OUTLINE
1. What is Project Finance? 2. How does project finance create value? 3. Project valuation 4. Case analyses 5. Recap
Definition:
Project Finance involves one or more corporate sponsors investing in and owning a single purpose, industrial asset through a legally independent project company financed with limited or non-recourse debt.
A relevant question to investigate: Finance separately with non-recourse debt? (Project Finance) SPONSOR + PROJECT? Finance jointly with corporate funds? (Corporate Finance)
Major characteristics:
Economically and legally independent project company Founded extensively on a series of legal contracts that unite parties from input suppliers to output purchaser Project assets/liabilities, cash flows, and contracts are separated from those of the sponsors, conditional on what accounting rules permit Investors and creditors have a clear claim on project assets and cash flows, independent from sponsors financial condition Debt is either limited (via completion guarantees) or nonrecourse to the sponsors
Major characteristics:
Highly leveraged project company with concentrated equity ownership Partly due to firms need for flexibility and excess debt capacity to invest in attractive opportunities whenever they arise Syndicate of banks and/or financial institutions provide debt Typical D/V ratio as high as 70% and above Debt has higher spreads than corporate debt One to three equity sponsors Sponsors provide capital in the form of equity or quasi-equity (subordinated debt) Governing Board comprises of mainly affiliated directors from sponsors
Major characteristics:
Historically formed to finance large-scale projects Industrial projects: mines, pipelines, oil fields Infrastructure projects: toll roads, power plants, telecommunications systems Significant financial, developmental, and social returns Examples of project-financed investments $4bn Chad-Cameroon pipeline project $6bn Iridium global satellite project $1.4bn aluminum smelter in Mozambique 900m A2 Road project in Poland
Major characteristics:
Statistics as of year 2002 $135bn of capital expenditure globally using project finance $19bn of capital expenditure in the US Smaller than the $612bn corporate bonds market, $397bn asset backed securities market and $205bn leasing market; approximately same size with the $27bn IPO and $26bn venture capital market
Source: Esty, B., An Overview of Project Finance 2002 Update: Typical project structure for an independent power producer
OUTLINE
1. What is Project Finance? 2. How does project finance create value? 3. Project valuation 4. Case analyses 5. Recap
Contractual structure
Structuring the project contracts to allocate risk, return, and control
Governance structure
Benefits of debt-based governance
Non-recourse project debt is more expensive due to greater risk and high leverage
High leverage and extensive contracting restricts managerial flexibility Project finance requires greater disclosure of proprietary information to lenders
Still, the combination of organizational, financial, and contractual features may offer an opportunity to reduce net cost of financing and improve performance
Contractual structure
Structuring the project contracts to allocate risk, return, and control
Governance structure
Benefits of debt-based governance
Structural Solutions:
Cash Flow Waterfall mechanism reduces potential conflicts in distribution and re-investment of project revenues Legally/economically separate project company eliminates potential for risk shifting and debt shifting
Concentrated debt ownership is preferred (i.e. bank loans vs. bonds) to facilitate the restructuring and speedy resolutions
Usually subordinated debt (quasi equity) is provided by sponsors Strong debt covenants allow better monitoring Single cash flow stream and separate ownership provides easier monitoring
Structural Solutions: Non-recourse debt in an independent entity allocates returns to capital providers without any claim on the sponsors balance sheet. Preserves corporate debt capacity. The fact that non-recourse debt is backed by project assets/cash flows and not by the sponsors balance sheet increases the chances of an already highly leveraged sponsor to separately finance a viable project
Benefit from portfolio diversification is negative (risk is higher) when sponsor and project cash flows are strongly positively correlated.
Separate incorporation eliminates potential increase in risk when financing a project strongly correlated to sponsors existing asset portfolio.
