Project Finance Notes

Project Finance Objectives
1. Identify key risks in the project through due diligence
and develop risk mitigate structures
and develop risk mitigate structures
2. Risk allocation to the various participants who are best
capable of handling it through structured contracts –
This depends upon negotiating power and risk premiums
hi d d i i d ik i
(lower tariff for offtake contract) – Risk trade off skills;
No point in allocating risk to a party who cannot sustain
the financial consequences.
h f l
3. (a) Quantifying and considering the acceptability of the
p y
residual risks that remains with the company / lenders
(Mitigation, Impact). Transferring all risk – not possible
(b) Increasing interest rate is not risk mitigation
1
Project Finance Objectives
4. Development of security structures to protect lenders’
interest.
5. Financial Modelling
6 The project should be structured for risk and priced and
6. The project should be structured for risk and priced and
pricing should not be on risk alone
7. Security and Documentation
2
Why Risk is important
• Huge upfront cost / Earnings back ended over long term.
• No recourse to promoters .
No recourse to promoters .
• No adequate tangible / saleable security – Hyderabad Airport,
BOT, Oil exploration.
• If we de‐risk the project, raising funds from banks is not
difficult.
3
Deal Diagram
Sponsors
Advisers
Government Invt. Bankers,
Advisers
Fuel Supply Technical & Legal
Advisers
Invt. Bankers,,
Technical & Legal Advisers/Experts
Advisers Equity
Insurance
Rating agency
Companies
Financial Concession/Licence
Investors Agreement
Equity/
Sub-debt
Insurance Policies
Offtake O&M O&M

Users Project SPV Contract
contracts Operator
TRA/Escrow
TRA/Escrow
Agreement EPC Contract
Agent
Substitution
Agreement EPC
Debt
(Assignment Contractor
of interests,
rights etc.)
Lenders
Risk Case Study
RAS LAFFAN LIQUIFIED NATURAL

GAS COMPANY LTD (RASGAS)
5
RAS LAFFAN LNG
Qatar Govt. Mobil Itochu Nissho Iwai
66.5% 26.5% 4% 3%
Equity
Minimum price guarantee
Offshore contractor
LNG project Onshore contractor
Drilling contractor
Offtake agreement
Korea Gas Project

coordination
agreement
Security Exim
Trustee facilities
T t
Trustee Bond Bond
B d
agreement holders
Trustee
1. 25 year take or pay agreement with Korea Gas
2
2. Mobil to guarantee minimum price of LNG linked to crude
oil price of $10.40 per barrel
3. Maximum liability of Mobil $200 million
4. Maximum period of guarantee – 2009 (10 years)
Risks - Price
Project
Production of 10 million tonnes of LNG from North field
which is world’s largest non associated gas field – 9% of
world gas reserves
Project Cost $ million
Drilling 239
Offshore facilities 453
Onshore facilities
h f l 1670
Interest during construction 593
Other costs 380
‐‐‐‐‐‐‐
3335
‐‐‐‐‐‐‐
7
Project (cont’d)
Financial Plan
Equity $ million
Qatar Petroleum Company 651 (19.9%)
Mobil 260 ( 8.0%)
Itochu 39 ( 1.2%)
Nisso Iwai
i i 29 (
( 0.9%)
)
979 30%
Debt
Commercial Banks 382 (11.7%)
ECA (US Exim, UKECGD
Italy‐Sace) guaranteed loans
l ) dl 703 ((21.5%)
%)
Bonds redeemable in 2006 400 (12.3%)
Bonds redeemable in 2013 800 (24.5%)
2285 70%
3264 100%
8
Project (cont’d)
Korean Gas, offtaker has an option to take 5% equity
‐ Bonds were considered because of long duration debt and long moratorium
requirement (6‐8 years)
Long term bond yield ‐ 8.294% (U.S. Treasury + 1.875%)
‐ International investors
International investors 20%
‐ US Investors 80%
‐ Lead manager – Goldman Sachs
9
Project details
RAS LAFFAN LIQUIFIED NATURAL GAS COMPANY LTD (RASGAS)
RAS LAFFAN LIQUIFIED NATURAL GAS COMPANY LTD (RASGAS)
State of Mobil Itochu/ Nisso

