Project Finance By Melvin J. Howard
Introduction to health care risk finance
Project finance refers to the method of financing a particular project as a unit at least partially separate from the owner, or “equity sponsor,” of the project. This typically means that the financing must be repaid out of the cash flows generated by the project itself without recourse to the cash flows or assets of the sponsor. Projects appropriate for project finance are large in scale and require a large capital investment. In addition, such projects will normally involve a considerable delay between initiation and the first positive cash flow. Many of the projects are also outside of the home country of the sponsor and in many cases are in an emerging market. All of these, and other characteristics of typical project finance projects, introduce several different types of risk. The key to successful project finance is the identification and allocation of risk.
Often contractors and future operators sponsor the project and provide a large part of the equity while a syndicate of commercial banks provides debt financing. In addition, because project finance is often used to finance the private provision of public services, the local government is often involved in a contracting out or regulatory capacity and a state-owned enterprise might be one of the participants in the project. A complex contractual structure is usually established with lenders asking for maximum guarantees and securities from other players. The focus of risk allocation is usually on the construction and start-up period, which is generally the riskiest period in the project's lifespan.
Under the financing structures outlined below, investors must look to expected cash flows, as opposed to fixed assets, for repayment. As a result, extremely careful risk assessment is necessary for each investor prior to investment. With any valuation model used to assess the value of the project, or any financial portion of the project, sensitivity analysis will be particularly important. Analyses, which improve the accuracy of the forecasts, and reduce the uncertainty surrounding the forecasts, such as engineering studies, market analyses, etc. will be well worth the time and effort.
The ability to obtain financing for a particular project, and the structure of the financing, are highly dependent upon the nature and characteristics of each project. Among the critical characteristics of a project are the various types and magnitudes of risk. There may be construction risk, currency risk, political risk, market risk, timing risk, along with many other types of risk. A successful project finance structure will efficiently allocate these various types of risks to those investors/participants most able and willing to assess and bear the risk. Doing so can reduce the cost of capital as an average compared to normal financing where the party providing the financing may not be comfortable and/or familiar with the risk and may attach a considerable cost premium to be willing to accept such risk.
Connected to this feature is the allocation of cash flows, risk and control in a way that provides the correct incentives for the participants to the project. Whereas debt and equity financing at the firm level
1
and traditional construction/operating contracts may provide distorted incentives, a carefully structured project financing structure can mitigate or remove such problems for each individual project. By allocating risk to those parties in a position to control the risk we can ensure that the various participants have proper
1 For example, the incentive problem associated with too much debt which leads equity holders to prefer very risky projects over safer projects with higher net present values.
incentives. For example, by assigning the construction risk to the developers so that they bear the cost of a delay in completion or a cost overrun, we can align their incentives with those of the remaining sponsors.
There is also the off-balance sheet nature of project financing that may be attractive to many sponsors. This is especially true the larger the project and the further away the eventual positive cashflows. As stated above, both the project’s assets and the financing, which is non-recourse to the sponsor, are legally separate from the sponsor except to the extent that the sponsor holds equity in the project company. Thus, the large amount of financing necessary to move the project forward does not appear on the sponsoring firm’s balance sheet. While often cited as a benefit and reason for project finance, the real value of this off-balance sheet feature depends on the efficiency (or lack thereof) of the capital markets as will be discussed below.
There are often tax advantages to carefully structured financing plans. Countries often provide large tax concessions or other tax incentives to encourage investment. However, taking full advantage of these tax breaks often requires specialized financing (such as leasing techniques in Western Europe and North America). In order to benefit from these tax incentives in developing countries, it is generally necessary to incorporate locally, which results in project financing as we know it.
We can view project financing as a form of financial engineering, where each project is carefully examined to determine the optimal structure given its particular characteristics. In such a way, the overall cost can be minimized, providing maximum value for the participants. Indeed, such financial tailoring may enable the undertaking of many large projects which might never get off the drawing table if only conventional modes of financing were available.
As with all activities, there are costs and benefits to project finance. The clear allocation of risks, cashflows, and ownership rights almost certainly reduces agency costs and bankruptcy costs. The project financing is also structured to reduce tax liabilities, avoid borrowing restrictions, and improve management of political risk. However, arranging and tailoring the financial structure for a project is a tedious, timeconsuming and expensive task. This imposes additional information gathering, monitoring, and contracting costs relative to traditional forms of financing. An additional cost for the owner due to the use of a project finance structure is the reduced transferrability of the equity investment. While secondary markets for project equity interests exist, these are typically very illiquid.
The Participants and Players Ownership and Equity
In a typical project financing, the sponsors establish a project company as either a partnership or as a corporation. This will be the legal owner of the assets of the project and will be usually be legally responsible for the repayment of all financing used to support the construction and operation of the project. In many cases, the project company has a pre-specified, limited life corresponding to the length of the concession granted by the local government or the amount of the natural resource available for extraction. Because of the size and complexity of most projects for which project finance is appropriate, there is rarely a single sponsor. The various sponsors are chosen to obtain the synergistic benefits of complimentary strengths. These will typically include a combination of financial, operating, and construction expertise.