Debt may be the only option and project finance the optimal structure. Besides, host government may grant the project tax holiday, which provides sponsors exemptions from taxation
Contractual structure
Structuring the project contracts to allocate risk, return, and control
Governance structure
Benefits of debt-based governance
Contractual structure in Project Finance to reduce cost of risk and create value
Other earners of net income (or net value added) from investment can also share risk:
Net Value added = Return to equity + Interest expenses + Taxes + Labor costs = Revenues Material / service costs Depreciation
Profit sharing mechanisms or tax incentives may change how variability in income is shared among sponsors, lenders, government, and labor
Output purchasers and input suppliers can also share the risks as they experience variability in their markets
Some risks can be reduced by spreading the burden across many participants; some other risks cannot be spread, but can be shifted or reallocated
Different stakeholders in a project may have different preferences, and hence different willingness and capacity to bear risks Cost of risk is lower to those with greater capacity and willingness to bear risk Risk-return trade-offs may enable integrative (not necessarily competitive) negotiations among different stakeholders and may create value in a project setting Gains in economic efficiency can be achieved if overall cost of risk declines through risk shifting and reallocating: The same risk will have a lower cost if born by parties better capable and willing to do so
Additional considerations:
Solution
A government support agreement Reputation, references for similar projects and technology being used Experience with the country, good relationships with local subcontractors Similar references for the subcontractors Contract supervision by the project companys other personnel not directly related to the contractor Careful review of contractors credit standing Careful review of the project scale in relation to the size of contractors overall business If project too big for the contractor to handle alone, a joint venture approach with a larger contractor Guarantees of obligations by the contractor's parent company
Is it also one of projects sponsors? (Conflict of interest) The contractors credit standing? If the contractors wider business gets into difficulty, the project is likely to suffer
Delay in completion: failure to meet the milestones increase costs, reduce equity returns, and reduce DSCR Financing costs, especially as debt will be outstanding longer Revenues from operating the project will be lost or deferred (significant risk also especially if part of financing depends on early revenues) Penalties may be payable under contract to input suppliers or off-taker Process failures
The project may be dependent on completion of another project worst type of third party risk especially when the project financing is dependent on it. Sponsor-related risks (Lenders perspective): Sponsor commitment to the project Financially weak sponsor
Hedging contracts Operating cost risk: Uncertainty regarding the changes in the operating cost throughout the life of the project Risk sharing contracts to increase correlation between revenue and some cost items:
If there is an off-take contract, linking input supply price to it:
Basing the product price under the off-take contract on the cost of the input supplies (more likely if input supply is a widely traded commodity like oil) Basing the input supply price to product price under the offtake contract: (more likely if the input is a specialized commodity, or if there is no off-take contract and risk is passed to the input supplier)
Price ceilings Profit sharing contract with labor Output or cost target related pay
Organizational risks: Incentive problems relating to management or workers Operating risk: operating difficulties due to technology (being degraded or obsolescent), processes used, or incapacity of operator team leads to inefficiencies and insufficient cash flow
Force majeure risk: Likelihood of occurrence of events like wars, labor strikes, terrorism, or nonpolitical events such as earthquakes, etc.
Currency convertibility / transferability risk: As it is often not possible to raise funding in local currency in developing countries, revenues earned in local currencies need to be converted into foreign currency amounts needed by offshore investors/lenders, and then need to be transferred outside the country to pay for them. Additionally, foreign currency may be needed to import materials, equipment, etc.
Expropriation: Direct, diversion, creeping Governments breach of contract and court decisions
Government guarantees or regulatory undertakings to cover taxes, royalites, prices, monopolies, etc. Involvement of multilateral/bilateral agencies Offshore accounts for proceeds Governments equity ownership Using external law or jurisdiction
Government support agreement Using external law or jurisdiction Involvement of multilateral/bilateral agencies A general principle is that the party who is paying for the output under a project contract should pay for the losses incurred due to changes in law specific to the industry, because such change is reflected in the entire industry and any extra costs will normally be passed on to end users; therefore an offtaker who does not bear this risk would earn extra profits at the expense of the project company
Legal system:
Unclear and/or inconsistent legal/regulatory framework for projects operations Insufficient protection of private investment and private ownership/control of project Bureaucratic hurdles Changes in law, such as imposition of new environmental/health/safety requirements, price controls, import duties/controls, increase in taxes, royalties, deregulation, amendment or withdrawal of projects permits, changing the control of company
Contractual structure
Structuring the project contracts to allocate risk, return, and control
Governance structure
Benefits of debt-based governance
Tighter covenants limit managerial discretion and enforces greater discipline via better monitoring High leverage reduces free cash flow exposed to discretion High leverage reduces expropriation risk High leverage also reduces accounting profits thereby reducing the potential of local opposition to the company Tax shields
Contractual structure
Structuring the project contracts to allocate risk, return, and control
Governance structure
Costs and benefits of debt-based governance
Selection of strategic sponsors who would bring the most value to the project Mitigation of market risk: Growing demand and capacity shortfall that triggers competition, rapid improvements in cable technology and resulting price decline necessitates moving very quickly Completion risk: Potential delays due to environmental approvals and other permits Management of possible agency conflicts between: 1. sponsors and management 2. sponsors and other parties (capacity buyers (purchasers), suppliers, etc.) 3. sponsors and creditors - decision of how many and which banks to invite to participate
2.
