Project Finance Professor Pierre Hillion * Bank

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Project Finance

• Professor Pierre Hillion

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Project Finance

• A project company is like a leveraged buyout
  (LBO), except that an LBO is a financing decision
  involving existing assets, whereas project
  finance is an investment and a financing decision
  involving new assets
• B. Esty

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Outline 

• Introduction
• Part 1 Overview of Project Finance
• Part 2 Statistics
• Part 3 Project Finance versus Corporate Finance
• Part 4 Leverage and Financing Issues
• Conclusion
• Appendices

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INTRODUCTION

• Definition Project Finance

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Definition of Project Finance 

• Project Finance (PF) involves
• the creation of a legally independent project
  company
• financed with
• -non-recourse debt
• -equity from one or more sponsoring firms
• for the purpose of financing an investment in a
  single-purpose capital asset
• usually with a limited life.

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PART 1

• Overview of Project Finance

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Overview of Project Finance Parties Involved

• Sponsors and investors they are generally
  involved in the construction and the management
  of the project. Other equity-holders may be
  companies with commercial ties to the project,
  i.e., customers, suppliers
• Lenders The needed finance is generally raised
  in the form of debt from a syndicate of lenders
  such as banks and less frequently from the bond
  market.
• Government project company need to obtain a
  concession from the host government.
• Role of type of contract Build-own-operate (BOO)
  or Build-transfer-operate (BOT).
• Control on revenues such as for example
  Eurostar, British Jail,
• Suppliers and Contractors Role of turnkey
  contracts to make sure that construction is
  completed within costs and on schedule. Turnkey
  contracts specify a fixed price and penalties for
  delays.
• Customers Depending on the contract, multiple or
  a single customer.

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Overview of Project Finance Main Characteristics 

• Organizational Structure
• - Project companies involve separate legal
  incorporation.
• Capital Structure
• - Project companies employ very high leverage
  compared to public firms.
• Ownership Structure
• - Project companies have highly concentrated
  debt and equity ownership structures.
• Board Structure
• - Project boards are comprised primarily of
  affiliated directors from the sponsoring firms.
• Contractual Structure
• - Project finance is referred to as contract
  finance because a typical transaction involves
  numerous contractual agreements from input
  suppliers to output buyers.

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Overview  of Project Finance Main
Characteristics

• Independent, single purpose company formed to
  build and operate the project.
• Extensive contracting
• As many as 15 parties and up to 1000 contracts.
• Contracts govern inputs, construction, operation,
  outputs.
• Government contracts/concessions one off or
  operate-transfer.
• Ancillary contracts include financial hedges,
  insurance for Force Majeure, etc.
• Highly concentrated equity and debt ownership
• One to three equity sponsors.
• Syndicate of banks and/or financial institutions
  provide credit.
• Governing Board comprised of mainly affiliated
  directors from sponsoring firms.
• Extremely high debt levels
• Mean debt of 70 and as high as nearly 100.
• Balance of capital provided by sponsors in the
  form of equity or quasi equity (subordinated
  debt).
• Debt is non-recourse to the sponsors.
• Debt service depends exclusively on project
  revenues.
• Has higher spreads than corporate debt.

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Overview of Project Finance Contractual
Agreements

• Contractual and financing arrangements between
  the various parties are essential in project
  finance
• Concession agreement with a government
• Engineering, Procurement and Construction (EPC)
  Contract
• between the Project Company the Engineering
  Firm
• Operations and Maintenance (O M) Agreement
• between the Operations Contractor and the Project
  Company, obligates the Operator to operate and
  maintain the project
• Shareholders Agreement
• governs the business relationship of the equity
  partners
• Inter-creditor Agreement
• an agreement between lenders or class of lenders
  that describes the rights and obligations in the
  event of default.
• Supply Agreement
• agreement between the supplier of a critical key
  input and the Project Company (e.g. agreement
  between a coal supplier and a power station)
• Purchase Agreement
• agreement between the major user of the project
  output and the Project Company
• agreement between a metropolitan council and a
  power station

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Overview of Project Finance Return Distribution

