Presentation on theme: "Project Finance A General Introduction1"— Presentation transcript:
1 Project Finance A General Introduction1 One Example of Off Balance Sheet Financing Techniques
2 Project FinanceA Definition from the Association of Corporate Treasurers*‘A financing of a particular economic unit in which a lender looks initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan’*author, FSMD
3 Project Finance The project is Not consolidated as not controlled by the reporting entityLiabilities remain within ring fenced entityorSpecial Purpose Vehicle (SPV)
4 Source WikipediaA special purpose entity (SPE) (sometimes, especially in Europe, "special purpose vehicle" or simply SPV) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives. SPE's are typically used by companies to isolate the firm from financial risk. A company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk.A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.
5 Project Finance Two important principles in relation to Recourse Has the legal structure succeeded in taking the obligations, risks and returns of the project, off the balance sheet of the Sponsors?Accounting standards are constantly tightened (due to Enron, Worldcom etc) so substance becomes more important than form
6 Project FinanceA Project usually defined as a major productive capital investment e.g. in- oil or mineral development- heavy industry (aluminium smelters etc)- forestry, agriculture- power generation, transportation, (tollroads, bridges)- telecoms
7 Project Finance Characteristics of PF Project cash flowsNormally higher levels of debt ( which may lead to the need for additional support)Variety of contractual obligations and undertakings to manage and reduce risk- Bank Guarantees- Letters of Creditto cover greater risk during construction period
8 Project Finance Characteristics of PF A variety of funding sources- export credits- development funds- specialised asset finance- conventional debt and- equity finance
9 Project Finance Project finance is a ‘classic example of fundamental principles of credit and corporate finance’ (ACT/FSMD)i.e. managing risk and return for thedifferent parties from a stream of futurecash flows
10 Project Finance BOT Build – Operate – Transfer Sponsors project and supplies equityJVSupply and Construction ConsortiumLicense to operate and purchase of sharesSupply and ConstructionProjectHost GovernmentProvide FinancePower purchase agreementBanksElectricity Authority
12 Project Finance Why use Project Finance Amount too large for company Balance SheetToo much risk for one company to bear- share different risks with those better able to assess and managee.g. Oil exploration, development and production
13 Project Finance Why? continued What risks for oil?Exploration- geological interpretation- harsh environments- political risks
14 Project Finance Why? continued Once found then, Development/Production- reservoir risk- recovery risk- technology risk- production risk- transportation riskStill have market risk, environmental risk de- commissioning and so on
15 Project Finance Why? continued Company policy for off balance sheet with or without recoursePolitical risks- e.g. local regulations ref foreign shareholdingsExisting covenantsProject development timeRing fence also helps protect the project from sponsor failure
16 Project Finance Recourse from full to zero Determined by the contract - provide extra cost- take a particular risk- agree to take (off-take) productRecourse may also vary in kind (type)as well as degree- Legal obligations- Moral obligations
17 Project Finance Process Strategic/commercial evaluationSystematic identification and exploration of risksValuation (NPV of cash flows)Design of risk bearing/sharing packageAppropriate funding packageImpact of financing package on net cash flows and sensitivity analysis
18 Project Finance Risk Analysis Pre construction Construction Operation But many risks may be present at all stagesResource availability- Geological-Infrastructure-Technological-Construction-Operating-Labour supply-Material sourcing-Product market-Management-FX-Political-Regulatory-Environmental
19 Project Finance Common causes of failure Completion delay-Cost overrun-Technical failure-Uninsured casualty losses-Increase price/shortage of raw materials-Technical obsolescence-Government interference-Loss of competitive position-Expropriation-Poor management
20 Project Finance Design of Risk Sharing Contractual Structure Objective to prevent or limit their effectConcession agreements-Construction and equipment contracts-Completion guarantees-Supply agreements-Throughput agreements-Cost over run insurance-Cash deficiency agreements-Political risk insurance-Management contracts
21 Project Finance Design of Risk Sharing Contractual Structure Banks will useAssignment of proceedsCash handling proceduresFinancial guaranteesfrom sponsor, governments, other banks, third partiesCredit protectionInsurance
22 Project Finance Design of Risk Sharing Contractual Structure ‘What may be an unacceptable risk for one party may be perfectly acceptable to another’Government permissionsPhysical completionCost over runsDelaysCosts of inspectionTechnical performancePricesSupplyThroughput or off take agreements
23 Project Finance Design of Risk Sharing Contractual Structure Lending BanksAdvisorsProject SponsorsFinancing AgreementFinancial, Legal, Insurance adviceShareholders AgreementProject CompanyOfftake/Purchase ContractOfftake/Product PurchaseInsurersInsurance PoliciesSupply contractOperation and MaintenanceAgreementRaw Material supplierConstruction contractOperatorConstruction
24 Project Finance The Funding Package 1 The objective is toCreate an acceptableRisk/Returnrelationship for the participantsBuild in flexibility to cater for variations in project outturnRisk hedging- financial by debt- interest rate risk- foreign exchange rate
25 Project Finance The Funding Package 2 As little straight equity as possible (but some)Quasi equity e.g. subordinated loan stock- more flexible- performs like mezzanine finance(leveraged buyouts)
26 PF: Subordinated DebtWhat Does Subordinated Debt Mean? A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings. Also known as a "junior security" or "subordinated loan".