As a result of multiple owners, the project company must be set up as either a partnership or a joint venture to legally clarify the rights and obligations of the multiple sponsors. Each of these structures has benefits and costs which will determine the choice made by the sponsors:
Partnerships
· partners can be held responsible for liabilities of partnership
· partnerships have some tax benefits for sponsoring corporations (taxes are not paid at the project company level on distributed earnings)
sponsors can form subsidiaries which are nominally capitalized, to enter into partnerships, thereby limiting liabilities while still enjoying tax benefits
Joint Ventures
· sponsors’ liability is limited to their investment
· each sponsor owns undivided interest in project as tenants in common sponsors can sue each other for breach of contract (particularly important with combinations of financial and construction or operating sponsors)
similar to corporation status for tax purposes
usually find it difficult to borrow in JV’s own name. Borrowing is obtained through additional structures (operating or leasing companies are established among other arrangements)
While the operator/sponsor maintains operating control, it normally gives up flexibility compared to internal financing.
Debt Financing Bank debt
A major portion of the financing is in the form of debt. As mentioned above, the main distinguishing feature of project finance debt is that it has limited or no legal recourse to the sponsor for repayment. Thus, the debt is supported exclusively by the equity investment in the project and the cash flows and assets of the project itself. While this structure preserves the debt capacity of the sponsors, it limits coverage for lenders to the project. In an efficient market this should not change the overall cost of borrowing. As the distinction between on and off-balance sheet financing is purely an accounting one, its value depends on its impact on the tax treatment of the firm’s actual cash flows.
Conventionally, project debt is arranged with a syndicate of banks. The specialized project finance departments within several large banks, with knowledge of the risks involved, are able to provide a lower cost of financing than banks unfamiliar with such projects. Bank debt generally contains specific performance thresholds and other restrictive covenants. In addition, the banks closely monitor the project company to ensure that covenants are respected. There are often clearly defined roles for various banks to play in arranging and managing the loans, providing trust services (for security assets), and monitoring technical aspects of the project and project performance.
The bank financing will often have partial or full recourse during the development and construction phases, with repayment guarantees disappearing upon attainment of pre-specified completion conditions. An alternative to the two extremes of full recourse debt or non-recourse debt is given by multiple-tranche debt. In its recent offering to finance eight Scottish cable franchises, Telewest split its £190 term loan with
the Canadian Imperial Bank of Commerce (CIBC) into two tranches. A totally non-recourse tranche of £122 was at a cost of Libor + 250 basis points while the second tranche of £72.5 held a repayment guarantee from Tele-Communications Inc. (TCI) and US West and had a cost of Libor + 62.5, both with maturities of 9 years 7 months.
While we continue to talk about the legal distinction between recourse and non-recourse debt, there is more involved than simply the legal standing of each party. In most projects, even with non-recourse loans, lenders have a form of (non-legally binding) recourse, which hinges on the sponsors’ inability to walk away from project. If leaving the project would be detrimental to the sponsor’s ongoing business or reputation, this provides a form of recourse or security for lenders. Indeed, the larger the equity investment of the sponsor (while a sunk-cost for the sponsor and therefore immaterial in future decision-making), the better the terms on non-recourse loans and the easier is access to public bond markets. The perception that sponsors cannot easily walk away from the project inspires confidence in lenders.
Public Bonds
Increasingly, project companies are able to issue bonds either to be placed privately or publicly. The key to the use of “public” debt in project finance is Rule 144A which permits qualified investors to trade what would otherwise be private debt as if it were public bonds. The benefit of bonds vis a vis bank debt depends upon several factors. Some believe that it is easier to get longer maturity loans from the markets than from the banks which are not comfortable making loans of longer maturity than twelve to fifteen years. Another often cited benefit is flexibility. In some cases project companies are able to obtain borrowing at costs comparable to bank loans but with less restrictive covenants by using bonds. According to partner Tony Bankes-Jones at the UK law firm Clifford Chance, “Bond investors tend to be less concerned than bankers in making sure that things are running correctly on a day-to-day level. Due diligence tests are easier and covenant elements such as negative pledges are normally less rigorous.”
Summer 1994 witnessed two public issues byUK cable companies; Videotron for $200 million and Bell Cablemedia for $300 million. The Videotron issue has no interest payable for first 5 years, with repayments starting semi-annually and a final bullet payment of $342 in 2004 yielding 11.125%. While this repayment structure is tailored to Videotron’s cashflow forecasts, the bonds required a swap from dollars to sterling which resulted in a cost which was not below a syndicated loan. “The real advantage was in the covenant requirements, which were considerably easier than on a normal term loan,” according to Videotron’s finance director Julian Riches. However, both issues received a B2 (speculative) rating from Moody’s, which cited the companies’ “lack of operating profitability.”