• Capital providers earn an appropriate
  risk-adjusted rate of return on a portfolio of
  investments by earning, either high rates of
  return on just a few investments, or low rates of
  return on many projects. The former corresponds
  to the venture capital (VC) industry, and the
  latter to PF.
• VC is used for intangible assets with significant
  return uncertainty and little residual value in
  the event of failure. Equity has an effective
  payoff structure because it allows investors to
  capture unlimited upside. In contrast, debt does
  not work for these high risk investments with
  positively skewed returns. In VC, managers are
  responsible for managing growth options and
  transforming a small amount of capital into large
  companies.
• In PF, managers are responsible for transforming
  a large amount of capital into something worth a
  little more. Project returns have a limited
  upside. This means that a large fraction of
  projects must be successful and generate positive
  returns for capital providers to earn proper
  returns.

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Overview of Project Finance Return Distribution

• Projects are exposed to three types of risk
• - Symmetric risks including market risk
  (quantity), market risk (price), input or supply
  risk, exchange, interest and inflation rate
  risks, reserve risk, throughput risk. Exposures
  to symmetric risks causes larger positive and
  negative deviations from the expected outcome.
• - Asymmetric risks including environmental
  risk, expropriation risk. These risks cause only
  negative deviations in the expected outcome.
• - Binary risks including technology failure,
  full expropriation, counterparty failure,
  regulatory risk, force majeureThese risks
  increase the probability that an asset ends up
  worthless.
• In practice, projects have relatively low asset
  risk allowing a high debt capacity. The use of
  leverage introduces financial risk which allow
  equity-holders to capture unlimited upside once
  debt claims have been satisfied.

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Overview of Project Finance Risk Management
Matrix
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Overview of Project Finance Risk Management
Matrix
15
Overview of Project Finance Comparison with
Other Forms of Financing  
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PART 2

• Statistics

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Project Finance Statistics

• Historically project finance was used by private
  sector for industrial projects, such as mines,
  pipes, oil fields. In the early 70s, BP raised
  945 million to develop the Forties Field in
  the North Sea.
• The beginning of modern project finance starts
  with the passage of the Public Utility Regulator
  Act in 1978 in the US to encourage investment in
  alternative non-fossil fuel energy generators.
• From early 1990s, private firms start financing a
  wide range of assets such as toll roads, power
  plants, telecommunications systems located in a
  wider range of countries.
• Project sponsors have been pushing the boundaries
  of project finance for most of the last 15 years
  by increasing sovereign, market and technology
  risks.
• World Bank study global investment in new
  infrastructure assets 369 billion per year from
  2005-2010 with 63 in developing nations, e.g.
  Asia, Africa.

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Project Finance Statistics 

• Outstanding Statistics
• Over 408bn of capital expenditure using project
  finance in 2008.
• US67bn in US capital expenditures which is
• smaller than the US 645 billion investment grade
  corporate bonds market, 187 billion
  mortgage-backed security market, 160 billion
  asset-backed security market, and 387 billion
  tax-free municipal bond market (NB these markets
  shrank significantly in 2008 from 2006 levels due
  to subprime crisis).
• but larger than the 26bn IPO market and the
  45bn venture capital market.
• Some major deals
• US10.65bn 2005 Qatargas 2 project (LNG
  production) involved 57 lenders
• US3.8bn 2006 Peru LNG plant
• US3.7bn 2007 Madagascar Nickel-Cobalt Mining and
  Processing Project
• In Singapore, US1.4bn Singapore Sports Hub

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Project Finance Statistics
Overall 5-Year CAGR of 19 for private sector
investment. Project Lending 5-Year CAGR of 21.
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Project Finance Statistics
21
Project Finance Statistics
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Project Finance Statistics

• 34 of overall lending in Power Projects, 21 in
  Transportation.

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Project Finance Statistics

• 5-Year CAGR for Power Projects 30, Oil
  Gas30, Mining 59 and Leisure Property 36.

