R.

Kannan
MODULE - 1
BASICS OF PROJECT FINANCE
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BASICS OF PROJECT FINANCE
Investment - Investor, IRR, NPV
(Land, Working capital)

Project Finance Process of raising finance for
gross root projects.

How Bankers look at project for financing.

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Project Finance Objectives
1. Identify key risks in the project through due diligence
and develop risk mitigate structures
2. Risk allocation to the various participants who are best
capable of handling it through structured contracts This
depends upon negotiating power and risk premiums
(lower tariff for offtake contract) Risk trade off skills;
No point in allocating risk to a party who cannot sustain
the financial consequences.
3. (a) Quantifying and considering the acceptability of the
residual risks that remains with the company / lenders
(Mitigation, Impact). Transferring all risk not possible
(b) Increasing interest rate is not risk mitigation
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4. Development of security structures to protect lenders
interest.
5. Financial Modelling
6. The project should be structured for risk and priced and
pricing should not be on risk alone
7. Security and Documentation
Project Finance Objectives
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Why Risk is important
Huge upfront cost / Earnings back ended over long
term.
No recourse to promoters
No adequate tangible / saleable security
If we de-risk the project, raising funds from banks
is not difficult.
Invt. Bankers,
Technical & Legal
Advisers
Concession/Licence
Agreement
Insurance
Companies
O&M
Operator
EPC
Contractor
Government
Sponsors
Invt. Bankers,
Technical & Legal
Advisers
Financial
Investors
Users
TRA/Escrow
Agent
Lenders
Project SPV
Advisers
Insurance Policies
O&M
Contract
EPC Contract
Equity
Equity/
Sub-debt
Offtake
contracts
TRA/Escrow
Agreement
Debt
Substitution
Agreement
(Assignment
of interests,
rights etc.)
Advisers
Fuel Supply
Advisers/Experts
Rating agency
Deal
Diagram
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RAS LAFFAN LIQUIFIED NATURAL GAS
COMPANY LTD (RASGAS)
Risk Case Study
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1. 25 year take or pay agreement with Korea Gas
2. Mobil to guarantee minimum price of LNG linked to crude
oil price of $10.40 per barrel
3. Maximum liability of Mobil $200 million
4. Maximum period of guarantee 2009 (10 years)
Risks - Price
Qatar Govt. Mobil Itochu Nissho Iwai
66.5% 26.5% 4% 3%
Equity
LNG project
Security
Trustee
Bond
Trustee
Exim
facilities
Bond
holders
Offshore contractor
Onshore contractor
Drilling contractor
Offtake agreement
Minimum price guarantee
Trustee
agreement
Project
coordination
agreement
Korea Gas
RAS LAFFAN LNG
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Project
Production of 10 million tonnes of LNG from North
field which is worlds largest non associated gas
field 9% of world gas reserves
Project Cost $ million
Drilling 239
Offshore facilities 453
Onshore facilities 1670
Interest during construction 593
Other costs 380
-------
3335
-------
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Project (contd)
Financial Plan
Equity $ million
Qatar Petroleum Company 651 (19.9%)
Mobil 260 ( 8.0%)
Itochu 39 ( 1.2%)
Nisso Iwai 29 ( 0.9%)
979 30%
Debt
Commercial Banks 382 (11.7%)
ECA (US Exim, UKECGD
Italy-Sace) guaranteed loans 703 (21.5%)
Bonds redeemable in 2006 400 (12.3%)
Bonds redeemable in 2013 800 (24.5%)
2285 70%
3264 100%
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Korean Gas, offtaker has an option to take 5% equity
- Bonds were considered because of long duration debt and long
moratorium requirement (6-8 years)
Long term bond yield - 8.294% (U.S. Treasury + 1.875%)
- International investors 20%
- US Investors 80%
- Lead manager Goldman Sachs


Project (contd)
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Project details
RAS LAFFAN LIQUIFIED NATURAL GAS COMPANY LTD (RASGAS)
State of
Qatar
Mobil
Corporatio
n
Itochu/
Nisso Iwai
Facility
agent
Bond
Trustee
Qatar
Petroleum
Corporatio
n
Mobil QM
Gas Inc
Banks ECA Bonds
Ras Gas
Republic of
Korea
Korea
Electric
Power
Corporatio
n
Regional
Governments
Korea Gas
Corporation (Kogas)
Korea Electric Power
Corporation (Kepco)
100% 100%
71% 29%
Equity
28%
Equity 2%
Debt 70%
Offshore Trust
Account (Industrial
Bank of Japan)
Kogas, Kepco enjoy Korea sovereign rating AA
Default probability 1.07%
LNG Supply
50%
34.7%
15.3%
47.4%
52.6%
Operating Cost
Other LNG
Buyers
Condensate
Buyers
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LNG
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a) Offtaker: Korea Gas (Kogas) offtakes 75% of gas and
supplies to Korea Electric Power Corporation (Kepco)

b) Shareholding of Kogas - Republic of Korea
50.0%
- Kepco 34.7%
- Regional Governments
15.3%
-----------
100.00%
-----------

