Project Finance -Traditional Products v/s Modern Day

Structured Products-Risk Return Analysis

A Project Report Presented to

Dr. Mayank Joshipura

Faculty Member

Narsee Monjee Institute of Management Studies

Mumbai
February 22nd, 2014
in

partial fulfillment of the academic requirements for the MPE Programme

by

Mr. Yogesh Rawool

(Roll No-43)

School Of Business Management

SVKMs NMIMS, MUMBAI
2014
 SVKMs NMIMS, University
(School Of Business Management)

Certified that the project titled Project Finance -Traditional Products v/s
Modern Day Structured Products-Risk Return Analysis presented by Yogesh
Rawool (043) represent their original work which was carried out by him at
the SVKMs NMIMS, University under my guidance and supervision during
the period from December 15th, 2013 to February 22nd, 2014.

Name of the Guide: Dr Mayank Joshipura

Signature of the Guide:

Date: 22nd February, 2014

 Table of Contents

Preface (i)
Acknowledgements (ii)
Executive Summary (iii)
List of Tables, Graphs & Figures (iv)
Chapter 1 Introduction to Project Finance 1
1.1 Project Financing 1
1.1.1 Project Financing Structure 2
1.1.2 Participants in Project Finance 2
1.1.3 Features of Project finance 5
1.1.4 Types of Projects 7
1.1.5 Comparison of Corporate and Project Financing 7
Chapter 2 Project Funding Options 10
2.1 Introduction to Project Funding Options 10
2.1.1 Traditional Methods of financing 10
2.1.2 Modern Methods of Financing 14
2.1.3 Project Funding Risks 18
2.1.4 Mitigation of Project Risks 24
2.1.5 Issues in Project Finance 26
Chapter 3 Research Methodology 28
3.1 Research Objective 28
3.2 Methods of Data Collection 28
3.2.1 Primary Data 28
3.2.2 Secondary Data 29
3.3 Questionnaire & Data Analysis 30

Chapter 4 Findings & Recommendations 35

Bibliography A-1
 PREFACE

It gives me immense pleasure to present this report on Project Finance -Traditional Products
v/s Modern Day Structured Products Risk and Return Analysis. The objective is to
introduce the reader to project financing in general and also provide insight into traditional and
modern methods of financial available for financing.

The following pages essentially reflect the efforts made by me to acquaint the reader with the
basic information about various project funding options, typical risks associated with projects and
their mitigating factors.

The main purpose of the project is to understand the whole concept of Project Financing, and the
funding existing traditionally and current modern structured products. In initial chapters of the
project was given to general concept and fundamental principles for project financing, method of
project financing, the various issues and challenges, risks and mitigants for Project financing.

This report is submitted as a part of course curriculum of Narsee Monjee Institute of Management
Studies, Mumbai.
This report is written in an easy and comprehend-able language using systematic methodology.
I have ensured my best to cover all the aspects related to this topic and make the report
purposeful.

(i)
 ACKNOWLEDGEMENTS

I would like to express my sincere gratitude to my Project Guide Dr. Mayank Joshipura, Faculty
Member, NMIMS University for giving me the freedom of thought and action during the Project.
The support, guidance and appreciation given by him were truly valuable in the completion of the
Project and providing me with insights into the finer details of Project Finance.

Secondly, I would like to convey my gratitude towards the NMIMS University for providing me
opportunity to work on the concept of Project Financing.

A special word of thanks to Mr. Rahul Patil Course Co-coordinator, MPE, NMIMS for giving us
all the help and support required the guidelines regarding the CAPSTONE Project.

Last but not the least my friends and group at MPE with whom I had healthy discussions and
arguments on various topics which came handy while working on this project.

(ii)
 EXECUTIVE SUMMARY

Financing large projects has always been considered a specialized activity requiring considerable
domain knowledge and experience in appraising such projects. An accurate assessment of
concomitant risks plays an important role in the ultimate success or failure of the project and
consequent impact on the quality of such large assets. A ritualistic appraisal of project financing
is thus fraught with grave risks.

Conceptually, Project Financing involves limited recourse or sans recourse financing with
attendant rise in the risks associated with such financing, and requires not only a different
approach for lending but a different mindset for dealing with the same.

The project studied the concept of Project Financing with reference to various sectors and risks
involved in funding standalone Projects & risks mitigants.

The Project in later chapter covers the various methods of funding Projects. The traditional and
Modern day structured methods.

In the concluding sections it covers the research with regard to various challenges faced with
Commercial Banks in terms of risk faced and Project developers in terms of return analysis and
recommendations for meeting those challenges.

(iii)
 List of Tables, Graphs & Figures

Figures
1.1 Project Financing Structure 2
1.2 Participants in PF 3
1.3 Types of Risks 19

Tables
1.1 Types of Projects 7
1.2 Comparison of Project finance Vs Corporate finance 9
1.3 Risk Allocation Matrix 23

(vi)
 Chapter 1 Introduction to Project Finance

1.1. Project Financing

Project Finance - A definition

There does not seem to be any universally accepted definition of the term Project Financing.
Broadly, however,
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. It relies on
future cash flows from a specific development as the primary source of repayment with that
developments assets, rights and interests legally held as security.
Project Financing is, thus, a method of financing capital intensive projects and refers to financing
of a particular economic unit in which a lender is satisfied to look initially to the cash flows and
earnings of that economic unit as the source of funds from which a loan will be repaid and to the
assets of the economic unit as a whole as security for the loan. Project finance usually involves
limited or non-recourse financing of a new project through the establishment of a (separately
incorporated) special purpose vehicle (SPV) company.
Reliance on non-recourse debt represents one of the key differences between project finance and
traditional corporate finance (a gist of broad differences between project and corporate finance is
placed at Annexure I). In corporate finance, the primary source of repayment for investors and
creditors is the sponsoring company, backed by its entire balance sheet, not the project alone.
Thus, credit risks faced by the lenders in project financing are very project-specific with little
scope for diversification. If the project fails, significant losses can accrue to investors even if
it is sponsored by highly rated company/government. However, insulation of the project from
sponsors downside and diversification of project risks makes it attractive for the lenders. In order
to cope with the asset specificity of credit risk, lenders are making increasing use of innovative
risk sharing structures, alternative sources of credit protection and new capital market
instruments to broaden the investors base.
Sponsors Perspective: From the sponsors perspective, project-financing appeals to
them as the possibility of funding projects with 70% and more non-recourse debt allows:
Taking up large size projects and thus gaining potentially large revenues while committing
relatively little equity.
Risk minimization - risks of the new project remain separate from their other
activities, avoiding any potential risk contamination.
Preservation of sponsor borrowing capacity and credit rating by deconsolidating projects
off balance sheet. Also helps in keeping their cost of funding low.
May be the only way that enough funds can be raised.
Lenders Perspective: From the lenders/investors perspective, a key feature of project
financing is that the arrangement invariably involves strong contractual relationships
among multiple parties. An extensive network of contractual agreements is developed to

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 suit specific project structures and various project risks are usually allocated to those
parties best suited to appraise and control them (e.g. construction risks are borne by the
contractors, market/demand risks by the purchaser, etc.). Project financing can, therefore, only
work for those projects that can establish such relationships and maintain them at an
acceptable cost.
1.1.1 Project Financing Structure

Project finance is special in the sense that unlike corporate finance where optimal ratios by
setting up an extensive contractual framework between the various stake holders/participants. On
the other hand, structuring deals involving a complicated nexus of contracts involves high legal
and transaction costs and can be relatively time consuming compared to other forms of financing.
Companies are often receptive to projects, which can be highly leveraged or financed entirely or
substantially on their own merits. In project financing, the project assets, contracts, inherent
economies and cash flows, etc. are segregated and analysed in order to permit a credit appraisal
and a loan specific to the project.
A typical project financing structure would be as follows:

Fig 1.1 Project Financing Structure

1.1.2 Participants in Project Finance
The following section describes the major participants of Project financing:
Government. Though local governments generally participate only indirectly in projects, their
role is often most influential. The local governments influence might include: approval of the
project, control of the state company that sponsors the project, responsibility for operating and
environmental licenses, tax holidays, supply guarantees, and industry regulations or policies,
providing operating concessions.
Project sponsors or owners. The sponsors are the generally the project owners with an equity
stake in the project. It is possible for a single company or for a consortium to sponsor a project.

