What is project finance?

1. What is project finance? “A form of financing in which lenders look solely or primarily to the cash flows of a project to repay debt service and to all of the underlying project assets (including all physical and contractual assets) as collateral for the loan. Also known as limited or non-recourse financing.” (IFC) It should be noted that while limited recourse is the rule (after completion of the project), some project financings have full recourse to the project sponsors. And if the project fails to meet the conditions for completion, then the financiers have full recourse to the sponsors.

2. Costs and risk entirely borne by the main project sponsor(s) Development phase The different phases of a project financing High costs are incurred. Financiers will normally not take large risks on efficient engineering and construction and ask the project sponsors to cover these risks. Engineering & construction phase Lenders will only consider the project complete once it has worked for some time at the cost and to the specifications previously arranged. This phase may last from a few months to several years. Start-up phase Operational phase Once the project has operated according to specifications for the arranged minimum time. The different phases will have different financiers (with capital market investors coming in at the operational phase), and different risk takers.

3. Main sources of funds Sponsors. Sponsors provide equity and subordinated loans. Even if the project looks good, banks will generally insist that sponsors take a significant financial exposure in the project, simply to ensure that they will make an effort to make the project successful. Banksprovide senior debt, normally on a secured basis. Because of the usually large amounts involved, most projects involve a syndicate of banks. The arranger or lead managers (1-3 banks) carry the negotiating responsibility with the borrower and the participating banks. The agent bank (usually one of the lead managers) arranges the documentation and loan disbursements. The lead managers arrange a syndicate of banks, first choosing the managers (2-6 banks) and the co-managers (3-10 banks) whose ranking depends on the amounts of the loan; and finally the participating banks. The types of bank syndicates vary from fully underwritten or club deals among the lead managers to best-efforts commitment to raise money over and above the amount committed by the lead managers. A fully underwritten financing requires a slightly higher interest margin than a best-efforts financing. Export credit and multilateral agencies. Many governments provide longer-term project finance as well as guarantees to their country’s companies. The World Bank group as well as the regional development banks also provide loans and guarantees. Capital market investors.Investment funds and institutional investors have considerable interest in investing in buying project bonds. In the United States, the major market is the private placement market, under rule 144A. Others: Leasing companies, raw material and equipment suppliers, buyers and contractors may be able to provide funds.

4. Main supporting elements of the transaction Contractual arrangements: - with construction companies could be used to ensure certain maximum construction costs. - with electricity/gas suppliers, to lock in part of long-term operation cost; but be careful, are these not ultra vires? - with offtakers, perhaps guaranteeing prices or minimum payments. - with service providers (eg, maintenance contracts), which could “lock in” certain minimum performance standards. - between financiers and sponsors, eg, for the latter to buy the financiers out if completion is not reached in time. Cross-default clauses: can be a powerful tool to reduce default risk, in particular if multilateral lenders are involved. Insurance: is this more than just a moral support? Guarantees: it is important to verify that these are not ultra vires Government consents: with a sovereign risk that may be re-insured Escrow accounts: to ensure sufficient funds are held to meet debt obligations - is there a risk that the government will intervene in the arrangement? Special Purpose Vehicle: to isolate the project’s earnings stream from most outside interventions.

5. What risks will the financiers take? Design risk: this is the risk that the engineer/design work of the project was of poor quality. It can lead to major cost overruns and delays. The financiers will try to reduce this risk by insisting on the use of appropriate, experienced engineering firms, but will try to defer most of it through use of sponsor guarantees, insurance or independent certification of the engineering/design work. Engineering & construction phase Start-up phase Operational phase

6. What risks will the financiers take? Completion risk: the financiers will generally lay off this risk, and thus, other financial support is necessary prior to completion. Normally, “steps” are formulated to signal when the project is deemed “complete”. Once the project is “complete”, the financial supports which give the bank full recourse fall away, and the project starts its limited-recourse status. There are two main types of completion tests. One calls for the construction to be finished by a certain date and the loan is immediately due if completion has not occurred by that fixed date. A more common test is a >performance= completion test which might include all or some of the following: (a) Continuous operations for "A" consecutive months (b) (90%) of throughput/traffic achieved and delivered (c) Acceptable project availability/performance (d) On specification facilities/outputs (s) ; and (e) Achieve a defined operating cost per unit. Lately, completion tests are becoming more complex and can now include: (f) Supply/traffic completion test (that is, is the “supply” of commodities/ activities - such as number of cars using the toll road - sufficiently large) (g) Project life greater than "x" years (h) Net present values of cash flows greater than (150%) of loan outstanding; and (i) Financial covenants on working capital, debt, equity, net worth, are satisfied. The main sponsors (not necessarily all sponsors) must provide subordinated loans or additional equity until completion conditions are met. And usually, unless when other arrangements are made, if completion is not attained by a certain date, the financiers’ loan remains a corporate credit. Such other arrangements can include completion guarantees, stand-by facilities, shortfall pools, default agreements and insurance. Engineering & construction phase Start-up phase Operational phase