3.
8.
The growth strategy includes building and operating a power system consisting of multiple power plants. Project financing and corporate financing alternatives are considered.
Costs: The high-yield market was thinner and more volatile compared to investment grade market, creating pricing and availability risk As a firm with high leverage and sub-investment grade rating, the high cost of corporate financing might lead Calpine to miss the opportunity to invest in a positive NPV growth project (Debt Overhang) A large debt issue might further jeopardize Calpines debt rating
2.
3.
Costs: Project might create additional risks in BP Amocos current asset portfolio Risk contamination BP Amocos absence in the IFC/EBRD finance deal for the MIG would make it harder for the weaker partners to negotiate good terms, reducing flexibility in operations and management BP Amocos using corporate funding while at least some of the other partners using the IF/EBRD deal might potentially create disagreements Other partners might accuse BP Amoco as free rider, since BP Amoco would benefit at no cost from the political risk protection IFC/EBRD deal would have provided How they funded the initial phase would change possibilities of financing for the coming stages
Costs: Harder, costlier, and more time consuming to set up Less flexibility compared to corporate finance alternative
OUTLINE
1. What is Project Finance? 2. How does project finance create value? 3. Project valuation 4. Case analyses 5. Recap
Project Valuation
Background Approaches to calculating the Cost of Capital in Emerging Markets Country Risk Rating Model (Erb, Harvey and Viskanta)
Background
Projects are characterized by: unique risks high and rapidly changing leverage imbedded flexibility to respond to changing conditions (real options) changing tax rates early, certain and large negative cash flows followed by uncertain positive cash flows Traditional DCF method is inaccurate: Single discount rate does not account for changing leverage Ignores imbedded options Idiosyncratic risks are usually incorporated in the discount rate as a fudge factor Traditional CAPM method is inaccurate: Many mega projects are in emerging markets Many of these markets do not have mature equity markets. It is very difficult to estimate Beta with the World portfolio. The Beta with the World portfolio is not indicative of the sovereign risk of the country (asymmetric downside risks). E.g. Pakistan has a beta of 0. Most assumptions of CAPM fail in this environment More appropriate approaches to project valuation may include: Usage of non CAPM based discount rates especially for emerging markets investments Changing discount rate to account for changing leverage Incorporate idiosyncratic risks in cash flows and account for systematic risks in discount rate Valuation of real options Usage of Monte Carlo simulation
The credit rating may proxy for many of these fundamental risks as it is survey based
Average returns
If cash flows are in local currency, convert into $US: Calculate the difference between the multiyear forecasts of inflation in the host country and those in US Use the difference to map out the expected exchange rates Use calculated expected exchange rates to convert cash flows into $ Adjust for industry risk:
Calculate the country risk premium from ICCRC: Country risk premium = Country cost of equity capital US cost of equity capital Calculate US industry cost of capital by using industry beta Add the country risk premium to US industry cost of capital
Adjust for project specific risks that deviate the project from the average level of risk in the host country Risks incorporated in cash flows or industry adjustment:
Pre-completion: technology, resource, completion. Post-completion: market, supply/input, throughput. Sovereign risk: macroeconomic, legal, political, force majeure. Financial risk.