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Typical sponsors include foreign multinationals, local companies, contractors, operators,
suppliers or other participants. The World Bank estimates that the equity stake of sponsors is
typically about 30 percent of project costs. Because project financings use the project company
as the financing vehicle and raise nonrecourse debt, the project sponsors do not put their
corporate balance sheets directly at risk in these often high-risk projects. However, some project
sponsors incur indirect risk by financing their equity or debt contributions through their
corporate balance sheets. To further buffer corporate liability, many of the multinational
sponsors establish local subsidiaries as the projects investment vehicle.
Figure 2.2 Participants in PF

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Project Company. The project company is a single-purpose entity created solely for the purpose
of executing the project. Controlled by project sponsors, it is the center of the project through its
contractual arrangements with operators, contractors, suppliers and customers. Typically, the
only source of income for the project company is the tariff or throughput charge from the
project. The amount of the tariff or charge is generally extensively detailed in the off-take
agreement. Thus, this agreement is the project companys sole means of servicing its debt. Often
the project company is the project sponsors financing vehicle for the project, i.e., it is the
borrower for the project. The creation of the project company and its role as borrower represent
the limited recourse characteristic of project finance. However, this does not have to be the case.
It is possible for the project sponsors to borrow funds independently based on their own balance
sheets or rights to the project.

Contractor. The contractor is responsible for constructing the project to the technical
specifications outlined in the contract with the project company. These primary contractors will
then sub-contract with local firms for components of the construction. Contractors also own
stakes in projects.

Operator. Operators are responsible for maintaining the quality of the projects assets and
operating the power plant, pipeline, etc. at maximum efficiency. It is not uncommon for
operators to also hold an equity stake in a project. Depending on the technological sophistication
required to run the project, the operator might be a multinational, a local company or a joint-
venture.

Supplier. The supplier provides the critical input to the project. For a power plant, the supplier
would be the fuel supplier. But the supplier does not necessarily have to supply a tangible
commodity. In the case of a mine, the supplier might be the government through a mining
concession. For toll roads or pipeline, the critical input is the right-of-way for construction
which is granted by the local or federal government.

Customer. The customer is the party who is willing to purchase the projects output, whether the
output be a product (electrical power, extracted minerals, etc.) or a service (electrical power
transmission or pipeline distribution). The goal for the project company is to engage customers
who are willing to sign long-term, offtake agreements.

Commercial banks. Commercial banks represent a primary source of funds for project
financings. In arranging these large loans, the banks often form syndicates to sell-down their
interests. The syndicate is important not only for raising the large amounts of capital required,

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 but also for de facto political insurance.19 Even though commercial banks are not generally
very comfortable with taking long term project finance risk in emerging markets, they are very
comfortable with financing projects through the construction period. In addition, a project might
be better served by having commercial banks finance the construction phase because banks have
expertise in loan monitoring on a month-to-month basis, and because the bank group has the
flexibility to renegotiate the construction loan.

Large-scale capital-intensive projects usually require substantial investments up front and only
start to generate revenues after a relatively long construction period.
Therefore, matching debt repayment obligations with project revenue cash flows implies that, on
average, project finance is characterized by much longer maturities compared to other forms of
financing. Thus, 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.
Projects like power plants, toll roads or airports share a number of characteristics that make their
financing particularly challenging.
First, they require large investments in a single-purpose asset. In most industrial sectors where
project finance is used, such as power, airports, oil and gas and petrochemicals, roads, in majority
of the cases, total value of project would normally exceed Rs. 1,000 crs.
Second, projects usually undergo two main phases (construction and operation) characterized by
quite different risks and cash flow patterns. Construction primarily involves technological and
environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of
inputs or outputs), regulatory risk, etc. among other factors. Further, capital expenditure is
primarily concentrated in the initial construction phase; revenues (cash flows) start to accrue only
after the project has begun operation.
Third, the success of large projects depends on the joint effort of several related parties (from the
construction company to the input supplier, from the government to the off taker and so on).
Coordination failures, conflicts of interest and free riding of any project participant can have
significant impact/costs.
Moreover, the project company can have substantial discretion in allocating the usually large free
cash flows generated by the project operation, which can potentially lead to opportunistic
behaviour and inefficient investments.

1.1.3 Features of Project finance

How can a project financing be identified? What details should we expect to find about the
transaction? Not every project financing transaction will have every characteristic, but the
following provides a preliminary list of common features of project finance transactions.

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Capital-intensive. Project financings tend to be large-scale projects that require a great deal of
debt and equity capital, from hundreds of millions to billions of dollars. Infrastructure projects
tend to fill this category. A World Bank study in late 1993 found that the average size of project
financed infrastructure projects in developing countries was $440 million. However, projects that
were in the planning stages at that time had an average size $710 million.

Highly leveraged. These transactions tend to be highly leveraged with debt accounting for
usually 65% to 80% of capital in relatively normal cases.

Long term. The tenor for project financings can easily reach 15 to 20 years.

Independent entity with a finite life. Similar to the ancient voyage-to-voyage financings,
contemporary project financings frequently rely on a newly established legal entity, known as the
project company, which has the sole purpose of executing the project and which has a finite life
so it cannot outlive its original purpose. In many cases the clearly defined conclusion of the
project is the transfer of the project assets For example, in a build-operate-transfer (BOT) project,
the project company ceases to exist after the project assets are transferred to the local company.

Non-recourse or limited recourse financing. The project company is the borrower. Since these
newly formed entities do not have their own credit or operating histories, it is necessary for
lenders to focus on the specific projects cash flows. That is, the financing is not primarily
dependent on the credit support of the sponsors or the value of the physical assets involved.
Thus, it takes an entirely different credit evaluation or investment decision process to determine
the potential risks and rewards of a project financing as opposed to a corporate financing. In the
former, lenders place a substantial degree of reliance on the performance of the project itself. As
a result, they will concern themselves closely with the feasibility of the project and its sensitivity
to the impact of potentially adverse factors.8 Lenders must work with engineers to determine the
technical and economic feasibility of the project. From the project sponsors perspective, the
advantage of project finance is that it represents a source of off-balance sheet financing.

Many participants. These transactions frequently demand the participation of numerous

international participants. It is not rare to find over ten parties playing major roles in
implementing the project. The different roles played by participants was described in the section
above.

Allocated risk. Because many risks are present in such transactions, often the crucial element
required to make the project go forward is the proper allocation of risk. This allocation is
achieved and codified in the contractual arrangements between the project company and the other
participants. The goal of this process is to match risks and corresponding returns to the parties
most capable of successfully managing them. For example, fixed-price, turnkey contracts for
construction which typically include severe penalties for delays put the construction risk on the
contractor instead on the Project Company or lenders. The risks inherent to a typical project
financing and their mitigants are discussed in more in later sections.

Costly. Raising capital through project finance is generally more costly than through typical
corporate finance avenues. The greater need for information, monitoring and contractual

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 agreements increases the transaction costs. Furthermore, the highly-specific nature of the financial
structures also entails higher costs and can reduce the liquidity of the projects debt. Margins for
project financings also often include premiums for country and political risks since so many of the
projects are in relatively high risk countries. Or the cost of political risk insurance is factored into
overall costs.

