Project Finance Concents and Applications

Padmalatha Suresh holds a post-graduate diploma in Management from the Indian Institute of Management, Ahmedabad, as well as a degree in Law.
She is a Certified Associate of the Indian Institute of Bankers. She has more than two decades of work experience at senior levels in the Banking and IT industries. At present, she is a consultant in the areas of Banking and Finance. A visiting faculty of Finance at the Indian Institutes of Management at Kozhikode and Indore, she also teaches at Great Lakes Institute of Management, Goa Institute of Management and the Icfai Business School. Apart from post-graduate programs, she has also taught at Executive Education programs and Management Development Programs of reputed Business Schools, including corporate in-house training programs. She has presented papers in the areas of Banking and Infrastructure financing and her works have been published in reputed business dailies and magazines.
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Project Finance
Concepts and Applications
Edited by
Padmalatha Suresh
ICFAI B OOKS
The ICFAI University Press
Project Finance Concept and Applications

Editor: Padmalatha Suresh
2005 The ICFAI University Press. All rights reserved.
Although every care has been taken to avoid errors and omissions, this publication is being sold on the condition and understanding that the information given in this book is merely for reference and must not be taken as having authority of or binding in any way on the authors, editor, publisher or sellers. Neither this book nor any part of it may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, microfilming and recording or by any information storage or retrieval system, without prior permission in writing from the copyright holder. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Only the publishers can export this book from India. Infringement of this condition of sale will lead to civil and criminal prosecution. First Edition: 2005 Printed in India Published by
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Contents
Overview Section I
The Project Finance Market An Overview

1. Project Finance: The Need to Treat Large Projects Differently
Padmalatha Suresh
2.
Project Finance in Developing Countries The Importance of Using Project Finance

Padmalatha Suresh
14
3.
Public-Private Partnerships: The Next Generation of Infrastructure Finance

www.fitchratings.com
25
Section II
How Project Structures Create Value

4. 5. 6. Budget: Overcoming Roadblocks to Growth
Padmalatha Suresh
51 57 70
Structure Matters in Project Finance

Padmalatha Suresh
Assessing the Economic Impact of Infrastructure Projects The ERR

Padmalatha Suresh
7.
Complexities in Valuing Large Projects

Prof. R Subramanian
81
Section III
Managing Project Risks

8. 9. The Nature of Credit Risk in Project Finance
Marco Sorge
93 107
Refinancing Risk Permutations of Project Finance Structures

10. 11.
Exchange Rate Risk

Philip Gray and Timothy Irwin
124 131
Contingent Liabilities for Infrastructure Projects: Implementing a Risk Management Framework for Governments
Christopher M Lewis and Ashoka Mody
Section IV
Financing Projects
12. The Syndicated Loan Market: Structure, Development and Implications
Blaise Gadanecz
141
13.
Equator Principles Why Indian Banks Too Should be Guided by Them

Pratap Ravindran
158
14. 15. 16.
Synthetic Leasing
164 172 197
Project Finance: Debt Rating Criteria

Peter Rigby and James Penrose, Esq.,
Pension Funds In Infrastructure Project Finance: Regulations and Instrument Design

Antonio Vives
Section V
Applications and Cases

17. Private Power Financing From Project Finance to Corporate Finance
Karl G Jechoutek and Ranjit Lamech
225
18.
Pooling Water Projects to Move Beyond Project Finance

David Haarmeyer and Ashoka Mody
232
19.
Financing Water and Sanitation Projects The Unique Risks

239
20. 21.
Successful Project Financing HUB Power Project

World Bank Project Finance Group
246 254
Insurance Funds to Flow into Road Projects-lic Finalising Loan Pact with Nhdp
P Manoj
Index
257
Overview
Project Finance is like a chameleon: It always finds a way to take advantage of changes in the Business1 The last two decades have witnessed the emergence of a new, important method of financing large-scale, high-risk projects, both domestic and international. The distinguishing features of this method are that the creditors share much of the business risk in the projects, and the funding is obtained, based on the strength of the viability of the project itself, rather than on the creditworthiness of the project sponsors. The method, called project finance is typically defined as limited or non-recourse financing of a new project through separate incorporation of a vehicle or project company. Project finance is not a new financing technique. The earliest known project finance transaction took place in 1299, when the English Crown negotiated a loan from a leading Italian merchant bank of that period to develop the Devon silver mines. Under the loan contract, the lender
1
Esty Benjamin C, Overview of the Project Finance Market, Harvard Business School, 2000.
II
would be able to control the operations of the mines for one year. He was entitled to all the unrefined ore extracted during the contract period, but had to pay all the operating costs associated with the extraction. There was no provision for interest, nor did the Crown guarantee the quantity or quality of silver that could be extracted. In current parlance, this transaction would be known as a production payment loan. Since the 1970s, when Project finance was used on a large scale to develop the North Sea Oil fields, this financing technique has been extensively associated with several financial and operating success stories in developing natural resources, electric power, transport and telecommunication projects. Equally spectacular have been some recent financial failuresthe Dabhol Power project (India), the Eurotunnel, EuroDisney (Paris), and Iridium (the USA). In spite of these failures, which have attracted considerable public attention, the market for project finance has been growing worldwide. Project financing has been increasingly emerging as the preferred alternative to conventional methods of financing infrastructure worldwide. New financing structures, access to private equity and innovative credit enhancements make project finance the preferred alternative in large-scale infrastructure projects. According to World Bank estimates, the demand for infrastructure investment is staggering. Asian countries alone, which historically have accounted for about only 15% of the Project Finance market, need to invest USD 2 trillion in infrastructure in this decade to maintain their current rate of development. Most studies on economic development find that large-scale infrastructure investment is associated with one-for-one growth in the countrys GDP. Similar country studies of economic development find that inadequate or absent infrastructure severely impede economic growth. The intricacies of large scale project financing are formidable and call for skills that are different from other financial applications. Consequently, these intricacies can be misunderstood, and even misused. Although project financing structures share certain common
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features, every project is unique and requires tailoring of the financial package to the particular circumstances and features of the project. Here lie both the benefits and the challenges. India, too, will be witnessing a boom in the infrastructure sector in the years to come. Infrastructure has been recognized as a national priority in India. It is preferable that long-term Infrastructure finance in emerging markets like India, is based on project financing arrangements, thus attempting to mitigate the extreme risks of operating very large projects. Large infrastructure projectscustomarily implemented by the government now being implemented with private participation and management, reflect the new trend. All these projects use some form of Project Finance, a term currently being used synonymously with Contractual Finance. Due to its increasing importance and use as a funding vehicle for large projects, Project Finance has been attracting a great deal of academic interest. The innovative deals being crafted in project finance revolve around financial packages that offer rich opportunities for testing core financial theories. The large number of financial contracts that characterize project finance must be able not only to allocate risks to various parties who can best bear them, but also should be able to solve basic agency problems between sponsors and creditors. Recent researches have achieved theoretical breakthroughs in the analysis of separate incorporation (a distinctive feature of project finance), secured debt financing, the maturity structure of debt contracts, the choice between private debt (bank loans) and public debt (bonds and notes), the role of covenants and collateral in debt contracts, the optimal design of securities, and the monitoring role of financial intermediaries, and have yielded important insights into project finance structures. Drawing on existing finance theory, detailed case studies, and extensive field research, Benjamin Esty 2 mentions three primary motivations for using project finance: (1) reduced agency costs and
2
Esty Benjamin C, The Economic Motivations for using Project Finance, 2003, Harvard Business School.
IV
conflicts, (2) reduced debt overhang problem and (3) enhanced risk management. The motivations explain why financing assets separately with debt creates value, and why it can create more value than financing assets jointly with corporate debt, the traditional and most popular financing alternative. The research on project finance, though limited, collectively helps reinforce the practice of project financing techniques. Practitioners 3 assert that Project finance will most commonly be used for capitalintensive projects, with relatively transparent cash flows, in riskier than average countries, using relatively long-term financing, and employing far more detailed loan covenants and allocating risks far better to those parties best able to manage them, than to those who will manage conventionally-financed projects. In the above context, an understanding of the basic concepts underlying project finance is necessary. This book, presented in five distinct sections, presents insights into the concepts and applications of project finance through articles by experts. The first section defines Project finance, and provides an overview of the Project finance market, the second section elaborates the unique value that project financing structures generate, the third section is devoted to risk management and the fourth to innovative financing instruments. The last section outlines some applications of project finance, by sectors and projects. Section I provides an overview of the Project finance Market. The opening article Project Finance: The Need to Treat Large Projects Differently, by Padmalatha Suresh describes the origin and growth of project finance. It explains the features of project financing, how it differs from corporate finance, and the advantages and disadvantages of using project finance for large infrastructure projects. The second paper, Project Finance in Developing Countries The Importance of Using Project Finance sourced from the
3
Kensinger and Martin (1988), Smith and Walter (1990), and Brealey, Cooper and Habib (1996) from Kleimeier, Stefanie, and Megginson, William L, An Empirical Analysis of Limited Recourse Project Finance, July 2001.
International Finance Corporation (IFC), features the growing importance of Project Finance as a tool for economic investment and describes non recourse and limited recourse project finance concepts. Some examples of IFC supported projects and their developmental impact on the economy, along with data on the project finance market have been provided. Differentiating project finance from traditional balance sheet financing, the paper outlines the advantages that project finance has for private sponsors, and concludes that in spite of all the advantages, the rigorous requirements ensure that there are no free lunches in project finance. Analysts from the pre-eminent rating company, Fitch Ratings, have contributed the third article, a special report titled Public Private Partnerships: The Next Generation of Infrastructure Finance. The report looks at the larger roles PPP models would play in emerging and other economies, for funding the infrastructure requirements far in excess of the currently available financing resources. The private sector can play an active role as project sponsor or a passive role as an institutional bond investor. The report identifies the pre-requisites for a receptive PPP debt market as a relatively stable macro economic environment, a sound legal framework for concessions, contract enforcement and bankruptcy remedies, a stable regulatory framework and a developing domestic debt market. With more and more innovations coming into PPPs, the article expresses confidence that the PPP market is all set for growth. Some of the next-generation developments relate to (a) pooling of credit risks (b) the US SRF model, and (c) enhancing Pooled credit risk. The report in conclusion, quotes the successful experiment with such credit enhancements in the case of USAID support of the Water and Sanitation Pooled Fund (WSPF) in Tamil Nadu, India. Section two of the book is titled How project structures create value. The section elaborates the uniqueness of project structures that enable them to take on the inherent risks of long-term projects. The first article in this section is published by Padmalatha Suresh in the Business Line, titled Budget: Overcoming Road Blocks to Growth.
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Taking the cue from the remarks on FDI flows made by Indias Finance Minister in his 2005 Budget Speech, the article outlines the role of the banking system and the government in building world class infrastructure in India, with particular reference to transport. Drawing extensive references to the remarkable transformation of the Chinese economy, the article underscores the need for innovative project financing and active involvement of the banking system, capital markets and legal system in this process. The next article Structure Matters in Project Finance by Padmalatha Suresh, summarizes the rationale for various types of contracts and models that form the backbone of project financing transactions. In doing so, the article tries to seek answers to the following questionsWhat are the structural attributes of project companies that enable them to find the financial and other resources for very large projects? Having found the resources, how do the project companies structure the project organization to take care of its longterm needs? How do project companies take care of the risks involved in constructing, financing and operating very large projects? What are the structural features of project companies that enable lenders and equity holders to invest substantial funds? In the next article in this section, Assessing the Economic Impact of Infrastructure Projects The ERR, Padmalatha Suresh avers that an infrastructure project has to generate social returns as well, apart from private returns. While the Financial Rate of Return measures the private returns, the Economic Rate of Return [ERR] measures the social returns from the project. Since the ERR is the basic criterion for governments, multilateral agencies and development banks to lend for an infrastructure project, the article discusses the issues involved in calculating the ERR. Traditional capital budgeting techniques may not be able to measure the value of long term, risky projects effectively. In the last article of this section, titled Complexities in Valuing Large Projects, R Subramanian outlines the shortcomings of traditional methods while valuing large projects, and describes some prevalent methodologies for valuing such projects. Most of the
VII
methodologies being used now, do not take into account the embedded options in investments in large projects. Real options methodologies are now being preferred for valuing long-term infrastructure projects. Section three has been devoted to the vital issue of Managing project risks. Project financing structures are designed to allocate risks through contracts to the parties who can best bear the risks. In the first article in this section, Marco Sorge from the Bank of International Settlements (BIS) describes The Nature of Credit Risks in Project Finance. This paper aims to establish that in project finance, credit risk tends to be relatively high at project inception and to diminish over the life of the project. Hence, longer-maturity loans would be cheaper than shorter-term credits. In order to cope with the asset specificity of credit risk in project finance, 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. Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors. Two main findings have emerged, based on the analysis of some key trends and characteristics of this market. First, unlike other forms of debt, project finance loans appear to exhibit a humpshaped term structure of credit spreads. Second, political risk and political risk guarantees have a significant impact on credit spreads for project finance loans in emerging economies This is particularly relevant, given the predominant role of internationally active banks in project finance and the fundamental contribution of project finance to economic growth, especially in emerging economies. The second article is a report from analysts from Fitch Ratings, elaborating on Refinancing Risk Permutations in Project Finance Structures. Fitch observes that, refinancing risk is increasingly creeping into the financing of single revenue-generating assets. Refinancing risk, in some instances, has arisen from financings that aim to avoid some of the restrictions commonly imposed by the terms of project financings, such as stringent limits on additional debt or from the
VIII
implementation of a debt structure that finances a project that is changing in design or scope (expansion of a toll road or pipeline network). More frequently, refinancing risk has resulted from the limited term or tenor available in a particular debt market. Assets and projects with strong economics that are financed subject to covenants or structural elements have been observed to mitigate refinancing risk adequately. In Fitchs viewpoint, acceptable flexibility in the repayment structure can have a beneficial effect on project credit quality. In the third article of this section, a World Bank Group note, Philip Gray and Timothy Irwin discuss an important risk in large projects Exchange Rate Risk. Private foreign investment in the infrastructure of developing countries seems to hold great promise. But foreign investors must cope with volatile developing country currencies. This note proposes that investors take on all financing-related exchange rate risk, even though this may mean higher tariffs for consumers as a premium for bearing that risk. Reducing reliance on foreign debt may mean that the volumes of private finance and privatizations in developing countries will not be forthcoming; and that the initial costs of finance will be higher. But the benefits may be long-lived and quite robust. The fourth article in this section Contingent Liabilities for Infrastructure Projects: Implementing A Risk Management Framework for Governments is also drawn from a World Bank publication. This article is relevant to India, where the government is getting involved in PPP projects in a big way. The authors, Christopher M Lewis and Ashoka Mody propose that to manage their exposure arising from guarantees to infrastructure projects, governments need to adopt modern risk management techniques. Because guarantees come due only if particular events occur, and involve no immediate cost to the government, they rarely appear in the government accounts or have funds budgeted to cover them. The note introduces an integrated risk management system that draws on recent advances in the private sector. The approach to risk management suggested in this note also provides a mechanism for governments to critically assess the distribution of risks within a loan guarantee or insurance
IX
program and come up with better-designed contracts and fewer and smaller calls on guarantees. And as risks change over time, the framework provides a basis for easy re-estimation and quick adjustments to the budgetary and reserve system. Project financing has been characterized by innovative deal structures and financing instruments. Section four takes a look at some New sources of Project financing. Syndicated loans are credits granted by a group of banks to a borrower. They are hybrid instruments combining features of relationship lending and publicly traded debt. They allow the sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face. Blaise Gadanecz, in the BIS Quarterly Review, describes The Syndicated Loan Market: Structure, Development and Implications. Syndicated credits are a significant source of international financing, with signings of international syndicated loan facilities accounting for no less than a third of all international financing, including bond, commercial paper and equity issues. The paper presents a historical review of the development of this increasingly global market and describes its functioning, focusing on participants, pricing mechanisms, primary origination and secondary trading. In the second article titled Equator Principles Why Indian Banks Too Should Be Guided By Them?, Pratap Ravindran, writing in The Hindu, describes the equator principles adopted by leading banks for financing infrastructure projects around the world, at the behest of IFC. The article impresses that Indian banks too should be guided by these principles, since most large projects need environmental clearance. The synthetic lease has emerged as a popular financing structure since it provides off balance sheet treatment for book purposes, while allowing a company to retain the tax benefits associated with asset ownership. Energy firms, to finance the acquisition of new assets or to refinance existing assets, frequently use this structure. In the third
article in this section, analysts from Fitch Ratings have described "Synthetic Leasing" as a viable alternative structure that can be readily applied to various types of energy-based assets, including electric turbines and other generating assets or natural gas and liquids pipelines. The synthetic lease moves the asset off the balance sheet while maintaining ownership for tax purposes. The vast majority of the financing for the asset purchase is achieved through a combination of senior and subordinated notes issued by the special purpose entity (SPE) created for this purpose. The next article, excerpted from the Standard & Poor's Yearbook, describes in detail the Debt Rating Criteria for project financing transactions. This article summarizes an analytic framework that can be used to systematically assess cash flows based on project-level risks and then to analyze risks external to the project. Standard & Poor's project ratings address default probability. Project ratings do not distinguish between the debt issue rating and the issuer credit rating, as is the case with corporate credit ratings. Five levels of analysis forming Standard & Poor's framework of project analysis are: (a) project level risks (b) sovereign risk (c) business and legal institutional development (d) force majeure risk and (e) credit enhancements. Standard & Poor's expects that as infrastructure investment needs increase, project debt will remain a key source of long-term financings, and nonrecourse debt will most likely continue to help fund these changes. The last paper in this section is Pension Funds in Infrastructure Project Finance: Regulations and Instrument Design by Antonio Vives for Inter American Development Bank. The article discusses in detail the experiences of the Latin American economies, which are building a pool of individual savings to be invested in attractive investment opportunities, and the applicability of these experiences to other emerging economies. On the other hand, infrastructure projects are providing needed services that promote economic growth and social well-being and require long-term local financing. The time is now right to enact the necessary measures that will bring the pension funds and infrastructure investment together. This paper describes what it takes
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to achieve such a union. Fortunately, there has been an almost simultaneous trend toward pension fund reform, including the creation of privately managed pension fund accounts. The paper suggests ways to structure projects to make them more attractive to pension funds, and describes needed regulatory changes to permit pension funds to invest in them. Section five describes Applications of project finance concepts in various infrastructure projects the world over. Karl Jechoutek and Ranjit Lamech, in their World Bank publication Private Power Sector Financing From Project Finance to Corporate Finance, argue that to achieve substantive progress in Independent Power Producer (IPP) financing, limited recourse project financing will have to evolve toward structures with greater balance sheet support. The IPP experience in the United States offers useful insights, and indicates new evidence that variants of corporate financing are being used for financing electric utilities. Developers are pooling projects into entities that are then able to raise capital on the strength of a combined balance sheet comprising the "pooled" assets of different projects. Providers of equity and debt then finance the business of building and operating private generation facilities rather than an individual power plant. Pooling spreads project risk. Industry consolidation has become a steady trend in the IPP business. Greater corporate finance support will make it possible to raise private capital for independent power financing from wider, deeper, and cheaper sources. But innovative strategies will be required from governments, lenders, investors, and power sector enterprises alike. The second article in this section is a study of water projects, Pooling Water Projects to Move beyond Project Finance. This paper reviews the new trends in financing water projects. Many commercial banks have had little interest in water and sanitation projects not only because of noncommercial, political and regulatory risks, but also the small size, weak local government credit, and high transactions costs. The move from project to corporate (balance sheet) financing, is occurring in stages. Designed in part to shield a companys
XII
balance sheet and improve a project's credit strength, innovative structures and financial instruments are emerging. Ultimately, the goal is for water utilities to raise debt and equity from capital markets on the basis of their own balance sheets, strengthened by a diversified and stable rate-paying customer base. Carrying this vital subject further, the next article titled Financing Water and Sanitation Projects The Unique Risks by David Haarmeyer and Ashoka Mody (World Bank publications), reviews some recent innovative projects, and shows that private participation on a limited recourse or no recourse basis has required support from multilaterals and federal government agencies to absorb noncommercial risks. In industrial countries the credit strength of off-taking municipal governments and the sector's traditional monopoly structure expose lenders to potentially significant credit, regulatory, and political risks. These risks, combined with the sunk, highly specific, and non-redeployable nature of water investments, mean that lenders and investors are vulnerable to government opportunism and expropriation. The challenge for the future is in mitigating the noncommercial risks that characterize the sector. Pakistans HUB Power Project, is one of the success stories of recent times. This World Bank publication describes how the Project marks the first use of a World Bank guarantee for a private sector project and is a major step forward in the Banks effort to increase private sector investment in infrastructure. The last article in this section explores another potential avenue for financing long-term projectsInsurance funds. Titled Insurance Funds to Flow into Road Projects, and authored by P Manoj (in the Business Line), this note describes the use of LIC funds in financing road projects in India. Project finance is fast emerging as the most preferred alternative for financing infrastructure projects all over the world. In India, project finance models have been used recently in the NOIDA toll bridge and
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the Bangalore Airport projects. In this book, an attempt has been made to elaborate upon the key financial concepts underlying project finance and illustrate a few applications. This book, therefore, would serve as an introduction to the exciting and growing field of project finance. There are several changes in the project finance market that are either under way or likely to emerge in the near future. Co-financing structures conventional corporate finance with project finance, or Islamic financing structures in combination with project finance, have already been implemented successfully in infrastructure projects in other parts of the world. In the coming years, in India, the banking system and the capital markets will have to gear themselves up to handle the demand for funds. Similarly, more private players will enter infrastructure development either with the government in public-private-partnerships (PPPs) or with government guarantees, or even without government guarantees. The biggest changes would occur in the capital markets, and more specifically, bond markets. From the issuer's perspective, project bonds are attractive because they have longer maturities, fewer covenants, and represent a deeper market. As the supply of bonds increases, there will be more participation from institutional investors such as Insurance funds and Pension funds. Project bonds would appeal to these investors since their tenure would match the long-term liabilities of the investors. As the project debt market develops, securitization of project loans will occur with greater frequency. The derivative market and secondary project debt markets would also have to develop alongside. There will have to be simultaneous innovations in the equity markets as well. Already sponsors and financial advisors in developed countries are forming dedicated pools of capital, to invest in infrastructure and other long-term projects. To take advantage of the growth and deepening of the project finance market for development of its infrastructure, India will have to institute several reformsfinancial, regulatory, legal and social. In conclusion, the Project Finance market will continue to grow well into the future, in tandem with increasing globalization,
XIV
deregulation and economic development. As markets integrate and firms globalize, the scale of projects is likely to increase. These new markets will contain opportunities to appraise and finance not only larger projects, but also different kinds of projects. Many countries that have not used Project Finance techniques historically, for financing their large-scale investments, are likely to do so in the coming years.
Project Finance: The Need to Treat Large Projects Differently
Section I
The Project Finance Market: An Overview
PROJECT FINANCE CONCEPTS AND APPLICATIONS
1
Padmalatha Suresh
Large infrastructure projects are unique. Typically, they take five to seven years to structure, require huge upfront capital, comprise of mostly large, tangible assets, and have a very long life. The risks of such projects are different from those of capital investments for shorter time frames. Traditionally, the government was financing infrastructure projects. However, government finances are increasingly under pressure, necessitating greater private participation in financing such projects. What are the capital providers incentives to participate in infrastructure development? Would they be willing to bear the construction and completion risks of the project and the operating, financial and political risks once the project is completed? Would they be able to bring in the phenomenal amounts of equity and debt needed? Would they be prepared for the financial risk, which could, in bad times, lead to financial distress? Project finance provides satisfactory answers to these questions, and is increasingly being used to finance very large projects. The article outlines the evolution of modern project finance and the global project finance market, contrasts it with conventional corporate financing, and concludes that project finance is relevant for Indias infrastructure development.
The ICFAI University Press. All rights reserved.
Rationale for Project Finance

What is a large project? Benjamin Esty1 defines large projects as those costing USD 500 million or more, accounting for 25% of the worlds projects by number and 75% by value. Typically, these large investments take five to seven years to structure, require huge doses of capital upfront, comprise of mostly large, tangible assets, and have a life of 15 to 25 years or more. Such projects are mostly in the nature of necessary social infrastructure in a country, or a large investment that fills a need of economic development. Most studies on economic development find that infrastructure investment is associated with one to one percentage increases in the countrys Gross Domestic Product (GDP). Similar country specific studies find that absent or inadequate infrastructure severely impedes economic growth. A study by the International Finance Corporation2 has shown that insufficient or irregular power supply reduces GDP by one to two percent in India, Pakistan and Columbia. Traditionally, the public sector or the government financed large infrastructure projects in a country. However, finances of governments are increasingly under pressure, leading to greater use of the private sector in financing such projects. In some cases, use of private financing for infrastructure has enabled the governments to invest in more developmental projects. In other cases, private sector financing of large projects has aided the governments in reducing their public borrowings, thus rejuvenating the flagging financials of the governments. However, given the nature of such projects as described above, it is evident that the risks of such long term projects will be quite different from the risks of capital investments for shorter time frames. While the returns of a viable project will have to be commensurate with the risks in the long run, the private investors and the government should be able to sustain the upfront investment of enormous capital and the gestation period till positive cash flows are generated. In some infrastructure projects such as toll roads, the mindset and number of users of the facility will largely determine how profitable the project would be.
1
Esty Benjamin C, Why Study Large Projects? An Introduction to Research on Project Finance, European Financial Management, vol 10, no 2, 2004, 213-224. 1996, Lessons of Experience #4: Financing Private Infrastructure, World Bank, Washington DC, pp 43-44.
What then are the incentives for capital providers to participate in infrastructure development? Would the private investors or lenders be willing to bear the construction and completion risks of the project and the operating, financial and political risks once the project is completed? Would they have the financial muscle to wait patiently for cash flows that may happen only over a very long period of time, with no certainty that these cash flows would sustain over the life of the project? Would they be able to bring in the phenomenal amounts of equity and debt needed to finance these projects? And having decided to borrow, would the project sponsors be able to service the debt from the project cash flows, or would they have to intermingle the cash flows from their other operations in order to service the debt? Would they be prepared for the financial risk to be undertaken, which could, in bad times, lead to a financial distress situation? Project finance provides satisfactory answers to most of the questions raised above. Project finance is increasingly being used to finance very large projects during the last decade, due to the advantages it offers over the conventional corporate finance.
Defining Project Finance

Simply put, Project finance involves the creation of a legally independent project company, with equity from one or more sponsoring firms, and non- or limited recourse debt, for the purpose of investing in a single purpose, industrial asset.3 Other working definitions of project finance include the following: 1. The raising of funds to finance an economically separable capital investment, in which the providers of funds look primarily to the cash flows from the project as source of funds to service their loans and provide the return of, and a return on their equity invested in the project. 4 A project is further defined as a set of legally and economically independent assets with a single industrial use. 2. Limited or non-recourse finance of a newly to-be-developed project through the establishment of a vehicle company. 5
3
Esty Benjamin C, Why Study Large Projects? An Introduction to Research on Project Finance, European Financial Management, vol 10, no 2, 2004, 213-224. Finnerty John D, Project Finance: Asset Based Financial Engineering, 1996, John Wiley and Sons, p 2. Kleimeier Stefanie and Megginson William I, An Empirical Analysis of Limited Recourse Project Finance, working draft, 2001.
4 5
3. Financing of a particular economic unit in which the lender is satisfied to look at the cash flows of earnings of that economic unit as a source of funds, from which the loan will be repaid and at the assets as collateral for the loan.6
Evolution Of Project Finance

Contrary to the general impression that it is a recent phenomenon, Project finance has a history that dates back to about 700 years. The earliest recorded Project financing transaction was in 1299, when the English Crown asked a Florentine Merchant Bank to develop the Devon silver mines. The agreement was in the form of a years lease of the total output of the mines to the Bank, in exchange for bearing the operating costs. This implied that the bank was entitled to all the output, whether more or less than the expected level; and in case the value or volume of output fell below the banks expectations, the bank would have no recourse to the Crown. In current parlance, this is known as a Production payment loan. A similar concept was used in some of the earliest applications (1930s) of Project finance in the US, in natural resources and real estate. For instance, wildcat explorers in places like Texas and Oklahoma used production payment loans to finance oilfield explorations. In the case of commercial development of real estate, developers used loans whose repayment depended on project cash flows only. Figure 1: How Project Finance Works
Sponsor Minimum Recourse Project Lender Sufficient Credit Support
Credit/ Contract Support Third Party Participants
Hewitt, 1983
Figure 2: Non-Recourse Project Finance Structure

Equity Equity
Vehicle Company Contracts Revenues Guarantees 3rd Parties Construction, Ownership, Operation
Loan Repayment Loan
Project Assets Collateral
Lenders
However, Project finance in its modern form, started evolving only in the 1970s. Several natural resource discoveries and spiraling demand for energy were the triggers that set off this development. Some of the applications during this period were: British Petroleum raised USD 945 million from the market on a project basis, to finance the development of the oil reserves in the North Sea. The Erstberg copper mines in Indonesia were project financed by Freeport Minerals. Conzinc Riotionto of Australia project financed the Bougainville copper mines in Papua New Guinea. The 1980s saw a spurt in project financing of power projects in the US and other developed countries. In the US, the Power Utilities Regulatory Policy Act (PURPA) aided the growth of project finance by necessitating financing of new power plants with long-term purchase agreements. In this period, project finance was seen as being synonymous with power finance in developed markets like the US. Since the 1990s, project finance applications have widened, both geographically and sectorally. A wide array of asset types has been project financed around the world in developing and under-developed economies.
The use of Municipal bonds by the government and municipalities in many countries, has also contributed to the growth in modern project finance. As government finances got scarce, municipalities and the public sector started floating bonds secured only by the revenues to be generated by the public utility projects. To create confidence in investors, private sector participation in public projects was solicited. The entry of the private sector into typical public sector projects, brought with it the necessary funds, managerial expertise and risk sharing. Public Private Partnerships (PPPs) have now been given a formal structure in many countries. In the UK and some other countries, this acronym takes the form of PFIPrivate Finance Initiative.
Features of Project Finance

A specially incorporated project company is formed to build and operate the project. The project company enters into a concession agreement with the host government. The project company enters into extensive contracting with several partiesthere could be up to 1000 contracts in very large projects. contracts govern inputs, offtake, construction and operations. ancillary contracts include financial hedges, insurance contracts etc. Project companies are distinguished by their highly concentrated equity and debt ownership, with frequently more than one equity sponsors, a syndicate of banks and other financial institutions providing credit, and the governing board comprising primarily of affiliated directors drawn from sponsoring firms and lending institutions. Project companies are characterized by their highly leveraged structures with mean debts as high as 70%, and the remaining equity contributed by the group of sponsoring firms in the form of either equity or quasi-equity (subordinated debt), debt being non-recourse to the sponsors. The debt is also termed project recourse since debt service depends exclusively on project cash flows. Typically, debts to project companies have higher spreads than corporate debt, though this scenario has been changing as lenders develop more experience in lending to large projects.
Structuring a project finance deal entails substantial transaction costs in the nature of fees to lawyers, consultants, and financial advisors, apart from obtaining necessary permits, environmental clearances, etc. A deal could typically take five to seven years to structure, since it also involves identifying and entering into suitable contracts with construction companies, suppliers of equipment and inputs, purchasers of output, operating companies and tying up the financing with various capital providers.
Comparison of Project Finance With Other Financing Vehicles

1. Secured debt is collateralized by a specific asset or assets. To that extent it is similar to project finance. However, secured debt almost always has recourse to other assets of the firm as well. Herein lies the dissimilarity with project finance. 2. Asset-backed securities can often be mistaken for project finance, since they appear to have all the features of the lattercollateralized by asset cash flows, and non-recourse to the originator. However, the major difference lies in the fact that asset-backed securities hold single-purpose financial assets, not single-purpose industrial assets, the latter being mostly illiquid. One of the latest developments in project finance is the securitization of project finance loans. 3. Leveraged buy outs/management buy outs may seem similar to project finance due to their high debt levels. However, LBOs/MBOs are dissimilar in that, they do not have separate corporate/government sponsors and may not consist of single purpose industrial assets. 4. Privatizations: Those that involve single purpose, industrial assets could be categorized as project finance, provided the debt is non-recourse to the private sponsors. Privatization of airports or large telecom facilities could fall under this category. However, privatization of banks or administrative bodies would not be termed project finance, since they do not satisfy the single-purpose industrial asset criterion. 5. Venture-backed Companies display concentrated equity ownership like project companies. However, debt levels are much lower than project companies, and in most cases, the managers themselves are equity holders.
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Comparison of Project Finance With Conventional Corporate Finance

Project finance and conventional corporate finance can be compared on several parameters to bring out the relative advantages and disadvantages of the two forms of financing. 1. Organization: Project companies can be structured as independent entities; hence project cash flows and assets can be segregated from the sponsors other assets and cash flows. If conventional corporate financing is used, there will be no such distinction between the new projects and the sponsors cash flows and assets. Hence, project companies can insulate sponsors from failure of risky projects. 2. Control and Monitoring: In project finance, closer control is possible since the assets and cash flows are segregated, and project specific contracts and covenants lead to closer monitoring and accountability to investors. Such close monitoring would not be possible in the conventional financing model. 3. Risk Allocation: This is one of the most important advantages of Project financing. Project structures add value since they effectively allocate risks to parties, who can best bear them through contractual arrangements. Under conventional financing, however, the project risks are spread over the entire asset portfolio of the sponsor firm, and creditors have full recourse to project sponsor. 4. Financing Arrangements: Financial closure can be achieved under project financing after substantial structuring, which could be time consuming and costly. Structuring and obtaining finance under the conventional financing mode are relatively easier, quicker and less costly. 5. Free Cash Flow and Agency Costs: This is another important advantage of Project finance. Free cash flows arising out of conventional financing structures can be allocated according to corporate policy, implying that managers of these firms have discretion over allocation of cash flows. Such discretion sometimes leads to the underinvestment problem, whereby managers of highly leveraged firms pass up positive Net Present Value (NPV) projects, because the additional cash flows would go towards debt service. These are agency costs attributed to conventional corporate financing. On the other hand, in project financing structures, managers have limited
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discretion in allocating free cash flows due to the cash waterfall mechanism inherent in most projects. Further, by contract, residual cash flows have to be distributed to equity holders. Closer monitoring by investors is possible due to segregation of assets and cash flows. Hence, the agency costs arising out of underinvestment are greatly reduced. 6. Debt Contracts and Debt Capacity: In conventional corporate financing, the lender looks to the entire asset portfolio of the sponsor for debt service. In some cases, the credit granted by the lender could also be unsecured. Further, the amount of debt depends largely on the sponsors capacity for additional debt on the balance sheet. However, in project finance, the lender looks solely at the projects cash flows for debt service, and to the assets for collateral. A unique advantage of project finance is its ability to expand the debt capacity of the sponsors by being off-balance-sheeteven sponsors with weak balance sheets can look at project finance as a viable alternative for their projects. In fact, in spite of the risks of funding long-term projects, high leverages are achieved in project finance, which provides valuable tax shields to the project company. Supplemental credit supports are also available in project financed structures. 7. Financial Distress: A significant advantage of project financing structures is the lower cost of financial distress or bankruptcy. The fact that the project and the sponsor are two different entities, isolates the project from the sponsors possible bankruptcy and vice versa. The creditors cannot claim their dues from unrelated projects. This scenario can be contrasted with the conventional corporate financing alternative, where the lenders have access to the sponsors entire asset portfolio in case of project failure. Under this scenario, difficulties in one key line of business could drain off cash from good projects, with the converse holding good too. Such complications make financial distress costly and time consuming in the traditional corporate lending option.
The Flip Side of Project Finance

Project finance takes longer to structure than an equivalent size of corporate finance.
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Transaction costs are higher in project finance due to the complexity of transactions involved. Project debt could be more expensive (50 to 400 basis points over the comparable rate under corporate finance) due to its non-recourse nature. However, research shows that the average cost of project finance is not much more than corporate finance, because of the superior risk management techniques employed in project finance. Extensive contracting could impose constraints on managerial decision-making in the case of project finance. Project finance requires more transparent disclosure of proprietary and strategic information. This is both an advantage and disadvantageadvantage since asymmetric information and the associated costs would be lower, and disadvantage since revealing more and more information leads to higher costs.
The Global Project Finance Market 7

Recent statistics show that, globally, Project finance investment has grown steeply between 1994 and 2001, with a major portion of the investment in the form of bank loans. Compared to bank loans, the growth in project finance equity has been lower; even lower than the equity growth, has been the growth in project finance bonds. However, the proportion of project bonds in project debt is increasing. Leverage of projects is increasing substantially. Most project companies have debt to value ratios of more than 70%, with less than 10% of project companies having leverage ratios of less than 50%in any case, these leverage ratios are well above those of the typical firm. Investment in electric utilities, telecommunications and transport have grown substantially during the period 1999-2002, as compared to the two decade period up to 1999. The syndicated loan market for project finance has shown sizeable growth in the four years up to 2001.
7
Esty Benjamin C, An Overview of the Project Finance Market, Harvard Business School, 2002.
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Conclusion
It is evident that the dynamic nature of globalization and economic development would necessitate innovative financing structures and instruments. Project financing structures, with their innate flexibility and risk management capabilities, will continue to adapt to future requirements of large investments. Project financing concepts and structures are of great interest and relevance in the Indian context. There is no gainsaying the fact, that the primary impediment to Indias fast track growth is the lack of quality infrastructure. It is also obvious that the government cannot fund the enormous requirements, which according to one estimate, is a staggering Rs.2000 billion in the next three years. If the private sector has to take the initiative in partnering the government in infrastructure development, sweeping changes will be required in the mindsets and framework of regulators, investors, markets and financing agencies. (Padmalatha Suresh is a post graduate in Management from IIM-A, holding LLB and CAIIB. She has two decades of banking and IT sector experience. She is currently running a financial consultancy, she is visiting faculty at IIMs and other reputed B-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached at padmalathasuresh@yahoo.com).
References
1. 2. 3. 4. Finnerty John D, Project Finance: Asset-Based Financial Engineering John Wiley and Sons, 1996. Kleimeier Stefanie and Megginson William L, An Empirical Analysis of Limited Recourse Project Finance, working draft, 2001. Esty Benjamin C, Why Study Large Projects? An Introduction to Research on Project Finance, European Financial Management, vol 10, no 2, 2004, 213-224. Esty Benjamin C, An Overview of the Project Finance Market, Harvard Business School, 2002.
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2
Project Finance in Developing Countries The Importance of Using Project Finance
Padmalatha Suresh
Project Finance is growing in importance as a tool for economic investment, by structuring the financing around the projects own operating cash flow and assets, without additional sponsor guarantees, thus alleviating risks and raising finance at a relatively low cost. Non-recourse and limited recourse project finance concepts are discussed citing examples of IFC supported projects, and their developmental impact on the economy. Government willingness in emerging markets, to fund large-scale infrastructure investments through private participation, has given the impetus for the growth of project finance. The report differentiates project finance from traditional balance sheet financing, and outlines the advantages that project finance has for private sponsors. The report concludes that in spite of all the advantages described, there are rigorous requirements and hence no free lunches in project finance.
The ICFAI University Press. All rights reserved. This article is a summary of Chapter I from Project Finance in Developing Countries The Importance of Project Finance by International Finance Corporation, April 1999.
Project Finance in Developing...
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he settings are different; the industries are different; the needs of the countries are different. Yet a common thread runs through the following examples:
Argentina, 1993: Project finance structuring helped raise USD329 million to finance the rehabilitation and expansion of Buenos Aires water and sewerage services. The concession of 30 years had been awarded to Aguas Argentina. Hungary, 1994: Project finance structuring helped finance a 15-year concession to develop, install and operate a nation-wide digital cellular network at a cost of USD185 million. China, 1997: Limited recourse project financing helped launch a $57 million greenfield project to install modern medium-density fiberboard plants in interior China, using timber plantations developed over the previous decade. Mozambique, 1998: Project finance structuring helped establish a $1.3 billion greenfield aluminum smelter. All the projects cited above used project finance to fund the huge investments required to develop the facilities in these developing countries. All these investments were financed with International Finance Corporations (IFC) support. All these investments were made with private sector participation for creating public infrastructure. Above all, these investments helped improve the quality of life of people in these countries, generated employment, increased export earnings and fostered more infrastructure development and thus, tangible economic growth. What is project finance, and what has caused this new wave of interest in project finance as a tool for economic development? The Report elaborates, Project finance helps finance new investment by structuring the financing around the projects own operating cash flow and assets, without additional sponsor guarantees. Thus, the technique is able to alleviate investment risk and raise finance at a relatively low cost, to the benefit of sponsor and investor alike. (p.1) Project finance is not a new concept. It has been used for hundreds of years, primarily in mining and natural resource projects. Its other possible applications in developing markets, especially for financing large greenfield projects
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(new projects without any prior track record or operating history) have been receiving serious attention of late. The shift in focus to the private sector to supply the investment required for large scale investments have necessitated regulatory reforms, which in turn have created new markets in spheres of activity previously considered to be the exclusive domain of governments. For example, in the United States, the Public Utility Regulatory Policy Act (PURPA), passed by the government in 1978, not only encouraged a private market for electric power, but was also seen as a precursor to the growth of project financing models in many other industrial countries. More recently, in the late 1990s, large-scale privatizations in developing countries were embarked upon to bolster economic growth and stimulate private sector investment. These developments and the governments willingness to provide incentives for attracting private investors into new sectors have given further fillip to the growth of project finance. The surge in the use of project finance was temporarily halted in the wake of the East Asian financial crisis in mid 1997, since many large projects that were being implemented at that time, suddenly turned economically and financially unviable. Contractual arrangements, the backbone of project finance structures, were all of a sudden unenforceable; though, in hindsight, many projects had failed to adequately mitigate potential risks, including currency risks. Analysts started questioning the prudence of continued use of project finance. In IFCs experience, however, project finance remains a valuable tool. Although many projects are under serious strain in the aftermath of the East Asia crisis, project finance offers a means for investors, creditors, and other unrelated parties to come together to share the costs, risks, and benefits of new investment in an economically efficient and fair manner. As the emphasis on corporate governance increases, the contractually based approach of project finance can also help ensure greater transparency. (p.3) Despite the setbacks of the past, project finance techniques are likely to grow in importance, as developmental investment in emerging markets needs enormous capital, which cannot be met through government finances alone. Moreover, the ability of project finance structures to allocate and mitigate risks will be valuable for getting several projects with private investment off the ground. The crisis has also demonstrated that individual projects have to be adequately supported by
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far reaching regulatory reform designed to enhance competitiveness and efficiency, and to develop domestic financial markets to support local investment. IFC is certain that in the appropriate framework, project finance can provide a strong and transparent structure for projects and through careful attention to potential risks, it can help increase new investments and improve economic growth. The Report then goes on to outline the basic concepts and features of project finance: Every project finance deal is tailored to meet the needs of a specific project. Repayment to capital providers depends solely on the cash flows and the project assets. Along with the sponsors, the risks and returns are borne by various investorsequity holders, debt providers, or quasi-equity investors. The important criterion to decide if an investment can be project financed is the projects ability to stand alone as a distinct legal and economic entity. Project assets, project related contracts and project cash flows are segregated from those of the sponsor. Project finance can be non-recourse or limited recourse. Non-recourse project finance is an arrangement under which investors and creditors financing the project, do not have any direct recourse to the sponsors, as is the conventional practice. Although creditors security will include the assets being financed, lenders rely solely on the operating cash flow generated from those assets for repayment. The project must therefore be carefully structured to satisfy its financiers about its economic, technical, and environmental feasibility, its debt servicing capacity and its ability to generate financial returns commensurate with its risk profile. Limited-recourse project finance permits creditors and investors some recourse to the sponsors. This frequently takes the form of a pre-completion guarantee during a projects construction period, or other assurances of some form of support for the project. Creditors and investors, however, still look to the success of the project as their primary source of repayment. In most developing market projects and in other projects with significant construction risk, project finance is generally of the limited-recourse type.
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Project Finance vs. Corporate Lending

Project finance differs in many respects from conventional corporate lending. The most striking point of difference is that in traditional corporate financing, the primary source of repayment for investors and creditors is the sponsoring company itself, its reputation, and the strength of its balance sheet, apart from the project economics. The sponsors financial standing is a hedge against project failure for the lenders. On the other hand, in project finance, the primary source of repayment is the project cash flows alone. In corporate finance, if the project fails, lenders do not necessarily suffer, as long as the sponsoring company remains financially viable and solvent. However, in project finance, since the lenders look primarily to the project cash flows for their repayment and have little or no recourse to the sponsors balance sheets, project failure may entail significant losses to lenders and other investors. Therefore, all types of assets may not benefit from being project financed. IFC believes that project finance benefits primarily those sectors or industries in which projects can be structured as separate entities, distinct from the other activities of the project sponsors. A stand-alone production facility, which could be isolated from the project sponsors other assets and separately assessed in accounting and financial terms, would therefore benefit from project finance. Typically, these projects tend to be relatively large, take a long time and, are costly to structure and absorb huge doses of debt. Since market risk greatly affects the potential outcome of most projects, project finance tends to be more applicable in industries where the revenue streams can be defined and fairly easily secured. In recent years, private sector infrastructure projects under long-term government concession agreements, have been able to attract major project finance flows. Though, in developing countries, project finance techniques were traditionally used in the natural resource sectorsmining, oil and gas and such others, regulatory reform and a growing body of project finance experience continue to expand the situations in which project finance structuring makes sense. For example, project finance is used for building merchant power plants that have no Power Purchase Agreements (PPA), but sell into a national power grid at prevailing market prices.
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In IFCs experience, project finance is applicable over a fairly broad range of nonfinancial sectors, including manufacturing and service projects such as privately financed hospitals (wherever projects can stand on their own and where the risks can be clearly identified upfront). Although the risk-sharing attributes of a project finance arrangement make it particularly suitable for large projects requiring hundreds of millions of dollars in financing, IFCs experienceincluding textile, shrimp farming, and hotel projectsalso shows that the approach can be employed successfully in smaller projects in a variety of industries. (p.4) Thus, IFCs vast experience suggests that project finance could help attract private funding to a wider range of activities in many developing markets. IFCs experience also shows that of late, increasing proportions of project finance flows go into developing markets. Since project finance allocates costs, risks and rewards of a project effectively among a number of unrelated parties, an economically viable privatization or infrastructure improvement program in developing markets now has wider opportunities and sources to raise funds. As a result, it is now standard practice for large and complex projects in developing markets to employ project finance techniques. The total volume of project finance transactions concluded in 1996 and 1997 before the financial crisis (an estimated 954 projects costing $215 billion), would have been hard to imagine a decade ago. The number of active participants in these markets also increased as many international institutions (investment banks, commercial banks, institutional investors, and others) started to quickly build up their project finance expertise. Most of this dramatic growth had taken place in East Asia. However, the financial and economic crisis that began in mid-1997, and spread to other countries since then, had temporarily slowed market evolution. The estimated number of projects in developing markets fell in 1998. IFC opines, When the growth of new productive investment picks up again, however, project financing is likely to increase, particularly in countries where perceptions of risk remain high, and investors could be expected to turn to structuring techniques to help alleviate these risks.1
1
Note: The article was published in 1999, hence developments after this period have been surmised by IFC. Recent statistics show that project finance transactions are on the rise again, especially in developing countries.
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Advantages of Project Finance