OUTLINE
1. What is Project Finance? 2. How does project finance create value? 3. Project Valuation 4. Case analyses 5. Recap
Case analyses
Chad-Cameroon Petroleum Development and Pipeline Project Petrozuata and Oil Field Development Project Financing the Mozal Project
Background
ExxonMobil, Chevron, and Petronas undertake a $4 Billion petroleum development and pipeline project in Chad, which presented a unique opportunity to stimulate Chads economic development, and yet entailed environmental and social risks. Corporate finance for the development of the field system and project finance for the pipelines Debate on unstable political structure and how Chad would use its share of project revenues WBs introduction of Revenue Management Plan to target Chad Governments returns from the project for developmental purposes, and debate on the likelihood of effectiveness of such a plan
Subjects of opposition:
The environmental and social impacts were claimed to be irreversible The revenue management plan was claimed to be flawed and to lack effective oversight Govt claimed to have little intention of allowing the plan to affect local practice Criticism on oversight committees composition and power The RMP was a concept untested According to Harvard Law School, Oil will not lead to development in Chad without real participation, real transparency, and real oversight, none of which currently exists The revenue management plan also regarded as infringement of sovereign rights The sovereign rights controlled by undemocratic rulers versus people The beneficiaries of the project were claimed more to be the corporate sponsors and commercial banks, as opposed to people of Chad Valuable funds could have been used in alternative causes, rather than potentially strengthening a corrupt Govt
RMP provisions and future linking of developmental funds to Govt compliance may deter potential misuse of project revenues by the Govt Project helps leveraging WB and other financial resources which Govt could not have mobilized by itself Leveraging technical expertise of the reputable sponsors significantly reduces Chads exposure to operational risks Potential employment opportunities created for local people in operations Environmental/social concerns seem to be well addressed in contingency plans with extensive public consultation Another positive externality may be WBs capacity building efforts to establish the sufficient infrastructure for a well-functioning petroleum industry and investment climate in Chad Greatest protection from downside risk (i.e. price or volume risk) compared to corporate sponsors, probably because bulk of the revenues (royalties) independent from price or reserve levels.
Any social or political instability in either Chad or Cameroon would adversely effect the export of oil through the pipelines across the two countries
However, the construction of pipelines underground may have helped reduce the negative consequences of being exposed to such risk
Real options
Shadow costs: In case WB is not involved in the project, it is likely that the Govt will go with Libya Temporary stop option if oil price drops
Project Update
After WB approved the deal, President Deby used part of the proceeds to buy weapons Huge criticism by social activists/interest groups against WB and sponsors WB responded by requiring that the proceeds should be repaid out of general revenues, suspended new loan programs, and also set up a new oversight body headed by external people After these reforms, WB and IMF permitted debt relief to Chad In December 2005, the National Assembly of Chad amended the countrys Petroleum Revenue Management Law in the following ways*:
broadening the definition of priority sectors to include, among other areas, territorial administration and security; and by allowing that further changes in the definition of priority sectors can be made by decree; eliminating the Future Generations Fund, thus allowing the transfer of more than US$36 million already accumulated there to the general budget increasing from 13.5 % to 30% the share of royalties and dividends that can be allocated to non-priority sectors that are not subject to oversight and control
Project Update
WB considered these changes a breach of contract, and on January, 2006, it suspended new loans and grants to Chad, as well as disbursements under eight ongoing IDA operations in the country. The suspension automatically freezed the flow of part of Chads oil revenues within the offshore escrow account WB states in its web site that it remains in dialogue with the Chadian authorities, and is determined to safeguard the oil revenues intended for poverty reduction programs included in its original agreement with Chad, while recognizing the fiscal strains currently experienced by the government of Chad.
Background
Petrozuata is a $2.4B integrated oil field development project in Venezuela. The project is planned to be financed under project financing structure. The project sponsors Conoco and Maraven are subsidiaries of Du Pont and PDVSA, a Venezuelan state owned enterprise. The sponsors decide on 60% debt financing, and seek for alternative ways to raise the required funds. The alternatives considered are project bonds, securing of which are contingent on securing investment-grade rating for the project; or bank loans, which may need to be covered by PRI provided by multilateral agencies. The priority and challenge for the sponsors is to craft the projects operational and financial details so as for the project to achieve an investment grade rating.