1.1.4 Types of Projects

BOO Build-Own-Operate Private sector finances, constructs, owns and operates

the facility, e.g. new airports at Hyderabad & Kochi.
BOOT Build-Own-Operate- Private Sector finances, constructs, owns, operates the
Transfer facility and transfers the ownership upon expiration of
contract period, e.g. power generation projects.
BOT Build-Operate- Private sector finances, constructs and operates the
Transfer facility and transfers to Govt. after the expiration of the
contract period, e.g. road projects
BOLT Lease-Build-Operate- Private Sector leases, constructs, operates the facility
Transfer and transfers the ownership upon expiration of contract
period, e.g. renovation & modernization (R&M) of old
power generation stations.
Table 1.1 Type of Projects
1.1.5 Comparison of Corporate Financing and Project Financing

Criterion Corporate Financing Project Financing

Organization Large businesses are generally The project can be organised as a
organised incorporate form partnership, unincorporated joint venture,
Cash flows from different assets and unlimited company or limited liability
businesses are co-mingled. company to utilise more efficiently tax
benefits of Ownership.
Project related assets and cash flows are
segregated from the sponsors other
activities
Control & Control is vested primarily in Management remains in control but is subject
Monitoring Management. to closer
Board of Directors monitors corporate monitoring than in a typical
performance on behalf of the corporation.
shareholders. Segregation of assets and
Limited direct monitoring is done by cash flows facilitates greater
the shareholders. accountability to investors
Contractual arrangements
governing debt and equity
investments contain covenants

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 and other provisions that
facilitate monitoring.

Allocation of Creditors have full recourse to the Creditors typically have limited
risks project sponsors. recourse and in some cases
Risks are diversified across the non-recourse to the project
sponsors portfolio of assets. sponsors
Certain risks can be transferred to Creditors financial exposure is
others by purchasing insurance, project specific although supplemental credit
engaging in hedging activities and so support can at least partially offset this risk
on. exposure
Contractual arrangements
redistribute project related
risks
Project risks can be allocated
among the parties who are
best able to bear them.
Financial Financing can be typically arranged Higher information, contracting
flexibility quickly and transaction costs are
Internally generated funds can involved.
be used to finance other projects by Financing arrangements are highly
passing the discipline of the capital structured and very time consuming.
market Internally generated cash flow
can be reserved for proprietary
projects.
Free Cash Managers have broad discretion Managers have limited
Flow regarding allocation of free cash flows discretion.
between dividends and reinvestments By contract, free cash flow
Cash flows are commingled and then must be distributed to equity
allocated in accordance with corporate investors.
policy
Agency costs Equity investors are exposed to the The agency costs of free cash
agency cost of free cash flow flow are reduced.
Making management Management incentives can be
incentives project specific is tied to project performance
more difficult Closer monitoring by investors
Agency costs are greater than is facilitated.
for project financing The underinvestment problem
can be mitigated.
Agency costs are lower than
internal financing.
Structure of Creditors look to the sponsors' entire Creditors look to a specific
debt finance asset portfolio for their debt service. asset or a pool of assets for
Generally, when the borrower is a their debt service.
large corporation, the debt is unsecured. Typically debt is secured
Debt contracts are tailored to

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 the specific characteristics of
the project.
Debt Capacity Debt financing uses part of the sponsor Credit support from other
debt capacity. sources such as purchasers of
project output, can be channeled to support
project borrowings.
Sponsors debt capacity can be
effectively expanded.
Bankruptcy Costly and time consuming financial The cost of resolving financial
distress can be avoided. distress is lower.
Lenders can have the benefit of the the project can be insulated
sponsors entire asset portfolio. from the sponsors possible
Difficulties in one key line of business bankruptcy.
could drain cash from good projects. Lenders chances of recovering
principal are more limited; the
debt is generally not repayable
from the proceeds of other
unrelated projects.
Table 1.2 Comparison of PF and CF

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 Chapter 2 Project Funding Options

2.1 Introduction to the Project Funding Options

As policy makers continue to sort through the wreckage caused by the financial tsunami that
engulfed the world in 2008, the infrastructure sector has not been immune. In fact, it could be
argued that infrastructure is uniquely disadvantaged in the current climate. At this point only one
thing is certain: the landscape for infrastructure funding and finance has been dramatically altered
and could remain so for at least the near term
Three trends are emerging. First, governments are attempting to use increased infrastructure
spending as a tactic for economic stimulus. Second, tightened credit markets are posing an
obstacle to raising debt finance for infrastructure delivery models public or private that
depend on high levels of up-front capital repaid over the long term through user fees or general
taxation. Thirdly, government balance sheets are constrained, making it more difficult to fund
infrastructure projects.
While many market participants view infrastructure as an attractive defensive asset class during
these volatile times, the dynamics of the credit markets, particularly with respect to the tenor of
debt, have moved in the opposite direction. As a result, deal volume is down.
For the SPV mode of non-recourse financing the sponsors would bring their share of project
funding by way of equity or quasi-equity etc. However, leveraging the equity for optimal project
funding structure is one of the key roles of project financing.

2.1.1 Traditional Methods of financing

In order to meet financial requirements of infrastructure projects, banks extend

funded credit facilities by way of term loan/project loan for setting up projects and
working capital finance during operations phase. Non-funded facilities are extended
in the form of bank guarantees and letters of credit both for capex as well as part of
working capital financing. Credit facilities are provided both in Rupee terms as well
as in foreign currency depending upon requirements of the project.

In case of brown-field projects where existing cash flows are available, even 100%
debt funding is feasible.

Subscription to bonds and debentures/ preference shares/ equity shares acquired

as a part of the project finance package which is treated as "deemed advance.

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Financing promoter's equity: In view of the importance attached to the
infrastructure sector, under certain circumstances, with the approval of the banks
Board, financing the acquisition of the promoter's shares in an existing company,
which is engaged in implementing or operating an infrastructure project in India is
also now permitted in line with RBI guidelines in this regard.

Inter-institutional Guarantees: Banks are permitted to issue guarantees favoring

other lending institutions in respect of infrastructure projects, subject to RBI
guidelines from time to time.

Term Loan
A term loan is a monetary loan that is repaid in regular payments over a set period of time. Term
loans usually last between one and ten years, but may last as long as 30 years in some cases. A
term loan usually involves an unfixed interest rate that will add additional balance to be repaid.
Term loans can be given on an individual basis but are often used for small business loans. The
ability to repay over a long period of time is attractive for new or expanding enterprises, as the
assumption is that they will increase their profit over time. Term loans are a good way of quickly
increasing capital in order to raise a business supply capabilities or range. For instance, some
new companies may use a term loan to buy company vehicles or rent more space for their
operations.
Corporate term loans can be structured under the FCNR (B) scheme as well, with the option of
switching the currency denomination at the end of interest periods. This will help you take
advantage of global interest rate trends vis--vis domestic rates to minimize your debt cost.
The banks corporate term loans are generally available for tenors from three to five years,
synchronized with your specific needs.The Banks expert credit crew gauges the applicants
particular fund requirements and evaluates the companys credit worthiness, factoring in the cash
flows generated by it.
Working Capital
Working capital (abbreviated WC) is a financial metric which represents operating liquidity
available to a business, organization or other entity, including governmental entity. Along with
fixed assets such as plant and equipment, working capital is considered a part of operating capital.
Net working capital is calculated as current assets minus current liabilities. It is a derivation of
working capital, which is commonly used in valuation techniques such as DCFs (Discounted cash
flows). If current assets are less than current liabilities, an entity has a working capital deficiency,
also called a working capital deficit.
A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and
upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable, and cash.
Bank Guarantee