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Project Finance Statistics

• Size distribution of projects
• - 41 lt 100 million, (7 of the total value
  of the PF market)
• - 19 gt 500 million, (70 of the total value)
• - 8 gt 1.0 billion, (55 of the total
  value)
• - mean size 435 million, median size 139
  million
• Project duration
• - Mean (median) construction years 2.1 (2.0)
  years
• - Mean (median) concession contract 28 (25)
  years
• - Mean (median) length of off-take agreements
  19 (20) years
• Project leverage Mean (median)
  debt-to-capitalization ratios 71 (76)
• Maturity of debt instruments
• -Median maturity of bank loans 9.8 years
• - Median maturity of bonds 11.6 years

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PART 3

• Project Finance (PF) versus Corporate Finance (CF)

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PF versus CF Rationale for Project Finance

• Project finance allows firms
• to minimize the net costs associated with market
  imperfections such as
• - incentive conflicts,
• - asymmetric information,
• - financial distress,
• - transaction costs,
• - taxes.
• to manage risks more effectively and more
  efficiently.

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PF versus CF Rationale for Project Finance

• Corporate Finance
• A company invests in many projects
  simultaneously.
• The investment is financed as part of the
  companys existing balance sheet. The lenders can
  rely on the cash flows and assets of the sponsor
  company apart from the project itself. Lenders
  have a larger pool of cash flows from which to
  get paid. Cash flows and assets are
  cross-collateralized.
• Publicly traded firms have typical leverage
  ratios of 20 to 30.

• Project Finance
• Purpose a single purpose capital asset, usually
  a long-term illiquid asset. The project company
  is dissolved once the project is completed. No
  growth opportunities.
• A legally independent project The project
  company does not have access to the
  internally-generated cash flows of the sponsoring
  firm and vice versa.
• The investment is financed with non-recourse
  debt. All the interest and loan repayments come
  from the cash flows generated from the project.
• Project companies have very high leverage ratios,
  with the majority of debt coming from bank loans.

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PF versus CF Rationale for Project Finance

• Modigliani and Miller show that corporate
  financing decisions do not affect firm value
  under perfect and efficient markets. The rise of
  project finance provides strong evidence that
  financing structures do matter.
• it is not clear why firms use project finance
  given that
• - It takes longer and it costs more to structure
  a legally independent project company than to
  finance a similar asset as part of a corporate
  balance sheet.
• - Project debt is often more expensive (50 to
  400 bps) than corporate debt due to its
  non-recourse nature (no benefit of
  co-insurance).
• - The combination of high leverage and extensive
  contracting restricts managerial discretion and
  managerial flexibility.
• - Project finance requires greater disclosure of
  proprietary information which can be costly from
  a competitive perspective.
• - It is harder to obtain operating synergies as
  the project is independent.
• - The likelihood of using interest tax shields
  and net operating losses is lower.

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PF versus CF Rationale for Project Finance

• Financing decisions matter under
  imperfect/inefficient markets. Firms bear
  deadweight costs (DWC) when they invest in and
  finance new assets.
• DWCs result from market imperfections. They
  include
• - agency costs and incentive conflicts
• - asymmetric information costs
• - financial distress costs
• - transaction costs
• - taxes
• DWCs change under alternative financing
  structures, i.e., corporate finance versus
  project finance.
• Sponsors should use project finance whenever the
  DWC are lower than their corporate finance
  counterparts.

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PF versus CF Rationale for Project Finance

• Project finance reduces costly agency conflicts
• - Conflicts between ownership and control
• - Conflicts between ownership and related
  parties
• - Conflicts between ownership and debtholders
• Project finance reduces information costs
  (asymmetric information).
• Project finance reduces costly underinvestment,
  in particular leverage-Induced underinvestment.
• Project finance, as a organizational risk
  management tool, reduces the potential collateral
  damage that a high risk project can impose on a
  sponsoring firm, i.e., risk contamination. It
  also reduces the costs of financial distress and
  solves a potential underinvestment problem.

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Project Finance versus Corporate Finance

• Resolution of Agency Conflicts between Ownership
  and Control

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Agency Conflicts between Ownership and Control

• Costly agency conflicts arise when managers who
  control investment decisions and cash flows have
  different incentives from capital providers.
• Certain asset characteristics make assets prone
  to costly agency conflicts Tangible assets that
  generate high operating margins and significant
  amounts of cash flow can lead to
• - inefficient investment
• - excessive perquisite consumption
• - value destruction
• Ex The agency costs of free cash flows are
  higher in cement than in drugs.
• Solving the problem of ownership and control is
  important in project companies where few of the
  traditional sources of discipline are present or
  effective.

