the economics of large scale infrastructure project finance an empirical examination of the propensity to project finance

The Economics of Large Scale Infrastructure Project
Finance: An Empirical Examination of the Propensity to
Project Finance






A Thesis
Presented to the Faculty
Of
The Fletcher School of Law and Diplomacy
By


RAJEEV JANARDAN SAWANT


In partial fulfillment of the requirements for the
Degree of Doctor of Philosophy


DECEMBER 2007



Dissertation Committee
Prof Laurent Jacque, Chair
Prof Patrick Schena

Prof Bruce Everett
3320163

3320163

2008
ii
Abstract
This dissertation empirically examines a financing and governance structure called
Project Finance that typically funds large scale, capital intensive, infrastructure
investments in risky countries. Separate incorporation by investing firms (sponsors), long
term detailed contracts between suppliers and buyers, vertical integration, high debt
levels and non-recourse lending characterizes project finance. Project finance finances
tangible, decaying assets with low growth options that do not require strong managerial
skills. UK’s North Sea oil fields, Ras Laffan gas company in Qatar, and Chad Cameroon
pipeline are examples of project financed transactions. Lenders achieve a high degree of
transparency for project financed transactions due to the non-recourse nature of the debt
which also entails higher setting up costs and cost of debt compared to corporate finance.
Theoretical research hypothesizes that project finance solves the problem of potentially
opportunistic concentrated suppliers/buyers facing large sunk investments in risky
countries. Theory also hypothesizes that project finance mitigates underinvestment
resulting from conflict between debt and equity holders within a firm. The dissertation
compares project financed and corporate financed transactions in the oil, gas and
petrochemical industry to test these hypotheses. I compile a dataset of over 400
investments by 340 firms in 74 countries over 17 years to test these two theories. I find
that the propensity of firms to use project finance is high and statistically significant
when large sunk investments have concentrated buyers/suppliers in risky countries. The
propensity for project finance is high when debt coverage ratios are low after controlling
for leverage and the volatility of the debt coverage ratios but weakly so. Project finance
therefore fulfills the role of a self regulating contract that reduces transaction costs.

iii


DEDICATION





To
my parents,

Janardan and Charulata Sawant

whose passion, encouragement, dedication and
personal example made all this possible,


Manisha for patience and understanding,


Mehr and Manav, my personal investments in the future,


and Rahul for constant and loyal support.

iv
ACKNOWLEDGEMENTS

I thank my committee members for their advise, rigor and generosity. I especially
thank Prof Laurent Jacque for his insightful, penetrating, incisive and rigorous feedback,
for his patience, compassion and faith in me. I thank Prof Schena for his attention and
enormous help with the econometric details and Prof Bruce Everett for his tremendous
knowledge of the oil and gas industry, for enabling the data collection effort and for his
sense of humor. I thank Prof Paul Vaaler for starting me off and supporting me as his
Teaching Assistant and Prof Robert Nakosteen who selflessly gave of his time with
statistical advice. I also thank the Hitachi Center for financial support and for selecting
me as a Hitachi Scholar. None of this would have been possible without the dedication,
passion, and superb teaching skills of my teachers particularly Prof Richard Shultz, Prof
Carsten Kowalczyk, Prof Steve Block, Prof Joel Trachtman, Prof Ravi Sarathy, Prof
Sanjiv Das, Prof Julie Schaffner. Finally I thank Carol Murphy the International Student
Advisor for her enormous patience, Nora Moser and the Registrars Office for their
understanding and support, Miriam Seltzer, Paula Cammarata and the staff of the Ginn
library, Shelley Adams, Dorothy Orszulak and Jenifer Burckett-Picker for making the
Fletcher experience an incredible one. All errors and mistakes are entirely mine.

v
TABLE OF CONTENTS

Introduction 1

Chapter 1: Literature Review of Project Finance 4
1.1 Introduction Project Finance 7
1.2 Project Finance Applications 8

