Project Finance

Professor Pierre Hillion

 Project Finance

“A project company is like a leveraged buyout (LBO),

except that an LBO is a financing decision involving
existing assets, whereas project finance is an
investment and a financing decision involving new
assets”
B. Esty

2
 Outline 

• Introduction

• Part 1: Overview of Project Finance

• Part 2: Statistics

• Part 3: Project Finance versus Corporate Finance

• Part 4: Leverage and Financing Issues

• Conclusion

• Appendices
3
INTRODUCTION
Definition: Project Finance
 Definition of Project Finance 

Project Finance (PF) involves:

• the creation of a legally independent project company

• financed with:
-non-recourse debt
-equity from one or more sponsoring firms
• for the purpose of financing an investment in a single-
purpose capital asset

• usually with a limited life.

5
 PART 1

Overview of Project Finance

 Overview of Project Finance: Parties Involved

• Sponsors and investors: they are generally involved in the construction and the management
of the project. Other equity-holders may be companies with commercial ties to the project, i.e.,
customers, suppliers…

• Lenders: The needed finance is generally raised in the form of debt from a syndicate of lenders
such as banks and less frequently from the bond market.

• Government: project company need to obtain a concession from the host government.
– Role of type of contract: Build-own-operate (BOO) or Build-transfer-operate (BOT).
– Control on revenues such as for example: Eurostar, British Jail,

• Suppliers and Contractors: Role of turnkey contracts to make sure that construction is
completed within costs and on schedule. Turnkey contracts specify a fixed price and penalties
for delays.

• Customers: Depending on the contract, multiple or a single customer.

7
 Overview of Project Finance: Main Characteristics 

• Organizational Structure
- Project companies involve separate legal incorporation.

• Capital Structure
- Project companies employ very high leverage compared to public firms.

• Ownership Structure
- Project companies have highly concentrated debt and equity ownership structures.

• Board Structure
- Project boards are comprised primarily of affiliated directors from the sponsoring
firms.

• Contractual Structure
- Project finance is referred to as “contract finance” because a typical transaction
involves numerous contractual agreements from input suppliers to output buyers.
8
 Overview  of Project Finance: Main Characteristics

• Independent, single purpose company formed to build and operate the project.

• Extensive contracting
– As many as 15 parties and up to 1000 contracts.
– Contracts govern inputs, construction, operation, outputs.
– Government contracts/concessions: one off or operate-transfer.
– Ancillary contracts include financial hedges, insurance for Force Majeure, etc.

• Highly concentrated equity and debt ownership

– One to three equity sponsors.
– Syndicate of banks and/or financial institutions provide credit.
– Governing Board comprised of mainly affiliated directors from sponsoring firms.

• Extremely high debt levels

– Mean debt of 70% and as high as nearly 100%.
– Balance of capital provided by sponsors in the form of equity or quasi equity (subordinated debt).
– Debt is non-recourse to the sponsors.
– Debt service depends exclusively on project revenues.
– Has higher spreads than corporate debt. 9
 Overview of Project Finance: Contractual Agreements

Contractual and financing arrangements between the various parties are essential in project
finance:

• Concession agreement with a government

• Engineering, Procurement and Construction (EPC) Contract
– between the Project Company & the Engineering Firm
• Operations and Maintenance (O & M) Agreement
– between the Operations Contractor and the Project Company, obligates the Operator to
operate and maintain the project
• Shareholders Agreement
– governs the business relationship of the equity partners
• Inter-creditor Agreement
– an agreement between lenders or class of lenders that describes the rights and obligations
in the event of default.
• Supply Agreement
– agreement between the supplier of a critical key input and the Project Company (e.g.
agreement between a coal supplier and a power station)
• Purchase Agreement
– agreement between the major user of the project output and the Project Company
– agreement between a metropolitan council and a power station 10
 Overview of Project Finance: Return Distribution

• Capital providers earn an appropriate risk-adjusted rate of return on a portfolio

of investments by earning, either high rates of return on just a few
investments, or low rates of return on many projects. The former corresponds
to the venture capital (VC) industry, and the latter to PF.

