be equity providers.

Existing concession revenues In some cases the SPV of a new IPP must accept the operation and maintenance of existing concessions already generating revenues. These revenues can be used to reduce borrowing on the new IPP. Readers are invited to apply financial engineering techniques to this project and determine how the project economics and cash availability can be improved from that shown in Table 10.2. There are a number of suggested techniques discussed in Chapter 9 as well as other techniques readers may develop themselves.


10.4

109

Summary

The assessment developed and presented in this chapter can now be structured for financial close as described in Chapter 11. Although many SPV/borrowers, private equity firms and bank equity teams would carry out due diligence before going to the lender, a similar assessment would be performed. It should be understood that the assessments carried out in Chapters 7, 8 and 10, respectively, are based on forecasts, particularly the cash flows which are subject to changes should risks occur. In most cases, costs for construction, operation and maintenance, equipment, supply and offtake, and the like, where initially based on estimated figures, these must be fixed and agreed prior to or during the due diligence process along with any guarantees offered by the principal or third party organisations.

Chapter 11 Financial close

11.1

Introduction

During closing a project agreement, both parties, those being the principal and borrower/SPV, need to take extensive due diligence procedures to establish a third party confirmation of the feasibility of a project before financial close. The results of the assessment performed in Chapter 10 will form a major part of the diligence and financial close processes. This chapter outlines the major process as described by Lamb and Merna (2004b) in the procurement of projects procured using project finance.

11.2

Due diligence

The aim of the due diligence process is to provide a technical, legal, insurance and financial understanding for all parties involved in the project agreement, outlining specific considerations made by each party, which they are committed to, once financial close is attained. The objectives of a due diligence in project financings are: ❒ Due diligence provides a thorough check of participants’ ability to meet the future demands placed upon the organisation post-project agreement signature, determining the participants’ legal eligibility to enter into such an agreement. ❒ Development of a report providing financiers with an independent assessment of the business and quantify areas of commercial and financial risk.

111

112


Due diligence should take into account and review the following: ❒ The risks identified and the systems used for mitigation; ❒ Confirmation or rejection of the accuracy of the information and assumptions on which a bid is based; ❒ Validation of the practices and methodologies applied to the project appraisal. A due diligence report should then summarise the credibility of the technical, financial and commercial elements of the project. In effect, it audits the final proposal and identifies critical areas that may have been neglected or assumptions that may pose severe problems to the deal in the future. The due diligence process can be conducted concurrently, by the parties involved, assessing the four elements described below. Depending on which stakeholder commissions due diligence, the final report may incorporate all or some of the items contained in each element (Figure 11.1). Technical Cost and programme audit Method statement Contingency and risk Standards and best practices

Legal Project agreement Lenders’ direct agreement Service provision direct agreement Guarantees and warranties

Due diligence report

Financial Trigger step in rights Model audit and sensitivity analysis Risk valuation Term sheet ICA Hedge strategy Letters of credit Reserve accounts Escrow and ring fencing Economic indicators Taxation

Insurance Cover and policy cross-over Maximum probable loss Scenario reviews

Figure 11.1 Due diligence process (Merna and Smith 1994).

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Each element relies on a degree of information from other elements to verify the integrity of the project. For example, the financial element draws information from the payment mechanism contained in the project agreement legal element, and the performance assumptions from the technical element of the project to verify the expected project’s cash flow.

Technical The technical element of the project may consist of many work packages. To efficiently audit the packages, the auditor should select a small number of packages and carry out due diligence. Audits conducted may range as follows. Cost and program audit Cost audits are designed to establish if any under- or overestimates could affect a short-term gain or loss on return on equity. Similarly, the programme may increase or decrease due to over- or underestimates of time. Construction and life-cycle maintenance cost estimates must be assessed with respect to the performance of the materials used in the project and backed by relevant guarantees or warranties. Method statement audit The audit determines the appropriateness of method statements associated with the capital and operational expenditure incurred on the project. Market analysis of the types of resources – human, mechanical and material – to be expended may identify issues associated with availability and short-term localised inflation, having implications on the programme and cost estimate. Best practice guidance, operational standards and accreditations held by contracting parties may all be reviewed to identify weaknesses in the special project vehicle (SPV) organisational structure, strategy and method for completing the project agreement. Areas where complex methods of construction or high skill set required possess further areas for consideration.

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Contingency and risk management Identifying all the risks in a project is critical to understanding how the project may perform under specific circumstances. Reviewing the risk register and identifying where allowances (contingency and float) have been allocated to address identified risks provide an insight into the robustness and likely success of the project. Premiums placed on the transference and acceptance of the risk by promoting parties are difficult to substantiate unless a sensitivity analysis is performed. Identifying areas where the borrower or the principal has incorrectly priced allocated risk must be addressed. The responses to the risks in the project are often formed using risk management processes that seek to identify, analyse, respond and review risk in projects. Information gained from risk management reviews of previous projects may contribute to the adequacy of risk management responses. Standards and best practice The identification and application of relevant standards to the production and operation of the asset and service are crucial. In some projects, dual standards have been offered, although the standard offering the higher specification is used. On completion of the technical audit, the stakeholders are issued with a closing document confirming their opinion of the adequacy and security of the technical element.

Legal due diligence Stakeholders require a thorough review of the project agreement verifying content and context to appraise the assumptions used in further financial and technical modelling. The project agreement may contain a host of agreements that must not impinge one another. Lenders’ direct agreement Due diligence on the lenders’ direct agreement (LDA) should leave the financier in no doubt over their rights on collateral and to step in to either remedy the SPV defaults or ultimately take over the operation of the project agreement.

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Service provision direct agreement This agreement is contractually subordinate to the LDA. The principal’s right to step in and take over the project agreement subject to the LDA during default, termination or transference is contained in this agreement. Processes that fail to outline such dependencies are unstable and could lead to misuse or abuse by either party during the life of the project agreement. Guarantees and warranties Guarantees and warranties are often difficult to define as each provider has their own terms, conditions and definitions. Where the project agreement or the lenders are reliant on recourse upon specific parties in the event of specific failures or faults based on reassurances provided by guarantees and warranties, the financier may require detailed due diligence to be carried out on the following areas. Parent company guarantee in support of SPV A parent company of the SPV may provide a guarantee in support of the SPV obligations. However, such a guarantee may be minimal and the constitution of such guarantees may need to be investigated if they are to provide levels of recourse to the SPV. A collateral warranty is a guarantee committing party X to contractual obligations that they made with party Y, which remain enforceable by a third party Z. Due diligence should be carried out regarding the following areas: ❒ Assignment of right is essential to the enforcement of the warranty. ❒ Limitation periods and the date on which the guarantee may begin, completion of the asset or when the guarantee is signed. On completion of the legal due diligence, the stakeholders are issued with an appropriate closing document, confirming the opinion of the auditor on the adequacy and security of the legal programme. Financial due diligence is linked to the commercial considerations assigned in the project agreement. Cross-referencing the LDA to the project agreement is vital in maintaining the financiers’ interest in the investment. Checks performed on assumptions made within the

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model set against the terms preliminary agreed in the project agreement may highlight areas of deficiency.

Trigger step in rights Trigger events are events or incidents that may occur during the life of the project agreement that allow specific parties to take control of/or action towards the project, as outlined in the LDA. In some cases, for example, such events may be linked to debt service coverage ratio (DSCR). If the SPV fell below the stipulated DSCR in the term sheet then the lender may have the right to take control or remedial action to restore the robustness of the projects’ cash flow. Often DSCR triggers vary over the life of a project agreement, and the suitability of such variance should be reviewed. The assignment of an unsuitable DSCR could result in inappropriate defaults or termination by the lenders. Due diligence must be carried out to establish appropriate factors of safety as designated by the DSCR triggering schedule.

Model audit and sensitivity analysis The financial models are reviewed with regards to the following areas: ❒ Up-to-date information; ❒ Acceptability of the assumptions; ❒ Sensitivity of key variables within the model; ❒ Worst case scenarios of debt service capabilities; ❒ Default scenarios. The auditor is not involved in producing the quantitative models rather the assumptions, variables and limitations of the methodologies applied during the modelling of the project. Auditing of the model confirms the accuracy of the information provided including an assessment of the suitability of any typical

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response structures models used to identify the commercial acceptability of the project. Sensitivity analysis, scenario analysis and default scenarios are all assessed to identify how the combination of risks within the project may affect the future cash flows. The priority is the identification of risks not previously addressed which could result in a commercially non-viable project.

Risk valuation The valuation (the cost of mitigating risks) is often covered in a risk register, which identifies, classifies, values and assigns the responsibility of risks to the various parties involved in the project (Merna and Faisal Fahad Al-Thani 2008). Evaluating the cost of mitigating risks often requires knowledge of similar past projects. Where such information is unavailable, reasonable estimates may be based on practitioners’ experience.

Term sheet The term sheet indicates the amount and type of finance available from each financier in accordance with specified conditions. Due diligence on the amounts of finance and in some cases the currency outlined in the term sheet and the cash flow models are a simple yet vital check. Drawdown intervals, drawdown sizes, stand-by and bridging loans, working capital should be reviewed specifically concentrating on handover periods where the facilities begin to operate typically not at 100% revenue generation potential. Identifying SPV with low solvency ratios may provide cause for concern.

Inter-creditor agreement Projects that involve more than one lender may require an intercreditor agreement (ICA). Participants of the ICA can lend under different or similar terms of lending. ICAs provide clarification of the levels of seniority specific lenders have over other lending parties to the SPV. It is there primarily to prevent disputes from occurring and to reduce the levels of litigation between the creditors if the project were to fail.