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Agency Conflicts between Ownership and Control

• Project Finance
• Project company is dissolved once the project
  gets completed. No future growth opportunities.
• Cash flows of the project are separated from
  cash flows of sponsors. The single discrete
  project enable lenders to easily monitor project
  cash flows.
• The verifiability of CFs is enhanced by the
  waterfall contract that specifies how project CFs
  are used.

• Corporate Finance
• Company invests in many projects and possesses
  many growth opportunities.
• Cash flow separation is difficult to accomplish
  in corporate finance. Project cash flows are
  co-mingled with the cash flows from other assets
  making monitoring of cash flows difficult.
• The verifiability of cash flows is difficult.

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Agency Conflicts between Ownership and Control

• Project finance
• Monitoring mechanisms include
• Managerial discretion is constrained by extensive
  contracting. Claims on cash flows are prioritized
  through the CF waterfall.
• Concentrated equity ownership provides critical
  monitoring, The unique board of directors and
  separate legal incorporation makes monitoring
  more simple and efficient.
• High leverage both the amount and type
  (maturity) Bank loans provide credit
  monitoring.
• Senior bank debt disgorges cash in early years.

• Corporate Finance
• Traditional monitoring mechanisms include
• Takeover market
• Product market
• Reputation
• Staged investment
• Staged financing
• Leverage high debt service forces managers to
  disgorge free cash flows.
• Creditors rights lenders threat to seize
  collateral and threat of liquidation to deter
  borrowers opportunism.

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Agency Conflicts between Ownership and Control

• From a sample of 6045 project loans (provided to
  project companies and corporations) from 40
  countries originated between 1993 and 2003
• PF is much less likely in the US (19) than in
  the rest of the world (53) and in English and
  Scandinavian legal origin countries than in
  French or German legal origins. Why?
• PF is more likely in countries with weak
  protection against managerial self-dealing.
• In countries that provide weak protection to
  minority investors against expropriation by
  insiders, PF is relatively more likely than CF in
  industries where free cash flows to assets is
  higher.
• In countries that provide stronger protection to
  creditors, the effects of weaker protection
  against managerial self-dealing in encouraging PF
  is lower.
• Large deadweight costs incurred in bankruptcy
  increase the likelihood of PF as bankruptcy costs
  are lower in PF than in CF. PF is less likely
  when the bankruptcy process is more efficient.

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Project Finance versus Corporate Finance

• Resolution of Agency Conflicts between Ownership
  and Related Parties

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Agency Conflicts between Ownership and Related
Parties
Problem (Hold Up) A second type of agency
conflict is the opportunistic behavior by related
parties, causing ex-ante reduction in expected
returns and ex-ante incentives to invest. The
most common culprits are related parties that
supply critical inputs, buy primary outputs, and
host nations that supply the legal system and
contractual enforcement.

• Standard Approach
• Vertical integration (not always possible or
  desirable).
• Long term contracts, with contract duration
  increasing with asset specificity.

• Project Finance Approach
• Joint ownership that allocate the residual cash
  flow rights and asset control rights among the
  deal participants.
• High debt level. With high leverage, small
  attempts to appropriate value will result
• In costly default and possibly a change in
  control.

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Agency Conflicts between Ownership and Related
Parties
Problem (Expropriation) Opportunistic behavior
by host governments. They provide a critical
input, the legal system and the protection of
property rights. Either direct through asset
seizure or creeping through increased
tax/royalty. This causes an ex-ante increase in
risk and required return.

• Standard Approach
• Visibility/reputation
• High leverage.

• Project Finance Approach
• High leverage to discourage expropriation (excess
  cash is disgorged, lower profits and less
  visibility).
• Multilateral lenders involvement as a deterrent
  against expropriation.
• Joint ownership.

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Agency Conflicts between Ownership and Related
Parties

• Why corporate finance cannot deter opportunistic
  behavior?
• Do not allow joint ownership and when they do
  (VC), they are susceptible to free cash flow
  problems.
• Direct expropriation can occur without triggering
  default because corporate assets and cash flows
  cross-collateralize each debt obligation.
• .
• Multi lateral lenders which help mitigate
  sovereign risk lend only to project companies.
• Non-recourse debt had tougher covenants than
  corporate debt and enforces greater discipline.
• In the presence of a corporate safety net, the
  incentive to generate free cash is lower.