In situations where project finance is the most suitable, it scores over traditional corporate finance on two major counts(a) it increases the availability of finance, and (b) it reduces the overall risk for major project participants to an acceptable level. As already stated in an earlier paragraph, corporate sponsors of risky projects prefer project finance since the risks of the new project would be isolated from the sponsors existing business, and project failure would not contaminate the sponsors balance sheet or its core businesses. Since the project debt is also isolated, a properly structured project finance transaction would protect the sponsors capital base and debt capacity, and would also allow the new project to be financed without the high doses of equity investment that traditional corporate finance would demand for a similar project. Thus, the technique enables sponsors to increase leverage to high levels and simultaneously expand their business, without being tainted by the projects risks. Since project finance structures typically involve multiple sponsors, it would be possible for interested sponsors to take on larger projects with greater risks. By allocating risks effectively among a group of interested parties, project finance enables effective risk management. This was the case in 1995, when IFC helped structure financing for a $1.4 billion power project in the Philippines during a time of considerable economic uncertainty there. Sharing the risks among many investors was an important factor in getting the project launched. The Report remarks in this context, To raise adequate funding, project sponsors must settle on a financial package that both meets the needs of the projectin the context of its particular risks and the available security at various phases of developmentand is attractive to potential creditors and investors. By tapping various sources (for example, equity investors, banks, and the capital markets), each of which demands a different risk/return profile for its investments, a large project can raise these funds at a relatively low cost. Also working to its advantage is the globalization of financial markets, which has helped create a broader spectrum of financial instruments and new classes of investors. By contrast, project sponsors traditionally would have relied on their own resources for equity, and on commercial banks for debt financing. (p. 5)
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Private equity investors, who are willing to take more risk, are becoming increasingly important players in the project finance market. They are willing to extend long-term subordinated debt in anticipation of higher returns, which could be in the form of equity or income sharing. Such investors, who tend to take a long-term view of their investments, are being increasingly attracted into projects to supplement or even substitute for bank lending. Box 1: Project Financing Instruments, Sources, and Risk-Return Profiles
Commercial Loans: Funds lent primarily by commercial banks and other financial institutions, generally securitized by the projects underlying assets. Lenders seek: (1) projected cash flows that can finance debt repayment with a safety margin; (2) enough of an equity stake from sponsors to demonstrate commitment; (3) limited recourse to sponsors in the event of specified problems, such as cost overruns; and (4) covenants to ensure approved usage of funds and management of the projects. Equity: Long-term capital provided in exchange for shares, representing part ownership of the company or project. Provided primarily by sponsors and minority investors. Equity holders receive dividends and capital gains (or losses), which are based on net earnings. Equity holders take risks (dividends are not paid if the company makes losses), but in return, share in profits. Subordinated Loans: Loans financed with repayment priority over equity capital, but not over commercial bank loans or other senior debt in the event of default or bankruptcy. Usually provided by sponsors. Subordinated debt contains a schedule for payment of interest and principal but may also allow participation in the upside potential similar to equity. Supplier Credit: Long-term loans provided by project equipment suppliers to cover purchase of their equipment by the project company. Particularly important in projects with significant capital equipment. Bonds: Long-term debt securities generally purchased by institutional investors through public markets, although the private placement of bonds is becoming more common. Institutional investors are usually risk-averse, preferring projects with an independent credit rating. Purchasers require a high level of confidence in the project (for example, strong sponsors, contractual arrangements, and country environment); this is still a relatively new market in developing countries. Internally Generated Cash: Funds available to a company from cash flow from operations (that is, profit after tax plus noncash charges, minus noncash receipts) that are retained and available for reinvestment in a project. In a financial plan, reinvested profits are treated as equity, although they will be generated only if operations are successful.
Contd...
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Contd...
Export Credit Agency (ECA) Facility: Loan, guarantee, or insurance facility provided by an ECA. Traditionally, ECAs asked host governments to counterguarantee some project risks, such as expropriation. In the past five years, however, many have begun to provide project debt on a limited-recourse basis. Multilateral or Bilateral Agency Credit Facility: Loan, guarantee, or insurance (political or commercial) facility provided through a multilateral development bank (MDB) or bilateral agency, usually long term. Loans may include a syndicated loan facility from other institutions, paralleling the MDBs own direct lending.
Source: IFC: Project Finance in Developing Countries: The Importance of Using Project Finance.
No Free Lunch
For all its advantages, project finance cannot be said to offer a free lunch. On the contrary, it has rigorous requirements. To render a project suitable for project finance, the following aspects need to be taken care of : The project has to be carefully structured to ensure that all the parties obligations are negotiated and are contractually binding. Considerable time and effort on the part of financial and legal advisers and other experts may have to be expended to do a detailed appraisal of the projects technical, financial, environmental and economic viability, and structure the project in the most optimal manner. Identification and analysis of the projects risks, and allocation and mitigation of these risks, are extremely important steps. Though it may be costly and time-consuming, detailed risk appraisal is absolutely necessary to assure other parties, including passive lenders and investors, that the project makes sound economic and commercial sense. These preliminary steps imply that transaction costs could be much larger than for conventionally financed projects. Framing the detailed contracts will add to the cost of setting up the project and may delay its implementation. Moreover, the sharing of risks and benefits brings unrelated parties into a close and long relationship. A sponsor must consider the implications of its actions on the other parties associated with the project (and must treat them fairly) if the long-term relationship is to remain harmonious.
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Lenders and investors must be kept abreast of the projects operational performance as it progresses. The largest share of project finance normally consists of debt, which is usually provided by creditors who have no direct control over managing the project. They try to protect their investment through collateral and contracts, broadly known as a security package, to help ensure that their loans will be repaid. The quality of the security package is closely linked to the effectiveness of the projects risk management. It is therefore, essential to identify the security available in a project and to structure the security package to mitigate the risks identified (see Box 2). Box 2: A Typical Security Package
The security package will include all the contracts and documentation provided by various parties involved in the project, to assure lenders that their funds will be used to support the project in the way intended. The package also provides that if things go wrong, lenders will still have some likelihood of being repaid. A typical security package will include a mortgage on available land and fixed assets; sponsor commitments of project support, including a share retention agreement and a project funds agreement; assignment of major project agreements, including construction and supply contracts and offtake agreements; financial covenants ensuring prudent and professional project management; and assignment of insurance proceeds in the event of project calamity. The quality of the package is particularly important to passive investors, since they normally provide the bulk of the financing, yet have no say in the operations of a project and, therefore do not want to bear significant operating risks. The strength of the package, as judged by the type and quality of security available, governs the creditworthiness of the project, effectively increasing the share of project costs that can be funded through borrowings. Significant additional expense may accrue in identifying and providing the security arrangements, which will also require detailed legal documentation to ensure their effectiveness.
Source: IFC: Project Finance in Developing Countries: The Importance of Using Project Finance
The IFC report further clarifies, Some projects may need additional support in the form of sponsor assurances or government guaranteesto bring credit risk to a level that can attract private financing. The overall financial costs of a project finance transaction may not be as high as under corporate finance if the project is carefully structured, risks are identified and mitigated to the extent possible, and appropriate financing is sourced from different categories of investors. The senior debt component may be more expensive, however, because debt repayment relies
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on the cash flow of the project rather than on the strength of the sponsors entire balance sheet. The project sponsors will need to carefully weigh the advantages of raising large-scale financing against the relative financial and administrative costs (both upfront and ongoing) of different sources of finance. (p 7)
Conclusion
The report has drawn on IFCs experience in more than 230 greenfield projects costing upward of USD30 billion. All these projects had relied on project finance on a limited recourse basis. IFC and other multilateral, bilateral and export credit institutions have been playing major roles in making project finance more attractive in developing markets. IFC, in particular, was a pioneer of project finance in developing countries and has a unique depth of experience in this field, which spans more than 40 years in the practical implementation of some 2,000 projects, many of them on a limited-recourse basis. IFCs ability to mobilize finance (both loan and equity for its own account and syndicated loans under its B-loan program), the strength of its project appraisal capabilities, and its experience in structuring complex transactions in difficult environments have been reassuring to other participants and important to the successful financing of many projects. (Padmalatha Suresh is a post graduate in Management from IIM-A, holding LLB and CAIIB. She has two decades of banking and IT sector experience. She is currently running a financial consultancy, she is visiting faculty at IIMs and other reputed B-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached at padmalathasuresh@yahoo.com).
Public-Private Partnerships: the Next Generation...
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3
Public-Private Partnerships: The Next Generation of Infrastructure Finance
The private sector can play an active or passive role in infrastructure investment as project sponsor or an institutional bond investor. PPP models have larger roles to play in emerging and other economies for funding infrastructure requirements far in excess of currently available financing. The pre-requisites for a receptive PPP debt market are a relatively stable macroeconomic environment, a sound legal framework for concessions, contract enforcement, and bankruptcy remedies, a stable regulatory framework and a developing domestic debt market. The blurring of the thin line between structured financing and PPPs has given rise to some myths regarding PPPs, which are listed out and explored. With more and more innovation, the PPP market is all set for growth. Some of the next-generation developments relate to (a) pooling of credit risks (b) the US SRF model, and (c) enhancing Pooled credit risk The successful experiment with such credit enhancements in the case of USAID support of the Water and Sanitation Pooled Fund (WSPF) in Tamil Nadu, India, has also been highlighted.
Source: http://www.fitchratings.com.au/projresearchlist.asp 2004 Fitch Ratings, Ltd. Reprinted by permission of Fitch, Inc.
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Summary
The scope of global demographic, public health and safety needs, as well as economic development goals, translates into infrastructure requirements, far in excess of currently available financing resources. While the degree of this funding backlog differs from country to country, it extends from the poorest to the richest of nations. This is true even in the United States, which enjoys the full benefits of decentralized governmental responsibility and an extensive domestic debt market. Recognition of this funding gap has resulted in a nearly universal acceptance that the private sector can and should play a larger role in the financing of infrastructure in partnership with the public sector, whether actively as a project sponsor or passively as an institutional bond investor. The latter role carries greater promise for enhancing the supply of capital for infrastructure, provided that structural elements meaningfully enhance the credit quality of proposed debt instruments so as to engage a countrys domestic debt market. Sustainable infrastructure financing can be achieved from the traditional lending roles of national and international development banks, although not in meaningful amounts. Dependence on existing project sponsor companies is even less reliable, given the ongoing contraction within that industry. In developed countries, these funding partnerships arise regularly through varying combinations of bond and commercial (or government-owned) bank loan transactions issued directly by local governments, government-owned enterprises and private companies contracted by government authorities to provide a public service. In the 1990s, private sector participation in the financing of infrastructure needs outside of the Organization for Economic Cooperation and Development (OECD) countries was defined actively by privatizations and concessions. Passively, it occurred through private debt placements with a select group of foreign institutional investors or loan syndications sponsored by a few multilateral banks. These efforts yielded some positive results but failed to resolve the global infrastructure funding gap outside the OECD countries. In emerging markets, the public and private sectors jousted over sovereign control versus investor rights and remedies, as well as expectations over public access to infrastructure versus a reasonable rate of return on capital. Market expectations were further battered by
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macroeconomic volatility, the political expense of privatization without public involvement at the local level, and the incompatibility of financing documents with the host countrys legal practices and customs. Finally, private sector project equity relied largely on a collapsing field of financially extended construction companies and showed little capacity for sustained investment. After considerable expectations and a thorough education concerning the various iterations of designing, building, operating and transferring, the global infrastructure funding gap grew. For a number of countries, a new and more interesting generation of publicprivate partnerships (PPPs) is now emerging, which Fitch Ratings believes will center on a more efficient and sustainable allocation of capital. Local governments, in partnership with development banks, and international aid agencies are slowly discovering that, by pooling project credit risk through infrastructure banks and adding layers of credit enhancement (initial payment of project debt by local user fees or taxes, followed by the ability to intercept intergovernmental aid, reserve funds and partial credit risk guarantees from external sources), they can engage domestic private capital. By providing an enhancement role with its capital, this public sector coalition will be able to leverage its funds much further, while domestic investors will benefit from the gradual diversification of their investment portfolios. The remaining construction conglomerates are still on the scene, but their role is less for equity and more for their expertise in designing, constructing and operating projects. Privately financed infrastructure banks that pool project risk are not far behind. In this new generation of PPPs, the private sector role shifts to the financial engineers who work in conjunction with government authorities, as well as development and multilateral banking partners, to create enhanced investment vehicles that are attractive to domestic capital. Stabilized revenue streams and a strong ultimate recovery value of infrastructure assets open the door for progressively longer debt tenures, correcting an age-old mismatch between the term of debt and the useful life of an infrastructure asset. While a state-owned highway or municipal water system may default on its debt, these are assets with long useful lives that will not be wound up, as in a bankruptcy of a corporate entity. The ultimate test for these developing domestic debt markets is whether this more efficient allocation of risk between the public and private sectors will also translate into more realistic (i.e., achievable) rates of return on
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private investment. If it does, then for these countries the allocation of capital will not only be efficient, but it will also be sustainable. For this new generation of PPPs to flourish, the host countries must nurture some important prerequisites. These include promoting a relatively stable macroeconomic environment, developing a legal and regulatory framework for infrastructure projects and nurturing the development of a domestic debt market. Unfortunately, these prerequisites do not exist in most parts of the world, which means that some of the traditional roles of the multilateral and development banks will remain necessary over the long term. In countries where these prerequisites are taking shape, however, there are real opportunities to expand the availability of capital by using pooled financings and credit enhancements to harness a developing domestic debt market. Stimulating the efficient use of capital is not the only challenge facing the next generation of PPPs. These partnerships must also expel a set of myths that have developed along with PPPs. This includes a careful evaluation of partnership structures that utilize private sector expertise and efficiency without also embracing corporate bankruptcy and consolidation risk. (Consolidation risk, in particular, is not widely understood or anticipated in many non-common law countries, partly due to codified provisions on the nature of trusts and other legal entities that presumably guarantee their assets are separated and, therefore, protected from third-party claims). Due to their nature, PPPs will be affected legally by both administrative law and commercial or corporate laws. Consequently, a court might dictate against the rights of the private partners on the reasoning that the public interest must be elevated above the interests of the private entity. This decision may be based on the essentiality of services derived from the infrastructure project and their function with respect to maintaining social order and safety, as well as public health. Evidently, public partners can and will change their minds, so that structured debt transactions will never achieve the level of securitization (security) expected of credit card or residential mortgage receivable transactions. Trustee relationships, while greatly enhancing the credit quality of PPP debt transactions, will never mitigate credit risk fully.
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Finally, a more sophisticated approach to understanding the true enhancement value of government project support, which is too often overinterpreted as a direct government guarantee, is required. Does this support promote the full and timely payment of debt service or enhance a transactions ultimate recovery value? Is it a general obligation of the government or a contingent obligation subject to budgetary appropriation? The shades of gray concerning government guarantees form a broader spectrum than most market participants acknowledge, even in developed countries. The perpetuation of these myths impedes the participation and pace of development of domestic capital for infrastructure. Nevertheless, the next generation of PPPs, armed with pooled project risk and supplemented by multiple layers of credit enhancement, is perhaps the best chance for a sustainable supply of capital to meet global infrastructure needs.
Prerequisites for a Receptive PPP Debt Market

A relatively stable macroeconomic environment. A developing legal framework for concessions, contract enforcement, bankruptcy and lender remedies. A relatively stable regulatory framework that recognizes the lifecycle needs of the project. A developing domestic debt market. The traditional alternatives to infrastructure finance in most countries are central government deficits and debt and multilateral bank lending, as well as the foregone economic opportunities of simply not investing in infrastructure. A greater capacity of infrastructure investment is present in the developed countries due to the participation of the private sector, both passively as institutional and retail investors in infrastructure bonds and actively through companies that sponsor projects as contractors, operators or equity investors. However, private sector participation requires some structural prerequisites (i.e., a stable playing field) that lessen a countrys susceptibility to economic and financial contagions and create an orderly legal and regulatory environment in which to invest and operate. Unfortunately, a quick perusal of these investor prerequisites reveals how few countries fit all of these categories. Nevertheless,
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private investors (both domestic and international) have shown interest in countries that are at least moving toward these structural prerequisites. This allows Fitch to distinguish certain countries, such as Mexico, Korea, Chile and Poland, as more ripe for private sector investment than others.
Relatively Stable Macroeconomic Environment

Only a few countries have truly stable macroeconomic environments, and most are susceptible to the contagion effect of a financial and economic crisis. Nevertheless, countries that have taken steps to control inflation and external debt, increase official international reserves and utilize trading partnerships often provide fertile ground for domestic and foreign private investment. For an infrastructure project, a national and economic crisis creates not only risk for the financial performance of the infrastructure transaction (i.e., its ability to generate sufficient revenues to cover operating and debt service costs) but also added uncertainty as to the range of political responses that might affect its operations during a crisis.
Developing Legal Framework

The private sector requires clear and stable rules of engagement as provided through a countrys legal framework. If a countrys public policy wants to encourage private sector participation in the financing of infrastructure, its laws should support that policy. This includes laws governing concessions and/or privatizations, a clear process for dispute resolution and the ability to enforce contracts, as well as lender remedies under bankruptcy and insolvency. A number of countries, including Chile, Panama and Korea, have developed comprehensive and transparent concession laws, where public sector goals and objectives in private participation are clear. Equally clear is the process by which the private sector is to bid on an infrastructure project or system, operate after winning a concession contract and recover a return on its investment. Nevertheless, dispute resolution systems in many countries look good on paper but do not work well in practice. The rules of negotiation continue to prevail over rules for contract enforcement, in most legal documentation. Finally, legal precedents (such as in the state of Parana, Brazil) where a court upheld a contested concession provision (in this case, a scheduled rate increase) are rare.
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Bankruptcy laws also have been amended in many countries, as borrowing migrates from commercial bank loans to the capital markets. Still, as lender rights become codified, their application in the real world is often untested due to the continuing propensity to negotiate financial arrangements outside the courts. For these reasons, the ongoing practice of diluting, rather than eliminating, the equity participation of construction and project sponsor firms that are in or near bankruptcy, as in Korea, may unnecessarily expose an otherwise economically viable project to bankruptcy and consolidation risk. Of equal concern is the belief, as in Mexico, that a future flow securitization can sidestep the ongoing bankruptcy proceedings of a private project partner. With new and untested legal regimes, it is dangerous to rely solely on the integrity of financial structuring techniques, especially during a financial and economic crisis. For the private partners, the range of compensation mechanisms for political risk is still developing. Public sector partners can and will change their minds, thereby affecting the projects operating environment. Compensation is usually expressed as extraordinary rate relief or as an extension of the term of the concession. In the case of termination of a concession, provisions that provide compensation based on some measure of the net present value of revenues over the remaining life of the concession but for no less than the amount of debt outstanding, are increasingly present.
Relatively Stable Regulatory Framework

A countrys regulatory framework is simply the reflective implementation of its legal and public policy framework. The base set of regulations should be developed in tandem with the legal framework for concessions and privatizations. This process takes time, but it allows the host government to gain its own comfort level with the classic trade offs between access to private capital and the dilution of its own sovereignty. Regulations should focus on the lifecycle of the project (i.e., from design, to construction, to operation and to its eventual return to the public sector). In Korea, the project selection process involves representatives of all the governmental ministries that will be involved with that project over its lifespan. This mitigates much of the regulatory risk upfront, since the concession agreement can reflect the concerns and agendas of the various government ministries that will be involved with the project. The private sector operator can choose to adapt its concession expectations to an onerous regulatory environment. However, project economics often lack the flexibility to adapt to a shifting regulatory environment.
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Developing a Domestic Debt Market

Development of a domestic capital market is key to creating a sustainable supply of capital for infrastructure. For infrastructure finance, the domestic debt market should be the cake, while the foreign capital markets should be the icing, since in most cases the source of repayment will be generated in the host countrys currency. Local investors also are in a better position to assess the concessions service area and political risk. Infrastructure transactions with either a US dollar revenue stream or with construction or acquisition costs that exceed the financing capability of the local debt market make better candidates for foreign capital but not without structural enhancements, such as offshore reserves and multilateral risk guarantees. A growing number of emerging-market countries are developing domestic debt markets. The development process requires financial sector reforms, including the ability to invest funds in more than direct government debt. It also necessitates a savings plan. Typically, these markets are shallow in that investments are usually limited to the bonds of the central government and a handful of other governmental or privatized entities. Investments also are limited to short- and medium-term maturities. The ability to issue the long-term debt maturities needed by infrastructure projects simply does not exist throughout most of the world. Even in countries that have robust domestic debt markets, like Korea and Mexico, the average life of a corporate bond is still approximately 37 years; a notable exception is Chile, where to date nine projects have been financed in the national bond market at terms of 20 years. Generally, the remarketing of these medium-term debt maturities is a big risk for infrastructure projects, where revenue growth and financial margins may not be able to accommodate interest rate volatility. Finally, infrastructure bonds often represent a new form of asset class for domestic investors. Until these userbased revenue streams prove themselves, many domestic investors will continue to require other forms of government support.
Critique of Traditional PPPs

The drive toward privatization and concession-based project financing in the mid1990s was seen by many governments as a way to jump start infrastructure investments. The belief was project finance could infuse new capital and better management practices into poorly maintained and overutilized infrastructure
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systems. The initial efforts of the 1990s were promising, but they soured throughout the emerging-market countries with the contagion effect of the Asian financial crisis of 1997. While this explains the sudden interruption of new capital, it does not fully explain why infrastructure finance never really recovered. Evidence from the past decade points to difficulties caused by the government sectors rush to privatize basic public services, in most cases without a proper transition period. This resulted in an inevitable clash between public policy goals, public expectations and the private sectors desire for a reasonable rate of return on capital. While the project finance community enjoyed creating a new vocabulary for the many iterations of these partnerships (e.g., build-operate-transfer, build-transferoperate, build-own-operate, buy-build-operate and design-build-operate, among others), most of these transactions did not have the transitional underpinnings to operate as independent enterprises, or the credit enhancements necessary to withstand macroeconomic volatility. The developed world pushed its construction and financing contractual frameworks onto the developing world, external financing was seen as synonymous with external expertise and both sides misinterpreted the consequences.
Public-Sector Risk in Traditional PPPs

It is important for the private and public sectors to understand the risks of transacting with each other. The key risks that the private sector faces in dealing with the public sector are described below, followed by the key risks of dealing with the private sector. In all cases, this is not intended to discourage interaction but to point out areas where proper structuring can enhance the survivability of an infrastructure transaction.
Determining Service Ownership

In many countries, ownership disputes over certain public services continue between state and municipal governments. While some governments, like Mexico and Brazil, slant resources and regulation at state-owned water utilities, actual title to the water services remains unresolved. It will be difficult to engage private capital until the ownership issue is legally addressed. In many cases, state-owned utilities have contracts with neighboring municipalities, but these are often short-term contracts, and the utilities desire longer term debt. Ownership disputes lend uncertainty to the continuity of utility revenue streams.
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Creating Dependable Project Revenue Streams

Capital markets count on dependable revenue streams to make full and timely payment of debt service. State and local revenues (including infrastructure user fees), outside of central government transfers, rarely make a dependable revenue stream for infrastructure debt in emerging markets. This is partly because local governments in many parts of the world depend on central government transfers as their main source of revenues. The relative newness of decentralized governmental services is another factor. Local enterprises, such as water authorities, are often plagued with poor revenue collections, reflecting relative inexperience and feeble administrative capacity to operate their enterprises as a business. These challenges are coupled with a still weak public acceptance for user fees and, equally, hikes in user fees after an improvement in service. The opportunity for a public enterprise to operate as a publicly owned business, including productivity gains and rate increases for capital improvements, can facilitate its transition to the private sector. Corporatization, whereby the publicly owned enterprise is organized and run as an independently financed and operated business, can prepare users for the consequences of improved and reliable services. Along this line, the state of So Paulo, Brazil, operated the Anchieta-Imigrantes toll road as a public enterprise, first implementing tolls along this important route and then increasing rates commensurate with capital improvements or with inflationary cycles. When the private consortium Ecovias won concession over the toll road, its customers had already adjusted their behavior to paying for service enhancements. Similarly, the National Water Commission in Mexico has targeted certain service-level and administrative efficiencies as prerequisites, before state-owned water utilities can borrow for additional water or sewer capacity.
Protecting Against Political Risk

Many governments, until recently, were caught up in the rush to privatize now and worry about the consequences later, causing a general public backlash against privatization. This is especially the case in Latin America, where project contractual covenants, government budgetary capabilities and public expectations are at odds with one another. The absence of corporatization, as mentioned, and the lack of public participation at the local level resulted in an escalation of political risk for both privatizations and concessions. For countries where the prerequisites attract
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private sector investment and the legal system supports compensation, effective ways to mitigate political risk are as follows: Select projects that best fit the national, state or local priorities for economic development. Choose projects with sound economic value. Seek project partners with strong levels of commitment and expertise with infrastructure assets. Provide an adequate period of corporatization prior to privatization to ensure interim improvements in the efficient delivery of public services. Endow projects with sufficient financial protections to mitigate risk, such as liquidity to offset completion risk, operating ramp-up risk and economic cycles. Clarify the relationship between the subnational entity and its public-service companies; the flows of capital and the administrative control between parent government and enterprise should be well understood.
Private Sector Risk in Traditional PPPs

Host governments want the expertise, efficiency and capital that the private sector can bring to infrastructure and local government services. They should avoid exposure to the corporate sectors bankruptcy and consolidation risk. PPP structures are improving upon their ability to isolate voluntary bankruptcy risk (via starting with an economically viable project). However, the relative newness of revisions to bankruptcy codes contributes to a lesser understanding of the risk of involuntary bankruptcy in countries where this legal concept applies. Evaluating bankruptcy risk requires a full understanding of who the projects partners are and their roles with respect to ultimate ownership of the projects land, facilities, equipment and cash.
Mitigating Voluntary Bankruptcy

For mitigating voluntary bankruptcy, the foremost rating consideration is the economic value of the infrastructure project or system. If it has strong economic value, there is less reason to worry about testing the host countrys legal environment, which in most cases is either underdeveloped or untested. After
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that, credit quality can be enhanced by the structure of the projects financial transaction. Governing by covenants provides investors with minimum legal parameters for an infrastructure transactions financial margin and limits the events of default that could lead a project into bankruptcy. Typical infrastructure project covenants include the following: A revenue covenant with minimum required debt-service coverage levels. Lowest required funding levels for various debtservice and operating reserves. Minimum financial tests for the issuance of additional debt. An order of priority for the payment of operations, debt service and the replenishment of reserves, as well as certain tests prior to making equity distributions. Requirements to re-engage financial consultants if the performance of a project does not meet the minimum covenant levels. Conditions that cause an infrastructure transaction to default should be sufficiently limited to promote its survival. Typical defaults are for nonpayment of debt service and a continuing breach of other covenant requirements beyond a prescribed cure period. The latter provides some latitude for reaching compliance without placing the project into immediate default.
Mitigating Involuntary Bankruptcy

More difficult to detect is the involuntary bankruptcy risk of a private sector partner. This partly reflects shortcomings in corporate sector accounting, as well as the market volatility of certain corporate activities. Involuntary bankruptcy exposure of infrastructure projects to which these corporate entities are counterparty assumes the project is functioning fine, but its ability to meet financial obligations is interrupted externally by investor claims on the corporate parent or subsidiary to the company associated with the project. There are a number of ways to mitigate this involuntary bankruptcy risk.
Structuring the Issuer (Creating a Bankruptcy-Remote Entity)

The type of vehicle employed to issue project debt will depend on the possibilities afforded by national laws. Thus, in Mexico trust is the one entity that enjoys legal
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person status under Mexican law. In the United States and other countries, trusts and special-purpose vehicles are also available, with respect to which bankruptcy risk mitigation is the most vital characteristic. Chile created a special corporation under its concession laws. Generally, a nationally incorporated subsidiary or consortium can be created as a special-purpose, bankruptcy-remote entity. The further this independent entity is removed from the operations of the infrastructure project or system, the more bankruptcy-remote it becomes. A special-purpose entity can be a shell, with it being solely responsible for receiving and transferring a given asset to a trustee. A special-purpose entity also can own an asset, have no ability to voluntarily file for bankruptcy and contract out for operations. A bankruptcy-remote structure can be an independent commercial entity and protects against consolidation of the issuers assets in a bankruptcy case involving either its parent corporation or another subsidiary of the parent. Many so-called, special-purpose companies are not so limited. They may be incorporated under the host countrys law, but their articles of incorporation and shareholder documents may not create enough distance from the parent company or subsidiaries. In addition, many articles permit engagement into ancillary businesses, creating an additional window for bankruptcy risk.
Structuring the Transaction (Creating a Trust Estate)

Another approach structures the infrastructure debt transaction. The debt issuer sells its rights to the cash flow, securing the debtholders obligation to a specially created trust estate. Alternative structures can include a limited liability corporation (LLC) or a limited partnership. Under this deed of trust, all of the issuers interests, rights and obligations are sold to a trustee on behalf of the bondholders. While the issuer has assigned away its rights, it can still earn returns from the project, although no money is released until the trustee has satisfied all other financing agreement requirements. The trust estate concept is gaining acceptance in such domestic debt markets as Mexico through the creation of a master trust agreement. Nevertheless, there are cases in which a trusts value may be overestimated, particularly where a project trust is created during the ongoing bankruptcy of a parent project sponsor company.
Limiting the Operators Interest in the Project

In addition to sponsor companies in a project consortium, project operators are
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the other private partners in an infrastructure transaction. Their role is important since it is often the operator that holds the cash. Legal structures that limit the operators interest in the project to that of an agent contractually obligated to provide a specified service for the project (i.e., the operator has no legal rights to the cash) can eliminate its bankruptcy risk. It is also important to have provisions in an operating agreement for the potential replacement of an operator under certain conditions of nonperformance.
Common Myths Concerning Public Infrastructure Finance

Much of the discussion has centered on how structural elements enhance the credit profile of PPP transactions. The lines between PPPs and structured finance have blurred considerably, which carries both positive and negative consequences. The most positive consequence is that domestic debt markets for infrastructure bonds are now developing in countries like Korea, Mexico and Chile, where until recently such projects were financed only by commercial or government development banks. Strong concession laws, revised bankruptcy regimes, the creation of special-purpose entities and new trustee relationships have set the stage for an exciting evolution in infrastructure finance for both local governments that have large infrastructure financing needs and domestic investors that need to diversify their investment portfolios. Nevertheless, while PPP transactions have much of the appearance of securitizations, they will never be true securitizations. There are two explanations for this. The primary reason is the role of administrative law, not only corporate law, in the legal frameworks in which most public infrastructure is developed. Namely, the essentiality of the public service can persuade a court under certain circumstances to dictate against the interests of the private sector and cut off investors from the revenues and assets derived from the project. In addition, a public-sector partner in the PPP can and will change its mind about public policy objectives, its regulatory framework and interest in cooperating with private sector requirements for return on capital, especially during difficult economic times. This leads to the secondary reason, which concerns the ratio dynamics that drive much of the structured finance world. Collateral and other tests that are developed for the securitization of traditional asset classes, such as residential mortgages, are based on the collective behavior of thousands of loans observed over a long period. Traditional PPPs are often single-asset facilities instead of a
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portfolio of thousands of credit card or mortgage accounts. There are not enough existing PPPs from which to derive statistically meaningful default behavioral patterns or to develop fixed-coverage tests for a given rating category. Add to this individuality the constant possibility that a PPPs operating environment can change with the policies of a new administration. This diminishes the value of traditional structured finance ratio-driven analysis. From this experience, some important misconceptions about PPPs have emerged. Fitch has categorized four as myths, not because their claims are never true or cannot be made true but because they are frequently misconstrued as true.
Myth 1: Bulletproof Financial Transaction

Experience with PPPs suggests it is not possible to structure the kind of bulletproof transactions common among more conventional securitization asset classes. Governments from China to Argentina to the United States can and do change the rules governing PPP transactions. Every project has multiple agreements, but they generally fall into two broad sets. One set governs the projectconcession, construction and operating agreements fall into this category. The other governs financingtrustee, assignment and intercreditor agreements. While the financial community likes to focus its attention on the protections afforded by the financing documents, it is important to remember that the concession agreement actually sets the tone for everything to do with the project. The concession agreement is the governments grant to a public- or private sector partner to build, operate and benefit from a projects revenue stream for a period, and under a certain set of conditions, until the project reverts back to the government. This includes the governments grant to the project partner to charge and collect user fees, that will recover operating and capital costs of the project and pay debt service and potential dividends to private sector partners. The concession agreement can also determine the circumstances and timing of fee increases (e.g., annual increases tied to inflation, with a maximum allowable rate of return on capital). All the protections afforded by the financing documents should be calibrated to these overriding rights and obligations under the concession agreement if they are to remain enforceable. Strengths of various Mexican toll
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road master trust agreements, are the broad cross-referencing to the underlying concession agreement and the enabling legislation for the toll road. Sometimes, the financing documents are not harmonized with the concession document, and that is where bulletproof turns into bullet-ridden. Governments can change their regulations for a project, and they can even terminate a concession agreement through expropriation. When they do, this can seriously impair or cease access to revenues under a financing agreement, rendering it ineffective. That is why many concession agreements contain provisions for extraordinary rate relief, extension of the term of the concession or compensation in case the concession is terminated. For these reasons, PPP financial transactions, with their assignment of rights, covenants and reserves as well as all of the other bells and whistles, which provide so much credit enhancement, cannot be viewed as true securitizations.
Myth 2: Financial Transaction Through a Special-Purpose Entity

Every project has internal and external bankruptcy risk unless it has statutory protection that prevents a default from leading into bankruptcy. For financial transactions involving PPPs, sheer economic strength, combined with structural elements, can act as the best mitigant to voluntary bankruptcy risk. For involuntary bankruptcy and consolidation risk, the best protection comes from a special-purpose entity, as previously discussed. A determination of whether or not the transaction benefits from a special-purpose entity status requires an opinion from a qualified local counsel or other source (such as a third-party guarantee), providing a clear description of the powers and obligations of the entity and certainty with respect to the obligation pledged. Only a handful of countries require this opinion to be rendered, or even requested, as part of the documentation to market such bonds. In most countries, while it is customary for Fitch to request this opinion as part of its due diligence for a rating, it is simply not demanded by the market.
Myth 3: Trustee Controls Revenue Flow

Trustee relationships are a critical feature of project and structured finance. They provide passive bond investors with the comfort that project revenues and accounts are assigned to the trustee on their behalf and payments from these accounts will
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be made in a prescribed manner and timetable, as determined by the trust indenture. Nevertheless, investors should be aware of when the trustee takes control of the revenue flow and the full range of circumstances under which the trustee retains control. The tightest trustee control over revenues requires frequent (often daily) deposits of project revenues into an account maintained by the trustee. From here, the trustee can follow the dictates of the financing document with respect to when deposits are required into predetermined accounts for operations, debt service and reserves, among other costs. The now familiar theme of bankruptcy remoteness plays a role here. Legal circumstances can limit the value and effectiveness of trustee control. To begin with, the trustee is not the first participant to handle the revenue. The project operator collects user fees from the projects patrons and channels them to the trustee. As mentioned, it is important to structure around operator bankruptcy risk. The second consideration is the full range of circumstances under which the trustee retains control over the revenues; thus it is necessary to return momentarily to the risks posed under the second myth (the importance of determining whether the concessionaire is really a special-purpose entity). If the bankruptcy remoteness of the project entity is not established, the trustee can only have full contractual control over the revenue flow under normal circumstances. Under an involuntary bankruptcy proceeding, there are a variety of ways the trustee can lose control over the revenue flow. The shortest period that loss of control can occur is when the court determines whether to allow project assets under the proceeding. If it decides not to allow the projects assets, trustee control can resume under normal operating conditions. If the court decides to allow project assets as collateral under the proceeding, their fate can take several courses. One is where the court allows the project to continue operating but diverts revenues into the ultimate creditor settlement. The other is when the court decides to wind up the projects assets as part of the ultimate creditor settlement. It is important to remember that the court may consider not just project revenue as an allowable asset but also amounts held by
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the trustee under the reserve. The legal process and interpretations of bankruptcy proceedings vary from country to country, emphasizing the importance of an independent bankruptcy opinion.
Myth 4: Financial Transaction Debt Is Government Guaranteed

Debt guarantees from host governments are often required by investors, if an infrastructure asset class is new or unfamiliar to the market or investors do not believe the user revenue stream from the project can provide a reliable payment source for the debt. This can either be because the project has a public developmental purpose in a region that needs the infrastructure but cannot pay debt service solely through user fees, or because the organizational and administrative mechanisms to operate infrastructure on a self-sufficient basis are either untested or not trusted. While part of the rationale for bringing private partners into an infrastructure project is to provide the skills and efficiency to run the project on a business basis, the high probability of political risk with respect to rate flexibility, among other things, often causes investors to still demand a government guarantee. There is a long-held financial proverb that the government guarantee is as good as the sovereigns own credit risk (i.e., equal to its unsecured obligation risk). A sovereign obligation is an unconditional, irrevocable risk, which although it may not be guaranteed or collateralized is still a high bar for the vast majority of guarantees provided to PPP transactions. In fact, investors should question the logic of why a government would grant the same pledge to a project with a private sector partner as it does to its own bonds. For an investor to assign a value to the debt guarantee, experience suggests a number of considerations, such as the following: It is important to determine whether the guarantee is automatic or subject to appropriation as part of the governments budgetary process. A financial obligation that is subject to budgetary appropriation is of lesser credit quality than the sovereigns unsecured debts. Investors should know the guarantees priority of payment with respect to other government obligations. Pari passu status with respect to general obligation debt is the strongest. Anything less than pari passu is a subordinate obligation and of lesser credit quality than a general obligation.
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It is important to be familiar with the mechanism that triggers the guarantee. Essentially, there are two types of triggers. A proactive trigger requires a trustee and/or concessionaire to formally notify the government in advance if the debt-service account is deficient for an upcoming debt-service payment. Giving the government prior notice and time to respond by making a deposit of the deficiency into the debt-service account on or prior to the payment date preserves the full and timely nature of the payment and is the strongest type of trigger. A reactive trigger waits for a payment default to occur, then asks the government to retroactively use its guarantee mechanism to make up the payment deficiency; this is a weaker guarantee but also the most common. The concession agreement should outline the process and timing by which the government will evaluate and settle upon the guarantee commitment. The most effective guarantee specifies which government representatives are responsible for evaluating the guarantee request and how many days they have to respond. A time-certain review and payment under the guarantee clause is the strongest form of guarantee. An open-ended review process is the weakest. Of equal concern is whether the responsible government agency can reach a different conclusion than the trustee or concessionaire as to the deficiency amount. The concession agreement should restrict the governments ability to interpret a guarantee request. Nevertheless, governments may exercise their own calculations as to guarantee amounts regardless of the mathematical debt-service deficiency. Nothing is ever simple where PPPs are concerned. Investors should be concerned about the financial sustainability of guarantee commitments, given other financial and service demands on the government. One should not compare the small debt-service commitment of a project to the largeness of the governments budget. Instead, the focus should be on the rigidity of the expenditure budget (how much of it is already accounted for under legally mandated programs). Additionally, contingent liabilities of a growing portfolio of project guarantees as more PPPs are executed could cause financial pressures on the government. Finally, investors should consider the political risk inherent to every project finance transaction. It is reckless to believe that documentation creates equality among projects in the governments opinion. Some projects will
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be successful and politically popular, while others will be economically or politically unpopular. Governments will not treat each project equally, especially at election time or during a crisis. For Fitch, this is a rating consideration. Project documents can mitigate political risk, but they do not create an impervious barrier.
PPPs: The Next Generation of Infrastructure Finance

After considering the litany of risk considerations described, it easy to understand why there has not been a greater proliferation of PPP financial transactions (i.e., a stronger response to the infrastructure funding gap), despite much anticipation and effort. However, Fitch believes this situation is about to change, as explained herein.
Pooling Credit Risk

The greatest concern for lenders to local government enterprises and PPPs in nonOECD countries, is a lack of confidence in the ability of local revenue streams to repay debt service when due. Economic and political factors often lead to unacceptable rates of default on project debt. Over time, public and lender interest would be best served if these enterprises became self-sufficient, but in most countries, this is a long-term goal at best. In the more desperate environments, self-sufficiency may never be attainable. For this reason, the pooling of new or refinanced infrastructure loans into a bank is an important way to mitigate against individual loan loss. This concept may be less applicable to the pooling of existing loans that have different debt structures. Where the ultimate recovery value of the loan portfolio looks promising, the country with multilateral bank grants, if necessary, can capitalize the fund with reserves against the expected cash flow deficiencies within the loan portfolio. Interest income from the collateral can be used to reduce the borrowing costs of the entities within the infrastructure pool. A single debt emission by the bank on behalf of the pool participants will also create liquidity within the domestic debt market on the theory that the market has more appetite for the larger debt issuance of the bank than for the smaller individual project loans of the banks participants. Liquidity in the capital markets also lowers borrowing costs for the participants. This cheaper access to pooled capital greatly increases the resources available to meet local infrastructure needs.
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US SRF Model
The state revolving funds (SRFs) model was used to create the wastewater and water projects in the United States. Matching capitalization grants from the Environmental Protection Agency (EPA) and their respective states evidence a prioritized list of eligible municipal projects. The model includes qualitative adjustments for a lack of geographic diversity within the pool (in the United States, SRFs are single-state funds), as well as expected loan default rates. Capitalization grants can be set aside in a debt-service reserve fund and invested in collateralized guaranteed investment contracts (GICs) with highly rated financial institutions. They can also be used to make direct loans, the repayment of which can be pledged against future leveraging. Many SRFs issue bonds, lending debt proceeds to participating municipal utilities. Loan repayments from the municipalities are used to repay SRF debt and provide capital for additional lending. Investment income can subsidize loan interest rates and, of course, invested reserves can act as collateral against the loan portfolio, as can overcollateralized loans. Key factors supporting a high ratings profile for SRFs include the extent of overcollateralization and low default rates on this type of loans. Other rating factors are the funds criteria and managerial expertise as they relate to structured and municipal finance transactions, the loan pool structure (including expected default rates), loan underwriting and due diligence guidelines, and investment practices. Substantial reserves and excess cash flows allow bond payment, even during stress scenarios with unprecedented loan defaults.
Enhancing Pooled Credit Risk

Where the default risk of the loan portfolio is expected to be high and its ultimate recovery prospects are weaker, the initial reserves will not be enough to protect the bank. In these situations, extra layers of credit enhancement are needed to improve the cash flow of the loan portfolio. These layers include the initial payment of project debt service by local user fees or taxes, followed by the ability to tap the funds reserves for cash flow purposes and then to intercept intergovernmental aid to replenish the funds reserves. These layers could be further supplemented by available lines of credit or other partial credit risk guarantees from external sources, such as multilateral banks, international aid agencies or monoline insurers.
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Repayment of multilateral lines of credit should be a subordinate obligation to the banks debt, but it should not be a grant. In this case, the bank may have to divert interest income from its reserves as a form of repayment for the external lines of credit. The multilateral agencies can determine on a country-by-country basis (by a combination of needs assessment and public policy), which pooled recovery rates they expect for these subordinated lines of credit (e.g., full and timely basis in one instance, 75% recovery after 10 years in another, 40% recovery over 10 years in another, and so on). While unrecovered amounts can be written off as uncollectible by the multilaterals (having the same economic effect as a grant), this system allows the multilaterals to benefit from the possibility of improved recovery rates over time. Since the assets being financed will have a long useful life, entry into the bank should be accompanied by acceptance of measures to increase the administrative and service level efficiency of the local government or PPP enterprise. This increases the prospects for better financial performance over time. For the borrowing entities, the incentive to improve loan performance is that it progressively frees up the banks interest income to provide interest rate subsidies instead of repayment to the multilaterals for use of their lines of credit. The pooling of infrastructure loans plus credit enhancements provides much-needed stability to project revenue streams, creating an opportunity to engage the domestic capital market as an investor in the infrastructure banks debt. This has the additional benefit of diversifying domestic investment portfolios. Stabilized project revenue streams also allow for progressively longer debt tenures, correcting a long-standing mismatch between the term of debt and the useful life of an infrastructure asset. The ultimate test for these developing domestic debt markets is whether this more efficient allocation of risk between the public and private sectors will also translate into more realistic (achievable) rates of return on private investment. If it does, then for these countries, the allocation of capital will not only be efficient, it will also be sustainable and regenerative.
Outlook
In this new generation of PPPs, the private sector role shifts to the financial engineers who work in conjunction with government authorities, as well as
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development and multilateral banking partners, to create enhanced investment vehicles that are attractive to domestic capital. Old allies, the remaining construction conglomerates, will still be involved, but their role is less for equity and more for their expertise in designing, constructing and operating projects. Is this visionary portrait of the future of PPPs in non-OECD countries realistic? Fitch believes that it is close to becoming a reality. The first steps have been taken, with some multilateral banks starting to provide credit enhancement (partial credit risk guarantees) to project debt in the local markets and in the local currency. This enhancement role allows these banks to allocate their capital further than through direct lending. If they were enhancing pooled project loans, their capital could be extended even further. Enhanced pooled capital is the concept behind the US Agency for International Developments (USAID) support of the Water and Sanitation Pooled Fund (WSPF) in the state of Tamil Nadu, India. WSPF is a special-purpose vehicle to be incorporated under the Indian Trust Act, with an initial debt-service reserve contribution from the Tamil Nadu government. Tamil Nadu Urban Infrastructure Financial Services, Ltd. (TNUIFSL) will manage the fund. Loan repayments for certain municipal users will be made directly by user fees or local taxes, with the ability to intercept state aid if there is a deficiency. For other types of municipal users, the WSPF has the authority to directly intercept state aid for loan repayment. The debt-service reserve fund carries an amount equal to one full year of debt service. If these layers are insufficient, USAID contractually plans to guarantee an amount equal to 50% of WSPFs principal. The funds debt will be offered to domestic investors. Private banks are also exploring the creation of infrastructure banks in select emerging-market countries. These banks would most likely work in conjunction with a host countrys development bank to achieve the risk allocation and cost-offund advantages of the SRFs. Finally, for certain emerging-market countries with an investment-grade sovereign rating on the international scale, the monoline insurers are exploring opportunities to provide credit enhancement at the AAA national scale rating level. All these signs are important for the development of domestic capital markets and the creation of a sustainable and regenerative supply
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of capital for infrastructure projects. The financial engineers from both the public and private sectors will create the next generation of PPPs. A more efficient allocation of capital engages a broader set of participants and creates new incentives to enhance the capacity for infrastructure finance while also promoting a more efficient delivery of municipal services. The process has already begun. (Fitch Ratings is a leading global rating agency committed to providing the worlds credit markets with accurate, timely and prospective credit opinions.)
Budget: Overcoming Roadblocks to Growth
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Section II
How Project Structures Create Value
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4
Padmalatha Suresh
Taking a cue from the comparison of FDI flows into China with that into India in the Indian Finance Ministers 2005 budget speech, this newspaper article identifies the role of the banking system and the government, in building world-class infrastructure in India, with particular reference to transport. Building world-class infrastructure has been the key to the transformation of the Chinese economy from planned to market-oriented. According to studies, infrastructure investment is associated with one-for-one growth in GDP, while inadequate infrastructure impedes economic growth. With GDP growth expected to be around seven percent this year, the Plan target is achievable only if GDP growth for the next two years is ten percent. The article underlines the need for innovative project financing and proposes active involvement of the banking system, capital markets and legal system in this process.
erhaps one of the most striking pronouncements by the Finance Minister, Mr. P Chidambaram, during his Budget speech was, to quote Mr. Chidambaram, At a recent meeting of G-7 finance ministers in London
Source: http://www.thehindubusinessline.com/2005/03/22/stories/2005032200810800.htm, March 2005 Business Line. Reprinted with permission.
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(that India and China attended), Chinas finance minister looked in my direction and said China had received $60 billion of foreign direct investment in 2004. Indias Foreign Direct Investment (FDI) last year was less than ten percent of Chinas. Ignoring for the time being the ongoing academic discussion on FDI composition anomalies, the comparison with China in the Budget speech is acknowledgement of the increasing international visibility of Chinas aggressive growth policies. Building world-class infrastructure has been the key to the transformation of the Chinese economy from planned to market-oriented. According to studies, infrastructure investment is associated with one-for-one growth in GDP, while inadequate infrastructure impedes economic growth. The Tenth Plan targeted an average GDP growth rate of 8.1 percent. The actual performance was 4.6 percent for 2002-03 and 8.3 percent for 2003-04. The shortfall is disturbing since the momentum for acceleration, essential to achieve the 8.1 percent target, is absent. With GDP growth expected to be around seven percent this year, the Plan target is achievable only if GDP growth for the next two years is ten percent. A McKinsey study estimates that addressing impediments to economic growth such as inadequate infrastructure, bureaucracy, corruption, labour market rigidities, regulatory and foreign investment controls, reservation of key products, and high fiscal deficits, would enable Indias economy to grow as fast as Chinas, at ten percent a year, and create some 75 million new jobs. It was, therefore, expected that infrastructure would occupy the pride of place in the recently announced Budget. But it appears that the dream-budget merchant has not woven innovative dreams for infrastructure development and financing in the ensuing year. Consider Indias road infrastructurethe primary mode of transport increasingly seen as a major factor influencing economic growth and social development.
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India has a very large network of poor quality roads. The 58,000 km stretch of national highways that carries 45 percent of total traffic, is mostly two-lanes with heavy traffic, low service and slow speeds. Despite the 3.5 million km stretch of roads (the worlds second largest), 40 percent of Indias villages have no all-weather access. Government expenditure on roads accounts for 12 percent of capital expenditure and three percent of total expenditure, but road maintenance is grossly under-funded, with only one-third of needs being met. This has led to road deterioration, high transport costs and accessibility loss. While highway length has grown 1.26 times over the last five years (2000-04), traffic on these highways has increased 14 times. Even if the Golden Quadrilateral (GQ) project is completed by mid-2005, and the north south-east west (NS-EW) highway project is completed on schedule by 2008, India will have reasonably well-surfaced, four-lane national highways that accounts for just 22 percent of the countrys national highways. India has 3,000 km stretch of four-lane highways, and no inter-state expressways. In contrast, China has highway network of over 25,000 km stretch of four or six-lane access-controlled expressways linking major cities, all built during the last decade. The Centre plans to spend over Rs.2,25,000 crore on highway improvements in the next six years, apart from the substantial investment to connect villages. In addition, annual expenditure of Rs.7,000 crore is essential to maintain the 1,70,000 km stretch of national and state highways, and further funding is required to maintain urban networks, district and rural roads. All these expenditures have to be financed within the current fiscal environment of deficits amounting to 9.5 percent of GDP. In comparison, by 2020, China plans a 35,000 km stretch, $150 billion trunk highway system. While continuing massive reforms, Chinas budget deficit for 2005 is expected to be hardly two percent of GDP. India, therefore, has to grapple with the serious
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issues of financing the development of highways and other infrastructure, and its structuring. There are two approaches to highway financingtraditional and commercial. The traditional approach treats roads as public goods, and finances construction from general revenue with little connection between road-provision costs and road-user charges. The commercial approach treats roads as capital assets, and charges road users directly or indirectly. In India, the traditional approach largely persists, although national and state fuel cesses, tolls and private financing are increasingly being introduced. Not adopting the commercial approach has contributed to under-funding of road maintenance, and substantial economic losses. The need of the hour, therefore, is innovative infrastructure financing. China has been financing infrastructure growth through private domestic investment, multilateral funding and FDI. The achievement is laudable, when viewed against the backdrop of a relatively weak banking system. China also proposes to invite cross-border investments from strong global players. The Budget has proposed some measures for infrastructure financing. Are these sustainable? Using a portion of Indias foreign exchange reserves for financing infrastructure carries the potential danger of fuelling money supply and inflation. The Inter-Institutional Group (IIG) of Banks can finance infrastructure, provided they source long-term funds on a sustainable basis. Besides, the security aspects need to be worked out. The allocation of Rs.10,000 crore for the year to the new financial special purpose vehicle seems meagre, given the required infrastructure investment.
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It is becoming imperative that India look increasingly at private participation, domestic and international, to fund infrastructure growth. The most attractive option for these private investors would be to use project financelimited or non-recourse financing of a project through the establishment of a vehicle company. The project financing structure permits multiple equity investors, lenders and long-term contracts with third parties. The risk-return trade-off of long-term infrastructure projects would be rendered attractive through the project and capital structures and the risk management techniques employed. Indias strength is its relatively robust financial system. However, use of project financing structures call for a sound legal system, since project financing is governed by contracts. Financial regulations and laws have been upgraded but poor enforcement weakens market discipline and integrity.
Involvement of the Banking System

World over, bank lending plays a key role in project finance due to its disciplining effect on borrowers cash flows. However, project lenders should re-orient their skills to assess and hedge the risks of non-recourse lending. Development of syndicated loan and long-term bond markets to cater to the enormous funding requirements. Presence of strong insurance mechanisms for risk-mitigation. Development of innovative financial and hedging instruments tailored for deal structureshybrid-financing structures, such as mix of corporate and project finance, leveraged leasing structures, etc. Investment bankers would have to upgrade deal-structuring skills, and project capital providers, their negotiating skills. Superior project management capabilities. Indias ongoing portfolio performance in the World Bank funded projects is less than satisfactory. Chinas portfolio performance is the best in the World Bank. Fast track government clearances/permits/licences/concession agreements and minimal government interference in project implementation. Soon, China will adopt innovative private participation models, as is evident by the infrastructure construction plan for Beijing to be implemented from
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October 1. Infrastructure development has been vital for Chinain the 1990s, breaking infrastructure bottlenecks was critical to the sustaininghigh-growth-without-inflation strategy; in recent years, infrastructure development has been considered the most effective way of promoting market integration, poverty reduction, and inland China development. Past experiences indicate that India has innovated best in the face of external triggers. A decade ago, it was the IMF loan that triggered financial reforms. Will Chinas policies trigger innovation in infrastructure development and financing? (Padmalatha Suresh is a post graduate in Management from IIM-A, holding LLB and CAIIB. She has two decades of banking and IT sector experience. She is currently running a financial consultancy, she is visiting faculty at IIMs and other reputed B-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached at padmalathasuresh@yahoo.com).
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5
Padmalatha Suresh
What are the structural attributes of project companies, that enable them to find the financial and other resources for very large projects? Having found the resources, how do the project companies structure the project organization to take care of its long term needs? How do project companies take care of the risks involved in constructing, financing and operating very large projects? What are the structural features of project companies that enable lenders and equity holders to invest substantial funds? This article summarizes the rationale for, and various types of contracts and models that form the backbone of project financing transactions.
Introduction
Project financing structures have been the subject of substantial research during the last decade or so. How do standalone project entities with separate legal incorporation, high leverage and concentrated equity ownership manage the risks associated with long-term infrastructure development and still deliver financial, social and developmental value?
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Project financing involves innovative techniques to be used in many high-profile large-scale and infrastructure projects. Employing a carefully engineered financing mix, it has been used over the last decade to fund large-scale natural resource projects, from pipelines and refineries to hydroelectric, telecommunication and transportation projects and even projects, in the entertainment and social sectors. Although project-financing structures share certain common features, every project is unique and requires tailoring the financial package to the particular circumstances and features of the project. Here in lie both the benefits and the challenges. India is on the verge of an infrastructure boom. The pressures created by the need for central and state governments to balance their fragile budgets, have led to a greater use of the private sector in infrastructure development and financing. Large infrastructure projectscustomarily implemented by the government now being implemented with private participation and management, reflect the new trend. It is preferable that long-term Infrastructure Finance in emerging markets like India is based on project financing arrangements, thus attempting to mitigate the extreme risks of operating very large projects. All these projects use some form of project finance, a term which is currently being used synonymously with Contract or Structured Finance. Project finance involves the creation of a legally independent project company financed with non-recourse debt for the purpose of investing in a capital asset, usually with a single purpose and a limited life. One of the most important aspects of this definition is the distinction between the asset (the project) and the financing structure. In other words, project companies have evolved as institutional structures, that reduce the cost of performing important financial functions such as pooling resources, managing risk, and transferring resources through time and space (Merton and Bodie, 1995). We are talking here of projects which typically take five to seven years to complete, have a finite life of 20 to 30 years or more, with very large upfront investments followed by very large expected cash flows. These features are characteristic of most large, infrastructure projects. What are the structural attributes of project
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companies that enable them to find the financial and other resources for such projects? Having found the resources, how do the project companies structure the project organization to take care of its long-term needs? How do project companies take care of the risks involved in constructing, financing and operating very large projects?
Structural Attributes of Project Finance