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The ICA addresses: ❒ Identifies whom the agreement is between; ❒ The rights of the borrower and lender in relation to all the supporting project agreement documentation; ❒ Definition of terms enabling fluent communication between parties; ❒ Expectations placed on each party (what each party must provide and the consequences of failure); ❒ The seniority lenders have and the financial instruments they provide; ❒ Levels of recourse; ❒ Notice of default or action by any lender; ❒ Stipulation of lenders’ and borrowers’ rights; ❒ Termination and process; ❒ Amendments and refinancing. The ICA formalises the process outlining procedures relating to circumstances for default or termination. The ICA is reviewed to assess the probity of the procedures and the covenants incorporated therein.

Hedge strategy Hedging financial risk via financial instruments within fluctuating financial markets is often seen as a vital business activity to securing future returns. Hedging strategies may be typically formed using options, futures, forwards and swaps.

Letters of credit Letters of credit tend to contain the following details: ❒ Confirmation of continued interest;

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❒ The maximum amount of funding available (term sheet); ❒ Areas for clarification; ❒ Outline of areas for improvement. When carrying out due diligence, the auditor should assess the content and implied financial commitment made to the SPV. Although a financial issue, due diligence provides legal support to this item. A certain amount of due diligence has to rely on appropriate business behaviour. However, letters of credit confirming a borrower’s commitment to equity or mezzanine finance are a prerequisite.

Reserve account Reserve accounts are those first called upon for specific purposes. In the case of the debt service reserve account (DSRA), this may be called upon during periods of poor liquidity. If the DSRA is required over the life of the agreement, additional management and arrangement fees are incurred. The formula used to determine the amounts allocated within the DSRA is normally 3–6 months peak interest repayment charges. Cash flows and their predictability, however, are considered far more important. Other accounts that may be established are the maintenance reserve account, which is established for the future maintenance of the assets of the SPV.

Escrow and ring-fenced facilities Funds are paid out from this account for a particular purpose or on the occurrence of an event. For example, the principal opened an escrow account, which would only pay amounts to a contractor on completion of specific elements of the project, approved by the clients’ representative. Investigating such structures and establishing whether they will adversely affect timely payments from one party to another is crucial, particularly with respect to liquidity.

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Economic indicators During financial due diligence, the following economic parameters may be compared with previously successful projects to assess the commercial viability of the investment: ❒ Net present value; ❒ Minimum acceptable rate of return; ❒ Return of equity; ❒ Internal rate of return for specific investment instruments; ❒ Payback period/break-even; ❒ Total amount of money expected to be borrowed; ❒ Total amount of revenue expected to be generated; ❒ Annual debt service coverage ratio – stipulated ranges over specific periods; ❒ Loan life coverage ratio – stipulated ranges over specific periods; ❒ Valuation multiples. Comparisons are made with previously completed projects, whilst recognising trends within the market, such as increasing lower return margins, lower cover ratios to determine the economic viability of the project. However, variations in the economic parameters are expected, and stakeholders must consider such variations. Auditors should seek to identify lenders that may have overly aggressive entry strategies such as low coverage ratio requirements, which could lead to future step in and termination of the project.

Taxation Providing taxation authority’s access to the project agreement due diligence assessment and its treatment of taxation for a project is recommended. Unique or innovative tax structures, which seize upon loopholes, should attain clarification from the relevant authorities.

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Principals may seek to transfer risks associated with amendments to the tax regimes to the borrower; it is therefore essential that both parties clarify such issues as this could lead to default or termination. Attaining letters of support from relevant tax authorities outlining conformance of the tax structure and tax assumptions within the financial models provides further support to the investment.

Insurance Banks and financial institutions (financiers) require assurance that statutory and common risks facing a project have been adequately insured to protect their investment. The following areas need to be investigated: ❒ Claims settlement process; ❒ Agree appropriate terms of insurance (levels of liability and indemnity); ❒ Notes outlining coverage and policy; ❒ How the risks should be distributed what should be covered; ❒ Checking for double insurance or crossover of policies; ❒ Checking the market – is the current cover competitive and does it provide affordable and efficient cover?; ❒ Maximum probable loss scenario review; ❒ Identification and allocation of uninsurable risks. Insurance companies provide numerous insurance instruments, for example credit enhancement to cover specific risks facing an SPV cash flow. Such cover may require specialist assessment to avoid dual coverage. On completion of the insurance due diligence, stakeholders are issued with a closing document confirming the adequacy and security of the insurance programme. If there are foreseeable problems with the project, a programme outlining a timeframe allowing errors or omissions to be readdressed is submitted.

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11.3


Financial close

A project entering into financial close experiences a heightened degree of auditing activity and contractual negotiation. Financial close occurs once both the principal and the borrower sign the project agreement, committing the principal to procuring services from the SPV via the commercial mechanism. The project agreement and granted commercial mechanism then form the basis through which finance can be securitised, based on the predicted revenue streams over the life of the agreement. Financial close is the point at which the project agreement becomes unconditional and all the conditions within the loan agreement are satisfied or waived. The agreement between lender X and SPV Y is for the provision and arrangement of finance to be used by Y for the completion of outlined and agreed capital works and expenditure based on agreed terms of repayment and collateral. The objectives of financial close are as follows: ❒ Both parties accept technical, financial and legal position of the project and make the necessary funds available for the completion of the project agreement. ❒ That funds available are committed but with specific safeguards that promote the successful operation of the SPV and reduce the risk of failure. ❒ The signing LDA with the terms and conditions contained within the term sheet. In the majority of projects, the signing of financial close documentation takes place once the project agreement has been granted to the SPV. This is referred to as technical closure in Figure 11.2. Before financial close takes place, each type of finance must be committed to the project before technical closure can be reached. However, as there are often levels of seniority in project finance, the senior finance may not be secured until the subordinate finance is committed to the project. Therefore, both the senior and subordinate lenders review the due diligence report, project agreement and business case which forms the basis for decision-making.

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Financial close

Senior finance evaluation Due diligence report Project agreement Credit committee Current/full business case

Subordinate finance evaluation Due diligence report Project agreement Credit committee/representatives/individuals Current/full business case

Rejection

Marketing/placement acceptance

Acceptance

Technical close Project agreement Principal/SPV/lender’s signature SPDA signature Principal/operator/lender

Marketing/placement rejection

Reject project

Alternative procurement

Financial close Direct lender agreement signature SPV/lender’s signature

Commencement Execution of financial instruments Technical execution Figure 11.2 Typical financial close process (Merna and Smith 1994).

Each risk affects the source of finance available and the ability to reach financial close. Underwritten issuance can be used to remove the risk associated with the market price and quantity sold, hence allowing financial close to be secured much sooner and providing financial fixity to the quantity of senior term loans required.

Credit committee approval process Financial commitment to an SPV by an institution is approved by a credit committee. The credit committee demands due diligence takes place before financiers commit funding. The committee takes into consideration their current portfolio of investments and the benefits such

124


a project has on that portfolio and future lending opportunities and the deal itself. New guidance outlined in the Basel Committee on Banking Supervision (2004) states that an organisation’s financial standing must conform to a specific credit standing based on the risks it faces. This in turn determines the level of funding available to the credit committee. Once due diligence has been performed and the effects upon the portfolio are identified, the committee makes a decision on the provision of funding.

Due diligence report The due diligence report is a summary of the credibility of the technical, financial, legal and insurance elements of the project. It provides critical areas that may have been omitted or assumptions that may pose problems in the future.

Technical closure The signing of the project agreement assigns the right to the SPV to be the sole provider of services for the life of the project agreement. After technical closure, the principal and borrowers of the SPV are in agreement to how the technical elements of the project are to be delivered.

Financial close Financial close is the signing of the documents, binding the financiers to provide a specified amount of finance to the SPV for the completion of the project agreement. There is a risk that the SPV financiers may drop out during the project or even worse at the point of financial close.

Technical commencement After signature, the project derives a start date that being the date of signature or a period from the point of signature.

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125

Execute interest rate swaps At the point of financial close, a fixed rate may be preferable to the borrower to mitigate the risks associated with fluctuating interest rates. Such fluctuation could have a positive or negative effect on cash flow and the ability to service the debt. However, the borrower may only be able to attain a floating rate. By finding a party (X) who desires a floating rate rather than a fixed rate, a swap can be initiated at financial close. This may operate vice versa, depending on the desired hedging strategy outlined in financial due diligence. The outputs of financial close can be summarised as follows: ❒ Finance is in place and the project commences. ❒ The SPV operates secondary contracts to construct the asset used for the provision of services. ❒ The principal, SPV and the lender sign a direct lending agreement. ❒ Commence date set.

Chapter 12 Islamic finance and project finance

12.1

Introduction

Islamic finance is a form of finance based on the principles of shariah law. It differs substantially from conventional finance. The receipt and payment of interest (riba) which is forbidden (haram) is prohibited under Islamic law. The growth of Islamic finance in the Middle East has been driven largely by demand. An increasingly confident Muslim population and growing middle class have contributed towards the demand for Islamic financial products. In the West, its growth has been largely driven by institutions seeking to benefit from the immense liquidity and petrodollars of Middle Eastern individuals and institutions that demand such products. This chapter outlines the main principles, products and techniques used in Islamic finance and its role in project financings.