40
Project Finance versus Corporate Finance

• Resolution of Agency Conflicts between Ownership
  and Debtholders

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Agency Conflicts between Ownership and
Debtholders

• Standard Approach
• Strong debt covenants allow both equity/debt
  holders to better monitor management.

• Problem
• Debt/Equity holder conflict in distribution of
  cash flows, re-investment and restructuring
  during distress. High leverage can lead to risk
  shifting and underinvestment.

• Project Finance Approach
• Cash flow waterfall reduces managerial discretion
  and thus potential conflicts
• Concentrated ownership ensures close monitoring
  and adherence to the prescribed rules.
• To facilitate restructuring, concentrated debt
  ownership, less classes of debtors, and bank
  debt, are preferred. Bank debt is much easier to
  restructure than bonds.
• With few growth options, the opportunity cost of
  underinvestment due to leverage is negligible in
  project companies.
• Opportunities for risk shifting do not exist
  because the cash flow waterfall restrict
  investment decisions.

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Project Finance versus Corporate Finance

• Decrease in Asymmetric Information Costs

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Decrease in Asymmetric Information Costs

• Standard Approach
• Disclosure.
• Analyst-relationship.
• Institutional shareholder, activist game.
• Signaling

• Problem
• .Insiders know more about the value of assets in
  place and growth opportunities than outsiders.
  Asymmetric information increases monitoring
  costs and increases cost of capital (equity is
  more costly than debt).

• Project Finance Approach
• Segregated cash flows enhance transparency, which
  decreases monitoring costs.
• Segregation eliminates the need to analyze other
  corporate assets or cash flows. Creditors can
  analyze the project on a stand-alone basis.
• Project structure reserves the sponsors debt
  capacity/ flexibility to fund higher risk
  projects internally

44
Project Finance versus Corporate Finance

• Resolution of Under-Investment problem

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Resolution of Under-Investment Problem

• Debt Overhang Firms with high leverage, risk
  averse managers and asymmetric information have
  trouble financing attractive investment
  opportunities. This leads to under investment in
  positive NPV projects due to limited corporate
  debt capacity as new debt is limited by
  covenants.
• Standard Approach Use of secured debt, senior
  bank debt, new equity (raised at a discount).
• Project Finance Approach
• - Non recourse debt in an independent entity
  allocates returns to new capital providers
  without any claims on the sponsors balance
  sheet. This preserves scarce corporate debt
  capacity and allows the firm to borrow more
  cheaply than it otherwise would.
• - Project finance is more effective than secured
  debt because it eliminates recourse back to the
  sponsoring firm.

46
Project Finance versus Corporate Finance

• Project Finance as an Organizational Risk
  Management Tool

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Project Finance as an Organizational Risk
Management Tool

• Standard Approach
• Hedging, or foregoing the project
  (under-investment)

• Problem
• A high risk project can potentially drag a
  healthy corporation into distress. Short of
  actual failure, the risky project can increase
  cash flow volatility, the expected costs of
  financial distress, and reduce firm value.
  Conversely, a failing corporation can drag a
  healthy project along with it.

• Project Finance Approach
• Project financed investment exposes the
  corporation to losses only to the extent of its
  equity commitment, thereby reducing its distress
  costs.
• Through project financing, sponsors can share
  project risk with other sponsors. Pooling of
  capital reduces each providers distress cost due
  to the relatively smaller size of the investment
  and therefore the overall distress costs are
  reduced.
• PF adds value by reducing the probability of
  distress at the sponsor level and by reducing the
  costs of distress at the project level. This
  facilitates the use of high leverage.