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Bank Guarantee is an instrument issued by the Bank in which the Bank agrees to stand
guarantee against the non-performance of some action/performance of a party. The quantum of
guarantee is called the 'guarantee amount'. The guarantee is issued upon receipt of a request from
'applicant' for some purpose/transaction in favour of a 'Beneficiary'. The 'issuing bank' will pay
the guarantee amount to the 'beneficiary' of the guarantee upon receipt of the 'claim' from the
beneficiary. This results in 'invocation' of the Guarantee.
Bank issues Guarantee favoring beneficiaries abroad either directly or through our correspondent
banks across the continents.
Letter Of Credit
A letter of credit (L.C) is a document issued by a financial institution, or a similar party, assuring
payment to a seller of goods and/or service. The seller then seeks reimbursement from the buyer
or from the buyer's bank. The document serves essentially as a guarantee to the seller that it will
be paid regardless of whether the buyer ultimately fails to pay. In this way, the risk that the buyer
will fail to pay is transferred from the seller to the letter of credit's issuer. The letter of credit also
insures that all the agreed upon standards and quality of goods are met by the supplier.
The parties to a letter of credit are the supplier, usually called the beneficiary, the issuing bank, of
whom the buyer is a client, and sometimes an advising bank, of whom the beneficiary is a client.
Almost all letters of credit are irrevocable, i.e., cannot be amended or cancelled without the
consent of the beneficiary, issuing bank, and confirming bank, if any.
Deferred Payment Guarantee
Banks can extend deferred payment guarantees to industrial projects for obtaining imported
equipment. The DPG is a standby credit guaranteeing deferred payment, usually for paymenys of
capital goods, turnkey contracts etc.
SME Loans
SME finance is the funding of small and medium sized enterprises, and represents a major
function of the general business finance market in which capital for different types of firms are
supplied, acquired, and priced. Capital is supplied through the business finance market in the form
of bank loans and overdrafts; leasing and hire-purchase arrangements; equity/corporate bond
issues; venture capital or private equity; and asset-based finance such as factoring and invoice
discounting.
However, not all business finance is external/commercially supplied through the market. Much
finance is internally generated by businesses out of their own earnings and/or supplied informally
as trade credit, that is, delays in paying for purchases of goods and services.
Receivable Financing
A type of asset-financing arrangement in which a company uses its receivables - which is money
owed by customers - as collateral in a financing agreement. The company receives an amount that
is equal to a reduced value of the receivables pledged. The age of the receivables have a large
effect on the amount a company will receive. The older the receivables, the less the company can
expect. Also referred to as "factoring".

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Factoring is a financial transaction whereby a business sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount.
In "advance" factoring, the factor provides financing to the seller of the accounts in the form of a
cash "advance," often 70-85% of the purchase price of the accounts, with the balance of the
purchase price being paid, net of the factor's discount fee (commission) and other charges, upon
collection from the account client. In "maturity" factoring, the factor makes no advance on the
purchased accounts; rather, the purchase price is paid on or about the average maturity date of the
accounts being purchased in the batch.
Leasing
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must
pay a series of contractual, periodic, tax deductible payments.
The lessee is the receiver of the services or the assets under the lease contract and the lessor is the
owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and
can be for a fixed or an indefinite period of time (called the term of the lease). The consideration
for the lease is called rent. A gross lease is when the tenant pays a flat rental amount and the
landlord pays for all property charges regularly incurred by the ownership from lawnmowers and
washing machines to handbags and jewelry.
Under normal circumstances, a freehold owner of property is at liberty to do what they want with
their property, including destroy it or hand over possession of the property to a tenant. However, if
the owner has surrendered possession to another (the tenant) then any interference with the quiet
enjoyment of the property by the tenant in lawful possession is unlawful.
Financial Lease is a means of financing capital equipments. It is a contract between the Bank
(Lessor) and the Customer (Lessee) for the hire of a specific asset, selected from a manufacturer /
Supplier of lessee's choice and to suit the lessee's requirements. The lessee has possession of the
asset and uses the same on payment of specified rentals and other usual charges / fees, while the
lessor retains ownership of the asset. All the risks (major or minor) and rewards of ownership are
normally transferred to the lessee and the obligations are non-cancellable. The lessee is to bear the
costs of insurance, maintenance and other related costs and expenses for the leased equipment
Lease finance may be Cheaper Compared to Term Loans under certain circumstances.
100% Financing - No margin is generally required in leasing whereas term loans
generally stipulate a margin of 30% to 50%.
Terms Of Payment Extremely Flexible - Structured as per the cash flow of the lessee.
Lease is an Off-Balance Sheet financing option which increases capability to raise
additional resources for expansion, diversification modernization.
The lead time for sanction of lease assistance is much less compared to term loans etc.
Simple documentation.

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2.1.2 Modern Methods of financing
Innovative financial products, such as take-out financing, structured financial loans, securitization,
credit and other derivatives etc. have not been extensively used in infrastructure financing in our
country yet. These products are being extensively used internationally. These includes:
Structured Financing
Structured finance is a broad term used to describe a sector of finance that was created to help
transfer risk and avoid laws using complex legal and corporate entities. This risk transfer as
applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto
loans, etc.) has helped provide increased liquidity or funding sources to markets like housing,
and/or to transfer risk to buyers of structured products. However, it arguably contributed to the
degradation in underwriting standards for these financial assets, which helped give rise to both the
inflationary credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.
Common examples of instruments created through securitization include collateralized debt
obligations (CDOs) and asset-backed securities (ABS).
Structured finance involves assembling unique credit configurations to meet the complex fund
requirements of large industrial and infrastructure projects. Structured finance can be a
combination of funded and non-funded facilities as well as other credit enhancement tools, lease
contracts for instance, to fit the multi-layer financial requirements of large and long-gestation
projects.
Dealer Financing
Loans that are originated by a retailer to its customers and are then sold to a bank or other third-
party financial institution. The bank purchases these loans at a discount and then collects principle
and interest payments from the borrower. Also called an indirect loan.
Take-out financing arrangement
Take-out financing structure, simply stated, helps individual participating lenders in
managing their ALM constraints and funding capabilities by breaking up long tenors of
infrastructure projects into shorter durations as another institution takes on their obligation
stepping into the project in a pre-determined manner. A bank financing the infrastructure project
will have an arrangement with another financial institution for transfer to the latter
outstanding in respect of such financing in their books on a predetermined basis. Such a product
will have three parties viz. lending bank/FI, taking over institution and the borrower. Some of the
options are:
Conditional or non-conditional take-out.
Partial or 100% take-out. Take-out commitment could be for partial or full amount
and/or only for principal debt or plus interest, etc. This type is suitable for smaller to
medium sized lenders with inadequate appraisal skills/experience

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 With risk or without risk (i.e. loan take-out can be independent of/dependent on
asset quality at the material time of take-out).
No constraint on duration (i.e. participating institutions will decide the stage at which
take-out will kick in.)

Subordinate Debt
Subordinate debt, or quasi-equity, is senior to equity capital but junior to senior debt.
Subordinated debt usually has the advantage of being long-term, unsecured and may
be considered as equity by senior lenders for the purpose of computing debt-equity
ratios. A subordinated debt is often used by a sponsor to provide capital to a project,
which will support senior borrowings from third party lenders. Subordinated debt can
sometimes be used advantageously for advances required by investors, sponsors or
guarantors to cover construction cost overruns or other payments necessary to maintain
debt-equity ratios or other guaranteed payments. In the case of default, subordinated
debt providers will get paid after the senior debt holders have been paid in full and
hence is more expensive.
Banks may also provide subordinate debt in certain cases taking into account the risk profile of
the project.
Mezzanine Financing
Mezzanine financing provided by specialized agencies is a hybrid of debt and equity that gives
the lender the right to convert their loan to equity if the loan is not fully paid back in time. It is
generally subordinated to debt provided by senior lenders such as banks etc. Mezzanine financing
is usually unsecured and thus expensive, but is treated like equity making it easier to obtain
standard bank financing.
Debt Securitization
Securitization is a financial transaction in which assets are pooled and securities representing
interests in the pool are issued. It is a process whereby a pool of homogenous cash-flows is
packaged into a single large cash flow. These packages are sold to various investors as
securities collateralised by the underlying assets and their associated income stream.