12.2

Islamic finance

The number of Muslims worldwide, institutions offering shariah products, the size of the Islamic finance industry and growth rate based on 2008 data are presented as follows: ❒ 1.8 billion Muslims (approximately 27% of the world population); ❒ Distributed across more than 50 Islamic countries; ❒ 525 institutions offering shariah-compliant products in 47 countries;

127

128


❒ An industry in excess of US$1.2 trillion; ❒ Growth rate of more than 20% per annum. An Islamic bank is an institution offering Islamic financial intermediation and structured transactions compliant to shariah law. All Islamic financial institutions have to have shariah board (committee) in addition to the conventional board of directors. The shariah board role is to ensure: ❒ All the structures tailored by Islamic banks are religiously permissible; ❒ Fatwas (Islamic legal opinions) are given; ❒ These structures are of intrinsic financial value. The functions of a shariah board are: ❒ Maintain shariah conformity; ❒ Review and endorse documents; ❒ Supervise investment portfolio; ❒ Resolve daily shariah issues; ❒ Research; ❒ Training; ❒ Assist legal personnel. It should be noted, however, that Islamic finance is a relatively new business to many financial institutions and customers alike. There still remain a number of Islamic financial products that are considered to be ambiguous and some differences between shariah board members in different institutions. Islamic banks’ assets are typically in the form of: ❒ Murabaha: cost plus or markup financing; ❒ Musharaka: equity participation;

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129

❒ Mudaraba: fund management with pre-determined share of profits; ❒ Ijara: leasing contract; ❒ Istisna’a: transaction of a commodity before it comes into existence; ❒ Salam: sale whereby the seller undertakes to supply specific goods to a buyer at a future date in exchange of an advanced price fully paid on the spot.

12.3

Shariah

The literal translation of the Arabic term shariah is ‘the way’, but it is now widely understood to mean the principles of Islamic law. Shariah is not a finite standard; it is a set of rules, principles and parameters. The primary source of shariah is the Quran. Shariah governs every aspect of a Muslim’s life. While some parts of shariah are quite specific and incapable of further interpretation, some of its requirements are of wider application and take the form of principles or guidelines. To that extent, shariah is subject to a further process of interpretation. In the context of Islamic finance, the Accounting and Auditing Organisation for Islamic Financial Institutions has recently agreed shariah standards with leading shariah scholars applicable to the main financial products and principles in Islamic finance sectors.

Qiyas and Litihad Shariah scholars use Qiyas, or ruling by analogy, to deal with cases where some form of precedent exists. Where Qiyas is not deemed possible, scholars use Litihad, the derivation of law through personal reading. Shariah scholars performing Litihad have to be highly skilled in the knowledge of the Quran, shariah objectives, finance and Arabic grammar. Each rule resulting from a Litihad process is a fatwa, or personal opinion, from the scholar in question. For example, all deals structured need to be signed off by a scholar stating whether they are ‘in line’ with shariah.

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12.4


Core principles of Islamic finance

Sharing (profit/loss and risk) A distinctive feature of Islamic finance is its concern with development and social goals. Profit and loss sharing, or partnership finance, with its focus on cash-poor but promising entrepreneurs is believed to hold more economic potential than conventional, collateral-based lending, which favours established businesses. As profit cannot be assured, an Islamic financial institution must assume at least part of the risk of a given transaction. There can be no guarantee of a fixed return. Equally, depositors with Islamic institutions may not invest on a basis of guaranteed return. However, taking security is permitted in order to guard against negligence, wilful wrongdoing or breach of contract by parties to the contract.

No unfair gain The charging of interest is strictly prohibited; any return should be linked to the profits of enterprise. The concept of riba extends beyond that of interest to include the idea of unfair gain or exploitation.

No speculation Transactions relying on chance or speculation, rather than the effort of the parties, to produce a return are considered void under shariah. Any contracts involving speculation are not permissible (haram) and are often considered as gambling. Shariah, however, does not prohibit ordinary commercial speculation or risk taking. Transactions involving the use of swaps and options, for example, will need to be considered carefully to check whether the commerce substance of the transaction complies with this principle (see the section ‘Hedging’).

No uncertainty The existence of uncertainty in a contract is prohibited as it requires the occurrence of an event that may not occur. When entering into


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a contractual relationship, there must be full disclosure by all parties involved – a transaction ‘tainted’ with uncertainty will not be allowed. This suggests that detailed risk assessments should be performed by both parties to a transaction before entering into an agreement. Any transaction where the subject matter and the price are not fixed in advance will be viewed with suspicion under shariah.

No investments that are not in the public interest Investments must be shariah compliant. Transactions involving certain products such as pork, alcohol, armaments, conventional finance products and gambling are prohibited. Typically, institutions work from a blacklist of prohibited investments developed by the shariah board.

No hoarding of money Trade and enterprise, which can generate real wealth for the benefit of the community as a whole, are encouraged between partners sharing profits and losses; therefore, money should be treated as a means of exchange and should not be treated as a commodity that is accumulated. For example, making money out of money in the form of interest is deemed unacceptable.

Deception Gharar is the term used to define an exchange in which there is an element of deception through ignorance of the goods or project or relevant price, or a false description of the goods or project. All such transactions are prohibited under shariah. Gharar includes such exchanges as the selling of goods that the seller is not in a position to deliver or the making of a contract which is conditional on unknown or uncertain events.

Islamic financial institutions There are many opportunities for the establishment of Islamic finance institutions around the world. Business plans and strategies

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will however need to cover the different product risks and application in Islamic finance. Apart from the usual Financial Services Authority (FSA) licences, the institutions’ constitutional documents will need to conform to shariah and include shariah-compliant governance procedures.

Shariah supervisory boards Most Islamic institutions have their own shariah supervisory board (SSB); this will comprise one or more shariah scholars with expertise in finance and Islamic commercial jurisprudence. These boards will examine in detail the structure and documentation of a proposed transaction or product to ensure its compliance with shariah. Islamic investors, whether financial institutions, investors or individuals, rely heavily on the involvement of the SSB in the structuring, documentation and approval of transactions and financial products and may request that the board issues a fatwa before an investment is made.

12.5

Project finance

Until recently, Islamic finance played a minor role in large project financings in the Middle East. A Murabara (a transaction where the underlying assets are commodities such as metals, typically used in Islamic liquidity management and working capital facilities) facility might have been deployed to provide working capital during the startup phase of a project, but the scope for Islamic finance has expanded beyond such a limited role. Islamic finance techniques are now a tried and tested addition and, in some cases, a credible alternative to conventional financing for projects. For example, the US$526-million Al-Waha petrochemical facility, to be constructed in Saudi Arabia, was the first to demonstrate that such large projects could be financed wholly with Islamic finance. The growing use of Islamic financing for projects opens up the syndication market to Islamic financial institutions, many of which are keen to finance the continued development of their region. The introduction of shariah principles to these types of project that have historically been financed through conventional finance means


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that the relevant parties will face risks that may be different to the ones they are used to in traditional financial transactions. Parties new to Islamic finance will need to understand just what those risks are and how they may be mitigated. As with conventional finance, larger finance deals are often syndicated. Since syndication involves the sharing of risk in the underlying transaction or asset, it complies with the core Islamic principle of profit and loss sharing.

The Ijara principle Ijara involves the act of leasing in which the owner of the assets transfers the ‘rights’ to another person to use for an agreed period for an agreed rent. The subject of the lease should be valuable, identifiable and quantifiable. Anything cannot be used without it being consumed cannot be leased. Title of the leased asset remains with the lessor; therefore, all liabilities arising from its ownership must be borne by the lessor. The period of the lease must be determined in clear terms and the lessee cannot use the leased asset for any other purpose than that contemplated by the lease agreement. The use by the lessee of the leased asset must also be shariah compliant.

Ijara Mawsufah Fi Al Dhimmah (forward lease) Where the assets do not exist, a forward lease can be used. Under a forward lease, the lessor (the body who grants the lease) undertakes to the lessee (the body that takes the lease) to deliver the asset according to predefined specifications. During the construction stage, the lessee pays the lessor advanced rental payments. Shariah requires that, since rent will have already been paid, the advance rent must be taken into account when actual leasing begins. In addition, the advance rent must be repaid if the assets are not delivered on time, usually derived from agreed liquidated damage schedules.

Istisna’a Istisna’a is an order to a manufacturer to produce a specific asset for the purchaser, in which the manufacturer uses their own materials

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to produce the required goods. The product (or project) on which Istisna’a is based is always something that needs to be manufactured or constructed. The price payable by the purchaser must be fixed with the consent of the parties involved. The price in Istisna’a does not necessarily need to be paid in full in advance. It can be paid after completion/construction. Title to the asset to be manufactured/constructed is transferred to the person who sanctioned the product/project at a specified date. In the financing context, the client commissions the financier to manufacturer/construct a specified asset for one price (the purchase price). In parallel, the financier commissions a third party, usually a contractor to manufacturer/construct the same asset for a lower price (the sale price). The difference between the sale price and the purchase price represents the profit for the financier. More advanced Istisna’a structures have involved the phasing of discrete parts of a project to reduce the overall costs of financing to the client, as well as the inclusion of only a partial sale of the asset to the client with a lease of the unsold portion to achieve long-term floating rate finance.

Sukuk Sukuk means a claim similar to that represented by a trust certificate. The claim stems from the fact that the certificate represents a beneficial ownership interest in the underlying asset-generating cash flow: these instruments are also known as Islamic bonds. In essence, the Sukuk is a financial instrument that sits above a shariah-compliant underlying structure, which generates income for the holder of the instrument. There are many structures that can generate the revenue paid to Sukuk holders. Most Sukuk issuances are wholly asset-based rather than asset-backed; this has an impact on their ratings. In an asset-based Sukuk, Sukuk holders rely on the company seeking to raise finance for repayment similar to a corporate bond issue. In asset-backed Sukuk, Sukuk holders rely on the assets of the Sukuk for security. More recently, the market has seen issuances with a mix of cash and assets, and in several cases Sukuk has been issued for a new business with no tangible assets.