7. What risks will the financiers take? Sponsor (credit) risks: if one or more of the sponsors in the project is weak financially or technically (e.g., a local partner), the financiers are likely to require cross guarantees from the other sponsors. This is essential in order to cope with eventual cost overruns in the engineering and start-up phase. The formulation of the concession agreement or the joint venture agreement is essential in this regard. The clauses in this agreement regarding provisions for forfeiture, dilution of interest, and contingent financing will determine what happens if one of the sponsors runs into problems or is unable to contribute to cost overruns. It should be noted that in large projects, the major sponsors have a reputation at stake, and are unlikely to let the project fail, even if in principle, it is “ring-fenced” from their other operations. So having large corporate names involved often gives comfort to financiers (and rating agencies). Credit risk can also be mitigated by structuring the project in such a way that the underlying project assets have some collateral value to the financiers (mortgages, negative pledge). Engineering & construction phase Start-up phase Operational phase

8. What risks will the financiers take? Management risks: the experience of the management (shown, in preference, by having handled similar projects previously, and having worked in countries with a similar climate, culture and government infrastructure) and the availability of an adequate work force is essential for the success of a project. The companies involved in the actual operation of the project must also be financially strong, not only because a major contractor’s bankruptcy would seriously damage the project, but also because contractors can be called upon to provide extra resources should problems arise. The financiers implicitly accept much of these risks throughout the project financing, but will normally try to mitigate them through mechanisms like an employment contract or "key-man" insurance to ensure the continued involvement of the company and of strategic individuals. If ownership of the project is to change after some time (eg, handover to the local government), then a government guarantee on maintaining management structures can be included. Engineering & construction phase Start-up phase Operational phase

9. What risks will the financiers take? The environmental risk is one that financiers will generally try to avoid, even though at the end, it is impossible to defer it completely. All projects will have to be carefully examined for environmental aspects, not just to identify potential liabilities, but also to ensure that the project will go ahead as planned (e.g., there will not be delays in the construction phase because of environmental action). Early environmental approvals need to be obtained from the local government. The project sponsors can also be required to include an environmental plan in the project planning, from engineering to operations; to provide rehabilitation guarantees; to give the financiers waivers of any costs related to environmental problems in the project (or resulting from previous pollution on the sites used for the project); or to take out specific insurance. Engineering & construction phase Start-up phase Operational phase

10. What risks will the financiers take? Political risk: Political risk encompasses a range of risks such as nationalization, currency inconvertibility, regulatory and tax risks. Financiers are willing to take some degree of the political risk for certain countries, but will often give part of (specific) risks to third parties. The major mechanism is to use coverage provided by one of the export credit agencies or other similar government organizations; use multilateral guarantees (e.g., MIGA, or the World Bank’s partial risk guarantee - these include cross-default clauses); or use private insurance. Due diligence is also important. For example, the risk of currency inconvertibility can be fairly well identified and mitigated by measures such as obtaining a governments approval of escrow arrangements and guarantee of sufficient supply of foreign currency for paying the project debt . It is important to obtain all the necessary government approvals. It often, helps to have local parties involved in the project. The actual project agreement should be formulated so that it directly reduces political risk (e.g., by including a direct guarantee from the government not to subvert the project agreement). One can also have a separate concession agreement, or letter of understanding between the project company and the government, to spell out all relevant agreements. Financiers will try to obtain a government guarantee that the relevant tax regime will not be changed, but will still try to share the risk of tax increases with the project sponsors (limiting their own liability to a certain level). In order to avoid the triggering of default clauses, proper conditions need to be built into the financing to deal with temporary problems such as strikes – e.g., permitting additional time for loan repayment. Engineering & construction phase Start-up phase Operational phase