48
Project Finance as an Organizational Risk
Management Tool

• Risky projects impose deadweight costs on
  sponsors. Costs of financial distress represent a
  low of 3 up to 10-20 of firm value. They
  include both direct costs, such as legal
  expenses, bankers fees and indirect costs such
  as
• - Underinvestment by the sponsor.
• - Underinvestment by related parties as distress
  may deter business partners, from making
  long-term investments.
• - Lost sales as distress may discourage
  customers.
• -Lost interest tax shield as volatility
  increases the probability of generating losses.
• - Human capital

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Project Finance as an Organizational Risk
Management Tool

• If a firm uses corporate finance, it becomes
  vulnerable to risk contamination, the possibility
  that a poor outcome for the project causes
  financial distress for the parent. This cost is
  offset by the benefit of co-insurance whereby
  project cash flows prevent the parent from
  defaulting.
• From the parent corporation perspective,
  corporate finance is preferred when the benefits
  of co-insurance exceed the risk of contamination
  and vice versa.
• Project finance is more likely when projects are
  large compared to the sponsor, have greater total
  risk and have high positively correlated cash
  flows.

50
Project Finance as an Organizational Risk
Management Tool

• Risk (variance) is a proxy fro distress costs and
  the probability of risk
• contamination. Combined cash flow variance (of
  project and sponsor) with
• joint financing increase with
• Relative size of the project.
• Project risk.
• Positive Cash flow correlation between sponsor
  and project.

Firm value decreases due to cost of financial
distress which increases with combined variance
Project finance is preferred when joint
financing (corporate finance) results in
increased combined variance.Corporate finance
is preferred when it results in lower combined
variance due to diversification (co-insurance).
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Project Finance as an Organizational Risk
Management Tool

• Corporate-financed investment involves the
  combination of 2 risky assets
• Sponsor (S) Project (P)
• Total Risk Variance of Combined returns
• Compare Risk with and without investment
  Var(RPRS) vs. Var(RS)
• Portfolio Theory tells us
• Var(RPRS) wP2Var(RP) wS2Var(RS)
  2wPwSCorr(RPRS)sPsS
• where
• wP ,wS proportion of value in the
  project/sponsor
• Var(RP), Var(RS) variance of project/sponsor
  returns
• sP ,sS standard deviation of project/sponsor
  returns

52
Project Finance as an Organizational Risk
Management Tool

• Financial Distress is costly
• Expected costs of financial distress
  Prob(distress)Cost of Distress
• Probability(distress) is related to Total Risk,
  leverage and asset/,liability matching
• Total Risk is a function of Risk Contamination.
• So what factors matter the most for Risk
  Contamination?
• Relative Size Project/(Project Sponsor)
• Project Risk Var(RP)
• Return Correlation Corr(RP,RS)

53
Project Finance as an Organizational Risk
Management Tool Impact of Project Size on Total
Risk (Project Risk 50)
Return Variance
Big Project (wP 50)
Medium Project (wP 33)
Sponsor Stand-Alone Return Variance 20
20
Small Project (wP 5)
1.0
-1.0
Correlation of Sponsor and Project Returns
54
Project Finance as a n Organizational Risk
Management Tool Impact of Project Size on Total
Risk (Project Risk 33)
Return Variance
High Risk (VarP 50)
Sponsor Stand-Alone Return Variance 20
Medium Risk (VarP 20)
20
Low Risk (VarP 10)
1.0
-1.0
Correlation of Sponsor and Project Returns
55
Project Finance as an Organizational Risk
Management Tool

• Usually diversification is beneficial. Here,
  diversification (corporate finance) can be worth
  less than specialization (project finance).
• If corporate-financed investment causes total
  risk, and hence costs of financial distress to
  increase enough, PF may reduces the incremental
  costs of financial distress by isolating and
  containing project risk.
• - For project finance to make sense, the
  reduction in the costs of financial distress must
  exceed the incremental transaction costs .
• - Project finance lowers the net costs of
  financing certain assets. Large, tangible, risky
  assets make the best candidates for project
  finance, particularly when they have returns that
  are positively correlated with the sponsors
  existing assets.