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Sukuk-holders

Shareholders

Periodic distributions

Sukuk proceeds

Equity

Return

Rent State/authority

Issuer

SPV Master lease

Project agreement Istisna’a

Title

Contractor

Sublease Project

Figure 12.1 Project financing structure.

Sukuk al Istisna’a Sukuk offers a number of solutions in Islamic project finance. One structure of particular interest in project finance is Sukuk Istisna’a (SAI) or commission to start the project. This structure allows project sponsors to leverage their project in an Islamic fashion and is useful where predelivery financing is required.

A typical SAI deal A major infrastructure project could be structured as follows (Figure 12.1): ❒ The Sukuk holders contribute a capital amount to the issuer. ❒ The issuer enters into a concession agreement with the state, based on which issuer acquires a right to develop and/or own the project. ❒ The issuer engages a contractor on an Istisna’a basis to construct the project. ❒ At the end of construction, the contractor transfers title of the project to the issuer. ❒ The issuer grants a master lease to the project company under which the project company pays rent to the issuer (within the master lease ijara and forward ijara will exist).

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❒ The rent payable by the project company is in effect the return to the Sukuk holders. ❒ Any income in excess of the rent payable by the project company is returned to its shareholders as a return on their investment.

Hedging Uncertainty is a vitiating factor in Islamic contracts. Any products that provide greater certainty by removing the ‘peril of uncertainty’ for the transacting parties are therefore desirable under shariah. There is a growing view that transactions and products that have the effect of prudential risk mitigation are acceptable – as opposed to transactions entered into purely for speculative reasons. The Arbun (down payment) concept, for example, provides clients with structures, documented products that hedge against future price fluctuations in commodities and equities. A typical Arbun arrangement is shown as follows (Figure 12.2): ❒ The client contracts to buy assets from a financier for an agreed price (target price) for delivery at a later date.

Maturity date: Sale proceeds less than target price Arrangement terminated

Vendor

Assets

Financier

Arbun payment

Net sale proceeds Maturity date: Sale proceeds greater than target price

Figure 12.2 Typical Arbun arrangement.

Client


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❒ The client makes a partial payment of the purchase price immediately by the way of a deposit. ❒ The client is not entitled to complete the purchase of the assets, but if the client elects not to complete the purchase they forfeit the deposit. ❒ If, on the maturity date, the target price is greater than the market price, the assets are purchased by the client and resold to the financier as agent of the client. The sale proceeds are distributed to the client net of the outstanding purchase price.

Swaps Whilst, conventionally, swaps may be used to hedge certain risks or to speculate on changes in the market, shariah-compliant swaps are used only to effect prudential risk mitigation. The manner in which a swap product is structured depends on the stream of cash flows which are being exchanged by counterparties. In any event, the stream of cash flows involved in shariah-complaint swaps will be created through fully funded transactions, unlike their conventional counterparties which often calculate cash flows using notional principal amounts. For example, the bank ‘invests’ in a deal and rents/leases the ‘investment’ to the client (the difference between what the bank receives (from the concessionaire) and what the client receives from the bank is the ‘Istisna’a’). The clients’ profit is floating over a concession period. The bank and the client then enter a four-spot commodity trade (maybe two sets of two metal trades in opposing positions, i.e. no party is ever out of the money). Movements in profit are then netted off the party out of the money in the four-spot trade at a set maturity date – the result – a fixed rate.

12.6 Other Islamic finance techniques for projects Musharaka (equity financing) The financier and the investor provide financing for a project in agreed proportions in the form of either cash contributions or contributions

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in kind (non-cash equity). In general, the financier and investor share equally in the profit and loss of the project in proportion to their initial investment.

Bai salam (forward financing) This technique may be used to provide working capital to a project. Essentially, bai salam financing is a forward financing transaction where the financier pays in advance for the purchase of specified assets which the seller will supply on a pre-agreed date. This allows the financier to acquire assets by advanced payments at a discounted price. The financier may sell the asset to be acquired on delivery for an increased price. A possible strategy would be to express interest in a secondary deal and analyse its structure, risks and suitable mitigation methods.

12.7

Risks and liabilities

The contracts and techniques used in Islamic finance may give rise to additional risks and liabilities for the financier. For example: ❒ The owner’s liability may be incurred if the financier owns an asset for a period before transferring it to the end-user. Injury to employees or environmental damage will require insurance. Under Islamic finance, insurance must take the form of Islamic insurance (takaful). ❒ A financier may wish to obtain insurance against liabilities such as delay, interruption to business or embargo (uncertainties) but may find conventional insurance does not suffice since these may be considered gharar. ❒ Tax liabilities may be required on the acquisition of the asset or on the sale of the asset. ❒ Warranties that may need to be provided by the financier must be considered.


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❒ Cost or construction delays during the construction period may be an issue to the financier. Can these risks be passed on to the customer? Non-Islamic financing organisations need to understand the risks and mitigation methods associated with Islamic project finance deals. This can best be achieved by working with an Islamic bank in the first instance to determine how the risk is shared and how financial products can be developed to meet the stringent requirements of Islamic finance.

12.8

Summary

The idea behind Islamic project finance is based on innovative efforts dedicated to devising structures that comply with shariah precepts. Islamic project finance is therefore closely linked to financial engineering. Different Islamic financing principles need to be assessed and projects modelled to determine how and what types of financial products can be used under Islamic finance. Similarly, any ambiguity regarding a financial product should be removed. Typically, debt, equity and bonds used in conventional project financings can be replaced, for example, by murabaha (instead of interest, profit comes from share commensurate with the difference between the purchase and sale price), musharaka and Sukuk, respectively, under Islamic financing.

Chapter 13 Conclusions and recommendations

13.1

Review

Chapter 2 provided a number of definitions of project finance and described the key characteristics of project finance and the parties and contracts typically involved in projects procured utilising project finance. Legal and financial considerations were also identified. Chapter 3 identified the typical financial instruments used in the procurement of projects utilising project finance, those being debt, equity and bonds and how cash flows can be developed and economic parameters determined in the assessment of projects utilising project finance. Chapter 4 briefly outlined a typical risk assessment process through identification, analysis in terms of qualitative, semi-quantitative (deterministic) and quantitative (stochastic) and response to risks that are used as part of the financial assessment processes in this guide. Chapter 5 provided a structured financial assessment process in the form of a flow chart mechanism, illustrating the different types of assessment to be carried out at each stage of the process and the parties responsible for each assessment. A brief description of each assessment process is provided. Chapter 6 provided the basic technical and financial details of the case study. The estimated costs and revenues and their timings for an independent power project to be procured utilising project finance in China were provided and parties and contracts involved. Chapter 7 illustrated how the special project vehicle (SPV) would initially determine the commercial viability of the project by developing cash flows on the basis of estimated times, costs and revenues and the economic parameters such as internal rate of return (IRR) and break-even points. A deterministic risk assessment to determine the

141

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best and worse case scenarios was then performed. No discount rate or the cost of finance is included in these computations. Chapter 8 provided a typical assessment process by lenders seeking to determine the merits of different financial packages, in this case based on 100% debt, 80% debt and 20% equity and 10% debt, 80% bonds and 10% equity. Economic parameters for each package were determined. The lenders’ perspective, unlike that of the SPV’s, is based on the worst case scenario and seeks to determine project economics and relevant coverage ratios. Chapter 9 described a number of financial engineering techniques that can be used in project financings. A method for reappraising public–private partnerships in terms of refinancing, restructuring and termination was also described. A number of these financial engineering techniques were considered in the final assessment in Chapter 10. Chapter 10 described how the final assessment of the case study is developed based on the chosen financial package and the risks to be considered. This assessment uses stochastic analysis to determine the probability of the project’s commercial viability and a number of financial engineering techniques. Chapter 11 outlined the legal considerations in project financing and the major elements of the due diligence process, essential prior to the financial close of a project procured utilising project finance. Chapter 12 outlined the principles, products and techniques used in Islamic finance and its role in project financings.

13.2

Conclusions

Project finance is a complex approach to procuring projects or services. Primary and secondary contracts need to be developed and assessed by all the stakeholders to the project, and the project’s ability to service funding must be determined through rigorous assessment. The structuring of these contracts in terms of risk share and responsibility is paramount to the success of a project. Unlike traditional project procurement methods, project finance relies on the private sector to provide all or most of the finance, through different financial instruments to fund a project. These financial instruments are usually in the form of debt, equity and bonds determined

Conclusions and recommendations

143

by projects’ cash flows and perceived risk in a project. The financial instruments chosen and proportioned to form a financial package are unique to every project financing. The cash flows of a project determine the type of financial instruments to be used. A project considered commercially viable for one financial package may not be viable for another financial package. In most cases the development of the finance package has far greater effect on the project than the engineering itself. The choice of financial instruments and the terms of lending are a major factor in the assessment process. A highly geared project may default on payments of principal and interest; however, the same project utilising more equity and less debt may meet the expected returns of both lenders and shareholders. The lenders are concerned with cash flows and possible default. The use of coverage ratios provides lenders a method of determining the headroom available should a project perform below that forecasted. The risk assessment process discussed in this guide relies on the identification, analysis and response to risks and considers both deterministic and stochastic analyses. No project financing should be sanctioned without a full risk assessment. Deterministic risk assessments should be used only to provide an estimate of potential outcomes. Detailed stochastic risk analysis which takes into account the effects of risk mitigation provides a more accurate evaluation and the probability of the project meeting required returns. As seen in the case study project, the initial deterministic analysis produced lower values of IRR than the stochastic analysis. The guide has provided a structured financial assessment process for projects procured utilising project finance that can be used by organisations involved in the procurement and operation of such projects. The assessment process provides analysts with the opportunity to make decisions about the project’s commercial viability at different stages of the assessment. The process described in this guide follows a logical path, allowing the analyst to make decisions at different stages of the assessment. By using financial engineering techniques, a project’s cash flows and commercial viability can be improved. Similarly, a project can be refinanced for both loss and gain situations at different stages of its life cycle.