• VC is used for intangible assets with significant return uncertainty and little
residual value in the event of failure. Equity has an effective payoff structure
because it allows investors to capture unlimited upside. In contrast, debt does
not work for these high risk investments with positively skewed returns. In VC,
managers are responsible for managing growth options and transforming a
small amount of capital into large companies.

• In PF, managers are responsible for transforming a large amount of capital

into something worth a little more. Project returns have a limited upside. This
means that a large fraction of projects must be successful and generate
positive returns for capital providers to earn proper returns.
11
 Overview of Project Finance: Return Distribution
• Projects are exposed to three types of risk:

- Symmetric risks including: market risk (quantity), market risk (price), input
or supply risk, exchange, interest and inflation rate risks, reserve risk,
throughput risk. Exposures to symmetric risks causes larger positive and
negative deviations from the expected outcome.

- Asymmetric risks including: environmental risk, expropriation risk. These

risks cause only negative deviations in the expected outcome.

- Binary risks including: technology failure, full expropriation, counterparty

failure, regulatory risk, force majeure…These risks increase the probability
that an asset ends up worthless.

• In practice, projects have relatively low asset risk allowing a high debt
capacity. The use of leverage introduces financial risk which allow equity-
holders to capture unlimited upside once debt claims have been satisfied. 12
 Overview of Project Finance: Risk Management Matrix
Stage and Type of Risk Who Bears the Risk
Pre Completion Risk

- Resource risk Sponsors (suppliers)

- Force majeure 3rd party insurers
- Technological risk Sponsors (contractors)
- Timing or delay risk Sponsors (contractors)
- Completion risk Sponsors (contractors)

Operating Risks

- Supply or input risk Sponsors (suppliers)

- Throughput risk Sponsors
- Force majeure 3rd party insurers
- Environmental risks Sponsors
- Market risk: quantity Sponsors (off-taker)
- Market risk: price Sponsors (off-taker)

13
Overview of Project Finance: Risk Management Matrix

Stage and Type of Risk Who Bears the Risk

Sovereign Risk

Macroeconomic Risks
- Exchange rates Sponsors
- Currency convertibility Sponsors
- Inflation Sponsors

Political and Legal Risks

- Expropriation Sponsors
- Diversion Sponsors
- Changing legal rules Sponsors
Financial Risks

- Funding risk Sponsors

- Interest-rate risk Sponsors
- debt service risk Sponsors

14
 Overview of Project Finance:
Comparison with Other Forms of Financing  

Financing vehicle Similarity Dis-similarity

Secured debt Collaterized with a Recourse to

specific asset corporate assets and
CFs
Subsidiary debt Possible recourse to
corporate balance
sheet

Asset backed Collateralized and Hold financial, not

securities non-recourse single purpose
industrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backed Concentrated equity Lower debt levels;

companies ownership managers are equity
holders
Lease Recourse to the
lessor 15
PART 2
Statistics
 Project Finance Statistics
• Historically project finance was used by private sector for industrial projects, such as
mines, pipes, oil fields. In the early 70s, BP raised $945 million to develop the “Forties
Field” in the North Sea.

• The beginning of modern project finance starts with the passage of the Public Utility
Regulator Act in 1978 in the US to encourage investment in alternative non-fossil fuel
energy generators.

• From early 1990s, private firms start financing a wide range of assets such as toll
roads, power plants, telecommunications systems located in a wider range of
countries.

• Project sponsors have been pushing the boundaries of project finance for most of the
last 15 years by increasing sovereign, market and technology risks.

• World Bank study: global investment in new infrastructure assets $369 billion per year
from 2005-2010 with 63% in developing nations, e.g. Asia, Africa.
17
 Project Finance Statistics 
• Outstanding Statistics:

– Over $408bn of capital expenditure using project finance in 2008.

– US$67bn in US capital expenditures which is:
• smaller than the US $645 billion investment grade corporate bonds market,
$187 billion mortgage-backed security market, $160 billion asset-backed
security market, and $387 billion tax-free municipal bond market (NB: these
markets shrank significantly in 2008 from 2006 levels due to subprime crisis).
• but larger than the $26bn IPO market and the $45bn venture capital market.