1.3 Project Finance loan characteristics 10

Chapter 2 : Theories of Project Finance 15
2.1 Project Finance as an asset specific investment by an initial user and a
‘redeployer’ of an asset 16
2.2 Theory of Incumbent management’s control benefits 19
2.3 Signaling Theory of Project Finance 21
2.4 Agency costs of free cash flow 23
2.5 Agency Costs of Risky Debt (Underinvestment) 25
3. Solutions to the Underinvestment Problem 29
3.1 Design of ex-ante contracts 33
3.1.1 The case of New Debt’s Strict Subordination to Existing Debt 34
3.1.2 The Case of New Debt’s Complete Seniority to Existing Debt 36
3.1.3 The Case of Project Finance 37
3.1.4 The Case of Secured Financing and Leasing 39
3.1.5 Analysis of corporate structure (Separate project finance structure or
combined corporate structure) 41
4. Project Finance Asset Characteristic – High value under default 43
4.1 The case of high project value under default and low cash flow variance 44
4.2 The Case of high asset value under default and high cash flow variance 45
4.3 The case of low asset value under default and high variance in cash flows 46
4.4 The case of low asset value in default and low variance in cash flows 47
5. Agency Costs of Opportunism or Asset Specificity (Hold-up problem) 48
5.1 Introduction 48
5.2 Solutions for the hold up problem 50
5.2.1 Vertical Integration 52
5.2.2 Long term contracts 54
5.2.3 Use of debt 58
5.3 Empirical Research on the hold up problem 62
6. Conclusion 64

Chapter 3: Development of Hypotheses 66
1. Introduction 66
2. Testable Propositions from theory of Underinvestment 67
3. Testable Hypotheses – Transaction Costs of Opportunism or Hold-up 71
4. Table of Explanatory Variables 78
5. Conclusion 79

vi
Chapter 4: Description of Data 81
1. Introduction 81
2. Data Collection Methodology 81
2.1 Corporate Financed Investments 81
2.2 Project Financed Investments 84
3. Data description 89
4. Conclusion 92

Chapter 5: Econometric Model Specification 93
1. Introduction 93
2. Model Specification 93
3. Logit and Probit models 95
4. Omitted variables bias 98
5. Treatment of JV partners 100
6. Conclusion 101

Chapter 6: Results of Econometric Analysis 102
1. Introduction 102
2. Bivariate Analysis 102
3. Panel 1 – Lead Firm In a project 104
4. Probit Model Results – Panel 1 109

5. Probit Model Results – Panel 2 114
6. Robustness Testing of the Results 116
7. Conclusion 121

Conclusion 123

Reference List………………………………………… ………………………………131

List of Sources 130











vii

List of Tables

Table I: Summary of Theoretical & Empirical Literature……………………………… 9
Table II: Analysis of Asset Risk…………………………………………………………46
Table III: List of Explanatory Variables…………………………………………… 82
Table IV: Summary of Data…………………………………………………………… 93
Table V: Statistical Properties of Corporate Vs Project Financed Investments… 93
Table VI: Summary of Statistics – Explanatory Variables………………………………94

Table VII: Pairwise Correlations………………………….……………………… 106
Table VIII: LPM, Logit and Probit Model coefficients… ……………………… 109
Table IX: Probit Model Marginal Effects, Panel 1……………………………… 113
Table X: Probit Model Marginal Effects, Panel 2…………………………………… 117


List of Figures


Figure I: LOWESS of PF Propensity and Size of Investment…………………………120
Figure I: LOWESS of PF Propensity and Country Risk…….…………………………121
Figure I: LOWESS of PF Propensity and Fuel Exports…… …………………………122
Figure I: LOWESS of PF Propensity and Debt Coverage Ratio….……………………123









1
Introduction

The financing and governance structure known as Project Finance has been used
since Roman times
1
. In modern times Project Finance has grown as the form of financing
structure for building pipelines, refineries, drilling oil wells, gasification plants

2
and other
large capital-intensive infrastructure projects. Infrastructure Journal reports that project
finance reached $212 B in 2006, an increase of 35% over 2005
3
. Project Finance has
traditionally been a significant tool for cash strapped governments seeking to develop
vital infrastructure. In fact according to a 2005 report by the Asian Development Bank,
Japan Bank of International Cooperation and World Bank, Asia alone needs to spend $1
trillion over the next five years in road, water, communication and other infrastructure
projects to meet the rapid rise of urbanization, population growth and growing demands
of the private sector
4
. The European Union plans to spend €300B up to 2013 on
infrastructure assets
5
. An understanding of project finance and its determinants is
therefore likely to be helpful to governments, lenders, infrastructure funds and firms
investing in these assets.
Stulz and Johnson (1985), Berkovitch and Kim (1990), John and John (1991) and
Esty (2003) all contend that firms use project finance to lower “deadweight” costs
induced by stockholder-debtholder conflict (underinvestment), and by the threat of
opportunism between project sponsors and suppliers, customers and host governments