Facility agent Bond Trustee
Qatar Corporation Iwai
100% 100%
Qatar
Mobil QM
Petroleum Banks ECA Bonds
Gas Inc Equity 2%
Corporation
71% 29% 47.4% 52.6%
Debt 70%
Equity 28%
Royaalties & taxes
Korea
ebt service
Dividends
Republic of Electric Regional

Ras Gas
Korea Power Governments
Corporation
D
De
50% 34.7% 15.3%

Operating Cost
LNG Supply
Korea Gas Corporation
(Kogas)
Offshore Trust Account
Offshore Trust Account
LNG
(Industrial Bank of Japan)
Korea Electric Power
Other LNG Condensate Corporation (Kepco)
Buyers Buyers
Kogas, Kepco enjoy Korea sovereign rating – AA
Default probability – 1.07%
10
Project details (cont’d)
a) Offtaker: Korea Gas (Kogas) offtakes 75% of gas and supplies
to Korea Electric Power Corporation (Kepco)
b) Shareholding of Kogas ‐ Republic of Korea 50.0%
‐ Kepco 34.7%
‐ Regional Governments 15.3%
‐‐‐‐‐‐‐‐‐‐‐
100.00%
‐‐‐‐‐‐‐‐‐‐‐
Kogas and Kepco enjoy Korea Sovereign rating AA according to
Standard and Poor
11
c) Risks in the project
Assets are of little value because of dedicated use and
location
‐ Spot sales of LNG world over forms only 2% of sales
‐ Heavy front end investment in dedicated facilities
‐ Lack of transportation capacity / lack of alternative
markets
‐ Demand risk for power (Kogas reduced offtake by 22%
during Asian crisis in 1998)
‐ Price risks
Price risks
‐ Quantity risks
Credit spread depends on firm specific contractual
Credit spread depends on firm specific contractual
structure.
12
d) Management of risks (credit enhancement / contracts)
i) Long term take or pay agreement (25 years) between Rasgas
Long term take or pay agreement (25 years) between Rasgas
and Kogas for 75% of production with LNG price linked to a
basket of crude oil
ii) Debt contract between Rasgas and Lenders
iii) Credit enhancement agreement by Mobil to lenders.
Credit enhancement agreement by Mobil to lenders
Unsecured subordinated revolving loan to meet shortage of
funds for debt service.
‐ Maximum liability $200M
‐ Maximum period of guarantee 1999‐2009
Maximum period of guarantee 1999‐2009
‐ Mobil’s guarantee to be activated if crude oil price falls
below $10.4 per barrel. At 75% production level and
$10.4 per barrel linked price the revenues would cover
operating expenses royalties and taxes and debt
operating expenses, royalties and taxes and debt
service. The oil prices in 1998 fluctuated between $12 to
14 per barrel.
13
e) Priority of fund utilisation from offshore account
Royalties and taxes to Qatar Government
Royalties and taxes to Qatar Government
(20% of revenue)
Operating Cost
Debt Service
Debt Service
Dividends
14
f) Standard and Poor estimates the average crude price
Standard and Poor estimates the average crude price
to be $10.15 per barrel through the project life
g) Rasgas input / output flow matrix
Assets a) Take or pay contract proceeds net of costs at NPV
b) NPV of other short term sales of products
c) Contingent debt service guarantee by Mobil
Liabilities a) NPV of royalties and taxes
b) Public debt : Bonds
c) Private debt : Debt from banks and ECAs
d) Equity ‐ Private
d) Equity ‐
15
h) Unmanaged risks
) g
Quantity ‐ counter party risk (Kogas / Kepco)
Price ‐ Brent crude oil price
Mobil guarantee ‐ Mobil Stock price
Kepco offtake risk ‐ Kepco credit spread / rating
‐ Kepco stock price
‐ High oil / LNG prices*
$ / won exchange ‐ Kepco’s revenues in Won but debt servicing in $
risk (fixed exchange rate transformation to floating)
Korea country risk
o ea cou t y s ‐ Cou
Country rating
t y at g
(Demand for power) ‐ Korea composite stock price index (KOSPI)
Competition ‐ Russian exports
Emerging market risks ‐ Kepco was downgraded from AA to B+ during
Asian crisis but subsequently upgraded to BBB**
Financial risk
Financial risk ‐ There is a probability that the defaults may be
There is a probability that the defaults may be
over $200 million, occur after 10 years
* While higher oil prices favour Rasgas it could affect Kepco.
Breakeven price for Kepco is $23 per barrel.
p (
Above this, Kepco will default (Dabhol))
** Default probability: AA – 1.07%; BBB – 4.48%
16
Finance
Corporate/Balance Assets based Project