Kogas and Kepco enjoy Korea Sovereign rating AA
according to Standard and Poor
Project details (contd)
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c) Risks in the project
Assets are of little value because of dedicated use
and location
- Spot sales of LNG world over forms only 2% of
sales
- Heavy front end investment in dedicated facilities
- Lack of transportation capacity / lack of alternative
markets
- Demand risk for power (Kogas reduced offtake by
22% during Asian crisis in 1998)
- Price risks
- Quantity risks

Credit spread depends on firm specific contractual
structure.
Project details (contd)
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d) Management of risks (credit enhancement /
contracts)

i) Long term take or pay agreement (25 years) between
Rasgas and Kogas for 75% of production with LNG
price linked to a basket of crude oil
ii) Debt contract between Rasgas and Lenders
iii) Credit enhancement agreement by Mobil to lenders.
Unsecured subordinated revolving loan to meet
shortage of funds for debt service.
- Maximum liability $200M
- Maximum period of guarantee 1999-2009
- Mobils guarantee to be activated if crude oil
price falls below $10.4 per barrel. At 75%
production level and $10.4 per barrel linked price
the revenues would cover operating expenses,
royalties and taxes and debt service. The oil
prices in 1998 fluctuated between $12 to 14 per
barrel.
Project details (contd)
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e) Priority of fund utilisation from offshore account

Royalties and taxes to Qatar Government
(20% of revenue)

Operating Cost

Debt Service

Dividends
Project details (contd)
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f) Standard and Poor estimates the average crude
price to be $10.15 per barrel through the project
life

g) Rasgas input / output flow matrix

Assets a) Take or pay contract proceeds net of costs at NPV
b) NPV of other short term sales of products
c) Contingent debt service guarantee by Mobil

Liabilities a) NPV of royalties and taxes
b) Public debt : Bonds
c) Private debt : Debt from banks and ECAs
d) Equity - Private
Project details (contd)
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h) Unmanaged risks

Quantity - counter party risk (Kogas / Kepco)
Price - Brent crude oil price
Mobil guarantee - Mobil Stock price
Kepco offtake risk - Kepco credit spread / rating
- Kepco stock price
- High oil / LNG prices*
$ / won exchange - Kepcos revenues in Won but debt servicing
in $
risk (fixed exchange rate transformation to
floating)
Korea country risk - Country rating
(Demand for power) - Korea composite stock price index (KOSPI)
Competition - Russian exports
Emerging market risks - Kepco was downgraded from AA to B+
during
Asian crisis but subsequently upgraded to
BBB**
Financial risk - There is a probability that the defaults may
be
over $200 million, occur after 10 years
* While higher oil prices favour Rasgas it could affect
Kepco.
Breakeven price for Kepco is $23 per barrel.
Above this, Kepco will default (Dabhol)

** Default probability: AA 1.07%; BBB 4.48%
Project details (contd)
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Types of Financing
Finance
Corporate/Balance
sheet financing
Assets based
financing
Project
financing
(Based on companys
financial position)
(Based on value of
Assets [Real Estate])
(Value of cash flows)
Why companies promote separate companies for large
projects?
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Project Financing versus Corporate
Finance
Project Financing Corporate Financing
a) Financial Plan Important; Difficult to change
during the loan tenure as it is
governed by contracts
Generally assumed to
be independent. Can be
changed at any time
during the tenure of the
loan
b) Repayment risk The repayment only out of cash
flows of the project. No sponsor
support. The financing is off
balance sheet.
Repayment out of
companys overall
earnings. Sponsor
support is possible
c) Security The security would include
intangible assets such as rights,
assets and interests.
(Overbridge, Airports, Toll
Road)
Normally either
unsecured or security of
tangible assets
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Project Financing Corporate
Financing
d) Quantum and tenure
of assistance
Usually large
8-10 years
Variable
e) Risk levels High, because of
uncertainty of project
cash flows
Low as the
companys working
data is available
f) Risk mitigation Through structured
financing and
contractual
commitments
-
g) Participants Project developers,
Governments
Engineers,
Contractors,
Equipment suppliers,
Fuel suppliers,
Product offtakers
Only lenders and
CEO