• Some major deals:

– US$10.65bn 2005 Qatargas 2 project (LNG production) – involved 57 lenders

– US$3.8bn 2006 Peru LNG plant
– US$3.7bn 2007 Madagascar Nickel-Cobalt Mining and Processing Project
– In Singapore, US$1.4bn Singapore Sports Hub
18
 Project Finance Statistics
Total Project Finance Investm ent (US$m )

$4 50

$4 0 0 Overall 5-Year
$3 50 CAGR of 19% for
private sector
$3 0 0
investment.
$2 50
Project Lending 5-
$2 0 0 Year CAGR of
21%.
$150
$10 0

$50

$-
2003 2004 2005 2006 2007 2008

Bank loans Bonds MLA/ BLA Equity Finance 19

 Project Finance Statistics
Amount of Project Lending by Sector (US$m)

300 Other
250 Water & Sewage
Mining
200
Industrial
150 Telecom
100 Leisure & Property
Petrochemicals
50
Oil & Gas
0 Transportation
03 04 05 06 07 08 Power
2 0 2 0 2 0 2 0 2 0 2 0

• 34% of overall lending in Power Projects, 21% in Transportation. 22

 Project Finance Statistics

5-year CAGR in Project Lending by Sector

60%

50%

40%

30%

20%

10%

0%

• 5-Year CAGR for Power Projects: 30%, Oil & Gas:30%, Mining: 59% and
Leisure & Property: 36%. 23
 Project Finance Statistics

• Size distribution of projects:

- 41% < $ 100 million, (7% of the total value of the PF market)
- 19% > $500 million, (70% of the total value)
- 8% > $1.0 billion, (55% of the total value)
- mean size: $435 million, median size: $139 million

• Project duration:
- Mean (median) construction years: 2.1 (2.0) years
- Mean (median) concession contract: 28 (25) years
- Mean (median) length of off-take agreements: 19 (20) years

• Project leverage: Mean (median) debt-to-capitalization ratios: 71% (76%)

• Maturity of debt instruments:

-Median maturity of bank loans: 9.8 years
- Median maturity of bonds: 11.6 years
24
PART 3
Project Finance (PF) versus Corporate Finance (CF)
 PF versus CF: Rationale for Project Finance

Project finance allows firms:

• to minimize the net costs associated with market imperfections such as:

- incentive conflicts,
- asymmetric information,
- financial distress,
- transaction costs,
- taxes.

• to manage risks more effectively and more efficiently.

26
 PF versus CF: Rationale for Project Finance
Project Finance Corporate Finance

• Purpose: a single purpose capital • A company invests in many projects

asset, usually a long-term illiquid asset. simultaneously.
The project company is dissolved once
the project is completed. No growth
opportunities.

• A legally independent project: The • The investment is financed as part of

project company does not have access the company’s existing balance sheet.
to the internally-generated cash flows The lenders can rely on the cash flows
of the sponsoring firm and vice versa. and assets of the sponsor company
apart from the project itself. Lenders
have a larger pool of cash flows from
• The investment is financed with non- which to get paid. Cash flows and
recourse debt. All the interest and loan assets are cross-collateralized.
repayments come from the cash flows
generated from the project.

• Project companies have very high

leverage ratios, with the majority of • Publicly traded firms have typical
debt coming from bank loans. leverage ratios of 20% to 30%.
27
 PF versus CF: Rationale for Project Finance
• Modigliani and Miller show that corporate financing decisions do not affect firm value
under perfect and efficient markets. The rise of project finance provides strong
evidence that financing structures do matter.

• it is not clear why firms use project finance given that:

- It takes longer and it costs more to structure a legally independent project company
than to finance a similar asset as part of a corporate balance sheet.

- Project debt is often more expensive (50 to 400 bps) than corporate debt due to its
non-recourse nature (no benefit of co-insurance).

- The combination of high leverage and extensive contracting restricts managerial

discretion and managerial flexibility.

- Project finance requires greater disclosure of proprietary information which can be

costly from a competitive perspective.

- It is harder to obtain operating synergies as the project is independent.

- The likelihood of using interest tax shields and net operating losses is lower.
28
 PF versus CF: Rationale for Project Finance

• Financing decisions matter under imperfect/inefficient markets. Firms bear

“deadweight costs” (DWC) when they invest in and finance new assets.

• DWCs result from market imperfections. They include:

- agency costs and incentive conflicts

- asymmetric information costs
- financial distress costs
- transaction costs
- taxes

• DWCs change under alternative financing structures, i.e., corporate finance

versus project finance.