1
Buljevich and Park (1999)
2
The Suez Canal was built on a PF basis as were the UK’s North Sea oilfields.
3

Global Investor, Feb 2007.
4
ADB, JBIC, and the World Bank, "Connecting East Asia: A New Framework for Infrastructure".
Accessed Jan 2008. Available from />Development/infrastructure-study.pdf.
5
Financial Times, Oct 22, 2007.
2
arising from high asset specificity. Although the theoretical literature is well developed,
supporting empirical evidence has largely been restricted to case studies (Esty 1999,
2001). I fill this empirical research gap with a large sample statistical study to formally
test the transaction costs problem and the underinvestment problem.
Since investments are a result of firm-level factors as well as project characteristics
I focus on why and how firm-level factors as well as project characteristics induce
managers to decide on the financing and governance structures of new investments.
Theory posits that the deadweight costs of underinvestment require an investigation of
individual firm level characteristics while deadweight costs from asset specificity and
opportunism between project sponsors, customers, suppliers and host governments
requires investigation of individual project characteristics. To this end I use firm-level
stock market and balance sheet data comprising both project finance and corporate
financed investments to test underinvestment variables. I use project-level supplier,
customer, and host government data comprising both project finance and corporate
financed investments to test the transaction costs from the threat of opportunistic
behavior. I construct a database of project finance and non project finance investments
restricting the sample to the oil and gas industry.
Consistent with the core contention of the underinvestment and transaction costs
theory, I test whether firms with high underinvestment and transaction costs are more
likely to undertake project finance than corporate financed modes of investments. I
conduct this test by regressing the propensity of a firm to undertake project finance
against a set of control variables and key explanatory variables suggested in previous
conceptual research as leading to high agency costs.

3
To make these points in greater detail, the remainder of my dissertation is
structured in five additional chapters. Chapter 1 reviews the theoretical and empirical
literature on project finance. Chapter 2 reviews the theoretical and empirical literature on
capital structure, underinvestment and transaction costs. Chapter 3 follows on with
statements of the key propositions of this research, that project finance reduces costs from
underinvestment and transaction costs and derives empirically testable hypotheses.
Hypotheses most important to this dissertation include, “Firms with risky debt
outstanding have a high propensity to undertake project finance.” and “Supplier and
Buyer concentration increases the propensity for project finance.”
Chapter 4 describes the data and the methodology of data collection. Chapter 5
explains how these and related hypotheses are to be tested. It lays out the econometric
models and the econometric issues arising from the possibility of omitted variables and
the independence of individual observations. Chapter 6 lays out and discusses the results
of this empirical investigation.
4
Chapter 1: Literature Review of Project Finance

Theoretical research (Nevitt (1979) and others) and empirical research (Megginson
and Kleimeier (2000), Esty (2003)) shows that project finance is indeed a distinct form of
financing with unique characteristics. Sections 1.1, 1.2 and 1.3 of the review lays out
these characteristics of project finance. The use of project finance and its persistence
through history and into modern times indicates that project finance indeed serves an
economic purpose. Theoretical research into the economic determinants of project
finance reveals at least six distinct theories about the economic problems that project
finance solves.
Project finance has been posited as a means of allocating optimal ownership over
specific assets by Habib and Johnsen (1996). This theory is explored in Section 2.1.
Analysis of managerial decisions leads Chemmanur and John (1996) to posit that the
project finance structure confers benefits on incumbent managers that is advantageous in

the competition for corporate control with rival managements. Section 2.2 delves further
into this theory. Research into informational asymmetry between lenders and borrowers
of capital has lead Shah and Thakor (1987) to posit that the project financing structure is
a means of signaling the riskiness of assets. Section 2.3 explores this theory. The theory
of agency costs delineates the perverse incentives arising from conflict between owners
and managers of firms. Esty (2003) theorizes that the project finance structure lowers
these costs. This theory is explored in Sections 2.4.
5
I then focus on the final two distinct strands of literature that have been identified
by research
6
as the economic determinants of project finance. The first strand of literature
deals with conflict between equity holders and debt holders that causes firms to bypass
investment in positive NPV projects. Existing risky debt creates incentives for equity
holders to bypass positive NPV projects or underinvest which destroys firm value.
Project finance has been proposed as a solution, among others, to this underinvestment
problem. I review this strand of theoretical and empirical literature in Sections 2.5 to
Section 4.4.
The second strand of literature deals with the possibility of opportunistic behavior
arising from investment in specific assets. This strand of literature considers the problem
of incomplete contracts that can be renegotiated after sunk investment in specific assets is
complete. A party making these sunk investments is liable to be ex-post held up by its
counterparty. Since this behavior can be anticipated ex-ante, rational investors do not
commit to sunk assets and the result is socially harmful underinvestment. A number of
solutions like vertical integration, long term contracts and the use of debt have been
proposed as a solution to the hold-up problem. The project finance structure incorporates
these features and has also been proposed as a way of ameliorating the agency cost of
opportunistic behavior. I review this strand of theoretical and empirical literature in
Section 5. Section 6 concludes the literature review.
The following table summarizes the main theoretical and empirical research in

