Indian Institute of Management, Ahmedabad Project Finance Session on Finance Sidharth Sinha Indian Institute of Management, Ahmedabad The views expressed here are those of the presenter and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they represent.

Project Finance Objective Project vehicle Financing a single purpose capital asset usually with a limited life Project vehicle Legally independent project company Financing (debt and equity definition) Equity from one or more project sponsors Non recourse (to sponsors) debt Equity at the minimum level to issue debt at reasonable cost Comparison with traditional or corporate finance

Standard & Poor’s defines a project company as a group of agreements and contracts between lenders, project sponsors, and other interested parties that creates a form of business organization - that will issue a given amount of debt at start; will operate in a focused line of business; lenders look only to a specific asset to generate cash flow as the sole source of principal and interest payments and collateral.

Project debt is not a permanent part of the capital structure, but is repaid in most projects according to a schedule based on the project’s useful life. Projects by design do not build up equity, but instead, use up cash quickly - First as operating expenses, then as debt service (often the most significant expense), and finally as dividends.

Project finance is suitable for large projects Takes a longer period of time to structure, negotiate and document a project financing than a traditional financing The legal fees and related costs associated with project financing can be very high It limits the risk of the sponsor to its equity investment - not the total project investment.

Main Parties in a Project Financing Vehicle Suppliers Purchasers Operator Lenders Contractor Shareholders Loan Agreement Concession Off - take Equity Subscription Supply Operation & Maintenance Construction Special Purpose Authority

Project Financing Participants Sponsor/Developer. The sponsor(s) or developer(s) of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in the project company. Additional Equity Investors. In addition to the sponsor(s), there frequently are additional equity investors in the project company. These include government, sponsors, contractors, insurers, suppliers, off-takers, etc, giving them a vested interest in the success of the project

Project Financing Participants (continued) Lender. The lender in a project financing is a financial institution or group of financial institutions that provide a loan to the project company to develop and construct the project and that take a security interest in all of the project assets. Lenders can also include bond investors in capital markets

Risk Analysis Since lenders provide bulk of the financing, risk is usually analyzed from the lenders’ perspective Project-level risks - agreements Default by counterparties Country risk - stability of economic, political, and regulatory environment Business and legal institutions risk - enforceability of agreements Force majeure risk - ‘acts of god/nature’ Insurance Credit enhancements The objective is to assess the risk of cash flows available for debt servicing Loan and security agreements

Project Level Risks Quality of sponsors Experience, commitment (equity investment) Strategic importance of the project Financial strength to meet future obligations such as contingent equity Construction risk Construction agreements Quality of contractors (could be a sponsor) Related investment requirements Operations risk Quality of operator Operations and maintenance contract

Project Level Risks Supply risk Availability Agreements for variability of input prices Offtake, demand & market risk Offtake agreement May not offer adequate protection against unfavourable market situation because of problems of enforceability of contracts Competitive position Cost of production relative to competitors Availability of substitutes Better competitive position implies lower demand risk

Construction Contract Price. Most project financing construction contracts are fixed-price contracts although some projects may be built on a cost-plus basis. If the contract is not fixed-price, additional debt or equity contributions may be necessary to complete the project, and the project agreements should clearly indicate the party or parties responsible for such contributions. Completion Date. If construction is not finished by the completion date, the contractor typically is required to pay liquidated damages to cover debt service for each day until the project is completed. If construction is completed early, the contractor frequently is entitled to an early completion bonus.

Construction Contract (continued) Performance Guarantees. Such guarantees are measured by performance tests conducted by the contractor at the end of construction. If the project does not meet the guaranteed levels of performance, the contractor typically is required to make liquidated damages payments to the sponsor. If project performance exceeds the guaranteed minimum levels, the contractor may be entitled to bonus payments

Operations and Maintenance Agreement Long-term agreement for the day-to-day operation and maintenance of the project facilities With a company having the technical and financial expertise to operate the project in accordance with the cost and production specifications for the project. The operator may be an independent company, or it may be one of the sponsors. The operator typically will be paid a fixed compensation May be entitled to bonus payments for extraordinary project performance and, Be required to pay liquidated damages for project performance below specified levels.

Input Supply Agreements Agreements for the supply of raw materials, energy or other resources over the life of the project. Frequently, supply agreements are structured on a "put-or-pay" basis - This means that the supplier must either supply the input or pay the project company the difference in costs incurred in obtaining the input from another source. Fixed or spot price

Product Offtake Agreements The product offtake agreements represent the source of revenue for the project. Frequently, offtake agreements are structured on a "take-or-pay" basis, The offtaker is obligated to pay for product on a regular basis whether or not the offtaker actually takes the product unless the product is unavailable due to a default by the project company. Price Fixed Scheduled changes Pass through of fluctuating input prices

Country Risk Stability and predictability Economic environment Political and regulatory environment Expropriation or creeping expropriation Currency risk Exchange rate volatility, transfer and convertibility risk Currency of revenue, expenses, debt servicing and shareholder return

Loan and Security Agreement Security. The project loan typically will be secured by multiple forms of collateral Mortgage on the project facilities and real property. Assignment of operating revenues. Assignment of any letters of credit or performance or completion bonds relating to the project under which borrower is the beneficiary. Assignment of insurance proceeds.  Assignment of all project agreements

Loan and Security Agreement (continued) Disbursement Controls. These frequently take the form of conditions precedent to each drawdown, requiring the borrower to present invoices, builders' certificates or other evidence as to the need for and use of the funds. Progress Reports. The lender may require periodic reports certified by an independent consultant on the status of construction progress.

Loan and Security Agreement (continued) Covenants Not to Amend. The borrower will covenant not to amend or waive any of its rights under the construction, feedstock, offtake, operations and maintenance, or other principal agreements without the consent of the lender. Completion Covenants. These require the borrower to complete the project in accordance with project plans and specifications and prohibit the borrower from materially altering the project plans without the consent of the lender.  

Loan and Security Agreement (continued) Dividend Restrictions. These covenants place restrictions on the payment of dividends or other distributions by the borrower until debt service obligations are satisfied. Debt and Guarantee Restrictions. The borrower may be prohibited from incurring additional debt or from guaranteeing other obligations. Financial Covenants. Such covenants require the maintenance of working capital and liquidity ratios, debt service coverage ratios, debt service reserves and other financial ratios to protect the credit of the borrower.

Credit Enhancement Some third parties offer various credit enhancement products designed to mitigate project level risks, sovereign risks, and currency risks, among others. Multilateral agencies, such as the Multilateral Investment Guarantee Agency, the International Finance Corp., and ADB offer various insurance programs to cover both political and commercial risks. Project sponsors can themselves provide some type of support in mitigation of some risks - a commitment that tends to convert a non-recourse financing into a limited recourse financing. These enhancement packages cover only specified risks.

Financial Modeling The most important decision making instrument in the financing of a project is its financial model. The model ties up the revenue model, capex, opex, capital structure and other inputs It provides projected multi-year financials, e.g. income statement, balance sheet and cash flow statement The model can also be programmed to do scenario testing, sensitivity analysis and stochastic analyses of performance measures.

Performance Measures Valuation measures Internal Rate of Return (IRR) and Net Present Value (NPV) Debt-service coverage ratios (DSCRs) as the primary quantitative measure of a project’s financial credit strength. The DSCR is the ratio of cash from operations (CFO) to principal and interest obligations. CFO is calculated strictly by taking cash revenues and subtracting expenses and taxes, but excluding interest and principal, needed to maintain ongoing operations. The ratio calculation also excludes any cash balances that a project could draw on to service debt, such as the debt service reserve fund or maintenance reserve fund.