Project Financing versus Corporate
Finance
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Characteristics of Project Finance
Project is a separate legal entity / special purpose
vehicle Ring fenced
Sometimes a Special Purpose Vehicle (SPV), where
each sponsor takes his share of rewards and meets his
share of expenses and project funding is availed by
sponsors Oil SPVs
Project revenue, the only source of loan servicing,
equity return limited recourse.
No sponsor credit support; sponsors shift debt
servicing to the project
Lenders to have a high degree of confidence in the
project cash flows
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Financial package is custom built
Risk is allocated to the party that can handle
it better with negotiated rewards (through
contracts), its credit worthiness, its role in the
project
Debt is of long term tenure
Financial plan takes into account taxation,
exchange controls, enforceability of claims
etc.
The borrowing structure is enforceable
contract driven with covenants
Characteristics of Project Finance
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Credit enhancement through contracts
(offtake agreement, contingent guarantees)
High cost of syndication;
Syndicated loans
Private public partnerships / FDI
Large size loans to be viable
High leverage
Characteristics of Project Finance
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a) Competition resulting in - Price erosion
- Lowering of security
requirements
- Not checking enforceability of
conditions / contracts
- Extension of maturities
- Higher credit risk

b) Competition is not - Skill development
adequately resulting in - Appointment of consultant

c) Increasingly becoming like corporate finance
Problems in Project Finance
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d) Higher NPA will block future project financing, lead to risk
averseness as lenders leverage is high
e) Lenders have only downside and no upside
f) i) Syndication groups aggressive price no risk
perception
ii) Relationship groups a cost & service centre; Pursues
a deal aggressively
iii) Structured finance groups comes with futuristic
structures
ignoring the core of the deal
iv) Risk groups
Departments in Project Finance
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Blockbuster deals
Pioneer deals
Why left behind deal / take it away from him
Market Image deal
Relationship deal
Various Deals
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Growth of Project Finance
1. Privatisation / Private Public Partnership (Private
sector participation Japan, Australia, Portugal,
Italy, UK)
2. Deregulation
3. Internationalization of Investments
4. Growth in Power, Telecom, Infrastructure, Oil and
Roads (Portugal), Natural Resources (Mining), Gas
(Brazil)
5. Project Finance is not necessarily
Privatisation
Structured financing
Securitization
Leveraged buyout
Acquisition finance
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Advantages of Project Finance
(sponsors / company)
Why existing companies implement large projects
in separate companies availing project finance?
a) Sponsor company can insulate itself from the credit
risks of the project with only equity at risk. Even if
sponsor credit support is required, it could be
limited to completion guarantee, ceiling of
guarantee amount, removal of guarantee in case of
satisfactory D/E or DSCR
b) Project loan is off the balance sheet of the
promotor company and hence doesnt affect rating
of sponsor
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c) From the lenders angle, the project is insulated
from promotor bankruptcy. This is important for
lenders, suppliers and offtakers. If there is a proper
contract structure, the rating of the new project
could be better than the parent and can raise low
interest loans.
d) The sponsor could invite equity participation from
other strategic investors like product offtakers, input
suppliers, technology suppliers to strengthen the
project rating but at the same time without diluting
their controlling interest in the sponsor company.
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e) In a similar way, the sponsors could promote larger
projects by inviting public participation in equity
without dilution of their control in the promoting
company.
i) Sponsor contribution 100
Debt 200
300

ii) Sponsor contribution 100
Public equity 100
Debt 400
600
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f) The promotors company avoids restrictive
covenants of the project lenders such as cross
defaults, dividend declaration, nominee director
etc.
g) Debt could be large and of long tenure
h) The sponsor after ascertaining performance of the
project can always merge it into the sponsor
company at a time of his choice or sell it away
i) The incorporation of a separate company may also
be due to different wage levels, regulatory issues
environmental issues.
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j) In many cases like power, fertilizers etc., there is a
need to segment the cost of the project/operational
cost for regulatory purposes. Hence there is a need for
a separate entity.
k) Sharing of risks by several parties who are in a
better position to handle them. For instance a
good offtake contract from a buyer more
creditworthy than sponsor improves project
rating.
l) Limiting security to the projects assets.