Securitisation of a portfolio of say power project related loans could be carried out which
will enable the financing bank to raise cash so it can issue more loans. For the bank,
this raises capital and gets the loans off its balance sheet, so it can issue new loans.
Syndication / Underwriting of Loans
Debt syndication is the process of distributing the money advanced/to be advanced to generally a
large loan to a number of lenders. By employing debt syndication, several banks share the risk of
making a large loan. This also allows smaller banks to participate in large loans.

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Syndication of a credit facility can be carried out using two basic approaches: best efforts or
firm-commitment.
Under the Best-Efforts approach, syndication, the lead arranger reaches an agreement with the
borrower on the proposed size of the borrowing and the key terms of the loan agreement.
In contrast, under the Firm-Commitment Approach, the lead bank makes a legally binding
commitment to the borrower to take up the entire amount of the loan, in the event that the loan is
not successfully syndicated i.e. underwrites the loan.
Risks: Under the Firm-Commitment Approach, to the extent that the lead Bank is
unsuccessful in the marketing efforts, it could be faced with the burden of carrying in its books
the entire underwritten portion of the loan.
Mitigation: These risks are mitigated by limiting the exposure only to top-rated clients. Further,
the material adverse changes (MAC) clauses in syndicated loan agreements specify
predetermined grounds for legitimate retraction of the commitment by the lender. The lead
bank is compensated for this greater risk through higher fees paid by the borrower.
Channel Financing
Channel financing is an innovative finance mechanism by which the bank meets the various fund
necessities along your supply chain at the suppliers end itself, thus helping you sustain a
seamless business flow along the arteries of the enterprise.
Channel finance ensures the immediate realization of sales proceeds for the SBI clients supplier,
making it practically a cash sale. On the other hand, the corporate gets credit for a duration
equaling the tenor of the loan, enabling smoother liquidity management.
SBI has the worlds largest banking network of over 9,000 branches and this enables it to deliver
the financial solution at your suppliers doorsteps, across the span of the country.
Buyers/Suppliers Credit
Suppliers Credit
The most common type of facility is suppliers credit arranged by Foreign Offices of the Bank
against Letters of Credit issued by banks in India.
Under supplier credit contracts, the exporter-supplier extends a credit to the buyer-importer of
capital goods. Typically, the terms are an agreed amount of down payment and the balance
payable in instalments spread over an agreed period. These deferred payments will be witnessed
by promissory notes or bills of exchange, often carrying the guarantee of the importers bank.
In cases where the suppliers credit arrangement is backed by LC, while negotiating documents
against LCs of banks in India, Foreign Offices would need to ensure that at the whole Bank level,
there is room for such exposure and thereafter negotiate documents that are in conformity with the
terms of credit. Such exposures would be against the respective LC issuing bank.
Buyers Credit

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In this type of arrangement, the buyer-importer raises a loan from a bank in the exporters
country. The loan is drawn to pay the exporter in full. For the exporter, the transaction is a cash
sale.
There could also be instances where the import to India is not backed by a LC. All such cases
including where some banks issue what is called a Letter of Comfort assuring payment would
amount to buyers credit.
In these transactions (with or without Letter of Comfort), the exposure is on the Indian
corporate. Therefore, Foreign Offices would need to have clearance for exposure. For this
purpose, the Foreign Office concerned should obtain an unconditional undertaking from the
domestic office (Relationship Point) of the Bank that on due dates, the loan amount and interest
due would be remitted to the Foreign Office. Domestic office in turn would need to ensure that
such exposures are within the approved levels.
Other instruments that are internationally used in infrastructure financing are:
1. Commercial paper;
2. Short-term roll-over notes;
3. Euro-commercial paper (a non-underwritten or uncommitted note issuance
programme in which one or more dealers place the issuers paper);
4. Collateralized revolving underwriting facility (CRUFs) (Euro-Commercial Papers
5. issued by companies other than strong investment grade companies collateralized
and/ or supported by guarantees such as a standby letter of credit);
Bond Financing including Zero Coupon Bonds (Bonds sold at a discount and whose
yield interest rate determined by a rise in value per unit of time);
6. Deferred Coupon Bonds (Bonds in which the interest payment is postponed to
some date prior to maturity);
7. Convertible Bonds;
8. Bonds with Warrants;
9. Dual-currency Bonds (Bonds where the interest is paid in one currency and
10. Principal paid in other currency at a specified exchange rate);
11. Commodity Notes & Bonds; Medium Term Notes (MTNs);
12. Asset-Backed Securities (Securities collateralized by a pool of assets); CLOs /
MBOs available in the mkt. Leases.

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2.1.3 Project Funding Risks

Risk is defined as the volatility or standard deviation (the square root of the variance) of net cash
flows of the firm, or, if the company is very large, a unit within it. In a profit-maximizing bank, a
unit could be the whole bank, a branch or a division. The risk may also be measured in terms of
different financial products. As can be seen, financing of infrastructure projects is different from
the traditional method of financing based on balance sheet support. The approach to such projects
is to properly identify the project risks and allocate various elements thereof to the entities
participating in the project and best able to absorb the same. Given their limited/ nonrecourse
financing structure, lenders would like to bear only a small percentage of the entire project risks.

Some of the typical characteristics of Infrastructure Projects include:

Large capital costs

Long gestation periods

Assets are not easily transferable and may be inadequate.

Services provided are not yet fully tradable.

Revenues only in local currency, borrowings could be substantially in foreign

currency.

Vulnerability to regulatory & policy changes

User charges are politically sensitive issues.

Social aspects like displacement of people, ecological impact, pollution etc.

Dependence on supportive infrastructure, which may be under Government or other

controls.

As a result of the above, lenders and investors need to concern themselves with the feasibility of
the project and its sensitivity to the impact of potentially adverse factors. Risk hedging
mechanisms are available including through various project contracts. Detailed due diligence
needs to be carried out, including reports of in-house/outside consultants, if any.

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 Project Funding Risks

Figure 1.3 Types of Risks

The above risks are described in brief as follows:

Financial Risk:
Counter Part / Borrower Risk
If two parties enter into a financial contract, counterparty risk is the risk that one of the parties
will renege on the terms of a contract. Credit risk is the risk that an asset or a loan becomes
irrecoverable in the case of outright default, or the risk of an unexpected delay in the servicing of
a loan. Since bank and borrower usually sign a loan contract, credit risk can be considered a form
of counterparty risk. However, the term counterparty risk is traditionally used in the context of
traded financial instruments (the counterparty in a futures agreement or a swap), whereas credit
risk refers to the probability of default on a loan agreement.
Intrinsic / Industry Risk
Market (or price) risk is normally associated with instruments traded on well-defined markets,
though increasingly, techniques are used to assess the risk arising from over the counter
instruments, and/or traded items where the market is not very liquid. The value of any instrument
will be a function of price, coupon, coupon frequency, time, interest rate and other factors. If a
bank is holding instruments on account (for example, equities, bonds), then it is exposed to price

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or market risk, the risk that the price of the instrument will be volatile. General or systematic
market risk is caused by a movement in the prices of all market instruments because of, for
example, a change in economic policy. Unsystematic or specific market risk arises in situations
where the price of one instrument moves out of line with other similar instruments, because of an
event (or events) related to the issuer of the instrument.
Thus, market risk includes a very large subset of other risks. Two major types of market risks are
currency and interest rate risk.
Portfolio / Concentration Risk
Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts
over the number or variety of debtors to whom the bank has lent money. This risk is calculated
using a "concentration ratio" which explains what percentage of the outstanding accounts each
bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan
would have a concentration ratio of .2; if it had 3, it would be .333.
Various other factors enter into this equation in real world applications, where loans are not
evenly distributed or are heavily concentrated in certain economic sectors. Risk of default is an
important factor in concentration risk. The basic issue raised by the concept of default risk is:
does the risk of default on a bank's outstanding loans match the overall risk posed by the entire
economy or are the bank's loans concentrated in areas of higher or lower than average risk based
on their volume, type, amount, and industry.
Interest Rate Risk
Interest rates are another form of price risk, because the interest rate is the price of money, or
the opportunity cost of holding money in the narrow form. It arises due to interest rate
mismatches. Banks engage in asset transformation, and their assets and liabilities differ in
maturity and volume. The traditional focus of an assetliability management group within a bank
is the management of interest rate risk, but this has expanded to include off-balance sheet items,
as will be seen below.
Liquidity Rate Risk
Liquidity risk is the risk of insufficient liquidity for normal operating requirements, that is, the
ability of the bank to meet its liabilities when they fall due. A shortage of liquid assets is often the
source of the problems, because the bank is unable to raise funds in the retail or wholesale
markets. Liquidity is an important service offered by a bank, and one of the services that
distinguishes banks from other financial firms. Customers place their deposits with a bank,
confident they can withdraw the deposit when they wish, even if it is a term deposit and they want
to withdraw their funds before the term is up. If there are rumours about the banks ability pay out
on demand, and most depositors race to the bank to withdraw deposits, it will soon become
illiquid. In the absence of a liquidity injection by the central bank or a lifeboat rescue, it could
quickly become insolvent since it can do nothing to reduce overhead costs during such a short
period.