The following facts on the structural attributes of project companies have emerged from research.1 Organizational Structure: Project companies involve separate legal incorporation. Special-Purpose Vehicles (SPVs), or Special-Purpose Entities, (SPEs), are created to facilitate construction, financing and operation of very large projects. Capital Structure: Project companies employ very high leverage compared to public companies. Research shows that the average (median) project company has a book value debt-to-total capitalization ratio of 70% compared to 33.1% for similar-sized public firms. While only a few project companies have leverage ratios below 50%, almost 30% of public companies have leverage ratios less than 5%! Ownership Structure: Project companies have highly concentrated debt and equity ownership structures. Most of the debt comes in the form of syndicated bank loans, and not bonds, and is non-recourse to the sponsoring firms (Esty, 2001b). As a result, creditors must look to the project company itself for debt repayment. In terms of equity ownership, the typical project company has around one to three sponsors, and the equity is almost always privately held. International research shows that the average (median) project has 2.7 sponsors. In the average project company, the largest single sponsor holds 65% of the equity. Board Structure: Project boards are comprised primarily of affiliated (or gray) directors from the sponsoring firms. Again, international research shows that 83% of the directors are affiliated with the project company compared
1
Esty Benjamin C, The Economic Motivations for Using Project Finance, Harvard Business School, Working draft, 2003.
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to 37% in reverse LBOs (Gertner and Kaplan, 1996), 25% in IPO firms (Baker and Gompers, 2001), and 10% in large public companies (Yermack, 1996). Contractual Structure: Project finance is sometimes referred to as contract finance because a typical transaction can involve a vertical chain of about 15 parties from input suppliers to output buyers bound through 40 or more contractual agreements. In a typical project, four major contracts are prevalentcontracts governing supply of inputs, purchase of outputs (off-take or purchase agreements), construction, and operations. Larger deals can even have several thousand contracts. According to the Australian Contractors Association, the Melbourne City Link Project, an A$2 billion road infrastructure project, had over 4,000 contracts and suppliers (see the 2002 award finalists at www.constructors.com.au) (Esty, 2002). How do the above structural attributes contribute to the success and popularity of project financing? There is no magic formula. Success is accomplished by prudent financial engineering that combines the various contracts, undertakings and guarantees between parties interested in the project in such a manner, that no one party has to assume the full risk of the project. Yet, when all these undertakings and contracts are viewed as a whole, the result has to be a satisfactory credit risk for the lenders and minimal equity risk for the sponsors. The key to successful project financing therefore lies in structuring the financing of the project with limited recourse to the sponsors, at the same time providing sufficient credit support through guarantees or undertakings of a sponsor or a third party, so that lenders will be satisfied with the credit risk. In other words, capital providers to the project (both equity and debt holders) should be confident of a reasonable return on the capital employed, which is commensurate with the risks taken by them. Since project financing is characterized by the plethora of contracts associated with the project company, a closer look at the common contractual structures of projects is warranted. Generally, contracts take the form of guarantees and undertakings, so that the combined guarantees and undertakings of all parties amounts to a credit-worthy
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transaction for the lenders. Guarantees also enable project and market risks to be allocated to the parties who can best bear them. There are generally two types of guarantors who will come forward to bind themselves to the project outcomes. The first of these are the owner-guarantors the obvious choice in any project. Direct guarantees by owners or project sponsors would appear on their balance sheets under international accounting standards.
The Role Contracts Play

However, the attractiveness of project financing lies in its being non-recoursein other words, off balance sheet for the project sponsors. Apart from keeping the new projects risks from tainting the balance sheets of the project sponsors, such non-recourse financing also preserves the capital and debt capacity of the sponsors for other uses. Therefore, project sponsors would prefer to enter into contracts with the project company, whereby they provide indirect guarantees to the project, and thus enhance the projects bankability. Apart from the project sponsors, there will be other third parties willing to guarantee some aspect of the projects functioning. These third party guarantors would be those, who are eligible to receive direct or indirect benefits from the projects successful implementation and functioning. Typically, these third party guarantors could be any one of the following: Suppliers of raw material and other inputs to the project. Sellers of plant and equipment for the project. Users or buyers of the project output. Contractors who construct the project infrastructure. Contractors who operate the infrastructure facility after construction. Government agencies interested in getting the project implemented successfully. Multilateral agencies such as the World Bank and its arms, particularly in developing countries. Banks, Insurance, Pension funds and other Institutional Investors. In project financing, where the typical capital structure is highly leveraged, lenders require security arrangements and contracts that ensure minimal default
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risk. This implies that lenders would require assurances that (a) the project will be completed on time and at the projected cost (b) even if there are cost or time overruns, the lenders debt would be serviced in full, (c) when completed, the project cash flows would be sufficient to service interest and principal repayment obligations, and, (d) if for any reason, force majeure or otherwise, the project is terminated or suspended, the lenders dues would be repaid in full. In the typical non- or limited recourse structure for project financing, the prime security for lenders is the viability of the project itself. However, even a good credit risk has to be supplemented by other security arrangements. In project finance, supplemental arrangements take the form of contracts, the benefits of which are assigned to the project lenders. Lenders have the first right over the project cash flows. One of the fundamental contracts in every project is the cash flow waterfall, which prioritizes claims on project cash flows. Through the waterfall, parties agree in advance to meet all operating expenses, capital expenditures, maintenance expenditures, debt service, and shareholder distributions in that order, from the project cash flows. Sometimes, appropriations to an escrow or reserve fund (described later) are also included in the cash waterfall. Typically, such cash flow waterfall mechanisms are under the control of a Trust set up specifically for this purpose, and therefore reduce managerial discretion over free cash flows from the project. Lenders would take direct security interest in the project assets/facilities by holding a first mortgage/lien. The lien gives lenders the right to seize project assets in the event of debt service default, and realize their dues. Completion risk is the risk that the project is not completed in time or not completed at all. Completion risk in a project would endanger the lenders chances of debt recovery. Hence the security arrangement to cover completion risk, typically requires that the sponsors or other creditworthy parties provide an unconditional undertaking to bring in additional funds to complete the project, or repay the debt in full. After the project construction is completed, operations commence. Operational risks include input risks (availability of raw material and other
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inputs), and output risks (production capability, demand for output, price of output, and other market risks). Here, contracts are framed to ensure that the project will receive cash flows sufficient to meet recurring operating expenses and meet the debt service obligations. Project debt is also normally secured by direct assignment of the project companys right to receive payments under various contracts, such as completion agreements, purchase and sale contracts or financial support agreements. In addition, the sanction of credit to the project company by lenders will also contain various covenants. These covenants take the form of representations and warranties, positive covenants and negative covenants. Many of these covenants, while disciplining the project companys operations and its use of cash flows, may also impose limitations on the functioning of the project company. Some of the typical indirect guarantees provided for project-financed transactions are: 1. Take-if-offered Contract: Under this contract, the buyer of the projects output is obligated to accept delivery and pay for the output that the project is able to deliver. The buyer need not pay if the project is not able to deliver the product. This implies that lenders will be protected only when the projects operations are adequate for debt service. Under this contract, therefore, lenders may require supplemental credit arrangements to compensate for the credit risk that may arise if the project is unable to operate. 2. Take or Pay Contract: Under this contract, the buyer has to pay for the output whether or not he takes delivery. Like the take-if-offered contract, the buyer need not pay if the project is unable to produce the required output. In this case also, lenders will require supplemental credit arrangements to offset the likelihood of a credit risk. For example, in the Dabhol power project, according to the Agreement signed with Oman LNG, MSEB was required to pay for a minimum of 90% of the contracted quantity of 1.6 MMTPA. Similarly, an agreement with ADGAS required it
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to pay a minimum of 75% of the contracted amount of 0.5 MMTPA. This means that MSEB was obligated to pay for 1.8 MMTPA of LNG, at a CIF price of US$ 3.35/MMBTU on a take or pay basis, which was the fuel requirement for 73% Plant Load Factor (PLF). LNG supply contracts are usually contracted on a take or pay basis. However, in this case, being the sole customer, the entire demand side risk had to be borne by MSEB. On the supply side too, MSEB was obligated to purchase all the power that the project generated, whether or not it took delivery. 3. Hell-or-High Water Contract: Under this contract, there are no outs for the buyer. He is obligated to pay whether or not any output is delivered. Lenders are more protected against force majeure events in this type of contract. 4. Throughput Agreement: Such agreements are found typically in oil or petroleum pipeline financing. Under this contract, the shippers (oil companies or gas producers) are obligated to ship, through the pipeline, enough output to provide the cash flow required to pay all operating expenses and meet all debt service obligations. Typically, such throughput agreements are supplemented by a cash deficiency agreement, which obligates the shipping companies to advance funds to the pipeline in the event of a cash shortfall. 5. Cost-of-Service Agreement: The contract requires each buyer to pay project costs as actually incurred, in return for a proportionate share in the projects output. Typically, such contracts require payments to be made whether or not the output is delivered. 6. Tolling Agreement: The project company levies tolling charges for processing raw material usually owned and delivered by project sponsors. 7. Step-up Provisions: These provisions are included in purchase and sale contracts when multiple buyers are involved. In case one of the buyers defaults, the provisions obligate the remaining buyers to increase their participation. 8. Raw material Supply Contracts: These are long-term contracts between the suppliers and the project company, for fulfilling the projects raw material requirements. For instance, under a supply or pay contract, the supplier has
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to make payments, sufficient to cover the debt service requirements of the project company, in the event of failure to supply the contracted amount of raw material to the project.
Some Common Models In Project Finance

The various well-known models of concession agreements, such as Build-OperateTransfer (BOT), or Build-Own-Operate-Transfer (BOOT) models are derived from contracts such as the Take-or-Pay contract. The features of a few frequently used models of project structure are presented below: Build-Operate-Transfer (BOT): This is one of the most popular models, where the project company enters into a long term concession agreement with the host government for building and operating an infrastructure facility. After the concession period, which may typically range up to 20 years or more, the ownership is reverted to the host government, to continue operating the facility. In some models, ownership reversion happens only after the vehicle company is able to generate a satisfactory return on the invested capital. Sometimes, the host government may also be asked to lend limited credit support or guarantee. Common variations of this model are the Build-Own-Operate-Transfer (BOOT) model, recently used in the Noida Toll Bridge project, or the Build-Own-Operate (BOO) model, recently seen in the Bangalore International Airport project. Several highway construction projects all over the world and in India have been using the BOT models successfully Build-Transfer-Operate (BTO): The ownership of the infrastructure to be developed is vested with the project company till construction is completed. Thereafter, the legal title is transferred to the host. The facility is subsequently leased back to the vehicle company for a fixed term, during which the company can collect the revenues generated by the completed facility. At the end of the term of lease, the host will operate the facility by itself or can hire another operating company. Buy-Build-Operate (BBO): In this model, the vehicle company buys the (typically underdeveloped) infrastructure from the host, builds on it by modernizing or expanding, and thereafter operates it.
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Lease-Develop-Operate: The option is attractive when the vehicle company is unable to raise sufficient resources for the purchase in a BBO. The leased facility is then operated for a fixed term, along with the host on a revenue sharing basis. This model signifying public-private risk sharing has been seen to be beneficial in cases when the project is losing money. Wraparound Addition: In this model, the vehicle company undertakes to expand an existing host facility. The vehicle company acquires legal title only to the addition of the facility. Though ownership is shared, the vehicle company is excluded from the liability for the debt already incurred by the core facility. Temporary Privatization: This model is workable when the host is unable to transfer legal title. The vehicle company repairs, operates levies and collects appropriate charges, and bears the financial risk. Speculative Development: This model is popular in developed economies like the US. The private sponsors identify an unmet public need and fulfill it through a financially feasible and economically viable project. The vehicle company set up for this purpose undertakes structuring the project and allocates risk to various parties. The host (government) may join the process by financing or issuing guarantees. A project company can therefore, choose a structure or model that is befitting the objective, financing pattern and risks associated with the project. The list of workable models given above is only illustrative and is by no means exhaustive.
Supplemental Credit Arrangements

In spite of the presence of contracts, several events can happen to disrupt the functioning of the project. To guard against these contingencies, Supplemental credit arrangements are woven into the contractual structure of projects. These mechanisms are also termed ultimate backstops, and can take the following forms: Financial Support Arrangement: Typically, the arrangement is in the form of guarantees or letters of credit from the project sponsors or the bank. In the event that payments are to be made under the guarantee or letter of credit, they will be treated as subordinated loans to the project company.
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Cash Deficiency Arrangement: As the name suggests, the arrangement is designed to make good the shortfalls in cash flows, that would ultimately impair the debt service capacity of the project company. Cash deficiency arrangements usually accompany throughput agreements and payments are made in advance for the output to be delivered in future. Capital Subscription Agreement: This is typically structured as purchase for cash of junior securities (equity or subordinated debt), issued by the project company. Clawback Agreement: In some cases, project sponsors agree to plough back the equity cash flows arising from the initial period of operation, or cash dividends received from the Project Company, or tax benefits that may flow in as a result of their investment in the project, back to the project company. In such cases, the investments may be treated as additional equity or subordinated loans to the project company. Escrow Fund: In many cases, lenders insist upon creation of an Escrow fund (sometimes called a Debt Service Reserve Fund) out of project cash flows, to cover from 6 to 18 months of debt service requirements. A trustee administers this fund, and in case of a shortfall in project cash flows, draws from the fund to ensure debt service. Insurance: This is emerging as one of the strong risk mitigating tools in project financing. Needless to state, appropriate insurance mechanisms are a prerequisite for successful project financing. The presence of costly insurance, for example, political insurance, may push up project costs, but the benefits, in many cases, are seen to outweigh the costs.
Motivations For Using Project Finance Structures

Research2 shows that there are three motivations for using project finance structures to finance large infrastructure projects. The first is agency cost motivation. Project structures can reduce costly agency conflicts between owners and related parties due to the transaction-specific nature of project assets and high leverage.
2
Esty Benjamin C, The Economic Motivations for Using Project Finance, Harvard Business School, Working draft, 2003.
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The second motivation to use project finance is to counter leverage-induced underinvestment. Though there may be several reasons for underinvestment in positive net present value projects by firms, John and John (1991) have identified leverage induced underinvestment as one of the major reasons. Managers of highly leveraged firms are more likely to pass up positive NPV investment opportunities, since the incremental cash flows from the new project would go towards servicing debt. Project finance structures allow project cash flows to be allocated to new capital providers, without impacting the sponsors debt capacity. The third motivation is risk management. By isolating the assets of the risky project in a separate standalone vehicle company, project finance reduces the possibility of risk contaminationthe phenomenon where an otherwise healthy firm faces financial distress through the projects failure. Through the project structure, sponsors are able to share project risks with other sponsors, with related participants (e.g. contractors, customers, suppliers, etc.), and with debt holders. In summary, this combination of structural features (extensive contracting, concentrated debt and equity ownership, separate legal incorporation, and high leverage) effectively manages risks, reduces asymmetric information and controls managerial discretion at the project level.
Conclusion
Recently, the BOOT (Build-Own-Operate-Transfer) model was employed in the NOIDA toll Bridge project in India. This USD 100 million project, implemented with a 30 year concession and an assured post tax rate of return of 20%, is Indias first major PPP initiative. The entire funding of the project has been on a non-recourse basis. Though beset by traffic risksthe risks that typically afflict any retail transportation project worldwidethe project is a precursor for more such workable initiatives. Structuring projects non-recourse to sponsors would therefore, be an incentive for the private sector to participate in large scale, risky infrastructure projects, so vital to economic development. (Padmalatha Suresh is a post-graduate in Management from IIM-A, holding LLB and CAIIB. She has two decades of banking and IT sector experience. She is currently
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running a financial consultancy, she is visiting faculty at IIMs and other reputed B-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached at padmalathasuresh@yahoo.com).
References:
1. 2. 3. Esty Benjamin C, The Economic Motivations for Using Project Finance, Harvard Business School, Working draft, 2003. Finnerty John D, Project Finance: Asset Based Financial Engineering John Wiley and sons, 1996. Nevitt Peter and Fabozzi Frank, Project Financing, 7th edition, Euro money books, 2000.
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PROJECT FINANCE - CONCEPTS AND APPLICATIONS
6
Padmalatha Suresh
Governments would be interested in supporting an infrastructure project, only if the social benefits exceed its social costs. This article explains why social returns are different from private returns, and outlines the difficulties in assessing the economic impact of very large projects. Some traditional approaches to determining social cost benefit are described. The focus of the article is on the Economic Rate of Return (ERR) used by Multilateral Institutions such as the IFC, to evaluate the developmental impact of large projects. The stakeholder analysis for calculating ERR has been elaborated, and the related issues dwelt upon. The article concludes that the ERR can be evolved to be a useful tool, for assessing the development impact of large infrastructure projects in the country.
Introduction
The decision to go ahead with a social infrastructure project is critical for any host government. This is because the private sponsors and the government view the value of a large project differently. While the private sponsors would be willing to
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implement the project if its return is commensurate with the risks, governments would be interested in supporting a project, financially or otherwise, only if the social benefits outweigh the social costs. In financial terms, the private sponsor of a large project would be looking for an attractive Internal Rate of Return (IRR) or Financial Rate of Return (FRR) from the project. However, the government supporting the project would look at a rate of return that would factor in, apart from the risks, the social costs and benefits as wellsuch a rate of return is called the Economic Rate of Return (ERR). Why should the profitability of an investment from the government or societys perspective differ from the private investors perspective?
Factors Influencing Social Returns

In a market where people are free to decide on the transactions they would like to enter into, there are a few primary factors that can explain why and where social returns would differ from private returns. 1. Taxes, Tariffs, Subsidies and other Government Interventions: For example, the amount a firm receives from sale of its product, may be less than the amount the customer pays to acquire it. The reason is taxes. Similarly, tariffs, subsidies and other public sector interventions result in differences between private and government or social returns. 2. Transaction Costs: A private investor may have to construct a road or bridge to make his new plant accessible to the firms employees and other stakeholders. However, the public living in the vicinity, which is unconnected with the firm, also starts using the facility. It may not be feasible for the private firm to restrict access of the facility to outsiders, nor collect tolls for usage since the transaction costs of toll collection may exceed the amount collected. Hence, the improved facility becomes an unpriced benefit to society. High transaction costs and other restrictions may keep the private firm away from charging a fee for the services provided to society.
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3. Externalities: Not easily quantifiable, non-market related effects fall under this category. A leather or chemical factory may give rise to environmental impacts like pollution. A plants location may lead to congestion in the vicinity. Such effects are not captured in private returns. There are two other types of externalities that may ariseNetwork and Demonstration effects. A firm may train a subcontractor or a supplier in improving the quality of his product. While the consequent improvement in quality would benefit the firm in the short run, the supplier would stand to benefit from the training received, since he can supply products of improved quality to outside firms as well. A demonstration effect would occur when a firm demonstrates the utility or viability of a new business model or technology, which can be replicated by other firms. 4. Imperfect Markets: Laborers or workers with similar skill sets may be paid more in a modern plant or a multinational firm than in traditional activities. This could be the case especially in developing countries, where markets are still evolving. In other words, the price paid for a good or service could be significantly different from the opportunity cost of that good or service.
Approaches to Assess Social Returns

Some of the difficulties in assessing social returns are: Assessing the social impact of educating and training the workforce, not only on the workforce itself, but also on the local and domestic economy; Assessing the developmental impact of construction of schools, hospitals, housing and other facilities that the project could bring with it; Assessing the spin-off effects of investment in a particular industry, or locality on the larger goal of economic development; and Assessing the multiplier effect of one large project on the community and the country. A look at the traditional approaches to social cost benefit analysis is appropriate before understanding the Economic Rate of Return (ERR) approach being practiced by multilateral institutions like the International Finance Corporation (IFC).
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A. UNIDO Approach1 The UNIDO approach has been structured in the following stages: 1. It calculates financial profitability at market prices. 2. It then shadow prices the resources, to obtain the net benefit at economic prices. Shadow prices reflect the uncontrolled market prices of goods and services in the economy. Some of the items typically shadow priced are the primary outputs of a project, the importable material inputs, the major non-imported material inputs and unskilled labor. 3. The next step is to adjust for the projects impact on savings and investment. Such adjustments are carried out by determining the amount of income gained or lost by different income groups due to the project, evaluating the net impact of these gains or losses on savings, based on the marginal propensity to consume of each of these groups, and finally estimate the additional savings the project would induce through the income generation potential of the project. 4. The fourth step involves adjusting for the projects impact on income distribution. The income flows for each group are derived from stage three, and suitable weights are assigned to reflect the relative changes in incomes for each group. 5. A final adjustment is made for the projects production or use of goods, whose social values could be less or greater than their economic value. Goods whose social values exceed their economic value are called merit goods, and if less, demerit goods. For example, a country may include tobacco or alcohol in the list of demerit goods. An upward adjustment is made to the social benefit in the case of merit goods, and a downward adjustment is made in the case of demerit goods. B. Little Mirrlees Approach (LM) The seminal work of Little and Mirrlees has developed a theoretical basis for the analysis and its underlying assumptions, and lays down step-wise procedure for undertaking benefit-cost studies of public projects. The mathematical formulation is identical to the UNIDO method, except for differences in assigning value to
1.
UNIDO - United Nations Industrial Development Organisation
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discount rates and accounting for imperfections and other market failures and social considerations. The five main elements of the LM approach to shadow pricing are in the nature of valuation of traded goods, valuation of non-traded goods, the choice of numeraire (the unit of account in which values of inputs and outputs are to be expressed), the shadow price of labor and the rate of discount. Little and Mirrlees have also suggested an elaborate methodology for calculating shadow prices of non-tradables. This methodology entails use of detailed input-output tables with a view to tracing down the chain of all non-traded and traded inputs that go into their production. However, in the case of non-availability of detailed input/output tables, a conversion factor based on the ratio of domestic costs of representative items to world prices of these items could be used for approximation of shadow prices of non-traded resources. The similarities of this approach to that developed by UNIDO are: Both approaches calculate the shadow prices for foreign exchange savings and unskilled labor. They take into account, equity as a factor. Both use discounted cash flow analysis. However, the dissimilarities between the two approaches are in the following areas: The LM approach measures costs and benefits in terms of international prices, while the UNIDO approach measures these in domestic currency. The LM approach measures costs and benefits in terms of net social income while the UNIDO approach concentrates on consumption. The LM approach considers efficiency, savings and redistribution simultaneously, while UNIDO takes a staged approach in measuring all three.
C. Approach Adopted by Indian Financial Institutions

The Indian financial institutions base their assessment of developmental impact on a modified version of the LM approach. The stages in their assessment are as follows: 1. All non-labor inputs and outputs are valued at international prices. The inherent assumption here is that international prices reflect true economic value.
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2. In the case of tradable items, for which international prices are readily available, inputs are valued at CIF prices and outputs are valued at FOB prices. Goods are called fully tradable if the impact of increased consumption will result in more imports or fewer exports, and increase in production results in fewer imports and more exports, other things being equal. It is also to be noted that, goods that are fully tradable, need not necessarily be freely traded. 3. In the case of tradable items whose international prices are not available, social conversion factors are used. The rupee values of these tradable goods are multiplied by appropriate social conversion factors to arrive at the social value. 4. The financial institutions also gauge the degree of protection available to an industry through a simple ratiothe Effective Rate of Protection (ERP). This ratio is arrived at by reducing the value added at world prices for an industry from the value added at domestic prices, and dividing the result by value added at world prices. The degree of protection enjoyed by an industry shows its vulnerability to overseas competition if the government withdraws the protection. The ERP being zero implies that the industry does not enjoy any protection from global competition. If the indicator is greater than zero, the industry is protected, and if less than zero, the domestic industry is more competitive. 5. A measure related to the ERP is the Domestic Resource Cost (DRC). This is expressed in terms of the relevant exchange rate multiplied by ERP plus 1, and indicates the spending of domestic currency required to generate savings of one unit of the relevant foreign currency. The higher the DRC, the more the domestic currency required to generate foreign currency savings. Hence as the DRC increases, the priority accorded to the project should typically decrease.
D. Approach Adopted By The Indian Planning Commission

The Project appraisal division of Indias Planning Commission appraises public sector projects on the following parameters: Border prices are used to value tradable inputs. Non-tradable items such as power or transport are valued at marginal cost.
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The amount of foreign currency involved in inputs or outputs is valued at a predetermined premium. Transfer costs such as taxes and duties are ignored. Semi-skilled and unskilled labor is valued at shadow wage rate.
The Economic Rate of Return (ERR)-Framework Used by Multilateral Institutions

Multilateral institutions such as the World Bank and its arms support private and public projects in developing countries, with the objectives of reducing poverty and stimulating economic growth. To participate in large projects of these countries, they need to understand and assess the private and social returns of the projects. In the traditional approaches to social cost benefit analysis described above, the private returns are calculated using actual market prices, and the social returns using shadow prices. The Multilateral institutions calculate the social return in two stages, also using shadow prices. In the first step, the Financial Rate of Return (FRR} or private returns, is calculated using market prices. In the second stage, a stakeholder analysis is carried out. Stakeholders are those who may be affected by the project. The development impact of the project is estimated by aggregating the net impact on each of the stakeholder groups affected by the project. The additional return to each of the identified stakeholder groups is assessed as the difference between the actual market price and opportunity costs. The framework for identifying stakeholders is presented in Figure 1. Project Financiers, including the owners, are the core organizers of the project, and the Internal Rate of Return to them is the stream of private cash flows (net of costs). This is the FRR and has already been calculated in the first step. Another important stakeholder group will be the labor employed by the project. The labor employed would benefit to the extent that the wages they earn as a consequence of being employed on the project, exceed what they would have otherwise received, had this project not been built. It is
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Figure 1: Framework for Assessing Development Impact

Producers of Complementary Products
Rest of Society
Customers
Neighbors
Financiers (FRR) Employees
Competitors
New Entrants
Suppliers
noteworthy that wages include annual bonuses and benefits such as healthcare, pensions, food and food allowances, housing and so on. A wage above the opportunity cost would hence be added to private benefits, as a component of the ERR. In addition, upgrading of skills due to training, and the consequent higher wages they can command in the market would also form part of the assessment. Customers can benefit in several ways. They can now get products that were not available before, or get products with better quality at the same price or get products of the same quality, cheaper. While the first two impacts are difficult to quantify, the impact of a fall in price is measurable as an increase in the consumers surplus. Producers of complementary products will benefit due to the increased demand for their products, if the project succeeds. A complementary product is one whose value increases, as a consequence of increased supply of another product. An example is the benefits accruing to tour operators, artifact sellers, taxi drivers, airlines operators and so on, as a result of a new hotel resort opened at a popular tourist destination.
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Suppliers will directly witness increased demand, and hence increased sales and profits. Then, there may be increases in wages to the additional labor force, employed to meet the increased demand. If considered important, the chain can continue to the suppliers suppliers and so on. Beyond these quantifiable benefits, the training given to the suppliers for providing better quality, which in turn upgrades the suppliers transactions with the outside world, and so on, forms an important network effect, that may or may not be quantifiable. The development of such backward linkages (forward linkages in the case of customers, who themselves may be producers), has been emphasized as being among the more important development impacts a project can have. Competitors may lose clientele due to the new project, which may result in lower demand or lower prices for their products. However, this is not a loss for the society. The lower prices are offset by the benefits derived by the consumers. The competitors may also benefit if the new project demonstrates a new technology or an innovative business model, or if the network effects lead to supply of better quality raw material for the competitors operations. New entrants will also benefit from the demonstration and network effects described above. Neighbors to the project encompass the entire surrounding community. Impacts on neighbors may be from environmental externalities, better physical infrastructure and the communitys social infrastructure. Environmental effects may be positive or negative, depending on what would have happened if there had been no investment. For instance, felling trees to make way for a new plant may have a negative impact, while replacing an old polluting plant with a modern non-polluting one may have a net positive impact. Physical infrastructure may cause or ease congestion. Finally, the communitys social infrastructure may receive a fillip if the project company creates the necessary social infrastructure such as healthcare and education for the community. Wherever feasible, these effects are quantified for calculating the ERR. Rest of society would include the impact of taxes, subsidies, tariffs and other government interventions. Profit taxes go to the government, and therefore can be added to the ERR calculations. However, the free cash flows to private investors will be computed after taxes, and hence might
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affect their FRR. The government may recycle the tax revenues into more socially beneficial projects, in which case there may be second order or third order effects on the economy. If important and quantifiable, such effects can be included in computing the ERR. Other tax revenues such as those from Value Added Taxes, Sales taxes and Excise duties would be expected to increase, as sales of the new project increase and have to be treated similarly. However, if the product is an import substitution product, the total sales may remain unchanged in the economy. The cost of providing subsidies, which would benefit the private sponsors and be reflected in the FRR, would have to be deducted from the ERR calculations. Similarly, for the goods produced by the project, the social revenue streams should be reduced by that portion of the price accounted for by the tariff. Thus, the steps to calculate ERR for a project must begin with the FRR. 1. Calculate free cash flow for every year in the project period. 2. Add net (positive/negative) returns to important stakeholder groups as the difference between the actual market price and the opportunity costs. 3. Add net profit or losses from taxes, tariffs and subsidies where applicable. 4. Calculate social cash flows for every year. 5. Calculate terminal values where appropriate. 6. Adjust cash flows for inflation. 7. Arrive at real social cash flows. 8. Calculate ERR.
Issues to be Considered While Applying the ERR Framework

The framework to some extent measures the efficiency of resource allocation, but treats all groups equally. For example, the framework does not measure the impact of a project on poverty alleviation in the economy. Similarly, environmental impacts are difficult to value in totality. Further, not all costs and benefits are quantifiable, and many times it is more worthwhile to make a qualitative assessment on the direction of the ERR, rather than attempt to quantify the demonstration and network effects.
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Another issue is the fact that the concept of a social discount rate is yet to attain clarity. At present, IFC uses an arbitrary 10% real discount rate for its social cost benefit analysis, which is also IFCs hurdle rate for accepting projects for financing. The framework is static and does not take into account the value of embedded optionality in project analysis. If embedded real options such as sponsors abandoning the project, or deferring the project are quantified, it is possible that the calculated ERR may lead to a different decision. Nevertheless, in spite of these limitations, the ERR is a useful framework for assessing the social impact of infrastructure projects.
Conclusion
In summary, the ERR gives results similar to traditional social cost benefit analysis, but is more scientific in its approach. Being adopted and in the process of improvement by IFC, the ERR would be a powerful valuation tool for governments and public bodies to make decisions on the economic viability of infrastructure projects. (The author is a post graduate in Management from IIM-A, holding LLB and CAIIB. With two decades of banking and IT sector experience. Currently running a financial consultancy, she is visiting faculty at IIMs and other reputed B-Schools, Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached at padmalathasuresh@yahoo.com).
References
1. 2. 3. Results on the Ground: Assessing Development Impact, International Finance Corporation, Washington DC, 2002. Esty Benjamin C, An Economic Framework for Assessing Development Impact , Harvard Business School, 2002. Social Cost Benefit Analysis ICFAI Books, Project Management, volume 3.
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7
Prof. R Subramanian
Traditional capital budgeting techniques exhibit various shortcomings when employed to value long-term projects. This article outlines the various methodologies that could be employed while valuing large projects.
Introduction
The economic development and prosperity of a nation depends on the quantum of funding by, and the quality of commitment of the government and private companies. In India there are many structural changes required, in the development of power, transportation and telecommunication sectors, and in the national and international logistics and distribution network systems. Infrastructure development, therefore, is the need of the hour. The structure, nature, size and complexity of financing infrastructure projects call for huge investments, and hence, enormous sources of capital to fund these projects. Such large projects require meticulous planning, a well-organized administrative setup, and a careful understanding of risks associated with it. Large engineering projects are complex in nature, and the degree of multiple risks associated with such projects will finally lead to failure of such projects. There are many factors, like technology, innovative engineering methods, financial re-engineering, international
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political changes and similar unpredictable factors, which could totally alter the very basis of infrastructure projects as they progress. The risks associated with such large mega projects therefore, need to be carefully scrutinized with a view to managing their risks effectively. For example, financial risk can arise at the commissioning, implementation and distribution phase in a power project, and in the case of highway projects, the general risk associated is usage rate. How do we value these projects, which are essentially long-term in nature and whose risks could be severe and dynamic? Are the typical capital budgeting methods adequately equipped to handle the complexities of infrastructure projects? It is therefore essential to study, at this juncture, the various techniques of Capital Budgeting which can be used to analyze long-term projects. In this exercise it is worthwhile to highlight the four basic points of view essential for valuing long term projects, viz., The project sponsors point of view. The project lenders point of view. The institutional investors point of view. The host governments point of view. How are their perspectives different? While project sponsors would look to the equity cash flows for their residual returns, lenders would look to the project cash flows to service the debt, and institutional investors would require a competitive rate of return on their investment. The government, however, would look more to the social costs and benefits of the project. Are the traditional valuation techniques geared to meet these requirements?
Techniques Generally Applied in Assessing Long-Term Projects

The common approach that a valuation analyst, must consider are threefold: Base year Company Cash Flow. The Future Cash Flow (projection). Cost of Capital.
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In the first step, the sponsor identifies the cash flow for the base year and bifurcates the firms reported cash flow into three possible sources: 1. Cash flow from operations. 2. Cash flow from passive investments. 3. Ancillary cash flows. The second step is to make adjustments wherever appropriate, to report the operating cash flow for the base year according to the Generally Accepted Valuation Standards. The areas where adjustments are to be made for valuation purposes are enumerated below: Sponsors Compensation. The Discretionary Expenses of the long-tem Projects. Other Discretionary Projects.
Issues in Valuation
Cost of Capital
The development of a unique Cost of Capital for each long-term project is inevitable, since characteristics of projects differ from country to country. The key to valuing a corporate investment opportunity as a viable option, is the ability to carry out an analysis of the project characteristics. The following are the chief characteristics that have to be taken cognizance of, while applying the capital budgeting techniques: 1. Project Feasibility details need to be worked out. 2. Length of the project. 3. Equity Cash Flow Analysis. 4. Financial leverage. 5. Operating Cash flow.
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Deficiencies of IRR in Valuing Long Term Projects

The basic IRR assumption about investment in mega infrastructure projects is that if two unrelated projects, like construction of ports or a golden quadrilateral, with identical cash flows, risk levels, and duration are identified, then the relevant reinvestment rate for interim cash flows has to be considered. If, for example, an investor invests in Project B, then the interim cash flows could be redeployed at a typical 8% cost of capital, while if he invests in Project A, the cash flows could be invested in an attractive investment, then both the projects are expected to generate a 30 to 40% annual return. Some analysts feel that mega projects should use a Modified Internal Rate of Return (MIRR), wherein the weaknesses of IRR can be circumvented and greater clarity can be arrived at, to assess such projects. When the calculated IRR is higher than the true investment rate for interim cash flows, the measure will overestimate the annual equivalent return from the project. Some analysts strongly recommend that managers must either avoid using IRR entirely or at least make adjustments and rely on MIRR. Empirical evidence shows that three-fourths of CFOs, generally involved in large projects, use IRR for assessing such projects, be it on irrigation, power or other infrastructure projects.
Valuation Threats
The resource-allocation process presents not one, but three basic types of valuation problems. Managers need to be able to value operations, opportunities and ownership claims. The three fundamental factors for evaluating the three types of valuation problems, which can be highlighted are timing, cash and risk. At this stage, to overcome these threats, the three complementary tools, which can be brought out are WACC-based DCF, APV and option pricing. Most of the companies now use Option Pricing as their workhorse valuation methodology. Weighted Average Cost of Capital is a tax-adjusted discount rate, intended to pick up the value of interest tax shields by using an operations debt capacity. The more complicated a companys capital structure, tax position, or fund-raising strategy, the more details need to be worked out about the feasibility of the application of WACC.
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The analysts task is, firstly, to forecast expected future cash flow, by period and second, to discount the forecast to present value at the opportunity cost of funds. Opportunity cost consists partly of time value, the return on a nominally risk-free investment. This is the return you earn for being patient without bearing any risk. Todays better alternative for valuing a business operation, is to apply the basic DCF relationship to each of a businesss various kinds of cash flow, and then add up the present values. This approach is most often called Adjusted Present Value or APV. It was first suggested by Stewart Myers of MIT, who focused on two main categories of cash flowsreal cash flows (such as revenues, cash operating costs and capital expenditure) associated with the business operation, and side effects associated with its financing program (such as the values of interest tax shields, subsidized financing, issue cost, and hedges). APV relies on the principle of value additivity. What are the practical payoffs from switching to APV from WACC? Both approaches are skillfully applied in a large project situation.
Long term Projects and Valuation

The issues concerning the valuation methodology of large projects, which need to be addressed are: How much are the expected future cash flows worth, once the company has made all the major discretionary investments? What are the sources for investing in long term projects? Regardless of the opportunities, the valuation tool should gear up to strengthen the corporate capability to allocate and manage resources effectively. Cyclical companies often commit themselves to big capitalspending on projects just when prices are high, and the cycle is hitting its peak, and retrenching when prices are low. Some of the companies develop business forecasting models that are quite similar to those used by equity analysts for interpolating and extrapolating the desired outcomes of the projects. Most aggressive managers aspire for trading approach after attempting at risk analysis, preferably adopting option pricing mechanism. Distributed generation, has tremendous promise for providing efficient, technologically advanced and environmentallyfriendly electricity supplies in the United States. There is an increasing interest in developing countries, in contracting
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with NGOs and the non-profit private sector to deliver primary healthcare (PHC), including nutrition and family planning services. There are few bitter experiences in the low-income countries, in the sense that the contracting will have high transaction costs, and be difficult for governments to implement. When it comes to the provision of major infrastructure in Australia, it seems that there are often alternative ways to deal with these situations, other than government provision. The transaction costs of negotiating such many-sided contracts may be sufficiently low, and improvements in technology can also resolve these issues. Businesses frequently solve free-rider problems, by developing means of excluding non-payers from enjoying the benefits of a good or service. For example, new tolling technology has made it easier to build private roads and charge tolls to road users. Several major international Grid development projects are underway at present, both within the European Community, and in the USA. All of these projects are working towards the common goal of providing transparent access to the massively distributed computing infrastructure, that is needed to meet the challenges of modern data-intensive applications.
International Organization for Standardization (ISO), ISO 9000, Quality Management and Quality Assurance Standards
The ISO 9000 collection is a suite of standards and guidelines, that help organizations implement effective quality systems for the type of work they do. Two items in the collection are most useful to organizations that design and build software: ISO 9001: Quality Systems Model for Quality Assurance in design, development, production, installation and servicing. ISO 9000-3: Guidelines for the Application of ISO 9001 to the development, supply, and maintenance of software. ISO 9001 covers the requirements for a quality system that supports the full product life cycle, from initial agreement on a deliverable, through design, development, and support of the product. ISO 9000-3 provides specific advice on how to interpret the
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standard for developing a quality system of an organization whose product is primarily software. This guideline has been very useful to software organizations, since the original focus of ISO 9000 was for managing manufacturing and process control type of activities, and interpreting the standards for software was sometimes difficult. Standard practices have been developed through field experience, through planning analyses, and from legal or regulatory directives. The government responsibility to ensure that good construction practices are used on public lands, and they apply to the surface-disturbing activities. Best management practices are developed by the responsive government and federal laws permit such practices as a well-accepted norms of the business enterprise. Box 1: Best Practices in Large Consulting Companies
Take up internal studies of an industry or an issue, for purposes of both business development and to push the boundaries of knowledge of internal professionals. The process of developing the standard, provides a laboratory for professionals committed to future marketing of the outputs of the commissioned work. An increasing number of professionals are involved as a methodology progresses from development to implementation. Carry out strategic studies, perhaps on a discounted basis, that would establish a firm as an early leader in a field or as a proponent of a methodology. Learning activity is emphasized in the first two or three projects in a new field. Encourage extracurricular training or professional development sabbaticals. Specific initiatives are tied to the results of project reviews that focus on identification of areas for improvement.
Valuing Opportunities: Option Pricing

Companies with new technologies, product development ideas, or access to potential new markets have vistas of valuable opportunities. A common approach is not to value them formally until they mature to the point where an investment decision can no longer be deferred. Generally two types of cash flows matter i.e., cash for investing and cash for operation. R&D is a major factor for exercising the option, and time also matters in two waysthe timing of the eventual flows and how long the decision to invest may be deferred.
Real Options as a Tool for measuring Long-Term Projects

Generally for evaluating long-term projects, the widely accepted techniques are accounting rate of return, payback period, net present value, modified internal
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rate of return and real options. The first four methodologies ignore the value of flexibility and embedded options, inherent in any large project. Real Option is one of the important tools used for valuing the investment opportunities under conditions of uncertainty, and to monitor, measure and adjust decisions according to economic changes. It is a well-accepted simple valuation technique under the Net Present Value method and principally the operation takes place through option valuation. Real option gives the right but not the obligation to undertake business decisions, for venturing into private public partnerships, or for attempting to fund large infrastructural projects. The technique can also be used for starting a new venture, a hotel project in a hill resort, a new factory, an industrial establishment or a long-term infrastructure project in transport, power or telecommunication. The sponsors have more flexibility, since they can now scale up or switch a project Generally, real options are used for scaling up or switching a project, which is a growth option, apart from exercising scaling down options, learning options and abandonment options. The concept of Real Option can be better understood from a long term perspective. While assessing a long term project, the real option mechanism will act as an important tool to evaluate, to judge and to bifurcate the projects into two dimensions, i.e., the pilot project and the main project. If the pilot project fails, then the sponsor can back out from funding such large non-result yielding projects.
Conclusion
Valuing mega projects, particularly, in infrastructure development and funding, where the future is uncertain, problems are complex and the risks are immense, calls for innovative valuation methodologies. In this context, the Real Option Mechanism can be a better tool provided the following points are considered before attempting to apply it: Real option mechanism must not be viewed in isolation, but with other time adjusted techniques preferably APV, MIRR. Flexibility and change mechanisms are definite pre-emptive measures before adopting a particular tool.
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It should be viewed as one of the tools which will act as a means to a final decision and not an end by itself. (Prof. R Subramanian, is a post graduate in Commerce, in Public Administration, in Business Administration, Master of Philosophy in Commerce, and presently pursuing his Doctoral Programme in Accounting for Derivatives. He has two decades of industry and academic experience and is presently a faculty in IBS Chennai, in the area of Accounting and Finance. He can be reached at srirsmanian@yahoo.co.in).
Reference
1. 2. 3. 4. Tom Copeland, Timothy Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, third edition, New York; John Wiley & Sons. Stewart C Myers, Interactions of Corporate Financing & Investment Decisions Implications for Capital Budgeting Journal of Finance, vol 29, March 1974. Harvard Business Review May-June 1997. Finance & Development, A quarterly magazine of the IMF, March 1999. vol. 36, No. 1.
Box 2: Some of the Accusations that were made against Enron Dhabol Power Project were:
There was no competitive bidding for the projectthe deal was negotiated exclusively between the Maharashtra government and Enron; The project costs and power tariffs were higher than other power projects in India, and the cost of electricity from the DPC project would significantly inflate prices in other areas; The MSEB promised to buy all the high-priced power produced by Enron, whether there was demand or not, and even if cheaper power were available from its own generating plants. These contracted annual payments to Enron would amount to half of Maharashtras entire budget expenditure; The DPC was assured a post-tax return of 16 percent on capital investment, and there was no limit on what Enron could make. Indian economists calculated that the after-tax rate of return would actually be 32 percent, about three times the average rate in the US; There were counter guarantees from the state and central governments for payments which would have been due to DPC from the MSEB. However, the contract shields Enron from Indian jurisdiction, as all disputes must be settled under English law in England; An assurance was given that the project would not be nationalized; The project authorities carried out no environmental impact assessment; and Enron paid $20 million as educational gifts. Critics consider these payments as bribes to clear the project.
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The Nature of Credit Risk in Project Finance
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Section III
Managing Project Risks
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8
The Nature of Credit Risk in Project Finance1
Marco Sorge
In project finance, credit risk tends to be relatively high at project inception and todiminish over the life of the project. Hence, longer-maturity loans would be cheaper thanshorter-term credits.
or decades, project finance has been the preferred form of financing for largescale infrastructure projects worldwide. Several studies have emphasised its critical importance, especially for emerging economies, focusing on the link between infrastructure investment and economic growth. Over the last few years, however, episodes of financial turmoil in emerging markets, the difficulties encountered by the telecommunications and energy sectors, and the financial failure of several high-profile projects2 have led many to rethink the risks involved in project financing.
1
I would like to thank Claudio Borio, Blaise Gadanecz, Mr Gudmundsson, Eli Remolona and Kostas Tsatsaronis for their comments, and Angelika Donaubauer and Petra Hofer (Dealogic) for their help with the data. The views expressed in this article are those of the author, and do not necessarily reflect those of the BIS. Three spectacular recent financial failures are the Channel Tunnel linking France and the United Kingdom, the EuroDisney theme park outside Paris, and the Dabhol power project in India.
Source: http://www.bis.org/publ/qtrpdf/r_qt0412h.pdf, Originally published in BIS Quarterly Review, Dec.2004. The full publication is available free of charge on the BIS website. BIS Quarterly Review. Reprinted with permission.
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The question whether longer maturities are a source of risk per se, is crucial to understanding the distinctive nature of credit risk in project finance. Large-scale capital-intensive projects usually require substantial investments upfront, and only generate revenues to cover their costs in the long-term. Therefore, matching the time profile of debt service and project revenue cash flows implies, that on an average, project finance loans have much longer maturities than other syndicated loans.3 This special feature argues that a number of key characteristics of project finance, including high leverage and non-recourse debt, have direct implications for the term structure of credit risk for this asset class. In particular, a comparative econometric analysis of ex ante credit spreads in the international syndicated loan market, suggests that longer-maturity project finance loans are not necessarily perceived by lenders as riskier compared to shorter-term credits. This contrasts with other forms of debt, where credit risk is found to increase with maturity ceteris paribus. Financing high-profile infrastructure projects not only requires lenders to commit for longer maturities, but also makes them particularly exposed to the risk of political interference by host governments. Therefore, project lenders are making increasing use of political risk guarantees, especially in emerging economies. This special feature also provides a cross-country assessment of the role of guarantees against political risk, and finds that commercial lenders are more likely to commit for longer maturities in emerging economies, if they obtain explicit or implicit guarantees from multilateral development banks or export credit agencies. This is shown to further reduce project finance spreads observed at the long end of the maturity spectrum. After a brief review of the history and growth of project finance, the second section illustrates the specific challenges involved in financing large-scale capital-intensive projects, while the third section explains how project finance structures are designed to best address those risks. The core of the analysis, in the fourth and fifth sections, shows how the particular characteristics of credit risk in project finance are consistent with the hump-shaped term structure of loan spreads observed ex ante for this asset class. The conclusion summarises the main findings and draws some policy implications.
3
The average maturity of project finance loans in the Dealogic Loanware database is 8.6 years, against only 4.8 years for syndicated loans in general.
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Recent Developments in the Project Finance Market

Project finance involves a public or private sector sponsor investing in a single-purpose asset through a legally independent entity. It typically relies on non-recourse debt, for which repayment depends primarily on the cash flows generated by the asset being financed. Since the 1990s, project finance has become an increasingly diversified business worldwide. Its geographical and sectoral reach has grown considerably, following widespread privatization and deregulation of key industrial sectors around the world. Graph 1: Project Finance Global Lending by Region (US$ bn)
1997
1998
1999
2000
2001
2002
Note: The amounts shown refer to new bank loan commitments for project finance, by year and region.
Source: Dealogic ProjectWare database.
In the years following the East Asian crisis (199899), financial turmoil in emerging markets led to a global reallocation of investors portfolios from the developing to industrialised countries. New investments, notably in North America and western Europe, more than offset the capital flight from emerging economies, such that total global lending for project finance rebounded from a two-year slump, reaching a record high in 2000 (Graph 1). Since 2001, the general economic slowdown and industry-specific risks in the telecoms and power sectors have led to a substantial decline in project finance lending worldwide (Graph 2). The power sector has been particularly hurt by
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accounting irregularities and high volatility in energy pricesthe debt ratings of ten of the leading power companies fell from an average of BBB+ in 2001 to B in 2003. Telecoms firms have been penalised for sustaining onerous investments in new technologies (like fibre-optic transmission or third-generation mobile licences in Europe), that have not yet generated the expected returns. Over 60 telecoms companies filed for bankruptcy between 2001 and 2002, as overcapacity led to price wars and customer volumes failed to live up to over-optimistic projections. Despite the recent downturn, the long-term need for infrastructure financing in both industrialized and developing countries remains very high. In the United States alone, between 1,300 and 1,900 new electricity generating plants need to be built in order to meet growing demand over the next two decades (National Energy Policy Development Group (2001)). For developing countries, an annual investment of $120 billion would be required in the electricity sector until 2010 (International Energy Agency (2003)). Graph 2: Project Finance Global Lending by Sector (US$ bn)
1997
1998
1999
2000
Note: The amounts shown refer to new bank loan commitments for project finance by year and sector.
The Main Challenges of Financing Large-scale Projects

Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging.
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Mining and natural resources Other 160 Petrochemical/chemical plant Infrastructure Telecoms 120 Power 80 40 0
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First, they require large indivisible investments in a single-purpose asset. In most industrial sectors where project finance is used, such as oil and gas and petrochemicals, over 50% of the total value of projects consist of investments exceeding $1 billion. Second, projects usually undergo two main phases (construction and operation) characterised 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) and political risk, among other factors.4 Most of the capital expenditures are concentrated in the initial construction phase, with revenues instead starting 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 host government to the offtaker5) so that coordination failures, conflicts of interest and free-riding of any project participant can have significant costs. Moreover, managers have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behavior and inefficient investments.
The Key Characteristics of Project Financing Structures