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Whilst structuring a project, all the stakeholders should be made aware of both upside and downside outcomes. The chosen financial package should strike a balance between the risk and reward for each individual stakeholder. Whilst structuring a project financing, thorough due diligence is necessary. Whilst giving an understanding of the underlying nature of a project, this process ensures the risks identified and the methods used for mitigation are suitable for the project under consideration. Islamic finance can be used through financial engineering in project financings. Already adopted on some projects, Islamic finance can play a major role in the development of projects as has conventional project finance and is expected to grow over future years.

13.3

Recommendations

All those stakeholders involved or those seeking to be involved in project finance should thoroughly understand the key characteristics and complexity of this procurement strategy. Projects procured by project finance are usually long-term projects, with operating phases as long as 50 years. Stakeholders should ensure they are aware of the liabilities over the operating phase of such projects before attempting to evaluate the short-term returns. Every project is unique with each financial package developed on the basis of the project’s cash flows and perceived risks. The types of financial instruments available should be made apparent to all stakeholders and how and why such instruments are employed to service repayments over defined periods. The terms of lending should be made clear, especially those terms associated with default or termination. The risk over the life cycle of a project should be identified, analysed and managed by those best suited to do so. This can be done only through sound risk assessment processes and a clear understanding by all stakeholders of the ownership of risks and how they would be mitigated. The authors recommend that inflation should be assessed prior to financial close as values of inflation are very difficult to predict. The project should be assessed against different ranges of inflation to

Conclusions and recommendations

145

determine at what level the project will not be commercially viable and where possible mitigated through financial engineering techniques. Most stakeholders involved in project financings have their own unique assessment processes. It is recommended that all stakeholders are made aware of those processes and where possible seek to provide an assessment process understood by all stakeholders which would form part of the due diligence process. Organisations assessing projects should ensure that their presentations are clear and unambiguous if they are to be used in the financial close and the decision-making processes. Islamic finance is relatively new in terms of project financings, and it is recommended that more research studies are carried out and findings are disseminated to all those involved or seeking to become involved in Islamic finance. A number of lenders involved in developing Islamic finance products for project financings suggest that a supreme of higher Islamic institution board should be instigated to provide a clear and unified understanding of shariah laws for all Islamic finance products.

Appendix Case study: water treatment plant procurement using project finance

The authors asked two practitioners to take the concepts put forward in this book and apply them to assess a water treatment plant in a country of their choice.

A.1

Introduction

With rising concerns on issues such as climate change, rapid population growth and the expansion of economic activities, governments are under increasing pressure to secure long-term provision of quality water and prevent future shortages in its supply. While water treatment plants are usually classified under the generic umbrella of public service infrastructure, their capital-intensive nature and long-life asset render them suitable to act as vehicles for private sector involvement. Governments are keen to attract private capital in water treatment projects because they benefit from transferring the financial burden and further initiate the development of domestic technology and ancillary to water sector industries. Increasingly, governments seek to engage in a BOT (build–operate–transfer) arrangement as part of their private finance initiative where the design and building of the facilities, the finance of the construction, and the operation and maintenance are the responsibility of the private sector for a fixed predetermined period before finally transferring the asset to the state. A Middle East country, the host country, has been considering largescale water projects as a means to deal with the imminent water crisis, which has become more acute over recent years due to extended droughts and overuse. The crisis is manifesting itself in the quantitative and qualitative reductions of water supplies to its citizens and in the gradual depletion and contamination of natural water sources. 147

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This increasing problem led the country to devise, in 2002, a master plan for the construction of seawater desalination plants to supply 400 million cubic metres of water between 2005 and 2006, with the opportunity of doubling this capacity by 2020. The water treatment plant considered in this study is planned to start operations in 2012.

A.2 The project – contractual structure and risk analysis AFCO Water (sponsor) has entered into a 17-year concession agreement (inclusive of a 2-year construction period) with a host country government agency, the Water and Desalination Authority (WDA) (principal). The project involves the financing, design, construction, operation, maintenance and transfer of a water treatment plant located on the coast of the host country with a total production capacity of 25 million cubic meters per year and to supply 350 000 people. Energy consumption is typically one of the main contributors to the operating costs of water treatment plants, amounting up to 10–30% of the total operating cost. The technology proposed will not be the traditional flash distillation, but the newer and proven reverse osmosis technology. This will significantly lower operational costs and energy consumption, especially as energy prices may escalate in the future. The project meets World Bank guidelines on environmental issues, and the operations are to start at full capacity from January 2012. A well-developed commercial framework has been opted by the sponsors, one that minimises the risk of the stakeholders and facilitates private investor participation. ABG Desalination, a special purpose vehicle, has been established for the investment of US$60 million and will be sponsored by AFCO Water (50%) and two local partners, TLC Construction (25%) and Ela Group (25%), a process contractor. The operator, AFCO Facilities, is established by the sponsor for this individual project, as is the EPC contractor, which is owned by TLC. To ensure the energy needs of the plant, ABG has entered into a contract with the national power utility, the Electricity Corporation. The offtake contract is contract-led, where the revenue stream is clearly defined through a tariff structure on the basis of a minimum

Case study: water treatment plant procurement using project finance

149

take or pay contract. ABG enters into a contract with WDA who agrees to purchase throughout the operation period an output of 20 million cubic metres per year, that being 80% of the plant annual capacity. To minimise lender exposure, the payment obligations for WDA will also constitute obligations from the host country government. The supply contract will be ‘free supply’ of seawater through a pipeline provided by the host country with a guaranteed supply in terms of quality and quantity. The business plan has taken into consideration ways to further increase the revenue of the project. Firstly, part of the output from the desalination process can be sold at a higher price to commercial outlets throughout the country, and additional revenue can ensue from corporate advertising on the bottling. Secondly, the concentrate from the desalination process, the brine, can be directed into land-based holding ponds, whereby after evaporation the remaining seawater salt is collected as a commercially viable product (used widely in cooking and cosmetics) to be sold in the market. Finally, in addition to the desalination function, the facility will be able to process small quantities of industrial wastewater and thus additional revenue streams can be created from the sale of the reclaimed water for industrial uses, primarily for agricultural and smelting purposes. The total cost for the project is US$60 million, and the revenue from the offtake agreement over the period of the contract will be US$195 million. The risk to the project is further reduced as there is an official commitment from the state in the form of the master plan for 2020 where the development of water desalination facilities is deemed critical for the country as a whole. The host country is AAA rated, and the economy is steadily growing, and the inflation rate has not been higher than 5.7% for more than 10 years with the current rate at 3.6%, which is expected to fall over the next few years. The sponsors have made additional considerations for mitigating the risk passed to the project, particularly those which are controllable. This has been feasible as there is strong government support from the host country. The BOT agreement stipulates that the sponsor is not obligated to increase the production capacity of the plant; however, if ABG decides to extend the facility, they are guaranteed that WDA will purchase at the agreed price up to an additional 10 million cubic metres per year. Furthermore, it is agreed that once the plant has started

150


operations in 2012, WDA will not approve any new groundwater intake licences for domestic or industrial use and neither will it renew existing ones, in effect establishing a monopoly over the operation period. ABG is also granted the first right of refusal for any future projects to be awarded by WDA in the county. ABG, in its effort to minimise risks related to unforeseen regulatory changes, seeks a twofold contractual arrangement whereby: (i) At the offtake purchase agreement, it is stated that the purchase price of the treated water will be compensated for increased costs and/or operational delays, for example, changes to environmental or labour regulation in the host country. (ii) The term of the concession can be extended to an additional period of 10 years in the case that such costs do occur.

