Project Finance.

Project Finance

SUMMARY Structuring a project financing deal
Introduction to project finance What is project finance? Main features Part 1 Structuring a project financing deal Project finance structure: actors (sponsors, lenders, contractors, etc.) and main project contracts Analysis and management of project risks Valuation of financial sustainability Conclusions Part 2

SUMMARY Introduction to project finance What is project finance?
Main features Part 1

WHAT IS PROJECT FINANCE?
Project finance can be defined as a loan intended to cover a specific financial requirement, well identified, for the construction and subsequent operation of a work, and drawn on the basis of the capacity of the funded project to generate cash flows necessary to repay the loan and remunerate the equity capital Part 1 Financing Project Cash flow Equity Share capital (pure equity) Subordinated debt Banking debt Work construction Work operation Debt service Interest Repayment of principal Shareholders distributions Subordinated debt interests and repayment Dividends

Three fundamentals of project finance: Part 1 Constitution of a separate economic and asset entity (Special Purpose Vehicle – "SPV ") that holds all project responsibilities Substantial financial independence of the project in respect of the sponsors (SPV’s shareholders) creditworthiness Centrality of the cash flows produced by the project for the loan repayment and for the remuneration of risk capital

Part 1 Cash flow binding SPV Ring fence Ring Fence: legal and capital separation between the project and its shareholders by way of an ad hoc company (SPV) with the aim to separate the cash flow and the project assets from the other entrepreneurial activities of the shareholders

SUMMARY Introduction to project finance What is project finance?
Main features Part 1

MAIN FEATURES OF PROJECT FINANCE
Part 1 High financial leverage Medium - long term timeline Participation of different stakeholders: banks, shareholders, commercial counterparties, public authorities, insurance companies, etc Structuring of the operation characterized by an intense negotiation process whose objective is to reach an adequate risk allocation Operation guaranteed by a set of contractual / real guarantee SPV’s assets considered as accessory guarantees Construction phase and operation phase are regarded as a whole, with centralization of the risks on the SPV Operation phase constitutes an element of primary importance (like construction one), as only an efficient operational quality allows to generate the cash flows necessary to meet banks and shareholders claims

CORPORATE FINANCE PROJECT FINANCE Part 1 Economic unit financed Nature of financing Guarantees Basic for credit concession Financial leverage Risk Multi-purpose organization Generic financial requirements Real (corporate guarantees) Overall financial health of corporate entity, focus on balance sheet Based on effects on borrower’s balance sheet Weighed on borrower Single-purpose entity Specific financial requirement Contractual guarantees + limited real guarantees Projected cash flows Based on balance between debt repayment and sponsor’s rate of return Fragmentation of risks between all counterparties involved

CORPORATE FINANCE PROJECT FINANCE Part 1 Effect on financial elasticity Accounting treatment Reduction of borrower’s financial elasticity On balance Minimal effects on sponsors’ elasticity - in addition to the commitments arising from the capitalization of the SPV: No recourse: no effect Limited recourse: possible patrimonial commitment (real guarantee) Off balance (the only effect for the sponsors is the cash out to inject equity in the SPV)

Part 1 Transaction requirements for project finance applicability: Mature and consolidated technology Relevant dimensions of the project Commercial counterparties and shareholders with a good reputation, track record, reliability and market knowledge Existence of a market for the goods or services produced Political stability and efficient public administration Presence of a regulatory framework and fiscal discipline sufficiently clear and non-contradictory

Part 1 Sectors historically fit for project finance techniques adoption, given the characteristics mentioned: ENERGY (photovoltaic, wind and cogeneration plants) ENVIRONMENT (waste to energy treatment, integrated water cycle) INFRASTRUCTURE (highways, local public transport) ACCOMMODATION (hospitals, schools, public buildings) TELECOMMUNICATIONS (networks)

Advantages arising from project finance: Efficient allocation of risk among the parties involved Access to credit resources that may be available for the project but not for the sponsors Maximizing the leverage effect Possibility for the lender to carry out a greater control over the use of funds More efficiency in providing the public service: greater certainty about the timing of design and construction work construction and operation linked to the levels and quality of performance expected Part 1

Part 1 Limits of project finance: Complexity of the operation (contractual structure, need to adapt the instrument to each specific project, protracted times) Coexistence of different stakeholders which determines the impossibility, for each, to structure the operation only on the basis of their needs High structuring costs and high financing cost to raise capital necessary for the realization of the initiative

Project finance structure: actors (sponsors, lenders, contractors, etc.) and main project contracts Analysis and management of project risks Valuation of financial sustainability Part 2

PROJECT FINANCE STRUCTURE
Part 2

Part 2 Project finance initiatives are the result of complex agreements involving a wide range of stakeholders. In general, the main players are: SPV (concessionaire) Sponsors (SPV’s shareholders) Public Administration (grantor) Lenders Technical, Legal, Insurance and Financial Advisors Commercial counterparties: O&M Operator, Engineering, procurement and construction ("EPC") Contractor Insurance companies