project finance. I have organized the table to reveal the research in underinvestment and


6
Myers (1977), E Berkovitch and Kim, E. H., (1990), Klein, Crawford and Alchian (1978), Bronars and
Deere (1991), Esty (2002).

6
the hold-up problem. The table also highlights the gap in empirical research in project
finance as a solution to the underinvestment problem or the hold-up problem.
Table I: Summary of Theoretical & Empirical Literature

Underinvestment –
Debt Overhang
Transaction Cost
Economics
Project Finance
Theoretical
Research
− Modigliani, F.
and M. H.
Miller, 1958
− Fama, E., 1978
− J. C. Stiglitz,
1969
− J. C. Stiglitz,
1974
− Smith C., and
Warner J., 1979
− Myers, S. C.,

1983
− Green, R., 1984
− Stulz, R. M. and
H. Johnson,
1985
− Mark J.
Flannery, Joel F.
Houston and S.
Venkataraman,
1993
− Titman S. and
Wessels R.,
1988.
− E Berkovitch
and Kim, E. H.,
1990
− Myers, S.C.,
1977
− Myers, S.C., and
N. S. Majluf,
(1984)



− Williamson O.E
(1975).
− Williamson O.E.
(1988).
− Jensen, M. C. and W.
H. Meckling, 1976

− Klein, B., Crawford,
R., Alchian, A.
(1978)
− Baldwin C., (1983)
− Titman Sheridan,
(1984)
− Grossman S., and
Hart O., (1986)
− Riordan Michael
(1989)
− Stulz R., (1990).
− Wiggins Steven
(1990)
− Bronars S., and Deere
D., (1991).
− Perotti E. and Spier
K., (1993).
− Hermalin and Katz
(1993) Subramaniam
V., (1996)
− Edlin and
Reichelstein (1996)

− J. W. Kensinger
and J. D. Martin,
1988
− T. A. John and K.
John, 1991
− S. Shah and A. V.
Thakor, 1987

− Chemmanur, T.
J., and K. John,
1996
− Esty B.C. 2002
− Esty B.C. 2003
− Brealey R. A.,
and Cooper I. A.,
and Habib M. A.,
1996
− Habib M. A., and
Johnsen B. D.,
1999
− Richard Tinsley,
2000
− Henri L.
Beenhakker, 1997
− Richard Tinsley,
2000
− Peter K. Nevitt,
and Frank
Fabozzi, 2000
− Esteban C.
Buljevich, and
Yoon S. Park,
1999

Empirical Research
(Note: Case studies
− Bradley M.,
Jarrell G. A.,

− Titman S., and Opler
T., 1993
− Megginson W. L.,
and Kleimeier S.,
7
are not included in
project finance.)
Kim E. H., 1984
− Lang L., Ofek E.,
and Stulz R.,
1996
− Parrino and
Weisbach, 1996.
− Morgado A. and
Pindado J., 2002.
− Lehn K., and
Poulsen A., 1989.
− Lieberman M.,
(1991)
− Levy D., (1985)
− Kelly T and Gosman
M, (2000)
− Cowley P R., (1986)
− McDonald J., (1985)
− Bronars S., and
Deere D., (1993)
2000
− Richard
Klompjan and
Marc J.F.