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 Currency Forex Risk
Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate
movement during a period in which it has an open position, either spot or forward or both in same
foreign currency. Even in case where spot or forward positions in individual currencies are
balanced the maturity pattern of forward transactions may produce mismatches. There is also a
settlement risk arising out of default of the counter party and out of time lag in settlement of one
currency in one center and the settlement of another currency in another time zone.

Non Financial Risk:

Operational Risk
Operational risk is defined as The risk of direct or indirect loss resulting from inadequate or
failed internal processes, people, and systems, or from external events.
The definition of operational risk varies considerably, and more important, measuring it can be
even more difficult. The Basel Committee has conducted surveys of banks on operational risk.
Based on Basel (2003), the key types of operational risk are identified as follows.
o Physical Capital: the subsets of which are: damage to physical assets, business
disruption, and system failure, problems with execution and delivery, and/or process
management. Technological failure dominates this category and here, the principal
concern is with a banks computer systems.
o Human Capital: this type of risk arises from human error, problems with employment
practices or employees health and safety, and internal fraud. An employee can
accidentally enter too many (or too few) zeroes on a sell or buy order. Or a bank might
find itself being fined for breach of health and safety rules, or brought before an
employment tribunal accused of unfair dismissal.
o Legal: the main legal risk is that of the bank being sued. It can arise as a result of the
treatment of clients, the sale of products, or business practices. There are countless
examples of banks being taken to court by disgruntled corporate customers, who claim
they were misled by advice given to them or business products sold. Contracts with
customers may be disputed
o Fraud: the fraud may be internal or external to the bank. For example, the looting of
his companys pension by Mr Maxwell affected the banks because they were holding
some of the assets he had stolen from the funds as collateral.

Strategic Risk
A possible source of loss that might arise from the pursuit of an unsuccessful business plan. For
example, strategic risk might arise from making poor business decisions, from the substandard

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execution of decisions, from inadequate resource allocation, or from a failure to respond well to
changes in the business environment.
Funding Risk
Funding risk usually refers to a banks inability to fund its day-to-day operations. The risk
associated with the impact on a project's cash flow from higher funding costs or lack of
availability of funds.
Political Risk
Political risk is a type of risk faced by investors, corporations, and governments. It is a risk that
can be understood and managed with reasoned foresight and investment.
Broadly, political risk refers to the complications businesses and governments may face as a result
of what are commonly referred to as political decisionsor any political change that alters the
expected outcome and value of a given economic action by changing the probability of achieving
business objectives. Political risk faced by firms can be defined as the risk of a strategic,
financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and
social policies (fiscal, monetary, trade, investment, industrial, income, labour, and
developmental), or events related to political instability (terrorism, riots, coups, civil war, and
insurrection).
Legal Risk
It can be broadly defined as state interference in the operations of a domestic and/or foreign firm.
Banks can be subjected to sudden tax hikes, interest rate or exchange control regulations, or be
nationalized. All businesses are exposed to political risk, but banks are particularly vulnerable
because of their critical position in the financial system.

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Risk Allocation Matrix
The various risks may be allocated to various Project partners in case of Project Financing. The
Risk allocation matrix may be captured in the table as follows:

Table 1.3 Risk Allocation Matrix

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3.1.3 Mitigation of Project Risk

With increase in reach, size and significance of payment systems the Bank is committed to
assuring their safe and efficient functioning by identifying various risks, addressing risk-reduction
by putting in place risk-mitigation measures and mandating appropriate risk-management
practices.

The risks in payment systems viz. concentration risk, counter-party risk, credit risk, legal risk,
liquidity risk, operational risk, regulatory risk, settlement risk and systemic risk will continue to
be addressed by the Bank.

Mitigating concentration risk in both large values as also retail payment systems by way of
limiting operations of multiple payment systems by a single entity as also one bank acting
as settlement bank for multiple payment systems or alternatively putting in place measures
for risk mitigation wherever necessary. Important large value payment systems are now
being operated by Clearing Corporation of India Limited (CCIL), which also acts as a
central counterparty for systemically important payment systems. This calls for very close
monitoring of the activities and functioning of CCIL and continuously reviewing the need
for an additional / alternate central counterparty operating some of the payment systems
with each capable of taking over the operations of the other in case of eventuality.
The risk of concentration of settlement in the form of a single central counterparty needs
to be carefully looked into. The retail payment systems are operated by various entities,
and the focus would be to ensure that there is no concentration of a single bank acting as
settlement bank for multiple payment systems. The other issue that needs to be addressed
as part of concentration risk is in the outsourcing arrangements entered into by system
participants with service providers.
Reliance on a single or few service providers gives rise to concentration risk and could
emerge as a significant single-point-of-failure. Proper risk mitigation measures in this
regard would be pursued in consultation and co-ordination with all the regulatory
departments.
Risk mitigation measures to address operational risk would be by way of (a) using latest
and relevant technology, (b) having straight-through-processing interfaces, (c) placing
controls in the form of maker-checker practices and building proper audit trails, (d)
encouraging vendor-neutral platforms and products, (e) addressing scalability issues by
monitoring adequacy of infrastructure and performance, etc.
Approaches to mitigating counterparty liquidity and settlement risks by regulating access
(access criteria, credit ratings, exposure limits, net debit cap, etc.), guaranteed settlement
by committed lines of credit, settlement guarantee fund using central counterparty,

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 preventing volatility (margins, haircuts, calling for additional securities, etc.) and secure
netting systems.

The Special Purpose Vehicle under Project Financing for the purpose of mitigation of risks could
be specifically structured through suitable credit enhancers/risk mitigants to become bankable,
some of which are discussed hereunder:
Sponsor support obligation: In a non-recourse financing structure, sponsors are
not liable for any contingencies not provided for/crystalized prior to financial closure.
However, if the sponsors undertake to provide standby support for some of the pre-
commissioning risks, say cost overrun (with a cap) in the project, it improves the
bankability of the project. In case the overrun exceeds the amount of such support,
the borrowers & the lenders can negotiate the quantum and terms of additional funding
requirement. Post-commissioning, sponsor support is usually not available, unless the
project depends on/envisages say product off-take as well by the sponsor. A suitable
agreement between the sponsor and the project company would then need to be in place.
In case of Public Private Partnerships where the Government sponsors the project, sponsor
support by way of some revenue shortfall support in the form of grants (like in the case of Road
projects) would, generally, be available.
Security Structure: SPVs have a security structure that is generally more stringent
than that for normal projects. The security package generally includes a registered
mortgage (except in the case of roads/bridges etc.) / hypothecation of all assets,
besides pledge of sponsor holdings/ negative lien on sponsor holdings and an
assignment in favour of lenders of benefits under all the project contracts and
documents as also charge on the future receivables.
Trust and Retention Arrangement (TRA): The cash flows of the SPV are captured
by way of a TRA arrangement. Such an arrangement provides for the appropriation
of all cash inflows of the company by an independent agent (TRA Agent)
Credit Enhancement Mechanism encompasses a variety of arrangements that
may be used to improve the credit worthiness of a project by mitigating some of the
risks associated therewith with a view to secure better terms or make the project
bankable. Some of the common forms offered in case of power generation projects
in our country to reduce payment risk include: Government Guarantee (Central or
State government), Escrowing of cash inflows of off-takers at source, Letter of
Credit from an acceptable bank to tide over temporary liquidity mismatches at
the hands of the off-taker, etc.
Lenders substitution rights/step-in rights (to replace borrower for non-performance),
termination payment, credit wrap insurance, etc. are some other mechanisms available.

