Risk management in context of project financing of infrastructure project

Risk Management in Context of
Project Financing
of Infrastructure Project

Prof. GLENN P. JENKINS
DEPARTMENT OF ECONOMICS
EASTERN MEDITERRANEAN UNIVERSITY
NORTH CYPRUS

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PROJECT FINANCE
What is Project Finance?
• No universally accepted definition of the term “Project Financing”
-- different people use it in different senses.
• Project financing refers to a financing in which lenders to a project
look primarily to the cash flow and assets of that project as the
source of payment of their loans.
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Origins and Development of
Project Finance
• Project financing had its origins in the energy industry in
industrialized countries (oil & gas production loans).
• Later extended to infrastructure, transportation, mining,
utilities and large industrial projects.
• Scope further expanded to include all kinds of
infrastructure projects.
• Today even medium-scale projects (US $5 million) can use

project finance

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Development of Project Finance
• Number of Project
Finance Transactions
in emerging markets

1994

1996

1997

50

400

380

• 41% of emerging markets project finance flows between
1994 and 1998 went to Asia.
• About 75% of project finance flows worldwide went to
infrastructure and energy in 1999.
Source (IFC 1999), Capital Data Project Finance Ware (2000)

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Why Project Financing?
• Project Owners’ Perspective
– Size and cost of projects
– Risk minimization
– Preservation of borrowing capacity
and credit rating
– May be only way that enough funds
can be raised
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Private Public Partnerships in
Infrastructure
• A major new user of project financing techniques
• Infrastructure traditionally financed and managed by
governments
• Demand for infrastructure has been growing faster than
available government funding particularly in emerging
economies.
• Recent trend has been to involve the private sector in the
supply and provision of these services
• There has to be a clear benefit for both the public and the
private partners
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Main Characteristics of Suitable
Investments for Projects Financing
• The ideal candidates for project financing are capital

investment projects that
• are capable of functioning as independent
economic units,
• can be completed without undue uncertainty, and
• When completed, will be worth demonstrably more
than they cost to complete.
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Main Characteristics of Project Finance (Summary)
– Project is a distinct legal entity.
– Project assets, project-related contracts, and project cash flows are separated to
a large degree from the sponsors.
– Sponsors provide limited or no recourse to cash flow from other assets.
– Lenders may have recourse to their funds through other stakeholders through
various types of security arrangements.
– Two-phase financing is common.

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The Basic Elements of a Project Financing
Lenders
Raw
materials
Suppliers
Supply
contract(s)

Loan

funds

Debt
repayment

Assets comprising the
project

Purchase
contract(s)
Purchasers
Output

Equity
funds

Equity
investors

Returns to
investors

Cash
deficiency
agreement and
other forms of
credit support

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Prerequisites for Project
Financing
•

Financial Analysis

•

Economic Analysis

•

Risk Analysis

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It’s All About Risk!
The key to project financing is
the reallocation of any risk away
from the lenders to the project.

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Definition of Project Completion
• Principle Categories of Risk: Pre-Completion and PostCompletion
• Physical Completion
– Project is physically complete according to technical

design criteria.
• Mechanical Completion
– Project can sustain production at a specified capacity for
a certain period of time.
• Financial Completion (financial sustainability)
– Project can produce under a certain unit cost for a certain
period of time & meets certain financial ratios (current
ratio, Debt/Equity, Debt Service Capacity ratios)
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Management and Alleviation of Risks
Principle Categories of Risk: Pre-Completion and Post-Completion
A:Pre-Completion Risks:
Types of Risks

Some Examples of
Ways to Reduce or Shift Risk
Away from Financial Institution

•Participant Risks
-Sponsor commitment to project - Reduce Magnitude of investment?
-Require Lower Debt/Equity ratio
-Finance investment through equity
then by debt
– Financially weak sponsor
- Attain Third party credit support for
weak sponsor (e.g.,Letter of Credit)
- Cross default to other sponsors
•Construction/Design defects

- Experienced Contractor
- Turn key construction contract
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Management and Alleviation of Risks
A:Pre-Completion Risks (cont’d):
Types of Risks

•Process failure
•Completion Risks
– Cost overruns
– Project not completed
– Project does not attain
mechanical efficiency

Some Examples of
Ways to Reduce or Shift Risk
Away from Financial Institution
- Process / Equipment warranties
- Pre-Agreed overrun funding
- Fixed (real) Price Contract
- Completion Guarantee
- Tests: Mechanical/Financial for
completion
- Assumption of Debt by Sponsors if
not completed satisfactorily

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B. Post-Completion Risks
Types of Risks

•

Natural Resource/Raw Material
– Availability of raw materials

•

Some Examples of
Ways to Reduce or Shift Risk
Away from Financial Institution

- Independent reserve certification
- Example: Mining Projects: reserves
twice planned mining volume
- Firm supply contracts
- Ready spot market

Production/Operating Risks
– Operating difficulty leads to
insufficient cash flow

- Proven technology
- Experienced Operator/ Management Team
- Performance warranties on equipments
- Insurance to guarantee minimum cash

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B. Post-Completion Risks
Some Examples of
Ways to Reduce or Shift Risk
Types of Risks

Away from Financial Institution

• Market Risk
–Volume -cannot sell entire output - Long term contract with creditworthy
buyers :take-or-pay; take-if-delivered;
take-and-pay
–Price - cannot sell output at profit - Minimum volume/floor price provisions
- Price escalation provisions

• Force Majeure Risks
–Strikes, floods, earthquakes, etc. - Insurance
- Debt service reserve fund

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Some Examples of
Ways to Reduce or Shift Risk
Types of Risks

Away from Financial Institution

• Political Risk
–Covers range of issues from
- Host govt. political risk assurances
nationalization/expropriation,
- Assumption of debt
changes in tax and other laws,
- Official insurance: OPIC, COFACE, EXIM
currency inconvertibility, etc.
- Private insurance: AIG, LLOYDS
- Offshore Escrow Accounts
- Multilateral or Bilateral
involvement

• Abandonment Risk
–Sponsors walk away from project
banks to run project

- Abandonment test in agreement for
closure based on historical and
projected costs and revenues

• Other Risks: Not really project risks but may include:
–Syndication risk
–Currency risk
–Interest rate exposure
–Rigid debt service
obligations
–Hair trigger defaults

- Secure strong lead financial institution

- Currency swaps / hedges
- Interest rate swaps
- Built-in flexibility in debt service

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The Need for Contracts
• Project financing arrangements invariably involve strong
contractual relationships among multiple parties.
• Project financing can only work for those projects that can
establish such relationships and maintain them at an acceptable
cost.
• To arrange a project financing, there must be a genuine
“community of interest” among the parties involved in the
project.
• In must be in each party’s best interest for the project financing
to succeed.
• Only then will all parties do everything they can to make sure
that it does succeed.
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