A number of typical characteristics of project financing structures are designed to handle the risks illustrated above. In project finance, several long-term contracts such as construction, supply, offtake and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behavior by any party involved in the project. The project company operates at the centre of an extensive network of contractual relationships, which attempt to allocate a variety of project risks to those parties best suited to appraise and control them. For
4
Hainz and Kleimeier (2003) identify three broad categories of political risk. The first category includes the risks of expropriation, currency convertibility and transferability, and political violence, including war, sabotage or terrorism. The second category covers risks of unanticipated changes in regulations or failure by the government to implement tariff adjustments because of political considerations. The third category includes quasi-commercial risks arising when the project is facing state-owned suppliers or customers, whose ability or willingness to fulfil their contractual obligations towards the project is questionable. The offtaker commits to purchase the project output under a long-term purchase (or offtake) agreement.
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example, construction risk is borne by the contractor and the risk of insufficient demand for the project output by the offtaker (Figure 1). Figure 1: Typical Project Finance Structure
International organisations or export credit agencies Bank syndicate Sponsor A Sponsor B Sponsor C
Non-recourse debt Inter-creditor agreement 70% 30%
Equity Shareholder agreement
Labor
Input (eg. gas) Supply contract
Project company (eg. power plant)
Output (eg. power supply) Offtake agreement
Construction equipment, operating and maintenance contracts
Host government Legal system, property rights, regulation, permits, concession agreements
Note: A typical project company is financed with limited or non-recourse debt (70%) and sponsors equity (30%). It buys labor, equipment and other inputs in order to produce a tangible output (energy, infrastructure, etc). The host government provides the legal framework necessary for the project to operate.
Source: Adapted from Esty (2003).
Project finance aims to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and, at the same time, the importance of effectively monitoring managerial actions and ensuring a coordinated effort by all project-related parties. Large-scale projects might be too big for any single company to finance on its own. On the other hand, widely fragmented equity or debt financing in the capital markets would help to diversify risks among a larger investors base, but
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might make it difficult to control managerial discretion in the allocation of free cash flows, avoiding wasteful expenditures. In project finance, instead, equity is held by a small number of sponsors and debt is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce projectspecific governance rules for the purpose of avoiding conflicts of interest or suboptimal investments. The use of non-recourse debt in project finance further contributes to limiting managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flows. Moreover, non-recourse debt and separate incorporation of the project company, make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets. In fact, despite some variability across sectors, the mean and median debt-to-total capitalization ratios for all project-financed investments in the 1990s were around 70%. Nonrecourse debt can generally be deconsolidated, and therefore does not increase the sponsors on-balance sheet leverage or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination. In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors core businesses. One drawback of non-recourse debt, however, is that it exposes lenders to project-specific risks that are difficult to diversify. In order to cope with the asset specificity of credit risk in project finance, 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. Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the idiosyncratic risks specific to individual projects are digressed by financing a portfolio of assets as opposed to single ventures. Public-private partnerships are becoming more and more common as hybrid structures, with private financiers taking on construction and operating risks, while host governments cover market risks.
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There is also increasing interest in various forms of credit protection. These include explicit or implicit political risk guarantees,6 credit derivatives and new insurance products against macroeconomic risks such as currency devaluations. Likewise, the use of real options in project finance has been growing across various industries.7 Examples include refineries changing the mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices; real estate developers focusing on multipurpose buildings, that can be easily reconfigured to benefit from changes in real estate prices. Finally, in order to share the risk of project financing among a larger pool of participants, banks have recently started to securitize project loans, thereby creating a new asset class for institutional investors. Collateralized debt obligations as well as open-ended funds have been launched to attract higher liquidity to project finance.8
The Term Structure of Credit Spreads in Project Finance

The specific risks involved in funding large-scale projects and the key characteristics of project financing structures, illustrated in the previous sections, (in particular, high leverage and non-recourse debt) have important implications for the term structure of credit spreads for this asset class. First, based on the widely used framework for pricing risky debt originally proposed by Merton (1974), we should expect to observe a hump-shaped term structure of credit spreads for highly leveraged obligors (Graph 3). In this approach, the default risk underlying credit spreads is primarily driven by two components: (1) the degree of firm indebtedness or leverage, and (2) the uncertainty about the value of the firms assets at maturity. Given Mertons assumption of decreasing leverage
6
The explicit guarantee is a formal insurance contract against specific political risk events (transfer and convertibility, expropriation, host government changing regulation, war, etc) provided by some commercial insurers. The implicit guarantee instead works as follows. The financing is typically divided into tranches, one of which is underwritten by the agency. The borrower cannot default on any tranche without defaulting on the agency tranche as well. The agency represents a G10 government or supranational development bank with a recognised preferred creditor status. Defaulting on the agency has additional political and financial costs that the host country would not want to incur, since agencies are usually lenders of last resort for host countries in financial distress. Analogous to financial options, i.e., derivative securities which give the holder the right but not the obligation to trade in an underlying security, real options provide management with the flexibility to take a certain course of action or strategy, without the obligation to take it (in both cases options are exercised only if deemed convenient ex post). Among the new capital market instruments used for project financing, revenue bonds and future-flow securitizations are debt securities, backed by an identifiable future stream of revenues generated by an asset; compartment funds offer shares with different levels of subordination, to different types of investors, and, are dedicated to make equity investments.
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ratios over time, postponing the maturity date reduces the probability that the value of the assets will be below the default boundary when repayment is due. On the other hand, a longer maturity also increases the uncertainty about the future value of the firms assets. For obligors that already start with low leverage levels, this second component dominates, so that the observed term structure is monotonically upward-sloping. For highly leveraged obligors, instead, the increase in default risk due to higher asset volatility will be strongly felt by debt holders at short maturities, but as maturity further increases, the first component will rapidly take over, thanks to the greater margin for risk reduction due to declining leverage. This leads to a hump-shaped term structure of credit spreads for highly leveraged obligors.9 Second, despite the extensive network of security arrangements illustrated in Figure 1, the credit risk of non-recourse debt remains ultimately tied to the timing of project cash flows. In fact, projects which are financially viable in the long run might face cash shortages in the short term. Ceteris paribus, obtaining credit at longer maturities implies smaller amortizing debt repayments due in the early stages of the project. This would help to relax the project companys liquidity constraints, thus reducing the risk of default. As a consequence, long-term project finance loans should be perceived as being less risky than shorter term credits. Third, the credit risk of non-recourse debt might be affected not only by the timing, but also by the uncertainty of project cash flows and how the latter evolves over the projects advancement stages. In fact, successful completion of the construction and setup phases can significantly reduce residual sources of uncertainty for a projects financial viability. Arguably, extending loan maturities for any additional year after the scheduled time for the project to be completely operational, might drive up ex ante risk premia but, only at a decreasing rate. 10 Finally, the term structure of credit spreads observed in project finance, is likely to be affected by the higher exposure of large infrastructure projects to political risk and by the availability of political risk insurance for long-term project finance loans. While long maturities and political risk represent in principle separate sources of uncertainty, commercial lenders are often willing to commit for longer
9
With leverage ratios approaching 100%, the second component completely dominates and the term structure becomes downward-sloping. This is consistent with the hypothesis of sequential resolution of uncertainty in Wilson (1982)
10
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maturities in emerging economies, only if they obtain explicit or implicit guarantees from multilateral development banks or export credit agencies. As political risk guarantees are most often associated with longer maturities,11 lenders should not necessarily perceive political-risk-insured long-term loans as being riskier than uninsured short-term loans, ceteris paribus. Graph 3: Term Structure of Credit Spreads
In basis points 20% leverage 50% leverage
400 300 200 100 0
5 Maturity (years)
10
25
Note: Volatility of firms asset value is set at 20% per unit of time. Leverage is defined as the ratio of debt to the current market value of the assets, where debt is valued at the riskless rate.
Source: Merton (1974).
A Comparative Analysis of Credit Spreads in the International Syndicated Loan Market

As argued above, several peculiar characteristics of project finance would imply that the term structure of credit spreads for this asset class, need not be monotonically increasing as observed for other forms of financing. This section will attempt to substantiate this claim empirically. Graph 4 illustrates the pricing of a few representative loans for projects both in industrialised and in emerging economies, which have received funding in tranches
11
For example, the World Bank has launched a programme of partial credit guarantees, that cover only against default events occurring in the later years of a loan. This encourages private lenders to lengthen the maturity of their loans.
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with different maturities. The general pattern shown in the graph suggests that the term structure of loan spreads in project finance may be hump-shaped. In order to test this hypothesis, the ex ante credit spreads over Libor for a large sample of loans12 are extracted from the Loanware database compiled by Dealogic, a primary market information provider on syndicated credit facilities. They are regressed on several micro characteristics of the loans (such as amount, maturity, third-party guarantees, borrower business sectors, etc) along with several control variables including the macroeconomic conditions (eg real GDP growth, inflation and current account balance) prevailing in the country of the borrower at the time of signing the loan, plus global macroeconomic factors (such as world interest rates and the EMBI index). Graph 4: Term Structure of Loan Spreads in Project Finance
Spread over Libor, in basis points Industrial countries United Kingdom United States 250 200 150 100 50 0 3 4 5 7 16.5 20 5 7 Maturity (years) 8 10 12 16 Croatia Philippines India Emerging markets 500 400 300 200 100 0
Note: The connected diamonds represent different loans to the same project. Five representative projects are illustrated from both industrial and emerging economies. The shaded points indicate coverage by political risk guarantee.
12
International syndicated bank loans accounted for about 80% of total project finance debt flows over the period 19972003 (source: Thomson Financial).
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Estimated coefficients for loan maturity and its logarithmic transformation reported in Table 1, suggest that the relationship between ex ante spread and maturity for project finance loans is indeed hump-shaped,13 while for all other loans it appears instead monotonically increasing. 14 This result applies to industrialised as well as emerging economies and is found to be robust to a large number of sensitivity tests.15 The regressions in Table 1 also control the impact on loan spreads of political risk and political risk guarantees. Political risk is proxied by the corruption index provided by Transparency International.16 Results suggest that while corruption is not a significant problem for project finance in industrialised countries, lenders financing projects in emerging markets, systematically charge a higher premium on borrowers from countries characterised by a higher political risk. However, this risk appears to be effectively mitigated by the involvement of multilateral Table 1: Microeconomic Determinants of Loan Spreads
Project finance loans Dependent Variable: Spread Maturity Log maturity Corruption index Agency guarantees Number of observations Adjusted R2 Industrialized countries 5.258** 52.426** 0.792 11.872 331 0.259 Emerging markets 5.039* 33.184** 19.340** 58.324** 687 0.337 Other loans 7.066** 0.761 13.339** 48.147** 12,393 0.329
Note: Only regressors of interest are shown. * and ** indicate statistical significance at the 5% and 1% confidence levels, respectively. Source: Sorge and Gadanecz (2004).
13
At short maturities, the positive logarithmic term prevails and accounts for the upward-sloping part of the term structure. As maturity increases, the negative linear term dominates and explains the downward-sloping section of the term structure. The corresponding estimated coefficient on log maturity in Table 1 is not statistically significant. The same result is found using alternative non-linear functions of maturity (eg. quadratic or square root). Including tests for endogeneity and sample selection as well as robustness checks for the range of maturities analysed, repayment schedules, bond ratings, loan covenants and fixed vs floating rates. See Sorge and Gadanecz (2004) for more details. In the reported regression, a higher score on the index indicates a higher degree of corruption in the political system of the host country.
14
15
16
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development banks or export credit agencies. In fact, Table 1 shows that loans with political risk guarantees from these agencies are priced on average about 50 basis points cheaper, ceteris paribus. The evidence also suggests that the availability of agency guarantees effectively lengthens maturities of project finance loans in emerging markets. However, even taking this effect into account through the inclusion in the regressions in Table 1 of an interaction term between maturity and agency guarantees, the estimated relationship between spread and maturity for project finance loans remains hump-shaped.17 This is consistent with the hypothesis that, while it is true that lenders especially use political risk guarantees for longer-term loans, the observed hump-shaped term structure of credit spreads may be due to more fundamental characteristics of project finance.
Conclusion
This special feature has analysed the peculiar nature of credit risk in project finance. Two main findings have emerged, based on the analysis of some key trends and characteristics of this market. First, unlike other forms of debt, project finance loans appear to exhibit a hump-shaped term structure of credit spreads. Second, political risk and political risk guarantees have a significant impact on credit spreads for project finance loans in emerging economies. These results need to be taken with some caution. In the absence of projectspecific ratings, the analysis relies on a number of micro- and macroeconomic risk characteristics that are admittedly imperfect proxies for the credit quality of individual projects. Moreover, loan spreads at origination are only ex ante measures of credit risk. In the future, the development of a secondary market for project finance loans would allow more light to be shed on the time profile of credit risk for this asset class. A deeper understanding of the risks involved in project finance and their evolution over time is important for both practitioners and policymakers. In particular, further research in this area might help in the implementation of risk-sensitive capital requirements providing market participants with the incentives
17
See Sorge and Gadanecz (2004) for more details.
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for a prudent and, at the same time, efficient allocation of resources across asset classes. This is particularly relevant, given the predominant role of internationally active banks in project finance and the fundamental contribution of project finance to economic growth, especially in emerging economies. (Marco Sorge is Economist at Bank of International Settlement. The author can be reached at marco.sorge@bis.org).
References
1. 2. 3. 4. 5. 6. 7. Esty B (2003): The Economic Motivations for Using Project Finance, mimeo, Harvard Business School. Hainz C and S Kleimeier (2003): Political Risk in Syndicated Lending: Theory and Empirical Evidence Regarding the Use of Project Finance, LIFE working paper 03014, June. International Energy Agency (2003): World Energy Investment Outlook, Paris. Merton R C (1974): On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, 29(2), pp 44970. National Energy Policy Development Group (2001): US National Energy Policy, Washington DC. Sorge M and B Gadanecz (2004): The Term Structure of Credit Spreads in Project finance, BIS Working Papers, no 159. Wilson R (1982): Risk Measurement of Public Projects, in Discounting for time and risk in energy policy, Resources for the Future, Washington DC.
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9
Increasingly, refinancing risk is creeping into the financing of single revenue-generating assets, often with debt structures more commonly associated with corporate and structured finance than traditional or classic project finance. Refinancing risk, in some instances, has arisen from financings that aim to avoid some of the restrictions commonly imposed by the terms of project financings, such as stringent limits on additional debt or from the implementation of a debt structure that finances a project that is changing in design or scope. More frequently, refinancing risk has resulted from the limited term or tenor available in a particular debt market. The sources of refinancing risk and some of the mitigating tools that can be employed in single-asset financing are discussed sequentially in this report. Assets and projects with strong economics, that are financed subject to covenants or structural elements have been observed to mitigate refinancing risk adequately.
Source: http://www.fitchratings.com.au/projresearchlist.asp 21 Oct, 2004. 2004 Fitch Ratings, Ltd. Reprinted by permission of Fitch Inc.
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Refinancing Risk Creeps Into Project Finance

A wide diversity of assets in a variety of economic sectors and industries worldwide including mining, oil and gas, power, transport and public infrastructurebenefit from project finance techniques. Project finance structures have been successfully employed in the construction of facilities, the refinancing of assets in operation, the acquisition of assets through a combination of leverage and equity, or the financing of portfolios of assets. The legal structure supporting the financing of projects typically aims to achieve a few of the following common goals: Mitigate construction risk (if applicable). Restrict the activity of the borrower (usually, but not always, through a special-purpose vehicle (SPV)) to avoid diversion of funds for uses unrelated to the functioning of the financed facility, and to protect the project against corporate bankruptcy and consolidation risk. Provide some form of security or collateral for the benefit of the lenders. Safeguard the projects cash flow and liquidity, usually the only sources of debt repayment. Fully repay the debt by its final maturity, which is usually within a term that is consistent with the useful life of the project. The projects term of debt is commonly constrained either by the physical characteristics of the project (power plants, upstream oil, and gas, and mining), by contractual terms (concessions, public private partnerships (PPPs), offtake agreements, etc.) or by a combination of these factors. In this respect, project finance, unlike corporate finance, traditionally is viewed as having quite limited room to accommodate refinancing risk, particularly at investment-grade levels. Nevertheless, Fitch observes that, increasingly, refinancing risk is creeping into the financing of single revenue-generating assets, often with debt structures more commonly associated with corporate and structured finance than traditional or classic project finance. Given the wide variety of asset types and circumstances associated with refinancing risk, it is impossible to generalize on the credit implications of these trends. Refinancing risk, in some instances, has arisen from financings that aim to avoid some of the restrictions commonly imposed by the terms of project financings, such as stringent limits on additional debt. In other instances,
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refinancing risk arises from the implementation of a debt structure that finances a project that is changing in design or scope (expansion of a toll road or pipeline network). More frequently, refinancing risk has resulted from the limited term or tenor available in a particular debt market. Instead of generalizing a credit approach to refinancing risk and sentencing all projects subject to it to either unrateable or non investment-grade status, Fitch analyzes the effect on a projects risk profile and determines the extent to which it will diminish credit quality on a case-by-case basis. In some cases, refinancing risk can be mitigated by an assets quality and specifications, low probability of technical obsolescence, strong economics and long useful life, as well as its ability to reduce leverage prior to a needed refinancing. It can also be mitigated by certain elements adopted in the financing structure. The sources of refinancing risk and some of the mitigating tools that can be employed in single-asset financing are discussed sequentially in this report.
Traditional Project Finance: Monolithic?

Traditionally, projects are financed on a non-recourse basis (i.e., relying only on the cash flows generated by the asset to meet debt-service payments without the benefit of support from a corporate or government entity). The financing structures have either mitigated or completely eliminated refinancing risk. In fact, a fundamental characteristic of such non-recourse financing has been the avoidance of refinancing risk altogether. Traditional project finance is, however, characterized by certain rigidities. Due to the considerable risks inherent in the asset and the reliance solely on the assets cash flows for debt repayment, as well as the usual existence of substantial leverage, especially during construction or at the point of acquisition of an asset, traditional project finance will impose a variety of constraints. These constraints include limits on activity, additional indebtedness and distribution of cash to the projects owners. Dilution of some of these rigidities is among the factors engendering refinancing risk.
Limit on Activity, Acquisitions, Disposals and Ownership

In conventional project finance, the borrower usually undertakes to limit its activity to the construction and operation of the specific asset being financed. In addition, acquisition and disposal of assets by the borrower, or engaging in ancillary or
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unrelated businesses, are usually restricted. The motivation underpinning these conventional limitations is to safeguard the projects cash flows, which if used for unrelated purposes, could erode the projects capacity to repay its debt. However, in some cases, expansion of activity will be permitted or even encouraged, which in turn may contribute to higher refinancing risk. This can include, for instance, additions to an existing oil pipeline or, particularly, changes in the design of government concessions for public infrastructure. With more private-sector participation in the development of public infrastructure worldwide, some of the traditional limitations of project finance could change to fit more adequately, the characteristics of the asset, ownership or management model, as well as government concerns. To illustrate, in recent years Chiles public toll road concessions have evolved from fixed to variable terms, and have instituted minimum revenue-guarantee mechanisms to encourage sponsors to undertake additional capital programs for road expansions beyond the initially specified scope. In this sense, the projects are no longer static or rigid but instead are assets with physical characteristics that change and conform to a varying service scope or design. The variable nature of the projects is then reflected in the structure of the financings, with longer amortization periods but also the option of taking on additional debt to finance the new capital programs demanded by the concession agreement or to refinance existing debts originally used to fund the initial construction. Without a strong project that benefits from access to fresh liquidity in the capital or bank markets as needed, holders of the original debt could assume considerable refinancing and credit risk. Ownership limitations tend to impede the sale or transfer of project-financed facilities, reflecting the concerns of creditors who typically demand security or collateral against an asset. In some cases, particularly in the oil and gas sector, the original owners must hold the asset until at least the end of the construction period and sometimes until the debt is fully repaid. A recent project financing for Qatargas II, a new liquefied natural gas (LNG) terminal developed by a joint venture between ExxonMobil and Qatar Petroleum, was structured with this limitation. Although consistent with tradition and at the same time a bit unusual in form, the Qatargas II limitations run contrary to the strong trend among institutional investors toward project debt and equity investments, as well as acquisitions, divestitures and consolidation of the physical projects or portfolios of projects, especially in the US power sector.
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Contrary to convention, specialized investment funds and other investors in existing assets with successful operating histories, such as profitable pipelines, power plants or other projects in the United States, are designing capital structures that address a number of competing concerns. These concerns include complying with regulatory capital requirements for certain assets in the power market, enabling the acquisition of various projects in investment portfolios under one holding entity (groups of power plants), accommodating debtholder concerns and maximizing leverage to the fullest degree possible for a targeted rating level. In some of these cases, refinancing risk may arise. Equity investors may leverage the asset to fund the acquisition and minimize the required cash or equity contribution to no more than 25%30% of the acquisition cost. The transaction might comprise a holding company (Holdco)/operating company (Opco) capital structure so that the operating asset or project (pipeline or power plant) is owned by the Opco, a subsidiary of a special- or sole-purpose Holdco. Depending on the amount of leverage required or desired to fund the acquisition and the effect of debt-service coverage on sustainable cash flow, tranches or classes of debt will be allocated to the Holdco and others to the Opco. Debt of the Opco will rank senior, with debtholders benefiting from a security pledge, as well as first position on cash flows from the project. However, the Opco debt might not fully amortize by the final maturity date, particularly when the project is regarded by the equity investors as sufficiently strong, economically, to stand on its own for a relatively long period. Opco debtholders will have assumed refinancing risk, or stated another way, they will assume that the useful life of the asset and its economic viability will enable the project to meet financial obligations indefinitely into the future. Holdco obligations, which are structurally subordinated to the Opco debt, will usually be structured to amortize, completely or almost completely, by the maturity dates and are usually of shorter life than the Opco debt.
Limit on Indebtedness
In most project finance transactions, the ability of the borrower to raise additional debt beyond the original financing is controlled more tightly than for corporate loansMost projects are of a certain economic value, which will not be increased by additional leverage (unless this debt is incurred to fund value-enhancing investments). At the most stringent end of the spectrum, the imposed additional debt
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test or limit will impede any other indebtedness above a certain minimal amount associated with mandated expenditures (legal or regulatory requirements) or expenditures necessary to maintain the integrity and the satisfactory operations of the asset. However, to facilitate additional financing, in some cases, the indebtedness limitations will permit the borrower to raise additional pari passu senior debt, if certain financial covenants are satisfied or specific minimum ratings are achieved after taking into account the additional debt. In other cases possessing less favorable financial and economic profiles, senior debt investors may not have an appetite for the implied refinancing risk. In such cases, subordinated debt may be employed to lessen senior debt refinancing risk, thus potentially benefiting, or at least not degrading, the credit quality at the senior level. To the extent that a default of subordinated debt can cause a default of the senior debt, or if the subordinated debt is not subject to payment restrictions similar to those applicable to equity distributions (as discussed later), additional subordinated debt could jeopardize the rating of the senior debt. Thus, proper structuring of employed subordinated debt is critical. (For more information on Fitchs approach to subordinated project debt, please refer to the criteria report, Layer It On The Essentials of Rating Project Subordinated Debt, dated Sept. 9, 2002, and available on Fitchs Website at www.fitchratings.com). Consistent with project finance conventions, Express Pipeline, a Canadian-US project, is subject to a comprehensive set of restrictive covenants, which limit managements options to fund anticipated expansions to the pipeline network (Graph 1). The projects owners (one operating sponsor and two financial investors) view the pipeline as a strong asset capable of standing on its own and requiring no additional equity support; the ultimate financing decision for the pipelines expansion thus resulted in the issuance of Holdco-level, structurally subordinated debt. These new notes carry the option to convert into senior project-level debt ranking pari passu to the original senior notes upon completion of the expansion by the end of 2005. Like the existing notes, the new notes rely on the projects cash flow (in the form of equity distribution payments from the pipelines Opco owner) to service debt interest. Principal is due as a bullet in 15 years. The legally inspired use of Holdco-level debt with a bullet maturity (unrated) satisfied the restrictive covenants, as the bullet repayment structure allows the project to
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maintain debt-service coverage margins consistent with the A rating on the Opco notes and withstand periods of significant stress. The risk of refinancing the bullet maturity is expected to be modest, as it is due after the full repayment of existing Opco senior and subordinated notes (the latter rated BBB). If properly maintained, the pipeline should enjoy a long useful life, and strong demand for Canadian oil throughout North America further mitigates Holdco refinancing risk. In sum, in Express Pipelines case, a traditional project finance limitation on additional debt was successfully and sensibly overcome with a viable project and legal structure that mitigated the refinancing risk incorporated in the expansions financing. Graph 1: Express Pipeline Debt-Service Schedule
120 100 80 60 40 20 0 ($ Mil.)
Principal Payment
Interest Expense
03
13
16
06
11 20 12
05
04
08
14
15
07
09
17
20
10
20
20
20
20
20
20
20
20
20
20
20
20
Source: Terasen.
Restricted Payments
While project finance aims to restrict diversion of cash, it usually allows payment of equity distributions if certain tests are met. This restriction differentiates project finance from, for example, leverage finance, where all cash generated by the asset is often used completely for the benefit of lenders. This difference stems from the fact that equity investors in project-financed assets usually demand current cash returns once a project achieves a steady state of operations. Customarily, project finance transactions include restricted payment provisions controlling whether equity distributions (or subordinated debt payments) can be paid. These payments are normally more tightly defined than those for corporate
20
20
20
18
19
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finance and are of key interest to Fitch, especially in project acquisitions. As stated previously, in their quest for returns, equity investors are increasingly resorting to leverage in ways that substantially heighten the debtrefinancing risk of long-lived projects. Therefore, Fitch pays special attention to restricted payment provisions, which typically include the following: Maintenance of certain minimum dedicated cash balances (in particular, the debt-service reserve account (DSRA) and the maintenance reserve account (MRA)), which may not be distributed, is a standard structural element in most project financings. Payment of dividends or principal and interest on subordinated debt is normally subject to compliance with certain financial covenants, usually a minimum DSCR or a bond life coverage ratio (BLCR, also known as a lock up). To be of value, these covenants will usually be forward looking, preventing the distribution of dividends unless the projects covenant threshold is reached. This was the case for AES Drax Holding, Ltd., a UK power project rated by Fitch, which could not meet its subordinated debt payment from cash flow in February 2002 because, based on the market consultants price forecast, the company would be below its DSCR covenant level in future periods. This cash retention occurred 10 months before the borrower defaulted on its senior debt as a result of the default of its power offtaker, TXU Europe. Repayment Structure as Source of Refinancing Risk Refinancing risk can arise from the need to surpass stringent constraints in project finance or from the design of the projects debt repayment structure (Graph 2). A wide variety of repayment modes can be employed in the financing of assets, including fixed amortization, indexed-linked bonds, and bullets and balloons, as well as, increasingly, debt deferral and flexible amortization structures, which sometimes incorporate cash-sweep mechanisms. The choice of structure is driven by the need to address competing concerns of sponsors and debtholders, as well as the inherent nature and characteristics of the asset. Fixed or Sculpted Amortization Project finance assets usually have a limited life and are, therefore, generally less capable than corporates of withstanding refinancing risk. For this reason, many
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Graph 2: Classic Repayment Debt Schedule

120 100 80 60 40 20 0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
($ Mn.)
Annual Principal Payment
Outstanding Debt Balance
project finance loans amortize fully according to a fixed amortization schedule in conformity with the indenture maturity date. Typically, mining and oil projects, as well as other projects affected by commodity-price risk, will be structured such that debt principal is fully repaid within the term of the debt. Lenders are keen to be repaid in full and will ensure that the debt will mature well in advance of the tail end of the mines recoverable reserves. Therefore, in properly structured mining transactions, the debts amortization will be front loaded, of relatively short duration and not subjected to refinancing risk. A trade off does materialize, however, as front loading can significantly burden a mining projects cash flows and hinder debt repayment capacity when substantial development or construction is required before revenues reach steady state. Therefore, the debt repayment profile will often be sculpted to match the expected output production and cash generation of the project, while leaving a sufficient tail reserve after debt maturity to cover contingencies. (Graph 3) Indexed-Linked Bonds The market for indexed-linked bonds has been growing rapidly in Europe in the past few years, fueled by the growth of the PPP sector. These bonds are suitable investments for asset-liability matching, particularly long-dated pension obligations. The bonds repayment tends to be back ended, which increases the average life of the bond, especially in high inflation periods. Nevertheless, this is not necessarily a source of concern, especially when the net cash flow generated
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by the project follows the bonds amortization repayment pattern. In addition, indexed-linked bonds issued for PPP projects are typically fully amortizing within the legal maturity term and are thus not significantly exposed to refinancing risk. Bullet or Balloon Repayments Shorter term, bullet maturity loans might be taken, with the expectation that the financed assets life will extend sufficiently beyond the maturity of the bullet loan to support a refinancing. During the 1990s, this type of financing (sometimes nicknamed miniperm) was popular in the US power sector. However, the ensuing deterioration of this market in the latter half of the decade highlighted the pitfalls associated with refinancing risk. These structures are, however, back in favor in the infrastructure sector. In Spain, recent toll roads were financed by banks with miniperm-like financing that included relatively short maturities but were underpinned by long-term concessions. Generally, a bullet1 or balloon 2 structure arouses concern, as it exposes the project to refinancing risk. Bullets or balloons can, therefore, sometimes be expected Graph 3: Derby Healthcare PLC Amortization Schedule
(GBP 000)
Principal Payment
Interest Expense
60,000 50,000 40,000 30,000 20,000 10,000 0
7 10 13
22 25
16 19
34 37
40 43
49 52
61 64
58
Payment Periods
GBP British pound. Source: Derby Healthcare PLC.
1 2
Bullet - 100% of initial amount is due at maturity Balloon - The credit is only partially repaid during its term and presents a lumpy repayment at maturity.
70 73
28
31
46
55
67
76
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to have a negative effect on credit quality. However, this type of repayment structure can achieve an investment-grade or near investment grade rating if the financed asset has a long, useful life and strong economics. This has been the case for certain Australian and New Zealand transportation and infrastructure transactions, which have been backed by strong assets generating cash flows that allow for debt to be paid or refinanced within the concessions term while maintaining robust coverage levels. A common characteristic of these transactions is the relatively modest size of the refinancing requirement or leverage relative to the availability of credit from either banks or bond investors in these markets; therefore, the bullet maturities are likely to be refinanced successfully at or prior to their due dates. Alternatively, as illustrated by the Coleto Creek project, a cash-sweep mechanism, whereby excess project cash flows beyond what is required to satisfy certain fixed costs, are applied to debt principal prepayments prior to the bullet payment date, can assure that the refinancing will be accomplished with less risk than relying simply on the timely access to credit. Fitch notes that recent infrastructure and PPP transactions in the UK have fully amortizing loans or bonds. However, these loans and bonds amortize over a very long period and effectively do not repay much more than a shorter bullet loan during the first 810 years. For instance, Derby Healthcare PLC, a UK hospital under a PPP, rated BBB (unenhanced) by Fitch, pays down only 0.3% of the bond debt during the first ten years after financial close. This project benefits from a 40-year concession and a predictable cash flow stream, which enables the back-ended amortization. In this respect, Fitch notes that with the small repayments during the first ten years, the amortization profile of the bond is not materially different from that of a bullet loan. Unlike a bullet structure, the project is in fact not exposed to refinancing risk, with debt serviced from the start. Flexible Repayment and Debt Deferral In between the two ends of the repayment-risk spectrum (scheduled amortization fully within the maturity term and bullet or no periodic amortization), the range of possible repayment structures is quite wide, limited only by the imagination of bankers, sponsors and investors.
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Coleto Creek WLE, LP

An illustrative case of an unorthodox repayment structure affected by refinancing risk is Coleto Creek WLE, LP(Coleto Creek). Fitch assigned a rating of BB to a $205 million secured term loan due 2011 (first-lien B loan)and BB to a $150 million secured loan due 2012 (second-lien C loan). Coleto Creek, a project domiciled inTexas, consists of a net 632-MW generating facility comprising a coal-fired boiler, a steam turbine with anameplate capacity of 570 MW and ancillary facilities. Due to the design of the loan repayment structure, ColetoCreek faces refinancing risk, as scheduled principal payments are insufficient to repay the loans fully upon theirrespective legal maturity dates. In fact, no principal payments are scheduled for the C loan, and payments on theB loan are minimal, amounting to a mere $1 million annually (20052011). In its analysis, Fitch assumed that arealistic refinancing scenario would include the aggregate amounts due, under both the B and C loans. To mitigate the risk, a cash-sweep mechanism in the credit agreement provides for the prepayment, or additionalprincipal payment, of the loans, above the scheduled amounts. This annual cash sweep captures 75% of excessproject cash flow, which is defined as cash available after operating expenses, capital expenditures, interest andscheduled principal, replenishment of a debt-service reserve and reimbursement of sponsors income taxpayments. Swept cash is first used to prepay the outstanding balance of the B loan. Once the B loan is fullyrepaid, swept cash is applied against the principal balance of the C loan. Implicit in the Fitch base case, all of thescheduled and swept cash will be applied to the amortization of the B loan. The cash-sweep mechanismsubstantially increases the amount of actual debt repayment relative to the scheduled amounts, thus improvingthe credit quality of the project, as well as refinancing prospects. The outstanding balance subject to refinancingby the legal maturity date of the B loan in 2011 will constitute approximately 57% of the combined issue. Thenon investment-grade ratings assigned to the loans consider both the credit strengths of the project (reliableoperations, low fuel supply risk and highly competitive cost structure) and the credit concerns (refinancing risk,merchant price risk and interest rate risk). The BB rating of the C loan reflects the loans balance at maturityin 2012 (original full amount, unamortized) and priority position in the cash sweep relative to the B loan. A moredetailed analysis is summarized in the new issue report on Coleto Creek that is dated Oct. 20, 2004, andavailable on Fitchs Web site at www.fitchratings.com. Fitch anticipates that the Coleto Creek repaymentstructure will be employed with increasing regularity for certain power projects in the United States.
One example would be debt with a target and a minimum repayment profile. In this instance, flexibility is provided in the repayment structure without adverse consequences, as long as the project meets the minimum repayment schedule. Such flexible repayment structures are more commonly seen in project finance bank loans than in bonds, as the majority of projects financed with bonds typically incorporate fixed-amortization terms, although, as noted, this is changing.
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Another source of flexibility is the capacity, whether limited or not, to defer some principal repayment. The deferred principal repayment, also known as a soft bullet, is commonly employed in structured finance. Assets monetized in this manner can vary widely in terms of their nature and characteristics, but mainly include financial assets (mortgages, loan portfolios and future payments on export receivables). It is still rare to see such structures employed in the financing of projects, although the use of soft bullets has become increasingly popular to mitigate refinancing risk. In cases where debt repayment deferral is permitted, the rating still addresses probability of default, though not of timely payments but whether they are made by the legal maturity date. A structure allowing for partial or full deferral of principal, will sometimes have the effect of lowering the probability of default. Consequently, such flexibility can potentially permit the project to achieve a higher rating than would have been achieved without the deferral feature, but only to the extent that lenders retain adequate control over the cash generated by the asset and refinancing risk is minimized. To illustrate, Fitch rated the various tranches of the refinancing of Tube Lines (Finance) PLC (Tube Lines), a company managing one-third of the London Underground infrastructure under a PPP contract with Transport for London. In all of the 20 sensitivity tests prepared, the investment-grade rated tranches will be fully repaid before final maturity. In the most severe case, however, the DSCR will fall below 1.0 times (x) on the BBB tranche in two periods. This suggests that the SPV would have to draw on cash reserves (which are expected to be more than adequate due to the implementation of the cash lock-up provision) or defer a payment during those periods. In these circumstances, the capacity to defer a payment reduces the risk of default on that tranche. A key consideration in the Tube Lines case, which is consistent with Fitchs approach to US toll roads and other long-lived projects (for example, the Pocahontas Parkway in Virginia), is the availability of an amply funded reserve. From Fitchs perspective, draws on a liquidity and debt-service reserve for short-term needs do not necessarily preclude an investment-grade rating, provided that full depletion of the reserves at any time during the debts life is highly improbable and the ability to replenish the reserves in a timely manner can be demonstrated. In fact, the reverse might be the casea reserve for liquidity can shield against not only downgrades but also refinancing risk.
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While a flexible amortization profile can lower the probability of default, it can negatively affect debt recovery to the extent that lenders do not retain appropriate control. To mitigate this, such flexibility is more suitable when accompanied by cash lock-up provisions, and the ability to accelerate amortization if forward-looking DSCRs fall below certain levels. In Fitchs opinion, investmentgrade transactions are likely to have only limited deferral capacity. If there is no limit in the number of times that the deferral can take place (or in the cumulative deferral amount), then the amortizing structure, if misused, can effectively become a bullet structure, exposing the project to unmitigated refinancing risk. Graph 4: Coleto Creek Debt-Repayment Profile
($ Mil.)
05
04
06
07
08
09
20
20
20
10
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20
20
Source: Coleto Creek WLE, LP.
Benefits of Traditional Project Finance Structures

As outlined in this report, the risk of refinancing project obligations may arise from a variety of sources, including the structural limitations imposed by traditional project finance, as well as debt repayment profiles adopted for assets with characteristics that may or may not be in conflict with them. Fitch continues to look favorably upon restrictive covenants that traditionally conform to project finance. Assets and projects with strong economics that are financed subject to covenants or structural elements, such as the following, have been observed to mitigate refinancing risk adequately: A cash flow lock up, which effectively causes cash to be retained in the projects SPV for the benefit of lenders, is obviously positive.
20
20
11
4321 4321 4321
4321 4321 4321
4321 4321 4321 4321
54321 54321 54321 54321 54321
4321 4321 4321 4321 4321 4321
4321 4321 4321 4321 4321 4321 4321
4321 4321 4321 4321 4321 4321 4321 4321
4321 4321 4321 4321 4321 4321 4321 4321
400 350 300 350 200 150 100 50 0
21 21
Term Loan B
Term Loan C
Cash-Sweep Amortization
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Fitchs ratings, especially at the lower BBB level and below, reflect an assessment of the probability of default and, sometimes, take into account the potential for loss upon default. Fitch views tight covenants as providing early warnings for the lenders of any deterioration in the projects creditworthiness, thereby allowing for corrective actions (including retention of cash) at an earlier stage. In this respect, tighter covenants can enhance recovery prospects. Lane Cove Tunnel Finance Pty Ltd.
The Lane Cove Tunnel project (the project) illustrates a repayment structure affected by refinancing risk, whichis more commonly assumed by investors in Australia and New Zealand than in North America or other highlydeveloped project finance markets. Fitch assigned a BBB rating to the standalone credit quality of the bonds(and AAA with the guarantee provided by MBIA Insurance Corp.). Lane Cove Tunnel Finance PtyLtd. (LCTF), the issuer, is a special-purpose finance company of a consortium contracted by the New SouthWales Roads and Traffic Authority to design, build, operate and maintain the project. The tunnel is an integrallink in Sydneys orbital motorway network. The projects debt comprises senior secured bonds issued, to date, in four tranches ranging in terms from 1025years for a total of AUD690.83 million. A fifth tranche for AUD451.2 million is expected to be issued byDecember 2004. The LCTF financing structure incorporates the expectation of a significant degree ofrefinancing, with bullet repayments on all bonds (except bond 1 for AUD126.83 million). The risk of refinancing these bullet payments is partly mitigated by the reasonably well-spread maturity profileof the bonds and also by a soft bullet structure, which provides for a two-year extension to the final maturity. Onbond 3 (for AUD191.76 million) and bond 4 (for AUD259.44 million), a call option also provides a four-yearperiod of flexibility to refinance a major portion of the debt due. Further, the LCTF consortium is obligated tocommence the refinancing arrangements of maturing obligations at least 12 months prior to scheduled maturity,and penalties are imposed on the consortium for refinancing after scheduled maturity. In its analysis, Fitch undertook a wide variety of sensitivity tests to determine the projects ability to withstandthe effect of certain stresses. Important structural elements supporting the financing are reserve accounts forliquidity that are to be drawn upon under stress. A cash-trap or lock-up provision also helps to ensure that the projectmaintains liquidity and the ability to effectively deliver (on a net basis) in periods of lower debt-service margins.Therefore, in spite of the refinancing risk, Fitch concludes that the projects financing structure possessesadequate capacity for timely payment of interest and principal on the bonds. Fitchs BBB rating balances the projects credit strengths and concerns. Among the strengths are thecharacteristics of the transport corridor served by the tunnel and its effect on time savings; low traffic risk, as theexisting road link is well known; strong counterparties; and the structural enhancements in the financing,including cash reserves and cash-trap provisions. Among the credit concerns are refinancing risk (mitigated bythe soft bullet maturity structure), high leverage and construction risk. A more detailed analysis is summarized inthe credit analysis on this project dated Jan. 30, 2004, and available on Fitchs Website at www.fitchratings.com.
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In Fitchs view, traditional covenants that may seem severely restrictive in certain situations provide valuable signals and control for creditors. However, it is not necessarily the case, that tight covenants will automatically improve the rating. The documentation should be carefully tailored to each specific situation. Fitch acknowledges the trade offs and tensions generated by sponsor or project owner motivations and interests, commodity market conditions, changes in asset specifications or scope, economic environment and availability of long-term financing at reasonable cost, among other variables. In addressing these wide-ranging concerns, which may engender refinancing risk, a variety of repayment and other structural elements, may be considered such as the following: Front-loading amortization in the early years, increasing default probability but also improving recovery prospectsThis is a sensible approach for mining and other resourcerelated projects, as well as power plants. Alternatively, a cash sweep can be used to ensure timely repayment of the debt without increasing probability of default. Back-loading amortization, decreasing default probability versus increasing debt costsToll roads, which are affected by the uncertainties of traffic flows in the early years but have long economic lives and a growing revenue stream, might benefit from this repayment structure. Providing for soft bullet maturitiesThis approach is analogous to the repayment models of structured finance. Limited deferral of debt principal can be an effective tool to providing financial flexibility without exacerbating refinancing risk, as was the case of Tube Lines with the lowest rated tranche, rated BBB. In some cases, Fitch might require the availability of a fully funded cash reserve in order to achieve investment-grade ratings targets. Tranching bullet paymentsInstead of one large bullet maturity, smaller payments fall under various maturity buckets, limiting refinancing risk in any one year. In Australias Transurban and Lane Cove Tunnel projects, this element is employed, making refinancing risk more manageable. Diversifying source of financingRefinancing risk, especially in markets vulnerable to a credit crunch or in which longterm maturities are not available, a combination of bank loans, bonds fully enhanced or wrapped, unenhanced bonds, and domestic and international credit, among
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other sources, can mitigate credit and refinancing risk. For Chiles 30-year toll road projects, a combination of financing sources is relied upon to limit refinancing and credit risk. Providing for mandatory prepayment and forward-looking cash lock up These mechanisms, if implemented properly, can effectively deliver a project on a net-debt basis (especially where performance is below the base), and the build up of cash can be used to reduce the level of debt to be refinanced and, hence, reduce refinancing risks. Providing for a cash-sweep mechanismThe likelihood that a bullet or substantial principal payment is due before the projects cash flow has fully amortized the debt, constitutes a refinancing risk. A viable mitigating mechanism is a cash sweep, through which excess project cash flow is applied periodically to the prepayment, or more rapid amortization of principal than provided for in the credit agreement schedule (as with the Coleto Creek project). Employing callable debtAt the issuers option, the projects debt would be called, allowing for a refinancing at a date favorable to the project. Callable bonds and bank loans are commonly employed for Australian projects. Limiting the size of the bullet paymentExpress Pipeline is expected to successfully refinance the Holdco bullet debt, as the bullet payment is due after the initial project debt is fully repaid. The pipeline also enjoys a long economic life and access to both the Canadian and US debt markets. Ostensibly, finding the most suitable repayment structure remains somewhat of a trial-and-error and evolutionary process. The choice of financing mode for a specific project is often as much driven by investors concerns and preferences and market conventions as it is by the projects intrinsic risk profile. From Fitchs viewpoint, acceptable flexibility in the repayment structure can have a beneficial effect on project credit quality, assuming that creditors, as provided for by indentures, remain in control of the asset and the cash flow it generates. (Fitch Ratings is a leading global rating agency committed to providing the worlds credit markets with accurate, timely and prospective credit opinions.)
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10
Exchange Rate Risk
Philip Gray and Timothy Irwin
Each year developing countries seek billions of dollars of investmentin their infrastructure, and private investors, mostly in richcountries, seek places to invest trillions of dollars of new savings.Private foreign investment in the infrastructure of developingcountries would seem to hold great promise. But foreign investorsmust cope with volatile developing country currencies. Many attemptsto do so have created as many problems as they have solved. ThisNote proposes that investors take on all financing-related exchangerate risk, even though this may mean higher tariffs for consumers asa premium for bearing that risk.
he standard advice on allocating riskto assign it to the party best able to manage ithas controversial implications for the allocation of exchange rate risk in a private infrastructure project. Three parties can bear the risk of exchange rate movements in the first instancethe private investors (whether foreign or local equity-holders or creditors), the host country government (ultimately, its taxpayers), and customers of the service. Some argue that investorsor at least their ultimate shareholdersshould bear the risk because they can diversify away country-specific exchange rate risk. Others argue that the government should bear
Source: http://rru.worldbank.org/PublicPolicyJournal/Summary.aspx?id=262. 2003, World Bank publication. Reprinted with permission
Exchange Rate Risk
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the risk because it is responsible for macroeconomic policies that strongly influence the exchange rate. Still others argue that customers should bear it because they must ultimately pay for the cost of the service and the risk can be shared widely to lessen the impact. The allocation of exchange rate risk is often done through tariff adjustment formulas that implicitly share risk through the way they adjust the tariff over time. If indexation is allowed, tariffs can reflect the exchange rate in several ways: Allowed prices or revenue can be fully or partially indexed to the exchange rate. Input costs that depend on the exchange rate can be treated as a pass-through, so that customers pay the actual costs of the inputs. The contract can provide for a renegotiation of allowed prices or revenue if the exchange rate moves outside a specified band. At one extreme of the risk sharing spectrum, Argentina effectively indexed 100 percent of costs to the dollar. The implications of this are now being fought out by the investors and the Argentine government, which has prevented significant tariff increases since the devaluation of the Argentine peso. Most countries use a hybrid approach to tariff adjustment. Part of the tariff is indexed to local inflation, part is indexed to dollar inflation, and some costs are straight pass-throughs. But there is still much debate about what share of the cost base should be indexed to local inflation and what share to international costs. And tariff adjustment mechanisms are not the only approachgovernments sometimes provide exchange rate guarantees to cover repayment of foreign currency debt.
Nature and Sources of Exchange Rate Risk

To shed more light on the debate requires first looking more closely at the nature and sources of the risk. Exchange rate risk, as defined here, is variability in the value of a project, or of an interest in the project, that results from unpredictable variation in the exchange rate. There are two types of exchange rate riskproject and financing related. Project exchange rate risk arises when the value of a projects inputs or outputs depends on the exchange rate. Typical infrastructure projects sell their outputs domestically,
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so, valued in local currency, revenues usually are not subject to exchange rate risk. But any input that is tradable, even if it is not imported, will have a world price, so its cost, measured in local currency, will vary inversely with the exchange rate. The cost of fuel, for example, creates exchange rate risk for a thermal electricity generator. Financing choices affect the amount of exchange rate risk borne by different participants in the project (shareholders, creditors, customers, taxpayers). In particular, loans requiring repayment in foreign currency expose shareholders to exchange rate risk. As a result, shareholders may seek to shape the contractual arrangements to pass on some or all of the risk to the government or customers (through exchange rate guarantees or indexation of the tariff to the exchange rate).
Optimal Allocation of Exchange Rate Risk

Parties can manage exchange rate risk in three ways: They can influence the underlying source of the risk. Governments, for example, can reduce the rate of depreciation and the volatility of the exchange rate by keeping budget deficits small and inflation low. They can influence the sensitivity of the value of a project or of their interest in it to the risk. Project sponsors, for example, can reduce the sensitivity of the value of their shareholding to the exchange rate by reducing the projects reliance on foreign currency debt. They can hedge or diversify away the risk. Hedging exchange rate risks is possible in only a few developing countries. But most of the ultimate foreign shareholders of the project companyindividuals with savings in mutual funds, pension plans, and life insurancecan diversify their savings, limiting their exposure to any one countrys exchange rate risk (as defined). The principle of optimal allocation can therefore be restated as follows Exchange rate risk should be allocated according to the parties ability and incentives to influence the exchange rate, change the sensitivity of the value of the project (or of their interest in it) to the exchange rate, and hedge or diversify away the risk. Since the principle involves three types of management, its implications are not clear cut (Table 1).
Exchange Rate Risk
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Table 1: Ability of Customers, Shareholders, and Government to Manage Exchange Rate Risk Customers
Project Risk Influence over exchange rate Influence over sensitivity of project to exchange rate None Limited, but can change consumption in response to changes in the cost of tradable inputs Little None Limited, but can sometimes change inputs in response to changes in the cost of tradable inputs Great (through diversification) None Great (through choice of financial structure) Great (through diversification) Little Great Little
Shareholders
Government
Ability to cope with risk by hedging or diversification Financing-related Risk Influence over exchange rate Influence over sensitivity of value of investors interest in company to exchange rate Ability to cope with risk by hedging or diversification
None None
Great None Little
Little
The governments influence over the exchange rate is one factor that, other things equal, argues in favor of allocating project and financing-related exchange rate risk to the government. But this argument should not carry too much weight. Allocating the risk to the government is unlikely to improve the quality of its decisions affecting the exchange rateboth because the relationship between the exchange rate and the governments financial position is affected in complex ways by many factors unrelated to the project and because governments do not respond to financial incentives in the same way as firms and individuals do. If the government does not assume the exchange rate risk, the risk must be shared between customers and investors (shareholders). Neither can influence the exchange rate, so the choice turns on the other two factors. First, consider project exchange rate risk. Customers can sometimes influence the sensitivity of a projects value to the exchange rate by changing their consumption levels in response to changes in the cost of tradable inputs. When the cost of fuel
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rises as the exchange rate depreciates, customers may be able to mitigate the adverse effect on a power projects value by cutting their electricity consumption. In other cases, investors may be better placed to mitigate project exchange rate risk. For example, they may be able to change the mix of inputs (using more hydro and less thermal power) to soften the effect of depreciation. Shareholders are also better placed than customers to diversify away or hedge exchange rate riskbecause of their ability to diversify risk in equity markets and, in a few developing countries, to hedge risk using exchange rate derivatives. This suggests that project exchange rate risk should be shared between investors and customers according to their ability to respond in value-enhancing ways to changes in the exchange rateerring toward investors, given their greater ability to hedge or diversify away the risk. For many infrastructure projects, however, project exchange rate risk is small. Financing-related exchange rate risk tends to loom much larger. Should investors or customers bear this risk? Customers are in a poor position to manage the risk because they have no influence over the sensitivity of the value of shareholders interest in the project, to the exchange rate (they have no control over whether the investors decide to use financing that creates exchange rate risk). Moreover, most customers have no good natural hedges against the risk of currency fluctuationsand in most developing countries no realistic opportunities to acquire hedges or diversify away the risk. Indeed, because exchange rates tend to fall during macroeconomic crises, their ability to pay higher tariffs is likely to be lowest just when the exchange rate has fallen. Investors, however, choose financing and thus control the extent of financingrelated exchange rate risk; and their ultimate shareholders are well placed to diversify away much of the risk they choose to take on.
Implications for Prices and Financing