• Sponsors should use project finance whenever the DWC are lower than
their corporate finance counterparts.
29
 PF versus CF: Rationale for Project Finance

• Project finance reduces costly agency conflicts:

- Conflicts between ownership and control

- Conflicts between ownership and related parties
- Conflicts between ownership and debtholders

• Project finance reduces information costs (asymmetric information).

• Project finance reduces costly underinvestment, in particular leverage-

Induced underinvestment.

• Project finance, as a organizational risk management tool, reduces the

potential collateral damage that a high risk project can impose on a
sponsoring firm, i.e., risk contamination. It also reduces the costs of
financial distress and solves a potential underinvestment problem.
30
Project Finance versus Corporate Finance
Resolution of Agency Conflicts between Ownership and Control
 Agency Conflicts between Ownership and Control
• Costly agency conflicts arise when managers who control investment
decisions and cash flows have different incentives from capital providers.

• Certain asset characteristics make assets prone to costly agency conflicts:

Tangible assets that generate high operating margins and significant
amounts of cash flow can lead to:

- inefficient investment
- excessive perquisite consumption
- value destruction

Ex: The agency costs of free cash flows are higher in cement than in drugs.

• Solving the problem of ownership and control is important in project

companies where few of the traditional sources of discipline are present or
effective. 32
Agency Conflicts between Ownership and Control

Corporate Finance Project Finance

• Company invests in many projects • Project company is dissolved once

the project gets completed. No
and possesses many growth
future growth opportunities.
opportunities.

• Cash flows of the project are

• Cash flow separation is difficult to
separated from cash flows of
accomplish in corporate finance. sponsors. The single discrete project
Project cash flows are co-mingled enable lenders to easily monitor
with the cash flows from other project cash flows.
assets making monitoring of cash
flows difficult.
• The verifiability of CFs is enhanced
by the waterfall contract that
• The verifiability of cash flows is specifies how project CFs are used.
difficult.
33
Agency Conflicts between Ownership and Control
Corporate Finance Project finance

Traditional monitoring mechanisms include: Monitoring mechanisms include:

• Takeover market • Managerial discretion is constrained by

extensive contracting. Claims on cash flows
are prioritized through the CF waterfall.
• Product market

• Concentrated equity ownership provides

• Reputation critical monitoring, The unique board of
directors and separate legal incorporation
• Staged investment makes monitoring more simple and efficient.

• Staged financing • High leverage both the amount and type

(maturity…); Bank loans provide credit
monitoring.
• Leverage: high debt service forces
managers to disgorge free cash flows.
• Senior bank debt disgorges cash in early
years.
• Creditors rights: lenders threat to seize
collateral and threat of liquidation to deter 34
borrowers’ opportunism.
 Agency Conflicts between Ownership and Control
From a sample of 6045 project loans (provided to project companies and
corporations) from 40 countries originated between 1993 and 2003:

• PF is much less likely in the US (19%) than in the rest of the world (53%) and
in English and Scandinavian legal origin countries than in French or German
legal origins. Why?
• PF is more likely in countries with weak protection against managerial self-
dealing.
• In countries that provide weak protection to minority investors against
expropriation by insiders, PF is relatively more likely than CF in industries
where free cash flows to assets is higher.
• In countries that provide stronger protection to creditors, the effects of weaker
protection against managerial self-dealing in encouraging PF is lower.
• Large deadweight costs incurred in bankruptcy increase the likelihood of PF
as bankruptcy costs are lower in PF than in CF. PF is less likely when the
bankruptcy process is more efficient.
35
Project Finance versus Corporate Finance
Resolution of Agency Conflicts between Ownership and Related Parties
 Agency Conflicts between Ownership and Related Parties

Problem (Hold Up)

A second type of agency conflict is the opportunistic behavior by related parties, causing ex-
ante reduction in expected returns and ex-ante incentives to invest. The most common
culprits are related parties that supply critical inputs, buy primary outputs, and host nations
that supply the legal system and contractual enforcement.

Standard Approach

• Vertical integration (not always possible or desirable).