A.3

The financing package of the project

Financing of BOT concessions follows the limited recourse project finance model, whereby a project’s cash flow and risk profile are used to determine the financial structure, sources of finance and terms of lending. The direct link between the cash flow generation potential and funding methods means that sponsors, investors and lenders must ensure that the project is financed in such a way that each will achieve their expected returns. Three financial packages are first considered to determine the most appropriate finance package for the water treatment plant (as shown in Table A1.1): Package 1: Debt/equity Package 2: Debt/equity Package 3: Debt/equity

65:35 75:25 70:30

AFCOs’ minimum acceptable rate of return (MARR) is assumed to be 11%, and the basic economic parameters of each combination


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Table A1.1 Economic parameters of the financial models Economic parameters

Model 1: 65/35

Model 2: 75/25

Model 3: 70/30

WACC (%) Debt/equity (US$) IRR (%)

8.61 39:21 12.6

5.97 45:15 17

7.88 42:18 13.2

of debt and equity after adjustment for inflation are illustrated in Table A1.1. The most important element in project finance is the raising of debt capital. Furthermore, water projects generate cash flows that are typically steady or grow slowly; thus, financing justifies higher debt ratios with long maturities. From Table A1.1, Model 2 (debt/equity ratio 75:25) is chosen as the best option of those initially considered to finance the project as it has a higher leverage of debt. Although the internal rate of return (IRR) for all three models exceeds the MARR of 11%, Model 2 generates the highest IRR and the lowest project WACC (weighted average cost of capital) but has the longest payback period. Project debt will be raised domestically, thus protecting the project from potential losses from currency fluctuation. Local finance is particularly suitable because the host country benefits from high volume of institutional financing strengthened by recent amendments to regulations which now permit increased involvement of insurance companies in AA-rated project bonds. Additionally, the debt market for infrastructure projects in the host country offers long-term loans. Finance for the water treatment project will be raised by commercial bank loans and institutional private placement. DIV Bank will provide the senior debt (45%). The financing terms of banks allow refinancing at lower interest rate every 3 years until the debt is fully serviced. Municipal bonds will also be used to finance the project, sold via private placement to institutional investors, mainly insurance companies and pension funds. The bond financing will be considered as subordinated debt, as this type of financing generally provides lower borrowing costs if the credit rating for the project is sufficiently strong. Many operators deem this method of financing as the forerunner of project finance. The cost of distributing bonds in the private market is

152


cheaper, and it is easier to renegotiate the terms and conditions of the bond in the event of default. The bond issue for the project will be managed by CECom Underwriters. This represents 55% of the total debt finance, and an AA rating from the host country local rating agency has been secured. The interest on municipal bonds is tax-free, which further boosts its attractiveness to the investors. The bond issue will comprise of two tranches, the first which will be disbursed during the institutional tender and the second after financial close. Overall, the project will utilise financial insurance products and services by commercial insurance underwriters to mitigate financial risks. Equity share in the total finance for the project as a margin of safety for the lenders is 25%. Equity finance is a condition to the host government granting the concession and to the availability of commercial debt funding. ABG, the consortium of the three original equity investors who participate in the equity of the concessionaire, namely AFCO Water, TLC Construction and Ela Group, shares a total contribution of 30% of the equity raised for the project. This high stake was required by the lenders to secure a continuing interest of the sponsors throughout the project’s life cycle. The project company has obtained funding opportunities both from the financial market of the host country where local commercial banks will contribute 40% of the equity, and has also attracted international commercial banks for a 20% share, and from multilateral agencies for the remaining 10%. In order to maintain greater levels of debt-to-equity ratios, part of the equity is in the form of mezzanine contributions (preferred stock), and a rate of return on equity of 15% has been secured throughout the project’s life cycle. Tariff mechanisms have been structured by the host country government to provide this maximum limit of 15% rate of return to the shareholders.

Assessment of Model 2 Base case The finance package for this project is 75% debt and 25% equity, which provides the lowest WACC and the best IRR.

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The project is considered on the following metrics:

Capital expenditures Operational expenditures Revenue MARR Lending rate Lending rate Lending rate Inflation rate Dividend rate Tax rate

US$60 million US$2 million per annum US$195 million 11% 4.0%, years 3–5 inclusive 3.0%, years 6–8 inclusive 2.5%, years 9–10 inclusive (through an IR swap) 2.0% 15% 26%

FigureA1.1 illustrates the cumulative cash flows of the project before the cost of finance is included at an annual inflation rate of 2%. This is the base case assessment performed by the sponsor. From Figure A1.1 and Table A1.2, it can be seen that the project will achieve an IRR of 17% with a payback period of just over 7 years from granting of the concession. The net present value is US$134.03 million with a discount rate of 0. Table A1.2 is now developed to show the project’s cash flow after the cost of finance is included and to determine the debt service coverage ratio (DSCR) for each year of operation. In years 3–9, the DSCR increases from 1.42 to 1.53, respectively.

150

US$ million

100 50 0 1

2

3

4

5

6

7

8

9

10

11

12

13

14

–50 –100 Time (years)

Figure A1.1 The project’s cumulative cash flow adjusted for inflation.

15

16

17

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

−30 −30

2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

Operations and Time Cost maintenance −30.00 −30.00 11.22 11.44 11.67 11.91 12.14 12.39 12.64 12.89 13.15 13.41 13.68 13.95 14.23 14.51 14.80 17%

15%

13 13 13 13 13 13 13 13 13 13 13 13 13 13 13

IRR

134

−30.00 −60.00 −48.78 −37.34 −25.66 −13.76 −1.61 10.78 23.41 36.30 49.45 62.86 76.53 90.48 104.71 119.23 134.03 −1.80 −1.56 −1.30 −0.77 −0.55 −0.33 −0.08

Inflationadjusted Cumulative Cost of cash flow cash flow finance

−30 −30 11 11 11 11 11 11 11 11 11 11 11 11 11 11 11

Cash Revenue flow

9.42 9.89 10.38 11.14 11.59 12.06 12.56

Cash flow available after interest payment

Table A1.2 Cash flow and DSCR for inflation-adjusted base case

−45.00 6.12 6.43 6.74 7.24 7.53 7.84 8.16 −38.88 −32.45 −25.70 −18.47 −10.93 −3.09 5.07

Cash dedicated to service Outstanding princi- balance of pal debt

3.30 3.46 3.63 3.90 4.06 4.22 4.40 12.89 13.15 13.41 13.68 13.95 14.23 14.51 14.80

1.42 1.43 1.45 1.49 1.50 1.52 1.53

0.49 0.52 0.54 0.58 0.61 0.63 0.66 1.93 1.97 2.01 2.05 2.09 2.13 2.18 2.22

116.94

2.80 2.94 3.09 3.31 3.45 3.59 3.74 10.96 11.17 11.40 11.63 11.86 12.10 12.34 12.58

Profit Cash after flow diviafter dend debt Dividend payfinance DSCR payment ment


155

US$116.94 million is available after debt service and dividend payments over the operational life of the project, rising from US$2.8 million at the end of the first year’s operation to US$12.58 million at the end of the final year’s operation. This assessment illustrates that there are sufficient margins in the project to make it attractive to lenders and equity takers. The authors have not assessed dividends after tax in this assessment as would be the norm.

Worst case For the worst case scenario, the authors have identified three potential risks: revenues decrease by 10%, operations and maintenance costs increase by 25%, and inflation increases by 3%. The effects of the risks described above are then represented in Table A1.3, and worst case cash flows and DSCRs are computed. The IRR has fallen to 15% but is still above the MARR of 11%. The DSCRs remain at, or above, 1.4, and the cash available before tax is US$107.68 million.

Conclusion On the basis of the context of the assessment, the finance package consisting of a mixture of debt and equity (75:25) is the least risky option in terms of finance because debt is the cheapest form of borrowing and generates the highest return for shareholders. The project is considered risky as the technology is proven and host country guarantees are in place and the project has contract-led revenues. Additional revenue streams can also be generated from this project under the concession. In the worst case scenario, typical risks for this type of project are considered, those being rising energy costs, possible shortfalls in the quality of water and higher-than-expected inflation. The initial assessment to determine the commercial viability for all those involved in financing the project is determined based on a single finance package, in this case 75:25 debt/equity, which was primarily selected on the basis of its WACC. Finally, the cash available in the worst case assessment when discounted at 6% would be US$42.7 million.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

−30 −30

2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5

−30.00 −60.00 −50.52 −40.76 −30.71 −20.36 −9.69 1.29 12.61 24.26 36.27 48.63 61.37 74.48 87.99 101.91 116.24 116.24

−30.0 −30.00 −30.0 −30.00 9.2 9.48 9.2 9.76 9.2 10.05 9.2 10.35 9.2 10.67 9.2 10.99 9.2 11.31 9.2 11.65 9.2 12.00 9.2 12.36 9.2 12.73 9.2 13.12 9.2 13.51 9.2 13.92 9.2 14.33 12% 15%

11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7 11.7

IRR

−1.80 −1.60 −1.39 −0.87 −0.69 −0.49 −0.24

InflationCapital expen- Operational Cash adjusted Cumulative Cost of finance Time ditures expenditures Revenue flow cash flow cash flow

Table A1.3 Cash flows and DSCR for worst case

7.68 8.16 8.66 9.48 9.98 10.49 11.07

Cash flow available after interest payment

−45.00 4.99 5.30 5.63 6.16 6.49 6.82 7.20

Cash dedicated to service principal

−40.01 −34.71 −29.07 −22.91 −16.43 −9.61 −2.41

2.69 2.86 3.03 3.32 3.49 3.67 3.88 11.65 12.00 12.36 12.73 13.12 13.51 13.92 14.33

Cash flow Outstanding after balance debt of debt finance

1.40 1.41 1.43 1.47 1.49 1.50 1.52

0.40 0.43 0.45 0.50 0.52 0.55 0.58 1.75 1.80 1.85 1.91 1.97 2.03 2.09 2.15

107.58

2.28 2.43 2.58 2.82 2.97 3.12 3.29 9.91 10.20 10.51 10.82 11.15 11.48 11.83 12.18

Profit after dividend Dividend payDSCR payment ment


157

Other combinations of debt and equity can be assessed in the same manner, although projects that generate revenues on a contract-led basis maximising debt are often the preferred route.

Acknowledgements Thanks go to Apostolos Chatzilakos and Fisayo Otudeko for preparing this case study.