11. What risks will the financiers take? Force majeure risk concerns events outside of the control of either the borrower or the lender. Some element of political risk may be included in the definition of force majeure. Financiers can usually absorb temporary force majeure risk during both the construction and operating phases of the project due, for example, to a strike or unavoidable delay in the delivery of a crucial equipment part. But they will lay off the risk of longer-term force majeure, to the sponsors or, if it is available and affordable, business interruption insurance. The financing contract should spell out what are the consequences of specific forms of force majeure. For example, sponsors could be asked to take most responsibility for the effects of strikes. If one of the sponsors is a state entity, then this sponsor should be prohibited in the contract from using “nationalization”, change in local laws and regulations and the like as reason for invoking force majeure. Engineering & construction phase Start-up phase Operational phase

12. What risks will the financiers take? Foreign exchange risk can occur when project revenues differ from the currency of the project loan. Financiers usually avoid foreign exchange risk in project financing (especially after experiencing some serious losses due to lack of currency risk management in infrastructure projects in Asia). Foreign exchange risks before completion of the project are usually directly borne by the project sponsors, who have to make up any foreign exchange losses by additional funding. After completion, the risk is generally managed directly through the pricing of the project’s products or services. The best hedge is to match the loan currency to the (underlying) currency in which the price/tariff is set (which,brings some political risk in that, in case of a strong devaluation, the government may balk at the idea of drastically raising electricity rates or toll road fees). A further step is to match equipment purchases to the sales revenue currency. This can be done through the purchasing/sales contracts or through separate market-based hedging operations (swaps and the like). Often, one would need specific government approval to use escrow accounts, index prices in foreign currency or hedging markets. Engineering & construction phase Start-up phase Operational phase

13. What risks will the financiers take? Engineering & construction phase Legal risk. The supporting legal documentation of the project financing apportions the risks among the lenders, insurers, governments, buyers and sponsors. There is the risk, fully borne by the financiers, that this documentation is ambiguous, or poorly formulated. This would create problems with taxes, enforcement possibilities and the like. It is often worthwhile to obtain a second opinion on a project’s legal documentation. ) Start-up phase Operational phase

14. What risks will the financiers take? Engineering & construction phase Technical risk: the risk that the facility will not work as planned because of technical defects (before completion, this is the sponsors’ risk). Generally, the financiers will be willing to accept these risks if: (a) Known and proven technology is used; (b) The facilities are projected to remain technologically competitive; and (c) Plant/project life is twice the funding life. To ensure this, they will scrutinize all technical documentation and will probably directly discuss with the project’s technical consultants. Even then, the financier will include in the financing a “prudent operator” clause (covenants to ensure that the company applies generally accepted practices and obeys the applicable laws including environmental regulations). If untried technology is used, the financier will normally insist on a technology warranty from the company that owns or licenses the technology. Start-up phase Operational phase

15. What risks will the financiers take? Engineering & construction phase Start-up phase Operating performance risk: the financiers are dependent on the continuing proper operation of the project, and the proper sale of its products/services. They will normally protect themselves by requiring the project company to maintain ratios and project covenants for maintenance of working capital, payment of dividends and build-up of cash. It is also possible to obtain performance bonds and guarantees from equipment providers with respect to quantity and quality of output, or their compensation could be explicitly linked to performance. Generally, the project would include a maintenance contract with penalty clauses if performance is not up to standards. Operational phase

16. What risks will the financiers take? • Operating costs:the financiers will accept part of this risk after appropriate analysis, but will try to mitigate it through one or more of the following means: • cost guarantees or cost waivers by the sponsors • guaranteed forward sales contracts which put the burden of cost increases on offtakers • longer-term inputs/feed stocks/services supply contracts at fixed costs (“supply-or-pay” contracts, which also contain clauses under which the supplier must make up for any extra costs which may arise if unable to supply and inputs need to be purchased from another entity). The financiers should consider the reliability of the supplier and their economic interests in meeting the contract. • longer-term inputs/feed stocks supply contracts at a cost directly related to realized sales prices • if the inputs/feed stocks are to be imported, a government guarantee that import duties/taxes will not be increased. Engineering & construction phase Start-up phase Operational phase

17. What risks will the financiers take? Engineering & construction phase Reserve risk (also known as supply or, in certain types of projects, traffic risk): the financiers will generally accept this risk, but to do this will require extensive independent studies. The financiers should never simply accept the sponsors’ estimates (one US bank fell bankrupt and several others into a deep crisis in the early 1980s because they had not properly verified the size of oil reserves against which they had made production payment loans. Furthermore, several banks have had problems due to over-estimates of traffic flows on toll-roads). If financiers have some concern that reserves or supply will be insufficient, they will ask for a warranty from the sponsors or other parties. E.g., a supply undertaking by a relevant government company; collateral; or a deficiency/make-up agreement with one of the sponsors or related entities. Start-up phase Operational phase