While no party assumes responsibility for the entire credit
risk, a combination of guarantees and undertakings which then
viewed together constitutes a bankable credit risk.
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Disadvantages of Project Finance
(sponsors / company)
1. Delay due to due diligence for lenders, protracted negotiations and time
for finalise risk allocation.
2. Higher risks for lenders projected cash flow
3. Generally higher fees and interest rates on non recourse financing
4. Complying with the lenders reporting requirements covenants, and the
reimbursement of the cost of lenders supervision (lenders engineers
fees) could add to the cost.
5. The non recourse loans have made the sponsors totally very aggressive
risk takers
6. Risk allocation leads to higher risk premium and increases cost.
7. High legal bills
8. Cumbersome documentation
9. Lenders have a large number of covenants
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Choosing a Bank
- Cost of project vis a vis the bank size
- Cost of funds of the bank and hence pricing
- Banks experience in project finance / flexibility /
realism
- Complexity of documentation
- Decentralisation of decision making (time factor)
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Components of a Project Appraisal
1. Promotor Evaluation
2. Management Aspects
3. Project Details
Location
Technical
Implementation
Raw material availability
Labour issues
Environmental aspects
4. Cost of Project
5. Means of financing
6. Profitability analysis
7. Risk Evaluation
8. Conditions
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Infrastructure Project Types
BOT - Build, Operate and Transfer The assets are owned by
(Roads, Power, Sewage treatment) Government agency which will
take back assets after
concession period
BOOT - Build, Own, Operate and Transfer Same as BOT except that asset
ownership is with the operator and
sold to the Government for either a nominal/
preagreed fixed sum / market value
with a cap
BOO - Build, Own, Operate Same as BOOT except that asset
is perpetually owned by the
operator
BOOST - Build, Own, Operate, Share and Same as BOOT except that
Transfer during the concession period
revenue is shared with the
Government agency
BOLT - Build, Own, Lease and Transfer Subleased to other tenants after
building in a leased land IT Park
Transfer to the government agency
after concession period.
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DBFO - Design, Build, Finance and Operate Designed, financed and
operated perpetually.
BTO - Build, Transfer, Operate Private operator transfers to
Government and leases it back
collects revenues.
BBO - Buy, Build, Operate Buy an existing facility,
modernise, operate and collect
user fees (Old Mumbai-Pune
road)
OMT - Operate, Maintain and Transfer Operated during the concession
period and transferred back to
the government agency.

Infrastructure Project Types
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Characteristics of Infrastructure Projects
a) Capital Intensive Fixed charges form a major
part of the expenditure
b) Mainly dedicated use market analysis is
important as product has specific use at specific
time and cannot be stored.
c) Cash flow is the only source of funds for loan
repayment. Asset utilisation is more important
than asset value
d) Usually implemented as Special Purpose Vehicles
(SPV).
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e) Offtake Agreements Long Term Agreements
to purchase a minimum amount of end product
at an agreed price.
f) There are different classes of investors with
varying risk return characteristics.
g) Contingent funds Equity/Debt with some
commitment charges
h) Loans are usually are of long term nature 15 to
20 years.
Characteristics of Infrastructure Projects
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Contingent Equity / Debt
- The project should be capable of repaying the debt
as otherwise it cannot function.
- The quantum of loans depends on the cash flow
(not profit) and volatility of cash flow (steel,
cement, fashion wear, power projects).
- What should be the cash flow for a loan of
Rs.100crores repayable equally over 5 years
carrying 10% interest.
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Contingent Equity / Debt
Year 1 2 3 4 5
Repayment 20 20 20 20 20
Interest 9 7 5 3 1
Total 29 27 25 23 21
(Rs. in Crore)
Minimum cash Rs.29 crores
Total cash flow Rs.125 crores
With 60% margin = 125 x 1.6 = Rs.200 crores
(50 to 100% = Rs.40 cores / year
(DSCR 1.5 2.0)
(i.e. 40% of the total loan amount).
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Contingent Equity / Debt
Possible Scenarios

