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Risk Management in Context of Project Financing

of Infrastructure Project

Prof. GLENN P. JENKINSDEPARTMENT OF ECONOMICS

EASTERN MEDITERRANEAN UNIVERSITY NORTH CYPRUS

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What is Project Finance?

• No universally accepted definition of the term “Project

Financing” -- different people use it in different senses.

• Project financing refers to a financing in which lenders to a

project look primarily to the cash flow and assets of that project

as the source of payment of their loans.

PROJECT FINANCE

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Origins and Development of Project Finance

• Project financing had its origins in the energy industry in industrialized countries (oil & gas production loans).

• Later extended to infrastructure, transportation, mining, utilities and large industrial projects.

• Scope further expanded to include all kinds of infrastructure projects.

• Today even medium-scale projects (US $5 million) can use project finance

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Development of Project Finance

1994 1996 1997• Number of Project Finance Transactions 50 400 380 in emerging markets

• 41% of emerging markets project finance flows between 1994 and 1998 went to Asia.

• About 75% of project finance flows worldwide went to infrastructure and energy in 1999.

Source (IFC 1999), Capital Data Project Finance Ware (2000)

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Why Project Financing?• Project Owners’ Perspective

– Size and cost of projects

– Risk minimization

– Preservation of borrowing capacity and credit rating

– May be only way that enough funds can be raised

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Private Public Partnerships in Infrastructure

• A major new user of project financing techniques• Infrastructure traditionally financed and managed by

governments• Demand for infrastructure has been growing faster than

available government funding particularly in emerging economies.

• Recent trend has been to involve the private sector in the supply and provision of these services

• There has to be a clear benefit for both the public and the private partners

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Main Characteristics of Suitable Investments for Projects Financing

The ideal candidates for project financing are capital

investment projects that

are capable of functioning as independent

economic units,

can be completed without undue uncertainty, and

When completed, will be worth demonstrably more

than they cost to complete.

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Main Characteristics of Project Finance (Summary)

– Project is a distinct legal entity.

– Project assets, project-related contracts, and project cash flows are separated to a large degree from the sponsors.

– Sponsors provide limited or no recourse to cash flow from other assets.

– Lenders may have recourse to their funds through other stakeholders through various types of security arrangements.

– Two-phase financing is common.

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The Basic Elements of a Project Financing

Loan funds

Debt repayment

Equity funds

Returns to investors

Cash deficiency agreement and other forms of credit support

Equity investors

Lenders

Suppliers Purchasers

Raw materials

Supply contract(s)

Purchase contract(s)

Output

Assets comprising the project

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Prerequisites for Project Financing

• Financial Analysis

• Economic Analysis

• Risk Analysis

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It’s All About Risk!

The key to project financing is the reallocation of any risk away from the lenders to the project.

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Definition of Project Completion• Principle Categories of Risk: Pre-Completion and Post-

Completion

• Physical Completion

– Project is physically complete according to technical design criteria.

• Mechanical Completion

– Project can sustain production at a specified capacity for a certain period of time.

• Financial Completion (financial sustainability)

– Project can produce under a certain unit cost for a certain period of time & meets certain financial ratios (current ratio, Debt/Equity, Debt Service Capacity ratios)

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Management and Alleviation of RisksPrinciple Categories of Risk: Pre-Completion and Post-Completion

A:Pre-Completion Risks:Some Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

•Participant Risks-Sponsor commitment to project - Reduce Magnitude of investment? -Require Lower Debt/Equity ratio

-Finance investment through equity

then by debt

– Financially weak sponsor - Attain Third party credit support for weak sponsor (e.g.,Letter of Credit)

- Cross default to other sponsors•Construction/Design defects - Experienced Contractor

- Turn key construction contract

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Management and Alleviation of Risks

A:Pre-Completion Risks (cont’d):Some Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

•Process failure - Process / Equipment warranties•Completion Risks

– Cost overruns - Pre-Agreed overrun funding- Fixed (real) Price Contract

– Project not completed - Completion Guarantee- Tests: Mechanical/Financial for

completion– Project does not attain - Assumption of Debt by Sponsors if

mechanical efficiency not completed satisfactorily

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B. Post-Completion RisksSome Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Natural Resource/Raw Material– Availability of raw materials - Independent reserve certification

- Example: Mining Projects: reserves twice planned mining

volume- Firm supply contracts- Ready spot market

• Production/Operating Risks– Operating difficulty leads to - Proven technology insufficient cash flow - Experienced Operator/ Management Team

- Performance warranties on equipments

- Insurance to guarantee minimum cash

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Some Examples of

Ways to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Market Risk–Volume -cannot sell entire output - Long term contract with creditworthy

buyers :take-or-pay; take-if-delivered; take-and-pay

–Price - cannot sell output at profit - Minimum volume/floor price provisions - Price escalation provisions

• Force Majeure Risks–Strikes, floods, earthquakes, etc. - Insurance

- Debt service reserve fund

B. Post-Completion Risks

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Some Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Political Risk–Covers range of issues from - Host govt. political risk assurances

nationalization/expropriation, - Assumption of debtchanges in tax and other laws, - Official insurance: OPIC, COFACE, EXIM

currency inconvertibility, etc. - Private insurance: AIG, LLOYDS- Offshore Escrow Accounts

- Multilateral or Bilateral involvement

• Abandonment Risk–Sponsors walk away from project - Abandonment test in agreement for banks to run project closure based on historical and

projected costs and revenues

• Other Risks: Not really project risks but may include:–Syndication risk - Secure strong lead financial institution–Currency risk - Currency swaps / hedges –Interest rate exposure - Interest rate swaps –Rigid debt service - Built-in flexibility in debt service

obligations–Hair trigger defaults

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The Need for Contracts Project financing arrangements invariably involve strong

contractual relationships among multiple parties. Project financing can only work for those projects that can

establish such relationships and maintain them at an acceptable cost.

To arrange a project financing, there must be a genuine “community of interest” among the parties involved in the project.

In must be in each party’s best interest for the project financing to succeed.

Only then will all parties do everything they can to make sure that it does succeed.