Although investors should generally face some project and all financing-related exchange rate risk, they still need to be able to recoup their costs and make a return that is reasonable, given the risks they take. Not protecting investors from exchange rate risk may well imply higher tariffs. Moreover, if tariffs are not linked to the exchange rate, they need to be linked to an index of local inflation, possibly adjusted to reflect the cost of inputs more closely. For example, an electricity utilitys
Exchange Rate Risk
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tariffs might be linked to an index, in which the price of fuel has greater weight than in the consumer price index. Over the long-term, the effect on prices will be similar whether tariffs are linked to local inflation or to the exchange rate (see the companion Note). But with a link to local inflation, currency crises will tend not to cause such immediate, politically perilous price increases. What are the implications for financing if neither the host country government nor customers, protect foreign investors from financing-related exchange rate risk? Unless the government provides explicit subsidies in place of the implicit subsidies where taxpayers or customers bear the exchange rate risk: Projects may be able to raise less financing, with shorter terms and higher initial rates. Traditional project finance deals, with dollar-denominated debt financing a large share of the project cost, may be less feasible, leading to greater use of local currency debt and local and foreign equity and therefore higher initial rates of return and higher project prices. In East Asian and other countries with high savings rates, the prospects for raising more local equity and debt for infrastructure seem promising. Elsewhere, progress will take longer. But governments can help by facilitating the development of local capital markets and contractual savings institutions, such as pension funds and insurance companiesby ensuring that tariff formulas do not implicitly discourage local currency financing. While foreign debt financing will be scarcer, innovative financing structures offer solutions. The Tiet project in Brazil illustrates one approach to mitigating investors exposure to financing-related exchange rate risk. To finance the generating facilities, AES (the US parent company of the operator, AES Tiet) issued US$300 million in US dollar bonds with an average maturity of ten years, at rates less than those paid by the Brazilian government for debt of an equivalent maturity. The project sells power at prices indexed to local inflation with no provision for changes in the exchange rate. If the exchange rate declines substantially and AES Tiet has insufficient cash to pay its debt service, however, it may draw on a US$30 million liquidity facility (revolving loan) provided by the US Overseas Private Investment Corporation. Once local inflation has caught up with the exchange rate reduction,
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AES Tiet will repay the advances from cash that would otherwise have gone to shareholders.
Conclusion
Despite the drawbacks of high levels of foreign currency debt, the argument for foreign capital remains. Developing countries need investment in infrastructure, and local debt and equity investors may well be unable to meet all the costs of the investment efficiently. The problem with many deals is the mix of foreign capital many projects have too much dollar-denominated debt, which drives the demand for allocating exchange rate risk to governments and consumers. While allocating the risk this way keeps the initial financing costs low, it risks a blowup in the longer term. Reducing reliance on foreign debt may mean that the volumes of private finance mobilized in the 1990s for greenfield projects and privatizations in developing countries will not be forthcomingand that the initial costs of finance will be higher. But the benefits may be longer-lived, and more robust investments that can weather the vagaries of emerging markets. (Philip Gray (pgray@worldbank.org) is a senior private sector development specialist, and Timothy Irwin (tirwin@worldbank.org) a senior economist, at the World Bank.)
Note
This Note is a companion to Philip Gray and Timothy Irwin, Exchange Rate Risk: Reviewing the Record for Private Infrastructure Contracts, Viewpoint 262 (World Bank, Private Sector and Infrastructure Network, Washington, DC, 2003). For different perspectives on the issue, see Ignacio Mas, Managing Exchange Rateand Interest RateRelated Project Exposure: Are Guarantees Worth the Risk? in Timothy Irwin, Michael Klein, Guillermo E Perry, and Mateen Thobani, eds., Dealing with Public Risk in Private Infrastructure, Latin American and Caribbean Studies Viewpoint (Washington, DC: World Bank, 1997); and Joe Wright, Tomoko Matsukawa, and Robert Sheppard, Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries, Energy and Mining and Water and Sanitation Sector Boards Discussion Paper (World Bank, Washington, DC, 2003).
Contingent Liabilities for Infrastructure...
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11
Contingent Liabilities for Infrastructure Projects: Implementing a Risk Management Framework for Governments
Christopher M Lewis and Ashoka Mody
To manage their exposure arising from guarantees to infrastructure projects, governments need to adopt modern risk management techniques. As guarantees come due only if particular events occur and involve no immediate cost to the government, they rarely appear in the government accounts or have funds budgeted to cover them. This Note introduces an integrated risk management system that draws on recent advances in the private sector. The system, adapted for use in the public sector, enables governments to budget for expected losses and to set aside reserves against unexpected losses, thus avoiding the budgetary stress associated with redirecting scarce public resources to cover a sudden increase in costs.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/148mody.pdf. World Bank publication. Reprinted with permission. This Note is based on a longer paper by the authors in Timothy Irwin, Michael Klein, Guillermo E Perry, and Mateen Thobani, eds., Dealing with Public Risk in Private Infrastructure (Latin American and Caribbean Studies, Washington, D.C.: World Bank, 1998).
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ver the past several years many large multinational firms, including Bankers Trust, Chase Manhattan, and Microsoft, have implemented enterprisewide systems for risk management. For each risk identified as important, these firms determine the best approach for improving their management of exposure, whether by insuring, transferring, mitigating, or retaining the risk. The goal is not just to hedge a fixed set of risk exposures, but to determine the areas and lines of business in which a company is willing to retain risks in order to generate target returns. Adapted to the public sector environmentand customized to reflect the governments budgetary and regulatory processes, the legislative and legal environments, and the risks being evaluatedthis approach can be used to manage a governments exposure to risk, particularly contingent liability risk. The model broadly involves six steps: Identifying the governments risk exposures. Measuring or quantifying expected and unexpected exposures. Provisioning for expected costs in the budgetary process. Assessing the governments tolerance for bearing risk. Using the governments risk tolerance as a basis for establishing policies and procedures for structuring reserves against unexpected losses. Implementing risk mitigation and control mechanisms to prevent unintended losses on those risks and establishing systems to continually monitor and reassess the governments risk exposure over time. As in the private sector, these steps should be applied to four general categories of riskfinancial, operational, business, and event risk.
Measuring Risk
A governments exposure to loss can arise from a wide variety of events, and attempting to account for every source of exposure is not feasible. A better approach, and that followed in the private sector model, is to first examine general categories of risk and then focus on the areas of highest risk (see Figure 1 for a lattice of generic risks). The next step is to value the expected and unexpected losses (see Box 1 for a definition of expected and unexpected losses). The valuation techniques used will depend on the
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type of risk being analyzed and the data available. Actuarial and econometric models can be used to estimate exposures, but both techniques require substantial data on the performance of a program (or on a comparable program). For project finance, where deals are unique and data records often missing or of low quality, more advanced modeling approaches are required. The most powerful are those commonly used to value options in financial markets; these can be applied to value direct loans, loan guarantees, and insurance contracts granted to support infrastructure liabilities.
Figure 1: Risk Identification Lattice

Government Risk Exposure
Financial Risk Market Risk Liquidity Risk Credit Risk
Business Risk Strategic Risk Management Risk
Opurational Risk Production Risk Legal Risk System Risk
Event Risk Political Risk Exogenous Risk
Budgeting for Expected Costs

Armed with a measure of risk exposure for expected costs, a government can use the information as a budgetary control mechanism and work out how to improve the budgetary process to provide stronger incentives for risk management. The government could publish its risk exposure in the national budget, use it to establish exposure limits or credit limits, or use it to develop risk-adjusted performance measures. (Such measures could be applied to reward programs that deliver social benefits with the least risk to the public budget.) The main impediment to implementing these options is the cash budget accounting system used by most governments. While private institutions compute virtually all investment decisions, expenditures, plans, and budget forecasts on a present value basis, most government bodies account for credit and insurance products using a simple cash-based system of budgeting. Cash-based budgeting misrepresents and masks the aggregate exposure associated with loan guarantees and
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government insurance programs, and creates perverse incentives for selecting one form of financing assistance over another. To see how these incentives skew decision-making, consider the different ways in which a government could help finance a US$100 loan to a private infrastructure provider. If the government provides a ten percent loan subsidy, the cash budget cost would be US$10 in year one. If it provides the loan directly, the cash budget cost in year one would be US$100 the full face value of the loan. And if it agrees to guarantee a loan by a private bank, the budgetary cost would be zero (or negative if a guarantee fee is collected) in the first year. Thus while the economic and financial values of the three forms of financial assistance are equal, a legislative body would favor the guarantee option. Only by enforcing budgetary controls at the time the financial assistance is committed, can the budgetary incentives be realigned to eliminate this effect. Many governments face significant legal, regulatory, and political hurdles in moving from current budgetary practices to a full accounting of the risks of contingent liabilities. Often governments prefer incremental changes or interim steps to smooth the transition. Implementing risk-adjusted performance measures allows governments to manage their exposures to contingent liabilities, even if an immediate change in national budgetary policy is not feasible. Nonbudgetary Box 1: Defining Expected and Unexpected Losses
Consider a government loan guarantee program characterized by the following very simple Probability distribution. While the expected costs of the program (the mean of the distribution) are US$10, losses will exceed this expectation 35 percent of the time. That means that if the government sets reserves only to cover expected losses, it will have to request outcomes of the guarantee. For a portfolio of thirty similar programs and with five-year guarantees, the central government would have to go to the legislature twice a year for additional funds. Probability (Percent) 5 5 15 15 25 15 5 5 5 2.5 2.5 Exposure (millions of US dollars) 0 2 5 8 10 12 14 16 18 20 30
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control mechanisms for contingent liabilities (publishing information, establishing credit quotas or exposure limits, and earmarking future funds to cover guarantee costs) also could be used during a transition to a new budgetary system. And they could be used on a permanent basis for liabilities grandfathered during a change in budgetary policy or as a permanent management solution if the government fails to enact a change in the budget law.
Reserving for Unexpected Costs

In addition to budgeting for the full expected present value of costs, governments need to set aside reserves against unexpected losses. For a private firm with multiple lines of business, determining the appropriate level of capital or reserves is a complex procedure that takes into account both the variability of losses for each product line and the correlation between product returns and the opportunity cost of capital. A private firm must also weigh the expectations of shareholders and stakeholders, rating agencies, and business partners in determining the optimal level of capital. The capital or reserves held by an enterprise reflect its relative risk aversion and its ability to withstand a specific level of unexpected losses. Thus, a firm seeking a AAA rating will hold considerably more capital against unexpected losses (say, capital to cover a 99 percentile event over a one-year period), than a firm seeking an A rating (capital to cover a 90 percentile event). Similar pressures come into play in assessing government tolerance for risk. But the assessment must also consider the unique question of how often the executive wants to go to the legislature for funds. Once the proper valuation tools are in place, the government can set reserve policy, based on an assessment of its aversion to making frequent funding requests. The governments leverage considerations will also be different from those in the private sector. Holding more funds in reserve increases the liquidity of the guarantees that the reserve supports, increasing their value and allowing the government to leverage more private funding in the guarantee program. But, reserving funds in a separate account reduces the money available for other public sector projects and services. If the net benefits of additional public spending exceed the liquidity benefits of adding to the guarantee reserve, the government may want to direct additional funds toward public spending.1
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Setting Reserves
Having assessed which risks and what level of loss it is willing to bear, the government can set its reserves against unexpected losses (risk capital) in its credit and insurance programs. But first, it needs to determine whether reserves will be set based on the additive unexpected loss exposure of each guarantee or on a portfolio value-at-risk approach to account for portfolio diversification, what the investment policy of the reserves will be, and where the reserves should reside. Under an additive reserve standard, the government calculates the unexpected loss exposure of each of its contingent liabilities independently (that is, examines the sensitivity of each guarantee valuation to changes in the underlying factors). Then, for a given confidence level and time interval, it determines the amount of unexpected loss it wishes to cover for each guarantee, taking into consideration the opportunity cost of capital. It then identifies the average cash reserve required to fund these unexpected losses. Finally, it aggregates the individual cash reserve balances to arrive at a total unexpected loss reserve. The problem with the additive approach is that it fails to account for portfolio diversification the fact that pooling imperfectly correlated risks will reduce the variance in the expected loss of a portfolio. As a result the risk of the overall portfolio will be overstated, and more protection against unexpected losses provided than originally sought by the government. The alternative is to calculate the aggregate loss distribution of the governments portfolio of risks, using a value-at-risk approach that incorporates cross-correlations between guarantee exposures, and then set reserves to cover unexpected losses based on the unexpected loss profile of the entire portfolio.
Investing Reserves
The objective in investing the reserve funds should be to maximize the value of the assets when the costs to the government increase that is, to invest the reserve funds in assets that provide the best hedge against the governments cost for a given return. In doing this, the government may achieve better results by managing its assets and liabilities at the balance sheet level rather than on a program basis. The government also needs to decide whether to hold its reserves offshore, in a foreign currency, or domestically, in the domestic currency. If the guarantees
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are denominated in dollars, the government should consider investing the reserve fund in dollar assets and possibly keep the reserve offshore to circumvent convertibility risk issues. This strategy would greatly enhance the market value of the guarantees and provide the government with greater leverage from the guarantee program. However, decisions on the location of the reserves must be made in the context of the governments broader foreign currency risk management program.
Next Step
This approach to risk management also provides a mechanism for governments to critically assess the distribution of risks within a loan guarantee or insurance program and come up with better designed contracts and fewer and smaller calls on guarantees. And as risks change over time, the framework provides a basis for easy reestimation and quick adjustments to the budgetary and reserve system. (Christopher M Lewis is Managing Director of Fitch Risk Advisory, a division of Fitch Risk. Ashoka Mody (amody@worldbank.org) is Project Finance and Guarantees Department, World Bank.)
Endnote
1 When a private company assesses the tradeoff between holding reserves and investing in other programs, it usually has a targeted economic return that helps guide its capital policy. For a government the comparable concept is social return. Calculating social return requires a complete asset-liability management program that goes beyond the valuation of infrastructure liabilities or other forms of direct loans, loan guarantees, and insurance. This Note focuses on reserving against contingent liabilities without considering a broader asset-liability management policy.
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The Syndicated Loan Market: Structure, Development and Implications
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Section IV
Financing Projects
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12
The Syndicated Loan Market: Structure, Development and Implications1
Blaise Gadanecz
This special feature has presented a historical review of the development of the market for syndicated loans, and has shown how this type of lending, which started essentially as a sovereign business in the 1970s, evolved over the 1990s to become one of the main sources of funding for corporate borrowers. The syndicated loan market has advantages for junior and senior lenders. It provides an opportunity to senior banks to earn fees from their expertise in risk origination and manage their balance sheet exposures. It allows junior lenders to acquire new exposures without incurring screening costs in countries or sectors where they may not have the required expertise or established presence. Primary loan syndications and the associated secondary market therefore allow a more efficient geographical and institutional sharing of risk origination and risk-taking.
The views expressed in this article are those of the author and do not necessarily reflect those of the BIS. I would like to thank Claudio Borio, Mr Gudmundsson, Eli Remolona and Kostas Tsatsaronis for their comments, Denis Ptre for help with database programming, and Angelika Donaubauer for excellent research assistance.
Source: http://www.bis.org/publ/qtrpdf/r_qt0412g.pdf. December 2004. BIS Quarterly Review. Reprinted with permission. The full publication is available free of cost on the BIS website.
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he syndicated loan market allows a more efficient geographical and institutional sharing of risk. Large US and European banks originate loans for emerging market borrowers and allocate them to local banks. Euro area banks have expanded pan-European lending and have found funding outside the euro area.
Syndicated loans are credits granted by a group of banks to a borrower. They are hybrid instruments combining features of relationship lending and publicly traded debt. They allow the sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face. Syndicated credits are a very significant source of international financing, with signings of international syndicated loan facilities accounting for no less than a third of all international financing, including bond, commercial paper and equity issues (Graph 1). This special feature presents a historical review of the development of this increasingly global market and describes its functioning, focusing on participants, pricing mechanisms, primary origination and secondary trading. It also gauges its degree of geographical integration. We find that large US and European banks tend to originate loans for emerging market borrowers and allocate them to local banks. Euro area banks seem to have expanded pan-European lending and have found funding outside the euro area.
Development of the Market

The evolution of syndicated lending can be divided into three phases. Credit syndications first developed in the 1970s as a sovereign business. On the eve of the sovereign default by Mexico in 1982, most of developing countries debt consisted of syndicated loans. The payment difficulties experienced by many emerging market borrowers in the 1980s resulted in the restructuring of Mexican debt into Brady bonds in 1989. That conversion process catalysed a shift in patterns for emerging market borrowers towards bond financing, resulting in a contraction in syndicated lending business. Since the early 1990s, however, the market for syndicated credits has experienced a revival and has progressively become the biggest corporate finance market in the United States. It was also the largest source of underwriting revenue for lenders in the late 1990s (Madan et al., 1999).
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The first phase of expansion began in the 1970s. Between 1971 and 1982, medium-term syndicated loans were widely used to channel foreign capital to the developing countries of Africa, Asia and especially Latin America. Syndication allowed smaller financial institutions to acquire emerging market exposure without having to establish a local presence. Syndicated lending to emerging market borrowers grew from small amounts in the early 1970s to $46 billion in 1982, steadily displacing bilateral lending. Graph 1: Syndicated lending since the 1980s
Total
1
Gross signings, in billions of US dollars

Syndicated credits Money market instruments Bonds and notes Equities
International
21 21 21 21
1,000
500
86
1
90
94
98
02
94
96
98
00
02
Of international and domestic syndicated credit facilities.
Sources: Dealogic Loanware; Euromoney; BIS.
Lending came to an abrupt halt in August 1982, after Mexico suspended interest payments on its sovereign debt, soon followed by other countries including Brazil, Argentina, Venezuela and the Philippines. Lending volumes reached their lowest point at $9 billion in 1985. In 1987, Citibank wrote down a large proportion of its emerging market loans and several large US banks followed suit. That move catalysed the negotiation of a plan, initiated by US Treasury Secretary Nicholas Brady, which resulted in creditors exchanging their emerging market syndicated loans for Brady bonds, eponymous debt securities whose interest payments and principal benefited from varying degrees of collateralisation on US Treasuries. The Brady plan provided a new impetus to the syndicated loan market. By the beginning of the 1990s, banks, which had suffered severe losses in the debt crisis,
21
21
2 1 2 2 1 2 1 1 2 2 2 1 21 1 21 1 2 1 2 2 1 1 221 121 211 121 2111 12122121 21 221 2 1 1 2 2 2 11 1 11 2 1 211 211 1 111 1112211 211211212221 1 22212 221 21 1 1 21 11 11 2 21 2 21 221 21 2 21 2 1 1 1 1 2 21 1 211 21 221 1 1 12211 12122111212211 2 22 1 111 1 121 1 1 122211212221 1 2 21 2 2 2 21 1 21 21 1 1 211 1 1 211 1 12221 21 21 2 1 2 1 2 1 2 1 2 2 21 1 211 1 1 221 1 1 12211 1 121 112121 2 22 2 11 2 1 2 2 21 221 2 1 21 1 211 21 221 1 2121 1 1 21 21 2 22 1 1 21 21 21 1 21 1 2 2 21 1 211 21 1 1 21 1 21 21 221 1 1 211 1 1 21 1 121 2 1 2 21 1 211 1 1 221 1 1 121 1 2 22 1 1 1 1 2 2 2 22 2 21 1 211 1 1 21 1 1 21 2 2 21 1 21 1 1 21 1 1 2 2 21 1 21 1 21 1 1 21 21 1 21 21 21 1 21 21 21 1 21 21 1 21 21 21 21
1,500
21 211
3,000
2,000
1,000
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started applying more sophisticated risk pricing to syndicated lending (relying in part on techniques initially developed in the corporate bond market). They also started to make wider use of covenants, triggers which linked pricing explicitly to corporate events such as changes in ratings and debt servicing. While banks became more sophisticated, more data became available on the performance of loans, contributing to the development of a secondary market which gradually attracted non-bank financial firms, such as pension funds and insurance firms. Eventually, guarantees and unfunded2 risk transfer techniques such as synthetic securitisation enabled banks to buy protection against credit risk while keeping the loans on the balance sheet. The advent of these new risk management techniques enabled a wider circle of financial institutions to lend on the market, including those whose credit limits and lending strategies would not have allowed them to participate beforehand. Partly, lenders saw syndicated loans as a loss-leader for selling more lucrative investment banking and other services. More importantly, in addition to borrowers from emerging markets, corporations in industrialised countries developed an appetite for syndicated loans. They saw them as a useful, flexible source of funds that could be arranged quickly and relied upon to complement other sources of external financing such as equities or bonds. As a result of these developments, syndicated lending has grown strongly from the beginning of the 1990s to date. Signings of new loansincluding domestic facilitiestotalled $1.6 trillion in 2003, more than three times the 1993 amount. Borrowers from emerging markets and industrialised countries alike have been tapping the market, with the former accounting for 16% of business and, for the latter, an equal split between the United States and western Europe (Graph 2). Syndicated lending in Japan reportedly makes up just a smallalbeit growing fraction of total domestic bank lending, not least because of the traditional importance of main banks for corporations. Syndicated credits have thus become a very significant source of financing. The international market3 accounts for about a third of all international financing, including bond, commercial paper and equity issues. The proportion of merger,
2
In an unfunded risk transfer, such as a credit default swap, the risk-taker does not provide upfront funding in the transaction but is faced with obligations depending on the evolution of the borrower's creditworthiness. An international syndicated loan is defined in the statistics compiled by the BIS as a facility for which there is at least one lender present in the syndicate whose nationality is different from that of the borrower.
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acquisition- and buyout-related loans represented 13% of the total volume in 2003, against 7% in 1993. Following a spate of privatisations in emerging markets, banks, utilities, and transportation and mining companies4 have started to displace sovereigns as the major borrowers from these regions (Robinson (1996)).5 Graph 2: Syndicated Lending by Nationality of Borrower
Gross signings, in billions of US dollars Industrial Countries
Other Euro area Japan United Kingdom United States
Emerging markets
Middle East & Africa Eastern Europe 200 Latin America Asia-Pacific 150
32132 321321 321321 321321 321321 321321 321321 321321 321 1 321321 321 321 321 321321 321321 321 321 321 321 321 321 321 321 1 321 32 21 21
500 0
93
95
97
99
01
03
93
95
97
Source: Dealogic Loanware.
A hybrid between relationship lending and disintermediated debt

In a syndicated loan, two or more banks agree jointly to make a loan to a borrower. Every syndicate member has a separate claim on the debtor, although there is a single loan agreement contract. The creditors can be divided into two groups. The first group consists of senior syndicate members and is led by one or several lenders, typically acting as mandated arrangers, arrangers, lead managers or agents.6 These senior banks are appointed by the borrower to bring together the syndicate of banks prepared to lend money at the terms specified by the loan. The syndicate is formed around the arrangersoften the borrowers relationship bankswho retain a portion of the loan and look for junior participants. The junior banks,
4
Syndicated loans are widely used to fund projects in these sectors, in industrial and emerging market countries alike. A feature article on page 91 of this BIS Quarterly Review explores the nature of credit risk in project finance. Interestingly, for most of the 1990s, emerging market borrowers were granted longer-maturity loans, five years on average, than industrialised country ones (three-four years). These bank roles, enumerated here in decreasing order of seniority, involve an active role in determining the syndicate composition, negotiating the pricing and administering the facility.
321321321 321321321 321321321 321321321 321321321 321321321 321321 321321 321321 321 321321 321 321
1,000
321321321 321321321 321321321 321321321 321321321 321321321 32132 321321 321321 321321 321321 321321 321321 1 321321321 321321321 321
321 321 321 321
1,500
32132 432 3213214321 3213214321 3213214321 3213214321 3213214321 321321 1 3213214321 321 1 3213214321 3213214321 321321 321 321 321
2132 21321 321 1 321 321
32 32 321321 321 321321 321 1 321 321321 3213213214321321321321 1 21 3 321321 321 4321 321 321321 3 21 3214321 32132143213213214321321321321 32 1 21 3 2 1 2 1 21 32 3214321 2 321 332 132 3213214321321 1 21 1 321 4321321 3321321 321 321 1 321
21 1 221 3
31 321 221 321 321 321 321 321 321 321 321
321
2,000
100 50 0
99
01
03
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typically bearing manager or participant titles, form the second group of creditors. Their number and identity may vary according to the size, complexity and pricing of the loan as well as the willingness of the borrower to increase the range of its banking relationships. Thus, syndicated credits lie somewhere between relationship loans and disintermediated debt (Dennis and Mullineaux, 2000). Box 1 below shows, in decreasing order of seniority, the banks that participated in a simple syndicate structure to grant a loan to Starwood Hotels & Resorts Worldwide, Inc in 2001. Senior banks may have several reasons for arranging a syndication. It can be a means of avoiding excessive single-name exposure, in compliance with regulatory limits on risk concentration, while maintaining a relationship with the borrower. Box 1: Example of a Simple Syndicate Structure Starwood
Starwood Hotels & Resorts Worldwide, Inc $250 million
Two-year term loan, signed 30 May, 2001 Loan purpose: General corporate Pricing: Margin: Libor + 125.00 bp; commitment fee: 17.50 bp Mandated arranger Deutsche Bank AG Bookrunner Deutsche Bank AG
mandated to originate, structure and syndicate the transaction issues invitations to participate in the syndication, disseminates information to banks and informs the borrower about the progress of the syndication banks providing funds
Participants Deutsche Bank AG Bank One NA Citibank NA Crdit Lyonnais SA UBS AG Administrative agent Deutsche Bank AG
title given to the arranger of a syndicated transaction in the US market
Source: Dealogic.
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Or it can be a means to earn fees, which helps diversify their income. In essence, arranging a syndicated loan allows them to meet borrowers demand for loan commitments without having to bear the market and credit risk alone. For junior banks, participating in a syndicated loan may be advantageous for several reasons. These banks may be motivated by a lack of origination capability in certain types of transactions, geographical areas or industrial sectors, or indeed a desire to cut down on origination costs. While junior participating banks typically earn just a margin and no fees, they may also hope that in return for their involvement, the client will reward them later with more profitable business, such as treasury, management, corporate finance or advisory work (Allen (1990))7
Pricing Structure: Spreads and Fees

As well as earning a spread over a floating rate benchmark (typically Libor) on the portion of the loan tha is drawn, banks in the syndicate receive various fees (Assen (1990), Table 1). The arranger8 and other members of the lead management team generally earn some form of upfront fee in exchange for putting the deal together. This is often called a praecipium or arrangement fee. The underwriters similarly earn an underwriting fee for guaranteeing the availability of funds. Other participants (those at least on the manager and co-manager level) may expect to receive a participation fee for agreeing to join the facility, with the actual size of the fee generally varying with the size of the commitment. The most junior syndicate members typically only earn the spread over the reference yield. Once the credit is established and as long as it is not drawn, the syndicate members often receive an annual commitment or facility fee proportional to their commitment (largely to compensate for the cost of regulatory capital that needs to be set aside against the commitment). As soon as the facility is drawn, the borrower may have to pay a per annum utilisation fee on the drawn portion. The agent bank typically earns an agency fee, usually payable annually, to cover the costs of administering the loan. Loans sometimes incorporate a penalty clause, whereby the borrower agrees to pay a prepayment fee or otherwise compensate the lenders in the event that it reimburses
7
In practice, though, these rewards fail to materialise in a systematic manner. Indeed, anecdotal evidence for the United States suggests that, for this reason, smaller players have withdrawn from the market lately and have stopped extending syndicated loans as a lossleader. For this discussion, it has to be recalled that the same bank can act in various capacities in a syndicate. For instance, the arranger bank can also act as an underwriter and/or allocate a small portion of the loan to itself and therefore also be a junior participant.
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Table 1: Structure of Fees in a Syndicated Loan

Fee Arrangement fee Legal fee Underwriting fee Participation fee Facility fee Commitment fee Type Front-end Front-end Front-end Front-end Per annum Per annum, charged on undrawn part Per annum, charged on drawn part Per annum Front-end One-off if prepayment Remarks Also called praecipium. Received and retained by the lead arrangers in return for putting the deal together. Remuneration of the legal adviser. Price of the commitment to obtain financing during the first level of syndication. Received by the senior participants. Payable to banks in return for providing the facility, whether it is used or not. Paid as long as the facility is not used, to compensate the lender for tying up the capital corresponding to the commitment. Boosts the lenders yield; enables the borrower to announce a lower spread to the market than what is actually being paid, as the utilization fee does not always need to be publicized. Remuneration of the agent banks services Remuneration of the conduit bank1 Penalty for prepayment
Utilisation fee
Agency fee Conduit fee Prepayment fee

1
The institution through which payments are channelled with a view to avoiding payment of withholding tax. One important consideration for borrowers consenting to their loans being traded on the secondary market is avoiding withholding tax in the country where the acquirer of the loan is domiciled.
Source: Compiled by author.
any drawn amounts prior to the specified term. Box 1 above provides an example of a simple fee structure under which Starwood Hotels & Resorts Worldwide, Inc has had to pay a commitment fee in addition to the margin. At an aggregate level, the relative size of spreads and fees differs systematically in conjunction with a number of factors. Fees are more significant for Euribor-based than for Libor-based loans. Moreover, for industrialised market borrowers, the share of fees in the total loan cost is higher than for emerging market ones. Arguably this could be related to the sectoral composition of borrowers in these segments.
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Non-sovereign entities, more prevalent in industrialised countries, may have a keener interest, for tax or market disclosure reasons, in incurring a larger part of the total loan cost in the form of fees rather than spreads. However, the total cost (spreads, front end and annual fees)9 of loans granted to emerging market borrowers is higher than that of facilities extended to industrialised countries (Graphs 3 and 4). There is also more variance in commitment fees on emerging market facilities. In sum, lenders seem to demand additional compensation for the higher and more variable credit risk in emerging markets, in the form of both spreads and fees. Spreads and fees are not the only compensation that lenders can demand in return for assuming risk. Guarantees, collateral and loan covenants offer the possibility of explicitly linking pricing to corporate events (rating changes, debt servicing). Collateralisation and guarantees are more often used for emerging market borrowers (Table 2), while covenants are much more widely used for borrowers in industrialised countries (possibly because such terms are easier to enforce there). Graph 3: Spreads and Fees1
(In basis points)
Quarterly averages weighted by facility amounts. Front-end fees have been annualised over the lifetime of each facility and added to annual fees.

9
One should note that the fees shown in Graphs 3 and 4 are not directly comparable. In Graph 3, for the purposes of comparability with spreads, annual and front-end fees are added together by annualising the latter over the whole maturity of the facility, assuming full and immediate drawdown. Graph 4, on the other hand, shows annual and frontend fees separately without annualising the latter.
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Graph 4: Breakdown of Fees1
(In basis points)
Quarterly averages weighted by facility amounts. borrowers only.
Not annualised.
Industrialised country
Primary and Secondary Markets: Sharing Versus Transferring Risk

While commercial banks dominate the primary market, both at the senior arranger and at the junior funds provider levels, other institutions have made inroads over time. Globally, there are virtually no non-commercial banks or non-banks among the top 200 institutions that have around 90% market share. However, investment banks have benefited from the revival of syndicated lending in the 1990s. They have taken advantage of their expertise as bond underwriters and of the increasing integration of bank lending and disintermediated debt markets10 to arrange loan syndications. Besides the greater involvement of investment banks, there is also growing participation by multilateral agencies such as the International Finance Corporation or the Inter- American Development Bank.11 Syndicated credits are increasingly traded on secondary markets. The standardisation of documentation for loan trading, initiated by professional bodies such as the Loan Market Association (in Europe) and the Asia Pacific Loan Market
10
For instance, it is very common nowadays for a medium-term loan provided by a syndicate to be refinanced by a bond at, or before, the loans stated maturity. Similarly, US commercial paper programmes are frequently backed by a syndicated letter of credit. This provides an opportunity for risk-sharing between public and private sector investors. It usually takes the form of syndicated loans granted by multilateral agencies with tranches reserved for private sector bank lenders.
11
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Share of syndicated loans with covenants, collateral and guarantees, in percent, by nationality of borrower
Table 2: Non-price Components in the Remuneration of Risk

Covenants Emerging Industrialised 16 24 19 Collateral Emerging 40 49 37 Industrialised 15 16 13 31 22 21
Guarantees Emerging Industrialised 7 4 4
199396 19972000 200104 1

1
0 2 3
First quarter only for 2004.
Association, has contributed to improved liquidity on these markets. A measure of the tradability of loans on the secondary market is the prevalence of transferability clauses, which allow the transfer of the claim to another creditor.12 The US market has generated the highest share of transferable loans (25% of total loans between 1993 and 2003), followed by the European marketplace (10%). The secondary market is commonly perceived to consist of three segments: par/near par, leveraged (or high-yield) and distressed. Most of the liquidity can be found in the distressed segment. Loans to large corporate borrowers also tend to be actively traded. Participants in the secondary market can be divided into three categories: market-makers, active traders and occasional sellers/investors. The marketmakers (or two-way traders) are typically larger commercial and investment banks, committing capital to create liquidity and taking outright positions. Institutions actively engaged in primary loan origination have an advantage in trading on the secondary market, not least because of their acquired skill in accessing and understanding loan documentation. Active traders are mainly investment and commercial banks, specialist distressed debt traders and socalled vulture funds (institutional investors actively focused on distressed debt). Non-financial corporations and other institutional investors such as insurance companies also trade, but to a lesser extent. As a growing number of financial institutions establish loan portfolio management departments, there appears to be increasing attention paid to relative value trades. Discrepancies in yield/return between loans and other instruments such as credit derivatives, equities and bonds are arbitraged away (Coffey (2000), Pennacchi (2003)). Lastly, occasional participants are present on the market either as sellers of loans to manage capacity on their balance sheet or as investors which take and hold positions. Sellers of risk can remove loans from
12
Transferability is determined by consent of the borrower as stated in the original loan agreement. Some borrowers do not allow loans to be traded on the secondary market as they want to preserve their banking relationships.
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their balance sheets in order to meet regulatory constraints, hedge risk, or manage their exposure and liquidity.13 US banks, whose outstanding syndicated loan commitments are regularly monitored by the Federal Reserve Board, appear to have been relatively successful in transferring some of their syndicated credits, including up to one quarter of their problem loans, to non-bank investors (Table.3). Buyers of loans on the secondary market can acquire exposure to sectors or countries, especially when they do not have the critical size to do so on the primary market. 14 Table 3: US syndicated credits1
Share of total credits 2 US Foreign Nonbanks banking banks 2000 2001 2002 2003
1 2
Total credits ($ bn) 1,951 2,050 1,871 1,644
US banks 2.8 5.1 6.4 5.8
Percentage classified 3 Foreign NonTotal banking banks credits 2.6 4.7 7.3 9.0 10.2 14.6 23.0 24.4 3.2 5.7 8.4 9.3
48 46 45 45
45 46 45 44
7 8 10 11
Includes both outstanding loans and undrawn commitments. Dollar volume of credits held by each group of institutions as a percentage of the total dollar volume of credits. Dollar volume of credits classified substandard, doubtful or loss by examiners as a percentage of the total dollar volume of credits.
Source: Board of Governors of the Federal Reserve System.
While growing, secondary trading volumes remain relatively modest compared to the total volume of syndicated credits arranged on the primary market. The biggest secondary market for loan trading is the United States, where the volume of such trading amounted to $145 billion in 2003. This is equivalent to 19% of new originations on the primary market that year and to 9% of outstanding syndicated loan commitments. In Europe, trading amounted to $46 billion in 2003 (or 11% of primary market volume), soaring by more than 50% compared to the previous year (Graph 5). Distressed loans continued to represent a sizeable fraction of total secondary trading in the United States, and gained in importance in Europe. Admittedly, this to some extent reflects higher levels of corporate distress in Europe. But as the investment
13
The seller banks often enhance their fee income by arranging new loans to roll over facilities they had previously granted to borrowers. They may sell old facilities on the secondary market to manage capacity on their balance sheet, which is required to hold some of the new loans. For example, minimum participation amounts on the primary market may exceed the bank's credit limits.
14
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Graph 5: US and European Secondary Markets for Syndicated Credits

United States, by loan quality
1 2
Europe, by loan quality
Europe, by counterparty
1,3
In billions of US dollars. 2 As a percentage of total loan trading. For Europe, distressed and leveraged. 3 From non-LMA members.
Sources: Loan Market Association (LMA); Loan Pricing Corporation.
grade segment matures, it is also indicative of sustained investor appetite and of the markets improved ability to absorb a larger share of below par loans (BIS (2004)). In the Asia-Pacific region, secondary volumes are still a tiny fraction of those in the United States and Europe, with only six or seven banks running dedicated desks in Hong Kong SAR, and no non-bank participants. In 1998, the Asian secondary market was exceptionally active. That year, large blocks of loan portfolios changed hands as Japanese banks restructured their distressed loan portfolios.15 Trading was more subdued in subsequent years,16 although banks interest appears to have recently been rekindled by the secondary prices of loans, which have decreased less than those of collateralised debt obligations and bonds. 17
Geographical integration of the market

As financial markets are becoming more integrated geographically, a question is how this process manifests itself in syndicated lending in the form of crossborder
15
Banks tend to trade blocks of loans when they restructure whole portfolios. In normal times, loan by loan trading is more common. Nonetheless, Japanese banks have recently been very active in transferring loans on the Japanese secondary market. According to a quarterly survey conducted by the Bank of Japan, for the financial year April 2003-March 2004, such transfers totalled 11 trillion, 38% of which were non-performing loans. This was followed in the second quarter of 2004 by unusually weak secondary market activity by historical standards. According to practitioners, major international banks with an Asian presence are among the main sellers of loans, while demand comes from Taiwanese and Chinese banks.
16
17
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deals. To answer this question, we examine the nationality composition of syndicates on the primary market, where information is readily available about institutional investors. We first perform this exercise at a global level and then within the euro area, in order to assess any impact from the introduction of the single currency. Table 4 shows the degree of international integration of syndicated loan markets, measured by the share of loans arranged or provided by banks of the same country or region as the borrower. At the senior arranger level, the nationality composition is calculated based on the number of deals, and at a junior participant level based on the dollar amounts provided by individual financial institutions. A number of findings stand out. First, unsurprisingly, there appears to be relatively little penetration by foreign lenders in the market for loans to Japanese, euro area and US borrowers. The senior arranger and junior funds provider banks in loan facilities set up for these borrowers are often from the borrowers own country, with the share of deals arranged or of funds provided by foreign institutions rarely exceeding 30%. 18 Second, foreign banks appear more present (with shares often in excess of 60%) in syndicates set up for European borrowers from outside the euro area and, in particular, the United Kingdom. It is interesting to note that Japanese borrowers tend to pay higher fees on average than UK borrowers, whose market is characterised by more foreign bank penetration. This may suggest that the market is more contestable in the United Kingdom. Third, with the possible exception of Asia, syndicates put together for emerging market borrowers tend to be dominated by foreign lenders. Interestingly, for all emerging market borrowers, but especially in the Middle East and Africa and Asia-Pacific regions, domestic banks (ie from the same geographical area as the borrower) are more present as junior funds providers than as senior arrangers. It would appear typical for a major international bank to arrange the syndication and then allocate the credit to regional lenders.19 Given that the presence of a reputable major foreign arranger has a certification effect for banks which are
18
For US borrowers, the statement about low foreign penetration should be balanced by the relatively high share approximately 45% since 2000of total syndicated credits held by foreign banking organisations, after allowing for transfers on the secondary market (Table 3). For more background and an extension of the analysis to bond markets, see McCauley et al (2002).
19
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Table 4: International Integration of the Market

By Borrower Nationality % of deals1 where the arranger % of funds1 provided by banks is of the same nationality2 as of the same nationality2 as the the borrower (based on borrower (based on USD number of deals) amounts) 199398 Main countries and regions United States Euro area4 United Kingdom Other western Europe Japan Other industrialised economies Asia-Pacific Eastern Europe Latin America/Caribbean Middle East & Africa Offshore Euro area countries Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Euro area5
1 3
19992004 3 70 72 43 26 84 65 37 12 7 20 36 42 22 13 50 46 29 18 53 8 29 27 51 42
199398 61 71 35 36 63 61 34 10 6 22 44 33 31 16 45 57 8 16 39 30 28 30 64 43
19992004 3 62 67 42 25 87 57 51 13 8 28 31 42 16 9 46 44 24 14 48 7 25 23 49 38
74 59 58 37 62 67 29 9 5 15 54 5 17 26 48 43 7 20 34 10 24 31 64 39
Calculated also including purely domestic deals. 2 From the same region, where regions are shown. For 2004, first quarter only. 4 Borrower from any euro area country, arranger/provider from any euro area country. 5 Borrower from same euro area country as arranger/provider, euro area average. Sources: Dealogic Loanware; authors calculations.
ranked lower in the syndicate, this makes cross-border investment in a junior funds provider capacity easier than the provision of screening and monitoring services as a senior arranger. Finally, the advent of the euro appears to have led to some integration in the pan-European syndicated loan market, especially at the arranger level. The first two columns of Table 4 show that within the euro area, the percentage of loans arranged by banks from the same country as the borrower is about the same
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before and after 1999 (39% versus 42%).20 Meanwhile, the overall share of euro area arrangers rose from 59% to 72%, suggesting that euro area banks have been arranging a higher share of loans for borrowers from euro area countries other than their own. 21 At the same time, the additional credits arranged at a pan-European level seem to have been funded largely by banks from outside the euro area, since the share of euro area banks among junior funds providers has remained relatively stable (last two columns of Table 4). This could reflect a greater balance sheet capacity outside the euro area.
Conclusion
This special feature has presented a historical review of the development of the market for syndicated loans, and has shown how this type of lending, which started essentially as a sovereign business in the 1970s, evolved over the 1990s to become one of the main sources of funding for corporate borrowers. The syndicated loan market has advantages for junior and senior lenders. It provides an opportunity to senior banks to earn fees from their expertise in risk origination and manage their balance sheet exposures. It allows junior lenders to acquire new exposures without incurring screening costs in countries or sectors where they may not have the required expertise or established presence. Primary loan syndications and the associated secondary market therefore allow a more efficient geographical and institutional sharing of risk origination and risk-taking. For instance, loan syndications for emerging market borrowers tend to be originated by large US and European banks, which subsequently allocate the risk to local banks. Euro area banks have strengthened their pan-European loan origination activities since the advent of the single currency and have found funding for the resulting risk outside the euro area. However, we find that the geographical integration of the market appears to vary among regions, as reflected in varying degrees of international penetration.
20
While the euro is widely used as a currency of denomination for European (including eastern European) borrowers, the US dollar is still the currency of choice for syndicated lending worldwide (US dollar facilities represented 62% of total syndicated lending in 2003, while the euro accounted for 21%, and the pound sterling and the Japanese yen for 6% each). In a study of the bond underwriting market, Santos and Tsatsaronis (2003) show that the elimination of market segmentation associated with the single European currency failed to result in an intensification of the business links between borrowers and bond underwriters from the euro area. It must be stressed, though, that bond underwriting and syndicated loan markets are quite different, as bonds are sold to institutional investors and loans mainly to other banks.
21
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While these differences could also be related to disparities in the sizes of national markets, further research is needed to improve our understanding of market contestability by assessing whether they are systematically related to differences in loan pricing, especially fees. (Dr.Blaise Gadanecz, Monetary and Economic Department, BIS. The author can be reached at blaise.gadanecz@bis.org).
References
1. 2. 3. 4. 5. 6. 7. 8. 9. Allen T (1990): Developments in the International Syndicated Loan Market in the 1980s, Quarterly Bulletin, Bank of England, February. Bank for International Settlements (2004): 74th Annual Report, Chapter 7, pp 133-4. Coffey M (2000): The US Leveraged Loan Market: From Relationship to Return, in T Rhodes (ed), Syndicated Lending, Practice and Documentation, Euromoney Books. Dennis S and D Mullineaux (2000): Syndicated Loans, Journal of Financial Intermediation, vol 9, October, pp 404-26. Madan R, R Sobhani and K Horowitz (1999): The Biggest Secret of Wall Street, Paine Webber Equity Research. McCauley R N, S Fung and B Gadanecz (2002): Integrating the Finances of East Asia, BIS Quarterly Review, December. Pennacchi G (2003): Who Needs a Bank, Anyway?, Wall Street Journal, 17 December. Robinson M (1996): Syndicated Lending: A Stabilizing Element in the Latin Markets, Corporate Finance Guide to Latin American Treasury & Finance. Santos A C and K Tsatsaronis (2003): The Cost of Barriers to Entry: Evidence from the Market for Corporate Euro Bond Underwriting, BIS Working Papers, no 134.
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13
Equator Principles Why Indian Banks Too Should be Guided by Them
Pratap Ravindran
What, exactly, does the adoption of the Equator Principles involve? The banks, to begin with, agree upon a common terminology in categorising projects into high, medium and low environmental and social risk, based on the IFCs categorisation process. They apply this to projects globally and to all industry sectors so as to ensure consistent approaches in their dealings with high and medium-risk projects. Second, the banks ask their customers to demonstrate in their environmental and social reviews, and in their environmental and social management plans, the extent to which they have met the applicable World Bank and IFC sector-specific pollution abatement guidelines and IFC safeguard policies, or to justify exceptions to them. Recent reports on the decision by ten leading banks from seven countries to adopt the Equator Principles make for encouraging reading. However, it must be said that the conspicuous absence of Indian banks from the list is distinctly depressing.
Source: http://www.equator-principles.com/hindu1.shtml. July 2003. The Hindu. Reprinted with permission.
Equator Principles Why Indian Banks...
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he Equator Principlesa voluntary set of guidelines developed for managing social and environmental issues, related to the financing development projectsapply only to projects which cost $50 million or more, as those costing less represent only three percent of the market. Recent reports on the decision by ten leading banks from seven countries to adopt the so-called Equator Principles make for encouraging reading. However, it must be said that the conspicuous absence of Indian banks from the list is distinctly depressing. While Indian financial institutions (including banks) can hardly be described as major players in the funding of infrastructure projects at a global level, the fact remains that their adoption of the Equator Principles or other similar ones to guide their lending within the country, would have given a major fillip to Indias environmental initiative, such as it is. They may argue that they see no need to adopt such principles as their lending to infrastructure projects is restricted, to those that have secured the environmental clearances mandated by statute. As these clearances can be purchased for a pittance, this argument is not particularly convincing. Unfortunately, the truth is that Indian financial institutions are concerned to the exclusion of all other considerationsabout the ecology of their balancesheets and, therefore, focused on ever-greening their assets. Banks adopting the Equator Principles undertake to provide loans only to projects, whose sponsors can demonstrate their ability and willingness to comply with comprehensive processes, aimed at ensuring that projects are developed in a socially responsible manner and according to sound environmental management practices. The banks which have taken the initiativeABN AMRO Bank, N V, Barclays PLC, Citigroup, Inc., Credit Lyonnais, Credit Suisse Group, HVB Group, Rabobank, Royal Bank of Scotland, WestLB AG, and Westpac Banking Corporationwill, henceforth, apply the principles globally and to project financings in all industry sectors, including mining, oil and gas and forestry. Their adoption of the Equator Principles is significant in that these banks, between them, underwrote approximately $14.5 billion of project loans in 2002, representing a whopping 30 percent of the project loan syndication market globally.
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According to a prepared statement of the International Finance Corporation (IFC) Executive Vice-President, Mr Peter Woicke, presented at the Equator Principles press conference in Washington DC on June 4, the adopting banks have done something that financial institutions rarely doStep forward to take a leadership role on global environmental and social issues. The adoption of the Equator Principles confirms that the role of global financial institutions is changing. More than ever, people at the local level know that the environmental and social aspects of an investment can have profound consequences on their lives and communities, particularly in the emerging markets where regulatory regimes are often weak. And if financial institutions want to operate in these markets, there is a bottom line value in having clear, understandable, and responsible standards for investing. It is possible that Indian financial institutions are under no pressure to factor environmental considerations into their lending activities, because most people are not aware of the Equator Principles. They were evolved when the IFC convened a meeting of banks, in London in October, 2002 to discuss environmental and social issues in project finance. At that meeting, the banks present decided to try and develop a banking industry framework for addressing environmental and social risks in project financing. This exercise culminated in the drafting of the Equator Principles which, in essence, represented an industry approach for financial institutions in determining, assessing and managing environmental and social risks in project financing. The preamble to the principles, states that project financing plays an important role in financing development throughout the world. In providing financing, particularly in emerging markets, project financiers often encounter environmental and social policy issues. We recognise that our role as financiers affords us significant opportunities to promote responsible environmental stewardship and socially responsible development. The preamble goes on to add, In adopting these principles, we seek to ensure that the projects we finance, are developed in a manner that is socially responsible and reflect sound environmental management practices. We believe that adoption
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of, and adherence to, these principles offers significant benefits to ourselves, our customers and other stakeholders. These principles will foster our ability to document and manage our risk exposures to environmental and social matters associated with the projects we finance, thereby allowing us to engage proactively with our stakeholders on environmental and social policy issues. Adherence to these principles will allow us to work with our customers in their management of environmental and social policy issues relating to their investments in the emerging markets. What, exactly, does the adoption of the Equator Principles involve? To begin with, it is important to understand that the term adopt does not mean that the banks sign an agreement of some kind. They do not. Instead, each bank that adopts the principles individually declares that it has or will put in place, internal policies and processes that are consistent with the Equator Principles. The banks, to begin with, agree upon a common terminology in categorising projects into high, medium and low environmental and social risk, based on the IFCs categorization process. They apply this to projects globally and to all industry sectors, so as to ensure consistent approaches in their dealings with high and medium-risk projects. Second, the banks ask their customers to demonstrate in their environmental and social reviews, and in their environmental and social management plans, the extent to which they have met the applicable World Bank and IFC sector-specific pollution abatement guidelines and IFC safeguard policies, or to justify exceptions to them. This practice allows them to secure information of the quality required for them to make judgments. And then again, the banks insert into the loan documentation for high- and medium-risk projects covenants for borrowers to comply with their environmental and social management plans. If those plans are not followed and deficiencies not corrected, the banks reserve the right to declare the project loan in default. What are the IFC safeguard policies and how do they differ from the World Bank safeguard policies? Basically, the IFCs set of environmental and social policies are based on the set used by the World Bank. However, some policies have been adapted to better reflect their applicability to the IFCs private sector client base
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while others have been retained in the World Bank format and, as such require, careful interpretation for private sector projects. The safeguard policies provide guidance on matters relevant to the IFCs operations, including environmental assessment, natural habitats, involuntary resettlement and indigenous peoples. The environmental assessment policy is a key umbrella policy for the IFC, and various requirementsenvironmental and socialflow from it. In addition, to reflect the fact that the IFC works with employers, it has adopted the Policy Statement on Harmful Child and Forced Labour. The Banks safeguard policies are geared to its public sector activities. And what is the relationship between the IFC safeguard policies and the World Bank and IFC guidelines? The safeguard policies generally represent an approach to critical issues that cut across industry sectors, such as the protection of natural habitats or the physical or economic displacement of people (resettlement), where it is important to apply a consistent set of environmental and social principles. The guidelines, on the other hand, are sector-specific environmental standards that are applicable to the processes, technology, and issues that apply in specific industries, and represent good practice within that sector. As such, the policies and guidelines are mutually supportive of each another. The Equator Principles apply to only projects which cost $50 million or more. The question now arises: How many projects fall below $50 million and what about them? According to the IFC, a cut off point and some level of materiality are necessary. Most of the sensitive project developments involve much larger sums. While the league tables for project loans do not necessarily record all small project loans, they indicate that projects costing less than $50 million represent only three percent of the market. Its proponents point out that a risk management rationale exists for banks to adopt the Equator Principles in that they will be able to better assess, mitigate, document and monitor the credit risk and reputation risk associated with financing development projects. In any case, they say, the principles will not hurt banks business as they have been championed by the project finance business heads of
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banks. They believe that having a framework for the industry will lead to greater learning among project finance banks on environmental and social issues, and that having greater expertise in these areas will better enable them to advise clients and control risks. Quite simply, they observe, the principles are good for business.
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14
Synthetic Leasing
While originally structured for real estate transactions, the synthetic lease can be readily applied to various types of energy-based assets, including electric turbines and other generating assets or natural gas and liquids pipelines. The synthetic lease has emerged as a popular financing structure since it provides off balance sheet treatment for book purposes, while allowing a company to retain the tax benefits associated with asset ownership. When rating companies that use synthetic leases, Fitch Ratings will effectively add the financing back to the balance sheet and income statement by adjusting leverage and other key credit ratios. In addition, Fitch may also assign a rating to the lease debt, based on the credit rating of the lessee and/or the value of the underlying asset(s).
Overview
The synthetic lease has emerged as a popular financing structure since it provides off balance sheet treatment for book purposes, while allowing a company to retain the tax benefits associated with asset ownership. This structure is frequently used by energy firms to finance the acquisition of new assets or to refinance existing assets. It provides an interim take-out to construction financing (usually five to
Source: http://www.fitchratings.com.au/projresearchlist.asp March 7, 2002. 2004 Fitch Ratings, Ltd. Reprinted by permission of Fitch Inc.
Synthetic Leasing
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seven years), and, like any interim financing, exposes the company to refinancing risk at the end of the lease term. When rating companies that use synthetic leases, Fitch Ratings will effectively add the financing back to the balance sheet and income statement by adjusting leverage and other key credit ratios. In addition, Fitch may also assign a rating to the lease debt, based on the credit rating of the lessee and/or the value of the underlying asset(s).
The Characteristics of Synthetic Leasing