18. What risks will the financiers take? Market risk is traditionally not taken by the financiers, but mitigated in a number of ways. It should be noted however, that since the late 1990s, there is a growing appetite of some capital market investors to accept selected price risks in project financings. Market risks is the result of falling prices, or falling sales( the latter, in turn, can be the result of non-competitive production costs, the new entry of competing suppliers/products or low quality of production). In project financings, risk has generally been absorbed through long-term contracts extending beyond the end of the loan life. These can be take-and-pay, or take-or-pay contracts. As a general rule of thumb, the financiers aim for the net present value of the sales proceeds net of operating costs to be at least 1.3 times (or 1.15 to 1.3 for an infrastructure project) the amount of loan outstanding. Other mitigants include throughput guarantees or agreements (e.g., for use of a pipeline, or refinery by the project sponsors), including merchants/suppliers/final consumers in the financing (who then have a vested interest in making the project work), buy-back clauses (through which one of the sponsors or a related party guarantees a minimum price). Hedging is also possible. In case the project’s output is sold locally, the project financiers would normally insist that the price, even if denominated in local currency, is indexed to world market prices - this provides protection against currency devaluation. Engineering & construction phase Start-up phase Operational phase

19. Mitigating market risk Take-and-pay contract: the payment by the buyer is contingent upon delivery. If the project fails to lead to delivery, there is no obligation to pay. Usually, financiers do not take much comfort from this kind of sales contract, unless when the “performance” risk of the project can be adequately covered by other risk mitigants. Take-or-pay contract: a long-term contract to make periodic payments over the life of the contract in certain fixed or minimum amounts as payments for a service or a product. The payments are in an amount sufficient to service the debt needed to finance the project which provides the services or the product and to pay operating expenses of the project. Minimum payments must be made whether or not the service or product is actually delivered (even when the facilities are destroyed by some natural event! - the contract often includes a clause like “payments must be made ‘come hell or high water’”, a clause based on unconditional ship charters), and the contract is in principle not cancelable. The take-or-pay buyers will usually pay to a trustee which pays the debt service directly to the creditors. The take-or-pay buyer will normally protect its interests by retaining rights to take over the project if the supplier fails to perform - on the condition that, when doing so, he would automatically assume all project debt. Take-or-pay contracts have become increasingly common in recent years, and buyers are not necessarily limited to companies which are themselves among the project sponsors (although this remains most often the case). From a financier’s point of view, a take-or-pay contract is equivalent to a guarantee, but for a sponsor, it has less negative impact on its credit. The buyers should normally be credit-worthy companies. If there are doubts in this regard, the financiers can ask for (government) guarantees; for direct assignment of part of the buyer’s revenue stream (e.g., if the offtaker of an IPP is a mining company which itself is an exporter) or for an escrow account which covers several months’ debt service.

20. What risks will the financiers take? Engineering & construction phase Infrastructure risk: this risk is de facto absorbed by the financiers. The existing infrastructure (e.g., port capacity, electricity) determines to a large extent the economics of the project. This risk can be mitigated through the sales contract (which could be on an “ex-works” basis, or at least a f.o.b. basis) to shift as much as possible transportation cost increases to the buyers. Alternatively, one could enter into long-term transportation contracts. Also, if the government builds and operates the railways and ports that are to be used, a government undertaking toincrease taxes may be crucial. Start-up phase Operational phase

21. What risks will the financiers take? Engineering & construction phase Start-up phase Interest rate risk: most bank project financings are on a floating-rate basis. So if rates increase, there is a risk that cash flow will be insufficient to cover debt service. These risks can be mitigated by obtaining part of the required funds from capital market investors (who are often looking for long-term fixed-rate placements), or from government or multilateral entities such as export credit agencies or the World Bank. The remaining risks can be hedged using interest rate swaps and the like. Operational phase

22. The financiers’ typical security package Sponsors Precompletion guarantee Project funds agreement; other financial support; subordinated loans in case of shortfall of project cash flows Construction and operation supports; arrange turnkey (ie, fixed-price) construction contracts; supply key managers, arrange management contract Pledge of shares Project assets and cash flows Mortgage on project assets Offtake agreements to ensure output demand (quantity and price) Supply agreements Assignment of receivables Escrow accounts, onshore and offshore (local and foreign currency) Financial covenants Assignment of casualty insurance payments Other sources Entitlement payments related to government concessions (eg, assignment of compensation due if concessions are terminated early) Letter of credit Political risk insurance Source: International Finance Corp.