sheet financing financing financing
(Based on company’s (Based on value of (Value of cash flows)
financial position) Assets [Real Estate])
Why companies promote separate companies for large
projects (Reliance, Raymond)
17
Project Financing versus Corporate Finance
Project Financing Corporate Financing
a) Financial Plan Important; Difficult to change Generally assumed to be

during the loan tenure as it is independent. Can be
governed by contracts changed at any time during
the tenure of the loan
b) Repayment risk The repayment only out of cash Repayment out of

flows of the project. No sponsor company’s overall
support. The financing is off earnings. Sponsor support
balance sheet. is possible
c) Security The security would include Normally either unsecured

i t ibl
intangible assets such as rights,
t h i ht or security of tangible
it f t ibl
assets and interests. assets
(Overbridge, Airports, Toll Road)
‐ Mahankali Flyover, Hyderabad
Flyover Hyderabad
Airport, Nandi Infrastructure
18
Project Financing versus Corporate Finance
Project Financing Corporate Financing
d) Quantum and tenure of Usually large Variable

assistance 8‐10 years
e) Risk levels High, because of Low as the company’s

uncertainty of project
y p j working data is
g
cash flows available
f) Risk mitigation Through structured ‐
g
financing and
contractual
commitments
g) Participants Project developers,
Project developers Only lenders and CEO
Only lenders and CEO
Governments Engineers,
Contractors, Equipment
suppliers, Fuel suppliers,
Product offtakers
19
Characteristics of Project Finance
• Project is a separate legal entity / special purpose vehicle –
Ring fenced
Ring fenced
• Sometimes a Special Purpose Vehicle (SPV), where each
sponsor takes his share of rewards and meets his share of
expenses and project funding is availed by sponsors –
d j f di i il d b Oil
Oil
SPVs
j y g q y
• Project revenue, the only source of loan servicing, equity
return – limited recourse.
• No sponsor credit support; sponsors shift debt servicing to
the project
the project
• Lenders to have a high degree of confidence in the project
cash flows
20
• Financial package is custom built
• Risk is allocated to the party that can handle it better with
negotiated rewards (through contracts), its credit
worthiness, its role in the project
worthiness, its role in the project
• Debt is of long term tenure
• Financial plan takes into account taxation, exchange
controls, enforceability of claims etc.
• The borrowing structure is enforceable contract driven
with covenants
with covenants
21
• Credit enhancement through contracts (offtake agreement,
contingent guarantees)
contingent guarantees)
• High cost of syndication;
Syndicated loans
• Private – public partnerships / FDI
• Large size loans to be viable
• High leverage
High leverage
22
Investment Models
Project Size: Rs.1,000 Crore
A) 100% Equity Financing –
100% Equity Financing No debt on the project or
No debt on the project or
subsidiary – Similar to Corporate Finance.
Treasury
i)
Equity Rs.500 Crores
Subsidiary
Partner‐I Public Equity
Rs.250 Crores
Project Rs.250 Crores
‐ Lenders unwilling to lend due to high risk. But strategic for the company.
‐ It can raise equity because of good public perception
It can raise equity because of good public perception
23
Investment Models
ii)
Treasury
Others Rs.500
Subsidiary Crores equity
Project
‐ Usually promoted by companies of the same group.
‐ Lenders are unwilling. But strategic for the group.
g g g p
24
Investment Models
iii)
Treasury
Others Rs.250 crores equity
Subsidiary (usually sister companies)
(usually sister companies)
Public/Partners
Project Rs.500 crores
25
Investment Models
B) Borrowing in subsidiary Project –
B) Borrowing in subsidiary – Project 100% equity
100% equity
High Risk Projects such as exploration. Banks are reluctant
to lend.
Treasury
Subsidiary Debt Rs.250 Crores
Partner‐I Public Equity
Rs.250 Crores
‐ The loan to subsidiary is usually guaranteed by the company.
‐ In this the company need not bring the entire contribution by internal
In this the company need not bring the entire contribution by internal