• Long term contracts, with contract duration increasing with asset specificity.
Project Finance Approach

• Joint ownership that allocate the residual cash flow rights and asset control rights
among the deal participants.

• High debt level. With high leverage, small attempts to appropriate value will result
37
• In costly default and possibly a change in control.
 Agency Conflicts between Ownership and Related Parties

Problem (Expropriation)

Opportunistic behavior by host governments. They provide a critical input, the legal system
and the protection of property rights. Either direct through asset seizure or creeping
through increased tax/royalty. This causes an ex-ante increase in risk and required return.

Standard Approach

• Visibility/reputation
• High leverage.

Project Finance Approach

• High leverage to discourage expropriation (excess cash is disgorged, lower

profits and less visibility).
• Multilateral lenders’ involvement as a deterrent against expropriation.
38
• Joint ownership.
Project Finance versus Corporate Finance
Resolution of Agency Conflicts between Ownership and Debtholders
 Agency Conflicts between Ownership and Debtholders
Problem
• Debt/Equity holder conflict in distribution of cash flows, re-investment and restructuring
during distress. High leverage can lead to risk shifting and underinvestment.

Standard Approach
• Strong debt covenants allow both equity/debt holders to better monitor management.

Project Finance Approach

• Cash flow waterfall reduces managerial discretion and thus potential conflicts
• Concentrated ownership ensures close monitoring and adherence to the prescribed rules.
• To facilitate restructuring, concentrated debt ownership, less classes of debtors, and bank
debt, are preferred. Bank debt is much easier to restructure than bonds.
• With few growth options, the opportunity cost of underinvestment due to leverage is
negligible in project companies.
• Opportunities for risk shifting do not exist because the cash flow waterfall restrict
41
investment decisions.
Project Finance versus Corporate Finance

Decrease in Asymmetric Information Costs

 Decrease in Asymmetric Information Costs
Problem
• .Insiders know more about the value of assets in place and growth opportunities than
outsiders. Asymmetric information increases monitoring costs and increases cost of
capital (equity is more costly than debt).

Standard Approach
• Disclosure.

• Analyst-relationship.

• Institutional shareholder, activist game.

• Signaling
Project Finance Approach
• Segregated cash flows enhance transparency, which decreases monitoring costs.

• Segregation eliminates the need to analyze other corporate assets or cash flows.
Creditors can analyze the project on a stand-alone basis.

• Project structure reserves the sponsors’ debt capacity/ flexibility to fund higher risk
43
projects internally
Project Finance versus Corporate Finance
Resolution of Under-Investment problem
 Resolution of Under-Investment Problem
• Debt Overhang: Firms with high leverage, risk averse managers and
asymmetric information have trouble financing attractive investment
opportunities. This leads to under investment in positive NPV projects due
to limited corporate debt capacity as new debt is limited by covenants.

• Standard Approach: Use of secured debt, senior bank debt, new equity
(raised at a discount).

• Project Finance Approach

- Non recourse debt in an independent entity allocates returns to new

capital providers without any claims on the sponsor’s balance sheet. This
preserves scarce corporate debt capacity and allows the firm to borrow
more cheaply than it otherwise would.

- Project finance is more effective than secured debt because it eliminates

recourse back to the sponsoring firm.
45
Project Finance versus Corporate Finance

Project Finance as an Organizational Risk Management Tool

Project Finance as an Organizational Risk Management Tool
Problem
• A high risk project can potentially drag a healthy corporation into distress. Short of actual
failure, the risky project can increase cash flow volatility, the expected costs of financial
distress, and reduce firm value. Conversely, a failing corporation can drag a healthy
project along with it.
Standard Approach
• Hedging, or foregoing the project (under-investment)

Project Finance Approach

• Project financed investment exposes the corporation to losses only to the extent of its
equity commitment, thereby reducing its distress costs.

• Through project financing, sponsors can share project risk with other sponsors. Pooling of
capital reduces each provider’s distress cost due to the relatively smaller size of the
investment and therefore the overall distress costs are reduced.
• PF adds value by reducing the probability of distress at the sponsor level and by reducing
the costs of distress at the project level. This facilitates the use of high leverage. 47
Project Finance as an Organizational Risk Management Tool

Risky projects impose deadweight costs on sponsors. Costs of financial distress represent a low
of 3% up to 10-20% of firm value. They include both direct costs, such as legal expenses,
bankers’ fees and indirect costs such as:

- Underinvestment by the sponsor.