23. Project finance: the example of the creation of a new fertilizer company in Bangladesh (1994) The Karnaphuly Fertilizer Company was a greenfield project; that is, the whole facility had to be constructed from scratch. There were no existing receivables to help support the financing, instead, it had to be entirely constructed around future production. A few elements of the transaction: The ratio between equity investment and loans was highly favourable for Bangladesh. In effect, equity funds are leverage by more than 400 per cent. This type of leverage is rather exceptional and would have been impossible with a more conventional type of loan. The banks ensured that their loans were indeed used for constructing the fertilizer factory and were not diverted for other uses by using an independent third party to approve all project expenditures. Further comfort about the operational efficiency of the fertilizer plant was given by the fact that those constructing the plant were willing to take part of the equity. More than half of equity was held by foreign companies, which would keep a strong control over the day-to-day management of the fertilizer plant once it had come into operation. Equity investors (of which Government of Bangladesh 41 %) Investment:130 million US$ 7-10 year loans: 423 million US$ Bank syndicate Karnaphuli Fertilizer Company Ltd. Security over plant site, property, equipment

24. The fertilizer company (still only existed on paper) already sold forward its production. A Swiss and a Japanese company agreed to commit themselves to buy this entire production for an extendible period of at least seven years starting from the commencement of plant operations. These two companies also agreed to deposit their payments for the fertilizers in an offshore escrow account, from which the debt would be served. As protection against the risk that either of these two companies would go out of business before the end of the seven-year period, a back-up agreement with another company could have been signed, but the banks were comfortable with taking the risks on Transammonia and Marubeni. • The banks took additional security over the plant site and so on, but this was really just an extra protection. • Marubeni also took an equity stake in the fertilizer company. Karnaphuli Fertilizer Company Ltd. Take-and-pay contract to buy full urea output, at market price Take-and-pay contract to buy full ammonia output, at market price Marubeni (Japan) Payment for purchases Escrow account. Transammonia (Switzerland) Payment for purchases

25. To protect against the risk of nationalization, a withdrawal of the government’s approval of the escrow account, etc., the financiers obtained insurance from export credit agencies, which would be triggered if the Government interfered in the escrow account arrangements, or otherwise effectively appropriated the project. Export Credit Agencies Investment insurance cover Bank syndicate The escrow account agreement needed to be approved by the Government of Bangladesh, which duly did so. The Government also agreed that it would not limit the amount of foreign exchange available to this escrow account, for example by forcing the fertilizer plant to directly repatriate its foreign exchange cover. Government Guarantee to approve escrow account, and make foreign exchange available Escrow account.

26. There are also financial risks related to the profitability of the fertilizer company. To reduce these risks, a 20-year agreement was signed with Bakrabad Gas Systems, a Government parastatal, for the delivery of gas, the main feedstock of the fertilizer production process. The gas company promised the delivery of minimal annual amounts (which will ensure that the fertilizer company has sufficient inputs to produce the amounts of urea and ammonium needed to serve its financial obligations) and in addition, agreed to tie the payments for this gas to regional bulk market prices for urea. As a result, the fertilizer company automatically hedged one of its major price risks, locking in a minimum profit - a least, if it reaches the expected operational efficiency. The Government, in turn, guaranteed the gas company’s performance. Karnaphuli Fertilizer Company Ltd. 20-year gas supply contract at price linked to urea prices Bakrabad Gas Systems (BGSL) Government guarantee on contract performance BGSL Government

27. An example of a greenfield project: the Karnaphuly Fertilizer Company Ltd. (Bangladesh, 1994): the end-result Export Credit Agencies Equity investors (of which Government of Bangladesh 41 %) Investment insurance cover Investment:130 million US$ 7-10 year loans: 423 million US$ Bank syndicate Karnaphuli Fertilizer Company Ltd. Security over plant site, property, equipment 20-year gas supply contract at price linked to urea prices Bakrabad Gas Systems (BGSL) Take-and-pay contract to buy full urea output, at market price Government guarantee on contract performance BGSL Take-and-pay contract to buy full ammonia output, at market price Government Guarantee to approve escrow account, and make foreign exchange available Reimbur-sement Marubeni (Japan) Payment for purchases Escrow account. Transammonia (Switzerland) Payment for purchases

28. Click here for a case study on the financing of a small power plant expansion project in Africa