Main project contracts Part 2

ANALYSIS AND MANAGEMENT OF PROJECT RISKS
Part 2 To ensure the sustainability of a project finance operation from an economic and financial point of view, it is necessary to "bind" the dynamics of the cash flows of the project so as to minimize the possibility of failure to repay the debt incurred by the SPV Preliminarily, it is therefore essential to carry out a careful and deep analysis of project risks and their possible impact on cash flow of the SPV, to assess, subsequently, the real financial sustainability of the project on the basis of the forms of risk mitigation deemed most appropriate Operating Cash Flow Financial Structure Risk Analysis Evaluation of any event that may cause a deviation in cash flows generated by the project Impact on cash flows Debt and equity amount Debt repayment profile Shareholders’ expected rate of return

Risk groups Part 2

Project phases and related risks Part 2 Obtaining necessary permits and authorizations Obtaining land PRE-CONSTRUCTION Cost overruns Delays Contractor default CONSTRUCTION PHASE EPC CONTRACTOR Cost overruns Technology/performance Supply Volumes O&M contractor default OPERATION PHASE O&M OPERATOR Environment Force Majeure Political risks Currency / interest / inflation risk Damage risk Change in law COMMON RISKS

Authorizations and permits obtaining Causes: failure of the granting authority or concessionaire, delays in authorizations, oppositions , appeals, litigations Consequences: delays, additional investment costs, increased debt Coverage: compensations in favour of SPV in concession agreement sponsors’ joint and several obligations (real guarantees) contingencies PRE-CONSTRUCTION Part 2

Land obtaining Causes: refusal to sell, appeals, long time to expropriation Consequences: delays, additional investments, increased debt Coverage: compensations in favour of SPV in concession agreement sponsors’ joint and several obligations (real guarantees) contingencies PRE-CONSTRUCTION Part 2

Cost overruns Causes: wrong cost estimation, change orders, inflation / exchange rate risk Consequences: higher investment costs, increased debt Coverage: turnkey fixed price contract specific and binding contractual commitments over EPC Contractor contingencies CONSTRUCTION PHASE Part 2

Delays Causes: geological risk, contractor/supplier plants default, force majeure Consequences: interruption of project, completion delay, additional costs Coverage: “delay liquidated damages“ in EPC contract (daily amounts equal to additional financial expenses resulting from delayed operational phase) economic-financial rebalancing of concession agreement for reasons not attributable to the SPV “Performance bond”: first demand guarantee to be delivered to the SPV by the EPC Contractor to cover its contractual obligations (normally issued by a bank, amount equals to 10-15% of contractual price) EPC Contractor experience and reputation, proven technology CONSTRUCTION PHASE Part 2

Cost overruns Causes: operating deficits, unexpected events Consequences: revenues insufficient to cover total costs Coverage: fixed price O&M contract OPERATION PHASE Part 2

Technology / performance Causes: plant underperformance, plant defects Consequences: inability to generate the assumed production, insufficient revenues Coverage: Warranty Bond (first demand guarantee to be delivered to the SPV by the O&M Contractor to cover plant faults and defects, normally issued by a bank, 2 years duration) O&M contracts with bonuses/penalties related to performance (“performance liquidated damages” to cover “cash flow available for debt service” shortfall resulting from underperformance) proven technology, O&M contractor track record OPERATION PHASE Part 2

Supply Causes: quantity/quality/price of raw material, supplier default Consequences: failure to satisfy the economic balance of the project Coverage: "put or pay” contracts with predetermined conditions in terms of quantity, price and time (multi-year agreements by which the supplier undertakes to deliver regularly the materials. In case of default, it undertakes to pay the supply by third parties) OPERATION PHASE Part 2

Volumes (market risk) Causes: insufficient sales of products/services, low prices, buyer’s insolvency Consequences: revenues insufficient to cover total costs Coverage: “take or pay” contracts with predetermined conditions in terms of quantity, price and time (multi-year agreements by which the buyer undertakes to make periodic payments for the supply of a specific product, but has to pay in case of non-delivery) market analysis performed by market advisors OPERATION PHASE Part 2

Environment Causes: environmental impact of the initiative (emissions, hazardous materials) Consequences: additional costs, business interruption, sanctions, penalties Coverage: insurance coverage preliminary technical analysis performed by technical advisor on environmental impact, compliance with procedures and standards COMMON RISKS Part 2

Political risks Causes: nationalization, expropriation, mandatory purchase, seizure or sequestration (in part or in full) of the Project, change in law, risk of economic instability (convertibility, transferability) Consequences: loss of the project, inability to transfer money, additional tax expenses Coverage: export credit agencies guarantees compensations in favour of SPV in concession agreement economic-financial rebalancing of concession agreement COMMON RISKS Part 2

Currency / interest / inflation risk Causes: uncertainty about interest rate, exchange rate, inflation rate Consequences: debt service increase, increased costs or lower revenues in case of movements in exchange rates or inflation rate Coverage: swaps and other hedging instruments indexing revenues and costs’ component calculation (in case of “Take or Pay” or “Put or Pay” contracts) COMMON RISKS Part 2

