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Project Finance - Intro

Ravi

Project Finance is a rather small area of


investment banking. The main purpose is to
help companies tofinance long-term
projectsthat require ahuge amount of
external financing.Constructing a new
office building can usually be done with a
single credit facility. But if a company wants
to build a nuclear power plant or an offshore
wind park, there is a need for much more
money than one bank is willing to provide.

Project Finance is a rather small area of


investment banking. The main purpose is to
help companies tofinance long-term
projectsthat require ahuge amount of
external financing.Constructing a new
office building can usually be done with a
single credit facility. But if a company wants
to build a nuclear power plant or an offshore
wind park, there is a need for much more
money than one bank is willing to provide.

Financing is provided offbalance sheet


The biggest difference between an ordinary bank credit and
Project Finance is that an ordinary bank credit goes directly
to the client. In Project Finance the money is given toa
separate legal entity the so-called special purpose
entity (SPE). This SPE is created just for one specific project.
Lets take a look at an energy producer who wants to build a
nuclear power plant. He would found a new company the
SPE having the power plant and other project related
assets asits only assets. The other side of the balance
sheet would consist of the debt provided by the banks and
the sponsors equity. The sponsors are in most cases the
company who initiated the project itself and private equity
investors

There are several reasons for the


creation of the SPE:
Risk allocation:The risk for the sponsor is reduced. If the power
plant will not generate enough cash-flow to pay off debt and
interest rates, the SPE will get into financial distress. However,
the sponsors assets will be protected.
Credit standing:The banks decision to provide debt is mostly
dependent on the future cash flows of the SPE, not on the credit
standing of the sponsor. Therefore, it is possible for a company
with a bad credit standing to get access to external financing.
Debt-to-equity ratio:These projects usually require a huge
amount of debt financing. Therefore, taking the project on to their
own balance sheet would significantly increase the sponsors
debt-to-equity ratio. Instead, maintaining the assets and debt
related to the project on the SPEs balance sheet will mean that
the sponsor will only show his equity stake in the project.

Several banks form a


syndicate
As no bank wants to finance a nuclear power plant alone, a syndicate
of banks is formed to bring in the required money. The sponsor
mandates one bank to be the leader of the syndicate, the socalledMandated Lead Arranger(MLA).
The MLAs role is to handle the communication between all
participating banks and the sponsor.He has a lead role in
underwriting the project and usually he also provides a portion of the
debt. The other participants just provide their tranche. A banker once
explained it to me with the following words: As a participant you get
offered a piece of the cake but as an arranger you make the cake.
A project includes more parties than just the sponsors and the banks.
There are also technical advisers, legal advisers, public agencies, and
sometimes even more, depending on the project. While the
participants handle all their communication with the MLA, the MLA
itself has to talk to all parties.

What is Project
Finance?

What is Project Finance?

Finance for capital intensive, long term


projects such as:

infrastructure projects building and


operating hospitals, roads

power projects / oil and gas


mining projects
Contrast Corporate Finance / Acquisition
Finance

Key Features of Project Finance

Project Co is an SPV lenders only have recourse to cash flows or revenue from the project
Lenders rely on technical and economic valuations of the project to ensure its ability to
generate sufficient revenues
Capital intensive projects on greenfield site
Lengthy and complex loan documentation
Highly leveraged
Higher margins and fees to reflect risk of lenders

Parties involved

Parties involved (cont.)

Borrowing side

Lending side

SPONSOR

Commercial banks (syndicate)

Non-bank fi nancial institutes

International agencies and ECAs

International development banks

Hedge providers

Mezzanine lenders

Government
Private

sector

specialist

retained by government
Private sponsor
PROJECT COMPANY
Local subsidiary
Joint Venture
Partnership of sponsors

Parties involved (cont.)


Advisers

Suppliers
Construction stage

Legal

Operating stage

Technical advisers

Financial advisers

Environmental advisers

Model auditors

Purchasers
Purchasers

of

the

projects

product(s) or service(s)

Contractual
Structure

Contractual Structure

Contractual Framework

Loan Agreement

Conditions precedent

To initial drawdown
Permits
Environmental diligence

To all drawdowns

Independent Engineer confirmation

Work proceeding in accordance with EPC


contract
Sufficient funds available for timely completion

Representations and warranties

Contractual Framework

Covenants
Financial ratios
Debt service coverage ratio
Debt to equity ratio
Dividends
Conditions
Modification of project contracts
Reporting
Events of default

Bankruptcy

of

sponsors

or

project

contract

counterparties
Concession or off take agreement defaults
Ability to replace other project contracts
Abandonment
Expropriation

What is Project Finance?


Project Finance can be characterised in a
variety of ways and there is no universally
adopted definition but as a financing
technique, the authors definition is:
the raising of finance on a Limited Recourse
basis, for the purposes of developing a large
capitalintensive infrastructure project, where
the borrower is a special purpose vehicle and
repayment of the financing by the borrower
will be dependent on the internally generated
cashflows of the project

This definition in itself raises a number of


interesting questions, including:
What do we mean by Limited Recourse
financing recourse to whom or what?
Why is Project Finance typically used to finance
large capital intensive infrastructure projects?
Why is the borrower a special purpose vehicle
(SPV) under a project financing?
What happens if the internally generated
cashflows of the project are not sufficient to
repay the financiers of the project?