generation. Part is by borrowing in subsidiaries.
26
Investment Models
ii)
Treasury
Subsidiary Debt Rs.500 Crores
Project
27
Investment Models
Borrowing in the project – Project Finance
i) Treasury
Cash outflow is minimal Subsidiary Others equity Rs.125 Crores
Debt
b Equity Others
i Oh
Rs.500 Crores
28
Investment Models
Borrowing in the project – Project Finance
ii) Treasury
Subsidiary
Debt
b
Rs.500 Crores
Project
Petrochemical / Power projects
/ p j
Business units evaluate based on weighted average cost of capital.
But finance unit will do the evaluation on the cost of structured
financing.
g
29
Advantages
g of Project
j Finance
(sponsors / company)
Why existing companies implement large projects in separate
Why existing companies implement large projects in separate
companies availing project finance?
1) Sponsor company can insulate itself from the credit risks of
the project with only equity at risk. Even if sponsor credit
support is required, it could be limited to completion
g
guarantee, ceiling of guarantee amount, removal of
, g g ,
guarantee in case of satisfactory D/E or DSCR (Reliance,
Raymond, Tanfac‐Birla Group)
S
Some of the companies do not consider risk reduction
f h i d id i k d i
through project financing as desirable as –
30
Advantages
g of Project
j Finance
a) Whether
Whether part of the company or outside as a project, the group
part of the company or outside as a project the group
would consider default as loss of reputation leading to difficulty
in raising finance in future from banks, international agencies
and Governments.
dG t
b) The project may have proprietary assets – Technology or it may
be a part of a larger development plans. The company cannot
p g p p p y
afford to walk away from the project on default and let lenders
take over the assets.
c)) Many a time lenders want completion guarantees even if the
M i l d l i if h
project is in a separate company. Hence there are risks even if it
is a separate project.
d) Usually, lenders value the risk very unfavourably and charge a
heavy premium in interest. 31
Advantages
g of Project
j Finance
If the company has to finance the default any way, here is no
If the company has to finance the default any way here is no
point in paying a heavy premium via project finance.
2) Project loan is off the balance sheet of the promoter company
and hence does not affect rating of the sponsor. But a detailed
analysis may bring this out.
3) From the lender
From the lender’ss angle, the project is insulated from promotor
angle the project is insulated from promotor
bankruptcy. This is important for lenders, suppliers and
offtakers. If there is a proper contract structure, the rating of
the new project could be better than the parent and can raise
h j ld b b h h d i
low interest loans. This is also used in rehabilitation. Segregate
the profit making activities and expand through project
financing.
32
Advantages of Project Finance
g j
4)) The sponsor could invite equity participation from other
p q yp p
strategic investors like product offtakers, input suppliers,
technology suppliers to strengthen the project rating but
at the same time without diluting their controlling
at the same time without diluting their controlling
interest in the sponsor company.
5) Some times, the sponsor needs a partner, particularly
when investment is made in location he is not familiar
and the partner doesn’t have enough funds to bring
q y, q y
equity, but wants to maintain 50% equity. In this case the
project needs outside debt.
33
g j
6) In a similar way, the sponsors could promote larger
projects by inviting public participation in equity without
j b i ii bli i i i i i ih
dilution of their control in the promoting company.
(Rs. crores)
i) Sponsor contribution 100
Debt 200
300
ii) Sponsor contribution 50
Public equity 50
D bt
Debt 200
300
Alternatively, they need to bring less equity and the balance being
brought in by others (Sponsor Rs.50 crore, Public Rs.50 crore)
34
g j
7) The promoters company avoids restrictive covenants of
the project lenders such as cross defaults, dividend
declaration, nominee director etc.
8) Debt could be large and of long tenure.