Debt financing for PDVSA more expensive under corporate finance structure:
PDVSA has low credit rating (long-term senior unsecured debt rating B from S&P), thereby relatively high cost of debt ~ 10.17% (Exhibit 10b) Under project financing, if the project can secure BBB investment grade rating, lower cost of debt ~ 7.70% A gain of 2.47% However, huge transaction and contracting costs as well as the longer time needed to structure a project financed deal should be weighed against the potentially lower cost of debt to see if there is a net gain in terms of costs
From lenders perspective, separated cash flows also allow easier monitoring and possibly lower monitoring costs Project finance allows better allocation or sharing of risks via contractual relationships, thereby reducing the cost of risk
Risk management
Identification and mitigation of: Pre-completion risks: Resource, technological, timing, and completion risks Post-completion risks: Market risk, supply risk, throughput risk, and force majeure Sovereign risks: Inflation risk, exchange rate volatility convertibility risk, expropriation Financial risks: Leverage risk under the constraint of investment grade rating
The price of oil is volatile + The off-take agreement with Conoco secures a significant portion of the output to be purchased for 35 years at a price pegged to market price of Maya crude + Petrozuata being a low cost producer with breakeven price well below industry average could still operate even if prices fell dramatically Currently there is no broader market developed for syncrude + However, in expectation of the development of such a market in the near future, Petrozueta retained the option to sell the syncrude to third parties if they demand at a higher price than Maya crude. + According to an independently conducted assessment, the development of a third party market was expected in 3-5 years, and that the syncrude output would sell at a $1/barrel premium.
+
+ + +
Risk of Governments changing the currently preferential tax and royalty treatment Possible negative influence of Govt on the effective functioning of offshore proceeds account History of nationalization in the 1970s Govt cannot afford to risk the future funding opportunities for the planned series of upcoming projects by getting involved in any form of expropriation The Govt owns a serious portion of the assets anyway (PDVSA and Maraven as sponsors) Any expropriation attempt may face a retaliation from US where PDVSA has assets (CITGO) Govt interests aligned with the projects success, as Govt receives tax and royalty payments, as well as benefits of employment opportunities created and access to the refining technology Project output syncrude has a narrow market limiting Governments motivation for a diversion attempt
0.05 0.03
0.00 0.00
Operating 0.00 Resource risk 0.00 Technology risk Financial -0.17 Probability of Default -0.09 Political Risk Insurance Real Options (some handled through cash flows) Project impacts other projects Option to delay the project Option to increase/decrease production Option to abandon the stages of the project Sum of weights (make sure = 1.00)
0.03 0.03
3.00 2.00
Output Category U.S. risk free in % Exhibit 9 U.S. risk premium in % Current U.S. Credit Rating Institutional Investor country credit rating (0-100) 31.04 Anchored Cost of Equity Capital for project of average risk in country (ICCRC) 18.44 Country Risk Premium
TN
19.44
What happened?
The project received ratings that exceeded the sovereign ratings by five notches Completed a $1B bond issue, which was five times oversubscribed, and a total of $450M bank financing (with 14 years maturity at 7.98%, 12 years maturity at 7.86%) The project considered by analysts as one of the best structured and best executed project finance deals ever done, 1997 PDVSA continued to structure deals for the Orinoco Basin Venezuelan economy was hit hard by the decline in crude oil prices S&P revised its outlook for Petrozuata to negative, as a result of the cost overruns, lower than expected early production revenues, falling prices, and political uncertainty As economic situation worsened, Govt demanded and received extraordinarily high dividends from PDVSA reaching up to 134% of projected income in 1999 Hugo Chavez won the 1998 elections and announced not to interfere with foreign oil investments
Background
Mozal is a $1.4 B aluminum smelter project in Mozambique. The sponsors are Alusaf, a subsidiary of a South African natural resource company, and IDC, a government-owned South African development bank with long-standing relationship with Alusaf. The sponsors are interested in structuring a limited-recourse financing deal with IFC involvement. IFCs concerns are the size of the project, as well as the political risks of doing business in Mozambique.