Glossary

accrued interest: Interest earned on a loan between two specified payment dates. amortisation: Periodic reduction of principal. bankable: Sufficiently secure for financing. base case: Cumulative cash flow developed using expected values. base rate: The underlying interest rate used by lenders to determine the total lending rate. capital expenditures (CAPEX): Expenditures for property and equipment. capitalised interest: The interest paid to service current loan obligations. debt service: Principal repayments plus interest payments usually expressed over a period of 1 year. debt service coverage ratio (DSCR): A metric used by lenders to determine whether a project’s net cash flow can service a given amount of debt under the terms of a loan. debt service reserve account: A reserve account set up to ensure timely payment of interest and principal should cash inflows be below base case expectations. discount rate: The annual percentage rate used to compute the present value of future cash flows. financial close: The date on which all project contracts and financing documentation are signed. gearing: A measure of leverage such as the debt-to-equity ratio or debt to total capitalisation. grace period: A period within which default is resolved without incurring charges. inter-creditor agreement: Agreement between lenders describing the rights and obligations in the event of default.

159

160

Glossary

interest rate coverage ratio: Safety margin of a project to meet interest obligations. internal rate of return (IRR): The discount rate that makes the net present value equal to zero. loan life coverage ratio (LLCR): The net present value of cash available for debt service from the initial date of calculation until the maturity date. margin: The percentage amount per time period above the interest rate or cost of funds. Monte Carlo simulation: Random number generation to quantify the effects of uncertainty in a financial model. net present value (NPV): The total present value of a time series of cash flows using the time value of money to appraise long-term projects. operational expenditures (OPEX): The ongoing expenses associated with operating a facility or business. project finance: A sponsor investing in and owning a single-purpose asset, usually for a fixed period, through a legally independent entity finance on a non-recourse basis. project life cover ratio (PLCR): The net present value of a project’s cash available for debt service over a defined life divided by the amount of principal outstanding at the time of computation. refinancing: Prepayment of existing debt through new debt on more attractive terms in illiquid markets. sponsor: A party developing and financing (with equity) a project.

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Index

AA-rated project bonds, 159 ABG, 156–8, 160 Actual cash flow available for debt service, 106 Agreements, 5, 12, 15–17, 21, 35, 40, 58, 60, 95, 97–8, 114–5, 118–9, 122, 124, 131, 133 direct, 112, 114–15 financial, 15 inter-creditor, 117–8, 147 throughput, 63 Arbun arrangement, schematic presentation, 136 f Arbun (down payment) concept, 136, 136 f Ash-handling systems (ASH), 70 Asia-Pacific project finance, 3 Assessment, 6, 8, 10, 39, 47, 51–4, 59, 69, 71, 75, 82–3, 85, 101, 107, 109, 145, 160 deterministic, 105 financial, 6–9, 51, 52 f , 56, 74, 141 initial, 34, 51, 65, 67, 69, 75, 78, 101, 163 lender’s, 51, 54, 77 Assessment of base case model, 52 f , 74–5 Asset-backed securities (ABS), 93–4 Asset-backed Sukuk, 134 Assets, 5–6, 11–12, 19, 26–8, 31, 33, 35, 38, 89, 93–4, 96, 119, 132, 136–8 leased, 133 project’s, 28, 38 Asset securitisation, 93–4 Assumptions, 57, 65, 112, 114–16, 124

Auditor, 113, 115–16, 119–20 Audits, 112–13 Availability-based payments, 21 AWA, 67, 70 Bai salam financing (forward financing), 138 Balance sheet, 13, 17–19, 37, 90 Banker, 18 Banks, 26, 34, 80, 121 Basel Committee on Banking Supervision (2004), 124 BDG, 68, 70 BLK, 68, 70 BLR, 68–70 Bonds, 8, 10, 17, 23, 25, 28–31, 35, 38, 54–5, 58, 67, 141–2 agreement, 15, 17, 58 finance, 29–31 holders, 7–8, 17, 29–30 Bond financings, 29 Bond issues, 30, 37–8 advantages over bank debt, 30 Bond ratings, 30 Standard and Poors’ & Moody’s, 32t BOOT, See Build-own-operatetransfer Borrower, 5, 15–16, 26–7, 29, 35, 37–8, 81, 92, 94, 109, 111, 114, 118, 121, 124–5 Build-own-operate-transfer (BOOT), 15, 15 f , 58–9, 64 assessments by SPV and lenders to determine the commercial viability, 59 f key organisations and contracts, 15–17

167

168

Budget, 5, 8, 46 Buyers, 14, 58, 63, 65, 90 CAPEX, 52–4, 78, 82–3, 84t–86t, 147 Capital asset, 12, 14 Capital intensive industry, 94 Cash flows, 4, 7, 9–15, 18–22, 25–7, 29, 34–7, 61, 67, 69, 71–2, 73, 79–80, 86, 91, 95, 101, 106, 108, 113 forecasted, 22, 38, 83 modelling, 13, 25, 34–8 projected, 35, 75 stream of, 137 Cash flow available for debt service (CFADS), 80 Cash lock-up, 37 CCFs, See Cumulative cash flow Channel Tunnel project, 34 China base case model, 69–75 activities, costs and revenue estimates and their timings, 70, 70t development of, 71–3 identify major project risks, 73–4 independent power project (IPP) under BOOT strategy utilising project finance, 57–8 projects with offtake contracts, 64 f projects with supply contracts, 62 f State Power Development Company (SPDC), 66, 69 primary and secondary contracts, 66–7 project programme: major activities, 67–8, 67 f SPV’s initial assessment, 69–70 Collars, 92–3 financial, 107 Collateral warranty, 115

Index

Committee, 123–4, 128 Commodities, 4, 90,129, 132, 136 Compound options, 93 Concerned with estimates of the project’s capital (CAPEX), 53 Concession agreement, 6, 15–16, 21, 59–60, 65–6, 69, 95, 97, 135, 156 types of, 21 Construction contract, 17 Construction package, 71 Contingency and risk management, 114 Contract finance, 14, 58 Contract-led contracts, 62–3 Contract-led project, 61 Contract-led revenue stream project, 19–20 Contractual agreements, 13–14, 40, 58 Contractual arrangement, 14–5, 58–9, 158 Corporate finance, 17 Cost audits, 113 Coverage ratios, 7 Credit committee, 123–4 Cumulative cash flows, 36, 53, 69, 71–2, 147, 161 base, best and worst case, 75 f model, 53 net cash flows, 36, 36 f stages, 136 f Currency futures, 91 Debt, 7–8, 10–12, 14, 18–19, 22, 25–31, 78, 80–87, 94–5, 98 bank, 28, 30 contract-led basis maximizing, 165 long-term, 26–7, 33 non-recourse, 12 refinancing, 94–5, 107 service, 77, 107 short-term, 27, 91

Index

Debt assessment, 83 Debt balance, 80 Debt capital, 33, 159 Debt coverage ratios, 22, 80 Debt/equity ratio, 33 Debt for equity, 98t Debt finance, 25–8 long-term, 26 short-term, 27 Debt instruments, 26 Debt payment, 19 Debt service cover ratio, 55, 80–81 unsuitable assignment, due diligence, 116 Debt service reserve account (DSRA), 119, 147 Debt sources, Debt-to-equity ratios, 147, 160 Debt-to-equity swap, 94 Demand-based payments, 21 Design, build, finance and operate (DBFO) route, 4 Detailed risk assessment, 101–5. See also Project risk. cumulative probability analysis, 104 f pre-tax profits generated by the project, 106t risks affecting the project’s IRR, 102 risks and their upside and downside ranges, 102t sensitivity analysis, effect of risks on project’s IRR, 103 f stochastic probability analysis, 102 Detailed stochastic risk assessment, 105, 143 Deterministic risk assessment, 74, 141, 143 Dhahol power plant, 62t Dividends, 18, 28, 31, 33, 35, 54, 80, 83, 85, 105, 107–8 Downside risk, 26

169

DSCR. See Debt service cover ratio. Due diligence, 111–5 economic indicators, 120 financial, 115 insurance, 121 legal, 114–6 model audit and sensitivity analysis, 116–7 process, 10, 111–21, 112 f taxation, 120–121 Eastern Europe, Middle East and Africa (EMEA) region, 2–3 Elemental risks, 50t Energy conversion agreements, 63 Equity, 22, 31–4, 38, 49, 55, 82, 107, 119, 141, 160 Equity capital, 31 Equity finance, 31–4, 160 Equity investors, 33 Equity providers, 16, 108 Escrow account, 119 Escrow and ring-fenced facilities, 119 Existing concession revenues, 108 Extending the concession, 107 Finance manager, 37 Finance package, 78–87 80:10:10 debt/bond/equity, 86 f finance package of 80:20 debt/ equity, 82 f project economics and cover ratio table under 80:20 debt/ equity (US$ million), 84t Projected cash flow allocation under allocation table under 10:80:10 debt/bond/equity for the bond with a 10-year maturity (US$ million), 86t project economics and cover ratios under 100% debt (US$ million), 79t

170

Financial and non-financial risks, 49t Financial agreements, 15, 58 Financial assessment, 6–9, 56 outputs of, 8–9 process, 51–6 structure, 51–6, 52 f Financial close, 122–5 credit committee approval process, 123–4 documentation, 122 due diligence report, 124 execute interest rate swaps, 125 objectives, 122 process, schematic presentation, 122, 123 f technical closure, 124 technical commencement, 124 Financial collar, 107 Financial engineering, 89–99 financial instruments used, 90–94 procurement techniques, 96, 99 tools used, 89 Financial engineering techniques, 55 Financial instruments, 25 Financial markets, 27–8, 37, 89, 118 Financial package assessment, 77–87 Financial risk, 49t Financial Services Authority (FSA), 132 Financially free-standing projects, 4 Fixed or floating swaps to mitigate interest rate changes, 107 Fixed-price lump-sum turnkey contract, 102–3 Fixed-rate borrower, 92 Funds, 4, 6, 19, 26, 29, 31, 33–4, 39, 82, 93, 119, 122, 148, 159 Foreign lenders, 26 Forward lease, 133 Forward purchase agreements, 21 Forward rate, 90 Fuel-based power generation, 63