9) The
The sponsor after ascertaining performance of the
sponsor after ascertaining performance of the
project can always merge it into the sponsor company at
a time of his choice or sell it away (Reliance, Raymond).
10) The incorporation of a separate company may also be
due to different wage levels, regulatory issues
due to different wage levels, regulatory issues
environmental issues.
35
g j
11) In many cases like power, fertilizers etc., there is a need
to segment the cost of the project/operational cost for
to segment the cost of the project/operational cost for
regulatory purposes. Hence there is a need for a
separate entity.
12) Sharing of risks by several parties who are in a better
position to handle them. For instance a good offtake
contract from a buyer more creditworthy than sponsor
y y p
improves project rating. But now risk structuring to
some extent could be done in corporate financing also.
13) Limiting security to the project
Limiting security to the project’ss assets.
assets
While no party assumes responsibility for the entire credit risk,
a combination of guarantees and undertakings which then
a combination of guarantees and undertakings which then
viewed together constitutes a bankable credit risk.
36
Disadvantages of Project Finance
1. Delay due to due diligence for lenders, protracted negotiations and
time for finalise risk allocation at least 4 months
time for finalise risk allocation at least 4 months.
2. Higher risks for lenders – projected cash flow
3. Generally higher fees and interest rates on non recourse financing.
Generally risk premiums are quite high
Generally risk premiums are quite high.
Additional upfront fees 1 – 2 %
Higher spreads 2 – 3%
Advisor fees
Advisor fees upto 1%
upto 1%
The project pays higher cost to reduce the risk to the promoters.
4. Complying with the lenders’ reporting requirements covenants, and
the reimbursement of the cost of lenders’ supervision (lenders
the reimbursement of the cost of lenders supervision (lenders’
engineers’ fees) could add to the cost.
5. The non recourse loans have made the sponsors totally very
gg
aggressive risk takers.
37
Disadvantages of Project Finance
6. Risk allocation leads to higher risk premium and increases cost.
7
7. Hi h l l bill
High legal bills
8. Cumbersome documentation / REPORTING.
9. Lenders have a large number of covenants – Assets disposal, raising
additional capital non disposal o err n financing nominee director
additional capital, non‐disposal, overrun financing, nominee director,
dividend restrictions.
10. Possible leakage of commercial / proprietary information.
38
Why subsidiary as a promoter
• Lenders stipulate conditions that the promoters should not sell
their shareholding in the project company If the promoters want to
their shareholding in the project company. If the promoters want to
sell off their shareholding, they can sell the subsidiary company
along with the project shareholding.
• The subsidiary will have more freedom to raise resources. Normally
lenders to the subsidiary would have no role in this matter as the
lenders have the guarantee of parent company as security. It is
possible to raise equity in subsidiary easily as raising equity in
parent company could dilute the promoters shareholding. This
helps in overrun financing.
39
Preference for Project Financing
High Risk Projects
• Mega projects which can cause company to fail, harm rating. Size of
project relative to the company.
• Projects in olatile areas war, strikes, sabotage, lack of property
Projects in volatile areas – ar strikes sabotage lack of propert
rights, nationalisation. These involve multinational agencies like
IBRD/KfW and export credit agencies to reduce risks. Normally
g p j y
Government do not act against projects and they will cut‐off
further credit.
• JVs with heterogeneous partners. Partners because of weak
balance sheet cannot raise equity, but want to maintain 50%
i t
interest. Hence debt is required.
t H d bt i i d
• The project is strategic for the company but the company has
inadequate funds. Hence debt is required.
40
Choosing a Bank
‐ Cost of project vis a vis the bank size

