Risk Management in Context of Project Financing of Infrastructure Project

1
Risk Management in Context of Project Financing
of Infrastructure Project
Prof. GLENN P. JENKINS DEPARTMENT OF
ECONOMICS EASTERN MEDITERRANEAN UNIVERSITY NORTH
CYPRUS
2
PROJECT FINANCE

• 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.

3
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

4
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)

5

• 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

6
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

7
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.

8
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.

9
The Basic Elements of a Project Financing
Lenders
Loan funds
Debt repayment
Purchase contract(s)
Raw materials
Assets comprising the project
Suppliers
Purchasers
Supply contract(s)
Output
Equity funds
Returns to investors
Cash deficiency agreement and other forms of
credit support
Equity investors
10
Prerequisites for Project Financing

• Financial Analysis
• Economic Analysis
• Risk Analysis

11
Its All About Risk!
The key to project financing is the reallocation
of any risk away from the lenders to the project.
12
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)

13
Management and Alleviation of RisksPrinciple
Categories of Risk Pre-Completion and
Post-Completion

• APre-Completion Risks
• Some Examples of
• Ways 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

14
Management and Alleviation of Risks

• APre-Completion Risks (contd)
• Some Examples of
• Ways 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

15
B. Post-Completion Risks

• Some Examples of
• Ways 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

16
B. Post-Completion Risks

• 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

17

• Some Examples of
• Ways 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/expropri
  ation, - 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

18
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 partys best interest for the
  project financing to succeed.
• Only then will all parties do everything they can
  to make sure that it does succeed.