While originally structured for real estate transactions, the synthetic lease can be readily applied to various types of energy-based assets, including electric turbines and other generating assets or natural gas and liquids pipelines. The synthetic lease moves the asset off the balance sheet, while maintaining ownership for tax purposes through the following steps: The energy company (the lessee) isolates the asset by having a special purpose entity (SPE) buy the asset or enter into the appropriate equipment and construction contracts on a build-tosuit basis, with the lessee acting as construction agent. To finance the asset purchase, the SPE raises debt and equity. The debt is generally tranched and issued in the bank and debt capital markets. The equity is a requirement to ensure the independence of the SPE and is privately placed. At the time of completion, the lessee can either purchase the asset from the SPE or lease the asset from the SPE. Under the typical structure, a synthetic lease is treated as an operating lease under Generally Accepted Accounting Principles (GAAP), and a financing for tax purposes. The legal ownership of the asset resides with the lessee, so the lessee retains all rights and obligations of ownership, including legal liability, market risk, and ownership in bankruptcy. In addition, the lessee will assume all maintenance and insurance requirements associated with ownership as in a triple-net lease. To qualify as an operating lease for GAAP purposes, the lease must be structured to meet the following requirements for operating leases detailed in the Statement of Financial Accounting Standards Number 13 (SFAS 13):
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The Synthetic Lease Basic Scheme

Tax Ownership Lessee Synthetic Lease Accounting Ownership 85% 12% 3% Investment Certificates SPE Special purpose entity. Residual Value Guaranty A Senior Notes
Plant
SPE
B Subordinated Notes
No automatic transfer of the asset to the lessee at the end of the lease term. No bargain purchase option at the end of the lease term. The lease term cannot be 75%, or more, of the economic useful life of the leased property. The present value of the minimum lease payments cannot be 90%, or more, of the fair market value of the property at the inception of the lease term. It is important to note that a synthetic lease does not result in any transfer of operating risk from the energy company to the SPE or the noteholders. In cases where the underlying asset is a generating plant, the lessee continues to bear all fuel supply risk, market off-take risk, and operating risk of the plant. Consequently, when assessing the impact of a synthetic lease on the rating of the lessee, Fitch will incorporate the energy companys risk management and hedging strategy on a qualitative basis. When assigning a rating to the lease debt, Fitch will look to the underlying credit quality of the lessee and its ability to satisfy the obligations under the lease. Treatment in Bankruptcy: While actual case law regarding synthetic leases in the area of bankruptcy is limited, the parties to the transaction generally represent and intend that the debt of the SPE would be treated as a secured financing of the lessee in the case of the lessees Chapter 11 filing. However, investors should be aware of the possibility that the bankruptcy court may take the opposite view
Synthetic Leasing
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and treat the structure as a lease. In this case, the lessee would have the option of affirming or rejecting the lease as part of its reorganization plan. If the lessee concludes that the underlying asset(s) is integral to its ongoing operations and decides to affirm the lease, it must continue to perform under the lease through the timely payment of scheduled interest and principal. If the lease is rejected, the lessee would effectively concede control of the asset, returning it to the lessor. In addition, the lessee would become subject to liabilities for breaching the lease, which would be an unsecured claim in a bankruptcy situation.
Financing Structure
Special Purpose Entity (SPE): The SPE can be a trust, a limited liability company, or any other passthrough entity that is separate and distinct from the operations of the lessee. It will have a very limited purpose, usually to construct, purchase, and/or own the asset, to raise funds to finance the purchase or refinancing, and to lease the asset back to the lessee. The SPE must be capitalized with a minimal amount of equity to classify as a separate subsidiary of the lessee. The minimum equity required under GAAP is currently 3% of the total project cost. Equity may be invested by independent, third parties or by parties related to the debt holders; however, affiliates of the lessee cannot supply the equity to the SPE. Equity holders will generally have a first loss position in the waterfall and are fully exposed to the residual value of the underlying asset. Equity raised by the SPE will be part of the overall financing of the asset. The remainder will be raised through the issuance of senior and subordinate notes. Debt Portion: The vast majority of the financing for the asset purchase is achieved through a combination of senior and subordinated notes issued by the SPE. In most instances, the debt portion represents up to 97% of project cost and is typically comprised of two tranchesthe senior note A tranche, equal to 85% of project cost; and the junior note B tranche, equal to 12%. The A notes will have a first claim on cash flows and on the residual value of the asset. The subordinated B notes will have second claim on cash flows followed by equity holders. Synthetic leases are usually structured in a manner that exposes the A noteholders solely to the underlying corporate credit risk of the lessee. In particular, if the lessee elects to return the assets to the lessor at the end of the lease term, the
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lessee is generally required to make a residual value payment equal to approximately 80%85% of the original cost (the residual value guarantee). This payment is applied first to the A notes with any remaining proceeds to the B notes and certificates. When providing ratings for synthetic lease transactions, Fitch will assess the credit quality of the lessee as well as the value of the underlying asset. Given the residual value guarantee, the A note portion is clearly recourse to the lessee and therefore will be assigned the senior credit rating of the lessee in most cases. This analysis assumes that the lease debt would be considered secured debt of the lessee in bankruptcy. However, if the credit rating of the lessee were to decline, Fitch may incorporate asset value into the analysis, on a secondary basis. With respect to the B note, Fitch will rate this tranche one or more notches below that of the A note to account for the return scenario risk (as described below) and potential residual value shortfall. The level of notching will be assessed on a case by case basis and could vary based on Fitchs assessment of the return risk, including the strategic importance of the asset to the lessee, potential fair market value, and replacement value.
Lease Term and Residual Value

To abide by GAAP requirements, the lease is structured with a periodic lease payment and a residual. The lease payments will generally be sized to cover interest payments on the debt and some minimal principal amortization. Although the term of the lease cannot exceed 75% of the useful economic life of the asset, which can range as high as 60 years for a generating facility, the initial term under a synthetic lease is relatively short, with most ranging from five to seven years. At the end of the initial lease term, the lessee will have three primary options to choose frompurchase the asset (for book purposes, effectively buying out the lease); renew the lease (extending the financing for tax purposes); or return the asset to the lessor and arrange for its sale. The credit implications surrounding the first two options are relatively straightforward. Under a purchase scenario, all debt and equity holders are effectively made whole as the lessee must buy the assets at a price equal to the entire outstanding lease balance. If a renewal is sought, the lessee can simply extend the lease term after receiving approval of the extension from the lenders or cash proceeds from refinancing in the case of a capital markets debt issuance.
Synthetic Leasing
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Under a return scenario, the A notes are, in most instances, fully protected by the residual value guarantee and are thus exposed only to the corporate credit risk of the lessee. On the other hand, the B note and certificate holders are exposed to a potential principal loss if the asset deteriorates significantly in value since accounting rules state that the guaranteed residual value cannot exceed 90% of the fair market value. However, Fitch believes that the return option is the least likely to be pursued by an energy company given the strategic importance of the underlying assets subject to the lease. In addition, lease terms often contain fairly onerous return provisions, which can discourage a sale.
Credit Implications for Lessee

As with any type of interim financing, a synthetic lease poses refinancing risk to the lessee at the end of the lease term. However, as described above, it also provides some intrinsic refinancing options. Under the purchase option, the lessee would be responsible for raising sufficient capital to repay the lease and purchasing the asset for book purposes (it would already own the asset for legal and tax purposes). Under the renewal option, the lessee would be responsible for arranging the extension terms with the lease debt holders and the lessor. Under the return option, the lessee would be responsible for the payment of the residual value guarantee and for arranging the sale of the asset. It is important to note that, as legal owner of the asset, the lessee had retained all risks of ownership (including market value risk) throughout the term of the lease. If, during this term, the market value of the asset had fallen, the lessee would suffer a loss if the residual value guarantee exceeded the market value of the asset. When assessing the impact of a synthetic lease on the credit of the lessee, Fitch will analyze the relationship of the synthetic lease debt to the companys existing corporate debt and loans. Some companies have very tight restrictions in their existing indentures or bank agreements regarding the ability to enter into secured financing such as synthetic leases. Other companies corporate debt covenants may include broad carve outs that allow for the creation of a significant or unlimited amount of secured debt to be incurred as synthetic leases or other types of contracts. If a corporation creates a material amount of additional obligations that have an equal or superior claim on cashflow to that of unsecured senior creditors, it may reduce the rating of the companys senior unsecured obligations.
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Hypothetical Credit Impact of Synthetic Lease with 90% Residual Value Guarantee
Scenario 1 Base Case Income Statement ($000) EBITDA (GAAP Basis) Gross Synthetic Lease Rent Adjusted EBITDAR Reported Interest Expense Interest Portion of Synthetic Lease Total Balance Sheet ($000) Reported Debt Synthetic Lease Residual Value Gurantee Synthetic Lease Uncovered Debt Total Adjusted Debt Shareholders Equity Plus: SPE Equity (3%) Total Adjusted Capitalization Unadjusted Ratios EBITDA/Interest Debt/EBITDA (x) Debt/Capital (%) Adjusted Ratios EBITDAR/Lease Adjusted Interest Lease Adjusted Debt/EBITDAR Lease Adjusted Debt/Capital (%) 195.00 0.00 195.00 70.00 0.00 70.00 707.00 0.00 0.00 707.00 900.00 0.00 1,607.00 2.79 3.63 44.00 2.79 3.63 44.00 Scenario 2 with $300 Million Synthetic Lease 170.50 24.50 195.00 70.00 21.20 91.20 707.00 270.00 21.00 998.00 900.00 9.00 1,907.00 2.44 4.15 44.00 2.14 5.12 52.30 Scenario 3 With $300 Million Additional Debt. 195.00 0.00 195.00 91.20 0.00 91.20 1007.00 0.00 0.00 1,007.00 900.00 0.00 1,907.00 2.14 5.16 52.80 2.14 5.16 52.80
EBITDA Earnings before interest, taxes, depreciation, and amortization, GAAP Generally accepted accounting principles. EBITDAR Earnings before interest, taxes, depreciation, amortization, and rent. SPE Special Purpose Entity.
Fitch will recalculate key interest coverage and balance sheet ratios, effectively consolidating the SPE back onto the balance sheet. Specifically, the following adjustments will be made: Earnings before interest, taxes, depreciation, and amortization (EBITDA) is adjusted by adding back the annual synthetic lease payment (principal and interest) to calculate EBITDA earnings before interest, taxes, depreciation, amortization, and lease rental expense (EBITDAR).
The interest component of the synthetic lease payment is stripped out and included as additional interest expense. As previously stated, the interest component represents the vast majority of the annual rental payment under a synthetic lease.
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Balance sheet debt is modified to treat a portion of the lease balance as on-balance sheet debt. Specifically, Fitch will adjust reported debt levels to include a portion of the original lease balance, equivalent to the residual value guarantee as senior debt. This represents the maximum potential principal payout for which the lessee would be responsible under a return/ sale scenario. The remaining B tranche would be treated as subordinated debt. SPE equity will be given credit as equity (in effect, treating the SPE equity as a minority). The table above provides a hypothetical illustration of the credit impact of financing an acquisition using a synthetic lease as opposed to senior debt. The first scenario shows the base case, with no additional financing. Scenario two shows the same balance sheet with an additional $300 million synthetic lease. The third scenario shows the balance sheet with $300 million of additional debt. As mentioned previously, Fitch will treat the SPE as though it were consolidated on the companys balance sheet. Before adjustments, in scenario two, the company seems to carry much lower leverage than in scenario three, and has a higher coverage ratio. After adjustments, scenario two and scenario three have the same coverage ratios, while scenario two has a slightly lower leverage ratio due to the treatment of the equity in the SPE. Note that the EBITDA in scenario two is lower than in the base case and in the debt case. This is due to the fact that under GAAP accounting rules, the lease payments would be classified as an operating expense, a difference that is eliminated by the use of ratios based on EBITDAR. For simplicity, the table assumes that the implied interest rate on the synthetic lease is the same as the actual interest rate on the debt. (Fitch Ratings is a leading global rating agency committed to providing the world's credit markets with accurate, timely and prospective credit opinions.)
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15
Peter Rigby and James Penrose, Esq.,
To address the challenge in analyzing project finance risk, Standard & Poors uses a framework of analysis that extends well beyond its traditional approach that grew out of rating US independent power projects. The approach begins with the assumption that a project is a collection of contracts and agreements among various parties, including lenders, that collectively serves two primary functions: The first is to create a company that will act on behalf of its sponsors, to bring together several unique factors of production to produce a single product or service. The second function is to provide lenders with the security of payment of interest and principal from a single operating entity. Standard & Poors analytic framework then focuses primarily on determining how competitive the project will be in its market segment, and which risks might undermine its competitiveness and hence, the assurance of repayment to lenders.
Source: http://www2.standardandpoors.com/spf/pdf/fixedincome/030502IFcriteria.pdf. November 2004 Standard & Poors Global Project Finance Yearbook. Standard & Poors Rating Services, a division of The McGraw-Hill Companies, Inc. Reprinted with permission.
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s project finance has adjusted to the increasingly diverse needs of project sponsors and their lenders, the analysis of risk has become more complicated. The increasing variety of project finance applications and locations suggests that perhaps project finance, despite weaker numbers recently, continues to be the viable means of raising capital. Yet, projects have departed from their traditional long-term revenue contract bases. Contract-based revenues are increasingly rare. Fewer projects are able to secure the highly desirable fixed-price, turnkey, date-certain construction contracts that protect lenders from construction and completion risk. Commodity price and market risk now complicate the analysis of project finance. Term B loan structures with minimal amortizations and risky bullet maturities have made inroads in project finance. Transactions span such industries as meatpacking, power generation, oil and gas, entertainment, transport and military housing, to name a few. For lenders and other investors, identifying, comparing, and contrasting project risk systematically can indeed be a daunting task. To address the challenge in analyzing project finance risk, Standard & Poors uses a framework of analysis that extends well beyond its traditional approach that grew out of rating US independent power projects. The approach begins with the assumption that a project is a collection of contracts and agreements among various parties, including lenders, that collectively serves two primary functions. The first is to create a company that will act on behalf of its sponsors to bring together several unique factors of production to produce a single product or service. The second function is to provide lenders with the security of payment of interest and principal from a single operating entity. Standard & Poors analytic framework then focuses primarily on determining how competitive the project will be in its market segment and which risks might undermine its competitiveness and hence, the assurance of repayment to lenders.
Project Finance Defined

Standard & Poors defines a project company as a group of agreements and contracts between lenders, project sponsors, and other interested parties that creates a form of business organization that will issue a finite amount of debt on inception; will
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operate in a focused line of business; and will ask that lenders look only to a specific asset to generate cash flow as the sole source of principal and interest payments and collateral. What the rating means: Standard & Poors project ratings address default probability, or put differently, the level of certainty with which lenders can expect to receive timely payment of principal and interest according to the terms of the bond or note. Project ratings do not distinguish between the debt issue rating and the issuer credit rating, as is the case with corporate credit ratings, for a number of reasons. First, project documentation generally allows a project to issue debt at its inception to operate with a single business focus and typically to maintain a constant risk profile. Second, project debt does not become a permanent part of the capital structure, but rather amortizes in most projects according to a schedule based on the projects useful life. Finally, projects do not by design build up equity, but instead, use up cash quickly, first as operating expenses, then as debt service (often the most significant expense), and finally as dividends. (For a more comprehensive discussion of project finance risk and for clarification of specific topics, see Debt Rating Criteria for Energy, Industrial, and Infrastructure Project Finance, March 19, 2001).
Framework for Project Finance Criteria

This article summarizes an analytic framework that can be used to systematically assess cash flows based on project-level risks and then to analyze risks external to the project. External risks, many of which are often country specific, include lack of host country institutional development needed to support the project, force majeure, and sovereign risk. Five levels of analysis form Standard & Poors framework of project analysis: (Chart 1) Project-level risks, Sovereign risk, Business and legal institutional development, Force majeure risk, and Credit enhancements.
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Chart 1: Framework of Project Analysis

Credit Enhancement
Force Majeure Risk
Institutional Risk
Sovereign Risk
Project Level Risks
The analysis begins with identifying and assessing project-level risks. These risks generally define most of the risks associated with the choice of business because if a project cannot reasonably forecast commercially ongoing operations, other concerns such as the viability of guarantees or credit enhancements will count for little. Project-level risk consists of the following categories: Contractual foundation; Technology, construction, and operations; Competitive market exposure; Legal structure; Counterparty exposure; and Financial strength. A project debt rating involves a marshaling of the various heads of risk, analyzing their respective magnitude and likelihood of occurrence, and assessing the effect thereof on the project to operate and to pay debt service on the rated obligations. Surprisingly, even though project finance is supposed to be non-recourse to the
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sponsor, some lender credit assessments are often based on the sponsors reputation, its creditworthiness, or boththe implication being that the sponsor will support the project in difficult times. When the sponsor is rated higher than the project, such an approach flies in the face of evidence that sponsors have walked away when the projects became uneconomical. Sponsor reputation and experience are certainly considered in the assessment of project completion and operations. But in the absence of an independent determination that, despite its non-recourse status, the project is strategically essential to the sponsor, the rating will reflect primarily the projects standalone economic viability.
Project Level Risks

The analysis of project finance risk begins with identifying and assessing project-level risks. Standard & Poors defines these risks as those intrinsic to the projects business and the industry in which it operates (e.g., a merchant power plant selling power to the UK electricity sector). The first objective of the analysis is to determine how well a project can sustain ongoing commercial operations throughout the term of the rated debt and, as a consequence, how well the project will be able to service its obligations (financial and operational) on time and in full. Assessing project-level risk takes six broad steps: 1. Evaluate project operational and financing contracts that, along with the projects physical plant, serve as the basis of the enterprise; 2. Assess the technology, construction, and operations of the enterprise; 3. Analyze the competitive position of the project against the market in which it will operate; 4. Determine the risk that counterparties, such as suppliers and customers, present to the enterprise; 5. Appraise the projects legal structure; and 6. Evaluate the cash flow and financial risks that may affect forecasted results. Contractual foundation. The primary objective of analyzing project contracts is to determine the level of protection from market and operating conditions each agreement provides. The secondary objective is to determine how well the various
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contract obligations address the projects operating risk characteristics and mesh with other project contracts. The project structure should protect stakeholders interests through contracts that encourage the parties to complete project construction satisfactorily and to operate it competently. The projects structure should also give stakeholders a right to a portion of the projects cash flow to service debt and, in appropriate circumstances, to release free cash to the equity in the form of dividends. Moreover, higher rated projects generally give lenders the assurance that project management will align their interests with lenders interests; project management should have limited discretion in changing the projects business or financing activities. Finally, the stronger projects distinguish themselves by agreeing to give lenders a firstperfected security interest (or fixed charge, depending on the legal jurisdiction) in all of the projects assets, contracts, permits, licenses, accounts, and other collateral so the project can be disposed of in its entirety, should the need arise. Table 1: Contractual Foundation Benchmark Scores
Score 1 Characteristics Project has a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments sufficient to cover debt service. Indenture creates a first-perfected security interest in all project assets, contracts, permits, and accounts necessary to run the project. Strict controls on cash flows and distributions. Trustee (offshore for cross-border debt). 2 Project has a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments. Indenture creates a first-perfected security interest in all project assets, contracts, permits, and accounts necessary to run the project. Strict controls on cash flow. Trustee (offshore for cross-border debt). 3 Project has excellent long-term concession or other offtake agreement, that provides predictable revenues that cover fixed payments and variable costs. Virtually no conditions that could reduce revenue payments. Revenues are protected from foreign exchange, inflation, and market risks. Solid supply contracts; minimal cost/revenue mismatch.
Contd...
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Contd...
Business interruption and casualty insurance policies in place. No regulatory outs or easy termination provisions. Indenture creates a first-perfected security interest in all project assets, contracts, permits, and accounts necessary to run the project. Strict controls on cash flow. Trustee (offshore for cross-border debt). 5 Project has good long-term concession or offtake agreement, but does not fully protect lenders from market, inflation, or foreign exchange risks. Project could be a merchant project, but is secured by licenses, permits, sites, and contractual access to markets. Contract outs for offtaker or government. Adequate supply contracts; potential for cost/revenue mismatch. Business interruption and casualty insurance policies in place. Indenture creates a first-perfected security interest in all project assets, contracts, permits, and accounts necessary to run the project. Strict controls on cash flow. Trustee (offshore for cross-border debt). 7 Project has fair long-term concession or offtake agreement, but exposes lenders to market, inflation, or foreign exchange risks. Contract outs or termination easily achieved. No contractual requirements to perform while disputes are being resolved. Contracts contain poorly defined provisions and ambiguous requirements. No provisions for international arbitration. Weak insurance program. Indenture provides little security or collateral for lenders. Few controls on cash flow. No trustee. 10 No contracts support revenue or supply. No contractual requirements to perform while disputes are being resolved. Contracts contain poorly defined provisions and ambiguous requirements. No provisions for international arbitration. Little or no insurance. Indenture provides virtually no security for project. Virtually no controls on cash flow. No trustee.
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Contract analysis focuses on the terms and conditions of each agreement. The analysis also considers the adequacy and strength of each contract in the context of a projects technology, counterparty credit risk, and the market, among other project characteristics. Project contract analysis falls into two broad categories commercial agreements and collateral arrangements. Examples of key commercial project agreements and contracts include the following: Power purchase agreements, Gas and coal supply contracts, Steam sales agreements, Concession agreements, and Airport landing-fee agreements. Collateral agreements include an analysis of the following: Project completion guarantees; Assignments to lenders of project assets, accounts, and contracts; Credit facilities or lending agreement; Equity contribution agreement; Indenture; Mortgage, deed of trust, or similar instrument that grants lenders a firstmortgage lien on real estate and plant; Security agreement or similar instrument that grants lenders a first mortgage lien on various types of personal property; Depositary agreements; Collateral and intercreditor agreements; and Liquidity support agreements, such as letters of credit (LOCs), surety bonds, and targeted insurance policies. Technology, construction, and operations. A projects rating rests, in part, on the dependability of a projects design, construction, and operation; if a project fails to achieve completion or to perform as designed, many contractual and other legal remedies may fail to keep lenders economically whole.
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Table 2: Technology, Construction, and Operations Benchmark Scores

Score 1 2 Characteristics Project is a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments. Project has fixed-price, date-certain, turnkey contract; one-year-plus guarantees; superior liquidated performance/delay damages; highly rated by Standard & Poors, EPC contractor, credible sponsor, completion guarantee, or LOC-backed construction; installed costs at or below market; contracts executed. Independent engineer (IE) oversight through completion, including completion certificate. Commercially proven technology used. Rated O&M contract with performance damages. Budget and schedule are credible, not aggressive. Thorough and credible IE report. 3 Project has fixed-price, date-certain, turnkey contract; one-year guarantees for adequate liquidated performance/delay damages; reputable EPC contractor or LOC-backed construction; installed costs at market rate; mostly permitted and well-sited. IE oversight through completion. Commercially proven technology used. O&M contract with performance damages. Budget and schedule are credible, possibly aggressive. Thorough IE report, but missing key conclusions. 5 Project has fixed-price, date-certain, turnkey contract; less than one-year guarantees; some liquidated performance/delay damages; known EPC contractor or surety bond-backed construction; installed costs at premium rate; many permits and well-sited; possible local political/regulatory problems. Limited IE oversight. Commercially proven technology used. O&M contract with performance damages. Budget and schedule are credible, possibly aggressive. Mostly complete IE report; conclusions are weak. 7 Project has partial fixed-price, date-certain, turnkey contract and cost-plus features; weak guarantees, if any; minor liquidated performance/delay damages; questionable EPC contractor or weak performance bond-backed construction; installed costs at premium rate or not credible; permits lacking and siting issues; possible local political/regulatory problems. No IE oversight. Technology issues exist. Aggressive budget and schedule. IE report leaves many issues open.
Contd...
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Contd...
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Project has cost-plus contracts, no cap; weak guarantees, if any; minor liquidated performance/delay damages; questionable EPC contractor. Costly budget. Permits lacking; siting issues exist. Possible local political/regulatory problems. No IE oversight. No IE report. Technology issues exist. Aggressive budget and schedule.
The technical assessment of project risk falls into two categoriespreconstruction and postconstruction. Preconstruction risk consists of: Engineering and design, Site plans and permits, Construction, and Testing and commissioning. Postconstruction risk is made up of: Operations and maintenance (O&M), and Historical operating record, if any. Project lenders frequently rely on the reputation of the engineering, procurement, and construction (EPC) contractor or the project sponsor as a proxy for technical risk, particularly when lending to unrated transactions. The record suggests that such confidence may be misplaced. Standard & Poors experience with technology, construction, and operations risk on more than 300 project finance ratings indicates that technical risk is pervasive during the pre- and postconstruction phases, while the possibility of sponsors coming to the aid of a troubled project is uncertain. Moreover, many lenders do not adequately evaluate the risk when making investment decisions. Thus, Standard & Poors places considerable importance on the technical evaluation of project-financed transactions.
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Standard & Poors relies on several assessments for its technical analysis, including a review of the independent engineers (IE) project evaluation. This review assesses whether the scope and depth of the engineers investigation support the sponsors and EPC contractors conclusions. Standard & Poors supplements its review of the independent experts report with meetings with the authors and visits to the site to inspect the project and hold discussions with the projects management and EPC contractor. Without an IE review, Standard & Poors will most likely assign a speculative-grade debt rating, regardless of whether the project is in the pre- or postconstruction phase. Competitive market exposure. A projects competitive position within its peer group is a principal credit determinant. Analysis of the competitive market position focuses on the following factors: Industry fundamentals, Commodity price risk, Supply and cost risk, Outlook for demand, Foreign exchange exposure, The projects source of competitive advantage, and Potential for new entrants or disruptive technologies. Given that most projects produce a commodity, such as electricity, ore, oil or gas, or some form of transport, low-cost production relative to the market characterizes many investment-grade ratings (Table 3). High costs relative to an average market price, in the absence of mitigating circumstances, will almost always place lenders at risk. But competitive position is only one element of market risk. The demand for a projects output can change over time, sometimes dramatically, resulting in low clearing prices. The reasons for demand change are many and usually hard to predict. Any of the following can make a project more or less competitive: New products, Changing customer priorities, Cheaper substitutes, or Technological change.
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Experience has shown, however, that offtake contracts providing stable revenues or that limit cost risk, or both, may not be enough to mitigate adverse market situations. Hence, market risk can potentially take on greater importance than the legal profile of, and security underlying, a project. Conversely, if a project provides a strategic input that has few, if any, substitutes, economic incentives will be stronger for the purchaser to maintain a viable relationship with the project. Table 3: Competitive Market Risk Benchmark Scores
Score 1 2 Characteristics Project is a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments. Project sells a commodity sold widely on the world market. Project is in first cost quartile of producers. Solid competitive advantage in location, technology, and know-how. Demand is excellent for product/service. Long-term market outlook is excellent. For non-commodity products/services, project is in first cost quartile of producers and enjoys defensible price premium. Revenue and supply contracts will likely keep project economical. 3 Project sells a commodity sold widely in regional markets. Project is in first cost quartile of producers. Solid competitive advantage in location, technology, and know-how. Demand is excellent for product/service. For non-commodity products/services, project is in second cost quartile of producers and enjoys defensible price premium. Revenue and supply contracts will likely keep project economical. 5 Project sells a commodity widely sold on the market. Project is in the second cost quartile of producers. Demand for product/service should be adequate through debt. Competitive advantage in location, technology, and know-how, but may be hard to defend long term. For non-commodity products/services, project is in second cost quartile of producers; does not have a premium product. Pricing controlled/influenced by a regulator. Project could be uneconomical to primary offtaker.
Contd...
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Contd...
Project sells a commodity, but sold in limited markets. Project is in the third cost quartile of producers Few competitive advantages. For non-commodity projects/services, project is in third cost quartile of producers producers; does not have a premium product. Demand for product/service is limited and decreasing. Project is out of market or soon will be. Project is uneconomical to primary offtaker.
10
Project sells a commodity, but sold only in a few markets. Project is one of the most expensive producers. Virtually no competitive advantage in any aspect of its business. For non-commodity projects, project is in fourth quartile of low-cost producers and does not have a premium product. Little demand for product/service. Project is uneconomical to any/all parties associated with it.
Legal structure. Standard & Poors assesses whether the project is chartered solely to engage in the business and activities being rated. It will also determine that the insolvency of entities connected to the project (sponsors, affiliates thereof, suppliers, etc.), which are unrated or are rated lower than the rating sought for the project, should not affect project cash flow. Standard & Poors also analyzes other structural features to assess their potential to manage cash flow and prevent a change in the projects risk profile. These may include: Choice of legal jurisdiction, Documentation risk, Trustee arrangements, or Intercreditor arrangements. Standard & Poors generally will not rate a project higher than the lowest rated entity (i.e., the offtaker) that is crucial to project performance, unless the entity may be easily replaced, notwithstanding its insolvency or failure to perform, or unless it is a special purpose entity (SPE). Moreover, the transaction rating may also be constrained by a project sponsors rating if the project is in a jurisdiction where the sponsors insolvency may lead to the insolvency of the project, particularly if the sponsor is the sole parent of the project. (Table 4)
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A project finance SPE, as defined by Standard & Poors, is a limited purpose operating entity whose business purposes are limited to: Owning the project assets, Entering into the project documents (e.g., construction, operating, supply, input and output contracts, etc.), Entering into the financing documents (e.g., the bonds; indenture; deeds of mortgage; and security, guarantee, intercreditor, common terms, depositary, and collateral agreements, etc.), and Operating the defined project business. The thrust of this single-purpose restriction is that the rating on the bonds represents, in part, an assessment of the creditworthiness of specific business activities. One requirement of a project finance SPE is that it is restricted from issuing any subsequent debt rated lower than its existing debt, unless such debt is subordinated in payment and security to the existing debt and does not constitute a claim on the Table 4: Legal Risk Benchmarks
Score 1 Characteristics Project is a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments sufficient to service fixed obligations. Project is a bankruptcy-remote SPE. Virtually no ability to issue additional debt. New York or London financing jurisdiction. Adequate legal opinions support project documentation, collateral, and relevant tax matters. Documents provide for superior ongoing disclosure and monitoring. Project is a bankruptcy-remote SPE. New York or London financing jurisdiction. Adequate legal opinions support project documentation, collateral, and relevant tax matters. Superior financing documentation. Extremely limited ability to issue additional debt. Collateral and security strongly enforceable. Documents provide for superior ongoing disclosure and monitoring.
Contd...
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Project is a bankruptcy-remote SPE. New York or London financing jurisdiction. Adequate legal opinions support project documentation, collateral, and relevant tax matters. Excellent financing documentation. Mostly limited ability to issue additional debt. Collateral and security strongly enforceable. Documents provide for superior ongoing disclosure and monitoring. Project is reasonably bankruptcy-remote and strong SPE. New York or London financing jurisdiction. Adequate legal opinions support project documentation, collateral, and relevant tax matters. Adequate financing documentation. Project can issue additional debt with some controls. Collateral and security adequately enforceable. Documentation provides for adequate ongoing disclosure and monitoring. Project is neither bankruptcy-remote nor an SPE. Financing jurisdiction is questionable. Legal opinions weak or unavailable. Marginal financing documentation. Project can issue unlimited additional debt. Collateral and security probably not enforceable. Ongoing disclosure and monitoring will probably be difficult. Project is neither bankruptcy-remote nor an SPE. Financing jurisdiction is questionable. Legal opinions unavailable. Weak financing documentation. Project can issue unlimited additional debt. Questionable enforceability of collateral and security. Documentation does not provide for ongoing disclosure or monitoring.
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project. A second requirement is that the project should not be permitted to merge or consolidate with any entity rated lower than the rating on the project debt. A third requirement is that the project (as well as the issuer, if different) continue in existence for as long as the rated debt remains outstanding. The final requirement is that the SPE must have an antifiling mechanism in place to hinder an insolvent parent from bringing the project into bankruptcy. In the US, this can be achieved by the independent director mechanism whereby the SPE provides in its charter
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documents that a voluntary bankruptcy filing by the SPE requires the consenting vote of the designated independent member of the board of directors (the board generally owing its fiduciary duty to the equity shareholder(s)). The independent directors fiduciary duty, which is to the lenders, would be to vote against the filing. In other jurisdictions, the same result is achieved by the golden share structure, in which the project issues a special class of shares to some independent entity (such as the bond trustee), whose vote is required for a voluntary filing. The antifiling mechanism is not designed to allow an insolvent project to continue operating when it should otherwise be seeking bankruptcy protection. In certain jurisdictions, antifiling covenants have been held to be enforceable, in which case such a covenant (and an enforceability opinion with no bankruptcy qualification) would suffice. In the UK and Australia, where a first fixed and floating charge may be granted to the collateral trustee as security for the bonds, the collateral trustee can appoint a receiver to foreclose on and liquidate the collateral without a stay or moratorium, notwithstanding the insolvency of the project debt issuer. In such circumstances, the requirement for an independent director may be waived. The SPE criteria will apply to the project (and to the issuer if a bifurcated structure is considered) and is designed to ensure that the project remains nonrecourse in both directions: by accepting the bonds, investors agree that they will not look to the credit of the sponsors, but only to project revenues and collateral for reimbursement. Investors, on the other hand, should not be concerned about the credit quality of other entities (whose risk profile was not factored into the rating) affecting project cash flows. Counterparty exposure. The strength of a project financing rests on the projects ability to generate cash, as well as on its general contractual framework, but much of the projects strength comes from contractual participation of outside parties in the establishment and operation of the project structure. This participation raises questions about the strength and reliability of such participants. The traditional counterparties to projects have included raw material suppliers, principal offtake purchasers, and EPC contractors. Even a sponsor becomes a source of counterparty risk if it provides the equity during construction or after the project has exhausted its debt funding. (Table 5)
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Important offtake counterparties to a project can include: Providers of LOCs and surety bonds, Parties to interest rate and currency swaps, Buyers and sellers of hedging agreements and other derivative products, Marketing agents, Political risk guarantors, and Government entities. Because projects have taken on increasingly complex structures, a counterpartys failure can put a projects viability at risk. Financial strength. Projects must withstand numerous financial threats to their ability to generate revenues sufficient to cover O&M expenses, nonrecurring items, Table 5: Counterparty Benchmark Scores
Score 1 Characteristics Project is a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments. Rated offtake counterparty with exceptional credit rating. Counterparty guarantees debt payment. 2 Project is a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments. Rated offtake counterparty with excellent credit rating. Counterparty guarantees revenue payments. 3 Supply and offtake contract counterparties have good credit ratings. Sponsor counterparty obligations are backed by good ratings or LOCs. Government counterparties, if any, have good credit ratings. Financial counterparties have good credit ratings. 5 Supply and offtake contract counterparties have adequate credit ratings. Sponsor counterparty obligations are backed by adequate ratings or LOCs. Government counterparties, if any, have adequate credit ratings. Financial counterparties have adequate credit ratings.
Contd...
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Contd...
Supply and offtake contract counterparties have doubtful creditworthiness. Sponsor counterparty obligations are uncertain. Government counterparties, if any, have adequate credit ratings. Financial counterparties have weak credit ratings. Service counterparties have weak credit ratings.
10
Supply and offtake contract counterparties have poor creditworthiness. Sponsor counterparty obligations are weak. Government counterparties, if any, have poor credit ratings. Financial counterparties have poor credit ratings. Service counterparties have poor credit ratings.
capital replacement expenditures, taxes, and annual fixed charges of principal and interest, among other expenses. Projects must contend with such risks as interest rate and foreign currency volatility, inflation risk, liquidity risk, and funding risk. Standard & Poors considers a projects capital structure a source of financial risk. Too much debt places a project at risk of volatile currencies, interest rates, and market liquidity. (Table 6) Investment-grade project debt should be amortizing debt. Few projects, particularly power projects, can adequately assume the refinancing risk of the bullet maturities characteristic of corporate or public financings. Unlike a corporate entity, a single-asset power generation facility is more likely to have a finite useful life. Because of this depreciating characteristic, a fixed obligation payable by an aging project near the end of the projects life is necessarily more risky and speculative, than an obligation payable from cash sourced in diverse assets. Standard & Poors relies on debt-service coverage ratios (DSCRs) as the primary quantitative measure of a projects financial credit strength. The DSCR is the ratio of cash from operations (CFO) to principal and interest obligations. CFO is calculated strictly by taking cash revenues and subtracting expenses and taxes, but excluding interest and principal, needed to maintain ongoing operations. The ratio calculation also excludes any cash balances that a project could draw on to service debt, such as the debt service reserve fund or maintenance reserve fund. To the extent that a project has tax obligations, such as host country income tax, withholding taxes on dividends and interest paid overseas, etc., Standard & Poors
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treats these taxes as ongoing expenses needed to keep a project operating (see Tax Effects on Debt Service Coverage Ratios, July 27, 2000). Note that some projects have been using subordinated debt recently in their capital structures to help mitigate commodity price risk. Although such structures can be helpful, subordinated debt is just that-inferior to senior lenders rights to cash flow or collateral until after the project has met senior lenders obligations. Moreover, in calculating the DSCR, and ultimately the rating, on subordinated debt, Standard & Poors divides total CFO by the sum of senior debt-service obligations plus the subordinated obligations. Such a formula more accurately Table 6: Financial Risk Benchmark Scores
Score Characteristics 1 Project is a credit lease, hell-or-high-water contract; even if the project is a technological/ operational failure, it receives full revenue payments. Financial flexibility not needed. Amortizing debt payments. No subordinated debt allowed. Financial model strongly reflects project documentation. Minimum DSCR exceeds 4.0x. Average DSCR exceeds 6.0x. Project insensitive to interest, inflation, and foreign exchange risks. Distress scenario analyses show less than 50 basis point coverage deterioration. Excellent financial flexibility protection. Amortizing debt payments. No subordinated debt allowed. Financial model reflects project documentation. Minimum DSCR exceeds 3.0x. Average DSCR exceeds 5.0x. Project slightly sensitive to interest, inflation, and foreign exchange risks. Distress scenario analyses show less than 100 basis point coverage deterioration. Good financial flexibility. Amortizing debt payments. Subordinated debt allowed, but rights against senior debt are unenforceable. Financial model adequately reflects project documentation. Minimum DSCR exceeds 1.5x.
Contd...
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Contd...
Average DSCRs range from 2.0x to 3.0x. Project sensitive to interest, inflation, and foreign exchange risks. Distress scenario analyses show less than 80 basis point coverage deterioration. Good financial flexibility. Mostly amortizing debt, but may have limited bullet payment(s). Subordinated debt allowed, but rights against senior debt are limited. 7 Financial model conflicts with project documentation. Minimum DSCR exceeds 1.2x. Average DSCR ranges from 1.5x to 2.5x. Interest, inflation, and/or foreign exchange changes significantly affect DSCRs. Distress scenario analyses show less than 80 basis point coverage deterioration. Limited financial flexibility. Bullet maturities likely. Subordinated debt allowed; distress may affect senior debt. Financial model conflicts with project documentation. Minimum DSCR exceeds 1.0x. Average DSCRs range from 1.1x to 1.5x. Interest, inflation, and/or foreign exchange changes significantly affect DSCRs. Distress scenario analyses show less than 50 basis point coverage deterioration. No financial flexibility. Bullet maturities likely. Subordinated debt likely to have enforceable rights.
10
measures the subordinated payment risk than using CFO after senior debt service obligations and dividing it by subordinated obligations.
Sovereign Risk
As a general rule, the foreign currency rating of the country in which the project is located will constrain the project debt rating. A sovereign foreign currency rating indicates the sovereign governments willingness and ability to service its foreign currency denominated debt on time and in full. The sovereign foreign currency rating acts as a constraint because the projects ability to acquire the hard currency needed to service its foreign currency debt may be affected by acts or policies of the government. For example, in times of economic or political stress, or both, the government may intervene in the settlement process by impeding commercial conversion or transfer mechanisms, or by implementing
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exchange controls. In some rare instances, a project rating may exceed the sovereign foreign currency rating if the project has foreign ownership that is key to its operations, if the project can earn hard currency by exporting a commodity with minimal domestic demand, or if other risk-mitigating structures exist.
Institutional Risk
Even though a projects sponsors and its legal and financial advisors may have structured a project to protect against readily foreseeable contingencies, risks from certain country-specific factors may unavoidably place lenders at risk. Specifically, these factors involve the business and legal institutions needed to enable the project to operate as intended. Experience suggests that in some emerging markets, vital business and legal institutions may not exist or may exist only in nascent form. Standard & Poors sovereign foreign currency ratings do not necessarily measure institutional risk. In some cases, institutional risk may prevent a projects rating from reaching the host countrys foreign currency rating, notwithstanding other strengths of the project. That many infrastructure projects do not directly generate foreign currency earnings, and may not be individually important for the hosts economy may further underscore the risk. (Table 7) In certain emerging markets, the concepts of property rights and commercial law may be at odds with investors experience. In particular, the notion of contractTable 7: Institution Risk Exposure Benchmark Scores
Score Characteristics 1 Well-developed legal system; significant precedent exists. Well-developed financial system. Significant history of transparency in financial reporting. 3 Developed legal system; reasonable precedent exists. Developed financial system; enforcement culture still developing. Transparency in financial reporting may raise concerns. 5 Developed legal system; limited precedent exists. Financial system beginning to develop. Contract culture developing. Transparency just taking hold. 10 No legal statutes for project finance. Bankruptcy code not developed or not enforced. Banking sector poorly monitored and/or poorly supervised. Little contract culture.
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supported debt is often a novel one. There may, for example, be little or no legal basis for the effective assignment of power purchase agreements to lenders as collateral, let alone the pledge of a physical plant. Overall, it is not unusual for legal systems in developing countries to fail to provide the rights and remedies that a project or its creditors typically require for the enforcement of their interests.
Force Majeure Risk

Project-financed transactions distinguish themselves from corporate or structured finance assets by their vulnerability to potential force majeure risks. Force majeure can excuse performance by parties when they are confronted by unanticipated events outside their control. A careful analysis of force majeure events is critical in project financing because such events, if not properly recompensed, can severely disrupt the careful allocation of risk on which the financing depends. Floods and earthquakes, civil disturbances, strikes, or changes of law can disrupt a projects operations and devastate its cash flow. In addition, catastrophic mechanical failure, due to human error or material failure, can be a form of force majeure that may excuse a project from its contractual obligations. Despite excusing a project from its supply obligations, the force majeure event may still lead to a default depending on the severity of the mishap. The risk of force majeure events, if unallocated away from the project, will limit most projects to the BBB category or below. Occasionally, some types of project, such as pipelines and toll roads, can achieve ratings that are less affected by force majeure risk because of the improbability of such an event materially disrupting operations. Thus, pipeline and road projects can more easily return to operations, compared with a mechanically complex, site-concentrated project such as a refinery or liquefied natural gas plant. In addition, some rating increase may be possible to the extent that a project can mitigate force majeure risk with business interruption and property casualty insurance. (Table 8)
Credit Enhancement
Some third parties offer various credit enhancement products designed to mitigate project-level risks, sovereign risks, and currency risks, among others. Multilateral agencies, such as the Multilateral Investment Guarantee Agency, the International Finance Corp., and the Overseas Private Investment Corp., to name a few, offer various
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Table 8: Force Majeure Risk Exposure Benchmark Scores

Score 1 Characteristics Highly linear, simple operations. Loose linkages. Geographically spread out. Greater complexity in operations. Specialized equipment used (compressors, generators, heat exchange, high pressure, high temperature). Tighter linkages of sequential operations. 10 Highly complex operations. Extremely tight linkages among system operations. Highly specialized equipment used. Operating accidents can be costly. Examples Toll roads, Pipelines, Hydro-electric power plants Coal-fired power plants, Natural gas-fired power plants,
Mines Petrochemical plants, Refineries, Liquefied natural gas, Nuclear power plants.
insurance programs to cover both political and commercial risks. Project sponsors can themselves provide some type of support in mitigation of some risks-a commitment that tends to convert a non-recourse financing into a limited recourse financing. Unlike financial guarantees provided by monoline insurers, enhancement packages provided by multilateral agencies and others are generally not comprehensive for reasons of cost or because such providers are not chartered to provide comprehensive coverage. These enhancement packages cover only specified risks and may not pay a claim until after the project sustains a loss; they are not guarantees of full and timely payment on the bonds or notes. Although these packages may enhance ultimate postdefault recovery, they may not prevent a default. On a project default, the delays and litigation intrinsic in the insurance claims process may result in lenders waiting years before receiving an insurance payment. Even if a project has a debt-service reserve fund of six to 12 months, the effect of the reserve would be limited in preventing the default; the insurance payment could come well after the reserve funds have been exhausted. For Standard & Poors to give credit value to insurers, the insurer must have a demonstrated history of paying claims on a timely basis. Standard & Poors financial enhancement rating (FER) for insurers addresses this issue in the case of private insurers (see Surety Policies as Mechanisms for Timely Credit Support in Project
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Finance Transactions, published on RatingsDirect, June 28, 2000), but it should be stressed that such policies or guarantees tend to be limited in scope and that as a result, ratings enhancement may be limited.
Outlook for Project Finance

For single-asset-based transactions and as an asset class for investors, project finance has seen a remarkable growth during the past 20 years This growth will likely continue. Hundreds of billions of dollars of debt have financed thousands of projects across many industries throughout the world. Currency crises tested many project structures and ultimately the financial viability of many projects, especially in Asia and Latin America. Some survived, while others folded. In the US and the UK, the massive buildout in gas-fired generation followed by the collapse in operating margins has underscored project vulnerability to commodity price risk as projects failed. Despite the failure of some projects, project sponsors will continue to use project finance to raise capital. It is a proven financing technique. Yet, political and country risks will persist, as will market risks. And clearly, the risk profile for project finance is as complex as it has ever been. Standard & Poors expects that project sponsors and their advisors will continue to develop new project structures and techniques to mitigate the growing list of risks and financing challenges. As investors and sponsors return to emerging markets, particularly as infrastructure investment needs increase, project debt will remain a key source of long-term financings. Moreover, as the march toward privatization and deregulation continues in all markets, nonrecourse debt will likely continue to help fund these changes. Standard & Poors framework of project risk analysis anticipates the problems of analyzing these new opportunities, in both capital debt and bank loan markets. The framework draws on Standard & Poors experience in developed and emerging markets and in many sectors of the economy. Hence, the framework is broad enough to address the risks in most sectors that expect to use project finance debt, and to provide investors with a basis with which to compare and contrast project risk.
Project Risk Benchmarks-Appendix

The analysis of project finance relies on many subjective judgments, although many quantitative techniques are available to assess comparative financial and
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competitive project attributes, such as sales price or cost of production. To facilitate comparing and contrasting key project risks across the spectrum of rated projects, Standard & Poors uses a series of benchmark scoring criteria for project-level and external risks (e.g., institutional, and force majeure). Benchmark scores, expressed as integers, range from one to 10, with one being the least risky. Higher numbers represent exponentially higher risk. The scores and their criteria represent only guidelines; they are not prescriptive but are flexible, given the specifics of a particular transaction. The different benchmark scores are not additive, as they might be in a scoringdriven rating model. As project finance is a form of structured finance, a deficiency in one small part of a transaction, such as the lack of a debt-service reserve fund, or an unsecured lending structure that prevents lenders from taking control of the project, could be cause for a speculative-grade rating. In such an example, a project could conceivably have relatively high benchmark scores in all categories but one and still achieve only a speculative-grade rating. Nonetheless, in general, scores of one to five will typically point to investment grade characteristics. (Standard & Poors is the worlds foremost provider of independent credit ratings, indices, risk evaluation, investment research, data, and valuations.)
Pension Funds In Infrastructure Project Finance: Regulations...
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16
Pension Funds In Infrastructure Project Finance: Regulations and Instrument Design
Antonio Vives
Private pension funds benefit from the opportunity to enhance the risk-return combination offered to the affiliates, hopefully enhancing the value of their savings and pensions. Private investments in infrastructure benefit from the possibility of tapping long-term resources in local currency and reducing financing costs. In the process, there is the opportunity to promote the development of the country in areas that can have a multiplier effect in terms of competitiveness and quality of living. To achieve this relationship, pension fund regulations must be restructured so that the goal of safeguarding the value of pensions does not hinder investments in viable and profitable infrastructure projects. On the other hand, infrastructure needs to tailor the instruments to satisfy the needs of pension funds. The discussion presented shows how this can be achieved for the benefit of all parties. This relationship is a positive sum game.
Source: http://www.iadb.org/sds/doc/IFM-110-E-Rev2002.pdf. May 1999. Inter-American Development Bank, Washington, DC. Reprinted with permission.
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Introduction
In the nineties, two major reforms were undertaken with intensity by Latin American countries; namely, private participation in pension fund management and in infrastructure investment. Many countries in other parts of the world have undertaken one or another of these reforms, but not both at the same time (with the exception of the United Kingdom, which closely resembles the case of many countries in Latin America and pioneered private participation in infrastructure). These dual reforms have created a sizable, mostly domestic source of long-term funds, while at the same creating a sizable need for domestic investment funds. Nevertheless, in spite of the potential benefits of a happy marriage, a relationship has not yet been developed. The liberalization of many emerging market economies and the attendant realization of the many benefits of private participation in infrastructure, have resulted in a considerable need for private capital. This liberalization, occurring in the context of relatively underdeveloped financial markets, has meant reliance on foreign capital to finance growing needs, with the concomitant risk for the economies of unexpected devaluations and/or sudden reversals of those flows. Even though foreign capital flows into infrastructure projects are more resilient than portfolio investment, recent crises have reduced the willingness of investors to provide capital for emerging markets. As a result, projects have been subjected to severe foreign exchange risks. This situation underscores the importance of developing domestic sources of long-term capital. The major, and sometimes only sources of domestic long-term capital are local pension fund resources, which, in addition, can contribute to the development of local financial markets. It is imperative that these resources be tapped by infrastructure projects. If they are to tap their resources successfully, project developers and the international project finance industry must be aware of the special needs of local pension funds. Even though the discussion is concentrated on Latin America, it has implications for most countries with privately managed pension funds and private infrastructure. The purpose of this paper is to promote this symbiotic relationship, outlining the conditions under which sources and uses of long-term resources can meet, and focusing the attention of both parties to the benefits of a properly structured
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relationship. There are benefits for both parties that can be exploited through a better mutual understanding of the needs of the other party. We do not propose that special subsidies, guarantees or tax benefits be granted to infrastructure works to make them attractive to private pension fund managers. Nor do we propose that public pension fund resources be directed or forced into infrastructure investments on account of their positive externalities or social benefits. Private infrastructure investment instruments must be structured so that they fit into the investment strategies of private pension funds, while appropriate changes in the pension fund regulatory framework should be encouraged. We propose a strictly voluntary private-to-private relationship, albeit with the participation of the public sector as grantor and regulator of private activities. The public sector has the important role of facilitator; it controls most of the rules of the game and its actions in either sector can make or break the relationship. Before embarking on the purpose of this paper, the discussion of the structure of infrastructure financial instruments needed to capture pension fund investments and the consequent policy and regulatory reforms needed in most developing countries, we briefly review the potential sources and needs for investment, the characteristics of the funds and of the projects, the current limitations to the relationship and the benefits for both parties. The article concludes with a discussion of the implications this can have for developed countries, like the United States and most of Europe, that lag in private participation in both areas, mandatory pensions and infrastructure.
Private Pension Fund Investments in Latin America