56
Project Finance as an Organizational Risk
Management Tool

• Example
• Consider a riskless sponsor. Its assets are worth
  100 in all states of the world and it is financed
  with 30 of riskless debt. It has the opportunity
  to invest in a 0 NPV, risky project worth 200 in
  the good state and 0 in the bad state and is
  financed with 85 of (junior) debt. Assume that
  with the possibility of default, the costs of
  financial distressed imposed on the sponsors
  existing assets are equal to 5. The managers
  job is to decide whether to invest using
  corporate finance, invest using project finance,
  or not at all.
• Assume
• - a one period model
• - the good and the bad states are equally
  probable
• - the risk-free rate is 0
• - the manager is risk-neutral
• - the organizational form does not affect
  operating synergies
• - no structuring costs
• - no relation between project structure and
  project cash flows

57
Project Finance as an Organizational Risk
Management Tool

• Example
• No investment The sponsor is worth 100, the debt
  is worth its face value of 30 and the equity is
  worth 70. There is no possibility of default.
• Corporate financed investment Assets are reduced
  by 5 in both states of the world. The new
  debt-holders invest only 75 for the project and
  equity-holders the remaining 25. Equity is worth
  65 (90-25). The equity-holders bear the distress
  costs. Managers acting on behalf on existing
  shareholders would not make the investment.
• Project-financed investment The sponsor raises
  42.5 of new project debt and invests 57.5 into
  the project. Default is contained at the project
  level and there is no collateral damage inflicted
  at the sponsor level. The sponsor does not incur
  incremental distress costs.

58
Project Finance Versus Corporate Finance

• Project Finance as Insurance

59
Project Finance as Insurance

• Compare the choice faced by sponsors between
  corporate finance and project finance
• When sponsors use corporate finance, they expose
  themselves to the full range of outcomes (NPVs).
• When sponsors use project finance, they truncate
  the downside. The decision to use project
  finance can be thought of as the decision to buy
  a walkaway put option on the project. The
  combination of holding an underlying asset
  (project) and buying a put option on that asset
  gives the payoff function of a call option.
• The downside protection may be valuable but the
  choice between corporate finance and project
  finance depends on the put premium and the
  willingness of sponsors to exercise the put
  option.

60
Project Finance as InsurancePayoffs to
Project-Financed vs.Corporate Financed Investment
Sponsor Equity Value
Corporate Finance Payoff
Project Finance Payoff
Project Value
0
Walkaway Put Option
D
61
Project Finance as Insurance

• Project Finance provides sponsors with a put
  option
• The put premium is paid in the form of higher
  interest and fees on loans. Lenders who are at an
  informational disadvantage are likely to charge a
  high price for the option. Sponsors may prefer to
  bear the risk rather than to buy an expensive
  option. As projects get bigger, distress costs
  increase, making the purchase of a put by
  sponsors more likely.
• The put option is valuable only if sponsors are
  able/willing to exercise the option. Sponsors who
  cannot walk away from the project because
• It is in a pre-completion stage and the sponsor
  has provided a completion guarantee,
• It has take or pay contracts,
• It is part of a larger development,
• It represents a proprietary asset,
• and for which default would damage the firms
  reputation and ability to raise future capital,
• cannot exercice the put and are more likely to
  use corporate finance than project finance.

62
Project Finance versus Corporate Finance

• Tax and Other Benefits of project Finance

63
Taxes, Location, Heterogenous Partners

• Location Large projects in emerging markets
  cannot be financed by local equity due to supply
  constraints. Investment specific equity from
  foreign investors is either hard to get or
  expensive. Debt is the only option and project
  finance is the optimal structure.

• Tax An independent economic entity allows
  projects to obtain tax benefits that are not
  available to the sponsors. When a project is
  located in a high-tax country and the project
  company in a lower tax country, it may be
  beneficial for the sponsor to locate the debt in
  the high tax country.

• Heterogeneous partners
• Financially weak partner needs project finance to
  participate.
• Financially weak partner if using corporate
  finance can be seen as free-riding.
• The bigger partner is better equipped to
  negotiate terms with banks than the smaller
  partner and hence has to participate in project
  finance.

64
Part 4

• Leverage and Financing Issues

65
Leverage and Financing Issues

• Debt offers multiple benefits
• Tax Advantages.
• Helps to solve Free Cash Flow Problem.
• Helps to solve Political Problem (Hold Up)
• There are lower bankruptcy costs than in
  corporate finance (large tangible assets).