Interest rate risk coverage: interest rate swap COMMON RISKS Part 2 Hedging Banks The borrower (SPV) receives from Hedging Banks a variable rate under the swap agreement The borrower (SPV) pays a fixed rate to the Hedging Banks Special Purpose Vehicle The borrower (SPV) pays a variable rate to the Lenders Lenders

Destruction / damage to project’s assets Causes: accidents Consequences: asset’s restoration cost, project abandonment Coverage: insurance policies COMMON RISKS Part 2

Risk mitigation for sponsors Part 2

The whole process of analysis and risk allocation is summarized through a summary document defined Risk Matrix Risk matrix allows to appreciate the contribution to risks mitigation by each party involved in the operation, also in relation to the individual stages of project development (pre-construction, construction, operation) The greater the number of correlations between subjects and risks, the lower the impact on the Special Purpose Vehicle and, consequently, the lower the risk of the transaction Part 2

Risk matrix Part 2

The risk allocation process aims to ensure a greater solvency of the initiative, making the operation solid and appealing to financial community (“bankability”) In fact, for the bankability of the operation, banks are interested to take on manageable and controllable risks, identified and mitigated through an efficient process of analysis and evaluation The term bankability indicates the acceptability for the banking sector of the overall structure of a project for the purpose of its financing and expresses, therefore, the possibility for a project to be funded on the basis of a certain financial structure and according to a specific risk allocation Part 2 Financial structure Bankability Risk allocation

Risk analysis and allocation Part 2

Due Diligence process Required by: Lenders Purposes: assess the bankability of a PF operation proper evaluation of the risks inherent in the nature and structure of the project identify the possibility to mitigate these risks (Risk Matrix) How it works: with the support of independent external consultants recognized in the financial market the independent consultants work in the interest of the Lenders Part 2

Project Due Diligence Technical: needed to assess the risks relating to the design, construction and authorization procedure Legal: needed to evaluate the legal framework of the project, with particular reference to the concession agreement bankability and the proper allocation of risks into commercial (EPC and O&M agreement) and financial contracts Insurance: needed to define the main features of insurance coverage that the SPV is called to implement in the construction and operational phase to ensure the continuity of the economic cash flows as well as forms of compensation for events that may cause partial or total damage to the project’s assets. Market: needed to assess the market context in order to provide with a reasonable estimate of future revenues Part 2

Technical Due Diligence Identification of any critical aspects, in terms of time, cost and quality, necessary to the Lenders to assess the technical viability of the operation Verification of the technical parameters of the plant (i.e., wind energy plant) and cost estimates used as data input in the economic and financial model Rationality of the technical choices assumed and of technological maturity of the plants Monitoring of construction phase Part 2

Legal Due Diligence: requirements for Concession Agreement bankability there should not be any unduly onerous terms imposed on the SPV (i.e., a high level of liquidated damages if completion is not achieved within a fixed date if the project company is unable to pass-through all of those liquidated damages to its own contractor) The Grantor of the concession should accept the change in law risk. So, for example, the concession period should be extended if the construction of the project is delayed because new regulations come into force requiring a re-working of the design or the retrofitting of new environmental protection equipment in case of termination of the concession should be envisaged an indemnity to the benefit of SPV and this indemnity amount should always be sufficient to repay the Lenders (even if the concession is being terminated for default by the project company) when a termination occurs, the Lenders should be able to freely transfer the concession to a third party (step-in right provision) Part 2

Legal Due Diligence: requirements for Concession Agreement bankability “financial balance” clause payment/indemnity provisions in case of contractual default by the public authority and revocation of the concession due to reasons of “public interest” payment/indemnity provisions in case of termination for breach of contract attributable to the concessionaire as an additional tool of credit enhancement, the terms of the concession must provide that any amount to be paid to the concessionaire in case of termination/revocation/withdrawal of the concession will have to be applied with priority to satisfy the claim of the Lenders of the project. As an additional security for financial institutions, concession agreement must provide that revocation of the concession shall be ineffective until full payment of the indemnity Part 2

VALUATION OF FINANCIAL SUSTAINABILITY
Economic and Financial Plan Part 2 What is? A computerized financial model that, through an iterative process, simulates the cash flow trend and allows the evaluation of financial sustainability of the operation

VALUATION OF FINANCIAL SUSTAINABILITY
Economic and Financial Plan Objectives: to estimate the total financing requirement of the Project to determine, preliminarily, the proportion of debt and equity to cover the financial requirement to determine an indicative profile of debt repayment to verify the adequacy and the capacity of future cash flows to serve the debt according to the supposed debt repayment profile and to guarantee a satisfactory return on equity to determine the debt sizing and the definitive optimal capital structure to check the reaction of the project to any critical situations (“sensitivity analysis”) to establish control mechanisms in behalf of the lenders Part 2

Project Finance.

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Project Finance.

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