Wouters, 2002


1.1 Introduction Project Finance

Nevitt (1979) defines project finance as “the financing of a particular economic
unit in which a lender is satisfied to look initially to the cash flows and earnings of that
economic unit as the source of funds from which the loan will be repaid and to the assets
of the economic unit as collateral for the loan.” Esty (2003) believes that non-recourse
lending is the sine qua non of project financing, i.e. his view alters the above definition
from “… a lender is satisfied to look initially to the cash flows…” to “…a lender is
satisfied to look only to the cash flows…” .
Brealey, Cooper and Habib (1996) define the characteristics of project finance as
a distinct financing structure. These characteristics are;
a) The project manager or sponsor establishes a separate company specifically limited to
execution and management of the project.
b) The sponsor/sponsors provide the major proportion of the equity of the project.
8
c) The project company’s relationships with its lenders, building contractors, suppliers,
customers, host government and international lending agencies are defined and
regulated through formal, legally binding, detailed contracts.
d) The project company exhibits high leverage.
e) Lenders to the project have only limited or no recourse to the equity-holders balance-
sheets. Therefore, they can only look to the performance of the project company’s
assets to satisfy their outstanding loans.


1.2 Project Finance Applications
Project finance applications were mostly related to the investments in natural
resources or extractive industries and to finance oilfield exploration, for e.g. British

Petroleum raised $945 million to develop the North Sea oilfields, Freeport Minerals
raised $120 million for the Ertsberg copper mines in Indonesia
7
. The Public Utility
Regulatory Policies Act of 1978 heralded the large scale use of project finance in the
electricity generation industry. Independent power producers financed electricity plants
with project finance. The generated power was contractually sold through long term
power purchase agreements. A host of contracts also linked fuel suppliers, contractors
and regulatory authorities. The 1990’s witnessed project finance being used for a wide


7
Esty (2002) p 72.
Project Finance is the financing of a particular economic unit in which a lender is
satisfied to look only to the cash flows and earnings of that economic unit as the
source of funds from which the loan will be repaid and to the assets of the
economic unit as collateral for the loan.

9
range of assets and industries. Project finance has been used to finance theme parks like
the Hong Kong Disneyland theme park, undersea telecommunication cable companies
like the Australia-Japan Cable project, the Euro-tunnel project, the A2 Motorway in
Poland, and Chad-Cameroon Pipeline. Project finance loans have been very successfully
used in the development of the North Sea oil fields, the Ras Laffan LNG project in Qatar,
the Hopewell Partners Guangzhou Highway in China and the Petrozuata heavy oil project
in Venezuela. Certainly some projects have not been financial successes such as the
Channel Tunnel (Eurotunnel) and the Eurodisney theme park in Paris. The box below
shows the structure of a fairly typical project, the $2.55 Billion Ras Laffan LNG project
in the state of Qatar.

The Ras Laffan project exploits the massive 265 terra cubic feet of gas reserves in
Qatar’s North Field and clearly demonstrates project finance characteristics. The size of
the investment can be gauged from the fact that all of Australia consumes less than 1 TCF
Typical PF Transaction
KOGAS

4.9 MMTA

$1.35 B

$1.2 B

Ras Laffan
LNG
Company
Qatar Petroleum- 63%
ExxonMobil - 25%
Korea Gas (KOGAS) - 5%
Itochu Corp - 4%
LNG Japan – Nisho Iwai - 3%
Debt

6.6 MMTA

25 Year
Agreement

Engineering &
Procurement
Contracts

EXIM Bank loan
guarantee
265 TCF gas
reserves in
Qatar’s North
Field
Equity

10
a year and that Qatar’s North Field is so large that ExxonMobil engineers actually had to
take into account the curvature of the earth’s surface when designing the project’s
infrastructure. Ras Laffan also shows that a large portion of the $2.55 B investment
comprises debt; $1.2 B. Project finance leverage is typically higher at about 70%. Ras
Laffan also shows that equity investors incorporate a separate project company – Ras
Laffan LNG Company and their composition reflects aspects of vertical integration. A
very large proportion of the project’s output (4.9 Million metric tons of gas out of total of
6.6 Million metric tons or 74.44%) is purchased by a single customer, Korea Gas which
also has a 5% stake in the project equity. The state of Qatar through Qatar Petroleum and
Japanese customers for the project, also have equity stakes in the project. The project’s
output is guaranteed for purchase through long term (25 year) contract and a host of
contracts for engineering and procurement lower risks. The presence of multilateral
funding institutions completes the picture with EXIM bank guaranteeing the debt.
Therefore, Project finance exhibits separate incorporation, high debt levels, long term
contracts, buyers/suppliers purchasing/selling large levels of output/inputs and vertical
integration. The next section explores some project finance loan characteristics.
1.3 Project Finance loan characteristics
Megginson and Kleimeier’s (2000) empirical study of project finance from a data
set comprising other types of syndicated credit lending (corporate control loans, capital
structure loans, fixed asset based loans, and general corporate purpose loans) shows that
project finance is a different form of financing. They measure the impact of loan size,