66
Leverage and Financing Issues How to Finance the
Project

• Bank Loans
• Advantages
• Cheaper to issue.
• Concentrated ownership makes it easier for
  lending.
• Tighter covenants and better monitoring.
• Easier to restructure during distress.
• Lower duration forces managers to disgorge cash
  early.
• Bond market may be fickle.
• Draw on credit line as needed.
• Disadvantages
• Short maturity.
• Restrictive Covenants.
• Variable interest rates.
• Limited size.

67
Leverage and Financing Issues How to Finance the
Project

• Project Bonds (144A Market)
• Advantages
• Private placement does not through SEC
  registration procedure.
• Lower interest rates (given good credit rating).
• Less and flexible covenants.
• Long Maturity.
• Fixed rates.
• Size, (US 100-200 million).
• Secondary trading.
• Disadvantages
• Disperse ownership
• less monitoring
• less efficient negotiations
• New market
• Lump sum nature

68
Leverage and Financing Issues How to Finance
the Project

• Project Bonds
• Project bonds have negotiated ratings sponsors
  adjust leverage, covenants and deal structure
  until the projects achieve an investment-grade
  rating.
• The largest advantage in pricing and liquidity
  occurs above the BBB- cutoff due to institutional
  restrictions against investment in sub-investment
  grade securities. Bonds must have an investment
  grade to sell in the market.
• Since 1998, the percentage of project bonds with
  an investment grade (BBB- or higher) has ranged
  from 63 to 67.

69
Leverage and Financing Issues How to finance the
project

• Agency Loans
• Advantages
• Reduce expropriation risk.
• Validate social aspects of the project.
• Reduce political risk
• countries less likely to want to injure
  multilateral agency.
• Provide political risk insurance
• Overseas Private Investment Corporation (OPIC) in
  U.S.
• Multilateral Investment Guarantee Agency (MIGA)
  of World Bank
• provide insurance against political risks for up
  to 20 years.
• Disadvantages
• Cost (300 bp)
• Time (12-18 months to arrange)

70
Conclusion
71
Conclusion Future of Project Finance

• The future of PF will be shaped by many factors
• Financing structure There are four specific
  financing trends
• - hybrid project-corporate financings (corporate
  debt structure with project-finance-like
  covenants, with recourse to the sponsors in the
  event of default unless default is due to
  political risk) portfolio financing, i.e., the
  bundling of multiple projects into a single
  transaction.
• - use of Term B loans, a bond with back-end
  amortization with bank-type covenants, heavily
  collateralized and carrying high interest rates.
• - use of monoline bonds, bonds that wrap the
  credit rating of the insurer around the debt
  issue to raise the credit rating to AAA.
• - participation of private equity, purchasing
  both non-distressed and distressed assets.

72
Conclusion Future of Project Finance

• Regulatory and environmental policy
• - new international capital standards (Basel
  II), risk-weighting of project loans.
• - management of environmental and social risks
  (Equator Principles) whose focus is to assess and
  minimize the social risks of large projects.
• Expropriation risk has risen especially in
  developing countries sponsors are increasingly
  challenged to design and implement sustainable
  long-term contracts and agreements with
  governments or face the risk of expropriation.
• Valuation of infrastructure assets with the
  infrastructure sector in danger of suffering from
  the dual curse of over-valuation and excessive
  leverage, the classic symptoms of an asset
  bubble.

73
APPENDIX

• Project Finance versus Corporate Finance An
  example

74
Example BP AMOCO The Corporate Finance Model

• Long-term Financing
• Bonds
• Equity

BP Amoco

• Short-term Financing
• Commercial paper
• Bank loans

Business Units
Treasury Group
Cash Management and Money Market Instruments
Operating Cash Flow
400m
40 of Cash Flow
Project Cost 1 billion
Partner A 25 share
Partner B 35 share
250m
350m
25 of Cash Flow
35 of Cash Flow
75
ExampleBP AMOCO The Project Finance Model
BP Amoco
Partner B 35 share
Partner A 25 share
Business Units
Treasury Group (40 share)
140 million equity
160 million equity
40 of operating cash flow
100 million equity
300 million secured loan
Project Cost 1 billion Equity 400
million Debt 600 million
300 million secured loan
144A Bond Market
Banks
payback Interest
paybackinterest
International Org.
Government
Suppliers
Contractors
76
Alternative Sources of Risk Mitigation
77
Alternative Approach to Risk Mitigation