(Rs. Crores)
Contingent Equity I II
Project 100.0 110.0
Cash flow 30.0 25.0
Loan 250% of cash flow 75.0 62.5
Equity 25.0 47.5
Contingent Equity = Escalation (Rs.10 crores) Plus Shortfall
(Rs.22.5 crores) in cash flow (Rs.12.5 crores)
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Contingent Equity / Debt
Contingent Debt I II
Equity 25.0 25.0
Contingent equity 22.5 12.5
Debt 62.5 62.5
Contingent debt* -- 10.0
Total 110.0 110.0
(Rs. Crores)
* Subordinated/quasi equity debt
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i) Stronger Security Structure:
Charge/assignment on assets including intangibles,
revenues, receivables, companys rights under project
documents, contracts, licenses, permits, approvals,
consents and insurance polices
Step in rights
Trust and Retention account
Pledge of equity of Promoters
L/c opening by customer for 1 to 3 months estimated
receivables
Debt Service Recovery Account
State Government Guarantee
Central Government Guarantee
Contingent Promoter's Support
Characteristics of Infrastructure Projects
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j) Restrictions due to contractual obligations
Recall rights if rating falls below a grade.
k) Water fall Mechanism.
Characteristics of Infrastructure Projects
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Agreements
Concession - Rights to the company to recover
Agreement project costs and operating costs
through levy of fees; Fees indexing
(Ports, Flyovers, Airports) / support / tax incentives
Throughput - Obligation on the part of the buyer
Agreement / to pay for the quantity of product
Take or Pay whether he lifts or not (LNG)
Long term pricing/Limited market (oil, toll road)
Put or Pay - Supplier indemnifies the project
Supply contracts company for excess cost incurred
in securing supplies from third parties
for revenue cost.
Long term sales - Quantity fixed but the price at the prevailing rates
agreement (oil , minerals) with a floor price (LNG)
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Cash deficiency - Overrun undertaking / cash
loss financing by sponsors
Capital Subscription - Equity
Agreement
Intercreditor Agreement - Between the creditors
Shareholder Agreement - Agreement between
shareholders on rights/
obligations of each (Board/
Management)
Completion Agreement - Guarantees for the loan by
sponsors till completion of the
project (guarantee to ensure
project completion)
Agreements
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Finance Providers
Equity - Private equity, Public, Banks, International Finance
Corporation, Customers, Contractors,
Equipment suppliers, Operators, offtakers, Input (Fuel)
suppliers, Infrastructure funds (GE Capital, Asian
infrastructure fund), Warrants
Underwriters - Investment Banks, Brokers, Banks, various mutual
funds
Quasi equity - Subordinated loans from promotors
- Interest free advance from customers (Oil)
- Royalty based loans (Technology Development Board)
- Convertibles (loans, preference shares)
- Interact free loans from sponsors
- Preference shares of long maturity
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Participants
Debt - Suppliers credit from equipment supplier
- Bonds subscribed by institutional investors
Pension funds, Insurance companies etc., based
on credit rating
- Loans, guarantees, insurance from export
credit agencies (Exim Bank / OPIC)
- Multilateral, bilateral credits, mixed credits
(IBRD, KFW, ADB)
- Senior debt / syndicated debt
- Debentures
- Bank loans
- Securetised debt



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Participants
Debt - Secured / unsecured
- Fixed / floating interest rates
- Foreign currency / local currency
- Ballooning repayment schedules
- Differential interest rates after construction
- Take o ut financing
Insurance - MIGA (Political insurance for equity / debt)
(AIG, GIC etc)
Guarantees - Banks, IBRD
- Letter of Credit (Banks)
Credit Enhancers - Offtake / supply agreements
Rating Agencies - CRISIL, ICRA, FITCH etc.
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Interest of various participants in the project
Sponsors
a) Segregation of project risk from the existing operations
b) Maximum leverage Maximum debt
c) Flexible loan covenants
d) Well negotiated risk sharing
e) Exclusion of all assets other than that of the project from
security
f) Lenders willing to restructure loans rather than recall in
case of difficulties
g) Management control
h) Low interest / low transaction cost
i) High cash flow potential
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Lenders
a) Good construction contract for timely completion
within the budget
b) Turnkey contracts with firm price, time of
completion, compatible with the regulatory
network and performance of the project with
respect of output
c) Completion guarantee / performance bonds
Interest of various participants in the project
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d) Good inter-creditor agreements
e) Financial closure no more loans required for
completion
f) Adequate contracts of economic value
g) Legally satisfactory contracts / structures
h) The entire risk is properly allocated to suppliers,
contractors and offtakers
i) Proper assignment of contracts
j) Good debt service coverage ratio (1.5 2.0)
k) Project complying with all the regulations
Interest of various participants in the project
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l) Good pricing
m) Favourable covenants
n) Proper warranties / representations
o) Collaterals viability funding / shadow toll agreement /
credit enhancement / completion guarantee
p) Right to appoint consultants to oversee project
q) Pari passu security for all
r) No overrun / delay
s) Credit worthiness of all project participants
t) Guarantees if project is abandoned
Interest of various participants in the project
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Contractor
a) Minimum penalties for escalation/ late delivery
b) Maximum price, bonus
c) Credit worthiness of the sponsor
d) Satisfactory financial tie up
Operator
a) Limiting the price risk penalties
Interest of various participants in the project