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 Guarantees: The payment risk in some of the infrastructure projects is further
mitigated by way of a guarantee from the State or Central Government. Escrow Account:
An account established to route specified cash flows of the off-taker to be used for
payment of dues of the supplier (project Company) in case of payment default situations.
Letter of credit: a payment security mechanism wherein the off-taker establishes a
revolving LC in favour of the supplier for a value representing slightly more than the
average periodic payment bill. For example, if power supply is to be paid for at
monthly intervals, a revolving monthly LC will be established for say 110/120% of the
average bill.

4.1.3 Issues in Project Finance

Long tenor financing - Banks are constrained on ALM considerations in extending credit for
long tenors required by infrastructure projects.

Inadequacy of resources with banking system to meet projected infrastructure funding needs.
The Infrastructure development-funding requirement during eleventh five-year plan period, as
per estimates, is likely to be in the region of $300-$350 billion, present deposit base of
banking system being about $ 460 billion.

Exposure norms - Risk-based external and internal exposure norms by way of sectoral and
individual / group company exposure caps, etc. are stipulated for individual banks.
Incremental exposure limits and their pricing may be an issue in funding of various
infrastructure sectors.

Direct funding by long-term players: Restricted LIC participation on account of

regulatory guidelines. As per IRDA guidelines, LIC can lend 20% of the capital employed or
contribute equity to the extent of 10% of the capital employed in each project. Capital
employed in a project includes long term funds - equity, amount in long-term bonds and other
long-term investments - subject to rating requirements.

Need for supplementing resources:

Participation by LT players like PF and Pension funds to be facilitated
Development of Bond market: Lacks depth and liquidity. Bond investors are forced to
hold the bonds till maturity. Necessary capital market related changes related to bond
market to be brought about to increase / diversify participation and liquidity of bonds.
As per the R. H. Patil Committee Report (December 2005), the following issues
emerge:
Issues relating to stamp duty and TDS to be addressed
Fiscal concessions for municipal bonds

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 Higher limit for FII participation
Simpler disclosure and listing requirements
Funding through external sources: FDI, ECB, ECA, etc. and participation by NRIs through
tailored tax free infrastructure bonds - withholding tax issues to be sorted out. Removal of
tenor restrictions in case of ECB funding.

Domestic issuance of infrastructure bonds with suitable fiscal incentives like tax free interest
income, eligibility for investments under Section 80C.

Infrastructure cess on various services and products like air and train passengers, cooking
gas/petrol/diesel users, purchasers of truck/car/ two wheelers, telecom services etc.

Securitization of existing loan portfolio

Government funding of projects and subsequent divestment after commissioning.

System for exit/entry at various stages during the life of the project based on the risk appetite
of lenders/investors - activating take-out financing.

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 Chapter 3 Research Methodology

The research methodology involved the systemic rules and procedures upon which this research
agenda was based and against which the data collected was interpreted and the findings evaluated.
It presents the research context in terms of the background of the study and statement of the
research problem addressed. The main aim of the study is stated, which is followed by specific
research objectives, and the research questions. A summary of the research methodology adopted
for the study is presented thereafter. The research design is descriptive and random sampling is
done.
An extensive literature review was conducted to help provide a thorough understanding of
methods of Project financing related to financing of infrastructure sector specifically for Power
sector. Qualitative and quantitative research strategies was adopted to elicit the relevant data from
the research participants The qualitative aspect of the study dealt with the exploratory interviews
which helped in the identification of the strategic issues in innovative financing of infrastructure
projects in the general context. Subsequently, a self-administered structured survey questionnaire
was conducted to collect primary data from the field. The results obtained from the literature
review and the in-depth interviews provided the framework and the basis for the development of
the questionnaire. The study is limited to select few developers and banks hence may

3.1 Research Objective

The primary aim of this study is to identify and analyze the financing challenges and issues
involved Project Financing by Commercial Banks & Project Lenders for infrastructure projects in
order to prescribe directions for improvement.

In order to achieve the stated aim, the following specific objectives were set:

To identify the categories of challenges faced by the Bank & Project Developers in terms
of investment and financing the infrastructure projects.
To analyze the financing gap due to limited availability of finance.
Measures and instruments to implemented to overcome such challenges and gaps.

3.2 Methods of Data Collection

3.2.1 Primary Data

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While keeping in mind the research objective a questionnaire was designed to collect the required
data. Interviews with Project Developers and various commercial bank were conducted so as
explore the problem areas. In it, participants were asked to rate the challenges according to their
"risk of hindering investment in Infrastructure projects. The ratings were given by 25 Banks & 20
Project developers as respondents. The respondent provided their observations based on their
project portfolio handled by them and their experience in the sector.

3.2.2 Secondary Data

Prior to the field survey a desk survey (literature review) was conducted. The desk survey formed
the basis for the development of the field survey instruments using questionnaires. Data available
from research studies, manuals, internet, books, research papers, surveys etc. were reviewed
intensively to analyse the outcomes.

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 3.3 Questionnaire & Data Analysis
Based on the open ended interviews & research data available the 5 categories were identified
with regard to challenges faced by banks and developers in Project financing arena. In it,
participants were asked to rate the challenges according to their "risk of hindering
investment in Infrastructure projects. Each category and its analysis & impact is presented
below:

1. Permitting Process: It relates to challenges related to delays in the permitting processes

for projects. Feedback from the interviews in this study reveals that delays to permitting
procedures are considered by far the most pressing challenge relating to the financing of
projects. Permitting processes pose a high risk to the timely completion and the cost of
projects. This has an impact on the financing of the projects, especially in the case of
Project Finance via a separate project company.

Commercial Banks Project Developers

Impact Impact
S Very Very
No. Scope Description Low Medium High High Low Medium High High
PERMITTING
1
PROCESS
Challenges Before
relating to funding for a
permitting project is
aspects obtained.
Complex &
lengthy and
leads to
delay in
completion

Analysis & Observation: It was rated high by both respondents. Before funding for a project is
obtained, the risk of a complex or lengthy permitting process implies a longer period of time until
(regulatory or other) revenues are generated. These revenues are used to pay interest, repay loans
and remunerate equity investors for their expenses up to this point. If such a risk is already
assessed as high before a project is developed, potential lenders and investors tend to be reluctant
to provide the required funds. Funding is provided post successful completion of permitting
process.
During the permitting process, significant delays can result in additional financing requirements
to cover the extra costs of the lengthy permitting process. Obtaining financing is then both
challenging and costly, as lenders adjust the financing costs to match the risk profile of the project

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 1 Financing Needs: It related to challenges in obtaining the funds required to carry out the
planned investments raised concerns about an investment gap for projects that are not
commercially viable under current market and regulatory conditions. Respondents
mentioned challenges to raising the required capital on the debt and equity side.