- Underinvestment by related parties as distress may deter business partners, from making
long-term investments.

- Lost sales as distress may discourage customers.

-Lost interest tax shield as volatility increases the probability of generating losses.

- Human capital

48
Project Finance as an Organizational Risk Management Tool

• If a firm uses corporate finance, it becomes vulnerable to risk

contamination, the possibility that a poor outcome for the project causes
financial distress for the parent. This cost is offset by the benefit of co-
insurance whereby project cash flows prevent the parent from defaulting.

• From the parent corporation perspective, corporate finance is preferred

when the benefits of co-insurance exceed the risk of contamination and
vice versa.

• Project finance is more likely when projects are large compared to the
sponsor, have greater total risk and have high positively correlated cash
flows.

49
Project Finance as an Organizational Risk Management Tool

Risk (variance) is a proxy fro distress costs and the probability of risk
contamination. Combined cash flow variance (of project and sponsor) with
joint financing increase with:
–Relative size of the project.
–Project risk.
–Positive Cash flow correlation between sponsor and project.

Firm value decreases due to cost of financial distress which increases with combined
variance

Project finance is preferred when joint financing (corporate finance) results in increased
combined variance.

Corporate finance is preferred when it results in lower combined variance due to 50

diversification (co-insurance).
Project Finance as an Organizational Risk Management Tool

Corporate-financed investment involves the combination of 2 risky assets:

Sponsor (S) + Project (P)
Total Risk = Variance of Combined returns
Compare Risk with and without investment: Var(RP+RS) vs. Var(RS)

Portfolio Theory tells us:

Var(RP+RS) = wP2Var(RP)+ wS2Var(RS)+ 2wPwSCorr(RP+RS)σPσS

where:
wP ,wS = proportion of value in the project/sponsor
Var(RP), Var(RS) = variance of project/sponsor returns
σP ,σS = standard deviation of project/sponsor returns
Corr(RP ,RS) = correlation of returns
51
Project Finance as an Organizational Risk Management Tool

Financial Distress is costly :

Expected costs of financial distress = Prob(distress)*Cost of Distress

Probability(distress) is related to Total Risk, leverage and asset/,liability matching

Total Risk is a function of Risk Contamination.

So what factors matter the most for Risk Contamination?

 Relative Size = Project/(Project + Sponsor)

 Project Risk = Var(RP)

 Return Correlation = Corr(RP,RS)

52
 Project Finance as an Organizational Risk Management Tool
Impact of Project Size on Total Risk (Project Risk = 50%)

Return Big Project

Variance (wP = 50%)

Medium Project
(wP = 33%)

Sponsor Stand-Alone
20% Return Variance = 20%

Small Project
(wP = 5%)

1.0 -1.0
Correlation of Sponsor and Project Returns
 Project Finance as a n Organizational Risk Management Tool

Impact of Project Size on Total Risk (Project Risk = 33%)

Return
Variance High Risk
(VarP = 50%)

Sponsor Stand-Alone
20% Medium Risk Return Variance = 20%
(VarP = 20%)

Low Risk
(VarP = 10%)
1.0 -1.0
Correlation of Sponsor and Project Returns
Project Finance as an Organizational Risk Management
Tool
• Usually diversification is beneficial. Here, diversification (corporate finance)
can be worth less than specialization (project finance).

• If corporate-financed investment causes total risk, and hence costs of

financial distress to increase enough, PF may reduces the incremental
costs of financial distress by isolating and containing project risk.

- For project finance to make sense, the reduction in the costs of financial
distress must exceed the incremental transaction costs.