Since the pioneering effort of Chile, which took place in 1981, many Latin American countries have undertaken pension fund reform, including the introduction of private management of mandatory pension savings along with or as a replacement for the public pension system. These pension funds have accumulated a significant amount of resources. 1 Table 1 shows that Chile has the largest pension funds relative to the size of its economy. At the end of 1998, accumulated assets exceeded US$31 billion,
1
Even though Brazils public system has not been reformed, the assets under administration under corporate pensions are so large that they are of considerable interest for financing infrastructure and as such are included in the discussion.
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representing 40% of GDP. Other regulated systems (mandatory and voluntary) are relatively recent, and more are added every year (the most recent one being that of El Salvador, which was established in 1998; a private pension fund system is slated to start in Venezuela in late 1999). While most systems are relatively incipient, they are growing rapidly, both as a result of the profitability of investments and the number of new entrants. Chile's private pension fund system has been in operation for almost 20 years, and in that period resources have grown at an annualized rate of 29.4% (in local currency). Most recent systems have posted very high growth rates. For example, in Argentina, pensions increased at a rate of 29% a year over three years; in Colombia the rate of increase was 39% over two and a half years; in Mexico it reached 168% over two years; and in Peru, 22% over three years. Nevertheless, they are still small when compared with their potential and relative to the size of the respective economies. If the countries that have started private pension funds were to reach the levels attained in Chile, Latin America would have over US$560 billion. This is a significant amount that the underdeveloped and thin capital markets would not be able to absorb, forcing investments in government paper or bank instruments (Table 7 gives an indication of capital market depth). There is a need to develop those markets and to introduce new instruments, which the pension funds are in a position to support.
Investment Regulations2
In order to protect the interests of the affiliates, all the countries of Latin America in which private pension funds operate, regulate the composition of portfolios. As these portfolios are expected to provide or supplement the pensions that were previously provided by the state, they tend to place strict limits on allowable investments and the performance of the portfolio. These regulations tend to favor stability and uniformity of investment portfolio performance, which tends (however unwittingly) to exclude worthwhile, and economically and socially desirable investments like the provision of new infrastructure. A few regulations that further exacerbate this difficulty must be overcome, if infrastructure investments are to be a part of pension fund portfolios.
2
This section benefits from the paper by Shah (1996), which criticizes the regulation for their effect on management expenses and sub-optimal portfolio choice, and Vittas (1998), which moderates the criticisms, for lesser developed countries, on account of under-developed financial markets and institutions.
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The regulations cover the range of allowable investments, their liquidity, valuation and risk characteristics and other regulations on the portfolios themselves, such as minimum return. They also govern the management, allowing freedom to switch administrators, the number of portfolios per affiliate, portfolios per administrator and allowable managers. Still other regulations set limits on the liquidity and valuation of investments and limit investments to rated instruments. Some of these regulations make it almost impossible to invest in infrastructure assets or at least tend to discourage such investments. Appendix II presents a summary of the most relevant regulations in the countries listed in Table 1. Table 1: Comparative Size of Private Pension Funds
Total Pension Fund System (a) (millions of US$) Argentina Brazil Chile Colombia Mexico Peru Germany Netherlands Spain UK USA (corporate)
(a)
GDP 1998 Population Pension/ Pension Assets (millions of US$) Projected 1998 GDP (%) per Capita (millions) (US$) 337,615 776,900 77,417 87,474 379,126 60,480 2,142,100 378,300 569,000 1,362,300 8,508,900 36.1 165.5 14.8 37.7 95.8 24.8 82.0 15.6 39.3 58.3 269.8 3.4 9.4 42.7 2.4 1.5 2.9 13.7 121.0 5.6 72.8 51.7 319 454 2,101 56 61 70 3,591 29,259 810 17,027 16,310
11,526 75,068 31,146 2,110 5,801 1,739 294,379 457,807 31,831 991,951 4,400,000
Pension Fund Data at Dec. 1998, Except Germany, Netherlands and UK at Dec. 1997
Sources: GDP data: IMF (1999). Latin America Pension data: FIAP, Boletin #5; Europe Pension data: Mercer W./Inverco. USA Pension data: Pensions and Investments (1999)
Regulations That Hinder

Ratings: In order to account for the risk of the allowable assets and the rules set by regulators, pension fund administrators tend to require that non-government paper be rated by an independent agency and have a local investment grade. Those pension schemes that allow investments in foreign assets require an investment grade for such assets, rated by internationally recognized credit rating companies. Even equity investments are sometimes limited to rated firms.
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Liquidity: To minimize problems with the valuation of security assets, most regulations prohibit, or in the best of cases, limit the holding of assets that are not traded or do not have a high degree of liquidity in major organized exchanges. For the purpose of identifying the level of liquidity, some regulations use liquidity indexes. Valuation Rules: Most regulations require mark-to market valuation, which by itself tends to favor investments whose prices are frequently quoted. This, again, would make investments in new infrastructure less likely to occur, because the instruments backing those assets would tend to be traded infrequently.
Regulations That Discourage

Allowable Investments: As of 1999, the most restrictive private pension fund regulation is that of Mexico, where the only allowable instruments are debt securities issued or guaranteed by the federal government or the central bank. The only exception is the investment of up to 35% of the assets of the fund, in debt securities issued or guaranteed by private companies and financial institutions with high credit rankings. Also, at least 65% of the portfolio should be invested in paper with maturities and/or review of interest rates not higher than 183 days, some of which must be invested in securities issued by the government or central bank with maturities of less than 90 days. At the end of 1998, the portfolio composition of all pension fund administrators in Mexico included 97% government or central bank paper. In addition to being conservative, these rules, which are expected to be temporary, aim to ensure financing for the government liability created by the transition from the old pays-you-go (PAYG) public pension system to the private system. The most liberal and oldest of the pension fund regulations are those of Chile, which allow investments in stocks, foreign securities, real estate, infrastructure and most negotiable instruments with an investment grade rating. These regulations have been progressively liberalized, as capital markets became more developed and confidence in the operation of the system increased. These investment regulations discourage investment managers from investing in infrastructure assets, as most (with the exception of Chiles) make the rules of liquidity, valuation and ratings applicable to all investments. This, in effect, limits direct investment in projects and, only in some cases, allows indirect investments
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through the purchase of stocks of well established infrastructure corporations or mutual funds. Furthermore, investments in non-recourse or limited recourse greenfield projects (i.e., investments that depend on the cash flows of newly constructed or under-construction projects) are even more restricted. These projects do not have an established track record, are rather risky, illiquid, and in most cases lack a rating (let alone an investment grade rating). Performance Regulations: In order to protect the value of the affiliate's pensions against overaggressive behavior by the administrators and to minimize the need for supplementary public pensions, most countries regulate the performance of portfolios. In many cases, they are required to earn minimum returns, measured in either absolute (nominal or real) terms or relative to the performance of other pension funds. In the case of Chile, administrators are required to earn a minimum, which is the lesser of 200 basis points below the average system return or half the average return. Those that do not meet this criteria are required to compensate the portfolio with resources from a fluctuation reserve, established with prior earnings exceeding the minimum, and/or the administrator's own capital. In the case of Argentina, minimum returns are measured as 30% below the system average. In order to avoid under-performance at a given point in time, pension fund managers tend to avoid volatility (inherent in infrastructure) and to invest in similar portfolios, reducing incentives for taking greater risks, while diversifying the portfolio within the limits allowed by local financial markets thereby precluding larger returns. Quantitative evidence from the Chilean system presented by Shah (1997), show that there are minimal variations in portfolio composition. This herding behavior is not exclusive of regulated funds. It can also be found in the management of private corporate pension funds, where managers often compare their performance with the industry average or with a standard benchmark and, in an attempt not to report under-performance relative to the average, tend to imitate each others portfolio. This tendency is obviously not as prevalent as that forced by regulation. Switching: Most regulations allow affiliates to switch accounts, between pension fund administrators, once or more in a given year. In addition to the obvious impact on marketing expenses, when combined with restrictions on portfolio
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composition and minimum performance requirements, this option tends to reinforce herding behavior since administrators do not want to lose customers on account of reporting volatility, arising out of infrastructure investments. One Portfolio Per Affiliate: All Latin American countries require that all pension assets of the affiliate be invested in the same portfolio, although several are considering a change. This precludes the existence of portfolios with different risk-return characteristics, that could adapt to the risk tolerance of the affiliate and his/her life-cycle. Again, this restriction conspires against the incorporation of illiquid assets. The model of the individual retirement accounts sponsored by private US corporations is a good one. In this case, the affiliate can opt to divide investments among several portfolios offered by the fund manager in order to tailor the combined portfolio based on age, risk tolerance or to take account of other investments he/she may have. Obviously in this case, there is no bailout of pensioners by the government, as is the case in some Latin American countries, which guarantee a minimum pension. Moreover, the level of development of the capital markets and the investment sophistication of the affiliates in Latin America, make it more difficult to allow this freedom. A better solution would be to allow flexibility in the choice of portfolio within a given pension administrator, after the pensioner has a part of his/her savings in one that guarantees a minimum pension. One Portfolio Per Administrator: Pension fund managers can only offer one portfolio to their clients. Combined with the restrictions described above, this one also reinforces the convergence to the mean portfolio and precludes the incorporation of riskier assets. In the case of Mexico, for example, the law establishes that pension fund administrators could manage several pension fund companies with different portfolio composition and risk levels, although the current, very strict investment and minimum return rules restrict the viability of this option. Monopoly of Pension Asset Management: Almost all Latin American countries currently restrict the management of pension assets to institutions exclusively devoted to this end, often regulated by a special regulator (in the case of Colombia, the Bank Superintendency regulates pension fund administrators). Competition from banks, insurers and other financial institutions is not permitted. While this
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allows for easier oversight of the industry, it also precludes the offer of alternative investment vehicles, which in general have had better returns than pension fund portfolios, albeit with greater risk. This choice, which should become available as the system matures, would allow for greater competition, portfolios which are more along the risk-return frontier, and a stronger interest in infrastructure assets, particularly as financial institutions gain experience in infrastructure finance. This is not to suggest that oversight be eliminated. As investment and pension management services become specialized, the industry will continue to need regulation to protect the interests of affiliates. But, as the system and financial markets mature, it will become more obvious that there are significant similarities between the pension fund and the banking and insurance industries, and that all can operate in the same markets with common regulations.
Portfolio Composition
Given the foregoing, the portfolio composition of pension funds tends to be rather conservative. The least conservative system is that of Chile because that country's system is more mature. (Table 2) Table 2: Portfolio Composition by Sector (End of 1998)
Bonds Argentina Brazil Chile Colombia Mexico Peru Germany Netherlands Spain UK USA (a)
(a)
Stocks 25.0% 36.5% 16.1% 3.2% 0.0% 33.5% 6.0% 15.0% 13.7% 54.0% 51.9%
Real Estate 0.3% 14.5% 1.7% 2.5% 0.0% 0.0% 13.0% 7.0% 0.0% 2.0% 3.0%
Foreign 0.3% 0.0% 5.7% 0.0% 0.0% 0.0% 7.0% 29.0% 16.7% 29.0% 10.5%
Other 3.5% 2.0% 0.1% 10.3% 0.0% 0.7% 3.0% 2.0% 7.2% 7.0% 5.7%
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
70.9% 47.0% 76.4% 84.0% 100.0% 65.8% 71.0% 47.0% 62.4% 8.0% 28.9%
Top 1,000 Funds aggregate asset mix.
Source: Latin America: FIAP (1999); USA: Pensions and Investments (1999); Europe: Mercer.
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The case of Chile, with its longer history, is illustrative of the possible evolution as funds mature and tend toward riskier portfolios, even within the very conservative limits set by regulations. At the beginning, most assets were invested in essentially riskfree securities, as is the current case in Mexico (although in this case, pension assets are also used to finance the deficit of the transition form the old to the new system). As time went by and capital markets developed, funds started to invest in mortgage bonds and corporate securities, to the point that in 1994 these represented a proportion similar to public securities. This changed in 1998, when the stock market was hit by uncertainties associated with the Asian crisis and funds moved into bank deposits and international diversification. Moreover, in 1990, pension funds were authorized to invest in foreign securities subject to a very low and slowly increasing limit (currently set at 12%). Foreign investments started in 1993, increasing by 38% in 1998, reaching US$1,785 million. Investments in venture capital and infrastructure funds were permitted in 1993; in 1995 the limit on equity holdings was raised to 37% (Vittas, 1996). (Table 3) Given their relatively large size, Chiles pension funds have also contributed to the development of the market. They have been instrumental in developing credit rating agencies (clasificadoras de riesgo), giving depth to the markets, stabilizing prices (because they are long-term investors), developing new products to attract them and the possibility of investing in infrastructure funds as we are exploring in this paper. Table 3: Evolution of Chiles Pension Fund Investments
Type of asset (percentage of total assets) 1981 Government Securities Bank Deposits Mortgage Bonds Corporate Bonds Corporate Equities Other Foreign Securities Total 28 62 9 1 0 0 0 100 1985 43 21 35 1 0 0 0 100 1990 44 17 16 11 11 1 0 100 1994 40 5 14 6 32 3 0 100 1998 41 14 17 5 15 3 6 100
Source: Vittas (1996), data for 1998 form Boletin #5, FIAP (1999).
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As can be seen, when private pension funds mature and capital markets develop, the range of investments tends to widen and move away from concentration in government securities. The current, very restrictive regulations can be expected to be liberalized as the systems gain the confidence of regulators and self-regulation is developed. Eventually those systems will adopt the prudent man rule (i.e., no restrictions, just common sense), that governs the pension programs of private corporations or the most advanced systems in Europe, like the Netherlands and the United Kingdom. This trend needs to develop for the inclusion of infrastructure as an allowable investment.
Infrastructure Investments
The only Latin American countries that now explicitly allow investments in infrastructure (even greenfield projects) are Argentina, Colombia and Chile. Pension fund managers in those countries are able to participate in infrastructure development programs and public services only indirectly by purchasing paper issued by specialized infrastructure investment funds or (titulos securitization), which spread the risks involved. Obviously, those systems that allow investments in private securities allow, indirectly, investments in infrastructure assets, through the purchase of mutual funds or stocks and/or bonds of the corporations owning those assets. Nevertheless, some of these assets may not have the required rating and/or liquidity necessary to comply with other regulations, and, as such, may have to be exempted if project finance investments are desired. Furthermore, most managers would have to acquire the capabilities to perform due diligence on these investments. The case of investment in established corporations that have a significant portion of their assets in infrastructure, falls within the categories of investments in stocks or bonds of traded corporations and is rather straightforward. As a result, we will not address it here. We are more concerned with investments in new infrastructure projects (project finance). Although no precise figures exist, in the case of Chile the private pension system has invested in several road and airport concessions by investing in the concession partners. In all cases, it was investment in already existing assets, not greenfield projects. In the case of Argentina as of the end of 1998, approximately 0.6% and 5.8% of total pension assets were invested in bonds and shares respectively, of infrastructure related projects or companies.
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The newly created pension funds should hope to emulate U.S. corporate pension funds, which operate in a very well-developed financial market. As of the end of 1998, the defined benefit corporate pension funds, in the top 1000 funds in the United States, have an average of 5.1% of their assets in private equity and real estate (these assets are the most similar to infrastructure projects) and 11.8% in international equity.3
Investment Needs of Private Pension Funds

The regulations described above determine, in most cases rather narrowly, the potential investments of pension funds. If these regulations were relaxed, pension funds would probably invest in other instruments. In particular, they are likely to be interested in instruments that: Provide higher returns. Provide opportunities to reduce risk through diversification. Provide inflation protection. Do not enhance volatility of reported returns. Do not add undiversifiable risks (like foreign exchange exposure). Have liquidity. Provide short-term and mid-term cash flows. Unfortunately, most financial markets in the developing countries do not have the instruments needed, even if the regulations were relaxed. Therefore, instruments will have to be created, as financial markets develop. If properly structured, infrastructure financial instruments can meet some of those needs and, as a result, should be attractive to those pension funds. Nevertheless, infrastructure investment is an activity which is inherently risky, both because of its strategic inflexibility (it cannot be moved or used for other purposes) and the fact that it provides basic public services subject to political interference (which could be reduced as a consequence of private pension fund participation). In this regard, it is important to distinguish between investments in well-established firms that provide
3
Even though private pension funds in Latin America are defined contribution, the management of the portfolios is in the hands of independent managers with a single portfolio and as such, the resulting portfolio is more comparable to the US-defined benefit case.
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infrastructure services (which should be treated as regular investments) and investments in new projects, which require special consideration in terms of the regulatory environment and financial instrument design. In terms of the latter, we propose that private pension funds invest between 1% and 5% in infrastructure project finance assets. Needless to say, this recommendation is not based on a comprehensive analysis of the risk return characteristics of infrastructure investments or the efficiency frontier of the allowable assets of pension fund portfolios. Nor does it incorporate the risk preferences of affiliates (the research required goes beyond the scope of this paper). This is merely a rule of thumb, based on the preceding analysis, in particular by looking at the evolution of the Chilean case and the practices of pension funds administered under the prudent man rule.
Potential Private Pension Fund Investment in Infrastructure

Based on the expected rates of growth in pension fund assets4 and assuming that 3% of those assets are invested in infrastructure, Table 4 gives an indication of the availability of resources in selected countries. The third column gives the stock of potential assets in the portfolio if the full 3% were invested. The fourth column gives the availability of resources for new investments during the year, assuming that investment of 3% of the new assets flow into the pension funds portfolio (growth). Table 4: Availability of Resources for Infrastructure in the Year 2000
Country Pension Fund Assets year end (billion US$) 20 117 49 3 20 3 Potential investments in infrastructure projects (portfolio) (million US$) 600 3,900 1,470 90 600 90 Potential new yearly investments in infrastructure projects (million US$) 120 780 180 30 180 30
Argentina Brazil Chile Colombia Mexico Peru

4
Assumes the following rates of growth: Argentina and Brazil, 20%; Chile, 12%; Colombia, Mexico and Peru, 30%. These rates are not critical for the point we want to show and are merely indicative.
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The investment of pension funds assets in infrastructure provides important benefits to those projects in which: Foreign exchange risk exposure is reduced, as most projects generate local currency revenues, but have traditionally depended on foreign exchange financing to cover long-term needs. Financing (refinance) risk is reduced because pension funds are able to provide longer tenors than those currently available in the local financial markets. The cost of capital is potentially reduced because these resources tend to be less expensive on a risk-adjusted basis than most of the alternatives (imported capital or short-term local finance). There would be less interference in decision-making because pension funds tend to be less involved in day-to-day management than the alternative sources (this must be compensated with proper governance system to ensure that pension funds are not taken for a ride). Political risk is reduced because the participation of resources representing the pensions of local workers should induce closer adherence and fairness in the application of infrastructure regulatory principles. Pension funds can be honest brokers, as affiliates are affected both by the returns of the projects and the rates charged by the services provided. These benefits are important enough for infrastructure projects to be very interested in pension fund resources and to take the necessary measures to capture them.
Private Participation In Infrastructure

The current decade has seen a significant transformation in the modalities of provision of infrastructure services concurrent with pension reform. There has been a major increase in private sector participation in the provision of infrastructure services. This is particularly the case in the countries that undertook pension reform, that also liberalized their economies, but it is not limited to them. In the case of Latin America, the main reasons for the increase in private participation has been the need to modernize and expand the services which the state can no longer finance and to redirect resources used to finance the deficits of public utilities to more pressing social needs. This has led most countries to privatize
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public utilities and to concession in transportation services, leaving the financing of the rehabilitation and expansion in the hands of the private sector. These investment needs, as will be seen below, are rather large and are well beyond the current capacities of domestic financial and capital markets, both in terms of volume and in terms of tenor. This forces the private sector to resort to international sources to finance investments that generate revenues mostly in domestic currencies.
Financing Needs
It has been estimated that for each 1% in GDP, investment in the traditional infrastructure sectors (telecommunications, energy, transportation and water and sewage) would need to increase by 1% of GDP (World Development Report, 1995). A reasonable goal for governments would be to make sure that infrastructure can support a long-term annual growth rate of 5%. Given the size of the Latin American economy, this would require investments of US$70 billion (in year 2000 dollars) per year. It is estimated that the telecommunications sector would require roughly $25 billion a year; energy, $28 billion; transportation, $10 billion; and water, $7 billion. Telecommunications can be considered a relatively safe and developed sector that should be part of the regular portfolio of investments of pension fund assets in publicly traded stocks and bonds. It should hence be excluded from the special project finance allocation we are suggesting. Also, a portion of the energy sector that includes well established utilities in countries Table 5: Investment in Infrastructure Projects with Private Participation, 1990-1997 Latin America and the Caribbean (million US$)
Year 1990 1991 1992 1993 1994 1995 1996 1997 Electricity 645.70 2,130.06 2,925.74 3,019.57 5,380.48 9,012.51 20,514.80 43,628.86
Source: World Bank (1999).
Water 75.00 4,153.00 434.00 1,178.80 153.90 1,625.20 7,619.90
Gas 2,930.00 142.80 1,342.90 796.50 915.80 2,490.88 8,618.88
Telecom 4,443.30 9,213.80 11,112.00 5,804.40 9,109.90 6,910.30 9,710.40 11,273.40 67,577.5
Transport 5,311.00 395.50 2667.50 835.80 1,517.10 1,600.70 2,785.40 3,658.50
Total 10,400.00 9,684.30 18,839.56 13,861.74 15,423.47 15,866.78 22,578.01 39,562.78
18,771.80 146,216.94
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with mature reforms could also be seen in this light. Nevertheless, as this is still a small segment of the overall Latin American market (although it represents a large part in Chile and Argentina), we will assume that the energy sector is in need of risk capital and include the estimates in our proposal. As a result, total annual needs that could potentially be covered by the risky portion of pension funds assets could amount to almost $50 billion in the year 2000. These large needs continue to be met mostly by the public sector and it is estimated that private sources only cover 15% (World Bank, 1997a). Table 6 shows the percentage of private investment covered assuming that the private sector finances around 15% of the infrastructure needs of those countries (15% of 5% of GDP).5 Obviously every country would be different, and the numbers shown only attempt to provide orders of magnitude to assess the overall feasibility of pension fund financing. They are more valid in the aggregate than on an individual country basis. Even though the potential contribution by pension funds appear to be small compared with the needs, they do represent an important contribution to the financing, particularly in terms of the very scarce local currency finance. When considered in the context of the financing package of any project, these figures, even excluding the special case of Chile, represent a large contribution from a single source of financing and surely would be the largest of the local financing sources. Table 6: Coverage of Infrastructure Needs in the Year 2000
Country Private financing of needs (15%) New investments in infrastructure projects per year (million US$). Exhibit 7. 120 780 180 30 180 30 Percent of yearly needs satisfied
Argentina Brazil Chile Colombia Mexico Peru

5
1,900 4,200 435 525 2,700 435
6.3 18.6 41.4 5.7 6.7 6.9
If the telecommunications sector is excluded from these estimates, under the assumption that they represent traditional investments, then the figures could, as a rough estimate, be multiplied by 1.5, as telecommunications account for about 30% of the estimated financing needs.
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What Do Infrastructure Investments Offer

Based on the discussion above, it should be clear that private infrastructure could and should tap into pension fund assets. Yet, this can only happen if those investments bring something which is of value to the pension funds. Indeed, infrastructure investments do have some valuable features: They tend to provide a higher return than the one obtained by pension fund portfolios. Although infrastructure projects are riskier, they provide diversification benefits given that their returns are less than perfectly correlated with existing pension fund portfolios. For risk averse investors, investments in infrastructure may move the overall return to a more desirable risk return combination. These investments could increase the volatility of returns, but given that the proportion would be very small, the impact should be negligible. These investments contribute to overall economic growth, including the creation of new jobs, thereby generating even more resources for the pension funds and benefiting their stakeholders. Nevertheless, these investments also have some undesirable features that must be overcome before pension funds undertake them: Higher expected returns are achieved over the long run. Even though pension funds can afford to wait for returns because their liabilities are long-term, current regulations lead them to prefer short-term, steady returns. These investments may not comply with some of the regulations described above, in particular with respect to ratings, valuation and liquidity. Given that these investments carry a higher (although mostly diversifiable) risk, they bring the nondiversifiable risk of having to report a failure in an investment, with the potential for increased switching by affiliates to another pension fund administrator. This is an agency problem, because even though the investment may benefit the affiliate in the long run, it poses a shortterm risk to the administrator.
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Compatibility Between Infrastructure Investments and Pension Fund Portfolios

At the end of the previous two sections, we analyzed the investment needs of the private pension fund portfolios. Based on the previous discussion, it is apparent that the incompatibilities outweigh the synergies. Nevertheless, it is important to emphasize that these incompatibilities are more the consequence of the lack of appropriate instruments and regulations, than of the fundamentals. We further discuss the ideal regulatory environment to foster the investments and make some policy recommendations. We also discuss the design of financial instruments needed to take advantage of that pool of resources.
Changes In The Regulatory Environment

Based on the discussion on pension fund regulation and the characteristics of infrastructure investment, it is no wonder that there has been so little participation. The regulations on ratings, liquidity, switching, minimum return, one portfolio per affiliate, one portfolio per administrator, monopoly by pension fund administrators, and valuation rules make these investments almost impossible. The ideal regulatory framework will use the prudent person rule, whereby decisions on investments are left to the administrators exercising their fiduciary responsibility, as is the case of corporate pension funds in the United States and pension funds in the Netherlands and the United Kingdom. However, the government continues to have a financial interest because, in many cases, it guarantees the minimum pension. Furthermore, in the case of developing countries, this relaxation must be accompanied by the corresponding enhancement of the capabilities of the supervisory agencies. Thus, regulations should allow affiliates to have several portfoliosa properly regulated one for the minimum pension, and several for supplementary pensions that are basically deregulated and operate under the prudent person rule. Minimum pension portfolios would be regulated under current rules, and gradually relaxed as the system matures. This ideal regulatory framework cannot be achieved in the short run, but should be the benchmark to be achieved as pension funds and financial markets mature. In the meantime, the regulations could be progressively relaxed and, move from regulating investment to measures that regulate overall portfolio risk. The performance of supplementary pension portfolios would be assessed based on
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measures of risk-adjusted returns. Each administrator should be allowed to manage several portfolios with different risk-return characteristics (with the number being compatible with the development of the local capital markets). Each portfolio would advertise the risk tolerance and net-of-expenses performance benchmark and under-performance (say 20% below benchmark return) would be covered through reserves or the administrators capital. Switching would still be allowed, but it would be less of an issue, because comparison is relative to net-of expenses benchmark and not to other competing portfolios (not comparable, unless they are of the same risk and same expenses). Ideally, all financial institutions would be able to manage pension funds and, would fall under a consolidated regulatory body, with specialized units (banking, securities, insurance, pensions). Regulations on ratings, liquidity and valuation should be handled through the proper design of infrastructure financial instruments. Nevertheless, it would help if these regulations were relaxed, not eliminated, for a small percentage of assets, say 5%. For instance, valuation and rating rules could be substituted by periodic independent assessments of the investment value. The Ideal Regulatory Framework:
Prudent person rule for supplementary pensions Progressive liberalization for minimum
Design of Financial Instruments

Based on the discussion above, it is clear that if these instruments are to be attractive to pension funds, without been forced, they need to be, to the extent possible: More liquid Less risky (lower probability of failure) Less volatile. The instruments can have either direct or indirect claims on the cash flows. In the case of direct claims, the instruments can be securities (the need to be marketable is a sine qua non condition) like general project bonds, securitization of specific cash flows or shares of the special purpose vehicles. In any case, to comply with
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these conditions, the securities would have to have claims on special cash flows. For instance, they should have a senior claim on revenues, be based on projects with track records (operation stage) or have some form of enhancement through the participation of the government, multilateral agencies and/or political or credit insurance. The above-mentioned conditions can be further enhanced if the securities are based on indirect claims on the cash flows through some form of investment pools. This would allow investment in the securities of several projects, over several sectors and even over several countries. The resulting securities would already constitute a well-diversified portfolio and, as such, would be more liquid, less risky and less volatile, and may even be rated. In all cases, the underlying projects must be well structured and backed by solid sponsors. Even though this is the ideal, barely achievable in practice, it is the benchmark that those seeking pension fund financing should strive for. In the United States and other developed capital markets, there are endless options for the private pension fund administrator to invest the portfolio assets, and to configure the desired risk-return profile. In the case of countries with lesser developed markets the options are rather limited, sometimes limited to government paper and the negotiable certificates of deposit or liquid deposits of financial institutions. The case of most countries of Latin America is paradoxical. The private pension fund industry generates long-term, domestic, investable resources, and it needs to enhance profitability and minimize risk. Unfortunately, it does not have a well-developed capital market capable of providing the necessary instruments, either because it is underdeveloped, or as the case of Chile, its size is rather small when compared with the size of the funds. On the other hand, there are large unsatisfied needs of legitimate long-term domestic investments waiting to tap into the pool of those resources. There is a real gap between the potential of the funds, the needs of infrastructure and the development of the capital markets that must be closed through the development of the proper instruments, regulations, and institutions.
Pension Fund Investments in Infrastructure Assets

As discussed above, changes in the pension fund regulations are needed, but these alone will not be enough. Changes in the design of infrastructure finance instruments are also needed. These regulatory changes, if any, will occur over prolonged periods of time. In the meantime, for pension funds to invest in project finance infrastructure
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assets, the instruments will have to adapt to the existing regulations and the proposal indicated in the box below requires minimal changes in regulations, and in some countries none at all. The ideal instrument proposed is the most conservative that can be designed, short of one guaranteed by AAA-rated institutions or governments. It should have ample liquidity, very low risk (obviously with a correspondingly lower return) and would be properly valued. Even though it would capture funds for infrastructure, pension funds could do better in the risk-return tradeoff with more direct investments. As regulations are relaxed, the instruments will not have to be as complex as implied by the recommendation and some funds may be able to acquire simpler instruments, including direct investments or the purchase of negotiable debt instruments of specific projects. The application of the prudent man rule most likely would not imply a dramatic change in the portfolios of pension funds, evidenced by the portfolio composition of countries that use this rule. Administrators would probably still insist on liquidity, ratings and valuation rules, but most likely, they would be willing to exempt a portion of the portfolio from these self-imposed rules and allow investment in illiquid, non-rated and subjectively valued assets. This would favor direct investment in the relatively riskier (diversifiable), but return-enhancing infrastructure assets.
The ideal financial instrument: Securities of a fund, invested in many carefully selected projects, with some form of credit enhancement (e.g. multilateral participation, credit guarantees, political risk insurance), over several sectors (heavy on energy, light on water, with a mix of transportation subsectors), covering several countries, mostly in operational stage, with shares quoted in some exchange.
Table 7: Indicators of Capital Depth

1996 Market Capitalization Argentina Brazil Chile Colombia Peru USA
Percent of GDP, except turnover. Sources: IMF, Financial Statistics, March 1999; Word Bank, World Development Indicators, 1998; (a) Provided by banking sector in 1996.
Domestic Credit (a) 26 37 60 46 12 138
1996 Turnover 50 86 10 10 26 93
1998 Fund Size 3.4 9.4 42.7 2.4 1.5 51.7
18 32 93 25 27 105
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Implications for Other Countries and Other Investments

Even though we have been mainly discussing Latin America, the conclusions have implications for all countries, taking into account the differences in financial markets development. This is particularly the case because pension fund reforms in many developing countries are following the Chilean model (with the needed variations). Also, many developed countries (particularly in Europe) are under pressure to reduce their fiscal deficits and, to do so, are considering the private provision of infrastructure services. Given that these countries already have corporate or private pension funds in place, the implications of our discussion are also valid for them. Obviously, as the discussion refers to a private-private relation, it is valid if both infrastructure and pension funds are in private hands. The discussion can also be applied in the case of other private investments, different from infrastructure, that share some of the problems of inflexibility and size, as would be the case of housing. In the United States, there was a proposal in the early nineties to utilize the vast resources of private corporate funds to finance public infrastructure (see US Department of Transportation, 1993). In this case, the proposal was to use resources under private management to finance public sector works. The proposal involved the creation of a public financial institution that would issue securities, insured by a separate insurance company and with the implicit guarantee of the US government and tax benefits for purchasers. These securities were to be purchased by institutional investors, including private pension funds, and the proceeds would be used to finance public infrastructure, leveraging the capital paid in the corporation by the federal government. Even though the idea was very well structured, the private sector was not enthusiastic about it, as it appeared to be a form of forced investment. The problem was that even though the corporation may have been managed along private criteria, the activities financed were public works without an underlying cash flow and the tax exempt pension funds were more interested in taxable securities (for a comprehensive analysis of the proposal, see US General Accounting Office, 1995). Given that corporate pension funds in the United States have very few investment restrictions, the problem of insufficient infrastructure finance could be solved by privatizing some of the infrastructure and issuing securities along the lines proposed in this paper.
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Concluding Remarks
If regulations of private pension funds were to be relaxed to allow investments in private infrastructure projects and, in turn, these projects adapted their financial instruments to the needs of those pension funds, both parties would be able to reap significant tangible and intangible benefits. Private pension funds benefit from the opportunity to enhance the risk-return combination offered to the affiliates, hopefully enhancing the value of their savings and pensions. Private investments in infrastructure benefit from the possibility of tapping long-term resources in local currency and reducing financing costs. In the process, there is the opportunity to promote the development of the country in areas that can have a multiplier effect in terms of competitiveness and quality of living. To achieve this relationship, pension fund regulations must be restructured so that the goal of safeguarding the value of pensions does not hinder investments in viable and profitable infrastructure projects. On the other hand, infrastructure needs to tailor the instruments to satisfy the needs of pension funds. The discussion presented shows how this can be achieved for the benefit of all parties. This relationship is a positive sum game. (Antonio Vives is Deputy Manager, Infrastructure, Financial Markets and Private Enterprise, of the Sustainable Development Department and Vice-Chairman of the Pension Fund Investment Committee at the Inter-American Development Bank in Washington, DC.)
References
1 2 3 4 5 6 Bustamante J Quince aos despus: Una mirada la sistema privado de pensiones, Santiago, Chile, 1997. Federacin Internacional de Administradoras de Fondos de Pensiones. Semi-annual Bulletins for the years 1996,1997, and 1998, Santiago de Chile. Financial Times. Pension Fund Investment, Financial Times Survey, Financial Times, May 14, 1998. International Monetary Fund. International Financial Statistics, International Monetary Fund, Washington DC, March 1999. Kilby P The Rising Tide of Local Capital Markets, Latin Finance, Number 92, October 1997. Latin Trade Growing Older: Latin Americas Pension Funds Come of Age, Latin Trade, December 1998.
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7 8 9
Mercer European Pension Fund Managers Guide, Investment and Pensions Europe, March 1998, W.H. Mercer Companies, Inc., 1998. Ministerio de Obras Publicas, Ministerio de Hacienda. Bonos de Infraestructura, Santiago, Chile, 1997. Pension and Investments: The International Newspaper of Money Management. January 25,1999. Crain Communications Inc.
10 Queisser M The Second-Generation Pension Reform in Latin America, Organization for Economic Cooperation and Development, Paris, 1998. 11 Riesen H Liberalising Foreign Investments by Pension Funds: Positive and Normative Aspects. Technical Paper No.120, Organization for Economic Cooperation and Development, Paris, January 1997. 12 Shah H Toward Better Regulation of Private Pension Funds, Policy Research Working Paper No. 1791, World Bank, Washington DC, March 1998. 13 US Department of Transportation. Financing the Future, Report of the Commission to Promote Investment in Infrastructure, US Department of Transportation , Washington DC, February 1993. 14 US General Accounting Office. Private Pension Plans: Efforts to Encourage Infrastructure Investment, US General Accounting Office, Washington DC, September 1995. 15 Vittas D Pension Funds and Capital Markets, Public Policy for the Private Sector, Note No. 71, World Bank, Washington DC, February 1996 16 Vittas D Regulatory Controversies of Pension Funds, Policy Research Working Paper No. 1893, World Bank, Washington DC, March 1998. 17 World Bank, Infrastructure for Development, World Development Report 1994, World Bank, Washington DC, 1994. 18 World Bank Facilitating Private Involvement in Infrastructure: An Action Program, World Bank, Washington DC, 1997. 19 World Bank Mobilizing Domestic Capital Markets for Infrastructure Financing, World Bank Discussion Paper No. 377, World Bank, Washington DC, 1997. 20 World Bank. World Development Indicators, World Bank, Washington DC, 1998. 21 World Bank. Private Sector Development Department, Private Participation in Infrastructure Database, World Bank, Washington DC, April 1999.
APPENDIX 1
Characteristics of Latin American Private Pension Funds
Chile Start of operations Public PAYGO system Privately-funded system Affiliation of new workers Fund management companies (a) Contribution rate for savings (% of wage) Commissions + insurance (% of wage) Contribution collection Past contributions (b) Disability/survivors insurance Supervision Account transfers (c) Minimum rate of return Minimum pension 1981 closed mandatory AFP 10 Peru 1993 remains voluntary AFP 8 (d) Colombia 1994 remains voluntary AFP 10 3.49 decentralized RB private integrated 2 x p.a. relative yes Argentina 1994 remains voluntary AFJP 7.5 Mexico 1997 closed mandatory AFORES 6.5+subsidy Bolivia 1997 closed mandatory AFP 10 Brazil 1977 remains corporate EFPP variable
2.94 3.72 decentralized decentralized RB RB private private specialized specialized 2 x p.a. 2 x p.a. relative unregulated yes no
3.45 4.42 3.00 variable centralized decentralized decentralized corporate CP life-time switch CP N/A private public private N/A specialized specialized integrated integrated 2 x p.a. 1 x p.a. 1 x p.a. N/A relative no no (e) N/A yes yes no N/A
Notes: (a) AFP = Administradoras de Fondos be Pensioners; AFJP = Administradoras de Fondos de Jubilacioness Pensiones; AFORE = Administradoras de Fondos de Ahorro para el Retiro; EFPP = Entidades Fechadas de Previdencia Privada. (b) RB = Recognition Bond; CP = Compensatory Pension; (c) Due to administrative delays, transfer may be more limited. (d) Contribution rate will be increased gradually to 10%. (e) Guarantees are required from the fund management companies.
Source: Queisser (1998) and own data.
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APPENDIX 2
Comparison of Investment Regulations (Percentages are of the Total Assets of the Pension Fund)
Securities issued Debt Securities Stocks Mutual Funds Foreign Investments Others guranteed by Government (non Government) and/or Central Banks Max. 65% Max. 100% Max. 35% Max. 14% Max. 17% Max. 2% In any case no more than 7% in securities issued or guaranteed by the same entity Max. 1% of the fund in a mutual fund and/or 10% of the capital of the mutual fund. If mutual fund ivests in the real estate sector, max. 5% of capital of the fund per real estate mutual fund or 20% of the issue. Max. 100% Max. 80% Max. 50% Max. 15% Max. 35% Max. 5%of the fund in the capital of a company or max. 20% of its capital Max. 10% of the fund in a company and/or group and max. 20% of the fund in a financial institution and/or group Max. 20% of the capital of a real state mutual fund Max. 50% Max. 100% Max. 37% Max. 15% Max. 16% Max. 10% Max. 7% of the fund in one entity or max. 15% of the fund in a group Max. 5% per diversification factor on mutual funds that invest in real state, development of enterprises and securitization; and/or 20% of its capital Max. 3% in debt of new companies (could include public infrastructure by private companies); and/or 20% of the issue Max. 5% in real estate companies (could include investments in public concession projects); and/or 20% of the capital of the company Max. 1% of the fund per foreign investment fund Max. 50% Max. 100% Max.30% Max. 10% Max. 5% of the fund per issuer, including group. If the issue is supervised by the bank superintendency, the limit is 10% Max. 10% of the capital of a company and max. 20% of an issue, including securitization, except government or central bank paper. Max. 100% Max. 35% Max. 10% issued or guaranteed by an entity, and max. 15% for a group Max. 15% for a serie or same issue Max. 40% Max. 100% Max. 35% Max. 15% Max. 10%Max. 10% In any case no more than 15% in one company or 25% in an economic group Max 30% Max. 20% Max. 25%; Real Estate Equities: EU, equities, including Germany: max 30%; Non EU equities: max. 6% Prudent person rule Self Investment: max. 5% Min. 90% invested in listed assets, real estate and bank deposits; Bank Deposits: max. 15%. Max. 5% (max. 10%) in securities issued or guaranteed by one entity (group). This limit doesnt apply to foreign estates/ international organization Prudent person rule
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Argentina
Brazil
Chile
Colombia Mexico Peru Germany Netherlands Spain United Kingdom
Source: Websites of Associations of Pension Fund Administrators, law and regulations.
Private Power Financing From Project Finance to Corporate Finance
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Section V
Applications and Cases
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17
Karl G Jechoutek and Ranjit Lamech
To achieve substantive progress in IPP financing, limited recourse project financing will have to evolve toward structures with greater balance sheet support. The IPP experience in the United States offers useful insights, and indicates new evidence that variants of corporate financing are being used for financing electric utilities. Developers are pooling projects into entities, that are then able to raise capital on the strength of a combined balance sheet comprising the pooled assets of the different projects. Providers of equity and debt then finance the business of building and operating private generation facilities rather than an individual power plant. Pooling spreads project risk. Industry consolidation has become a steady trend in the IPP business. It has been argued that the increasing size and scope of projects is the main factor driving this change. Although these mergers and acquisitions could be driven by a number of strategic objectives, increased balance sheet support in project development is clearly one of them.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/056lamech.pdf. October 1995 World Bank Publication. Reprinted with permission
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imited recourse project financing of power generation projects has been widely promoted, as a solution to the intractable problem of getting private credit to a sector dominated by non-creditworthy borrowers and public agenciesfrom the point of view of both those supplying capital and those needing it. When the lights are going out, incumbent power enterprises are financially unviable, and the public purse is nearly empty, project financing of independent power producers (IPPs) may seem the only way to get new capacity fast. In the developing world, however, the public-private partnership in project-financed IPP ventures has been disappointingly slow to produce results. This Note argues that, to achieve substantive progress in IPP financing, limited recourse project financing will have to evolve toward structures with greater balance sheet support. The need for corporate balance sheet support for private power sector investments is gradually being recognized, and the benefits of this shift in financing structure are worth reflecting upon. First, balance sheet support by the mainpartners in an IPP financing offers greater security to lenders and provides easier (and perhaps cheaper) access to long-term debtcritical to sustainable power sector financing given that IPPs typically depend on debt for 60 to 75 percent of their financing requirements. Second, while equity in limited recourse project finance is almost exclusively private, balance sheet support by IPP sponsors can open access to public equity markets, which are deeper and generally cheaper. Third, increased corporate balance sheet support is a corollary to the restructuring in the worlds power sectors. As sector unbundling and self-generation expand choice for wholesale and (potentially) retail consumers, and thus increase demand uncertainty, balance sheet support by IPPs will play an important role in sharing demand risk among key participants.
Project Finance is More Expensive for an IPP

Project finance implies that the lenders to a project have recourse (or claim) only to the projects cash flows and assets. In effect, then, the project is financed off the balance sheet of the project sponsors. Such project finance is termed nonrecourse and is at one extreme of the project financecorporate finance continuum of financing possibilities. In practice, project finance in developing countries is backed by sponsor or government guarantees provided to give lenders extra comfort. This is limited recourse project financing, involving at least a small degree of corporate or balance sheet support.
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In traditional corporate financing, at the other extreme of the financing continuum, lenders rely on the overall creditworthiness of the enterprise financing a new project to provide them security. If the enterprise is publicly held, information on its performance and viability is usually available through stock markets, rating agencies, and other market-making institutions. This combination of security, liquidity, and information availability allows debt to be issued at a lower cost than through project finance. Further, because the enterprises overall risk is diversified over all the activities that it is engaged in, the cost of equity is also usually lower. The financing advantage for both debt and equity makes the overall cost of capital lower for corporate finance. Systematic empirical evidence specific to the power sector in the developing world is lacking, but anecdotal evidence suggests that corporate finance is indeed cheaper than project finance. Corporate financing also has significant transaction cost advantages because it avoids the high cost of negotiating the web of carefully structured legal contracts with purchasers and commercial lenders necessary under project financing.1 The IPP experience in the United States offers useful insights, and indicates that the projectfinanced independent generation model may not necessarily be the most efficient mode for capital formation in generation. Nor is it the dominant mode in other countries. The United States pioneered generation by independent operators on a merchant basis, and it is where the now ubiquitous term independent power producer, or IPP, originated. Project-financed independent generators have thrived in the United States, contributing more than half the additions to generation capacity in recent years. It has been shown that the cost of capital for a purchasing US utility may be higher if it chooses to build its own generation capacity rather than purchase power from an IPP.2 But much of the advantage is due to the adversarial regulatory environment in the United States, which favors IPPs. Purchasing utilities weigh the risk that state regulators will disallow investment costs against the perceived lower risk (and lower profits) of purchasing electricity from an IPP, an arrangement in which all costs can be passed through or expensed. The preference for purchasing power from IPPs is easily rationalized when one
1 2
See Anthony A Churchill, Beyond Project Finance, Electricity Journal 8(5): 3644, 1995. For the only systematic presentation of information on this issue, see Edward Kahn, Steven Stoft, and Timothy Belden, Impact of Power Purchased from Non-Utilities on the Utility Cost of Capital, Utilities Policy 5(1): 311, 1995.
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notes how many utilities and their bondholders were hurt in the 1970s and 1980s, when regulators disallowed cost recovery for large investments in capacity.
Increasing Balance Sheet Support for IPPsThe Evidence

Project developers operate in a fiercely competitive market for international projects. Assuming competitive bidding, the primary source of competitive advantage lies in the ability to find financing at the lowest cost, as differences in technical and operating abilities become virtually indistinguishable among the frontrunners. (Other attributes may, however, predominate in negotiated, noncompetitive IPP deals.) In the competitive international IPP market, several trends indicate that balance sheet support is the preferred means for achieving this cost-of-capital advantage.
Raising Capital Using a Parents Balance Sheet

Project developers are putting their own balance sheets at riskor those of their parent companiesto raise cheaper debt for projects and to finance their equity contribution. Projects in which sponsors have used their own balance sheets to raise finance include the Puerto Quetzal project in Guatemala (Enron), the Puerto Plata project in the Dominican Republic (Enron), and the Upper Mahaiao and Mahanagdong projects in the Philippines (California Energy). Chinese IPP developers, such as Huaneng Power and Xinli (Sunburst Energy), an affiliate of CITIC, have also used this strategy. California Energy pioneered the largest corporate financing in the independent power business, raising US$530 million through ten year securitized bonds in March 1994.
Creating Consolidated Balance Sheets

Developers are pooling projects into entities that are then able to raise capital on the strength of a combined balance sheet comprising the pooled assets of the different projects. Providers of equity and debt then finance the business of building and operating private generation facilities rather than an individual power plant. Pooling spreads project risk. For a multinational developer, it also reduces countryspecific risk. And for a developer with a few projects already under commercial operation, pooling offers the advantage of an immediate revenue stream for repaying debt and paying dividends.
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Pooling has two other benefits. First, it enables project developers to tap public equity marketsmost private project developers finance the equity component of a project privately. Second, it enables developers to raise cheaper debt on a corporate finance basis. IPP sponsors that have used this approach include Consolidated Electric Power Asia (CEPA), the San Franciscobased Bicoastal Energy Investors Fund (EIF), and Huaneng Power International (HPI) of China. CEPA raised debt and equity in the capital markets on the basis of its corporate strategy of building multiple power plants in Asia. EIF securitized its equity interests in sixteen independent power projects in the United States, creating a synthetic balance sheet and issuing US$125 million of seventeen-year bonds. And HPI, which owns 2,900 megawatts of capacity under commercial operation and has another 5,900 megawatts under construction, raised US$332 million by listing its IPP business on the New York Stock Exchange in October 1994.3 Pursuing Mergers and Acquisitions Industry consolidation has become a steady trend in the IPP business. Notable transactions among international players include the purchase of CMS Generation by HYDRA-CO Enterprises, the purchase of Magma Energy by California Energy Inc. (creating an enterprise with annual revenues exceeding US$400 million), and the acquisition of J Makowski Co. Ltd. by PG&E Enterprises and Bechtel Enterprises to form International Generating Co. Ltd. It has been argued that the increasing size and scope of projects is the main factor driving this change. Smaller companies are at an important disadvantage in international capital markets compared with larger players, with their greater experience, capitalization, and track records. Although these mergers and acquisitions could be driven by a number of strategic objectives, increased balance sheet support in project development is clearly one of them. The IPP Financing Challenge Private financing needs to be tailored to the changing structural relationships in the sector. Core generation, transmission, and distribution functions are being separated, competition is being introduced in wholesale and retail markets, and technological progress is rapidly increasing the number of cost-effective options
3
The proclaimed success of this transaction is controversial, as the share price of Huaneng dropped from US$14.25 at listing (October 1994) to about US$9 in mid-1995.
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for decentralized self-generation or cooperative generation. This restructuring will require a redefinition of the underlying assumptions in power sector financing. The financial challenge will be to find ways to provide lenders with adequate long-term revenue security when the new industry structure might not allow utilities to guarantee demand risk and price risk for the maturities required. Traditional project finance is based on allocating demand risk to the purchaser, whether an integrated utility, a central generator and purchaser, a distribution utility, or a large consumer. This risk allocation works well because purchasers have a monopoly franchise area, which they are obliged to serve. But as direct access to consumers is encouragedwhether or not the sector is broken up purchasing utilities will face increased demand risk as the loss of retail customers becomes a greater possibility. The key to any debt-based financing is the ability to provide adequate security through a contract or other credible evidence of future revenue streams. Innovative sharing of demand risk between market playersthe power seller, the power purchaser, and the financierwill become necessary. An IPP developers ability to bear any of the demand risk will depend in part on its willingness to provide corporate assets and revenues as a backstop for lenders. The view that well-capitalized corporate entities will be the ones able to meet financial markets requirements in a competitive environment seems to be confirmed by market responses. Most recent additions to generation capacity in the United Kingdomthe model of sector unbundlinghave been corporatefinanced IPPs. And witness the efforts by industry players in the United States to create highly capitalized enterprises as competition for final consumers looms on the horizon. The recently announced US$1.26 billion merger of Public Service Co. of Colorado and Southwestern Public Service Co. is a reaction to the perceived increase in demand risk stemming from plans for wider retail competitionthe utilities are noncontiguous and plan to build a connecting transmission line to share generating resources.
Conclusion
Greater corporate finance support will make it possible to raise private capital for independent power financing from wider, deeper, and cheaper sources. But
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innovative strategies will be required from governments, lenders, investors, and power sector enterprises alike. The following strategies are worth considering: Encourage the formation of large, well capitalized independent generation companies. Purely private and quasi-private variants of the Huaneng merchant generation model in China might be workable in large power systems. Healthy competition should be engendered through prudent regulatory reviews of the market power of the IPP in a particular system. Encourage divestiture of commercially operating (and perhaps underperforming) generation plants by incumbent utilities to IPP developers. These sales should be conditional on the purchasers commitment to making specified investments. By making positive revenue streams available to IPP developers immediately, such transactions would give them the financial base to invest in multiple plants. In IPP prequalification under competitive bidding, give greater weighting to IPP developers with businesses listed on a stock exchange and to those with well-capitalized balance sheets. The strategic goals of publicly held entities are likely to be more transparent and longer term because of these entities obligations to public shareholders. Encourage project sponsors to use balance sheet support for subordinated debt and quasi-equity portions of the project financing plan in order to increase corporate financing. This strategy would ease the overall financing costs of projects and could be a transitional strategy for meeting the huge financing needs for IPPs in developing countries. (Karl G Jechoutek, Division Chief, Power Development, Efficiency, and Household Fuels Division (email: kjechoutek@worldbank.org), and Ranjit Lamech, Restructuring Specialist (email: rlamech@worldbank.org), Industry and Energy Department.) (For comments contact Suzanne Smith, editor, Room G8105, The World Bank, 1818 H Street, NW, Washington, DC 20433, or E-Mail: ssmith7@worldbank.org)
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18
Many commercial banks have had little interest in water and sanitation projects not only because of non-commercial political and regulatory risks, but also the small size, weak local government credit, and high transactions costs (legal, consulting, and financial costs of structuring). Most projects have been financed on a limited recourse basis, that is, with project cash flows and assets as the main security for lenders. The move from project to corporate (balance sheet) financing is occurring in stages. Financing project debt from the sponsor companys balance sheet exposes that company to significant risk and thus requires a strong and large balance sheet. Designed in part to shield a companys balance sheet and improve a projects credit strength, innovative structures and financial instruments are emerging. Ultimately, the goal is for water utilities to raise debt and equity from capital markets on the basis of their own balance sheets, strengthened by a diversified and stable ratepaying customer base. This Note reviews the new trends.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/152haarm.pdf. September 1998 World Bank Publication. Reprinted with permission. The Note is based on a longer paper by the auLthors Tappinig the Prisate Sector: Approaches to Maniaging Risk in Vater and Sanitation (RINC Discussion Paper 122, World Bank. Resource Mobilization and Cofinancing Vice Presidency, Washington, DC, 1998).
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n the transition from government to private financing, projects in the water and sanitation sector require a heavy focus on risk allocation and mitigation, which has often implied drawn-out negotiations before and sometimes after financial closure. To address non-commercial risk, many projects have required some form of ongoing government or third-party support (see Viewpoint151). To transform themselves into economically viable enterprises, projects must mitigate commercial risks and gain credit strength (significant cash for investments and the ability to raise funds from capital markets). Risk pooling structures and in water and asset aggregating instruments may be one way to achieve the funding objectives: Financing of project debt on the basis of the sponsors balance sheet, or corporate finance (pooling risks with the corporations other activities). Equity funds to leverage sponsors equity and attract a larger group of investors. Bundling of water and sanitation projects to form economically viable entities that can be integrative to lenders. Integration of water and sanitation utilities with other utilities (such as natural gas distribution or power generation and distribution entities) to form holding companies with stronger balance sheets.
Corporate Finance and Capital Markets