Commercial Banks Project Developers

Impact Impact
FINANCING Very Very
2 NEEDS Description Low Medium High High Low Medium High High
Limited Limited
availability of Financing
a financing due to poor
investment
condition
Completion of Cost Over
b Project within runs
budget
Banks reaching
c sectoral lending
limits
Limits on long Due to Basel
d term commercial II and III
debt
Financing Gaps Difficult in
during initial phases
construction due to lack
e
phase of cash flows
& higher
risks

Analysis & Observation: As observed the above, the above issue is challenging from both the
banks and developers pint of view. To finance Projects, require large additional volumes of both
debt and equity need to be raised in a generally tightening market on the debt side and limits on
long-term commercial debt provision etc. pose measure problems. Preconditions for additional
equity investments are limited in various cases due to a high degree of public ownership or a
return on equity that is too low for certain investor groups. Lack of finance during implementation
pose a high threat for banks on account of project getting delayed and postponement of cash flows
and loss of net present value of returns.

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2 Regulatory Uncertainties: It relates to challenges related to insufficient regulatory
remuneration or insufficient stability of regimes. According to almost all the experts we
spoke to, regulatory issues are the most important factor in the financing of energy
infrastructure projects.

Commercial Banks Project Developers

Impact Impact
REGULATORY Very Very
3 ISSUES Low Medium High High Low Medium High High
Project affected
a by Regulatory
Uncertainties
Returns too low
b to attract external
equity
Returns too low Specifically
to act as an for PSUs
c
incentive for
investment
Late recognition A specific
of pre- regulatory
operational cost shortcoming
due to which
capital
d expenditure
are not
reflected by
appropriate
Regulatory
concerns

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Analysis & Observation: As observed the above, the above issue is challenging from both the
banks and developers point of view. The risk of changing regulatory approaches creates
uncertainty for both debt and equity providers. This is essentially problematic for banks providing
long term financing. The current underactivity prevailing in the economy, lack of transparencies at
the regulatory front, lack of stability of regulatory policy, lack of clarity are major influencing
factor and deterrent for incentive for investments. Further Project developers conveyed that they
were depressed by regulatory shortcomings such as a compulsory debt ratio, delayed
consideration of capital costs and regulatory uncertainty about the acceptance of costs.

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 3 Financing Conditions: It relates to challenges related to the higher costs of capital and
inadequate conditions for acquiring such capital. Increasing financing costs for debt and the
lack of flexibility in regulation has also emerged as one of the major issue for banks and
developers.

Commercial Banks Project Developers

Impact Impact
FINANCING Very Very
4 CONDITIONS Low Medium High High Low Medium High High
Refinancing Long tenor
Risks due to of debt&
a
shorter Maturities ALM
mismatch
Changing
financing costs
b
not taken into
account
Lack of long
standing
c
credibility as a
debtor

Analysis & Observation: As observed the above, the above issue is challenging from both the
banks and developers point of view. As conveyed by respondents, debt capital costs are rising in
some countries as a result of the financial crisis. Mismatch between the maturities of loans and
project lifetimes is a major problem faced by banks in financing projects of life of 20-30 years
having long gestation periods. Infrastructure projects have an average economic lifetime of 20-50
years and require corresponding maturity structures to reduce the refinancing risk. The developers
also stated that new and unrated developers face difficulties in obtaining the required debt
volumes to deliver the planned investments. Alternatively, they have to pay significant risk
premiums to obtain the funding.

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1 Operator Capabilities: It relates to challenges related to relatively new to the market
developers lacking the necessary financing capabilities. They face the challenges of
obtaining the required volumes of debt and equity at favorable conditions.

Commercial Banks Project Developers

Impact Impact
OPERATOR Very Very
5 CAPABILITIES Low Medium High High Low Medium High High
Lack of credit Pricing &
rating or returns
a
insufficient credit
rating
Limited
b Financing
expertise
Independent Vetting &
Review & validation
c
Regular
Reporting
Delay in Project Risks of
d Completion time overrun

Analysis & Observation: As observed the above, the above issue is challenging concern from
developers point of view. As conveyed by respondents, to expand their debt financing
opportunities from bank loans to corporate bonds, they need a credit rating. Project financing in
the present markets in particular are practically inaccessible without a credit rating for unrated
developers. Obtaining funds under market conditions is also difficult, i.e. selecting suitable
financing partners and negotiating loan conditions. These challenges delay the acquisition of the
required debt. From the banks point of view, the independent review of the project of such
unrated developers and regular reporting becomes a critical for monitoring purposes as lack of

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regular monitoring may lead to time overruns and postponement of cash flows and increasing
risks.

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 Chapter 4 Findings & Recommendations
Based on the ratings given by the respondents, the analysis as presented in the previous chapter
can be summarized as following:
1 Commercial banks and the Project Developers rate the challenges faced in Project
Financing similarly. The ratings given by them sow strong convergence specifically with
regard to Regulatory Uncertainties.
2 Financing institutions consider the decreasing availability of debt a greater challenge than
developers. This may be because financing institutions have a broader view of the market
and clearly see the challenge of meeting the required future financing volumes themselves.
3 Financing institutions also view the lack of a credit rating as a significant disadvantage and
major risk enhancer.
4 The main challenges faced during Project Financing as identified are as follows:
Challenges relating to the stability of regulation:
Challenges relating to obtaining additional equity financing
Challenges relating to obtaining debt at favorable conditions
Challenges relating to specific types of projects
Challenges relating to the lack of transparency in the market

Recommendations
On the basis of the challenges identified in previous section a series of potential measures for
addressing the issues based on analysis of responses of Commercial Banks and Developers are
described as follows:

Improve the regulatory environment for financing energy infrastructure investments in

terms of transparency, reliability and returns.

Facilitate equity financing by removing institutional barriers and using grants and new
equity fund structures on a targeted basis.

Enhance the transparency and comparability for the financing of infrastructure

investment in general.

Permit greater foreign investment in rupee debt with suitable qualifications-such as

investment in long term instruments issued by Infrastructure Companies.

To remove asymmetry between binds and project loans by banks by allowing banks to
invest in unrated and unlisted bonds of Infrastructure companies.

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 Bring in lower rated credit through credit enhancements for unrated developers.

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 BIBLIOGRAPHY

1. Project Financing Manual of Banks.

2. IDFC Paper Series Financing Infrastructure January 2009 issue.

3. PWC article Mega Project 2012 Capital Projects and Infrastructure Survey.

4. Mc Kinsey & Co Survey Global Private Banking Survey 2013

5. Project Financing Teaching Note Profesor Gordon M. Bodnar-by Bruce Comer-1996

6. Project Financing: Asset-Based Financial Engineering (Wiley Finance) (Wiley Finance)

by John D. Finnerty

7. Introduction To Project Finance-An analytical Perspectiev-By H R Machiraju

8. www.wikipedia.org

9. http://www.investopedia.com/terms/n/non-recoursefinance.asp

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 10.
REGISTRATION FORM FOR PROJECT WORK

NARSEE MONJEE INSTITUTE OF MANAGEMENT STUDIES

1. NAME IN FULL CAPITAL LETTERS: RAWOOL YOGESH

2. ADDRESS (Local): RAJ LEGACY, G WING FLAT NO 1525

3. PROPOSED TITLE OF THE PROJECT:
5. BROAD AREAS CLASSIFICATION OF:
TITLE OF PROJECT
FOR OFFICE USE ONLY
L B S ROAD, VIKHROLI (W),
MUMBAI- 400086
PROJECT FINANCE TRADITIONAL
PRODUCTS V/S MODERN DAY
STRUCTURED PRODUCTS-RISK
RETURN ANALYSIS
PROJECT FINACE AND FUNDING
STRATEGIES

NAME OF THE GUIDE ASSIGNED: DR. MAYANK JOSHIPURA

FINAL TITLE OF THE PROJECT:
DATE OF SUBMISSION OF PROJECT:
PROJECT FINANCE TRADITIONAL
PRODUCTS V/S MODERN DAY
STRUCTURED PRODUCTS- RISK
RETURN ANALYSIS
22nd February, 2014

NAME & ADDRESS OF THE GUIDE:

(With Phone No. & e-mail ID)

SIGNATURE OF THE GUIDE:

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