- Project finance lowers the net costs of financing certain assets. Large,
tangible, risky assets make the best candidates for project finance,
particularly when they have returns that are positively correlated with the
sponsors existing assets.
55
Project Finance as an Organizational Risk Management Tool
Example
Consider a riskless sponsor. Its assets are worth 100 in all states of the world
and it is financed with 30 of riskless debt. It has the opportunity to invest in a
0 NPV, risky project worth 200 in the good state and 0 in the bad state and is
financed with 85 of (junior) debt. Assume that with the possibility of default,
the costs of financial distressed imposed on the sponsors existing assets are
equal to 5. The manager’s job is to decide whether to invest using corporate
finance, invest using project finance, or not at all.
Assume:
- a one period model
- the good and the bad states are equally probable
- the risk-free rate is 0
- the manager is risk-neutral
- the organizational form does not affect operating synergies
- no structuring costs
- no relation between project structure and project cash flows
56
Project Finance as an Organizational Risk Management Tool

Example

• No investment: The sponsor is worth 100, the debt is worth its face value
of 30 and the equity is worth 70. There is no possibility of default.

• Corporate financed investment: Assets are reduced by 5 in both states of

the world. The new debt-holders invest only 75 for the project and equity-
holders the remaining 25. Equity is worth 65 (=90-25). The equity-holders
bear the distress costs. Managers acting on behalf on existing shareholders
would not make the investment.

• Project-financed investment: The sponsor raises 42.5 of new project debt

and invests 57.5 into the project. Default is contained at the project level
and there is no collateral damage inflicted at the sponsor level. The sponsor
does not incur incremental distress costs.
57
Project Finance Versus Corporate Finance
Project Finance as Insurance
 Project Finance as Insurance

Compare the choice faced by sponsors between corporate finance and

project finance:

• When sponsors use corporate finance, they expose themselves to the full
range of outcomes (NPVs).

• When sponsors use project finance, they truncate the downside. The
decision to use project finance can be thought of as the decision to buy a
“walkaway” put option on the project. The combination of holding an
underlying asset (project) and buying a put option on that asset gives the
payoff function of a call option.

The downside protection may be valuable but the choice between corporate
finance and project finance depends on the put premium and the willingness
of sponsors to exercise the put option.
59
 Project Finance as Insurance
Payoffs to Project-Financed vs.Corporate Financed Investment

Sponsor Corporate
Equity Value Finance
Payoff
Project
Finance
Payoff

$0 Project Value

Walkaway Put Option

$D
Project Finance versus Corporate Finance
Tax and Other Benefits of project Finance
 Taxes, Location, Heterogenous Partners
• Tax: An independent economic entity allows projects to obtain tax benefits that are not
available to the sponsors. When a project is located in a high-tax country and the project
company in a lower tax country, it may be beneficial for the sponsor to locate the debt in
the high tax country.

• Location: Large projects in emerging markets cannot be financed by local equity due to
supply constraints. Investment specific equity from foreign investors is either hard to get
or expensive. Debt is the only option and project finance is the optimal structure.

• Heterogeneous partners:

– Financially weak partner needs project finance to participate.

– Financially weak partner if using corporate finance can be seen as free-riding.

– The bigger partner is better equipped to negotiate terms with banks than the smaller
partner and hence has to participate in project finance.
63
Part 4
Leverage and Financing Issues
 Leverage and Financing Issues

Debt offers multiple benefits:

• Tax Advantages.

• Helps to solve Free Cash Flow Problem.

• Helps to solve Political Problem (Hold Up)

There are lower bankruptcy costs than in corporate finance (large tangible assets).

65
Leverage and Financing Issues: How to Finance the Project:
• Bank Loans:
– Advantages
• Cheaper to issue.
• Concentrated ownership makes it easier for lending.
• Tighter covenants and better monitoring.
• Easier to restructure during distress.
• Lower duration forces managers to disgorge cash early.
• Bond market may be fickle.
• Draw on credit line as needed.

– Disadvantages
• Short maturity.
• Restrictive Covenants.
• Variable interest rates.
• Limited size. 66
Leverage and Financing Issues: How to Finance the Project
Project Bonds (144A Market):
– Advantages
• Private placement: does not through SEC registration procedure.
• Lower interest rates (given good credit rating).
• Less and flexible covenants.
• Long Maturity.
• Fixed rates.
• Size, ($US 100-200 million).
• Secondary trading.

– Disadvantages
• Disperse ownership:
– less monitoring
– less efficient negotiations
• New market
• Lump sum nature
– Negative carry
• Markets can change at any time making issuance difficult 67
• Bond need investment grade rating
Leverage and Financing Issues: How to Finance the Project

Project Bonds

• Project bonds have “negotiated” ratings: sponsors adjust leverage,

covenants and deal structure until the projects achieve an investment-grade
rating.