maturity, guarantee, currency risk, country risk and the presence of collateralizable assets
11
on the cost of project finance loans measured as a spread over LIBOR. They find that
project finance differs from corporate finance in the following manner:
a) PF loans have longer average maturities than corporate finance loans.
b) PF loans are more likely to have third party guarantees.
c) PF loans are more likely to be extended to non US borrowers and to borrowers in
riskier countries.
d) PF loans are more likely to be extended to tangible-asset-rich industries.
e) PF loans are not larger than non-PF loans but are significantly smaller than
corporate control or capital structure loans.
f) The spread over LIBOR for PF loans is about 130 basis points. A comparable
type of syndicated lending used to fund purchases of aircraft, property or shipping
and called “fixed asset based loans” by the authors have a spread of about 86
basis points over LIBOR. PF loans are also more expensive than general
corporate purpose loans which have a spread of 113 basis points over LIBOR.

195

130

113

86

135

Spread Over
LIBOR
Basis points

Project
Finance
Loans

Capital Structure
Loans
Fixed Asset
Based Loans
Corporate
Control
Loans
General
corporate
loans
Not to Scale
12
g) Interestingly PF loans have a lower spread than corporate control loans used to
fund acquisitions, leveraged buyouts, and employee stock option plans which
have a spread of 195 basis points.
h) PF loans are priced at about the same spread as that of capital structure loans
(those booked in order to repay maturing lines of credit or for recapitalizations,
share repurchases, debtor in possession financing, standby commercial paper
support, or other refinancing) at about 135 basis points over LIBOR.
i) Loan size does not seem to impact the spread over LIBOR for project finance
while it impacts corporate finance loans. An increase of $100 million in a project
finance loan decreases the spread by 5 basis points.
j) A project finance loan exhibits a reduction in spread if the maturity is increased
by a year while a one year increase in the maturity of corporate debt exhibits an
increase in spreads. Thus the impact of a maturity increase on a project finance
loan is opposite to that of a corporate finance loan. Megginson and Kleimeier

hypothesize that this result is explained because PF loans have a maturity that is
on average twice that of corporate loans. Without such a negative spread to
maturity relationship long tenor loans would be extremely expensive. However,
they reflect that additional research is required in this direction.
k) The presence of a guarantee reduces the spread for a PF loan by almost 43 basis
points while it only reduces the spread for a corporate loan by 3.7 basis points.
l) Finally, their model shows that the relationship between collateralizable asset rich
industries and the spread over LIBOR for PF loans is negative, i.e. a borrower
from a tangible asset-rich industry will be charged a higher rate. For corporate
13
loans however, a borrower from a collateralizable asset-rich industry will be
charged a lower rate. Megginson and Kleimeier hypothesize that this intriguing
result is because PF lending is concentrated in asset-rich industries, the specific
industries chosen as asset-rich industries may be riskier than these, or that only
risky projects are funded by PF loans. This study might shed additional light on
this result because of its treatment of project risk.
Klompjan and Wouters (2002) study of default risk in project finance examined 210
projects of which 37 were in default. Klompjan and Wouters use the following factors to
predict the probability of default.
a) Experience of the sponsor
b) Proven technology
c) Presence of commercial risk cover
d) Presence of political risk cover
e) Presence of host government
f) Presence of multilateral institutions
g) Industry
h) Country
i) Debt service coverage ratio
j) Presence of off-take agreement
k) Term to maturity

l) Debt/Equity ratio
m) Whether loan was extended in the same currency as that of income generated by
the project.
14
Klompjan and Wouters use a correlation matrix to investigate the relationship
between the event of default and the explanatory factors. They show that four factors,
presence of commercial risk cover, experience of sponsor, proven technology and debt
service coverage ratio, are significantly correlated with an event of default. Klompjan and
Wouters find that a project is less likely to default if the sponsor has prior experience and
the debt service coverage ratio is high. Proven technology also causes the probability of
default to fall. However, the presence of commercial risk cover increases the probability
of default. Klompjan and Wouters believe that the presence of commercial risk cover
indicates a higher commercial risk and therefore increases the probability of default.
Klompjan and Wouters however point out that their data belongs to the portfolio of only
one bank, that the transactions are still running and therefore future defaults could change
the results. The next section lays out the theoretical literature explaining the determinants
of project finance.
15
Chapter 2 : Theories of Project Finance