Corporate finance can simplify the transition to capital market financing, because the risk of a projects debt is absorbed in part by other corporate activities. As in other sectors, projects in water and sanitation have been financed with some (limited) recourse to a sponsors balance sheet. This mechanism focuses project performance incentives but is generally costly in terms of time and resources. Increasing balance sheet financing may require significant industry restructuring, such as consolidating the ownership and operation of water utilities in a region or encouraging the integration of different utility sectors (Box 1). Such restructuring is already happening. Malaysia has bundled its entire sewerage system under one concession, a case of project pooling. While this project has forgone the benefits of comparative competition achieved when systems operate side by side, it creates the potential for securing revenue streams to finance a large number of small investments that would not be commercially viable on their own.
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In the long term, however, achieving financial and operational sustainability will require a utility to finance investments from internal cash and long-term bond issues. As the English and Welsh water companies demonstrate, water projects have the potential to do this. Once established, they can produce stable revenues that not only permit internal financing but also allow access to a much broader class of investors through bond issues. Among developing country projects, only Aguas Argentinas has moved significantly in this directioninternal cash generation accounted for nine percent of financing in the first three years and was expected to rise to 30 percent in the next three. The use of bond financing by privately financed water projects and utilities is relatively new. Leading the way, the English and Welsh utilities have used bond financing based on their balance sheets. In most developing countries, however, the development both of bond markets and of economically viable water utilities is at an incipient stage. The United States has the most mature bond market for municipal infrastructure; its development has been aided by tax exceptions and credit enhancements (see the discussion below on state revolving funds). Although the funds are used primarily by utilities owned by local governments, this municipal bond market taps private financing. Box 1: Project Fragmentation
New investments in the water and wastewater sector tend to be much smaller than those in other infrastructure sectors because of the markets fragmentation. Municipalities are in charge of water and sanitation, so investments facilities reflect demand only within their jurisdictions. The Mexican wastewater program, for example, will build many small wastewater plants, with an average cost of about US$25 million to US$30 million. Even where large investments are expected, they are spread over time, keeping pace with growth in demand. The massive Buenos Aires concession is expected to make investments worth a few billion dollars over its lifetime but the initial financing was for less than US$200 million. Similarly, the Manila concessions are expected to invest about US$5 billion over thirty years, but the initial round of financing probably will not exceed US$350 million. This pattern of small, incremental investments contrasts with that of power and transportation projects, which typically require large investments over a short period and gain the attention, and often the support, of national governments.
Equity Funds
Over the past few years infrastructure equity funds have provided a means by which developers can raise financing for infrastructure projects and investors can participate in this emerging market. Such funds can be attractive to infrastructure
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developers because they allow them to leverage their contributions with those of other investors and thus to spread their capital. For investors, equity funds mitigate project and country risk by creating a portfolio of projects under one company. The French water and sanitation company Lvonnaise des Eaux for example, introduced an infrastructure equity fund in Asia in 1995, a US$ 300 million water fund. Besides Lyonnaise, contributors to the fund include Allstate Insurance Company, the Employees Provident Fund Board of Malaysia, and the Lend Lease Corporation of Australia. Investors are expected to benefit from the water companys significant market position and deal flow in the region. The fund refinances the equity of the original sponsors. Thus, it conserves sponsor equity for the riskier development phase; sponsors apply their expertise in the early phase to get projects started and can then move on to other projects. Investors in the fund expect to receive steady, utility-like returns and potentially stand to gain significantly if the fund or a portion of it is publicly listed. Houston-based Enron Corporation used a similar strategy, though the fund took the form of a publicly listed company. In 1994, Enron packaged its emerging market power plants and natural gas pipelines in a new company that it floated on the New York Stock Exchange. Capitalized at about US$165 million, Global Power and Pipelines (GPP) included the assets of two power plants in the Philippines, a power plant in Guatemala, and a natural gas pipeline system in Argentina. Enron retained a 50 percent share of the company and sold the rest to investors. GPP has the right to buy into projects developed by Eriron at favorable prices, providing Enron an ensured exit mechanism to free up capital for high-risk, high-return development opportunities.
EBRDs Private Multiproject Financing Facility

To mobilize private investment in Eastern Europe, the European Bank for Reconstruction and Development (EBRD) has developed a multiproject financing facility (MPF) that provides a framework for financing a series of projects that may be too small to be considered individually. The MPF is made available to a private company, which uses the facility to make equity investments in, and loans to private water and sanitation projects. Under this arrangement the company largely takes on the task of due diligence, which helps to reduce the transactions costs for each project financed.
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EBRD signed its first MPF in July, 1995a US$90 million equity and loan facility with Lyonnaise des Eaux. The company was recently awarded a project that could be the first to access the facility, a US$ 41 million, twenty-five-year BOT (build-operate-transfer) wastewater treatment project in Maribor, Slovenia (population 150,000). In 1996 the second MPF was signed, with three Austrian companies. The agreement involves a $700 million (approximately US$140 million) equity and loan facility to support an investment program of $2 billion. The Austrian companies will also receive financial support in the form of a guarantee from the East-West Fund of the Austrian Finanzierungsgarantie GmbH.
State Revolving Funds

In the United States the federal government has supported state and local governments in financing the construction of wastewater treatment plants since the 1950s. In 1987, in an effort to delegate more responsibility to state and local governments, the US Congress replaced the existing grant funding with a program to capitalize state revolving funds (SRFs). States are required to contribute an amount equal to at least 20 percent of the federal capitalization funding. The program is aimed at leveraging federal resources and creating a renewable and perpetual source of financial assistance for wastewater infrastructure. Unlike with grant funding, the need to repay SRF loans introduces an important element of accountability, as well as a basis for new loans. The structure of each states revolving fund program depends primarily on the states needs and circumstances (such as its borrowing limit and ability to repay loans). Some states use program funds to provide direct loans to local governments of up to 100 percent of a projects cost at below-market rates. Others provide excess reserves or excess debt payment coverage that helps secure bonds backed by the revenues of a wastewater facility. Program funds may be used as collateral to borrow new resources; because several jurisdictions borrow on the basis of the same collateral, spreading the risks, the overall costs of borrowing are lowered. The large, diversified pools of municipal borrowers created under SRF programs are attractive to lenders because they spread the risks of debt payment interruption or default. Pooling projects for financing on a statewide basis also makes it more economical for credit rating agencies to evaluate credit risks. While a single project might not be large enough to justify a credit assessment, a large group of projects
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will be attractive. Credit rating agencies provide important information to prospective lenders about the creditworthiness of SRF programs by, for example, assessing and monitoring reserve fund and debt coverage levels and evaluating the size and composition of the borrower pool. Size and diversity matter. Rating agencies have found that smaller pools (20-100 borrowers) generally face more stringent credit requirements from lenders than larger pools because the behavior of individual borrowers has an amplified effect. For pools with fewer than twenty borrowers the weakest borrower tends to determine the credit rating. The revolving nature of the funds has had a insignificant effect on purchasing power. According to the US Environmental Protection Agency, funds invested in the SRFs provide about four times the purchasing power over twenty years than funds used to make grants. Even so, the funds represent only a fraction of the investment needed to upgrade municipal plants. In 1997, states were expected to make SRF loans of US$ 3 billion, compared with US$ 11 billion in total capital investment in wastewater infrastructure from all sources (federal, state, and local).
Multi Utilities
Deregulation and increasing competition in industrial countries are creating pressures for different utility sectors to combine. By combining, utilities hope to achieve not only economies of scope but also larger balance sheets and increased credit strength (through diversity) to attract long- term private financing. The trend has been most pronounced in the United Kingdom but is growing elsewhere. United Utilities and Scottish Power, two of the three UK provide utility services that run the gamutprincipally electricity generation and distribution and water and sanitatiion, but also gas distribution and telecommunications services. Multiutilities in developing countries may soon play a growing role. Argentina and Slovenia have combined gas and water utilities. In Cote dIvoire the project company developing the water supply concession went on to develop the electricity distribution system and a power generation project. This multiutility approach is being adopted in the concessions recently awarded in Casablanca and Gabon and is being considered for water and power projects in the Republic of Congo. However, the implications for the concentration of monopoly power are a concern. Chile recently passed a law prohibiting owners of water utilities from simultaneously owning power distribution or telephone service in the same area.
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Conclusion
As a utility matures, and its revenues become increasingly predictable and secure, its financing structure can be expected to shift to corporate finance or greater balance sheet support. Internally generated revenues are an important source of funding for water projects that have achieved a stable and diversified customer base. And strong balance sheets permit utilities to obtain external financing by issuing long-term debt to a broader class of investors. However, as a result of high political risk and shallow or nonexistent capital markets, in developing countries, the work of building stronger balance sheets and tapping capital markets generally takes time. New financing techniques in other sectors and their early applications in water and sanitation, suggest that pooling projects may be a way to move beyond project finance, particularly for the many small projects that need financing. Multiutilities entities that deliver multiple infrastructure services such as water and electricity, offer another approach to attracting private capital. These multiutilities can gain credit strength through a diversified revenue base that enhances the prospects for corporate finance. (David Haarmeyer (david.haarmeyer@ stoneweb.com), Stone & Webster Consultants. Boston, and Ashoka Mody (amody@worldbank.org), Project Finance and Guarantees Department. For comments contact Suzanne Smith, editor, Room F6p-188, The World Bank,1818 H Street, NW, Washington, DC. 20433, or E-Mail: ssmith7@worldbank.org).
Financing Water and Sanitation Projects - The Unique Risks
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19
Financing Water and Sanitation Projects The Unique Risks
A project finance structure allows water projects with attractive cash flows and risk profiles to secure long-term private capital. This structure provides a direct link between a projects cash flow and its funding to give project sponsors, investors, and lenders strong incentives to ensure that projects are structured and operated to generate stable revenue streams. But even in industrial countries, the credit strength of offtaking municipal governments and the sectors traditional monopoly structure expose lenders to potentially significant credit, regulatory, and political risks. These risks, combined with the sunk, highly specific, and non-redeployable nature of water investments, mean that lenders and investors are vulnerable to government opportunism and expropriation. Reviewing some recent innovative projects, this Note shows that private participation on a limited recourse or no recourse basis has required support from multilaterals and federal government agencies to absorb non-commercial risks.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/151haarm.pdf. September 1998. World Bank Publication. Reprinted with permission.
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rivate sector participation in water and sanitation has often taken the form of special purpose build-operate-transfer (BOT) projects following the project finance or limited recourse model. These are self-contained projects that address the need for more water and sanitation. Although these bulk suppliers can alleviate immediate shortages, they have virtually no effect on systemwide revenue problems (for example, leakage and tax collection) or labor cost problems. These long-term problems are sometimes tackled incrementally through leases and management contracts. An increasing number of countries have gone further by awarding operating concessions for entire systems, which require investment commitments from the concessionaire. Beyond such concessions lies full privatization of assets, which facilitates financing by creating collateral. The promise of steady, if not growing, long-term future cash flows is the basis of the private sectors interest in financing these ventures. As one of the last monopoly utility sectors, water and sanitation can be especially attractive to longterm private investors. But financing water and sanitation projects has been a special challenge because of their unique risks: Expensive to transport but cheap to store, water is essentially a local service and subject to control by local government, which can be more politicized and have weaker credit than state or federal government. With most of the assets underground, their condition is hard to assess. That makes investment planning difficult, posing risks for contract renegotiations. Inadequate provision is associated with health and environmental risks, so government has a strong interest in extending access to service, regardless of ability to pay. Significant currency risk arises because customers pay in domestic currency that does not match the currency of international debt and equity financing. There has so far been little scope to introduce direct competition in treatment, transmission, and distribution. The risk profile of a project is also influenced by its type and by its stage of development. Greenfield projects with a build-operate-transfer or build-own-
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operate (BOO) structure, because they involve a period of construction before revenues are generated, generally expose lenders to greater credit, political, and regulatory risks than concessions for infrastructure services that are up and running. Similarly, older and more efficiently run systems with longer operating histories tend to have more secure and predictable cash flows and mature investment profiles, and thus expose lenders and investors to fewer risks. The water and sanitation sectors exposure to risks that are often difficult and costly to cover has two important ramifications: Fewer projects have been successfully financed with private capital than in other infrastructure sectors, such as power and telecommunications. Projects financed with private capital have tended to involve direct financial or credit support from government or third parties such as bilateral, multilateral, and export credit agencies.
Case Studies in Finance

The experience of six water and sanitation projects and one set of utilities in accessing and structuring private finance illustrates the level of government or third-party support (Table 1). All the projects follow the standard project finance structure except for the more mature English and Welsh water companies, which rely on corporate finance. Only the BOT project in Johor, Malaysia, was financed on a non-recourse basis with no sponsor or third-party support to cover risk of nonpayment. All other projects were financed on a limited recourse basis. The recourse was generally provided by payment guarantees to the parties offtaking the service (buying bulk water or wastewater services), such as a local government entity in a BOT or BOO project. For the BOT in Chihuahua, Mexico, for example, Banobras, the domestic development bank, provided credit support to the local government entity. In Izmit, the Turkish government stands behind the local governments water purchase agreement. In Sydney, the state government guarantees the payment of the city water utility (Sydney Water Corp.) to the private project company, even though the utilitys debt is rated AAA by Standard & Poors. In Buenos Aires, the Argentine governments guarantee to pay compensation if the concession is terminated early provides the chief form of security for lenders.
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Table 1: Funding for Selected Water and Sanitation Projects

Project Site, Type, and Date Malaysia Concession (1993) Buenos Aires, Argentina Concession (1993) Izmit, Turkey BOT (1995) Project Cost US$2.4 billion (about US$500 million in first 2 years) US$4 billion (US$300 million in first 2 years) US$800 million Debt/Equity 75/25 Countryrating A+ Source and Maturity of Debt Government soft loans due to severe tariff collection problems 10-year IFC A-loan,12-year IFC B-loan (recourse to Argentine government in event ofearly termination) 13-year export credit agency loans, 7-year MITIa loan, 7-year commercial bank loan (recourse to Turkish government) US$17 million US$284 million A$230 million 53/15/32b 50/50 80/20 BB A+ AAA 8.5-year commercial bank loan with limited recourse to Banobras 10-year project finance loan from Public Bank Bhd(non-recourse) 15-year commercial loans (State government stands behind Sydney Water Corp. payment) Capital markets, corporate finance, European Investment Bank, andother sources
60/40
BB
85/15
Chihuahua, Mexico BOT (1994) Johor, Malaysia BOT (1992) Sydney, Australia BOO (1993) England and Wales Full privatization (1989)
US$5.24 billion
25/75
AAA
a. Ministry of International Trade and Industry of Japan. b. Debt/equity/grant. Source: Haarmeyer and Mody 1998.
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Sources of Debt
In countries with weak sovereign credit ratings, financing has been provided by multilateral and export credit agencies. These agencies are generally in the best position to shoulder political and regulatory risk, and thus provide long-term finance at reasonable rates. The US$9 million Chase Manhattan Bank loan to the Chihuahua BOT project, which received no multilateral or bilateral funding but did receive grant and credit support from Banobras, is a rare case of commercial bank participation. In a similar BOT project in Puerto Vallarta, Mexico, the International Finance Corporation provided debt finance backed by a revolving and irrevocable letter of credit from Banobras. In countries with high sovereign credit ratings, projects have been financed by domestic commercial bank loans. The BOT project in Johor, Malaysia, and the BOO project in Sydney, Australia, were financed by commercial debt. As a result of the project structure (existing cash flows) and Malaysias highly developed capital market and relatively low interest rates, the Johor project was financed entirely with local debt. The Sydney project had both local and offshore financing. The limited capital market financing of water and sanitation indicates that individual investors are not in a position to accurately evaluate and mitigate the risks. But as the experience of the English and Welsh water companies shows, projects can be expected to access capital markets as their cash flows to support debt service become more stable and certain and independent regulatory agencies are established. The English and Welsh companies have drawn on a variety of financing sources, including the bond markets. Anglian Water, one of the ten privatized water companies, reflects the low risk profile of more mature water utilities. In 1990 the company floated a twenty-four-year bond issue priced at just fifty-three basis points over UK Treasury gilts due November 2006. Standard & Poors based its AA rating of the 150 million Eurobond on Anglians robust financial profile and stable operating environment, which should provide the company with a fair degree of insulation from the impact of key regulatory and political risks going forward. The English and Welsh companies have also taken advantage of low-cost loans from the quasi-governmental European Investment Bank.
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Equity Financing
Although debt is generally cheaper than equity, a long-term equity stake by the sponsor (which is sometimes also the operator) ensures that management has a long-term interest in the project and that cash flow growth leads to capital appreciation. Equity also reduces the debt service burden on the cash flow, which can be especially important in a projects early development phase. Equity has been provided largely by sponsors. For large projects especially, equity, like debt, is often sourced from multiple consortium members, both international developers and local investors. The Buenos Aires concession, for example, has four international shareholders and four local shareholders (including the utilitys employees). Lenders like to see sponsors achieve a reasonable return on their investment, to ensure that sponsors have adequate incentive to maintain support for the project, at least through the life of the loans. Equity holders partially shield lenders, because the lower priority of their claims on a projects revenues means that they will absorb unexpected shortfalls in revenue. In full concessions and privately owned utility companies internal cash generation can provide an important source of equity for financing investment. Although information on the return on equity for project sponsors is not widely available, the return can be expected to vary with project risk and cash flow profiles. In two of the cases discussed here, returns to investors are regulated: The Malaysian government has guaranteed returns of 14 to 18 percent on investment in the national sewerage project; actual returns are currently at 12 percent because the concessionaire failed to achieve a 90 percent tariff collection rate. For the English and Welsh water companies, the returns on regulatory capital (the assets of the core business) were 11.5 percent in 1995-96 and 12 percent in 1994-95. According to Ofwat, the UK water company regulator, these returns are expected to fall as the water companies become more established and capital expenditures decline. To compensate for the greater country and political risks, required returns in most developing country projects are likely to be significantly higher and closer
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to those in other infrastructure sectors. For a sample of power projects in Asia and Latin America, Baughman and Buresch (1994) estimated the equity return at between 18 and 25 percent. And for privately financed toll roads, Fishbein and Babbar (1996) found that investors expect annual returns to range between 15 and 30 percent.
Conclusion
The challenge for the future is in mitigating the non-commercial risks that characterize the sector and moving beyond the limited capacity of third parties. Part of the solution lies in generating better information about these risks so that they are more transparent and their costs are more fully recognized by parties that can mitigate them. Two tracks to achieve this end are independent regulatory agencies and competitionfor the market and for rights to supply individual customers, as in England and Wales. (David Haarmeyer (david.haarmeyer@ stoneweb.com), Stone & Webster Consultants, Boston, and Ashoka Mody (amody@worldbank. org), Project Finance and Guarantees Department.) (For comments contact Suzanne Smith, editor, Room F6p-188, The World Bank, 1818 H Street, NW, Washington, D.C. 20433, or E-Mail: ssmith7@worldbank.org)
References
1 Baughman David, and Matthew Buresch. (1994). Mobilizing Private Capital for the Power Sector: Experience in Asia and Latin America. US Agency for International Development and World Bank, Washington, DC. Fishbein Gregory, and Suman Babbar. (1996). Private Financing of Toll Roads. RMC Discussion Paper 117. World Bank, Resource Mobilization and Cofinancing Vice Presidency, Washington, DC. Haarmeyer David, and Ashoka Mody. (1998). Tapping the Private Sector: Approaches to Managing Risk in Water and Sanitation. RMC Discussion Paper 122. World Bank, Resource Mobilization and Cofinancing Vice Presidency, Washington, DC.
246
20
World Bank Project Finance Group
Hub Power Company (HubCo), was established by private developers in Pakistan to own and operate the power station. The sponsors, which led the development and negotiation process, were Xenel Industries of Saudi Arabia and National Power of the UK. HubCo will build, own and operate the conventional, oil-fired steam plant. The transmission interconnection between the plant and the national power grid is being handled by the Water and Power Development Authority (WAPDA), partially financed by a Bank loan. Hub is important to Pakistan for several reasons. In addition to being the largest private sector project in the country, it demonstrates investor confidence in the expansion of the private sectors role in infrastructure development. The project also played a significant role in the formulation of the Governments long-tem strategy to attract private investment to the power sector and the development of model independent power contracts. As a result, several follow-on projects are expected to be completed relatively quickly. Finally, the project will expand Pakistans generating capacity by approximately 20% and ease power shortages that currently constrain economic growth.
Source: http://siteresources.worldbank.org/INTGUARANTEES/Resources/HubPower_PFG_Note.pdf. Originally published as World Bank Guarantee Sparks Private Power Investment in Pakistan: The Hub Power Project, June 1995. World Bank Publication. Reprinted with permission.
247
The Hub Power Project

The Hub Power Project marks the first use of a World Bank guarantee for a private sector project, and is a major step forward in the Banks effort to increase private sector investment in infrastructure. In addition, the project sets several milestones for the Bank: First use of a partial risk guarantee; Largest private sector infrastructure project supported by the Bank to date; First Bank-financed infrastructure fund to support private sector projects;and First co-guarantee with another financial institution, the Japan Export-Import Bank. Financial closure occurred in January 1995, putting into place nearly US$1.8 billion in equity and long-term debt financing, required to refinance construction bridge loans and complete the project. Construction of the 1,292 megawatt power plant began in early 1993, and is expected to be completed by 1997. The project is located about 40 kms outside Karachi. The Banks guarantee, which protects commercial lenders against sovereign risks associated with the project, establishes a new method of supporting build, own, operate (BOO) projects which are normally financed on a project finance or limitedrecourse basis. Prior to Hub, Bank guarantees were utilized as cofinancing instruments, designed to help mobilize commercial funding for Bank-supported public sector projects. It is expected that the Bank guarantee for the Hub project will serve as a model for future guarantees in support of other BOO projects. What is Project Finance?
Project finance, sometimes referred to as limited-recourse finance, refers to financing structures under which lenders look to project cash flows for debt repayment and to project assets for collateral. In deciding whether or not to lend to a project, a lender bases its decision on an evaluation of a project's-not the sponsors-creditworthiness. In the event of default, the liability of project sponsors is limited to their investment in a project.
Project Overview
Bank involvement in the project dates back to the late 1980s, when Pakistan initiated an energy sector adjustment program with Bank assistance. A key element of the
248
program was the opening of the power sector to private investment To this end, the Bank, along with several bilateral donors, established the Private Sector Energy Development Fund (PSEDF). PSEDF, a Government-owned facility, provides debt financing of up to 30% of the financing needs of private sector energy projects. Project sponsors are expected to mobilize 20-25% equity and raise the remaining 45-50% of the funding in domestic and international financial markets. A special-purpose project company, Hub Power Company (HubCo), was established by private developers in Pakistan to own and operate the power station. The sponsors, which led the development and negotiation process, were Xenel Industries of Saudi Arabia and National Power of the UK. HubCo will build, own and operate the conventional, oil-fired steam plant. The transmission interconnection between the plant and the national power grid is being handled by the Water and Power Development Authority (WAPDA), partially financed by a Bank loan. Hub is important to Pakistan for several reasons. In addition to being the largest private sector project in the country, it demonstrates investor confidence in the expansion of the private sectors role in infrastructure development. The project also played a significant role in the formulation of the Government's longtem strategy to attract private investment to the power sector and the development of model independent power contracts. As a result, several follow-on projects are expected to be completed relatively quickly. Finally, the project will expand Pakistan's generating capacity by approximately 20% and ease power shortages that currently constrain economic growth.
Financing Structure
The total financing of US$1.8 billion includes US$1.7 billion equivalent in foreign exchange and about US$100 million equivalent in local costs. The capital structure is 20% equity and 80% debtthe debt is mobilized on a project finance basis. Included in the financing plan are costs associated with the turnkey construction contract, development costs, interest during construction and other finance related costs, as well as a reserve contingency fund. The Sponsors contributed a significant portion of the projects total equity. Other equity sources include Commonwealth Development Corporation (CDC)
249
of the UK, Entergy, Xenergy and other offshore and local investors. An innovative feature of the projects financial structure is the US$ 102 million global depositary receipt (GDR) issue underwritten by Morgan Grenfell, UK, the first GDR issue for an independent power project. The amount of debt financing required for the project (US$ 1.4 billion) necessitated that it be raised from a variety of sources, including PSEDF, foreign commercial banks supported by partial risk guarantees from the World Bank and J-Exim, and political risk insurance from export credit agencies of France, Italy and Japan, local commercial banks, and CDC. Other large private sector infrastructure projects will likewise be obliged to obtain debt financing from many different sources, given the exposure limitations of lenders, insurers and guarantors. Funding Structure
World Bank/ J-Exim Guarantee $360 Commercial Banks $695 PSEDF* Subordinated Loan $602 Hub Power Company (Project Cost: US$1.8bn) $163 Other Local and Offshore Lenders * World Bank, J-Exim, France, Italy, Others. $372 Equity Investors Export Credit Agency Insurance $335
Contractual Framework
A key element of project finance is the apportioning and allocation of risks, a difficult and complex process even in developed countries. In a developing country such as Pakistan, the process is substantially more difficult. There is often a lack of precedents to build on, and the process is further hampered by an undeveloped legal regulatory environment.
250
Under Hubs commercial arrangements, project-specific risks (completion, performance operation and underwriting risks) are assumed by equity investors and lenders, while sovereign-or political-risks are assumed by the Government (GOP) and its agencies. These risks are identified and allocated via the projects contractual framework, which comprises the following main agreements: Implementation Agreement (IA) Overall project implementation is being undertaken within the provisions of this 30- year agreement between HubCo and GOP. The IA grants HubCo the sole right to develop the project and defines each partys responsibilities during the construction and operation phases of the project. Power Purchase Agreement (PPA) The PPA, which secures the projects revenue streams, is the most important commercial agreement. The 30-year agreement also defines the interface between HubCo and WAPDA. Fuel Supply Agreement (FSA) Fuel supply is secured through this 30-year agreement between the Government owned fuel supplier, Pakistan State Oil Company, and HubCo. Operation & Maintenance Agreement (OMA) The OMA between HubCo and National Power International (a subsidiary of National Power, UK) has an initial term of 12 years and provides for operation and maintenance of the plant according to agreed terms and technical criteria. Construction Contract A fixed-price, date-certain turnkey construction contract between HubCo and a consortium led by Mitsui 7 Company of Japan was signed in 1991. In addition to Mitsui, the consortium includes Ishikawajima-Harima Heavy Industries Co., Ltd. of Japan, Ansaldo GIE, S.R.I. of Italy and Campenon Bernard SGE-SNC of France. Other Agreements Several other agreements/provisions are integral components of the contractual arrangements of the project. These include: (i) escrow agreements for local and offshore escrow accounts; (ii) foreign exchange risk insurance
251
provided by the State Bank of Pakistan for a fee included in the project cost; and (iii) a shareholders agreement and related corporate documentation
Bank Guarantee
To match project revenues with debt service, long-term financing is critical to the viability of power (and other infrastructure) projects. However, due to its poor credit standing, such long-term financing was inaccessible to Pakistan. Commercial lenders needed a creditworthy third party to back commitments made to the project by the Government of Pakistan to enable them to make long-term loans hence the need for the World Bank Guarantee. The Bank is providing a partial risk guarantee to a syndicate of international commercial banks. The guarantee covers, on an accelerable basis, principal repayments for up to US$240 million in loans. It would be triggered if GOP noncompliance with one ormore of its obligations, as outlined in project contracts, resulted in a default in the repayment of the loans. Specifically, these obligations are delineated in the project agreements (IA, PPA, FSAsee above). The US$120 million J-Exim co-guarantee is of an identical structure. The 12 year maturity of the projects commercial loan financing is a major achievement, considering that prior to Hub, Pakistans access to international credit markets was limited to shortterm trade credit and medium-term aircraft financing. Accelerability and Guarantees
If a loan is accelerable, lenders can demand payment of the unpaid balance if specified events of default occur. Under an accelerable guarantee, the unpaid balance of guaranteed exposure (which could be different than the unpaid balance) would be payable by the Bank upon call of the guarantee. Prior to call of the guarantee, however, all remedies specified in project agreements must exhausted. In contrast, under a nonaccelerable guarantee, each individual payment is, in effect, guaranteed, and the guarantee would be called each time a payment default occurs.
There are three main categories of risk covered by the Bank and J-Exim guarantees: (i) GOP guarantees of obligations (payment and supply) of state-owned entities, including WAPDA and PSO; (ii) GOP payment obligations specified in the Implementation Agreement, including payments resulting from occurrence of certain force majeure events ( force majeure events can be political events, such as war of civil strife, or natural events, such as lightning outside plant boundaries); and (iii) provision and transfer of foreign exchange through the Foreign Exchange Risk Insurance Scheme provided by the State Bank of Pakistan.
252
Risks guaranteed by the Bank were translated in GOP payment obligations so that the exact cause of a debt service default can be determined, and hence, what constitutes a legitimate call of the guarantee, is well-defined. The Bank entered into Guarantee Agreement with the commercial banks, which outlines the coverage and mechanics of the Banks guarantee. In parallel, the Bank entered into an Indemnity Agreement with GOP which counterguarantees the Bank for any disbursement made under the terms of the Guarantee Agreement. (A counterguarantee is a requirement of the Banks Articles of Agreement; it takes the form of an indemnity agreement.) The Banks US$240 million commitment under the guarantee was counted at 100% in the lending program, i.e., as if the Bank had made a loan, because the Bank is providing coverage on the whole loan amount (against certain risks). The commercial banks, despite the breadth of the Banks guarantee, are assuming substantial risks, including those associated with construction and completion of the project and on time and efficient plant operation. Construction cost overruns and delays, depending on their severity, would first erode returns to equity and could also jeopardize debt service. Although the debt-equity ratio grants debt providers a cushion of 20% (standby facilities are also available), lenders are still at risk in the event of a shortfall in project revenue. Cost overruns and/or inefficient management of the project during operation also could lead to debt service default. Security Structure
World Bank
Counterguarantee Government of Pakistan Pakistan State Oil Company National Power Plc O&M Agreement
Fuel Supply Agreement Hub Power Project
Implementation Agreement
Guarantee Agreement
State Bank of Pakistan
FX & Transfer
Power Purchase Agreement WAPDA Cash Flows
Construction Contract
Construction Consortium
Commercial Lenders
Offshore Escrow Account
Domestic Escrow Account
253
Bank Guarantees and Private Sector Projects

In order to streamline its appraisal of private sector projects involving Bank guarantees and shorten project development time, the Bank intends to capitalize on project reviews by other project participants. To this end, the Bank can incorporate third-party project assessments into its own appraisal. For instance, since commercial lenders will assume construction and performance risks of a project, they will closely scrutinize the projects technical and financial characteristics. If it finds them satisfactory, the Bank could incorporate the results of the analysis into its own appraisal. The Banks partial guarantee covers debt service default caused by nonfulfillment of government contractual obligation to a project. Therefore, risks covered by a Bank guarantee need to be clearly defined in the commercial contracts which set out the risk sharing allocation for a build, own, operate project. To allow the Banks guarantee to voucher these risks, they must be translated into government payment obligations. In the case of government guarantees of payment obligations of state-owned entities, this is relatively easy to quantify since payments are related to the provision of a service at a specified price. For other government obligations which could jeopardize project cash flows, such as the granting of permits, or political force majeure, this quantification becomes more difficult, This may be handled, as in Hub, by linking government defaults related to these events to the payment of fixed amount (defined in the Power Purchase Agreement as the capacity purchase price) which covers fixed costs, including debt service. In summary, the Banks guarantee can act as an important catalyst for mobilizing private sector financing for private sector infrastructure projects. As exemplified by the Hub Power Project, not only does the Bank guarantee provide coverage for a part of the debt financing, but the presence of the Bank in the project enhances the projects attractiveness to other providers of capital, both debt and equity. (For more information on the Hub Power Project and the Banks partial risk guarantee, please contact Suman Babbar, CFSPF (ext. 32029) or Per Ljung, SA1EF (ext. 81933)
254
21
Insurance Funds to Flow into Road Projects-LIC Finalising Loan Pact with NHDP
P Manoj
Insurance funds are set to be ploughed into the highways sector for the first time, with the National Highways Authority of India (NHAI) and Life Insurance Corporation (LIC) finalising the terms for a long-term loan agreement of Rs.6,000 crore, to part-fund the Rs.58,000-crore National Highways Development Project (NHDP).
ccording to the terms of the loan agreement to be signed in June, LIC would provide a maximum of Rs.6,000 crore or a minimum of Rs.4,000 crore to NHAI to be availed of in eight quarters as per a schedule to be drawn up. The 25-year loan with a moratorium of ten years will be repaid in 30 equal semi-annual instalments beginning from the second half of the tenth year to the terminal year of the loan. The LIC loan will carry an interest rate on par with Government of India Securities (G-Sec) plus 100 basis points. Besides, NHAI will pay a commitment
Source: http://www.blonnet.com/2003/05/25/stories/2003052501630100.htm. May 2003. @ Businessline, Reprinted with permission.
Insurance Funds to Flow into Road Projects-lic Finalising...
255
fee of 0.10 percent per annum of the funds to be disbursed in a particular financial year, a penalty fee of 0.25 percent per quarter of the amount undrawn out of the minimum agreed disbursement, for any quarter and expenses relating to listing. The debt will be drawn by issuance of bonds, which will be listed in the wholesale debt segment of the National Stock Exchange. Each bond carries a face value of Rs.1 crore and will be issued in demat form. The debt servicing obligations of the NHAI will be backed by a contingent Government of India guarantee, on an unconditional and irrevocable basis for which the highway authority will pay a guarantee fee of 0.25 percent every year to the Finance Ministry. All these elements will translate into a cost of less than 8 percent. Considering that such long-term loans are not available in the market, at this maturity, the cost is very competitive, a senior NHAI official said. LIC will have pari passu first charge on the funds assigned to NHAI from the Central Road Fund made up of the cess on petrol and diesel. The cess funds would be utilised to service the debt obligations of NHAI through an escrow mechanism operated by a suitable trustee, the official said. The loan agreement also contains a provision to review the G-Sec rates after seven years. Apart from ensuring a steady stream of funds to finance the NHDP, the LIC loan also fulfils a Government strategy to channelise insurance money to built highways, port and railway projects.
Index
257
Index
A
Active Traders, 151 Adjusted Present Value, 85 Africa, 95, 143, 145, 154, 155 Agency Costs, 10, 11 Agency Fee, 147, 148 Antifiling Mechanism, 186, 187 Argentina, 15, 39, 125, 143, 200, 201, 203, 205, 207, 209, 212, 217, 221, 222, 234, 235, 237, 242 Arrangers, 145, 148, 154, 156 Asia, 16, 19, 95, 143, 150 Asia-Pacific Region, 153, 154 Asset-Backed Securities, 9 Asymmetric Information, 12, 68 Austria, 155
C
Callable Debt, 123 Capital Markets, 20, 31, 32, 34, 44, 47, 51, 98, 129, 165, 168, 200, 202, 204, 206, 207, 211, 215, 216, 219, 220, 229, 232, 233, 238, 242, 243 Casablanca, 237 Cash Deficiency Agreement, 64 Cash-Sweep, 114, 117, 118, 120, 123 Cash-Trap, 121 Chile, 30, 32, 37, 38, 110, 123, 199-203, 205-207, 209, 212, 216, 217, 219-222, 237 Collateral, 6, 7, 11, 23, 38, 41, 44, 45, 108, 110, 149, 151, 174, 177-179, 185-187, 190, 193, 236, 240, 247 Collateralized Debt Obligations, 153 Completion Risk, 3, 5, 35, 62, 173 Concession Agreements, 18, 40, 55, 65, 97, 98, 179 Concessionaire, 41, 43, 240, 244 Consolidation Risk, 28, 31, 35, 40, 108 Contingent Liabilities, 43, 131, 133-137 Contingent, 29, 43, 131-137, 255 Contract Enforcement, 25, 29, 30 Contract Finance, 60 Cost-of-Service Agreement, 64 Counterparty Exposure, 175, 187
B
Bond Financing, 142, 234 Bond Market, 32, 55, 144, 154, 234, 243 Brady Plan, 143 Brazil, 30, 33, 34, 129, 143, 199, 201, 205, 209, 212, 217, 221, 222 Build-Operate-Transfer (BOT), 65, 240 Build-Own-Operate (BOO), 65 Build-Transfer-Operate (BTO), 65 Bullet or Balloon Repayments, 116
258
Covenants, 10, 21, 23, 34, 36, 40, 63, 104, 107, 112, 114, 120-122, 144, 149, 151, 161, 169, 187 Credit Default Swap, 144 Credit Derivatives, 100, 151 Credit Enhancements, 25, 28, 33, 46, 174, 175, 234 Credit Lease, 177, 180, 183, 185, 188, 190 Credit Ratings, 174, 188, 189, 196, 243 Credit Risk, 23, 25, 27, 28, 42, 44, 45, 47, 60, 62, 63, 93-95, 99, 101, 105, 110, 123, 133, 142, 144, 145, 147, 149, 162, 167, 169, 179, 236 Cross-Border Debt, 177, 178 Currency Risk, 16, 137, 193, 240 Currency Swaps, 188
Electric Utilities, 12, 225 Emerging-Market, 32, 33, 47 Entertainment, 58, 173 Equator Principles, 158-162 Escrow, 62, 67, 250, 252, 255 Europe, 95, 96, 114, 115, 144, 145, 150, 152, 153, 155, 199, 201, 205, 207, 218, 220, 235 European Bank for Reconstruction and Development, 235 European Investment Bank, 242, 243 Exchange Rate Risk, 124-130 Expropriation, 22, 40, 97, 100, 239
F
Financial Distress, 3, 5, 11, 68, 100 Financial Risk, 3, 5, 66, 82, 133, 176, 189, 190 Financial Sector Reforms, 32 Force Majeure, 62, 64, 174, 175, 193, 194, 196, 251, 253 Foreign Direct Investment (FDI), 52 Foreign Exchange Reserves, 54 Foreign Exchange Risk, 130, 178, 190, 191, 198, 210, 250, 251 France, 93, 155, 249, 250 Free Cash Flow, 10, 11, 62, 78, 79, 97, 99 Funding Gap, 26, 27, 44
D
Debt Market, 25-29, 32, 37, 38, 44, 46, 107, 109, 123, 150 Debt Service, 8, 10, 11, 29, 30, 34, 36, 39, 41, 42, 44, 45, 47, 62-65, 67, 94, 129, 174, 175, 177, 189, 191, 243, 244, 251-253 Debt-Service Coverage Ratios (DSCRs), 189 Debt-Service Reserve Fund, 45, 47, 194, 196 Debt-Service Reserve Account (DSRA), 114 Design-Build-Operate, 33 Dispute Resolution, 30 Domestic Resource Cost (DRC), 75 Dominican Republic, 228 Due Diligence, 40, 45, 207, 235
G
Gabon, 237 Generally Accepted Accounting Principles (GAAP), 165 Global Depositary Receipt, 249 Golden Quadrilateral (GQ), 53 Governance, 16, 99, 210
E
Economic Rate of Return (ERR), 70-72, 76 Economic Value, 35, 73, 74, 111
Index
259
Government Guarantee, 23, 29, 42, 226, 241, 253 Grant Funding, 236 Greenfield Projects, 15, 24, 130, 203, 207, 240 Guaranteed Investment Contracts (GICs), 45 Guatemala, 228, 235
International Finance Corporation (IFC), 72, 160 Involuntary Bankruptcy, 35, 36, 40, 41 IPP, 225-231 Italy, 155, 249, 250
J
Japan, 144, 145, 155, 242, 247, 249, 250
H
Hedging, 55, 126, 127, 166, 188 Hell-or-High-Water Contract, 177, 180, 183, 185, 188, 190 Hong Kong, 153 Hungary, 15
K
Korea, 30-32, 38
L
Latin America, 34, 95, 130, 131, 143, 145, 155, 157, 195, 198-201, 204, 205, 207, 208, 210-212, 216, 218-221, 245 Lead Managers, 145 Lease Rental Expense, 170 Legal Framework, 25, 29-31, 38, 98 Lender Rights, 31 Leverage Ratios, 12, 59, 99, 101 Life Insurance Corporation (LIC), 254 Limited Liability Corporation, 37 Little Mirrlees Approach (LM), 73 Loan Portfolio, 44, 45, 119, 151, 153
I
Indenture, 41, 115, 123, 169, 177-179, 185 India, 3, 4, 13, 25, 47, 51-56, 58, 65, 68, 75, 81, 89, 93, 103, 159, 254, 255 Infrastructure, 3-5, 13-15, 18, 19, 25-30, 32-38, 42, 44, 46-48, 51, 52, 54-58, 60, 61, 65, 67, 68, 70, 71, 78, 80-82, 84, 86, 88, 93, 94, 96, 98, 101, 108, 110, 116, 117, 119, 124, 125, 128-131, 133, 134, 137, 159, 174, 192, 195, 197222, 234-238, 241, 245-249, 251, 253 Insolvency, 30, 184, 187 Institutional Bond Investor, 25, 26 Institutional Risk, 175, 192 Inter- American Development Bank, 150, 197, 219 Interest Rate Risk, 118 Inter-Institutional Group (IIG), 54 International Arbitration, 178 International Development Banks, 26
M
Maintenance Reserve Account (MRA), 114 Malaysia, 233, 235, 241-243 Mandated Arrangers, 145 Market Risk, 18, 61, 63, 97, 99, 133, 165, 173, 177, 182, 183, 195 Market-Makers, 151 McKinsey, 52 Mexico, 30-34, 36-38, 142, 143, 200-202, 204-206, 209, 212, 221, 222, 241-243
260
Military Housing, 173 Modified Internal Rate of Return, 84 Multilateral Agencies, 46, 61, 150, 193, 194, 216 Multilateral Investment Guarantee Agency, 193 Multiproject Financing Facility (MPF), 235 Municipal Infrastructure, 234
Petrochemicals, 97, 100 Philippines, 20, 103, 143, 228, 235 Political Risk Guarantees, 94, 100, 102, 104, 105 Political Risk, 3, 5, 31, 32, 34, 35, 42-44, 94, 97, 100-106, 133, 188, 210, 217, 238, 239, 243, 244, 249, 250 Pooled Financings, 28 Portfolio Performance, 55, 200 Power Purchase Agreement (PPA), 250 Power Sector, 95, 110, 116, 226, 227, 230, 231, 245, 246, 248 Prepayment Fee, 147, 148 Private Pension Funds, 197, 199-201, 207-209, 218-221 Private Sector Risk, 35 Privatizations, 9, 16, 26, 30, 31, 34, 130 Project Debt Rating, 175, 191 Project Finance Market, 3, 12, 13, 21, 95, 121 Project Financing Structures, 10, 11, 13, 55, 57, 58, 97, 100 Project Risks, 10, 22, 68, 97, 196 Project Sponsors, 5, 18, 20, 24, 61, 64, 66, 67, 82, 126, 173, 194, 195, 226, 231, 239, 244, 247, 248 Public Utility Regulatory Policy Act (PURPA), 7, 16 Public-Private Partnerships, 25, 27, 29, 99
N
National Highways Authority of India (NHAI), 254 National Stock Exchange, 255 Natural Gas Pipelines, 235 Network Effect, 78, 79 New Zealand, 117, 121 Non-recourse, 5, 7-9, 12, 14, 17, 55, 58, 59, 61, 68, 94, 95, 98-101, 109,175, 176, 187, 195, 203, 226, 241, 242
O
Offtake Agreement, 23, 97, 98, 108, 177, 178 Oil and Gas, 18, 97, 108, 110, 159, 173 Open-Ended Funds, 100 Operating Agreement, 38, 39 Operating Risk, 23, 99, 166, 177 Organization for Economic Cooperation and Development (OECD), 26 Overseas Private Investment Corporation, 129
R
Ratings, 25, 27, 45, 48, 96, 104, 105, 112, 118, 121-123, 144, 164, 165, 168, 171, 174, 181, 182, 188, 189, 192, 193, 195, 196, 201, 202, 213-215, 217, 243 Raw Material Supply Contracts, 64, 100 Real Estate, 6, 100, 164, 165, 179, 202, 208, 222
P
Pari Passu, 42, 112, 255 Pension Asset Management, 204 Pension Funds, 61, 129, 144, 197-201, 203, 205-221
Index
261
Real Options, 80, 87, 88, 100 Refinancing Risk, 107-123, 169, 189 Refineries, 58, 100, 194 Republic of Congo, 237 Residual Value Guarantee, 168-171 Revolving Loan, 129 Risk Contamination, 68, 99 Risk Identification, 133 Risk Management, 12, 13, 20, 23, 55, 68, 131-133, 137, 144, 162, 166 Risk-Return Trade-Off, 55
Syndicated Loans, 24, 94, 141-145, 147, 150, 151, 156, 157 Synthetic Lease, 164-171
T
Take or Pay Contract, 63, 65 Take-if-Offered Contract, 63 Technical Risk, 181 Telecom, 9, 12, 58, 81, 88, 93, 95, 96, 211, 212, 237, 241 Throughput Agreement, 64, 67 Toll Road, 4, 34, 40, 96, 109, 110, 116, 119, 122, 123, 193, 194, 245 Tolling Agreement, 64 Transport, 12, 51-53, 58, 68, 75, 81, 88, 108, 117, 119, 121, 145, 173, 182, 211, 217, 218, 220, 234, 240 Trust Estate, 37 Trustee, 28, 37-43, 67, 177, 178, 184, 187, 255
S
Secondary Market, 105, 141, 144, 148, 150-154, 156 Securitization, 9, 28, 31, 38-40, 100, 207, 215, 222 Shadow Prices, 73, 74, 76 Slovenia, 236, 237 Sovereign Risk, 174, 175, 191, 193, 247 Spain, 116, 155, 201, 205, 222 Special Purpose Entity (SPE), 165, 167, 184 Special Purpose Vehicles (SPVs), 59, 95 Speculative Development, 66 Stakeholder Analysis, 70, 76 State Revolving Funds (SRFs), 45, 236 Step-up Provisions, 64 Structured Finance, 38-40, 58, 107, 108, 119, 122, 193, 196 Subordinated Debt, 8, 21, 67, 112-114, 171, 190, 191, 231 Supplemental Credit Arrangements, 63, 66 Supply or Pay Contract, 64 Surety Bonds, 179, 188
U
US Agency for International Developments USAID, 25, 47, 245, Underwriting, 45, 142, 147, 148, 156, 157, 250 UNIDO Approach, 73, 74 United Kingdom (UK), 93, 103, 114, 117, 130, 145, 154, 155, 176, 187, 195, 198, 201, 205, 207, 214, 222, 230, 237, 243, 244, 246, 248-250 United States (US), 6, 7, 16, 25, 26, 32, 37, 39, 45, 47, 64, 66, 85, 89, 95, 96, 103, 106, 110-112, 116, 118, 119, 123, 129, 134, 142-147, 150-157, 160, 161, 172, 173, 186, 195, 199-201, 204, 206, 208, 209, 211, 212, 214, 216, 218, 220, 225,
262
227-230, 234-237, 242-245, 247-249, 251, 252 User Fees, 27, 34, 39, 41, 42, 45, 47 Utilisation Fee, 147, 148
W
Water and Sanitation Pooled Fund, 25, 47 World Bank, 4, 55, 61, 76, 102, 124, 130, 131, 137, 158, 161, 162, 211, 212, 220, 225, 231, 232, 238, 239, 245-247, 249, 251, 252 Wraparound Addition, 66
V
Venezuela, 143, 200 Venture Capital, 206 Voluntary Bankruptcy, 35, 40, 187

Project Finance Concents and Applications

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Project Finance Concents and Applications

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Padmalatha Suresh holds a post-graduate diploma in Management from the Indian Institute of Management, Ahmedabad, as well as a degree in Law.

ICFAI Books An Introduction

The ICFAI University Press

Project Finance Concept and Applications

The Project Finance Market An Overview

Project Finance in Developing Countries The Importance of Using Project Finance

Public-Private Partnerships: The Next Generation of Infrastructure Finance

How Project Structures Create Value

Structure Matters in Project Finance

Assessing the Economic Impact of Infrastructure Projects The ERR

Complexities in Valuing Large Projects

Managing Project Risks

Refinancing Risk Permutations of Project Finance Structures

Exchange Rate Risk

Equator Principles Why Indian Banks Too Should be Guided by Them

14. 15. 16.

164 172 197

Project Finance: Debt Rating Criteria

Pension Funds In Infrastructure Project Finance: Regulations and Instrument Design

Applications and Cases

Pooling Water Projects to Move Beyond Project Finance

Financing Water and Sanitation Projects The Unique Risks

Successful Project Financing HUB Power Project

Project Finance: The Need to Treat Large Projects Differently

The Project Finance Market: An Overview

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Project Finance: The Need to Treat Large Projects Differently

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Rationale for Project Finance

Project Finance: The Need to Treat Large Projects Differently

Defining Project Finance

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Evolution Of Project Finance

Credit/ Contract Support Third Party Participants

Project Finance: The Need to Treat Large Projects Differently

Figure 2: Non-Recourse Project Finance Structure

Loan Repayment Loan

Project Assets Collateral

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Features of Project Finance

Project Finance: The Need to Treat Large Projects Differently

Comparison of Project Finance With Other Financing Vehicles

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Comparison of Project Finance With Conventional Corporate Finance

Project Finance: The Need to Treat Large Projects Differently

The Flip Side of Project Finance

PROJECT FINANCE CONCEPTS AND APPLICATIONS

The Global Project Finance Market 7

Project Finance: The Need to Treat Large Projects Differently

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Project Finance in Developing...

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Project Finance in Developing...

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Project Finance vs. Corporate Lending

Project Finance in Developing...

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Advantages of Project Finance

Project Finance in Developing...

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Project Finance in Developing...

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Public-Private Partnerships: the Next Generation...