Index

Future cash flow, 35 forecast, 37 Future income stream of a project, 6, 19 Futures contracts, 90–91 Futures market in currency and interest rates, 90 Gharar, definition, 131 Global and elemental risks, 49t Global risks, 50t Grace period, 108 Guarantees, 19, 21, 57, 78, 99, 113, 115 Hedge strategy, 118 High demand, cautious lenders, 25–6 High financial leverage, 33 Highly rated bond, 30 Hubco power project, 61, 64 Ijara, the act of leasing, 133 Ijara Mawsufah Fi Al Dhimmah, See also forward lease, 133 Increasing debt, 107 Independent credit rating services, 30 Independent power project, 57–8 Institutional investors, 29 Insurance companies, 26, 29, 31, 121–2, 159 Insurance due diligence, 121 Insurance instruments, 121 Inter-creditor agreement (ICA), 117–8 Interest rate cap, 92 Interest rate cover ratio (IRCR), 81–2 Interest rate floor, 92 Interest rate swap, 91 Internal rate of return (IRR), 46, 53 best and worst cases, 102–5 International Association of Financial Engineers, 89

171

Index

IRR. See Internal rate of return. Islamic bank, 128 Islamic banks’ assets, 128–9 Islamic finance, 127–9 deception, 131 hedging, 136–7 Islamic financial institutions, 131–2 project financings in the middle east, 132–7 risks and liabilities, 138–9 Shariah supervisory boards, 132 swaps, 137 Islamic financial institutions, 128, 130, 131–2 constitutional documents, 132 Islamic insurance (takaful), 138 Issuing or selling securities, 25 Istisna’a, 133–4 Joint ventures, 4 Large-scale, capital-intensive projects, 26 Legal and financial structures, 21 Legal due diligence, 114 Lenders’ assessment, 54–5 financial packages, assessment of, 55 identifying sensitivity of risk variables, 47 initial economic assessment, 77–87 investing equity in projects, 33–4 Lenders’ direct agreement (LDA), 114 Letters of credit, 118–9 Leverage/ gearing or debt/equity ratio, 33 Limited-recourse debt, 18 Limited-recourse model North Sea oil projects, 18 Loan agreement, 17

Loan life coverage ratio (LLCR), 80–81 London Interbank Offered Rate (LIBOR), 92 Long-term debt financing, 26 Long-term supply contracts, 60 Lower-rated bond, 30 Market-based structures, 25 Market-led contract, 63 Market-led revenue stream project, 20 Medium-term debt, 27 Method statement audit, 113 Mezzanine finance/quasi-equity groups, 28–31 Minimum acceptable rate of return (MARR), 53, 71 Monte Carlo simulation, 46–7 Musharaka (equity financing), 137–8 Negative cash flow, 36–7 Net present value (NPV), 53 Non-financial risks, 49t Non-Islamic financing organisations, 139 Non-/limited recourse, 17–18 amount, event, time, 18 lending, 19 Non-recourse debt, 12 Non-recourse financing, 33 Off-balance sheet transaction, 18–19 Offtake contract (s), 16–17, 61–4 Oil and gas sectors bond finance, 29 On-balance sheet financing, 19 Operation package, 71 Operational expenditures (OPEX), 53, 54t, 78, 161 Operations contract, 17 Options, 92 Ordinary equity, 31

172

Organisation’s ability to pay off their debt, 30 PFI. See Private finance initiative. PFI-type projects, 8 Phasing construction and operation, 108 Potential non-bank lenders, 26 Power purchase agreements (PPAs) with reliable offtakers, 61 market demand risk, 65 Power station projects supply and offtake contracts, 65–6 PPP. See Public–private partnerships. Predictable risks, 48 Preferred equity, 31 Preferred finance package, 55 Private finance initiative, 2 potential advantages of, 4–5 potential constraints and problems, 5 Private mezzanine transactions, 28 Probability analysis, 47 Production sharing agreements, 21 Profit and loss sharing/partnership finance, 130 Program audit, 113 Project finance, 11 applications and locations, 3, 64–5 supply-side factors, 3 brief history, 2 f contractual commitments among various project participants, 35 definitions, 11–13 demand for, 2 demand-side factors, 4 financial considerations, 22–23 financial parameters, 22–3 first quarter of 2008, 3 future revenue generation, 37 goal/requirements, 13 history of development, 1, 2 f infrastructure projects, 37

Index

key characteristics, 13–20 legal considerations, 20–22 mobilising commercial debt, 25–6 modern history, 1 North Sea developments, 1 ordinary share capital for project procured, 33 potential constraints and problems, 5 raising the finance, 37 requirements for successful projects, 13 revenues of a project (the project’s cash flow), dependence on, 37 strength of the contractual commitments, 35 supply and offtake contracts, 58–65 supply-side factors, 3 transportation sector, 2 Project finance deals, Middle East, 2 Project finance loans risk involved, 40 Project finance transactions contractual arrangement, 14 major contracts, 14–15 quantitative risk analysis, 46 Project financing, 1–10 due diligence, objectives of, 111–2 future income stream of a project, 6 schematic presentation, 135 senior debt, 27–8 typical risks, 49–50 Project life cover ratio (PLCR), 81 Project life cycle risks affecting phases, 50t typical costs and revenues, 54t Project operation, 60 Project procurement categories of, 4

Index

Project risk, 96. See also Detailed risk assessment. identification, 42 management process, variations of, 41 Project sponsors, 6 Project tender preparation and evaluation of, 16 Projected cash flows, 35 Public–private partnerships, reappraising of, 94–5 concession agreement, techniques applied, 95–6 base case, 96 contractual control heading, 97t–8t scale for project risk, 96 Pure equity, 31 Pure project financings, 18 Qiyas/ruling by analogy, 129 Qualitative risk analysis, 44–5 Quantified risks, effects of, 56 Quantitative risk analysis, 45–6 Rate of spending/‘cash burn’/, 37 Red line case, 53 Reducing risks, 48 Refinancing, 94, 95 Repayment for investors and lenders, 17–18 Repayment of loan, 12 Repayment of the financing, 19 Reserve accounts, 119 Residual risks, recognising existence of, 48 Restructuring, 95 Return on the equity, 33 Revenues streams, 19–20 Risk, definition, 39–40 Risk analysis, 44–7 Monte Carlo simulation, 46–7 probability analysis, 47 qualitative risk analysis, 44

173

quantitative risk analysis, 45–6 sensitivity analysis, 47 Risk assessment, flow chart, 43 Risk and uncertainty, differences between, 40 Risk avoidance, 48 Risk capital, 31 Risk identification methods, 42–4 Delphi technique, 43 outputs of, 43–4 Risk management process benefits, 48 cycle, 41–2, 41 f definition, 41 for an organisation, 43 f objective of, 41 processes, 41–9 Risk register, 117 Risk response, 47–9 Risk strategies, 47–8 Risk valuation, 117 Robust income stream of the project, 19–20 SAI deal, 135–6 project financing structure, 135 f Saudi Petrol-Rabigh project, 3 Secured loans, 28 Security for lenders, 21–2 Seed capital/pinpoint equity, 33 Senior debt, 27–8 Sensitivity analysis, 47 Service provision direct agreement, 115 Services sold to the public sector, 4 Shareholder agreement, 17 Shariah, 129 Shariah board function, 128 role, 128 Shariah compliant investments, 131 Shariah supervisory boards, 132 Sharing (profit/loss and risk), 130 Shifting the risk, 48

174

Short-term debt, 27 Short-term interest rate futures, 91 Special project vehicle (SPV), 29, 57, 69, 77, 101, 113, 141 assessment, 51–4 cumulative cash flow (CCF) model, 53 deciding supply–purchase contract, 65–6 initial assessment, 69–70 IPP procurement, 73–4 and lender final assessment, 55–6 project’s IRR, 53 parent company guarantee, 115–6 supply–purchase contract offers, 65 take-or-pay contract, 65–8 Spreadsheet software, 71 SPV. See Special project/purpose vehicle. Stand-alone project financing of, 12–13 Standard and Poor’s, 30–31 Standards and best practice, 114 State power development company (SPDC), 66, 69, 75 Stock index futures, 91 Subordinate loans, 29 Subordinated debt, 28-9 Sukuk al Istisna’a, 135 Sukuk, 134 Sukuk holders, 134 Sukuk issuances, 134

Index

Supply contract, 16, 60–61 Swaps, 91 Swaption, 93 Take-if-offered contract, 62 Take-or-pay contract, 63 Tax holiday, 105 Term sheet, 117 Termination, 95 Throughput agreement, 63 Tolling contract, 63 Traditional supply contracts, 61 Trigger events, 116 Typical cover ratios used by lenders, 55t UK PFI, 4 Unique or innovative tax structures, 120 Unsecured loans, 27–8 Upfront payments, 108 Warranties, 113–5, 138 Water treatment plants, 34, 173–4 procurement, 155–65 Water and Desalination Authority (WDA), 156 Working capital, 27 Worst case scenario, economic parameters for, 53–4 Zero coupon bonds, 29 Zero-cost collar, 93

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