• The largest advantage in pricing and liquidity occurs above the BBB- cutoff
due to institutional restrictions against investment in sub-investment grade
securities. Bonds must have an investment grade to sell in the market.

• Since 1998, the percentage of project bonds with an investment grade

(BBB- or higher) has ranged from 63% to 67%.

68
Leverage and Financing Issues: How to finance the project
• Agency Loans:
– Advantages
• Reduce expropriation risk.
• Validate social aspects of the project.
• Reduce political risk
– countries less likely to want to injure multilateral agency.
• Provide political risk insurance
– Overseas Private Investment Corporation (OPIC) in U.S.
– Multilateral Investment Guarantee Agency (MIGA) of World Bank
» provide insurance against political risks for up to 20 years.
– Disadvantages
• Cost (300 bp)
• Time (12-18 months to arrange)

• Insider debt:
– Reduce information asymmetry for future capital providers. 69
Conclusion
 Conclusion: Future of Project Finance
The future of PF will be shaped by many factors:

• Financing structure: There are four specific financing trends:

- hybrid project-corporate financings (corporate debt structure with project-
finance-like covenants, with recourse to the sponsors in the event of default
unless default is due to political risk); portfolio financing, i.e., the bundling of
multiple projects into a single transaction.

- use of Term B loans, a bond with back-end amortization with bank-type

covenants, heavily collateralized and carrying high interest rates.

- use of monoline bonds, bonds that wrap the credit rating of the insurer around
the debt issue to raise the credit rating to AAA.

- participation of private equity, purchasing both non-distressed and distressed

assets.
71
 Conclusion: Future of Project Finance

• Regulatory and environmental policy:

- new international capital standards (Basel II), risk-weighting of project

loans.
- management of environmental and social risks (Equator Principles)
whose focus is to assess and minimize the social risks of large projects.

• Expropriation risk has risen especially in developing countries; sponsors

are increasingly challenged to design and implement sustainable long-term
contracts and agreements with governments or face the risk of
expropriation.

• Valuation of infrastructure assets with the infrastructure sector in danger of

suffering from the dual curse of over-valuation and excessive leverage, the
classic symptoms of an asset bubble.
72
APPENDIX
Project Finance versus Corporate Finance: An example
 Example: BP AMOCO
The Corporate Finance Model
Long-term
Long-termFinancing:
Financing:
BP
BPAmoco
Amoco •• Bonds
Bonds
•• Equity
Equity

Short-term
Short-termFinancing:
Financing:
•• Commercial
Commercialpaper
paper
•• Bank
Bankloans
loans
Business
Business Treasury
Treasury
Units
Units Group
Group Cash
CashManagement
Management
Operating
Cash Flow and
andMoney
MoneyMarket
Market
Instruments
Instruments

$400m
40% of
Cash Flow

$250m $350m
Partner
PartnerAA
Project
Project Partner
PartnerBB
25%
25%share
share 25% of
Cost
Cost == $1
$1 billion
billion 35% of
35%
35%share
share
Cash Flow Cash Flow
74
 Example:BP AMOCO
The Project Finance Model
BP
BPAmoco
Amoco

Partner
PartnerAA Partner
PartnerBB
25%
25%share
share 35%
35%share
share Treasury
TreasuryGroup
Group Business
BusinessUnits
Units
(40%
(40%share)
share)

$140 million
equity $160 million
equity
40% of operating
$100 million cash flow
equity

$300 million
$300 million secured loan
secured loan Project
Project 144A
144ABond
Bond
Banks
Banks Cost
Cost==$1
$1billion
billion Market
Market
Equity
Equity==$400
$400million
million
Debt
Debt ==$600
$600million
million payback+ Interest
payback+interest

75
Contractors
Contractors Suppliers
Suppliers Government
Government International
InternationalOrg.
Org.
 Alternative Sources of Risk Mitigation

Risk Solution

Completion Risk Contractual guarantees from manufacturer, selecting

vendors of repute.

Price Risk Hedging

Resource Risk Keeping adequate cushion in assessment.

Operating Risk Making provisions, insurance.

Environmental Risk Insurance

Technology Risk Expert evaluation and retention accounts.

76