The rating is a significant hurdle and is important because pension funds and insurance companies can invest only in investment-grade bonds. Obtaining an investment grading is rarely possible for nonrecourse bonds, and is especially unlikely to projects in emerging markets. According to S&P, “projects cannot be rated higher than the countries in which the projects are being built.” S&P now publishes a criteria list by which project bonds will be judged such as the strength of turnkey construction contracts, the presence of dollar-based escrow accounts,etc. In attempting to satisfy these requirements however, the issuer undermines the main advantage which bonds hold over syndicated bank loans; greater flexibility. With increasing use of the public markets, the ratings agencies could become an important third party in the project financing process.
The Third Parties
Financial advisers, lawyers and experts
In addition to the sponsors and lenders, there are several other parties intimately involved in various stages of the project. Financial advisers and lawyers will normally b employed by different investors, or the local government when concessions are being granted, to ensure that local institutional, currency, market, and tax conditions are fully exploited. The financial advisers often prepare detailed reports on the economic feasibility of the project and present scenario analysis to determine the likelihood and magnitude of success or failure. Also involved in assessing the viability of the project will be technical experts, hired by different investors to validate claims and statements made by the sponsors.
International Financial Institutions
International Financial Institutions (IFIs) include the multilateral World Bank's group and regional development banks such as the Asian Development Bank. The World Bank and the regional development banks (the African Development Bank, the Inter-American Development Bank, the Asian Development Bank) advise and lend to governments and state-owned entities of recipient countries. The International Finance Corporation (IFC) is the private arm of the World Bank Group, and advises private corporations in recipient countries and provides them with equity and debt financing. The European Development Bank (EBRD) is the most recent IFI. It was created after the fall of the Iron curtain to help former centrally planned economies achieve the transition to free-market economies and democracy.It plays the role of both the World Bank and IFC, advising both governments and private corporations, and lending to them, as well as supplying equity to private corporations.
A key feature of the IFIs is their “ preferred creditor status ”vis-a-vis recipient countries. In case of difficulties, recipient countries always comply first with their obligations vis-a-vis the IFIs, before serving commercial banks’ debt service. No country has ever defaulted to an IFI because, in doing so, it would completely lose credibility in financial markets and deny itself any future support from the IFI community.
The IFIs usually act as a catalyst, providing only a share of the financing required, and attract cofinancing from other lenders, including commercial banks. For instance, for every $1 in financing approved by the IFC for its own account in fiscal 1994, other investors and lenders provided $5.43 through cofinancing or loan syndication and securities underwriting by the IFC. Under the A/B loan structure, the preferred creditor status of the IFI is in effect extended to the other lenders. Thus, having an IFI involved in a deal makes the project considerably more attractive to private financiers. Under an A/B structure, the IFI co-syndicates the loan with a private bank. The loan is split into 2 loans. The A loan is a loan provided exclusively by the IFI while the B loan is from the syndicate of private banks. The IFI acts as a lender of record for the B loan but does not take underwriting or commercial risk related to the B loan. Because the IFI is a lender of record, it removes all convertibility risk for the banking syndicate.
In addition, the involvement of IFIs also reduces the risk of unfavorable government interference with the project. IFIs advise recipient governments on, and often participate in, the establishment of a suitable legal and regulatory framework before the project is negotiated.
Export Credit Agencies (ECAs)
There is a wide variety of Export Credit Agencies. Some are government agencies, while others are private companies. They traditionally provide insurance or guarantees to exporters who are supplying equipment
or constructing projects, and/or to the banks who are lending to the project. The ECA cover usually embraces both political and commercial risks. This insuring activity is typical of some of the largest ECAs such as the Japanese EID/MITI,the German Hermes, the British ECGD, the French COFACE, the Italian SACE and the Spanish CESCE. In addition, some ECAs lend directly to the project. This is the case of the US EXIMBANK, the Canadian EDC, the Australian EFIC, and the Austrian OeKB.
The medium and long-term political risks insured by the ECAs are usually ultimately taken by their home Governments. In addition, the private, Overseas Private Investment Corporation (OPIC), has for many years specialized in providing political risk insurance to firms engaged in project finance in foreign, and especially, emerging markets.
Of course, there are many other types of risks which are traditionally insurable by large insurance companies such as liability for workers on a site, environmental liability, etc. These will also be used in project financing in the conventional ways.
The Host Government
The host government, except in infrastructure build-operate-transfer (BOT) projects, is normally a very passive player. The local tax and environmental laws often play a crucial role in the nature of the financing and in the feasibility of the project, but, except for some negotiation, the government’s role is not normally very large. I will discuss BOT projects in the future.