‐ Cost of funds of the bank and hence pricing
‐ Bank’s experience in project finance / flexibility /
realism
‐ Complexity of documentation
‐ Decentralisation of decision making (time factor)
41
Components of a Project Appraisal
1. Promoter Evaluation
(Nandi Infrastructure Corridor, Reliance Telecom, Reliance Retail, IOC –
Potato Chips)
2. Management Aspects
3. Project Details
¾ Location
¾ Technical
¾ Implementation
¾ Raw material availability
¾ Labour issues
¾ Environmental aspects
4. Cost of Project
5
5. Means of financing
Means of financing
6. Profitability analysis
7. Risk Evaluation
8
8. Conditions
42
Characteristics of Infrastructure Projects
a) Capital Intensive – Fixed charges form a major part
of the expenditure
p
b) Mainly dedicated use – market analysis is important
as product has specific use at specific time and
cannot be stored.
b d
c) Cash flow is the only source of funds for loan
repayment Asset utilisation is more important than
repayment. Asset utilisation is more important than
asset value
d)) Usually implemented as Special Purpose Vehicles
y p p p
(SPV).
e) Usually a natural monopoly such as airport, metro,
toll road implemented under PPP mode to avoid
exploitation of people. 43
Characteristics of Infrastructure Projects
f) Usually built for long term requirements – 30
years Hence in initial years assets utilisation is
years. Hence in initial years, assets utilisation is
low and long gestation period.
g) Offtake Agreements – Long Term Agreements to
purchase a minimum amount of end product at an
agreed price.
h) There are different classes of investors with
Th diff t l fi t ith
varying risk return characteristics.
i) Contingent funds
Contingent funds – Equity/Debt with some
Equity/Debt with some
commitment charges.
jj) Loans are usually are of long term nature –
y g 15 to
20 years.
44
Infrastructure Project Types
BOT ‐ Build, Operate and Transfer The assets are owned by
(Roads, Power, Sewage treatment) Government agency which will
take back assets after
concession period
BOOT ‐ Build, Own, Operate and Transfer Same as BOT except that asset
ownership is with the operator and
sold to the Government for either a
ld t th G tf ith
nominal/preagreed fixed sum / market
value with a cap
BOO ‐ Build, Own, Operate Same as BOOT except that asset
is perpetually owned by the
operator
BOOST ‐ Build, Own, Operate, Share and Same as BOOT except that
Transfer
Transfer during the concession period
during the concession period
revenue is shared with the
Government agency
BOLT ‐ Build, Own, Lease and Transfer Subleased to other tenants after
building in a leased land – IT Park
Transfer to the government agency
after concession period. 45
Infrastructure Project Types
DBFO ‐ Design, Build, Finance and Operate Designed, financed and
operated perpetually.
BTO ‐ Build, Transfer, Operate Private operator transfers to
Government and leases it back
collects revenues.
BBO ‐ Buy Build Operate
Buy, Build, Operate Buy an existing facility
Buy an existing facility,
modernise, operate and collect
user fees (Old Mumbai‐Pune
road)
OMT ‐ Operate, Maintain and Transfer Operated during the concession
period and transferred back to
the government agency.
46

Project Finance Notes

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Project Finance Notes

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Project Finance Objectives

Offtake O&M O&M

RAS LAFFAN LIQUIFIED NATURAL

Korea Gas Project

State of Mobil Itochu/ Nisso

Republic of Electric Regional

50% 34.7% 15.3%

Corporate/Balance Assets based Project

a) Financial Plan Important; Difficult to change Generally assumed to be

b) Repayment risk The repayment only out of cash Repayment out of

c) Security The security would include Normally either unsecured

d) Quantum and tenure of Usually large Variable

e) Risk levels High, because of Low as the company’s

Cash outflow is minimal Subsidiary Others equity Rs.125 Crores

‐ Cost of project vis a vis the bank size

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