Project Finance as a unique financing structure has received considerable attention in
the theoretical literature. The main theories are as follows;
a. Habib and Johnsen (1999) have posited that project finance is a means of
allocating optimal ownership over specific assets. The particular financing
structure of project finance enables investors to hand control over of project
financed assets to ‘redeployers’ in a state of the world where the primary use of
the asset has lost value. The redeployer is skilled in the alternate use of the asset.
b. Chemmanur and John (1996) analyze project finance through the lens of control
benefits to management.
c. Shah and Thakor (1987) posit that project finance may be used as a signaling

mechanism by firms.
d. Jensen and Meckling (1976) analyze agency costs arising from conflict between
managers of firms and shareholders who own the firm. Managers control the
assets of a firm and may misuse them particularly if the assets throw off large
amounts of free cash flow. Esty (2003) has theorized that project finance lowers
agency costs arising from conflict between incumbent management and
shareholders due to the unique structure of project financed firms.
e. Berkovitch and Kim (1990) argue that project financing structures mitigate the
problem of underinvestment pointed out by Myers (1977).
f. Williamson (1975) and Klein, Crawford and Alchian (1978) developed the theory
of the role of economic organization as a means of avoiding the threat of post
16
contractual opportunism. Esty (2003) theorizes that the project financing structure
minimizes the costs from the threat of hold up by parties to a transaction that have
invested in specific assets.
The following sub-sections elucidate these theories in greater detail.
2.1 Project Finance as an asset specific investment by an
initial user and a ‘redeployer’ of an asset.
Habib and Johnsen (1999) posit that non-recourse project finance is a means of
allocating optimal ownership over specific assets. Habib and Johnsen argue that firms
invest in specific assets, defined as “assets with a specified use before investment”. Firms
however do anticipate that there are states of the world wherein the assets in their
intended use may not be of any value. In the instance that this bad state of the world
occurs, the assets are redeployed to alternative uses. Habib and Johnsen assume that the
investing firm does not have the skills to redeploy the assets. The investing entrepreneur
is a specialized entrepreneur with the skills to use the asset in the good state of the world,
but lacks the skills to use the asset in a bad state of the world. Knowing this, the
entrepreneur firm contracts with a specialist redeployer to hand over control of the asset
in the bad state of the world.
Habib and Johnsen argue that lenders and lessors are asset redeployers. In the event of the

bad state of the world occurring, these asset redeployers change the use of the asset and
generate cash thereby creating value. Debt therefore acts as a means of transferring
control over assets in some states of the world.
Habib and Johnsen (1999) define specific assets as assets with a specified use before
investment.
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Habib and Johnsen argue that once the bad state of the world occurs, rents from
the redeployment of the asset should go to the redeployer. The entrepreneur should not be
in a position to extract rents from the redeployer. Since the entrepreneur is in control of
the asset when the investment is made and before the state of the world is known, he is in
a position to bargain with the redeployer. The redeployer has committed funds upfront by
contracting with the entrepreneur in anticipation of getting rents by redeploying the asset
once the bad state of the world occurs. The possibility of the entrepreneur resorting to
opportunistic bargaining and extracting rents that should go to the redeployer will cause
distortions in the investments made by both, the redeployer and the entrepreneur. Habib
and Johnsen argue that if the parties rely on negotiated spot exchange to transfer
ownership of the asset in the bad state the rents from redeployment are split between
them in some way. The redeployer has an incentive to reduce his investment in
identifying the asset’s next best use because he recognizes that the entrepreneur can
resort to opportunistic behavior.
If there is no possibility of post contractual opportunism by the entrepreneur, the
amount of investment by the redeployer should equal the value of the asset in the critical
state that separates the good and bad states. Habib and Johnsen argue that non-recourse
project finance loans solve the problem of investment distortion caused by post
contractual opportunism. If the good state prevails, the entrepreneur owns the asset which
is used as intended to generate the cash used for repaying the loan. If the bad state
prevails, the lenders repossess the asset, redeploy it and keep the rents arising from the
redeployment. Since there is no ex-post bargaining involved the entrepreneur captures the
surplus in the good state while the redeployers capture the surplus in the bad state. Thus,