27 PF: Junior Security/Debt What Does Junior Security Mean? A security that ranks lower than other securities in regards to the owner's claims on assets and income in the event of the issuer becoming insolvent.Investopedia explains Junior Security When bankruptcy occurs, holders of both preferred shares and debt securities have first claim on the remaining assets. Only after preferred shareholders have been paid back, remaining assets (if any) are divided among common shareholders.
28 PF:Senior DebtWhat Does Senior Issue Mean? An issue of bonds, preferred stock or other securities that represents the first priority lien on the issuer's assets or earnings. Senior issues have a higher priority claim on a firm's dividends, interest payments, or in case of a bankruptcy, the value salvaged from a liquidation.Investopedia explains Senior Issue Priority levels may change in the subordinated debt structure. An issue that is considered senior may lose that title in certain situations. For example, if a firm claims bankruptcy and begins acting as a debtor in possession (DIP), it may attempt to raise more funds to keep operations going. A new lender may require its lien to be given top priority, forcing the current senior issue of bonds down the claims ladder.
29 PF: Senior SecurityNotwithstanding the senior status of a loan or other debt instrument, another debt instrument (whether senior or otherwise) may benefit from security that effectively renders that other instrument more likely to be repaid in an insolvency than unsecured senior debt. Lenders of a secured debt instrument (regardless of ranking) receive the benefit of the security for that instrument until they are repaid in full, without having to share the benefit of that security with any other lenders. If the value of the security is insufficient to repay the secured debt, the residual unpaid claim will rank according to its documentation (whether senior or otherwise), and will receive pro rata treatment with other unsecured debts of such rank.Source: Investopedia and Wikipedia
30 PF: Mezzanine FinanceWhat Does Mezzanine Financing Mean? A hybrid of debt and equity financing that is is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies. Since mezzanine financing is usually provided to the borrower very quickly with little due diligence on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender seeking a return in the 20-30% range. Investopedia explains Mezzanine Financing Mezzanine financing is advantageous because it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing. To attract mezzanine financing, a company usually must demonstrate a track record in the industry with an established reputation and product, a history of profitability and a viable expansion plan for the business (e.g. expansions, acquisitions, IPO).
31 PF: Mezzanine FinanceMezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on company's assets, which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.Mezzanine capital often is a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a company's capital structure (i.e., in the event of default, the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements are also often used by smaller companies and may also involve greater overall leverage levels than issuers in the High Yield market and as such involve additional risk. In compensation for the increased risk, mezzanine debt holders will require a higher return for their investment than secured or other more senior lenders.Source: Wikipedia
32 PF: Mezzanine Finance Leveraged buyouts In a leveraged buyouts, mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior loans, second lien loan, high yield financings) and equity. Often, a financial sponsor will exhaust other sources of capital before turning to mezzanine capital.Financial sponsors will seek to use mezzanine capital in a leveraged buyout in order to reduce the amount of the capital invested by the private equity firm. Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firm's investment returns. Additionally, middle market companies may be unable to access the high yield market due to high minimum size requirements, creating a need for flexible, private mezzanine capital.
33 Project Finance Funding Package 2 Back to Subordinated LoanGives advantages such as- higher return than senior debt- can carry low and flexible coupon- tax deductible- can be regarded as equity by seniorlenders
34 Project Finance The Funding Package 3 Debt will be sourced from a variety of providersExport Credit Agencies e.g. ECGD, COFACE, HERMES, Eximbank, SACEBuyer and Supplier creditsNon commercial finance e.g. development loans from regional national or international development agencies e.g. EIB, EBRD, Asian Development Bank
35 Project Finance The Funding Package 3 Long and short term asset finance e.g. leasingConventional trade financeBond issuesConventional senior debt
36 Project Finance The Funding Package 4 Design and Monitoring- Debt service ratios- Based on free cash flowsEconomic test
37 Project Finance The Funding Package 5 Annual Debt Service Cover Ratio(ADSCR)Period project cash flows before interest payable and debt repaymentDivided byPeriod interest payable and debt repaymentsCalculated for each periodMinimum ratios between 1.25 to 2.00
38 Project Finance The Funding Package 6 Multi period ratiosLoan Life Cover Ratio (LLCR)NPV of free cash flows over loan lifeOutstanding DebtProject Life Cover Ratio (PLCR)NPV of free cash flows over project lifeNote Discount used is the average interest cost so relates to PV of the project to the bank