Risk Management
Identification and mitigation of: Pre-completion risks: Technological, timing, and completion risks Post-completion risks: Market risk, supply risk, and force majeure Sovereign risks: Inflation risk, exchange rate volatility, convertibility risk, expropriation Financial risks: Leverage risk
Sovereign risks
Expropriation risks: - Outright seizure of assets very unlikely: - The scale of the project relative to the size of the poor economy (9% of GDP), combined with short-term survival concerns may be tempting for a shortsighted Govt to expropriate + Govt wouldn't want to curb the investments, because they are interested in development + Govt cannot afford an outright seizure, due to potential reactions from WB/IFC, as this would jeopardize the much needed future development funds + Following a direct seizure, international suppliers may not be willing to work with the Govt, and Mozambique does not have local suppliers of the raw materials to go on with the business alone
Sovereign risks
Expropriation risks: - Seizure of cash flows (diversion) low risk: - Govt may divert the aluminum and sell it to others + However, the spot market for aluminum is very thin for Govt to divert and easily sell the output + Potential reactions from WB/IFC - Changing of taxation creeping moderate risk: - Govt may remove the privileges that the smelter would be exempt from customs duties and income taxes - It is highly likely that the Govt may change the 1% sales tax, which is more critical than the income tax
Sovereign risks
Political events: Political instability Risk of war: not completely eliminated Legal instability Bureaucratic hurdles Underdeveloped infrastructure Unskilled / untrained labor Macroeconomic risks: Currency exposure: + Not a major risk as the major inputs and all the output would be denominated in $. Convertibility risk: + Not a major risk since the proceeds will be kept at an overseas trustee
Existence of international commercial partners: + International suppliers: Power from Eskom of South Africa, alumina from an Australian supplier, technology from France, most of the other inputs (coke, petroleum, etc.) would be imported as well + Any expororpiation would jeopardize as well the trade relationships with these countries as they were at the same time Mozambiques important trade partners Involvement of multilateral/bilateral agencies: + IFC: Almost totally reduces the risk of expropriation and default + French and South African ECAs + Any expropriation would have impact on future flow of development funds Foreign trustee to keep the sales proceeds
Real options
Option to expand + Mozal would be constructed with all the infrastructure to double the capacity when needed.
What happened?
IFC approved the $120M investment in 1997, its largest investment by then In 1998, Project Finance International declared Mozal as the Industrial Deal of the Year Construction temporarily stopped in 1998 when workers went on strike to protest low wages and poor working conditions Workers on strike held management hostage in 1999 Despite the ongoing strike, the project proceeded as planned, and was in fact on time and below budget Critics argued that the sovereign risk had been too high, showing the strike as evidence Critics also defended that sponsors were treated too generously in the deal compared to Mozambique Despite the criticisms, the Mozal project appeared to set the stage for an inflow of additional private investments in Mozambique in the final analysis
OUTLINE
1. What is Project Finance? 2. How does project finance create value? 3. Project Valuation 4. Case analyses 5. Recap
When the asset is less than perfectly correlated to the rest of companys asset portfolio, corporate financing may help eliminate idiosyncratic risks via diversification When the sponsor has strong balance sheet to secure debt in favorable terms, and a vertically integrated business model (which minimizes variability) When the sponsor is better equipped than anyone else in assessing and bearing risks Corporate finance is preferred when it results in lower combined variance due to diversification (co-insurance). When the benefits of above told co-insurance outweighs cost of risk contamination
Discrete, non-core assets that can be separated from the rest of the business) Example: power plants Large, highly risky projects with cash flows highly correlated with those of sponsor (no benefits from diversification under one portfolio) Projects appropriate for high leverage (those with predictable cash flows, low distress costs, and minimal ongoing investment requirements) Projects that are more transparent and easier to monitor during construction, development, and ongoing operations (transparency can lower cost of capital by facilitating credit decisions) Projects with a structure that minimizes overall costs associated with market imperfections When it is possible and cost effective to allocate the project risks contractually Projects whose cash inflows and outflows can be set by long-term contracts (to reduce variability)
Acknowledgements
The content of this presentation has been derived from: Emerging Markets Corporate Finance Course materials taught by Campbell Harvey at Duke University Project Finance lecture slides by Campbell Harvey, Aditya Agarwal, Sandeep Kaul at Duke University Modern Project Finance: A Casebook, Benjamin Esty, John Wiley & Sons, 2004 Principles of Project Finance, E.R. Yescombe, Academic Press, 2002 Petrozuata, A Case Study of the Effective Use of Project Finance, Benjamin Esty, Journal of Applied Corporate Finance Contracting and Project Finance Lecture Notes, Program on Project Appraisal and Risk Management, May 16-June 10 2005, Duke Center for International Development Risk Management Lecture Notes, Evaluating Projects in the Public Sector Course, Program in International Development Policy, Duke University