The terms Project Finance and Limited Recourse


Finance are typically used interchangeably and
should be viewed as one in the same. Indeed, it is
debatable the extent to which a financing where
the Lenders have significant collateral with (or
other form of contractual remedy against) the
project shareholders of the borrower can be truly
regarded as a project financing. The limited
recourse that financiers have to a projects
shareholders in a true project financing is a major
motivation for corporates adopting this approach
to infrastructure investment.

Project financing is largely an exercise in the equitable


allocation of a projects risks between the various
stakeholders of the project. Indeed, the genesis of the
financing technique can be traced back to this
principle. Roman and Greek merchants used project
financing techniques in order to share the risks
inherent to maritime trading. A loan would be
advanced to a shipping merchant on the agreement
that such loan would be repaid only through the sale
of cargo brought back by the voyage (i.e. the financing
would be repaid by the internally generated cashflows
of the project, to use modern project financing
terminology).

Similarities to other forms of


financing
The extent to which Project Finance
should be regarded as a distinct
wholesale banking product, or as a
financing technique which incorporates
a number of disciplines, is debatable.
As a method of debt finance, project
financing shares a number of the
techniques and approaches found in
other areas of wholesale banking:

Comparison of Project Finance versus


other wholesale financing techniques

Comparison of Project Finance versus


other wholesale financing techniques
Form of
financing /

Parallels

Securitisation (Asset The borrower is an


Backed Securities)
SPV A form of off
balance sheet
financing for the
originator The
SPV issues bonds to
fund

commonalities
Key differences
A securitisation can
only occur for cash
generative assets
(e.g. a loan portfolio
which is generating
interest payments)
In a securitisation,
there are typically a
large volume of
assets being
financed via a single
SPV (e.g. a portfolio
of mortgages).
The pool of assets
may therefore be of
a variable credit
quality and hence
the financing

In a project financing, a single (or


very small number) of assets are
funded via a single borrower,
presenting a uniform credit profile for
all Lenders

Comparison of Project Finance versus


other wholesale financing techniques
Form of financing /

Parallels

commonalities Key
differences

Leveraged Buy-Out
(LBO)

Highly leveraged
transactions

In a project financing,
the shareholders to
the transaction are not
contractually at risk if
the project vehicle
(borrower) defaults on
its loans

Venture Capital

Discrete number of
equity investors
High focus on equity
return of an
investment

Venture Capital
investments are
speculative
assessments of a
companys potential to
generate returns. A
project financing is
predicated on robust,
long term and highly
predictable financial

Contractual
Structure

Contractual Structure

Course link: www.edureka.co/project-infrastructure-financing

Contractual Framework

Loan Agreement

Conditions precedent

To initial drawdown
Permits
Environmental diligence

To all drawdowns

Independent Engineer confirmation

Work proceeding in accordance with EPC


contract
Sufficient funds available for timely completion

Representations and warranties

Course link: www.edureka.co/project-infrastructure-financing

Contractual Framework

Covenants
Financial ratios
Debt service coverage ratio
Debt to equity ratio
Dividends
Conditions
Modification of project contracts
Reporting
Events of default

Bankruptcy

of

sponsors

or

project

contract

counterparties
Concession or off take agreement defaults
Ability to replace other project contracts
Abandonment
Expropriation

Course link: www.edureka.co/project-infrastructure-financing

Security Structure

Security Structure

Charge over Borrowers assets


Real property
Equipment & inventory
License / concession
Key contracts
Bank accounts

Completion Guarantee

Direct Agreements

Different Classes of Debt

Senior debt

Hedging liabilities

Mezzanine debt

Subordinated / junior debt

Investor debt (equity investors)

Intra-group debt

Inter-creditor Agreement

Ranking of debt and security - waterfall

Undertakings from creditors

Subordination on insolvency

Enforcement of security

Changes to parties

Amendments and waivers

Project Finance other financial products

Equity
Existing shareholders
New Shareholders

Mezzanine Lenders

Commercial Bank bridge and mini-perm lending

Project Bonds

Hedging

Other Bank Roles in Project Finance

Corporate Trustee Role


Enforcing security & top of the waterfall
Indemnities
Account Bank
On Shore Operating Accounts
Off Shore Operating Accounts

DSRA

Insurance proceeds

Equity deposits

Cost overruns

Distribution Account

When things go wrong

Waivers and amendments

Intercreditor Agreement

Standstill agreements

Sponsor debt other debt sources

Hair cuts priority amongst financiers

Administration

Enforcement

Current issues / Trends


Political Risk / Modes of Protection
Insurance
Export credit guarantees
Government undertakings & Bilateral investment treaties
Market perceptions can change over time
Land
Title, rights
Due diligence crucial
Environmental and social impacts
Change in law
Developing countries
Inconsistent policy applications / lack of clear regulatory structure